Fed Publishes Letter to Morgan Stanley on Credit-Linked Notes
More details on the views reflected in those FAQs from last month
Last month the Federal Reserve Board issued FAQs addressing the treatment of credit-linked notes under its capital rules. This memo from the law firm Mayer Brown, published yesterday, provides an overview of the background.
In the FAQs, the Federal Reserve staff effectively put into writing the views that many believe they have been communicating informally to banking organizations for the last several years. The FAQs indicate that notwithstanding [the fact that direct credit-linked notes may not meet the technical requirements of the capital rules for a synthetic securitization], Federal Reserve staff recognize that Direct CLNs can be an effective way to transfer credit risk. Therefore, the FAQs establish a process through which a banking organization may request that staff exercise their authority to assign a different RWA to the underlying assets (known as a “reservation of authority”). If granted, these approvals may contain limitations or conditions and may not be relied upon by other banking organizations.
As I mentioned on Twitter (X?) a couple weeks ago, and as Mayer Brown pointed out in their memo yesterday, these FAQs were released the day before the Federal Reserve Board approved a request by Morgan Stanley to treat CLNs as synthetic securitizations under the capital rule.
Mayer Brown also observed, though, that “[i]t is not clear if this approval included any limitations or conditions on its use by” Morgan Stanley.
While still not necessarily fully answering this question,1 today the Federal Reserve Board released its letter to lawyers for Morgan Stanley addressing the request in question. The letter provides further details on the conditions imposed:
[T]his action applies only to the CLN transaction and other substantially identical CLN transactions up to an aggregate outstanding reference portfolio principal amount of the lower of 100 percent of Morgan Stanley’s total capital or $20 billion. Morgan Stanley may not apply this treatment to less than the entirety of all the exposures arising out of any given CLN transaction.
***
As the Board stated in its FAQs, “[a] firm may not rely on these FAQs or on written action issued to any other firm as the basis for the capital treatment of any transaction.” So the extent other organizations seek the same treatment, they will have to request (if they have not already requested) similar relief.2
The Mayer Brown memo linked above concludes:
Given that the banking regulators are currently revising the regulatory capital requirements, one might see this as a golden opportunity to comprehensively address synthetic securitization. FDIC Director Jonathan McKernan noted this omission in his comments on the capital proposal, and asked for public comment on whether and how the banking regulators should clarify the treatment of CLNs. We expect that many securitization market participants will comment on this point and encourage the adoption of a uniform approach that does not require constant supplication to regulators.
The letter includes the standard statement that the action taken “is based on the specific facts and representations in the request and in communications with Board staff, as well as any commitments provided by Morgan Stanley.”
Also, of course, the FAQs and the letter to Morgan Stanley do not represent the views of any other banking regulator. Mayer Brown again: “While it is unlikely that the OCC or FDIC would prohibit a banking organization from recognizing capital relief that has been approved by Federal Reserve staff under the FAQs, the lack of interagency coordination further shows why one-off approvals are an inferior process.”