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IM-Attributed_Risk_Exposure_QA-02May2012.pdf

May 2, 2012

To: Chairman, Board of Directors
Chief Executive Officer
All Farm Credit System Institutions

From: Gary K. Van Meter, Director
Office of Regulatory Policy

Subject: Long-Term Standby Purchase Commitments

Purpose/Summary

This Informational Memorandum (IM) describes the treatment of Farm Credit System (System) loans covered by the Federal Agricultural Mortgage Corporation's (Farmer Mac) Long-Term Standby Purchase Commitment (Commitment) program for purposes of:

· Lending limits calculations under 12 CFR Part 614, Subpart J;

· Risk weighting of loans for regulatory capital ratios under 12 CFR Part 615, Subparts H and K; and

· Regulatory reporting and disclosure of asset quality statistics and System risk ratings.

A. Lending Limits

Yes. Notwithstanding that Commitment agreements are not described as guarantees, they serve the same function and purpose as a guarantee. Therefore, a Commitment is treated as a qualifying guarantee under § 614.4345 for the purpose of computing the loans to a single borrower under § 614.4358(b)(2).

Yes. Since a Farmer Mac Commitment qualifies as a guarantee under § 614.4345, loans in the Program may be omitted from the System institution’s lending limit calculation under § 614.4358(b)(2), but only up to the amount of the portion of such loans covered by the Commitment less borrower stock.

When a material breach of the representations and warranties occurs with respect to a loan in a Commitment pool, the Commitment on that loan is no longer valid. As such, the portions of loans previously covered by a Commitment agreement must be included in the System institution’s lending limit calculation under § 614.4358(a). The Commitment on all other loans in the Commitment pool continues to be valid so such remaining loans in the Commitment pool may continue to be omitted from the System institution’s lending limit calculation under § 614.4358(b)(2), but only up to the amount of the portion of such loans covered by the Commitment less borrower stock.

Yes. It is essential that each System institution, based on the unique risks in its territory and risk-bearing capacity, identify, define and effectively mitigate concentration risks. Therefore, the use of Commitments may be considered by each System institution as part of its overall concentration risk mitigation policy.¹ Concentration risks resulting, for example, from lending to producers/borrowers in territories that have limited agricultural markets or few agricultural sectors may be mitigated, but not eliminated, through guarantees such as those provided by the Program or by other loss-sharing agreements.² Accordingly, System institutions are still responsible for underwriting loans on a sound and constructive basis and ensuring that they adhere to Farmer Mac servicing and other requirements. As such, System institutions should not underwrite an unsafe or unsound loan on the basis of a Commitment providing risk mitigation.

B. Risk Weighting of Loans for Regulatory Capital Ratios

The loans and portions of loans covered by a Farmer Mac Commitment agreement are assigned to the 20-percent risk category under § 615.5211(b)(6) because they are "claims on, and portions of claims guaranteed by, [a] Government-sponsored agenc[y] . . . ."³ As noted above, the Commitments serve the same function and purpose as a guarantee.

Yes. The portion of credit risk retained on the first losses for loans covered by a Commitment is not unlike the credit risk retained on a securitization, whereby the risk of credit losses from the underlying assets is distributed to different parties. The "first dollar," or most subordinate, loss position is first to absorb credit losses; the most "senior" position is last to absorb losses. Each loss position functions as a credit enhancement for the more senior positions in the structure.

A "residual interest" includes any on-balance sheet asset that “exposes an institution to credit risk directly or indirectly associated with the transferred asset that exceeds a pro rata share of that institution's claim on the asset, whether through subordination provisions or other credit enhancement techniques.”⁴ Also, residual interests may include credit-enhancing retained subordinated interests.⁵ As such, the portion of credit risk retained on the first losses for loans covered by a Commitment, which functions as a credit-enhancement, is a residual interest as defined in § 615.5201.

Residual interests for loans covered by a Commitment receive the same treatment as residual interests for a loan or portion of a loan that is not in a pool of loans covered by a Commitment. To our knowledge, no residual interests retained by System institutions under the Program have been externally rated. Consequently, the face amounts of such residual interests are risk weighted under § 615.5210(c), which requires a dollar-for-dollar deduction from capital and assets (dollar-for-dollar deduction).⁶

We impose the dollar-for-dollar treatment for these residual interests because the level of credit risk exposure associated with deeply subordinated assets, particularly subinvestment grade and unrated residual interests, is extremely high. Residual interests are generally subordinated to all other positions.

C. Asset Quality Statistics and System Risk Ratings

Generally, loans in the Program would be classified as Acceptable, even if repayment problems or other credit weaknesses exist, provided the System institution has not done anything to undermine or jeopardize either the validity or enforceability of the Commitment. This treatment also is consistent with §§ 621.6(a)(3)(i) and (ii) since loans being serviced in accordance with the terms of the Program are normally presumed to be in process of collection and adequately secured. Nevertheless, if a loan in the Program becomes 90 days past due, it must be disclosed in the performance category “Loans 90 days past due still accruing interest” under § 621.6(c). However, if it becomes evident there is risk of loss and the loan is no longer fully collectible despite the existence of the Commitment, the loan must be transferred to nonaccrual as prescribed by § 621.6(a).⁷

Furthermore, if the collectability or enforceability of the Commitment is in doubt because the System institution’s compliance with the terms of such Commitment is questionable, the loan should be classified, accounted for, and reported in a manner consistent with its own unique risks without reliance upon the Commitment for ultimate collection.

2. How should loans in the Program be rated for risk management purposes?

Under the terms of the Program, the Commitment limits a System institution’s losses in the event of default, but it does not affect the likelihood of default. Thus, when a loan is placed in the Program its probability-of-default would be unaffected, but its loss-given-default would be reduced. The Combined System Risk Rating Guidance developed by the System contains related risk rating guidance.

1. Effective July 1, 2012, “the board of directors of each title I, II, and III System institution must adopt and ensure implementation of a written policy to effectively measure, limit and monitor exposures to concentration risks resulting from the institution’s lending and leasing activities.” 76 FR 29992 (12 CFR § 614.4362).
2. Beginning July 1, 2012, a System institution’s concentration risk mitigation policy must address counterparty risk, which would include when using guarantees provided by the Program or by other loss-sharing agreements. Id. See also IM dated October 21, 2003, regarding counterparty risk.
3. Under § 615.5210(f), the FCA reserves its authority, on a case-by-case basis, to determine the appropriate risk weight for any guaranteed loan portion, or a security that is backed by a guaranteed loan portion, that imposes risks that are not commensurate with a 20-percent risk weighting. Additionally, future amendments to the FCA’s capital regulations may affect risk weightings.
4. 70 FR 35336 (June 17, 2005).
5. Id.
6. See supranote 3.
7. See also IM dated July 10, 1998, for further discussion of the treatment of loans guaranteed by federal and local government agencies.