Davis Polk partner Chris Schell was quoted in Structured Retail Products discussing an FAQ released by the Federal Reserve on the treatment of credit-linked notes (CLNs).

“[The FAQ] will provide another reason for a financial issuer to do a CLN as the issuer would have a regulatory capital reason for pursuing the transaction,” said Chris. It could also “open up opportunities for funds and other counterparties that do not normally enter into credit default swaps (CDS) or provide guarantees to enter into capital relief transactions with banking organizations by investing in CLNs instead.”

The FAQ clarifies that CLNs that are directly issued by the institution on its balance sheet would not automatically be recognized as synthetic securitizations under the capital rule. One reason is that a synthetic securitization must include a guarantee or credit derivative, which must be executed under standard industry credit derivative documentation.

“[The direct CLNs] are executed using customary securities offering documentation of a disclosure statement and a note that reflects the terms,” Chris explained. “The notes would generally embed standard CDS credit event terms and definitions.”

Chris noted that following the FAQ, financial institution issuers may seek to discuss their CLN transactions with the Fed, including the types of underlying assets.

“As long as the CLNs and their embedded CDS or guarantee terms meet the synthetic securitization requirements, there is no particular reason the underlying reference assets could not consist of a fairly broad range of loans or other credit assets,” he said.

“Fed clarifies CLN treatment, approves MS deal,” Structured Retail Products (October 30, 2023) (subscription required)

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