WASHINGTON -- It may be the last banking agency to warn its wards about investing in structured notes, but the Federal Deposit Insurance Corp. is taking the most aggressive approach.
FDIC Director of Supervision Stanley J. Poling, in a memo to the agency's eight regional directors, said examiners should classify as "substandard" structured notes that could lead to a loss of principal.
What's more, uurealized losses - up to the bank's maximum exposure - must be classified as a "loss" by examiners, Mr. Poling said.
"Structured notes that explicitly, by their terms, expose a bank to risk of loss of principal or their original investment are unsuitable investments, anti the market value of these securities should be classified 'substandard' and the depreciation ... should be classified as 'loss,'" Mr. Poling wrote in the memo.
"The risks found in structured notes can adversely impact all areas of a bank's financial condition."
The FDIC is most concerned about principal-linked structured notes, William A. Stark, FDIC's assistant director for capital markets, said Wednesday. These notes are structured in a way that puts some portion of the bank's principal at risk, he explained.
"We've seen them where you can lose 100%," Mr. Stark said.
Structured notes are deceptive because they pose little credit risk; most are issued by highly rated government-sponsored entities like the federal Home Loan banks.
But the securities typically contain embedded options. such as caps, calls, and floors that can drastically affect the value of the securities. The cash flow on structured notes also fluctuates with interest rates or foreign exchange rates.
These market and liquidity risks are often overlooked by banks attracted to the notes' high yields and relatively low credit risk.
Mr. Stark estimated the structured note market at $275 billion.
The FDIC follows the Office of Thrift Supervision, the Comptroller of the Currency, and the Federal Reserve Board, which all sounded alarms over structured notes during the past month.
The FDIC's instructions to examiners go beyond the other agencies' rules, which focused mainly on a bank's written policies governing structured notes' investments and management's understanding of potential risks.
Aimed at the 6,521 state banks that do not belong to the Federal Reserve System, the FDIC alone is telling its examiners how to classify certain structured notes.
"We've gone the extra step," Mr. Stark said. "We want to go ahead and record .this in the financial statements.
"Classification by examiners gets the attention of the boards of directors ."
The FDIC explained its new position in an eight-page memo to regional directors this week. Those directors will disseminate the new guidelines to examiners who will begin applying them to banks immediately.
The FDIC's examiner instructions also require banks to be able to determine the change in market value of their structured notes, "given a reasonable range of changes in interest rates."