Letter provides confirmation that national bank may purchase and hold below investment grade debt in connection with a comprehensive program to hedge the counterparty credit risk exposure that arises from its derivatives activities. The letter concludes that the bank may engage in the transactions it proposes, where the bank's examiner-in-charge is satisfied that the bank has adequate risk management and measurement systems and controls and does not object to the activity.

O

Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219

Interpretive Letter #1051

March 2006

February 15, 2006 12 USC 24(7)

Re: [ ] (“Bank”)

Dear [ ]:

The Bank is seeking confirmation that it is permissible for the Bank to enter into contingent

credit default swaps (“C-CDS”) and hold below-investment grade debt to hedge and manage the

counterparty credit risks and liability exposures that arise from its derivatives activities. For the

reasons discussed below, we conclude that the Bank may engage in the hedging and risk

management transactions it proposes, provided the Bank’s examiner-in-charge is satisfied that

the Bank has adequate risk management and measurement systems and controls to conduct the

activities on a safe and sound basis.

Background

The Bank has an active and growing derivatives business. Counterparty credit risk is an

important risk of the derivatives business, and the Bank establishes credit limits to control such

exposures. When a new derivative transaction would create a potential credit exposure beyond

the limit for a client, the Bank may approve the transaction subject to the condition of dynamic

management of the resulting exposure. By dynamically managing the credit exposures of the

incremental derivative transaction, through a series of credit default swap (“CDS”) and bond

transactions, the Bank can manage counterparty credit risk more effectively and maintain

potential credit exposure within approved limits.

The Bank may hedge the price or market risk of an incremental derivative transaction by

executing a similar transaction in the opposite direction with a third party in the market (“Market

nsaction, through a series of credit default swap (“CDS”) and bond

transactions, the Bank can manage counterparty credit risk more effectively and maintain

potential credit exposure within approved limits.

The Bank may hedge the price or market risk of an incremental derivative transaction by

executing a similar transaction in the opposite direction with a third party in the market (“Market

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Risk Hedge”).1 Although this transaction protects the Bank from market risks, the Bank

continues to face credit risk2 if the counterparty defaults and owes payments to the bank. The

Bank also faces a liability risk, i.e., it has the obligation to make a cash payment to the

counterparty if the Bank is out-of-the-money on the derivative when the counterparty defaults.

The Bank proposes to manage the counterparty credit and liability exposures related to a single

OTC derivative contract or a portfolio of OTC derivative contracts in a more cost effective

manner, both before and after downgrades by rating agencies,3 by using CDS and debt

instruments. To implement effectively the dynamic management of the underlying exposures

requires the ability to purchase and sell securities issued by the derivatives counterparty as credit

exposure changes. As a result, the Bank seeks authority to acquire below-investment grade

debt.4 Under the proposed dynamic credit hedging program, the Bank seeks to be economically

indifferent whether the Bank owes or is owed money by a defaulting counterparty.

The Bank first hedges its counterparty credit exposure for the original trade by buying a C-CDS

(“Asset Hedge”). A C-CDS resembles a traditional CDS. Both instruments settle in the same

way. If a credit event occurs, the protection buyer delivers to the protection seller debt issued by

the reference entity with a total face amount equal to a notional amount

y by a defaulting counterparty.

The Bank first hedges its counterparty credit exposure for the original trade by buying a C-CDS

(“Asset Hedge”). A C-CDS resembles a traditional CDS. Both instruments settle in the same

way. If a credit event occurs, the protection buyer delivers to the protection seller debt issued by

the reference entity with a total face amount equal to a notional amount. In return, the protection

seller pays the protection buyer an amount in cash equal to the same notional amount. There is

an important distinction between the two instruments. While the notional amount of a CDS

remains constant over the life of the contract, the notional amount of a C-CDS will change to

reflect the current mark-to-market value of a specified reference derivative. The notional amount

of a C-CDS is fixed only if and when the specified reference entity defaults on its debt

obligations and the reference derivative has positive value for the bank. If the reference entity

does not default on its debt obligations over the life of the C-CDS, then the instrument will

expire at maturity.5

The Asset Hedge protects against the risk that the original trade may be in-the-money to the

Bank when the counterparty defaults and the counterparty is unable to pay at settlement on the

1 Price risk is the risk to earnings or capital arising from changes in the value of traded portfolios of financial

instruments. See Comptroller’s Handbook: Community Bank Supervision (2003) at p. 156.

2 Credit risk is the current and prospective risk to earnings and capital arising from an obligor’s failure to meet the

terms of any contract with the bank or otherwise to perform as agreed. See Comptroller’s Handbook: Community

Bank Supervision (2003), at p. 141.

3 The Bank represents that statistically, in a portfolio of investment grade names, a small percentage will migrate to

below-investment grade status over time as a result of downgrades by the rating agencies

ng from an obligor’s failure to meet the

terms of any contract with the bank or otherwise to perform as agreed. See Comptroller’s Handbook: Community

Bank Supervision (2003), at p. 141.

3 The Bank represents that statistically, in a portfolio of investment grade names, a small percentage will migrate to

below-investment grade status over time as a result of downgrades by the rating agencies. For example, a company

with a BBB rating has more than a 15% chance of becoming below-investment grade over a period of five years. As

a result, the Bank wishes to hedge the credit risk of its counterparty, notwithstanding the counterparty’s below-

investment grade rating, or any subsequent downgrade to below-investment grade.

4 The Bank currently uses CDS, C-CDS, and investment grade bonds to help manage credit and liability risks

arising from derivative transactions.

5 The C-CDS will also not have value to the bank if the reference entity defaults while the reference derivative

transaction has negative value to the bank, i.e., the bank has a negative mark-to-market on the transaction.

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trade. In an Asset Hedge, the Bank purchases credit protection through a C-CDS from a third

party or an affiliate6 where the reference entity is the counterparty to the original trade. If the

reference entity defaults on its debt obligations, and the reference derivative is in-the-money to

the bank, the protection seller pays the Bank cash in an amount equal to the notional amount

(i.e., the in-the-money amount of the reference derivative) of the C-CDS. In return, the Bank

delivers to the protection seller bonds issued by the reference entity with a total face amount

equal to this same notional amount. At the time of the reference entity’s default, the Bank will

need to obtain the requisite amount of bonds to meet this obligation

an amount equal to the notional amount

(i.e., the in-the-money amount of the reference derivative) of the C-CDS. In return, the Bank

delivers to the protection seller bonds issued by the reference entity with a total face amount

equal to this same notional amount. At the time of the reference entity’s default, the Bank will

need to obtain the requisite amount of bonds to meet this obligation. The ability to realize the

value of credit protection on a credit derivative contract requires a protection buyer to purchase

below-investment grade debt securities of an issuer that has had a credit event, such as a

bankruptcy filing. The Bank can recover all or a portion of the cost of the Asset Hedge by

selling credit protection to a third party or an affiliate through another C-CDS (“Liability

Hedge”).

In a Liability Hedge, the Bank manages the risk of owing money to its counterparty on the

original trade by selling credit protection to a third party or an affiliate through a second C-CDS

where the reference entity is the counterparty to the original trade, and the reference derivative is

the Market Risk Hedge. If the reference entity defaults on its debt obligations, and the reference

derivative is in-the-money (i.e., the original client trade is out-of-the-money to the Bank), the

Bank pays the protection buyer cash in an amount equal to the notional amount of this second C-

CDS. In return, the protection buyer delivers to the Bank bonds issued by the reference entity

with a total face amount equal to this same notional amount. Since the Bank is now the current

holder of these bonds, the Bank has a claim against the issuer (which is also the counterparty on

the original derivative) equal to the face amount of the bonds. If the Bank owes on the original

trade at the time of default, the Bank can set-off its claim on the bonds against the amount that

the Bank owes the counterparty under the original trade

nal amount. Since the Bank is now the current

holder of these bonds, the Bank has a claim against the issuer (which is also the counterparty on

the original derivative) equal to the face amount of the bonds. If the Bank owes on the original

trade at the time of default, the Bank can set-off its claim on the bonds against the amount that

the Bank owes the counterparty under the original trade. This set-off can occur with any

counterparty, either investment grade or below-investment grade, under the relevant derivative

contract.7 The Bank represents that purchases and sales of below-investment grade debt are

essential to administering and maintaining effective Liability and Asset Hedges that enable the

Bank to be economically indifferent whether the Bank owes or is owed funds when the

counterparty defaults.

There is a concern that, where a counterparty on the original trade is insolvent at the time of

default, and the Bank does not hold the bonds it receives in the Liability Hedge at least 90 days

before the reference entity’s bankruptcy filing date or insolvency, the Bank may be precluded

under the U.S. Bankruptcy Code from exercising its right to set-off the bonds it received through

the Liability Hedge against amounts the Bank may owe under the original trade. Therefore, to

achieve the economically indifferent position it seeks in structuring these transactions, the Bank

represents that it must purchase the bonds whenever necessary (including when it enters into the

original trade with its counterparty and subsequently). The Bank will periodically adjust its bond

6 The Bank represents that all transactions with affiliates will be consistent with sections 23A and 23B of the Federal

Reserve Act, 12 U.S.C. 371c and 371c-1, and the Federal Reserve Board's Regulation W, 12 CFR part 223.

7 The Bank represents that each of its counterparties on the original derivative trades has previously agreed to the

Bank’s right of set-off in the relevant derivative contract.

ank represents that all transactions with affiliates will be consistent with sections 23A and 23B of the Federal

Reserve Act, 12 U.S.C. 371c and 371c-1, and the Federal Reserve Board's Regulation W, 12 CFR part 223.

7 The Bank represents that each of its counterparties on the original derivative trades has previously agreed to the

Bank’s right of set-off in the relevant derivative contract.

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holdings throughout the life of the original trade to reflect any changes in the Bank’s 90-day

VAR model amount and the mark-to-market of the derivative. While it holds legal title to the

bonds, the Bank will use a total return swap to neutralize the economic risk of holding the bonds.

Discussion

Longstanding OCC precedent establishes that national banks may engage in certain customer-

driven derivative transactions as part of a financial intermediation business, subject to safety and

soundness parameters.8 National banks also may manage risks arising from permissible

derivatives activities as an essential part of the activities. 9 For example, national banks use

credit derivative transactions, including a CDS and C-CDS, to manage credit risks arising from a

permissible derivatives business.10 A C-CDS is identical to a common CDS, except that the

notional amount is variable at inception and becomes fixed only upon the default of a reference

entity, if a specified reference derivative has positive value. These differences do not affect the

ability of a national bank to engage in a C-CDS to manage risks arising from permissible

banking activities

permissible derivatives business.10 A C-CDS is identical to a common CDS, except that the

notional amount is variable at inception and becomes fixed only upon the default of a reference

entity, if a specified reference derivative has positive value. These differences do not affect the

ability of a national bank to engage in a C-CDS to manage risks arising from permissible

banking activities. National banks can engage in a variety of transactions where one (or more) of

the key terms is variable.11 Further, the OCC has specifically permitted national banks to use

below-investment grade debt to hedge the risks arising from bank-permissible derivative

activities.12

A national bank may use derivatives to hedge the risks arising from the gamut of activities that

are reflected on the Bank’s balance sheet and income statement, including holding assets, taking

liabilities, assuming off-balance sheet risks, and hedging the market risk associated with

investment advisory fee income.13 For example, in MII Deposit, the OCC authorized a national

bank to purchase equity index futures to hedge interest rate exposures on deposit accounts with

interest rates tied to movements in the S&P 500 Index.14 The OCC noted that national banks are

permitted and even encouraged to manage prudently the exposures arising from bank activities

and they must be allowed the flexibility to use the most suitable risk management tool. In DPC

Shares, the OCC permitted a national bank to buy and sell options to manage market risks

associated with changes in the value of shares of a company the bank had acquired in satisfaction

8 See 12 U.S.C. 24(Seventh).

9 See OCC Interpretive Letter No. 892 (Sept. 8, 2000).

10 National banks have engaged in credit derivative transactions since at least 1996. See OCC Bulletin 96-43 (Aug.

12, 1996).

11 See, e.g., Decision of the Office of the Comptroller of the Currency on the Request by Chase Manhattan Bank,

N.A

hares of a company the bank had acquired in satisfaction

8 See 12 U.S.C. 24(Seventh).

9 See OCC Interpretive Letter No. 892 (Sept. 8, 2000).

10 National banks have engaged in credit derivative transactions since at least 1996. See OCC Bulletin 96-43 (Aug.

12, 1996).

11 See, e.g., Decision of the Office of the Comptroller of the Currency on the Request by Chase Manhattan Bank,

N.A. to Offer the Chase Market Index Investment Deposit Account (Aug. 8, 1988) (“MII Deposit”), 1988 OCC Ltr.

LEXIS 266 (deposit rates tied to performance of S&P 500 Index).

12 See OCC Interpretive Letter No. 935, (May 14, 2002).

13 See OCC Interpretive Letter No. 1037 (Aug. 9, 2005).

14 MII Deposit, supra.

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of a debt previously contracted.15 The OCC found the hedging strategy helped the bank reduce

credit risk by protecting against fluctuations in the value of the shares. A national bank may use

derivatives to hedge a variety of financial risks, besides price or market risk, that may arise in

connection with permissible banking activities.

The Bank already has authority to use below-investment grade debt as a risk management tool

and it engages in a variety of customer-driven credit derivative transactions, including credit

default swaps.16 The primary difference between the Bank’s current activities and its proposal is

the types of risk that the bank would hedge or manage through the use of use below-investment

grade debt. Here the Bank proposes to manage both credit and liability risks arising from

permissible derivative activities. Banks have long had authority and recognized expertise in

managing credit risk.17 The Bank has designed the Asset and Liability Hedges specifically to

manage both credit exposures and liabilities to counterparties, so that the Bank is economically

neutral to counterparty performance on the derivative transaction

both credit and liability risks arising from

permissible derivative activities. Banks have long had authority and recognized expertise in

managing credit risk.17 The Bank has designed the Asset and Liability Hedges specifically to

manage both credit exposures and liabilities to counterparties, so that the Bank is economically

neutral to counterparty performance on the derivative transaction. The Bank represents that

purchases and sales of below-investment grade debt are essential to administering those hedges

and maintaining their effectiveness. When viewing the Bank’s risk management model as a

whole, the use of below-investment grade debt in the manner proposed is an essential part of that

strategy of managing risks associated with its derivatives business and therefore is permissible.

Safety and Soundness Requirements

For the Bank to engage in the proposed activity, the Bank’s risk management and measurement

capabilities must be of appropriate sophistication to ensure that the activity can be conducted in a

safe and sound manner and in accordance with applicable law. Accordingly, the Bank must

demonstrate to the satisfaction of its examiner-in-charge that the Bank has established an

appropriate risk management and measurement process for the proposed activity. As detailed

further in the OCC Handbook: Risk Management of Financial Derivatives18 and OCC Banking

Circular No. 277,19 an effective risk measurement and management process includes managerial

and staff expertise, comprehensive policies and operating procedures, risk identification and

measurement, and management information systems, as well as an effective risk control function

that oversees and ensures the appropriateness of the risk management process. Moreover, the

Bank should ensure that the reputation and other risks presented by this program are assessed

and reviewed by personnel from appropriate risk management areas within the Bank

ocedures, risk identification and

measurement, and management information systems, as well as an effective risk control function

that oversees and ensures the appropriateness of the risk management process. Moreover, the

Bank should ensure that the reputation and other risks presented by this program are assessed

and reviewed by personnel from appropriate risk management areas within the Bank. We note

that the Bank’s proposed risk management activities raise unique reputation risk issues because

the Bank may use below investment grade debt instruments, with market values below par, to

offset payments that the Bank would otherwise owe to the counterparty. The Bank’s risk

15 See OCC Interpretive Letter No. 961 (Mar. 17, 2003) (“DPC Shares”).

16 See OCC Interpretive Letter No. 935, supra.

17 See, e.g., OCC Interpretive Letter No. 1019 (Feb. 10, 2005).

18 OCC Handbook: Risk Management of Financial Derivatives (Jan. 1997).

19 OCC Banking Circular No. 277 (Oct. 27, 1993).

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management systems should include appropriate controls and disclosures to manage those

reputation risks.

The Bank may not commence the proposed activities unless and until its examiner-in-charge has

expressed no supervisory objection based on these criteria.

Conclusion

We conclude that the Bank may engage in the transactions it proposes, provided the Bank’s

examiner-in-charge is satisfied that the Bank has adequate risk management and measurement

systems and controls to conduct the activities on a safe and sound basis. The OCC views

expressed in this letter are based specifically on the Bank’s representations and written

submissions describing the facts and circumstances of the Bank’s proposed hedging and risk

management transactions. Any change in the facts or circumstances could result in different

conclusions. If you have any questions concerning this letter, please contact Donald N. Lamson,

Assistant Director, Securities and Corporate Practices Division, at (202) 874-5210

nk’s representations and written

submissions describing the facts and circumstances of the Bank’s proposed hedging and risk

management transactions. Any change in the facts or circumstances could result in different

conclusions. If you have any questions concerning this letter, please contact Donald N. Lamson,

Assistant Director, Securities and Corporate Practices Division, at (202) 874-5210.

Sincerely,

signed

Julie L. Williams

First Senior Deputy Comptroller and Chief Counsel