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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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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 Risk
Hedge").[^1] Although this transaction protects the Bank from market
risks, the Bank continues to face *credit* risk[^2] 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. 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 trade. In an Asset
Hedge, the Bank purchases credit protection through a C-CDS from a third
party or an affiliate[^6] 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. 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.
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 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. 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 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. 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 Derivatives*[^18] 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. 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
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.

Sincerely,

signed

Julie L. Williams

First Senior Deputy Comptroller and Chief Counsel

[^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. 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.

[^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.

[^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*.

[^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).