From Remarks by Governor Susan M. Phillips (of the Federal Reserve).

Securitization removes the assets from the bank's books, but does not necessarily remove all of, or even most of, the risk of the underlying credits. Indeed, as is the case with some other derivatives, a securitization can effectively result in a leveraging of credit risk for the sponsoring bank. To understand how, let's review the basic securitization process. Typically, the sponsoring bank creates a bankruptcy-remote vehicle called a loan securitization conduit. The conduit purchases loans or other assets from its sponsor or, in some cases, originates the loans directly within the conduit. The loans in the conduit are financed by the issuance of multiple classes of asset-backed securities. The most senior securities of the conduit generally are rated double-A or triple-A by the rating agencies. To achieve these high credit ratings, the conduit must obtain credit enhancements on the underlying assets in the conduit. These credit enhancements generally are provided by --you guessed it--the bank sponsoring the securitization conduit. The credit enhancements can take several forms, including purchase of subordinated securities or provision of a standby letter of credit to the conduit, generally large enough to absorb most of the risk of the assets being securitized. In return for providing the credit enhancement and servicing the loans on the books of the conduit, the bank sponsor lays claim to all the residual spread between the return on the conduit's assets, net of any losses, and the conduit's costs, including the interest cost of the securities issued.

The credit enhancement itself is a derivative instrument; its value, and its risk, derives from the underlying pool of loans in the conduit. It is fairly typical for these credit enhancement positions retained by the bank to involve considerably more credit risk, per dollar of book value, than is implied by retaining the underlying assets on the balance sheet. For example, the enhancement could guarantee absorption of first losses on the entire pool, not just the proportional share of losses represented by the face value of the credit enhancement. If you were assessing a bank's credit risk, what level of capital would you require the bank to hold to protect against losses, for example, on a junior security? Or suppose the bank held a credit enhancement position for a conduit whose assets themselves consisted of credit enhancements, such as other subordinated securities? Or suppose the bank, rather than holding a first loss position, holds a second loss position, insuring the conduit against losses beyond a particular amount up to some other particular amount?

You can see that securitization can very easily involve quite complicated risk positions. As in the case of the emerging derivatives markets and the direct conduct of nontraditional financial activities, we wholeheartedly support the development of securitization by banks. The technique has permitted the "slicing and dicing" of the risks associated with a pool of assets in ways that permit each investor to choose positions that most closely reflect desired risk versus return. Market efficiency and liquidity are enhanced. But like derivatives and other complex activities, securitization makes my life as a supervisor, and yours, more difficult in one respect. Measurement of risk becomes more difficult.

So the assets don't appear on the banks books, except for the equity tranches or derivatives used to "enhance credit" of the commercial paper sold by the special purpose entity. The bank also gets fees for administering the SPE and probably also as the originator and servicer of the underlying debt instruments.