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FEDERAL RESERVE BAWCC OF MEW YORK [ Circular No. 1 0 2 3 7 1 May 4, 1988 Selection off Securities Dealers; Unsuitable Investment Practices To All State Member Banks, and Others Concerned, in the Second Federal Reserve District: T h e fo llo w in g s ta te m e n t h a s b e e n is s u e d b y th e B o a rd o f G o v e rn o rs o f th e F e d e r a l R e s e rv e S y ste m : The Federal Reserve Board has issued a supervisory policy statement regarding selection of securities dealers and unsuitable investment practices. The purpose of this supervisory policy is to provide State member banks with recommended procedures to be used in the selection of a securities dealer and to advise them of certain securities practices that are viewed by federal banking regulators as unsuitable for an investment portfolio. In addition, the supervisory policy discusses several types of securities with very volatile price and high risk character istics and which, therefore, may be unsuitable for an institution’s investment portfolio, particularly if held in significant amounts. P rin te d b e lo w is th e te x t o f th e p o lic y s ta te m e n t, as p u b lis h e d in th e Federal Register o f A p ril 2 6 . Q u e stio n s th e re o n m a y b e d ire c te d to G e ra ld P . M in e h a n , A s s is ta n t C h ie f E x a m in e r , M u ltin a tio n a l B a n k in g D e p a rtm e n t (T e l. N o . 2 1 2 - 7 2 0 - 5 8 8 1 ) , o r A lb e r t T o s s , A s s is ta n t C h ie f E x a m in e r , D o m e s tic B a n k in g D e p a r tm e n t ( T e l. N o . 2 1 2 -7 2 0 -5 8 9 5 ). E . G erald C o r r ig a n , President. FEDERAL RESERVE SYSTEM Syp®rvjs@ry Policy Coraetimtaig Selection of Securities Dealer® and Unsuitable Investment PraetSees AGENCY: Board of Governors of the Federal Reserve System. action: Supervisory Policy Statement. The purpose of this supervisory policy is to provide State member banks with recommended procedures to be used in the selection of a securities dealer and to advise them of certain securities practices that are viewed by federal banking regulators as unsuitable for an investment portfolio. In addition, the supervisory policy discusses several types of securities with very volatile price and high risk characteristics and which, therefore, may be unsuitable for an institution’s investment portfolio, particularly if held in significant amounts. sum m ary: EFFECTIVE bays: April 20,1988. FOPJ FUKYHSK HNF@RMAYI©N CONTACT: Robert S. Plotkin. Assistant Director, (202) 452-2782: Edwin Demoney, Manager, (202) 452-2434: or Rhoger Pugh, Manager, (202) 728-5883, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System, Washington DC 20551. For the hearing impaired only, Telecommunication Device for the Deaf (TDD), Eamestine Hill or Dorothea Thompson, (202) 452-3544. SUPPLEMENTARY INFORMATION: This supervisory policy was developed by the Federal Financial Institutions Examination Council (FFIEC) because of concerns over the use of investment portfolios by depository institutions as vehicles for speculative activities. Such speculative activity has in a number of cases resulted from the depository institution’s investment portfolio manager following the advice of the securities dealers who, in order to generate commission income, encourage speculative practices that are unsuitable for the investment portfolio. The supervisory policy provides a list of standards that a depository institution should apply when selecting a securities dealer. These standards include: review of the securities firm’s financial strength: inquiry into the dealer’s reputation for financial stability and honest dealings with customer's; inquiry of regulatory authorities concerning the existence of any formal enforcement actions against the dealer; a review of the sales representative’s background. The supervisory policy states that investment portfolios are traditionally maintained to provide earnings, liquidity and a means of diversifying risks. It states that transactions entered into in anticipation of taking gains on short term price movements are not prudent in v e s tm e n t p r a c tic e s an d that su c h tr a n s a c tio n s sh o u ld b e c o n d u c te d in the d e p o sito r y in stitu tio n ’s c lo s e ly su p e r v ise d se c u r itie s trading a cco u n t a n d th en o n ly b y in stitu tio n s that h a v e stron g c a p ita l a n d earn in gs. T h e p o lic y d is c u s s e s trading p r a c tic e s— i.e., g a in s trading, w h e n -is s u e d se c u r itie s trading, p air-offs, corp o ra te se ttle m e n t on U .S. g o v e r n m e n t an d F ed e r a l a g en cy se c u r itie s p u r c h a se s, rep o sitio n in g rep u rch a se a g reem en ts, an d short s a le s — that are u n su ita b le for in v e s tm e n t p ortfolios. T h e su p erv iso ry p o lic y a ls o .d e sc r ib e s the risk a n d p rice ch a r a c te r istic s an d ap p rop riate a cco u n tin g treatm en t for se v e r a l e x trem ely v o la tile in stru m en ts su ch a s strip p ed m o rtg a g e-b a ck ed se c u r itie s (in terest-o n ly strips, c o m m o n ly referred to a s “IO s", an d p rin cip al-on ly strip s, co m m o n ly referred to a s “PO s") and a s s e t-b a c k e d sec u r itie s r e sid u a ls. T he a cco u n tin g treatm en t s p e c ifie d in the p o lic y sta te m e n t p r o v id e s that d e p o sito r y in stitu tio n s sh a ll a c c o u n t for th e s e in stru m en ts in a c c o r d a n c e w ith G e n e r a lly A c c e p te d A c c o u n tin g P rin cip les (G A A P ) a s se t forth in F in a n cia l A c c o u n tin g S ta n d a rd s B oard S ta tem en t t91. T h is sta te m e n t req u ires th at the carrying am ou n t o f th e s e instru m en ts b e a d ju sted w h e n a ctu a l p rep aym en t e x p e r ie n c e d iffers from the p rep aym en t e s tim a te s u se d in the in itia l va lu a tio n . In stitu tio n s n ot su b ject to G A A P are in stru cted to fo llo w G A A P or, a ltern a tiv e ly , to carry th e se in stru m en ts.at m ark et v a lu e or the lo w e r o f c o st or m arket v a lu e . A ctin g p u rsuant to its su p erv iso ry au th ority o v er S ta te m em b er b a n k s c o n ta in e d in S e c tio n 9 (12 U .S.C . 321, e t seq .) an d S e c tio n 11 (12 U .S.C . 248) o f the F ed eral R eserv e A c t an d the F in a n cia l In stitu tion s S u p erv iso ry A c t o f 1966 (12 U .S.C. 1818(b)) a n d rela ted p r o v isio n s o f la w , the B oard o f G overn ors h a s a d o p te d th e fo llo w in g su p erv iso ry policy: S u p erv iso ry P o licy C on cern in g S e le c tio n o f S e c u rities D ea lers an d U n su ita b le In v estm en t P ractices Purpose This supervisory policy is to provide recommended procedures to be employed by State member banks and other depository institutions when selecting securities dealers and to advise of certain securities activities that the depository institution regulators view as unsuitable in an investment portfolio. Background T h e d e p o sito ry in stitu tio n regu lators h a v e b e c o m e a w a re o f s p e c u la tiv e a c tiv ity w h ic h h a s tak en p la c e in a n u m b er o f d e p o sito r y in stitu tio n s in v e stm e n t p ortfolios. C ertain o f th e se in stitu tio n s h ave fa ile d b e c a u s e o f the sp e c u la tiv e a c tiv itie s, an d oth er in stitu tio n s h a v e b e e n w e a k e n e d sig n ific a n tly a s their ea rn in g s an d c a p ita l h a v e b e e n im p aired a n d the liq u id ity o f their se c u r itie s h a s b e e n e r o d e d b y the d e p r e d a tio n in their m arket v alu e. S p e c u la tiv e a c tiv ity o ften o ccu rs w h e n a d e p o sito r y in stitu tio n ’s in v e s tm e n t p ortfolio m an ager fo llo w s the a d v ic e o f se c u r itie s d e a le r s w h o , in order to g en era te co m m issio n in co m e, en co u ra g e sp e c u la tiv e p r a c tic e s th at are u n su ita b le for th e in v e stm e n t p ortfolio. Recommendations Concerning the Selection o f a Securities Dealer It is com m on for the in v e stm e n t p ortfolio m an agers o f m a n y d e p o sito r y in stitu tio n s to rely on the e x p e r t i s e an d a d v ic e o f a se c u r itie s s a le s rep r se n ta tiv e for: reco m m en d a tio n s o f p r o p o se d in v estm en ts; in v estm en t strategies; an d the tim ing a n d pricing o f se c u r itie s tra n sa ctio n s. A ccord in gly, it is im p ortan t for the m a n a g em en t o f d e p o sito r y in stitu tio n s to k n o w the se c u r itie s firm s an d the p e r so n n e l w ith w h o m th ey d eal. A n in v e stm e n t p ortfolio m an ager sh o u ld n ot e n g a g e in se c u r itie s tra n sa ctio n s w ith a n y se c u r itie s d e a le r that is u n w illin g to p ro v id e co m p lete a n d tim ely d isc lo su r e o f its fin a n c ia l co n d itio n . M a n a g em en t m u st r e v ie w the d e a le r ’s fin a n c ia l sta te m e n ts an d m ak e a ju d gm en t ab ou t the a b ility o f the d ea ler to h on or its com m itm en ts. A n inquiry in to the g en era l rep u tation o f the d e a le r a ls o is n e c e ssa r y . T he b oard o f d irectors a n d /o r an ap p ropriate board com m ittee sh o u ld r e v ie w an d ap p rove a list o f se c u r itie s firm s w ith w h o m the d e p o sito r y ’s m a n a g em en t is a u th orized to do b u sin e ss. T he fo llo w in g se c u r itie s d e a le r s e le c tio n sta n d a rd s are recom m en d ed , but are n o t a ll in c lu siv e . T h e d e a le r s e le c tio n p r o c e ss sh o u ld include: — A co n sid e r a tio n o f th e a b ility o f th e se c u r itie s d e a le r an d its su b sid ia r ie s or a ffilia te s to fulfill com m itm en ts a s e v id e n c e d b y c a p ita l stren gth and op eratin g resu lts d is c lo s e d in current fin a n c ia l d ata, an n u a l reports, cred it reports, etc.; 2 — A n inquiry into the d e a le r ’s g en era l rep u tation for fin a n cia l sta b ility an d fair an d h o n e st d e a lin g s w ith cu stom ers, in clu d in g an inq u iry o f p a st or current fin a n c ia l in stitu tio n cu sto m ers o f the secu ritie s dealer; — A n inquiry o f appropriate S ta te or F ed eral se c u r itie s regu lators an d se c u r itie s in d u stry self-reg u la to ry org a n iza tio n s, su ch a s the N a tio n a l A s s o c ia tio n o f S ecu rities D e a le r s, con cern in g a n y form al en fo rcem en t a c tio n s a g a in st the d e a le r or its a ffilia te s or a s s o c ia te d p erson n el; — A n inquiry, a s ap propriate, in to the b ack grou n d o f the sa le s r ep resen ta tiv e to d eterm in e h is or her e x p e r ie n c e an d exp ertise; — A d ete r m in a tio n w h e th e r th e d e p o sito r y in stitu tio n h a s a p p rop riate p r o c e d u r e s to e s ta b lis h p o s s e s s io n or c o n tr o l o f se c u r itie s p u rch a sed . P u r c h a se d se c u r itie s a n d r ep u rch a se a g r e e m e n t'c o lla te r a l sh o u ld o n ly b e k e p t in s a fe k e e p in g w ith se llin g d e a le r s w h e n (1) T h e b oard is c o m p le te ly sa tis fie d a s to th e c r e d itw o r th in e ss o f th e se c u r itie s d e a le r a n d (2) th e agg reg a te v a lu e o f se c u r itie s h e ld in sa fe k e e p in g in this m a n n er is w ith in cred it lim ita tio n s th at h a v e b e e n a p p r o v e d b y the b o a rd o f d irecto rs, or a c o m m itte e o f th e b oard , for u n se c u r e d tr a n sa c tio n s (s e e FFIEC P o lic y S ta te m e n t a d o p te d O c to b e r 1985). A s part o f the p r o c e s s o f m a n a g in g a d e p o sito r y in stitu tio n ’s r e la tio n sh ip s w ith se c u r itie s d e a le r s, the b o a rd o f d irecto rs m a y w is h to c o n sid e r in clu d in g in the fin a n c ia l in stitu tio n ’s c o d e o f e th ic s o f c o n d u c t a p roh ib ition b y th o se e m p lo y e e s , w h o are d irectly in v o lv e d in p u rch a sin g a n d se llin g se c u r itie s for th e d e p o sito r y in stitu tio n , from e n g a g in g in p e r so n a l se c u r itie s tr a n sa c tio n s w ith the sa m e se c u r itie s firm th at th e d e p o sito r y in stitu tio n u s e s for its tr a n sa c tio n s w ith o u t s p e c ific b o a r d a p p ro v a l and p e r io d ic r e v ie w . T h e b oard a ls o m a y w is h to a d o p t a p o lic y a p p lic a b le to d irecto rs, o ffic e r s or e m p lo y e e s co n c e r n in g th e re d p t o f g ifts, gra tu ities or tr a v e l e x p e n s e s from a p p r o v e d d e a le r firm s a n d th eir p e r so n n e l (a ls o s e e in th is c o n n e c tio n th e B ank B rib ery A ct, 18 U .S .C 215 a n d in terp retiv e r e le a s e s ). Objectionable Investment Practices D e p o sito r y in stitu tio n d irecto rs are r e s p o n s ib le for pru d en t a d m in istra tio n o f in v e s tm e n ts in se c u r itie s. A n in v e s tm e n t p o r tfo lio tr a d itio n a lly h a s b e e n m a in ta in e d b y a d e p o sito r y institution to provide earnings, liquidity and a means of diversifying risks. When investment transactions are entered into in anticipation of taking gains on short term price movements, the transactions are no longer characteristic of prudent investment activities and should be conducted in a securities trading account. Securities trading of the types described in section I of the attached appendix will be viewed as unsuitable activities when they are conducted in a depository institution’s investment account. Securities trading should take place only in a closely supervised trading account and be undertaken only by institutions that have strong capital and current earning positions. Acquisitions of the various forms of zero coupon, stripped obligations and asset backed securities residuals discussed in section II of the attached appendix will receive increased regulatory attention and, depending upon the circumstances, may be cdnsidered unsuitable for a depository institution. State chartered financial institutions are cautioned that certain of the investment practices listed in the appendix may violate state law. If any such practices are contemplated, the appropriate state supervisor should be consulted regarding permissibility under state law. Appendix to Supervisory Policy Statement on the Selection of Securities Dealers and Unsuitable Investment Practices. I. Trading in the Investment Portfolio Trading in the investment portfolio is characterized by a high volume of purchase and sale activity, which when considered in light of a short holding period for securities, clearly demonstrates management’s intent to profit from short-term price movements. In this situation, a failure to follow accounting and reporting standards applicable, to trading accounts may result in a misstatement of the depository institution’s income and a filing of false regulatory reports and other published financial data. It is an unsafe and unsound practice to record and report holdings of securities that result from trading transactions using accounting standards which are intended for investment portfolio transactions; therefore, the discipline associated with accounting standards applicable to trading accounts is necessary. Securities held in trading accounts should be marked to market, or the lower of cost or market, periodically with unrealized gains o f losses recognized in current income. Prices used in periodic revaluations should be obtained from sources that are independent of the securities dealer doing business with the depository. The following practices are considered to be unsuitable when they occur in a depository institution’s investment portfolio. A. “Gains T ra d in g “Gains trading” is a securities trading activity conducted in an investment portfolio, often termed “active portfolio management.” “Gains tracing” is characterized by the purchase of a security as an investment and the subsequent sale of that same security at a profit within several days or weeks. Those securities initially purchased with the intent to resell are retained as investment portfolio assets if they cannot be sold at a profit These “losers” are retained in the investment portfolio because investment portfolio holdings are accounted for at cost, and losses are not recognized unless the security is sold. “Gains trading” often results in a portfolio of securities with extended maturities, lower credit quality, high market depreciation and limited practical liquidity. In many cases, “gains trading” has involved the trading of “when issued" securities and “pair offs” or “corporate settlements" because the extended settlement period associated with these practices allows speculators the opportunity for substantial price changes to occur before payment for the securities is due. B. “When-Issued” Securities Trading. "When-issued” securities trading is the buying and selling of securities in the interim between the announcement of an offering and the issuance and payment date of these securities. A purchaser of a “when-issued” security acquires all the risks and rewards of owning a security and may sell the “when-issued” security at a profit before taking delivery and paying for it. Frequent purchases and sales of securities during the "when-issued” period generally are indications of trading activity and should not be conducted in a bank’s investment portfolio. C. “Pair-Offs”. A “pair-off’ is a security purchase transaction which is closed out or sold at, or prior to, settlement date. As an example, an investment portfolio manager will 3 commit to purchase a security; then, prior to the predetermined settlement date, the portfolio manager will "pair off’ the purchase with a sale of the same security prior to, or on, the original settlement date. Profits or losses on the transaction are settled by one party to the transaction remitting to the counter party the difference between the purchase and sale price. Like “when issued” trading, “pair-offs” permit speculation on securities price movements without paying for the securities. D. Corporate Settlement on U.S. Government and Federal Agency Securities Purchases. Regular-way settlement for transactions in U.S. Government and Federal agency securities is one business day after the trade date. Regular-way settlement for corporate securities is five business days after the trade date. The use of a corporate settlement method (5 business days) for U.S. Government securities purchases appears to be offered by dealers in order to facilitate speculation on the part of the purchaser. K Repositioning Repurchase Agreements. Dealers who encourage speculation through the use of "pair-off' “when-issued” and “corporate settlement” transactions often provide the financing at settlement of purchased securities which cannot be sold at a profit. The buyer purchasing the security pays the dealer a small “margin" that is equivalent roughly to the security. The dealer then agrees to fund the purchase by buying the security back from the purchaser under a resale agreement. Apart from imprudently funding a longer-term, fixed-rate asset with short term, variable-rate source funds, the purchaser acquires all the risks of ownership of a large^amount of depredated securities for a very small margin payment. Purchasing securities in these circumstances is inherently speculative and is a wholly unsuitable investment practice for depository institutions. F Short Sales. A short sale is the sale of a security that is not owned. The purpose of a short sale generally is to speculate on the fall in the price of the security. Short sales are speculative transactions that should be conducted in a trading account, and when conducted in the investment portfolio, they are considered to be unsuitable. Short sales are not permissible activities for Federal credit unions. II. Stripped Mortgage Backed Securities. Residuals and Zero Coupon Bonds There are advantages and disadvantages in owning these products, A depository institution must consider the liquidity, marketability, pledgeability, and price volatility of each of these products prior to investing in them. It may-he uneuitabl® for a depository institution-to commit significant amounts of funds to long term sMpped mortgage-backed securities, residuals and zero coupon bonds which fluctuate greatly in price. A. S trip p ed M ortgage B acked Securities (SM BS). Stripped Mortgage Backed Securities consist of two classes of securities with each class receiving a different portion of the monthly interest and principal cash flows from the underlaying mortgage backed securities. In its purest form, an SMBS is converted into an interest-only (IO) strip, where the investor receives 100% of the interest cash flows, and a principal only (PO) strip, where the investor receives 100% of the principal cash flows. All IOs and POs have highly volatile price characteristics based, in part, on the prepayment of the underlying mortgages and consequently on the maturity of the stripped security. Generally, POs will increase in value when interest rates decline while IOs increase in value when interest rates rise. Accordingly, the purchase of an IO strip may serve, theoretically, to offset the interest rate risk associated with mortgages and similar instruments held by a depository institution. Similarly, a PO may be useful as an offset to the effect of interest rate movements on the value of mortgage servicing. However, when purchasing an IO or PO the investor is speculating on the movements of future interest rates and how these movements will affect the prepayment of the underlying collateral. Furthermore, those SMBS thatdo'not .have the guarantee of a government agency or a government-sponsored agency as to the payment of principal and interest have an added element of credit risk. As a general rule, SMBS cannot be considered as suitable investments for the vast majority of depository institutions. SMBS, however, may be appropriate holdings for depository institutions that have highly sophisticated and well managed securities portfolios, mortgage portfolios or mortgage banking functions. In such depository institutions, however, the acquisition of SMBS should be undertaken only in conformance with carefully developed and documented plans prescribing specific positioning limits and control arrangements for enforcing these limits. These plans should be approved by the institution’s board of directors and vigorously enforced. In those depository institutions that prepare their published financial statements in accordance with Generally Accepted Accounting Principles, SMBS holdings must be accounted for in accordance with Financial Accounting Standards Board Statement #91 (FAS #91) which requires that the carrying amount be adjusted when actual prepayment experience differs from prepayment estimates. Other institutions may account for their SMBS holdings under FAS &91 or alternatively at market value or the lower of cost or market value. Several state® have adopted, or are considering, regulations that prohibit state chartered banks from purchasing IO strips. Accordingly, state chartered institutions should consult with their state regulator concerning the permissibility of purchasing SMBS. B. A s s e t B a c k e d Securities (A B S) R esiduals. Residuals are the excess cashflows from ah ABS transaction after the payments due to the bondholders and the trust administrative expenses have been satisfied. This cashflow is extremely sensitive to prepayments, and thus has a high degree of interest rate risk. Generally, the value of residual interests in ABS rises when interest rates rise. Theoretically a residual can be used as &risk management too! to offset declines in the value of fixed rate mortgage or ABS portfolios. However, it should be understood by all residual interest purchasers that the “yield" on these instruments is inversely related to their effectiveness as a risk management vehicle. In other words, the highest yielding ABS residuals have limitechrisk management value usually due to a complicated ABS structure and/or unusual collateral characteristics that make modeling and understanding the economic cashflows very difficult Alternatively, those residuals priced for modest yields generally have positive risk management characteristics. in conclusion, it i© important to understand that a residual cashflow is highly dependent upon the prepayments received. Caution should be exercised when purchasing @residual interest especially higher “yielding" interest, because the risk associated over the life of the XBS may warrant an even higher return in order to adequately compensate the investor for the interest rate risk assumed. Purchases of these equity interests should be supported by in-house evaluations of possible rate of return ranges in combination with varying prepayment assumptions. Residual interests in ABS are not . permissible acquisitions for Federal credit unions. Holdings of ABS residuals by other institutions should be accounted for in the manner discussed under stripped mortgage-backed securities and should be reported as “Other Assets" on regulatory reports. C. O ther Zero Coupon or S tripped Products. The interest and/or principal portions of U.S. Government obligations are sometimes sold to depository institutions in the form of stripped coupons, stripped bonds (principal), STRIPS, or propriety products, such as CATs or TIGRs. Also, Original Issue Discount Bonds (QIDs) have been issued by a number of municipal entities. Longer maturities of these instruments can exhibit extreme price volatility and, accordingly, disproportionately large long-maturity holdings (in relation to the total portfolio) of zero coupon securities may be unsuitable for investment holdings for depository institutions. By order of the Board of Governors of the Federal Reserve System, this 20th day of April, 198a William W. Wiles, Secretary of the Board. [FR D oc. 88-9087 Filed 4-25-88, 8:45 am) BU LLIN G C O D S PRINTED IN NEW YORK, FROM FEDERAL REGISTER, VOL. 53, NO. 80 4
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