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FEDERAL RESERVE BANK
OF NEW YORK
[
Circular No. 10432 ~l
February 8, 1991
Securities Practices of State Member Banks
To All State Member Banks, and Others Concerned,
in the Second Federal Reserve District:
Following is the text of a statement issued by the Federal Financial Institutions Examination
Council:
The Examination Council has announced that it is issuing for public comment a Supervisory Policy
Statement on Selection of Securities Dealers, Securities Portfolio Policies and Strategies and Unsuitable
Investment Practices, and Stripped Mortgage-Backed Securities, Certain CMO Tranches, Residuals, and
Zero-Coupon Bonds.
The Council requested that comments be received within 30 days of publication of the proposed
Supervisory Policy Statement in the F ederal R egister.
The proposed Policy Statement is being issued to promote uniform treatment by the five agencies
represented on the Council. It would amend the Supervisory Policy Statement issued by the Council
in April, 1988 entitled “Selection of Securities Dealers and Unsuitable Investment Practices.” This 1988
Policy Statement was adopted by the Federal Reserve Board, Federal Deposit Insurance Corporation,
National Credit Union Administration, and Office of the Comptroller of the Currency. The Office of
Thrift Supervision issued guidance in this area in 1988 through Thrift Bulletin 12, “Mortgage Derivative
Products and Mortgage Swaps” and in 1989 through Thrift Bulletin 41, “Interim Guidelines for Secu
rities Portfolio Policies and Strategies.”
The Policy Statement on which comment is requested is divided into three sections: It:
• recommends procedures to be used in selecting securities dealers;
• requires the documentation of prudent securities policies and strategies;
• requires securities to be reported as held for investment, held for sale or held for trading
in a manner consistent with the documented policies and strategies;•
• identifies specific trading or sales practices that are considered unsuitable when conducted
in an investment portfolio; and
• identifies the types of securities containing volatile price or other high-risk characteristics
that may be unsuitable investments for depository institutions.
In addition, the Council is requesting comment on the following specific matters relating to the
guidelines in Section III of the Policy Statement:
• whether it should define CMO tranche types and residuals in precise, quantitative terms. In this
regard, commenters are invited to submit quantitative criteria that could be used to separate
“high-risk” tranches from all other tranches.
• what methods can be employed to determine whether a security that was purchased to reduce
interest-rate risk is accomplishing that objective.
• what the economic and financial effects on financial markets and depository institutions would
be if the proposed Policy Statement were implemented.
Printed on the following pages is the text of the Supervisory Policy Statement, which has been
reprinted from the Federal Register. Comments thereon should be submitted by March 6, 1991, re
flecting the FFIEC’s extension of the period of time in which to submit comments (56 FR 3831);
such comments may be sent to the Federal Financial Institutions Examination Council, as specified
in the notice, or to our Multinational Banking Department.
E. G
e r a ld
C o r r ig a n ,
President.
FEDERAL FINANCIAL INSTITUTIONS
EXAMINATION COUNCIL
Supervisory Policy Statement
Concerning Selection of Securities
Dealers, Securities Portfolio Policies
and Strategies and Unsuitable
Investment Practices, and Stripped
Mortgage-Backed Securities, Certain
CMO Tranches, Residuals, and ZeroCoupon Bonds
Federal Financial Institutions
Examination Council.
ACTION: Request for comment.
AGENCY:
The Five member agencies
the Federal Financial Institutions
Examination Council (the "FFIEC”),
which include the Board of Governors 01
the Federal Reserve System ("FRB”), the
Federal Deposit Insurance Corporation
(“FDIC”), the National Credit Union
Administration (“NCUA”), the Office of
the Comptroller of the Currency
("OCC”), and the Office of Thrift
Supervision ("OTS”) (collectively, the
“Agencies”), are proposing to update
and revise the Supervisory Policy on the
“Selection of Securities Dealers and
Unsuitable Investment Practices” which
was approved in April 1980 (the “April
1988 Supervisory Policy”). The proposed
revised policy addresses the selection of
securities dealers, requires depository
institutions to establish prudent policies
and strategies for securities
transactions, defines securities trading
or sales practices that are viewed by the
Agencies as being unsuitable when
conducted in an investment portfolio,
indicates characteristics of loans held
for sale or trading, and denotes certain
types of securities with volatile price or
other high risk characteristics that are
generally not suitable investments for
depository institutions.
The FFIEC’s April 1988 Supervisory
Policy was adopted by the FRB, FDIC,
NCUA, and OCC. The OTS has issued
guidance with respect to these issues in
Thrift Bulletin 12, “Mortgage Derivative
Products and Mortgage Swaps” and
Thrift Bulletin 41, “Interim Guidelines
for Securities Portfolio Policies and
Strategies.” If approved by the FFIEC,
the revised Supervisory Policy would
supersede the earlier version and the
FFIEC would recommend to its member
agencies that they adopt the revised
policy. In the meantime, the member
agencies will continue to apply their
current supervisory policies on
securities to the institutions they
examine. In the interest of achieving
uniformity among the member agencies
in this area, the FFIEC is soliciting
comments on the proposed changes to
the April 1988 Supervisory Policy.
SUMMARY:
DATES: Comments must be received by
February 4,1991.
ADDRESSES: Comments should be
directed to Robert J. Lawrence,
Executive Secretary, Federal Financial
Institutions Examination Council, 1776 G
Street, NW., suite 850B, Washington, DC
20006.
FOR FURTHER INFORMATION CONTACT:
At the FRB: Rhoger H. Pugh, Manager,
Policy Development, Division of Banking
Supervision and Regulation (202) 7285883; Charles H. Holm, Senior
Accountant, Division of Eanking
Supervision and Regulation (202) 4523502. At the FDIC: Robert F. Storch,
Chief, Accounting Section, Division of
Supervision, (202) 898-8906: William A.
Stark, Assistant Director, Division of
Supervision, (202) 898-6972. At the
NCUA: Charles Felker, (202) 682-9640.
At the OCC: Owen Carney, Senior
Advisor for Investment Securities, (202)
447-1901. At the OTS: John M. Freeh.
Senior Accountant, Accounting Policy,
(202) 906-5649.
SUPPLEMENTARY INFORMATION: The
principal revisions and additions that
the FFIEC is proposing to its April 1983
Supervisory Policy are summarized as
follows:
Section I: Selection of Securities Dealers
Management of depository institutions
must have sufficient knowledge about
the securities firms, and personnel with
whom they are doing business in order
to conduct safe and sound securities
transactions. The revised policy
statement adds guidance providing that
the board should also establish and
periodically review dollar limits and
limits on the types of transactions to be
executed with each authorized
securities firm.
Section II: Securities Portfolio Policies
and Strategies and Unsuitable
Investment Practices
The April 1988 Supervisory Policy
described characteristics of trading and
gains trading, and stated that such
activities were not suitable when
conducted in a depository institution’s
investment portfolio. The revised
Supervisory Policy adds guidance for
safe and s j md management of
securities portfolios and activities, adds
and defines a held for sale supervisory
reporting classification and revises and
adds to the list of unsuitable investment
practices. The additions are described in
more detail as follows:
(1)
The additions provide that the
board of directors should understand
and approve the securities portfolio
policy and review management's
strategies and securities activities.
Safety and soundness guidance for
securities activities was added that
increases the oversight responsibility of
the board of directors. The strategies
and securities activities must be
reviewed no less than quarterly by the
board of directors for consistency with
the institution’s portfolio policy and
strategies. Also, the board of directors
should establish appropriate systems
and internal controls to ensure that
securities activities are consistent with
its policies and management’s
strategies.
(2) Safety and soundness
documentation requirements were
added that require the board of directors
to document its approval of the overall
portfolio policy, and require
management to document its strategies
for significant security portfolios.
(3) The additions describe the proper
supervisory reporting of securities
activities and describes the
characteristics of securities trading, held
for sale, and investment activities. The
additions require securities holdings
that do not meet the supervisory
reporting criteria for either investment
or trading portfolios to be reported as
held for sale. Also, securities held for
sale must be reported at the lower of
cost or market value. The additions
further provide that it is an unsafe and
unsound practice to report securities
held for sale using reporting standards
applicable to securities held for
investment.
(4) The additions provide that the
substance of an institution’s securities
activities will determine whether
securities reported as held for
investment are, in reality, held for
trading or for sale. Seven factors have
been added to the policy statement that
must be considered w’hen evaluating
whether the reporting of a depository
institution’s securities holdings is
consistent with management’s intent
and actions. The examiner is instructed
to scrutinize the pattern of securities
activities to determine whether
securities reported as held for
investment are, in reality, held for sale
or for trading.
(5) The policy statement was revised
to include loans and provides that loans
are required to be reported at the lower
of cost or market value when an
institution holds the loans for resale, or
demonstrates a pattern of sales
transactions that indicates that
management does not have the intent or
ability to hold the loans for investment
purposes.
(6) In the list of nine unsuitable
investment practices;
PRINTED IN NEW YORK, FROM FEDERAL REGISTER, VOL. 56, NO. 2, pp.263-271
3
Item 5. Repositioning Repurchase
Agreements: was clarified to allow for
safe and sound use of repurchase
agreements to fund securities held for
investment:
Item 7. “Adjusted Trading” or “Bond
Swapping”: was added:
Item 8. Delegation of Discretionary
Investment Authority: was added; and
Item 9. Covered Calls: was added.
Section III: Stripped Mortgage-Backed
Securities, Certain CMO Tranches,
Residuals, and Zero-Coupon Bonds
FFIEC particularly requests comments
on the following specific issues relating
to section III of the Supervisory Policy.
The FFIEC is not soliciting comments on
any guidance in the proposed policy
statement that reiterates guidance in the
April 1988 Supervisory Policy.
(1) Whether section III of the
Supervisory Policy should define certain
CMO tranches and residuals in precise
quantitative terms. In this regard, the
FFIEC is inviting commenters to submit
quantitative criteria that could be used
to separate "high-risk" CMO tranches
from all other CMO tranches. If possible,
Section 111 incorporates substantial
commenters should estimate the effect
additions to the April 1988 Supervisory
that these criteria will have on
Policy. That policy statement provided
depository institutions and financial
that the acquisitions of the various
markets.
forms of zero coupon, stripped
(2) Whether the policy statement
obligations, and asset backed securititts
should be expanded to prohibit
residuals will receive increased
depository institutions from holding
regulatory attention and may be
SMBSs, high-risk CMO tranches and
considered unsuitable. The following
items describe the additions to the April, residuals as investments due to their
extreme price volatility and other
1988 Supervisory Policy:
factors.
(1) High-risk collateralized mortgage
(3) If the policy statement permits
obligation (“CMO") tranches, as defined
depository institutions to hold SMBSs,
in this section, have been added to the
types of securities that are generally not high-risk CMO tranches and residuals as
interest rate risk reduction tools, what
suitable investments for depository
statistical or analytical methods can be
institutions.
employed by examiners and depository'
(2) Depository institutions that own or institutions to determine whether, prior
plan to purchase stripped mortgageto its purchase, a security will reduce
backed securities (“SMBSs”), high-risk
the interest rate risk of the institution
CMO tranches, and residuals must be
and of designated assets and whether,
able to perform interest rate risk and
subsequent to its purchase, the security
price sensitivity analyses. It is unsafe
has actually accomplished that
and unsound for management to rely on objective?
analyses and documentation obtained
(4) What will be the economic and
from an outside party without preparing financial impact on financial markets
independent internal analyses.
and depository institutions of
(3) SMBSs, high-risk CMO tranches,
implementing the changes in Section III
and residuals that have not been
of the proposed policy statement?
purchased to reduce the interest rate
The text of the proposed revised
risk of the institution and of designated
Supervisory Policy follows.
assets or that failed to reduce the
interest rate risk of the institution and of Purpose
designated assets will be considered
This supervisory policy informs
speculative holdings. The examiner will insured depository institutions about:
review the institution’s documentation
-Recommended procedures to be used
of the internal analyses prepared prior
in the selection of a securities dealer,
to purchase and prepared quarterly
—The need to document and implement
prudent policies and strategies for
thereafter to demonstrate that the
securities, whether they are held for
securities were effective in reducing
investment, for sale or for trading
interest rate risk.
purposes;
(4) The purchase or retention of
speculative holdings of SMBSs, high-risk —Securities trading or sales practices
that are viewed by the federal
CMO tranches, and residuals and
financial institution regulators as
disproportionately large holdings of
being unsuitable when conducted in
long-term zero-coupon bonds is contrary
an investment portfolio. Securities
to safe and sound practices. Examiners
held for trading must be reported at
may criticize such holdings and seek
market value and securities held for
their orderly divestiture, resulting in the
sale must be reported at the lower of
reporting of the securities at the lower of
cost or market value: and
cost or market value until their disposal.
—Types of securities with volatile price
Although the FFIEC invites comments
or other high risk characteristics that
on all aspects of the proposed updates
are generally no! suitable investments
to its April 1938 Supervisory Policy, the
for depository institutions. Such
4
securities may be subject to
supervisory criticism, and depository
institutions may be directed to
establish a plan for disposal.
The guidance set forth in this
supervisory policy statement with
respect to securities held for sale or
trading is also applicable to loans held
for sale or trading.
Background
This supervisory policy supersedes an
April 1988 supervisory policy statement
on the “Selection of Securities Dealers
and Unsuitable Investment Practices"
that was developed by the Federal
Financial Institutions Examination
Council ( 'FFIEC’’). The earlier policy
statement dealt with certain regulatory
concerns pertaining to speculative and
other inappropriate activities improperly
carried out in a depository institution’s
investment portfolio. This supervisory
policy statement updates its predecessor
by providing additional information on
securities practices that are
inappropriate for an investment account
and emphasizes the requirement that
securities held for sale, as well as loans
held for 9ale, should be reported at the
lower of cost or market value. It also
incorporates guidance for stripped
mortgage backed securities, certain
CMO tranches, residuals, and zero
coupon bonds.
In a number of cases where
depository institutions engaged in
speculative or other non-investment
activities in their investment portfolios,
the portfolio managers seemeid to place
undue reliance on the advice of a
securities sales representative. Some
depository institutions have failed
because of their speculative securities
activities. Other institutions have had
their earnings or capital impaired and
the practical liquidity of their securities
eroded by market value depreciation.
Many of the investment and speculative
problems may have avoided had sound
procedures been followed before using
certain securities dealers.
Depository institutions must
document prudent portfolio policies and
strategies for loans and debt securities
held as assets (hereinafter referred to as
portfolio policy or strategies). The
depository institution’s board of
directors is responsible for establishing
and approving the portfolio policy.
Securities must be recorded and
reported in accordance with generally
accepted accounting principles (GAA) 1
consistent with the institution’s intent to
1 In those cases where a difference in the
interpretation of GAAP arises between an
institution and its primary supervisory agency, the
supervisory agency will require the institution to
prepare its supervisory reports in accordance with
the agency’s interpretation.
commitments as evidenced by capital
strength, liquidity and operating results.
This evidence should be gathered from
current financial data, annual reports,
credit reports, and other sources of
financial information.
(2) The dealer’s general reputation for
financial stability and fair and honest
dealings with customers. Other
depository institutions that have been or
are currently customers of the dealer
should be contacted.
(3) Information available from State or
Federal securities regulators and
securities industry self-regulatory
organizations, such as the National
Association of Securities Dealers,
concerning any formal enforcement
actions against the dealer, its affiliates
or associated personnel.
(4) The background of the dealer's
Section I: Selection of Securities D ealers
sales representative with whom
business wTill be conducted to determine
M any depository institutions rely on
their expertise.
the expertise and advice of a securities
In addition, the board of directors (or
sales representative for
an appropriate committee of the board)
recom m endations concerning proposed
must determine that the depository
investm ents and investm ent strategies
institution has established appropriate
and for the timing and pricing of
procedures to obtain and maintain
securities transactions. Many of the
possession or control of securities
investm ent problem s experienced by
depository institutions may hav? been
purchased. In this regard, purchased
avoided had sound procedures been
securities and repurchase agreement
follow ed before using certain securities
collateral should only be left in
dealers.
safekeeping with selling dealers when:
It is essen tial that the m anagem ent of
(1) The board of directors is completely
depository institutions have sufficient
satisfied as to the credit worthiness of
know ledge about the securities firms
the securities dealer and (2) the
and personnel with w hom they are
aggregate market value of securities
doing business. A depository institution
held in safekeeping in this manner is
should not engage in securities
within credit limitations that have been
transactions with any securities firm
approved by the board of directors (or
that is unw illing to provide com plete
an appropriate committee of the board)
and tim ely disclosure of its financial
for unsecured transactions (see the
condition. M anagem ent should review
October 1985 FFIEC Policy Statement
the securities firm’s financial statem ents
entitled “Repurchase Agreements of
and evaluate the firm’s ability to honor
Depository Institutions with Securities
its com m itm ents before entering into
Dealers and Others”). Federal credit
transactions with the firm and
unions, when entering into a repurchase
periodically thereafter. An inquiry into
agreement with the broker/dealer, are
the general reputation of the dealer also
not permitted to maintain the collateral
is necessary. The board of directors (or
with the broker/dealer (see part 703 of
an appropriate comm ittee o f the
the National Credit Union
board 2) should develop a list of
Administration rules and regulations).
securities firms with w hom managem ent
As part of the process of managing a
is authorized to do business. The board
depository institution’s relationships
should also establish and periodically
with securities dealers, the board of
review dollar limits and limits on the
directors may wish to consider
types of transactions to be executed
prohibiting employees who are directly
with each authorized securities firm. At
involved in purchasing and selling
a minimum depository institutions
securities for the depository institution
should consider the follow ing in
from engaging in personal securities
selecting and retaining a securities firm:
(1)
The ability of the securities dealer transactions with these same securities
firms without the specific prior approval
and its subsidiaries or affiliates to fulfill
of and periodic review by the board.
2 An appropriate committee of the board is a
The board may also wish to adopt a
committee whose membership includes outside
policy applicable to directors, officers,
directors or whose actions are subject to review and
and employees concerning the receipt of
ratification by the board of directors.
trade, to hold for sale or to hold for
investm ent, and the u se of am ortized
cost is prohibited for certain
transactions.
Stripped mortgage backed securities,
certain CMO Tranches, and residuals
are g en era lly n ot suitable investm ents
fo r d ep o sito ry in stitu tion s. W hen
holdings of these securities are not used
to reduce interest rate risk, they should
be disposed of in an orderly manner and
reported on a low er o f cost or market
value basis.
Similarly, disproportionately large
holdings of long-term zero coupon bonds
are not suitable investm ents.
A ccordingly, they should be disposed of
in an orderly manner and reported on a
low er o f cost or market value basis.
D etailed guidance is provided in the
follow ing three sections.
5
gifts, gratuities, or travel expenses from
approved securities dealer firms and
their personnel (also see in this
connection the Bank Bribery Act, 18
U.S.C. 215, and interpretive releases).
Section II: Securities Portfolio Policies
and Strategies and Unsuitable
Investment Practices
Securities activities must be
conducted in a safe and sound manner.
The depository institution's board of
directors should understand and
approve the portfolio policy and review
management’s strategies and securities
activities. Securities activities should be
carried out consistently with the
portfolio policy and strategies. The
institution’s board of directors or an
appropriate committee of the board of
directors should also oversee the
establishment of appropriate systems
and internal controls that will ensure
that securities activities are consistent
with the board-approved portfolio policy
and management’s strategies.
P o lic ies e n d S tra te g ies
A portfolio policy is a written
description of authorized securities
activities and the goals and objectives
the institution expects to achieve
through its securities activities. A
strategy is a written description of the
way management intends to achieve
these goals and objectives. The portfolio
policy and strategies should be
consistent with the institution's overall
business plan which may involve
trading, held for sale, and investment
activities. However, securities trading
activity should only be conducted in a
closely supervised trading account by
institutions w ith strong capital and
earnings. Each institution’s portfolio
policy and strategies must describe
anticipated investment activities and
either identify anticipated trading and
held for sale activities or state that the
institution will not enter into any trading
or held for sale activities.
The board of directors must document
its approval of the overall portfolio
policy for the institution. Management
must also document its strategies for
significant security portfolios. The
policy must be approved periodically
(but no less than annually) by the
institution’s board of directors.
Furthermore, the institution’s strategies
and securities activities must be
reviewed no less than quarterly by the
institution’s board of directors or an
appropriate committee thereof to ensure
that securities activities are consistent
with the strategies of the institution and
that the strategies remain consistent
with the portfolio policy.
The portfolio investm ent policy should
take into account such factors as the
institution’s asset/liability position,
asset concentrations, interest rate risk
and market volatility, liquidity, credit
risk, management’s capabilities and
desired rate of return. If the board of
directors of a depository institution fails
to establish clear policies and strategies
related to securities and lending
activities or if an institution fails to
adhere to the policies and strategies
established by its board of directors,
examiners may determine that some or
all securities and loans are held for sale
or held for trading. Held for sale
securities must be reported at the lower
of cost or market value and trading
activities must be marked to market.
P roper R eporting o f S ecu ritie s A c tiv itie s
Depository institution investment
portfolios are maintained to provide
earnings consistent with the safety
factors of quality, maturity,
marketability, and risk diversification.
Securities that are purchased with these
objectives may be reported at their
amortized cost only when the depository
institution has both the intent and
ability to hold the assets for investment
purposes. Transactions entered into in
anticipation of taking gains or short
term price movements are not suitable
as investment portfolio practices. Such
transactions should only be conducted
in a closely supervised securities trading
account (by institutions that have strong
capital and earnings). Securities
holdings that do not meet the reporting
criteria for either investment or trading
portfolios must be designated as held for
sale.
Trading in the investment portfolio is>
characterized by a high volume of
purchase and sale activity that, when
considered in light of a short holding
period for securities, clearly
demonstrates management’s intent to
profit from short-term price movements.
In such situations, a failure to follow
accounting and reporting standards
applicable to trading accounts may
result in a misstatement of the
depository insitution’s income and other
published financial data and the filing of
inaccurate regulatory reports. It is an
unsafe and unsound practice to report
securities holdings that result from
trading transactions using reporting
standards that are intended for
securities held for investment purposes.
Securities held for trading must be
reported at market value, with
unrealized gains and losses recognized
in current income. Price used in periodic
re-valuations should be obtained from
sources that are independent of the
securities dealer doing business with the
depository institution. When prices are
internally estimated by and obtained
from the portfolio manager (when
reliable external price quotations are
not available), they should be reviewed
by persons independent of the portfolio
management function.
In other cases, a pattern of
intermittent sales transactions in the
investment portfolio may suggest that
securities ostensibly held as long-term
portfolio assets are actually held for
sale. Securities held for sale must be
reported at the lower of cost or market
value with unrealized losses (and
recoveries of unrealized losses) being
recognized in current income. It is an
unsafe and unsound practice to report
securities held for sale using reporting
standards that are intended for
securities held for investment purposes.
It is the substance of an institution’s
securities activities that deremines
whether securities reported as being
held as investment portfolio assets are,
in reality, held for trading or for sale.
Examiners will particulary scrutinize
institutions that exhibit a pattern or
practice of reporting significant amounts
of realized gains on sales from their
investment portfolio and that have
significant amounts of unrecognized
losses. If in the examiner’s judgment
such a practice has occurred, some or all
of the securities reported as held for
investment will be designated as held
for sale or for trading. On the other
hand, infrequent investment portfolio
restructuring activities that are carried
out in conjunction with a prudent
overall business plan and that do not
result in a pattern of gains being
realized and losses being deferred will
generally be viewed as an acceptable
practice and thus would not result in the
re-designation of securities held for
investment as securities held for trading
or for sale.
A number of factors must be
considered when evaluating whether the
reporting of a depository institution’s
securities holdings is consistent with
management’s intent for such holdings.
Some of the factors for each reporting
period include:
(1) The dollar amount of gains
realized from sales in relation to the
dollar amount of losses realized from
sales and in relation to unrealized losses
for other investment portfolio securities;
(2) The dollar amount of gains and
losses realized from sales in relation to
net income and capital;
(3) The number of sales transactions
resulting in gains and the number
resulting in losses;
(4) The gross dollar volume of
securities purchases and sales;
(5) The rapidity of turnover, including
consideration of the length of time
securities are owned prior to sale, and
6
the length of time securities are held
after an unrealized gain is evident; and
(6)
The reasons for the depository
institution engaging in specific
transactions, and whether these
reasons are consistent with the portfolio
policy and strategies.
Some of the factors that also must be
considered to evaluate the depository
institution’s ability to continue to hold
the securities include:
(1) The source and availability for
funding for commitments;
(2) The ability to meet margin calls
and over-collateralization requirements
related to leveraged holdings;
(3) Limitations such as capital
requirements, the legality of certain
securities holdings, liquidity
requirements, legal lending limits, and
prudential concentration limits; and
(4) The ability to continue as a goingconcern and to liquidate assets in the
normal course of business.
R eportin g o f L oans H e ld fo r S a le or
Trading
Historically, depository institutions
have tended to hold loans until maturity.
Consequently, the application of lower
of cost or market accounting to portions
of the loan portfolio has not been an
issue except in those depository
institutions that have regularly
originated loans for purposes of
subsequent resale. Nevertheless, as with
debt securities, reporting loans at the
lower of cost or market is required when
the institution does not have both the
intent and ability to hold these loans for
investment purposes.
The factors listed above should also
be considered when evaluating whether
the reporting of loans is consistent with
management’s intent and ability to hold
the loans. A pattern of originating loans
at yields below market and subsequent
sale at par once the yield approximates
market is another factor that should also
be considered when evaluating
management’s intent.
U n su itable In ve stm e n t P ra ctice s
The following activities raise specific
supervisory concerns. The first six
practices are considered unsuitable
when they occur in a depository
institution’s investment portfolio. Such
practices should only be conducted in
an appropriately controlled and
segregated trading or held-for-sale
portfolio. The seventh practice is wholly
unacceptable under all circumstances.
Practices eight and nine involve an
institution’s transfer of control over
individual assets, segments of the
portfolio, or the entire portfolio to
persons or companies unaffiliated with
the institution. In such situations, the
depository institution clearly no longer
has the ability to hold the affected
securities for investment purposes and
such securities should be reported as
held for sale. In addition, certain of the
following practices may violate state
law in certain states. State-chartered
depository institutions are therefore
cautioned to consult with their state
supervisors.
1. “Gains Trading”
“Gains trading” is characterized by
the purchase of a security as an
investment portfolio asset and the
subsequent sale of that same security at
a profit after a short-term holding
period. Securities that cannot be sold at
a profit are retained as investment
portfolio assets. These “losers” are
retained in the investment portfolio
because investment portfolio holdings
are accounted for at amortized cost, and
losses are normally not recognized
unless the security is sold. Gains trading
often results in a portfolio of securities
with one or more of the following
characteristics: extended maturities,
lower credit quality, high market
depreciation, and limited practical
liquidity. Frequent purchase and sale
activity, combined with a short-term
holding period for securities, clearly
demonstrates management’s intent to
profit from short-term price movements.
This indicates that other securities held
in the investment portfolio may also be
held for trading or for sale.
In many cases, “gains trading”
involves the trading of “when-issued”
securities, the use of "pair-off’
transactions (including transactions
involving off-balance sheet contractual
commitments), or “ corporate” or
"extended settlements” because these
speculative practices afford an
opportunity for substantial price
changes to occur before payment for the
securities is due.
2. “When-Issued” Securities Trading
"When-issued” securities trading is
the buying and selling of securities in
the period between the announcement
of an offering and the issuance and
payment date of the 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
having to take delivery and pay for it.
Purchases and subsequent sales of
securities during the “when-issued”
period may not be conducted in a bank’s
investment portfolio, but are regarded
instead as a trading activity.
3. “Pair-Offs”
A “pair-off’ is a security purchase
transaction or other contractual
commitment that is closed-out or sold at.
or prior to, settlement date or expiration
date. For example, an investment
portfolio manager will 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
transactions are settled by one party to
the transaction remitting to the counter
party the difference between the
purchase and sale price. Like “whenissued" trading, “pair-offs"’permit an
institution to speculate on securities
price movements without having to pay
for the securities. Such transactions are
regarded as a trading activity. “Pair
offs" involving financial instruments
with off-balance sheet risk such as
swaps and other interest rate exchange
agreements and optional forward
commitments are also indicative of
unsuitable investment activities.
4. Corporate or Extended Settlements
Regular-way settlement for
transactions in U.S. Government and
Federal agency securities (other than
mortgage-backed and derivative
products) is one business day after the
trade date. Regular-way settlement for
corporate and municipal securities and
stripped U.S. Treasury securities and
similar products is five business days
after the trade date. The use of an
extended or corporate settlement
method for U.S. Government securities
purchases and an extended settlement
period (more than 5 business days) for
stripped U.S. Treasury securities and
similar products appear to be offered by
securities dealers in order to facilitate
speculation on the part of the purchaser,
similar to the profit opportunities
available in a "pair-off” transaction. The
use of corporate or extended settlements
to facilitate speculation is a trading
activity.
Regular-way settlement for
transactions in mortgage backed and
mortgage derivative products varies and
can be up to 30 days after trade date.
Transactions with settlements in excess
of 30 days following trade date are
considered forward contracts and are to
be reported accordingly.
5. Repositioning Repurchase Agreements
A repositioning repurchase agreement
is a funding technique often used by
dealers who encourage speculation
through the use of "gains trading," “pair
off,” "when-issued," and “corporate or
extended settlement” transactions for
securities which cannot be sold at a
profit. The repurchase agreement is a
service provided by the dealer so the
7
buyer can hold the position until it can
be sold at a gain, but it imprudently
funds a longer-term, typically fixed-rate
asset with dealer supplied short-term,
variable-rate source funds. The buyer
purchasing the security pays the dealer
a small “margin" that approximates the
actual loss in the security. The dealer
then agrees to fund the purchase of the
security by buying it back from the
purchaser under a resale agreement.
Any dealer financing technique such as
repositioning repurchase agreements
that are used to fund the purchase of
securities may be indicative of securities
that were acquired with the intent to
resell at a profit at or prior to settlement
or after a short-term holding period. This
activity is inherently speculative and is
a w'holly unsuitable investment practice
for depository institutions. Securities
acquired in this manner should be
reported as either trading account assets
or as securities held for sale. The safe
and sound use of repurchase agreements
to fund securities held for investment is
not typical of repositioning repurchase
agreements.
6. 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 as a trading
activity and when conducted in the
investment portfolio, they are
considered to be unsuitable.
A short sale that involves the delivery'
of the security sold short by borrowing it
from the depository institution's
investment portfolio should not be
reported as a short sale. Instead, it
should be reported as a sale of the
underlying security with gain or loss
recognized.
Short sales are not permissible
activities for Federal credit unions.
7. “Adjusted Trading" or “Bond
Swapping"
“Adjusted trading" or "bond
swapping” is a practice involving the
sale of a security to a broker at a price
above the prevailing market value and
the simultaneous purchase and booking
of a different security, frequently a
lower grade issue or one with a longer
maturity, at a price greater than its
market value. Thus, the broker is
reimbursed for losses on the purchase
from the institution and ensured a profit.
Such transactions inappropriately defer
the recognition of losses on the security
sold and establish an excessive reported
value for the newly acquired security.
Consequently, such transactions are
prohibited and may be in violation of 18
U.S.C. sections 1001—False Statements
or Entries and 1005—False Entries.
8. Delegation of Discretionary
Investment Authority
Some depository institutions have
delegated the purchase and sale
authority for all or a portion of their
investment securities portfolio to either
an individual who is not an employee of
the institution or one of its affiliates, or
to a non-affiliated firm. Such a
delegation of authority is intended to
obtain a higher total return on the
portfolio than the institution would
realize if it managed the portfolio itself.
When an institution has delegated such
authority to individuals who are not
employees of the depository institution,
or its affiliates, then the depository
institution no longer has the ability to
control its own securities and all
holdings where such authority has been
delegated must be reported as held for
sale.
9. Covered Calls
The writing of covered calls is an
option strategy that, for a fee, grants the
buyer of the call option the right to
purchase a security owned by the option
writer at a predetermined price before a
specified future date. The option fee 3
received by the writing (selling)
depository institution provides income
and has the effect of increasing the
effective yield on the portfolio asset
"covering" the call.
Covered call programs have been
promoted as hedging strategies because
the fee received by the writer can be
used to offset a limited amount of
potential loss in the price of the
underlying security. If interest rates rise,
the call option fee can be used to
partially offset the decline in the market
value of a fixed rate security or the
increased cost of market rate liabilities
used to carry the security. However,
there is no assurance that an option fee
wiil completely offset the price decline
on the security or the increased cost of
liabilities and the resulting reduced
spread between the institution’s return
on assets and funding costs.
As a practical matter, gains on the
securities covered by the written call
are limited to the amount of the
difference between the carrying value of
the security and the strike price at
which the security will be called away.
The potential for losses on the covered
security is not limited. In an effort to
3
Recognition of option fee income should be
deferred until the option is exercised or expires. The
covered call writer shall value the option at the
lower of cost or market value at each repo-t date.
obtain higher yields, some portfolio
managers have mistakenly relied on the
theoretical hedging benefits of covered
call writing, and have purchased
extended maturity U.S. government or
Federal agency securities. This practice
can significantly increase risks taken by
the depository institution by
contributing to a maturity mismatch
between assets and funding.
Institutions should only initiate a
covered call program for securities when
the board of directors or an appropriate
board committee has specifically
approved a policy permitting this
activity. That policy must set forth
specific procedures for controlling
covered cal! strategies, including record
keeping, reporting, and review' of
activity, as well as providing for
appropriate management information
systems to report the results. Since the
purchaser of the call acquires the ability
to call the security away from the
institution that writes the option, the
ability of that institution to continue to
hold the securities rests with an outside
party. Securities held for investment
where call options have been written
are therefore held for sale and reported
at the lower of cost or market value.
Covered call writing is not a
permissible activity for Federal credit
unions.
Section III: Stripped Mortgage Backed
Securities, Certain CMO Tranches,
Residuals, and Zero-Coupon Bonds
Due to the significant price and yield
volatility caused in part by the
substantial prepayment and average life
variability of stripped mortgage-backed
securities (“SMBSs"), certain CMO
tranches (high-risk CMO tranches 4),
and residuals, these securities are
generally not suitable investments for
depository institutions. However,
SMBSs, high-risk CMO tranches, and
residuals may be used as interest rate
risk reduction tools by depository
institutions with well managed
securities portfolios that have specific
interest rate risk policies and
procedures governing the acquisition,
retention and disposal of such
instruments. Similarly, long term zerocoupon bonds exhibit significant price
volatility and disproportionately large
holdings of these securities are not
4 For purposes of this supervisory policy
statement, high-risk CMO tranches” are generally
defined to include any tranche that contractually is
responsible for a greater than normal share of the
risk (such as prepayment or interest rate risk)
inherent in the specific collateral supporting the
CMO structure: for example, support/companion
bonds, z-bonds, super POs, inverse floaters, and
other CMO tranches, however labeled, with similar
characteristics.
8
suitable investments. Depository
institutions that currently own or plan to
purchase SMBSs, high-risk CMO
tranches, residuals, and long-term zerocoupon bonds should possess
appropriate managerial and financial
controls and analytical models to
effectively measure and monitor the
risks associated with these instruments,
Overview of the Securities
A. SMBSs consist of two classes of
securities w'ith each class receiving a
different portion of the monthly interest
and principal cash flows from the
underlying mortgage-backed securities
("MBS”). In its purest form, an MBS is
converted into an interest-only ("iO”)
strip, where the investor receives all of
the interest cash flows and none of the
principal, and a principal-only (”PO)
strip, where the investor receives all of
the principal cash flows and none of the
interest.
IOs and POs have highly volatile price
characteristics based, in part, on the
prepayment variability of the underlying
mortgages and consequently on the
maturity of the stripped securities.
Generally, IOs will increase in value
when interest rates rise, as contrasted to
POs, which decrease in value.
Accordingly, the purchase of an IO strip
may serve theoretically, to offset the
interest rate risk associated with
mortgages and mortgage-backed
securities held by a depository
institution. Similarly, a PO may be
useful to offset the effect of interest rate
movements on the value of mortgage
servicing. The uncertainty regarding the
timing and amount of cash flows from
the underlying the timing and amount of
cash flows from the underlying mortgage
collateral makes it difficult to U 9e
SMBSs as long-term risk reduction tools,
SMBSs without a government or
government-sponsored agency
guarantee of payment for principal and
interest have the added characteristic of
potential credit risk.
B. Collateralized Mortgage
Obligations ("CMOs”) or Real Estate
Mortgage Investment Conduits (REMICs,
hereafter called CMOs) have been
developed in response to investor
concerns regarding the uncertainty of
cash flows associated with the
prepayment option of the underlying
mortgagor. A CMO can be collateralized
directly by mortgages, but more often is
collateralized by MBSs issued or
guaranteed by GNMA, FNMA or
FHLMC and held in trust for CMO
investors. In contrast to MBSs in which
cash flow is received pro rata by all
security holders, the principal cash flow
from the mortgages underlying a CMO is
rapidly falling interest rates, the market
segmented and paid in accordance with
value of a residual can disappear
a predetermined priority to investors
completely. In addition, the complexity
holding various CMO tranches (but not
of some CMO structures (e.q., multiple
necessarily to those holding certain
numbers or types of tranches) or
residuals). By prioritizing the principal
unusual collateral characteristics (e.g., a
cash flow from the underlying collateral
blend of fixed and floating rates or
among the separate CMO tranches,
unique demographic traits) can make
different classes of bonds are created,
evaluating and forecasting future cash
each with their own stated maturity,
flows of residuals even more difficult.
estimated average life, coupon rates,
Thus, it is extremely unlikely that a
and unique prepayment risk
residual can be used as a long-term
characteristics. Many CMOs are
interest rate risk reduction tool.
designed to have one or more Planned
D.
Long-term {generally, maturities
Amortization Class (“PAC”) tranches.
over ten years from dale of purchase)
PAC tranches commonly have a fixed
Zero-coupon, “stripped" or Original
monthly principal amortization which
Issue Discount (“OID") securities are
does not change over a range of
priced at large discounts to their face
prepayments on the underlying
value prior to maturity and exhibit
mortgages; thus, to a certain extent,
significant price volatility. “Stripped”
limiting the prepayment risk to
securities are the interest and/or
investors. This limiting process allows
principal portions of U.S. Government
investors to more accurately predict the
obligations, which are separated and
average life of the asset and, in general,
reduces the potential price volatility that sold to depository institutions in the
form of stripped coupons, stripped
would be assumed if the underlying
bonds (principal), STRIPS, or such
MBSs themselves had been purchased.
proprietary products as CATs or TIGRs.
Although a CMO tranche, such as a
Also, OID bonds have been issued by a
PAC, is designed to reduce the
number of municipal entities.
uncertainty associated with the
prepayment risk of the MBSs
Supervisory Policy
collateralizing a CMO, the presence of a
SMBSs, high-risk CMO tranches, and
PAC bond in a CMO will result in the
residuals
ar e g e n e r a lly not suitable
transf er of prepayment risk to one or
investments
for d e p o s ito ry in stitu tio n s
more of the other tranches. These nonbecause of their substantial prepayment
PAC tranches are sometimes referred to
risk and interest rate risk which can
as “CMO support tranches” or
cause significant price, yield, and
“companion bonds.” Unlike a PAC
average life volatility. Over time, these
tranche that has been designed to
instruments
may cause unintended
provide a high degree of comfort
changes in an institution's earnings and
regarding expected average life and
its interest rate, liquidity, and funding
final maturity, non-PAC CMO tranches
risk profiles. SMBSs, high-risk CMO
have a more volatile expected average
tranches, and residuals that have not
life, rate of return, and market price.
been purchased to reduce the interest
C.
Residuals are claims on any excess rate risk of the institution and of
cash flows from a CMO issue or an
designated assets or that did not
asset-backed security remaining after
perform as intended (i.e., the position
the payments due to bondholders and
failed to reduce the interest rate risk of
after trust administrative expenses have
the institution and of the designated
been met. The economic value of a
assets) will be considered speculative
residual is a function of the present
holdings for all depository institutions.
value of the anticipated excess cash
In addition, disproportionately large
flows under assumed prepayment
holdings of long-term zero-coupon/QID
speeds. This cash flow is highly
bonds will be considered an imprudent
sensitive to prepayments and existing
investment practice for all depository
levels of market interest rates. Other
institutions. In such circumstances, the
factors affecting the market value of
purchase or retention of these securities
residuals include a lack of liquidity and
is contrary to safe and sound depository
a wide bid-offer price spread.
institution practices and may result in
Certain CMO residuals, for example,
criticism by examiners. Examiners may
may be acceptable as risk management
also seek the orderly divestiture of such
tools to reduce variations in the value of securities which will result in the
a fixed-rate mortgage or MBS portfolio
reporting of the securities at the lower of
in a period of changing interest rates.
cost or market value until their disposal.
However, the uncertainly regarding
SMBSs, High-risk CMO Tranches, and
prepayments on the underlying
Residuals
collateral makes it very difficult to use
these securities as an effective risk
Dud to the high degree of interest rate
reduction tool. Under an environment of
risk and price volatility exhibited by
9
SMBSs, high-risk CMO tranches, and
residuals, depository institutions that
currently own or plan to purchase these
securities must have the ability to
internally perform interest rate risk and
price sensitivity analyses.
Prior to purchase, the institution must
conduct and document an analysis that
showms that the proposed purchase of
the security will reduce the interest rate
risk of the institution and of the
designated assets. In demonstrating
whether the purchase of the security
will reduce interest rate risk, the
institution must show that over a wide
range of plausible interest rate
scenarios, the combined market value of
the instrument to be purchased and the
designated assets will be less variable
than the market value of the designated
assets alone. The institution must also
demonstrate that the purchase will
reduce enterprise risk (i.e., the overall
interest rate risk of the institution).
Subsequent to purchase, the institution
must evaluate and document at least
quarterly whether the securities have
actually reduced the interest rate risk of
the institution and of the previously
designated assets. In determining the
effectiveness of the security in reducing
interest rate risk, the institution must
show that since the time of he security’s
purchase, the combined market value of
the security and the designated assets
has been less variable than the market
value of the designated assets alone.
The institution must also show that over
this same time period, the cumulative
change in the market value of the
security purchased has substantially
offset the change in the market value of
the designated assets. These analyses
should include appropriate
consideration of cash flows received
since purchase of the security. The
institution must also demonstrate that
the security purchased has reduced and
will continue to reduce enterprise risk.®
The institution's analyses performed
prior to purchase and subsequently
thereafter will be subject to examiner
review. Analyses performed and records
constructed to justify purchases on a
post-acquisition basis are insufficient,
are considered unacceptable
management tools, and will be subject
to examiner criticism. Reliance on
analyses and documentation obtained
from a securities dealer or other outside
party without internal analyses by the
institution are also considered
unacceptable and will be subject to
6 Purchases o f SMBS, re siduals a nd high risk
C M O tranches prior to the date of this supervisory
policy statement g e n e ra lly will be re v ie w e d in .
accordance wiih the previously existing policies.
examiner criticism. In addition, a
depository institution must document
the following: (1) Written portfolio
policies approved by the board of
directors addressing the goals and
objectives the institution expects to
achieve through its securities activities,
including interest rate risk reduction
objectives with respect to SMBSs, highrisk CMO tranches, or residuals: (2)
accounting and reporting policies for its
SMBS’s, high-risk CMO tranches, and
residuals consistent with the provisions
of Section II of this supervisory policy
statement; (3) limits on the amount of
funds that may be committed to these
securities; (4) diversification policies; (5)
specific financial officer responsibility
and authority; (6) adequate information
systems; (7j procedures for periodic
evaluation; and (8) appropriate internal
controls. The board of directors or an
appropriate committee thereof and the
institution’s senior management should
regularly (at least quarterly) review all
securities pursuant to the portfolio
policy to determine whether these
instruments are adequately satisfying
their objectives and to concur with the
results of the analyses performed. The
depository institution’s senior
management should be fully
knowledgeable about the risk associated
with prepayments and their subsequent
impact on the securities.
Other Zero-Coupon, Stripped or Original
Issue Discount (OID) Products
Although considered free from credit
risk if issued directly by the U.S.
Government, longer maturities of these
instruments (generally, maturities
exceeding ten years from the date of
purchase) have displayed extreme
volatility. Therefore, disproportionately
large long-maturity holdings of these
instruments, in relation to the total
investment portfolio or total capital of
the depository institution, are
considered an imprudent investment
practice. Such holdings will be subject
to criticism by examiners who may seek
the orderly disposal of such securities.
Such action will result in the reporting of
these securities at the lower of cost or
market value until their disposal.
O th er C o n sideration s
The exercise of extreme caution is
urged for investment portfolio owners
and prospective purchasers of SMBSs,
residuals, high-risk CMO tranches, long
term zero-coupon bonds, and other
securities and financial derivatives with
similar characteristics. It is the
responsibility of each depository
institution's management to continue
exercising care and prudence in the
selection of suitable investment
products, irrespective of brand names
10
and labels. Before purchasing any new
or unfamiliar investment instrument,
senior management should at the very
least internally produce a detailed
independent analysis of the security, in
order to fully understand the
performance characteristics, price
volatility, and potential hazards
inherent in owning the security under
various interest rate scenarios. A
prospectus supplement that fully details
the cash flows covering each of the
securities held by the institution should
be obtained prior to purchase and
retained for examiner review. Securities
with characteristics similar to the types
of securities detailed in this surpevisory
policy will be treated in the same
manner by the financial regulatory
agencies.
Several states have adopted, or are
considering, regulations that prohibit
state-chartered banks from purchasing
IO strips or other securities discussed
above. Accordingly, state-chartered
institutions should consult with their
state regulator concerning the
permissibility of these purchases.
Dated: December 28,1990.
Robert J. Lawrence,
Executive Secretary, Federal Financial
Institutions Examination Council.
[FR Doc. 91-48 Filed 1-2-91; 8:45 am]
BILLING CODE 6210-01-M
@FedFRASER