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FEDERAL RESERVE BANK
OF NEW YORK
[
C irc u la r No.
10517 "1
F e b ru a ry 2 6 , 1992
J
Revised Supervisory Policy Statement on Securities Activities
To A ll State M em ber B anks, a n d O thers Concerned,
in the Second F ederal Reserve D istrict:
The following statement has been issued by the Board of G overnors of the Federal Reserve
System:
The Federal Reserve Board has issued a revised Supervisory Policy Statement on Securities Ac
tivities to become effective on February 10, 1992. This policy statement supersedes the Supervisory
Policy Concerning Selection of Securities Dealers and Unsuitable Investment Practices issued on
April 20, 1988.
The new policy statement was developed under the auspices of the Federal Financial Institutions
Examination Council (“FFIEC”) and was recently adopted by the Board. It addresses the selection of
securities dealers and requires depository institutions to establish prudent policies and strategies for se
curities transactions.
In addition, the policy 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 establishes a framework for identifying when certain mortgage derivative prod
ucts are high-risk mortgage securities which must be reported as securities held for sale or for trading.
Enclosed — for m em ber banks in this D istrict — is a copy of the text of the B oard’s revised
Supervisory Policy Statement on Securities Activities, effective February 10, 1992. It supersedes
the “Supervisory Policy Concerning Selection of Securities Dealers and Unsuitable Investm ent Prac
tices” issued in A pril 1988, and sent to you with our C ircular No. 10237, date May 4, 1988; copies
of the revised Policy Statement will be furnished to others upon request directed to our Circulars
Division (Tel. No. 212-720-5215 or 5216). In addition, the Supervisory Policy Statement on Secu
rities Activities was published by the FFIEC in the Federal Register of February 3 (57FR 22,
pp. 4028-40).
Questions regarding this m atter may be directed to Donald E. Schm id, Manager, Dom estic
Banking D epartm ent (Tel. No. 212-720-6611)
E. G e r a l d C o r r i g a n ,
President.
o
Board of Gcwemors
of the
Federal Reserve System
SUPERVISORY POLICY STATEMENT ON SECURITIES ACTIVITIES
PURPOSE
This supervisory policy informs insured depositary institutions about:
rfniniwdri procedures to be used in the selection of a securities
dealer;
the need to document and implement prudent policies and strategies
for securities, whether they are held far investment, trading, or
far sale, and to establish systems and interned controls that are
designed to ensure that securities activities are consistent with
the policies and strategies;
certain securities trading and sales practices that are viewed by
the federal financial institution regulators as being unsuitable
when conducted in an investment portfolio, thereby precluding the
use of the amortized cost basis of accounting for securities
holdings resulting from such practices.
1
lEnc. Cir. No. 10517]
The substance of an institution's securities activities determines
whether securities reported as investments are, in reality, held
for trading or for sale. Securities held for trading must be
reported at market value and securities held for sale must be
reported at the lower of cost or market value. The guidance
regarding securities held for sale or trading is also applicable to
loans held for sale or trading;
high-risk mortgage securities that are not suitable investment
portfolio holdings for depository institutions. These securities
may only be acquired to reduce an institution's interest rate risk
and must be reported in the trading account at market value, or as
assets held for sale at the lower of cost or market value.
Examiners may seek the orderly divestiture of high-risk mortgage
securities that do not reduce interest rate risk. Other products
with risk characteristics similar to high-risk mortgage securities
may be subject to the same supervisory treatment? and
disproportionately large holdings of long-term zero-coupon bonds
that are considered an imprudent investment practice. Such
holdings will be subject to criticism by examiners who nay seek
their orderly disposal.
2
■m n
BK3CK3UND
In a umber of cases where depositary institutions engaged in speculative or
other non-investment activities in their investment portfolios, the portfolio
managers placed undue reliance on the advice of a securities sales
representative. Sane 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 these problems could have been avoided had
sound procedures been followed.
These factors led to the development of a supervisory policy statement on the
"Selection of Securities Dealers and Unsuitable Investment Practices" that was
approved by the Federal Financial Institutions Examination Council ("FFIEC") in
April 1988. That policy statement emphasized the importance of knowing the
securities firms with whan a depositary institution does business and also
dealt with certain regulatory concerns pertaining to speculative and other
activities improperly carried out in an institution's investment portfolio.
In addition, it identified risks associated with stripped mortgage-backed
securities, residuals, and zero-coupon bonds and concluded that they m y be
unsuitable investments far the vast majority of depository institutions.
This supervisory policy statement supersedes the April 1988 Policy Statement by
providing additional information on the development of a portfolio policy and
strategies for securities and on securities practices that are inappropriate
3
far an investment account. It also dincunnao factors that sust be considered
when evaluating whether the reporting of an institution's investment portfolio
holdings is consistent with its intent and ability. In addition, this policy
statement contains esqpanded guidance on the suitability of acquiring and
holding mortgage derivative products, other similar products, and zero coupon
bonds.
Detailed guidance is provided in the following three sections.
. Io s I ?
SECTION I:
SELECTION OF SECURITIES EEAIZRS
Many depositary instituticns rely on the expertise and advice of a securities
sales representative far reooanendaticns concerning proposed investments and
investment strategies and for the timing and pricing of securities
transactions. Many of the problems depositary institutions have experienced
with their securities activities could have been avoided had sound procedures
been followed.
It is essential that the nanagement of a depositary institution have sufficient
knowledge about the securities firms and personnel with whom they are doing
business. A depository institution should not engage in securities
transactions with any securities firm that is ursdlling to provide ccnplete and
timely disclosure of its financial condition. Management should review the
securities firm's financial statements and evaluate the firm's ability to honor
its ornnitments before entering into transactions with the firm and
periodically thereafter. An inquiry into the general reputation of the dealer
also is necessary. The board of directors, or an appropriate committee of the
board1, should periodically review and approve a list of securities firms with
whan ranagement is authorized to do business. The board or an appropriate
permittee thereof should also periodically review and approve limits on the
amounts and types of transactions to be executed with each authorized
securities firm. Limits to be considered should include dollar amounts of
unsettled trades, safekeeping arrangements, repurchase transactions, securities
lAn appropriate committee of the board is a committee whose
membership includes outside directors or whose actions are subject
to review and ratification by the board of directors.
5
lending and borrowing, other transactions with credit risk, and total credit
risk with an Individual dealer.
At a mininum, depository institutions should consider the following in
selecting and retaining a securities fin:
(1)
The ability of the securities dealer and its subsidiaries or affiliates
to fulfill ocnmitnents 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 deader's general reputation far financial stability and fair and
ijcnest dealings with customers. Other depositary 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 fornal enforcement
actions against the dealer, its affiliates or associated personnel.
(4)
In those instances when the institution relies upon the advice of a
dealer's sales representative, the background of the sales representative
with whom business will be conducted in order to determine his or her
experience and expertise.
6
7
In addition, the board of directors (or an appropriate oonmittee of the board)
nust ensure that the depository institution's management has established
appropriate procedures to obtain and maintain possession or control of
securities purchased. In this regard, purchased securities and repurchase
agreement collateral should only be left in safekeeping with selling dealers
when: (1) the board of directors or an appropriate permittee thereof is
ocnpletely satisfied as to the creditworthiness of the securities dealer and
(2) the aggregate narket value of securities held in safekeeping in this manner
is within credit limitations that have been approved by the board of directors
(or an appropriate permittee of the board) far unsecured transactions (see the
October 1985 FFIEC Policy Statement entitled "Repurchase Agreements of
Depository Institutions with Securities Dealers and Others"). Federal credit
unions, when entering into a repurchase agreement with a broker/dealer, are not
permitted to maintain the collateral with the broker/dealer (see fbrt 703 of
the National Credit Union Administration rules and regulations).
As part of the process of providing oversight over a depository institution's
relationships with securities dealers, the board of directors may wish to
consider adopting a policy concerning conflicts of interest when enplcyees who
are directly involved in purchasing and selling securities for the depository
institution are also engaging in personal securities transactions with these
same securities firms.
The board nay also wish to adopt a policy applicable to directors, officers,
and enplcyees concerning the receipt of gifts, gratuities, oar travel expenses
from approved securities dealer firms and their personnel.
7
(Also see in this
if^i i ra the Bazik Bribery Act* IB U5C 215, and intcrpt'fitive fbX
8
m n
SBCTZGN H:
SMJUKmES PORTFOLIO POLICY AND STRATEGIES AND IK5UTEAHLE
INVESTMENT PRACTICES
Policy and Strategies
A portfolio policy is a written description of authorized securities
investment, trading and held far sale activities and the goals and objectives
the institution expects to achieve through such activities. Strategies are
written descriptions of the way management intends to achieve these goals and
objectives and should address management's plans far each type of security
(e.g., U.S. Treasuries, mortgage-backed securities, etc.) that will be vised to
carry out the portfolio policy. 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 with strong capital and earnings and adequate liquidity. 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.
Securities activities must be conducted in a safe and sound manner. Each
depository institution's board of directors should review and approve the
overall portfolio policy and management's documented strategies annually, or
more frequently if appropriate, and these approvals must be adequately
documented.
Furthermore, the board of directors or an appropriate permittee
9
thereof should review the institution's securities activities and holdings no
less than quarterly. The board of directors or an appropriate oexzmittee
thereof should also oversee the establishment of appropriate systems and
internal controls that are designed to ensure that securities activities and
holdings are consistent with the strategies of the institution and that the
implementation of the strategies remains consistent with the portfolio policy's
objectives.
When developing its portfolio policy and strategies, an institution should take
into account such factors as asset/1iability position, asset concentrations,
interest rate risk, liquidity, credit risk, market volatility, and management's
capabilities and desired rate of return. If the board of directors of a
depositary institution fails to adopt policies and strategies related to
securities or if an institution fails to adhere to the policies and strategies
approved by its board of directors, examiners may determine that seme or all
securities are held far sale or held far trading. Held for sale securities
must be reported at the lower of cost or market value and trading activities
must be reported at market value.
Proper Reporting of Securities Activities
Securities must be reported in accordance with generally accepted accounting
principles (GAAP)2 consistent with the institution's intent to trade, to hold
2In those cases where a difference in the interpretation of
GAAP arises between an institution and its primary federal
supervisory agency, the supervisory agency will require the
10
lostfar sale or to hold far investment.
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 to anoonplish these
objectives may be reported at their amortized cost only when the depository
institution has both the intent and ability to bold the assets for long-term
investment purposes. Transactions entered into in anticipation of taking gains
on 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 and adequate liquidity. Securities holdings that do not meet the
reporting criteria far 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 m y result in a
misstatement of the depository institution'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
institution to prepare its supervisory reports in accordance with
the agency's interpretation.
11
held far investment purposes. Securities held far trading must be reported at
market value, with unrealized gains and losses recognized in current insane.
Prices used in periodic revaluations should be obtained from sources that are
independent of the securities dealer doing business with the depository
institution, ftoen prices are internally estimated by the portfolio manager
(when reliable external price quotations are not available), they should be
reviewed by persons independent of the portfolio management function.
A pattern of intermittent sales transactions in the investment portfolio may
suggest that securities ostensibly held es long-term portfolio assets are
actually held far sale. Securities held far 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 far sale using reporting standards that are
intended for securities held for investment purposes.
It is the substance of an institution's securities activities that determines
whether securities reported as being held as investment portfolio assets are,
in reality, held for trading or for sale. Examiners will particularly
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, sane or all of the securities reported
as held for investment will be designated as held far sale or far trading.
On the other hand, infrequent investment portfolio restructuring activities
12
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 on investment portfolio securities will generally be viewed as an
acceptable investment practice. Such activities usually would not result in
the redesignation of securities held far investment as securities held far
trading ar far sale.
A number of factors must be considered when evaluating vhether the reporting of
a depository institution's investment portfolio securities holdings is
consistent with management's intent far such holdings. Seme of the factors
relating to investment portfolio securities far each reporting period include:
(1)
the dollar amount of gains realized frcrn 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 frtxn sales in relation to
net inocme 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, the
13
length of tin securities are held after an unrealized
gain is evident, and the remaining life of the security at
the tin of sale; and
(6)
the reasons far the depository institution's engaging in
specific transactions/ and %tether these reasons are
consistent with the portfolio policy and strategies.
Some of the factors that also oust be considered to evaluate the depositary
institution's ability to continue to hold investment portfolio securities
include:
(1)
the sources end availability of funding;
(2)
the ability to meet margin cadis 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 going-concern and to liquidate assets in the
normal course of business.
14
lbs i V
Reporting of loons Held for Sale or Trading
Historically, depository institutions have tended to hold loans until maturity.
Consequently, the application of lower of cost or market value accounting to
portions of the loan portfolio has not been an issue except in these depository
institutions that have regularly originated or purchased loans far purposes of
subsequent sale. Nevertheless, as with debt securities, reporting loans at the
lower of cost or market value is required when the institution does not have
both the intent and ability to hold these loans far long-term 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
subsequently selling them at par once the yield approximates market is another
factor that will be considered when evaluating nanagemerit's intent.
Unsuitable Investment Practices
The following activities raise specific supervisory concerns. Ihe 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-far-sale portfolio.
Practices seven and eight involve an institution's transfer of control over
individual assets, segments of the portfolio, or the entire portfolio to
15
persons or occpanies unaffiliated with the institution. In such situations,
the depository institution clearly no longer has the ability to hold the
affected securities far investment purposes and such securities should be
reported as held far sale. The ninth practice is wholly unacceptable under all
circumstances.
In addition, certain of the following practices nay violate state law in
certain states. State-chartered depositary 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 nay also be held for trading or far sale.
16
■ 10511
In nary cases, "gains trading" involves the trading of "when-issued"
securities, the use of "pair-off" transactions (including transactions
involving off-balance sheet contracts), 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 awning a security and m y
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 m y 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 that is closed-out or
sold at, or prior to, settlement date or expiration date.
"Pair-offs"
m y also involve optional or mndatory off-balance sheet contracts (e.g.,
swaps, options on swaps, forward ocmnitments and options on forward
ccmnitments).
17
In a "pair-off", an investment portfolio manager will ocnmit to purchase
a security. Then, prior to the predetermined settlement date, the
portfolio manager will "pair-off" the purchase with a sale of the
security prior to, or on, the original settlement date, Refits 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 "when-issued" 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.
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
cne 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. In
addition, regular-way settlement for transactions in mortgage backed and
mortgage derivative products varies and can be up to 45 to 60 days after
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
appears to be offered by securities dealers in order to facilitate
18
10511
speculation on the part of the purchaser, similar to the profit
opportunities available in a "pair-off" transaction. The use of a
settlement period in excess of the regular-way settlement period
appropriate for an instrument and, in any event beyond 60 days, in order
to facilitate speculation is considered a trading activity.
5.
Repositioning Repurchase Agreements
A repositioning repurchase agreement is a funding technique often vised by
dealers who encourage speculation through the use of "gains trading,"
"pair-off," "when-issued trading," and "corporate or extended settlement"
transactions for securities which cannot be sold at a profit. The
repositioning repurchase agreement is a service provided by the dealer so
the buyer can hold the speculative position until it can be sold at a
gain. 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. Ary dealer financing technique such
as a repositioning repurchase agreement that is used to fund the
speculative 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 wholly unsuitable investment practice for
depositary institutions. Securities acquired in this manner should be
reported as either trading account assets or as securities held for sale.
19
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 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.
Delegation of Discretionary Investment Authority
Seme depository institutions have delegated the purchase and sale
authority far all or a portion of their investment securities portfolio
to a non-affiliated firm or to an individual who is not an enployee of
the institution or one of its affiliates. Such a delegation of authority
is intended to obtain a higher total return on the portfolio them the
institution would realize if it managed the portfolio itself. Wien an
institution has delegated such authority to a nen-affiliated firm or to
one or more individuals who are not employees of the depository
institution or its affiliates, then the depository institution no longer
20
losn
has the ability to control its own securities and all holdings far which
such authority has been delegated oust be reported as held far sale.
The centralized management of investment portfolios of affiliated
depository institutions by the parent holding ocopany or another
affiliate is not ordinarily considered to be the delegation of investment
authority.
Investment authority will also not be considered delegated to
unaffiliated parties when a depository institution's portfolio manager is
required to authorize a reoccmended purchase or sale transaction prior to
its execution and the portfolio manager, in practice, reviews such
reccnmendaticns and does, in fact, authorize such transactions.
8.
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 fee3 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.
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
report date.
21
Covered cell programs have been prenatal 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 will 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, the gain on a security covered by a written call
is 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 net similarly
limited.
In an effort to 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. Uiis practice can significantly increase
risks taken by the depository institution by contributing to a maturity
mismatch between its assets and its funding.
Institutions should only initiate a covered call program for securities
when the board of directors or an appropriate board oenmittee has
specifically approved a policy permitting this activity. Uiis policy
sust set forth specific procedures for controlling covered call
22
IDS! 7
strategies, including recordkeeping, reporting, and review of activity,
as well as providing far 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 security rests
with an outside party. Securities held far investment against which call
options have been written should therefore be redesignated as held far
sale and reported at the lower of cost or market value.
However, if an option contract requires the writer to settle in cash,
rather than by delivering an investment portfolio security, the
institution writing the option maintains the ability to hold the security
and, thus, the security may be reported as an investment. In this case,
the option must still be reported at the lower of cost or market value.
Covered call writing is not a permissible activity for Federal credit
unions.
"Adjusted Trading"
"Adjusted trading" is a practice involving the sale of a security to a
broker or dealer 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 or dealer is reimbursed for losses on
the purchase firm the institution and ensured a profit. Such
23
transactions inappropriately defer the recognition of losses on the
security sold and establish an excessive reported value far the newly
acquired security. Consequently, such transactions are prohibited and
say be in violation of 18 U.S.C. sections 1001-False Statements or
Entries and 1005-Fa!se Entries.
24
IOSI7
SECTION X U :
M2KIGAGE DERIVATIVE H O O C IS , OTHER ASSET BACKED PRODUCTS, AND
ZERD-OOUFON BONDS
Mortgage derivative products Include Collateralized Mortgage Obligations
("CMDs"), Real Estate Mortgage Investment Conduits ("KEMICs"), at) and REMIC
residuals, and Stripped Mortgage-Backed Securities ("SMBSs") • Xhe cash flows
from the mortgages underlying these securities are redirected to create two or
more classes with different maturity or risk characteristics designed to meet a
variety of investor needs and preferences.
Sane mortgage derivative products exhibit considerably more price volatility
than mortgages or ordinary mortgage pass-through securities and can expose
investors to significant risk of loss if not managed in a safe and sound
manner. Uiis price volatility is caused in part by the uncertain cash flows
that result frcm changes in the prepayment rates of the underlying mortgages.
In addition, because these products are perplex, a high degree of technical
expertise is required to understand how their prices and cash flows may behave
in various interest rate and prepayment envirorments. Moreover, because the
secondary market for sane of these products is relatively thin, they m y be
difficult to liquidate should the need arise. Finally, there is additional
uncertainty because new variants of these instruments continue to be introduced
25
and their price performance under varying market and eocncxnic conditions has
not been tested.
A general principle underlying this section is that mortgage derivative
products possessing average life or price volatility in excess of a benchmark
fixed rate 30-year mortgage-backed pass-through security are "high-risk
mortgage securities" and are not suitable investments. All high-risk mortgage
securities, as defined in detail below, acquired by depository institutions
after February 10, 1992, must be carried in the institution's trading account
or as assets held for sale. On the other hand, mortgage derivative products
that do not meet the definition of a high-risk mortgage security at the time of
purchase should be reported as investments, held-for-sale assets, or trading
assets, as appropriate.
Institutions must ascertain no less frequently than
annually that such products remain outside the high risk category.
Institutions that hold mortgage derivative products that meet the definition of
a high-risk mortgage security must do so to reduce interest rate risk in
accordance with safe and sound practices.4 Furthermore, depository
institutions that purchase high-risk mortgage securities must demonstrate that
they understand and are effectively managing the risks associated with these
‘Notwithstanding the provisions of this supervisory policy
requiring the use of high-risk mortgage securities to reduce
interest rate risk, this supervisory policy is not meant to
preclude an institution with strong capital and earnings and
adequate liquidity that has a closely supervised trading department
from acquiring high-risk mortgage securities for trading purposes.
The trading department must operate in conformance with welldeveloped policies, procedures, and internal controls, including
detailed plans prescribing specific position limits and control
arrangements for enforcing these limits.
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I0SI7
instruments. Levels of activity involving high-risk mortgage securities should
be reasonably related to an institution's capital, capacity to absorb losses,
and level of in-house management sophistication and expertise. Appropriate
managerial and financial controls must be in place and the institution oust
analyze, monitor, and prudently adjust its holdings of high-risk mortgage
securities in an envirorment of changing price and maturity expectations.
Prior to taking a position in any high-risk mortgage security, an institution
should conduct an analysis to ensure that the position will reduce the
institution's overall interest rate risk. An institution should also consider
the liquidity and price volatility of these products prior to purchasing them.
Circumstances in which the purchase or retention of high-risk mortgage
securities is deemed by the appropriate federal regulatory authority to be
contrary to safe and sound practioes for depository institutions will result in
criticism by examiners, who may require the orderly divestiture of high-risk
mortgage securities. Purchases of high-risk mortgage securities prior to
February 10, 1992, generally will be reviewed in accordance with
previously-existing s u p e r v is o r y policies.
Securities and other products, whether carried on or off the balance sheet
(such as CMD swaps, but excluding servicing assets), having risk
characteristics similar to high-risk mortgage securities will be subject to the
same supervisory treatment as high-risk mortgage securities.
Long-term zero coupon bonds also exhibit significant price volatility and m y
expose an institution to considerable risk. Disproportionately large holdings
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of these instruments nay be considered an imprudent investment practice, which
will be subject to criticism by examiners. In such instances, examiners nay
seek the orderly disposal of sane ar all of these securities. Assets slated
far disposal are reported as assets held for sale at the lower of cost or
market value.
Overview of the Securities
A.
SMBSs consist of two classes of securities with each class receiving a
different portion of the monthly interest and principal cash flows from the
underlying mortgage-backed securities ("MBS"). In its purest farm, an MBS is
converted into an interest-only ("IO") strip, where the investor receives all
of the interest cash flews 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 FOs have highly volatile price characteristics
based, in part, on the prepayment variability of the underlying mortgages.
Therefore, IOs and FOs will nearly always meet the definition of high risk in
this policy.
From a market perspective, IOs and FOs have relatively wide bid/ask spreads
cccpared to mortgage-backed securities. This decreases the effectiveness of
SMBSs as interest rate risk reduction tools from a price sensitivity
perspective because interest rates and prepayments need to change by a
significant amount before the price at which the security can be sold (i.e.,
the bid price) will exceed the price at which the security was purchased (i.e.,
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tbsn
the ask price) •
B.
OOs and REMICS, hereinafter called CM3S, have been developed in response
to investor concerns regarding the uncertainty of cash flows associated with
the prepayment option of the underlying mortgagor. A CM3 can be collateralized
directly by mortgages, but more often is collateralized by MBSs issued or
guaranteed by the Government National Mortgage Association (GNMA), Federal
National Mortgage Association (FNMA), or Federal Heme Loan Mortgage Corporation
(FHLMC) and held in trust for CM3 investors. In contrast to MBSs in which cash
flow is received pro rata by all security holders, the cash flow firm the
mortgages underlying a CM3 is segmented and paid in accordance with a
predetermined priority to investors holding various CM3 tranches. By
allocating the principal and interest cash flows from the underlying collateral
among the separate CM3 tranches, different classes of bonds are created, each
with its own stated maturity, estimated average life, coupon rate, and
prepayment characteristics. Notwithstanding the irportanoe of the CM3
structure to an evaluation of the timing and amount of cash flows, it is
essential to understand the coupon rates on the mortgages underlying the CM3 to
assess the prepayment sensitivity of the CM3 tranches.
C.
Residuals, in the traditional sense, are claims on any excess cash flows
from a CM3 issue or other asset-backed security regaining after the payments
due to the holders of the other classes and after trust administrative expenses
have been met. The economic value of a residual is a function of the present
value of the anticipated excess cash flows. These cash flews are highly
sensitive to prepayments and existing levels of mrket interest rates, and the
29
mortgages underlying the CMD most be understood in order to assess this
sensitivity. Accordingly, most of these residuals meet the definition of
high-risk in this policy. Other factors affecting the market value of
residuals include a lack of liquidity and a wide bid-ask price spread.
In addition, the 1986 legislation creating the KEMIC structure requires that
one class of each KEMIC issue be designated the residual interest for tax
purposes. Same of these REMIC residuals are not residuals in the traditional
sense.
However, these REMIC residuals also are subject to this policy statement.
Definition of "High-Risk Mortgage Security"
In general, any mortgage derivative product that exhibits greater price
volatility than a benchmark fixed rate thirty-year mortgage-backed pass-through
security will be deemed to be high risk. For purposes of this policy
statement, a "high-risk mortgage security" is defined as any mortgage
derivative product that at the time of purchase, or at a subsequent testing
date, meets any of the following tests.5 In general, a mortgage derivative
product that does not meet any of the three tests below will be considered to
be a "nonhigh-risk mortgage security."
*When the characteristics of a mortgage derivative product are
such that the first two tests cannot be applied (such as with IOs),
the mortgage derivative product remains subject to the third test.
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105
(1)
Average Life Test. The mortgage derivative product has an
expected weighted average life greater than 10.0 years.
(2)
Average Life Sensitivity Test. The expected weighted average life of the
mortgage derivative product:
a.
extends by more than 4.0 years, assuming an immediate and sustained
parallel shift in the yield curve of plus 300 basis points, or
b.
shortens by mare than 6.0 years, assuming an immediate and
sustained parallel shift in the yield curve of minus 300 basis
points.
(3)
Price Sensitivity Test. The estimated change in the price of the
mortgage derivative product is more than 17 percent, due to an immediate
and sustained parallel shift in the yield curve of plus or minus 300
basis points.6
6When performing the price sensitivity test, the same
prepayment assumptions and same cash flows that were used to
estimate average life sensitivity must be used.
The only
additional assumption is the discount rate assumption.
First, assume that the discount rate for the security equals the
yield on a comparable average life U.S. Treasury security plus a
constant spread. Then, calculate the spread over Treasury rates
from the bid side of the market for the mortgage derivative
product.
Finally, assume the spread remains constant when the
Treasury curve shifts up or down 300 basis points. Discounting the
aforementioned cash flows by their respective discount rates
estimates a price in the plus and minus 300 basis point
environments.
The initial price will be determined by the offer side of the
market and used as the base price from which the 17 percent price
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In applying any of the above tests, all of the underlying assumptions
(including prepayment assumptions) far the underlying collateral must be
reasonable. All of the assumptions underlying the analysis must be available
far examiner review. For example, if an institution's prepayment assumptions
differ significantly from the median prepayment assumptions of several major
dealers as selected by examiners, the examiners may use these median prepayment
assumptions in determining if a particular mortgage derivative product is high
risk.
The above tests say be adjusted in the event of a significant movement in
market interest rates or to fairly measure the risk characteristics of new
mortgage-backed products. Furthermore, each agency reserves the right to take
such action as it deems appropriate to prevent circumvention of the definition
of a high-risk mortgage security and other standards set forth in this policy
statement.
Generally, a CMD floating-rate debt class will not be subject to the average
life and average life sensitivity tests described above if it bears a rate
that, at the time of purchase or at a subsequent testing date, is below the
contractual cap on the instrument.
(An institution may purchase interest rate
contracts that effectively uncap the instrument.) For purposes of this policy
statement, a CM3 floating-rate debt class is a debt class whose rate adjusts at
least annually on a one-for-cne basis with the debt class's index. The index
must be a conventional, widely-used market interest rate index such as the
sensitivity test will be measured.
32
London Interbank Offered Rate (LTBCR). Inverse floating rate debt classes are
not included in the definition of a floating rate debt class.
Supervisory Policy f a r Mortgage Derivative Products
Prior to purchase, a depository institution aust determine whether a mortgage
derivative product is high-risk, as defined above. A prospectus supplement or
other supporting analysis that fully details the cash flows covering each of
the securities held by the institution should be obtained and analyzed prior to
purchase and retained for examiner review. In any event, a prospectus
supplement should be obtained as soon as it becomes available.
Nonhiah-risk Mortgage Securities
Mortgage derivative products that do not meet the definition of high-risk
mortgage securities, at the time of purchase should be reported as investments,
held-for-sale assets, or trading assets, as appropriate.
Institutions must ascertain and document prior to purchase and no less
frequently than annually thereafter that nonhigh-risk mortgage securities that
are held for investment remain outside the high-risk category.
If am
institution is unable to make these determinations through internal analysis,
it must use information derived from a source that is independent of the party
from whan the product is being purchased. Standard industry calculators used
33
in the mortgage-related securities marketplace are acceptable and are
considered independent sources. In order to rely on such independent analysis,
institutions are responsible for ensuring that the assumptions underlying the
analysis and the resulting calculation are reasonable. Such documentation will
be subject to examiner review.
A mortgage derivative product that was not a high-risk mortgage security when
it was purchased as an investment may later fall into the high-risk category.
If this occurs, the mortgage derivative product must be redesignated as held
for sale or trading. Once a mortgage derivative product has been designated as
high-risk, it may be redesignated as nonhigh-risk only if, at the end of two
consecutive quarters, it does not meet the definition of a high-risk mortgage
security. Upon redesignation as a nonhigh-risk security, it does not need to
be tested for another year.
High-Risk Mortgage Securities
An institution may only acquire a high-risk mortgage derivative product to
reduce its overall interest rate risk. (Institutions meeting the guidance
established in footnote 4 may also purcha.se these securities for trading
purposes.) An institution that has acquired high-risk mortgage securities to
reduce interest rate risk needs to manage its holdings of these securities
because of their substantial prepayment and average life variability. Such
management inplies that the institution does not have both the intent and
ability to hold high-risk mortgage securities for long-term investment
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i05< 7
purposes. Accordingly, high-risk mortgage securities that are being used to
reduce interest rate risk should not be reported as investments at amortized
cost, but must be reported as trading assets at market value or as held-farsale assets at the lower of cost or market value.
In appropriate circumstances, examiners may seek the orderly divestiture of
high-risk mortgage securities that do not reduce interest rate risk. These
securities must be reported as held-far-sale assets at the lower of cost or
market value.
An institution that owns or plans to acquire high-risk mortgage securities must
have a monitoring and reporting system in place to evaluate the expected and
actual performance of such securities. The institution must conduct an
analysis that shows that the proposed acquisition of a high-risk mortgage
security will reduce the institution's overall interest rate risk. Subsequent
to purchase, the institution must evaluate at least quarterly whether this
high-risk mortgage security has actually reduced interest rate risk.
The institution's analyses performed prior to the purchase of high-risk
mortgage securities and subsequently thereafter must be fully documented and
will be subject to examiner review. This review will include an analysis of
all assumptions used by management regarding the interest rate risk associated
with the institution's assets, liabilities and off-balance sheet positions.
Analyses performed and records constructed to justify purchases on a
post-acquisition basis are unacceptable and will be subject to examiner
criticism. Reliance on analyses and documentation obtained from a securities
35
dealer or other outside party without internal analyses by the institution are
unacceptable and reliance on such third-party analyses w ill be subject to
examiner criticism.
Management should also maintain documentation demonstrating that it took
reasonable steps to assure that the prices paid far high-risk mortgage
securities represented fair market value. Generally, price quotes should be
obtained from at least two brokers prior to executing a trade. If, because of
the unique or proprietary nature of the transaction or product, or for other
legitimate reasons, price quotes cannot be obtained from more than one broker,
ranagemerrt should document the reasons far not obtaining such quotes.
In addition, a depository institution that owns high-risk mortgage securities
most demonstrate that it has established the following:
(1)
A board-approved portfolio policy which addresses the goals and
objectives the institution expects to achieve through its securities
activities, including interest rate risk reduction objectives with
respect to high-risk mortgage securities?
(2)
Limits on the amounts of funds that m y be permitted to high-risk
mortgage securities;
(3)
Specific financial officer responsibility for and authority over
securities activities involving high-risk mortgage securities?
36
(4)
Adequate infcarnation systems
(5)
Procedures fear periodic evaluation of high-risk mortgage securities and
their actual performance in reducing interest rate risk; and
(6)
Appropriate internal controls.
Ihe beard of directors, or an appropriate ccnmittee thereof, and the
institution's senior management should regularly (at least quarterly) review
all high-risk mortgage securities to determine whether these instruments are
adequately satisfying the interest rate risk reduction objectives set forth in
the portfolio policy. The depository institution's senior management should be
fully knowledgeable about the risks associated with prepayments and their
subsequent inpact on its high-risk mortgage securities.
Failure to ocxrply with this policy will be viewed as an unsafe and unsound
practice.
Purchases of high-risk mortgage securities prior to February 10, 1992,
generally will be reviewed in accordance with previously-existing supervisory
policies.
Securities and other products, whether carried on or off the balance sheet
(such as CMD swaps, but excluding servicing assets), having characteristics
similar to those of high-risk mortgage securities will be subject to the same
supervisory treatment as high-risk mortgage securities.
37
Supervisory P o licy for O ther Zero-Coupon, S trip p ed or O riginal
Issu e D iscount (dD ) Products
Zero-coupon, "stripped" and certain Original Issue Discount ("onP) securities
are priced at large discounts to their face value prior to maturity and exhibit
significant price volatility.
"Stripped" securities are the interest or
principal portions of U.S. Government obligations (uhich are separated and sold
to depository institutions in the farm of stripped coupons ar stripped bonds
(principal)), STREPS, and such proprietary products as CATs or TIGRs.7 Also,
deep discount OID bonds have been issued by a number of municipal entities.
Although considered free from credit risk if issued directly by the U.S.
Govemnent, longer maturities of zero coupon, stripped, and deep discount OID
products (generally, remaining maturities exceeding ten years) have displayed
extreme price volatility. Therefore, disproportionately large long-maturity
holdings of these instruments, in relation to the toted investment portfolio or
total capital of the depository institution, are considered an inprudent
investment practice. Such holdings will be subject to criticism by examiners
7STRIPS (Separate Trading of Registered Interest and Principal
of Securities) is the U.S. Treasury program that permits separate
trading and ownership of the interest and principal payments on
certain long-term U.S. Treasury note and bond issues that are
maintained in the book-entry system operated by the Federal Reserve
Banks. CATs (Certificates of Accrual on Treasury Securities) and
TIGRs (Treasury Investment Growth Receipts) are proprietary names
for a form of coupon stripping that has been developed by
securities firms.
The securities firm purchases U.S. Treasury
securities, delivers them to a trustee, and sells receipts
representing the rights to future interest and/or principal
payments from the U.S. Treasury securities held by the trustee.
38
who say seek the orderly disposal of sene or all of these securities.
Securities slated for disposal Bust be reported as held-for-sale assets at the
lower of cost or market value.
Other Considerations
Several states have adopted, or are considering, regulations that prohibit
state-chartered banks from purchasing interest-only strips or other securities
discussed above.
Accordingly, state-chartered institutions should consult
with their state regulator concerning the permissibility of these purchases.
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@FedFRASER