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Report of the
Joint Treasury- SEC- Federal Reserve

Study of the Government-Related
Securities


Federal Reserve Bank of St. Louis

Markets

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t}£Co5

20fl1

Board


Federal Reserve Bank of St. Louis

0.3

Report of the
Joint Treasury- SEC- Federal Reserve

Study of the Government-Related
Securities

Markets

December 1980


Federal Reserve Bank of St. Louis

Board


Federal Reserve Bank of St. Louis

PREFACE

The following study of the government-related securities markets

was prepared by the Department of the Treasury, the Federal Reserve System
and the Securities and Exchange Commission (SEC) pursuant to a request by

Senator Harrison A. Williams, Jr., Chairman of the Subcommittee on Housing
and Urban Affairs, for information and advice on problems arising in these

markets, particularly in the forward market for mortgage-backed securities

guaranteed by the Government National Mortgage Association.
The study deals only with the cash and forward markets for certain

government-related securities and does not attempt an evaluation of either
the futures market for these securities or the proposed options market in

the same securities.
It should be noted that, although the Treasury staff has fully

participated in this study, the Administration has not taken a position on
the study's recommendations.

The SEC and the Board of Governors of the

Federal Reserve System have endorsed the recommendations.


Federal Reserve Bank of St. Louis


Federal Reserve Bank of St. Louis

TABLE OF CONTENTS

Page
I.

Introduction and Summary of Study's Conclusions
and Recommendations

II.

Overview of Federal and Federally Assisted Borrowing
In Securities Markets

III.

Review of Major Characteristics of Markets for
Government Related Securities

24

— U.S. Treasury Securities
— Government Sponsored Agency
Securities
C — Government National Mortgage

Appendix A
Appendix B
Appendix

—

Review of Cases of Abusive Trading Practices in
Markets for Government Related Securities and
of Regulatory Measures to Reduce Such Problems

Appendix

— SEC

83

91

.......

Investigations of Cases of Abusive
Trading Practices

— State

176

Regulatory Actions

201

Federal Regulation of Brokers and Dealers in
Government Related Securities: Analysis,
Conclusions and Recommendations

Appendix A

Appendix B


Federal Reserve Bank of St. Louis

104

140

Review of Recent Actions by Federal Regulators
and Industry Participants to Reduce Abusive
Trading Practices
Appendix

VI.

66

—

Appendix E

V.

58

Association Guaranteed
Mortgage-Backed Securities
Federal Home Loan Mortgage
Corporation Mortgage-Backed
Securities
Government Guaranteed Securities
(Other than Mortgage-Backed
Securities)

Appendix D

IV.

49

205

— Discussion

of Losses and Costs
of Regulation

— Government

Related Securities Act of 1980

230

....

236


Federal Reserve Bank of St. Louis

CHAPTER

I

INTRODUCTION AND SUMMARY OF STUDY'S CONCLUSIONS
AND RECOMMENDATIONS

This report presents the results of a study of markets for government

guaranteed securities and other related securities that has been conducted
jointly by the U.S. Treasury, the Federal Reserve and the Securities and
Exchange Commission (SEC).

The study was prompted by the widespread problems

attributable in great part to abusive trading practices

— recorded

in government

guaranteed securities markets in recent years, particularly the market for

mortgage-backed securities guaranteed by the Government National Mortgage
Association (GNMA).

Trading activities in these markets are currently exempt

from federal regulation

— except

for the SEC's antifraud authority.

The purpose

of the study was thus to consider whether federal regulation should be extended
to these markets, and,

if so, to develop proposals for how this might best be

accomplished.
In the course of the study, interviews were conducted with federal

agencies that either guarantee or issue securities currently exempted from SEC

regulations or are responsible for regulating financial institutions that
invest in such securities.

Interviews were also held with various entities in

the private sector including interested trade associations, issuers, dealers

and investors in government guaranteed securities. 1/

The cases in which the

SEC has instituted actions in response to complaints about abusive practices
in government related securities have also been reviewed.

Other background

information was obtained from within the agencies conducting the study.

1/

See list of those interviewed at the end of this chapter.


Federal Reserve Bank of St. Louis

- 2 -

The following chapters present the results of these efforts.

Chapter

II provides a broad overview of federal and federally assisted borrowing and

reviews the history of legislation that has exempted such debt securities from
SEC regulation.

Chapter III presents a summary review of the major character-

istics of securities, the market participants, and the trading practices in the

government related securities markets.

The discussion is supplemented by five

appendices that provide more detail on the market sectors described.

Chapter

IV provides a review of problems and abuses that have developed in various

sectors of the government related securities market and an analysis of regu-

latory measures that, if imposed, would reduce such abusive practices.

An

appendix providing a detailed review of cases in which the SEC has instituted
legal actions accompanies this chapter.

Chapter V reviews the various actions

taken by federal agencies charged with regulating issuers of and investors in

government guaranteed mortgage-backed securities and other government related
securities, and also discusses the efforts made by the securities industry to

establish a self-regulatory framework.
Finally, Chapter VI examines the question whether regulation should
be extended to brokers and dealers in government related securities and sets

forth conclusions and recommendations.

These conclusions and recommendations

are summarized in the following sections of this chapter.

They are also embo-

died in a legislative proposal that is being submitted by the three agencies
in connection with this study.

Appendix B to Chapter VI.


Federal Reserve Bank of St. Louis

That legislative proposal is presented as

- 3 -

Conclusions

After carefully reviewing and evaluating problems which have arisen
in the trading of government related securities and taking into account the

opinions of other interested federal agencies and market participants, it is
the joint view of the Treasury, Federal Reserve and SEC that there is need to

extend government regulation to forward trading in GNMA guaranteed mortgage-

backed scurities.

Losses suffered by market participants trading in these

securities have been substantial.

It is recognized that the potential for

problems to develop in the future has been reduced as a result of the rules
and guidelines imposed by GNMA on issuers and by federal regulatory authori-

ties on financial institutions that Invest in these securities.

serious abuse, however, appear to remain unacceptably great.

Prospects for

Tn particular,

it is still possible to assume large positions in GNMA securities for long

delayed delivery without being required to provide an initial or maintenance

margin

— the

practice that has contributed to a high degree of speculative

activity and, thus, to losses incurred by dealers and investors in these
securities.

To date, there have been only a few instances in which investors
have incurred losses in forward transactions in mortgage-backed securities

guaranteed by the Federal Home Loan Mortgage Corporation (FHLMC) because of
abusive trading practices.

Nevertheless, these securities are also traded

on a forward delivery basis without margin, and thus the potential exists for
serious problems to develop in this market sector similar to those recorded
in GNMA forward trading.


Federal Reserve Bank of St. Louis

Accordingly, it has been concluded that forward

- 4 -

trading In FHLMC guaranteed mortgage-backed securities should come under the
same mantle of regulation as that Imposed on GNMA forwards.
As for the other sectors of the government and government related

securities markets, it appears that the small number of problems in these
sectors does not presently warrant elimination of the exemption of these

securities from formal federal regulation (except for the SEC's antifraud
statutes).

There have been only a few cases of abusive practices that have

involved these other sectors, and losses have been relatively small compared

with those recorded in mortgage-backed securities as well as with the total
volume of transactions in these markets.

Moreover, a major portion of these

markets is subject to the informal oversight of the Federal Reserve System
and the Department of the Treasury.

Recommendations
The regulatory system that appears best suited to extend regulation

over forward trading in GNMA and FHLMC guaranteed mortgage-backed securities
is one based on self regulation with governmental oversight, a system that

has worked well in other sectors of the financial markets.

Accordingly, it

is proposed that a new self-regulatory organization, which would be named

the Federal Mortgage-Backed Securities Rulemaking Board (Board), be estab-

lished to promulgate rules to be followed by brokers and dealers trading on
a forward basis in GNMA and FHLMC guaranteed mortgage-backed securities.

This "Board" would be composed of representatives of bank and nonbank securities dealers and public representatives, including investors.


Federal Reserve Bank of St. Louis

It would have

- 5 -

authority to set initial margin and margin maintenance requirements for forward transactions in GNMA and FHLMC securities.

In addition, if deemed neces-

sary, it could establish financial and fair practice standards and other rules.

The proposed Board would exercise rulemaking authority subject to the
oversight of a Council composed of the Secretary of the Treasury, the Chairman
of the Federal Reserve Board, and the Chairman of the Securities and Exchange

Commission, or their respective designees.

The Council would have the power

to approve or disapprove the rules of the Board and to abrogate, add to, or

delete from such rules.

Before taking actions that would affect trading prac-

tices in markets for GNMA and FHLMC securities, the Council would be required
to request and consider the views of GNMA and FHLMC.

Brokers and dealers,

including bank dealers, trading in GNMA and FHLMC securities on a forward
basis would be required to register with the Council, although the Council

would delegate this registration function, in the first instance, to the
SEC.

Clearing agencies for forward trading in GNMA and FHLMC securities

would also be subject to registration and oversight.

Governmental entitles other than the Council would also be assigned
certain direct rulemaking responsibilities.

While the Board's margin setting

authority would be exercised under the general review of the Council, the
Federal Reserve Board would be given residual rulemaking authority in this
area, and any margin rules it might promulgate would take precedence over

those of the Board.

Also, the SEC would have antlfraud rulemaking authority.

All nonbank securities dealers trading in GNMA and FHLMC securities on a
forward basis, moreover, would be required to become members of the Securities

Investors Protection Corporation (SIPC) and subject to its requirements.


Federal Reserve Bank of St. Louis

- 6 -

To assure compliance with the rules promulgated by the Board, pri-

mary inspection and enforcement authority would be allocated to the National
Association of Securities Dealers (NASD), national securities exchanges, and
the federal bank regulatory agencies, with concurrent enforcement authority
in the SEC.

This is similar to the division of responsibilities currently

followed in ensuring compliance with rules established by the Municipal
Securities Rulemaking Board.

Thus, such an approach would appear likely to

minimize costs associated with such activities for both the government and
securities dealers.
It is proposed that the Board be given authority, subject to unani-

mous approval of the Council, to extend regulatory controls to cash trans-

actions in regulated securities where necessary or appropriate with respect
to the regulation of forward transactions.

Further, the Council would have

the authority, by unanimous vote, to extend regulation to transactions in

other government related securities (but not to Treasury securities).

While

such an extension of federal regulation does not appear to be necessary at
the present time

— except

perhaps to the extent that effective regulation of

forward transactions in GNMA and FHLMC securities may require some regulation
of the cash markets

— the

availability of this authority would facilitate

such actions, should this be warranted by future developments.


Federal Reserve Bank of St. Louis

- 7 -

FIRMS AND ORGANIZATIONS INTERVIEWED

I.

Government Securities Dealers
A.G. Becker, Inc., New York
Carty & Company, Memphis
The First Boston Corporation, New York
Merrill Lynch Government Securities, Inc., New York
Paine, Webber, Jackson & Curtis, Inc., New York
Salomon Brothers, Inc., New York

II.

Regulatory Agencies
Arkansas Securities Department
Bradford Securities Processing Corporation
Federal Deposit Insurance Corporation
Federal Home Loan Bank Board
Federal Home Loan Mortgage Corporation
Federal National Mortgage Association
Government National Mortgage Association
Municipal Securities Rulemaking Board
National Association of Securities Dealers, Inc.
National Credit Union Administration
Office of the Comptroller of the Currency
Securities Investor Protection Corporation
Small Business Administration
Texas Securities Board

III.

Mortgage Issuers
Cameron-Brown Company, Raleigh
The Lomas & Nettleton Company, New Haven

IV.

Trade Associations
Mortgage-Backed Securities Assocation
Public Securities Association

V.

Investors
Greater New York Savings Bank, New York
Several individual investors, Memphis

VI.

Others
Arthur Young & Company, Houston
Baker & Botts, Houston
Francis J. Scott, Memphis (Presently co-trustee in bankruptcy
for G. Weeks Securities, Inc.)
Mortgage-Backed Securities Clearing Corporation


Federal Reserve Bank of St. Louis

CHAPTER II

OVERVIEW OF FEDERAL AND FEDERALLY ASSISTED BORROWING
IN SECURITIES MARKETS

This chapter provides a brief overview of the major categories of
federal and federally-assisted obligations that are exempt from regulation by
SEC,

their growth over the past decade, and the general trends in the methods

of Federal financing in the securities markets.

This chapter also discusses

the role of the Federal Financing Bank in determining the future development

and growth of programs of guaranteed obligations financed directly in the

securities markets.

A fuller discussion of the characteristics of these

securities is presented in Chapter III.

Classes of Obligations
The market for federal and federally-assisted obligations consists

of (1) obligations issued by federal agencies (currently the Treasury is the

only federal agency issuing obligations in the market, although

a

small amount

of debt previously issued by other federal agencies remains outstanding in the

market),

(2) obligations issued by government-sponsored agencies

(i.e.,

federally

chartered but privately owned agencies), and (3) obligations guaranteed by
federal agencies.

These three classes of obligations, which are described below,

are referred to in the U.S. Budget documents as "borrowing under federal

auspices" or as "federal and federally-assisted borrowings".

The amounts of

these various obligations outstanding over the past ten years are shown in the

tables attached to this chapter.

SEC Exemption

These federal and federally-assisted obligations, as well as obli-

gations of international financial institutions, such as the International Bank

Federal Reserve Bank of St. Louis

- 9 -

for Reconstruction and Development,

are exempt from regulation by the Securities

and Exchange Commission, except for the anti-fraud provisions of the SEC statutes.

However, the issuance of federal and federally-assisted obligations is subject
to the supervision of federal agencies, other than the SEC, with direct responsi-

bilities to the Congress to provide for the efficient financing of the public
debt and of various programs to assist housing, agriculture, small business,

education and many other sectors of the economy.
As discussed in Chapter IV, the laws administered by the Securities
and Exchange Commission generally exempt from regulation "any security issued
or guaranteed by the United States".

1/

Moreover the laws authorize the SEC

to exempt either by rule or regulation certain securities, as necessary or

appropriate in the public interest or for the protection of investors.

Using

this authority, the SEC has adopted a rule classifying mortgages and interest
in mortgages sold by the Federal Home Loan Mortgage Corporation as exempted

securities. IJ

The Securities Exchange Act of 1934 authorizes the Secretary

of the Treasury to exempt securities issued or guaranteed by corporations in

which the United States has

\J

a

direct or indirect interest.

Under this authority

section 3(a)(2) of the Securities Act of 1933 (15 U.S.C.
section 3(a)(12) of the Securities Exchange Act of 1934 (15
U.S.C. 78 c(a)(12)), and Section 304(a)(4) of the Trust Indenture Act of
1939 (15 U.S.C. 77 ddd(a)(4)).
See,

for example,

77 c(a)(2)),

V

Rule 3al2-l, 17 CFR 240.3al2-l,
The SEC adopted this rule in light of "the
congressionally determined public need for more capital in mortgages,
FHLMC's abilities and desire to regulate this field to the extent necessary
and the probable lack of small investor participation." 37 Fed. Reg.
25166-67 (Nov. 28, 1972).


Federal Reserve Bank of St. Louis

- 10 -

the Secretary of the Treasury has designated certain obligations issued by

government-sponsored agencies, such as the Federal Land Banks, and the Federal
Intermediate Credit Banks, as exempt securities,

"hj

In addition to the general exemptions contained in federal securities
laws,

the charter acts for several federal agencies

4^/,

agencies 5/, and international financial institutions

6^/

federally-sponsored
provide that securities

issued or guaranteed by these agencies shall be treated as exempt securities.
The exemption of federal and federally-assisted securities from SEC

regulation is based in part on the unquestioned integrity of federal agencies
and the credit quality of their securities, which eliminates the need for dis-

closure of information relating to the financial condition of the issuer Ij and
also makes these obligations less subject to abuses in secondary market trading

compared to other securities which are more speculative in nature.

ZJ

Securities Exchange Act Releases No. 34-14853 (June 27, 1978) (Farm Credit
Investment Bonds); 34-13190 (Feb. 1, 1977) (consolidated systemwide bonds);
34-11258 (Feb. 19, 1975) (notes); 34-8829 (May 6, 1970) (Farm Credit
Investment bonds).

4/

E.g., Government National Mortgage Association,
Financing Bank, 12 U.S.C. 2290(b).

~

_5/

12 U.S.C.

1723c; Federal

E.g., Federal National Mortgage Association, 12 U.S.C. 1719(d),
Student Loan Marketing Association, 20 U.S.C. 1087-20(1).

1723c;

6/

E.g., International Bank for Reconstruction and Development, 22 U.S.C.
286K-l(a); Inter-American Development Bank, 22 U.S.C. 283h(a).

7/

Hearings before House Comm. on Interstate and Foreign Commerce on H.R, 7852
and H.R. 8720, 73d Cong., 2d Sess. 818 (1934) (Federal government has
"strongest credit of all [issuers]"); Hearings before the House Comm. on
Interstate and Foreign Commerce on H.R. 4314, 73d Cong., 1st Sess. 110
(1933) (Federally-issued securities "unquestionably sound").

~

~


Federal Reserve Bank of St. Louis

- 11 -

Growth of Exempt Securities Markets
The pre-1970 period

.

Prior to 1970 the exempt government securities

markets consisted almost entirely of (1) direct Treasury debt issues under the
surveillance of the Treasury and its fiscal agents, the Federal Reserve Banks,
and (2) sponsored agency debt issues under the surveillance of the privately-

owned issuing agencies (and their federal supervisory agencies):

Federal

National Mortgage Association (Department of Housing and Urban Development),
the Federal Home Loan Banks (Federal Home Loan Bank Board) and the Federal

farm credit banks (Farm Credit Administration).

These markets were well-

established and highly competitive.
While guaranteed obligations prior to 1970 were financed largely

by traditional mortgage lenders, rather than in the securities markets, there

were several notable exceptions such as the Government National Mortgage Association (GNMA) participation certificates (PCs

—not

to be confused with

GNMA

mortgage pass-through certificates) in pools of loans sold in the late 1960's,
public housing bonds, Farmers Home Administration notes, and small business
investment company (SBIC) debentures.

These guaranteed security issues in the

market have since been discontinued, not for regulatory reasons, but for budget
and debt management reasons.

The GNMA participation certificates were discon-

tinued after the adoption of the Unified Budget in 1968, which required that

GNMA PCs be treated as a means of financing rather than as asset sales (which
reduced budget outlays), the effect of which was to eliminate the immediate
budget advantage of PC sales.

The marketing of guaranteed securities had

resulted in excessive financing costs and competition with direct Treasury
issues, and these concerns led to the enactment of the Federal Financing Bank


Federal Reserve Bank of St. Louis

- 12 -

Act of 1973, which created the Federal Financing Bank ("FFB") and provided for

consolidated financing by the Treasury of obligations issued, sold, or guaranteed by federal agencies.

Consequently, new issues of guaranteed public housing

bonds, SBIC debentures. Farmers Home notes, and certain other guaranteed securi-

While the volume of these guaranteed

ties are no longer financed in the market.

securities issued in the market had been substantial, they were sold mainly by
the federal guaranteeing agencies themselves, by means of asset sales and other

consolidated financing techniques, and these markets were largely free of
reported abuses.
The post-1970 period

.

The decade of the 1970

's

was a period of

extraordinary growth in federal and federally-assisted borrowing because the

Treasury was required to finance a succession of large budget deficits (the
last budget surplus was in fiscal year 1969) and off-budget federal credit

assistance programs were expanded in virtually all sectors of the economy.

With growing pressures to reduce budget deficits, and as record
increases in market rates of interest led to disintermediation and the drying
up of traditional sources of mortgage funds,

federal agencies turned increas-

ingly to the use of guaranteed securities, rather than direct budget loans, as
a

means of tapping the bond market to fund their programs.

Agency guarantees

of obligations issued directly in the securities markets served to by-pass both
the Treasury (and thus the budget) and to some extent the financial interme-

diaries which had traditionally been the main source of funds for many programs.
In the fiscal years 1970-1979,

total federal and federally-assisted

borrowing from the public increased by $604 billion, from $409 billion outstanding at the end of fiscal 1969 to $1,013 billion outstanding on September 30,


Federal Reserve Bank of St. Louis

1979

13

(see table 1).

Three fifths of the amount outstanding on September 30,

1979,

or

$645 billion, was direct federal debt, virtually all in the form of Treasury

securities.

Federal agencies other than the Treasury (e.g., Tennessee Valley

Authority, U.S. Postal Service, and Export-Import Bank) reduced their outstanding borrowings from the public over the period by about $6 billion.

These

agencies now finance their activities through the FFB.
The outstanding Treasury debt included $64 billion of Treasury

issues required to finance the activities of the Federal Financing Bank.

As

discussed more fully below, in the absence of the FFB, most of these activities
would have been financed with

a

variety of government-guaranteed securities

issued directly in the securities markets and,

like Treasury securities, would

have been exempt from SEC regulation.

Federally-guaranteed borrowing increased from $110 billion in 1970
to $228 billion in 1979,

including $70 billion of GNMA guarantees of mortgage-

backed securities (see table 2).
of guaranteed obligations.

Over the period, the FFB purchased $47 billion

In fiscal year

1979,

GNMA and the FFB accounted

for about 80 percent of the net increase in outstanding guaranteed loans.

Borrowing by federally-sponsored agencies increased from $32 billion
to $140 billion over the 1970-79 period,

largely because of the housing support

activities of FNMA and the FHLBB system (see table 3).

Government-Sponsored Agency Debt
The federally-sponsored credit agencies consist of seven federally

chartered but privately-owned agencies which provide credit for agriculture,
housing, and education.


Federal Reserve Bank of St. Louis

They are essentially financial intermediaries,

14

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Federal Reserve Bank of St. Louis


Federal Reserve Bank of St. Louis

-

15

-


Federal Reserve Bank of St. Louis

16

17

borrowing in the securities market and relending the borrowed funds for
specifically authorized purposes.
The agricultural credit agencies are the Federal Land Banks,

created in 1916; the Federal Intermediate Credit Banks, established in
1923; and the Banks for Cooperatives, created in 1933.

Serving the housing

sector is the Federal Home Loan Bank System, created in 1932, its wholly-

owned subsidiary, the Federal Home Loan Mortgage Corporation (FHLMC) created
in 1970,

and the Federal National Mortgage Association (FNMA), initially

established in 1938 and restructured in 1954 and 1968.

The Student Loan

Marketing Association (SLMA), created pursuant to 1972 legislation, provides
secondary market support for guaranteed student loans.

Obligations of these government-sponsored agencies are issued with
the approval of or in consultation with the Treasury.
the Federal Home Loan Banks and FNMA,

Also, in the case of

the Secretary of the Treasury is autho-

rized to lend up to $4 billion and $2.25 billion, respectively, to these
institutions.

Yet the law specifies that their obligations are not obliga-

tions of the United States, and they are not guaranteed by the government

except for certain mortgage-backed bonds issued by FNMA and FHLMC and guar-

anteed by the Government National Mortgage Association.

(Obligations of SLMA

are guaranteed by HEW, but SLMA borrows exclusively from the FFB.)

Neverthe-

less, sponsored agency obligations enjoy an excellent standing in the credit

markets because of the long record of successful operations by these agencies
and their close association with the government.


Federal Reserve Bank of St. Louis

18 -

Federally-sponsored agency obligations share many of the
characteristics of Treasury securities.

—

For example, they are:

Lawful investments and may be accepted as security for
all fiduciary, trust and public funds, including Treasury

tax and loan accounts, the investment or deposit of which
is under the authority of any officer of the United States.

—

Eligible for Federal Reserve Bank open market purchases.

--

Eligible as collateral for Federal Reserve Bank advances
to member banks

—

Eligible for purchase by national banks without restriction.

Eligible for investment by federally-chartered savings and
loan associations and federally-chartered credit unions.

Government-Guaranteed Debt
In addition to providing credit through the vehicle of the government-

sponsored credit agencies, the Federal Government also provides credit assistance
in the form of direct loans made by Federal agencies and financed by the Treasury
or by the FFB and agency guarantees of loans financed by the FFB or other lenders.

The original loan guarantee programs were not financed in the securities markets.

The federal government guaranteed mortgages and other loans made

by local lending institutions which serviced the loans through direct contact
with the borrowers and generally assumed a portion of the loan risk.

The

classic example of this guarantee approach was the highly successful program
of FHA single family mortgage insurance.


Federal Reserve Bank of St. Louis

This program assured private lenders

-

that they could safely make long-term,

19

low down payment mortgage loans at

reasonable rates of interest, thus filling an important credit gap.

Since

establishment of the FHA in the 1930's, the guarantee technique has been
expanded to provide credit assistance to

a

wide variety of housing and other

areas such as agriculture, education, economic development, export financing,
small business, transportation, and energy.

Shift to securities market financing

.

Prior to 1973,

a

number of

trends fostered the development of direct securities market financing of

guaranteed loans:

—

A broadening of the guarantee instrument from the direct
mortgage insurance provided by FHA to such indirect but
equally effective guarantees as purchase and lease agreements,
contracts to make debt service grants, price support agreements
or commitments by Federal agencies to make direct take out loans
in the event of default on a private obligation.

These and other

arrangements have been used to provide federal backing for securities market issues, they are included in the definition of

guaranteed obligations in the Federal Financing Bank Act of 1973,
and they are generally classified as guaranteed obligations in

the Budget of the United States.

—

A reduction in private lender participation in risk assumption as
full guarantees of principal and interest became widespread.

A shift away from direct government loans to guaranteed loans
financed in the market in part to escape the budget discipline.


Federal Reserve Bank of St. Louis

20

—

Reduced reliance on local private lenders in favor of direct
agency debt (Eximbank), sale of agency assets in the form of

certificates of beneficial ownership (Farmers Home Adminisration)
loan pooling arrangements (Farmers Home Administration, SBA and

other loans), and by federal guarantees of other securities (GNMA

mortage-backed securities, public housing and urban renewal notes
and bonds, WMATA bonds, new community debentures, and merchant

marine bonds).

This shift to bond market financing had grown to such extent that by the time
the Federal Financing Bank Act was enacted in 1973 some form of Federal or

federally-assisted financing was coming to market on three out of every
five business days.

Creation of the FFB

.

The proliferation of federal and federally-

guaranteed obligations financed directly in the securities markets led to
market congestion and higher borrowing costs.

Borrowing costs on federally-

backed credit other than Treasury obligations, that is, agency securities and

federally-guaranteed private issues, are higher because of the small size of
issues, maturity and cash flow constraints, problems in developing markets for

new issues, investor portfolio restrictions, underwriting costs, and market
congestion resulting from crowding of competing issues in the financing calendar.
Additional costs were incurred because agencies that were selling securities
directly in the market were required to develop their own financing staffs to
cope with complex debt management and regulatory problems that diverted resources

away from principal program functions.


Federal Reserve Bank of St. Louis

- 21

Creation of the FFB substantially alleviated these problems.
the close of fiscal year 1979,

At

the FFB held $64 billion of federal agency

and federally-guaranteed obligations, most of which would have been sold

directly in the securities market in the absence of the FFB.

Because of

the FFB, the growth of the guaranteed securities market, other than GNMAs,

was sharply curtailed.
the FFB,

In the four years prior to the establishment of

these guaranteed obligations increased by $38 billion,

billion in 1970 to $148 billion in 1974.

In the next

from $110

four years these

obligations increased by only $4 billion, to $152 billion in 1978 (see
table 1).

The $5 billion further increase in 1979 was largely in the form

of Export-Import Bank and student loan guarantees, with minor increases in
a

number of other guaranteed loan programs.

Consequently, the $39 billion net financing requirements for loan

guarantees in fiscal year 1979 was largely financed in the Treasury and GNMA
markets.

That is,

$13.3 billion was financed through the Federal Financing

Bank, and thus by the Treasury, and $17.6 billion was financed by GNMA mortage-

backed securities (see table 4).

In addition,

several smaller guarantee pro-

grams were financed directly in the securities markets, including public housing
notes ($.5 billion), merchant marine bonds ($.3 billion) and partial guarantee

programs of the Farmers Home Administration and the Small Business Administration under which the lending bank sells the 90 percent guaranteed portion in
the securities market and retains the 10 percent unguaranteed portion.

smaller programs are eligible for FFB financing.


Federal Reserve Bank of St. Louis

These

22

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Federal Reserve Bank of St. Louis

23

Consequently, except for GNMAs

,

government-guaranteed obligations

are now only a minor portion of the newly issued exempted securities.

they

Whether

become a significant factor will depend largely on the extent to which

guaranteed securities are marketed directly or purchased by the Federal

Financing Bank,


Federal Reserve Bank of St. Louis

24

-

CHAPTER III

REVIEW OF MAJOR CHARACTERISTICS OF MARKETS FOR
GOVERNMENT RELATED SECURITIES

The characteristics of instruments, participants and trading practices
in markets for federally related securities are reviewed below.

Attention is

first directed to the U.S. Treasury market and then, in turn, to markets for

federally sponsored agency securities, federally guaranteed mortgage -backed
securities, and other obligations guaranteed by various federal agencies, l/

A final section briefly reviews markets for securities of government-sponsored
international organizations.

Federally guaranteed mortgage-backed securities receive particular
attention in the discussion because these instruments account for the largest

volume of actively-traded, guaranteed debt.

Moreover, unlike other sectors of

the government-related securities market, a substantial proportion of trading in

mortgage-backed securities is done on a long delayed delivery basis, and it
is here that most of the problems in these markets have arisen.

The trading

of contracts for long forward delivery is a natural consequence of the underlying

cycle of loan production inherent to the mortgage market.

This process is dis-

cussed in some detail in the section that reviews GNMA securities.

U.S. Treasury Securities

Instruments and Method of Issuance

The Treasury issues marketable debt in all areas of the maturity

spectrum in order to attract the widest possible range of investors while
meeting the objective of maintaining an overall debt structure consistent

1/

The five appendices at the end of this chapter provide more detail on each
of these major sectors of the government-related securities market.


Federal Reserve Bank of St. Louis

25

with sound financial practice.

In 1979,

for example, the Treasury sold a total

of $464 billion of new marketable obligations to help finance the federal budget

deficit. Treasury loans to the Federal Financing Bank and to refinance maturing
debt.

Of this total, about $370 billion of securities were issued in the form

of Treasury bills with maturity dates of about

2

weeks to 52 weeks.

The remain-

der consisted of longer-term coupon obligations (notes and bonds) with maturities

ranging from

2

years to 30 years.

Given the substantial volume of its financing

needs, the Treasury conducted at least one financing operation in each week of
the past year and in a number of weeks came to the market with

3

or 4 offerings.

In the past the Treasury used a number of techniques to sell its debt,
but in recent years has relied exclusively on competitive auctions.

announces these auctions in advance

— from

1

to about 10 days ahead

The Treasury

— indicating

the type and amount of securities to be sold as well as terms and conditions
to be met by those wishing to bid in the auction.

In general,

any institution

or person is eligible to submit competitive bids in these auctions, if they are

willing to take a volume of issues above a specified minimum and meet other
conditions set by the Treasury. 2/

2/

Competitive bids for notes and bonds have usually been submitted on a
yield basis that is, the bidder specifies the yield at which he is
willing to acquire a given volume of issues and the Treasury then makes
awards by accepting bids starting with the lowest yield bid submitted.
Bids for bills are submitted on the basis of a discount from par.
It
is also possible for investors to participate in the auction on a noncompetitive basis, if they are willing to submit bids for quantities
below a specified amount. Noncompetitive bids are always awarded in
full at a yield equal to the average rate set in the competitive auction,
The Federal Reserve and foreign official accounts also bid on a noncompetitive basis.
On some occasions, the Federal Reserve also submits
competitive bids in these auctions.

—


Federal Reserve Bank of St. Louis

—

26

While a sizable share of the issues offered in an auction is sold
directly to final investors, there are many dealer firms of various size
throughout the country that acquire securities in the auctions and then distribute them to final investors.

The great proportion of such activity is

undertaken by primary dealers in U.S. Treasury securities, firms that submit
daily reports for the review of the Federal Reserve and U.S. Treasury and are
subject to surveillance by these agencies.

Trading Activity
In addition to taking and distributing securities awarded in Treasury

auctions, dealer firms also make secondary markets in Treasury securities as well
as in other government related securities, by standing ready to purchase or sell

these instruments from their own positions.

Spreads between bid and asked prices

quoted by dealers are ordinarily quite narrow.

Banks and other major financial

and nonfinancial firms have traditionally used the Treasury securities market
as a means of making adjustments in liquidity positions and realigning invest-

ment portfolios.

Thus, with this trading activity plus substantial trading

among dealers, the daily volume of outright transactions in the U.S. Treasury

securities averaged about $13 billion in 1979; this compares with an average

daily trading volume on the New York Stock Exchange (which accounts for about
85 percent of the dollar value of all trading of stocks in the U.S.) of about
$1 billion.

Essentially all trading in outstanding Treasury issues is done on a
cash (same day) delivery basis or regular (next business day) delivery basis.

There is also a substantial volume of "when issued" trading of securities that
takes place between the time a security has been auctioned and the time it is


Federal Reserve Bank of St. Louis

- 27

issued.

Parties to these trades agree to buy or sell a given amount of the

security at

a

specified price on the day the security is issued. 3/

A substantial volume of trading in contracts for future delivery of
Treasury securities also occurs on

a

number of the commodity futures exchanges.

These futures contracts call for the delivery of a specified volume of desig-

nated Treasury securities on a particular date in the future.

Currently, there

are contracts being traded that specify the delivery of Treasury bills, shortto intermediate-term Treasury notes, and long-term Treasury bonds. WJ

U.S. Treasury securities have also been purchased and sold on a

forward (or delayed) delivery basis.

Such transactions are similar to futures

contracts in that delivery of a given amount of a designated security is specified for some date in the future.

These terms are not standardized, however,

as they are in futures contracts; and trades are negotiated between parties on

an over-the-counter basis rather than effected in a centralized exchange.

There

appears to be little, if any, forward trading in U.S. Treasury securities at the
present time. ^/

3/

The when-issued period generally ranges from a few days in length in the
case of cash management bills and 3- and 6-month Treasury bills to about
a calendar week in the case of notes and bonds sold in the Treasury's 4
quarterly refunding operations.

4/

For a detailed discussion of Treasury futures, see the Treasury /Federal
Reserve Study of Treasury Futures Markets published in May 1979.

5/

The major volume of forward trades in Treasury securities appears to have
taken place in the period before May 1978.
In that period, a number of
municipalities issued term bonds and set up sinking funds to accumulate
To obtain a
revenues that would eventually be used to repay these bonds.
known return on the sinking fund, these governmental entities purchased
Treasury securities forward from dealers, thus "locking in" a certain
return that exceeded the interest costs on the term bonds. The Treasury
changed its regulations in May 1978 to eliminate the economic advantages
of these arrangements.


Federal Reserve Bank of St. Louis

-

28

Investors

Because Treasury securities are free of default risk and highly
liquid, they are in broad demand by the investing public.

The Treasury's

latest survey indicates that of the roughly $410 billion of marketable debt

held by private investors, commercial bank holdings account for the largest

proportion of the total

—about

one-fourth.

In addition, insurance companies,

other financial institutions, nonfinancial corporations, state and local

governments and pension funds have large holdings.

Individuals also own a

sizable share of the total.

Repos

The market for repurchase agreements (repos) and reverse repurchase
agreements (reverse repos) was originated as an adjunct of the Treasury securities market and still is primarily associated with this market.

These agree-

ments involve the sale (purchase) of a security coupled with a promise to repurchase (resell) the security at a later date.

(By convention the party initially

selling the security is said to be arranging a repurchase agreement.)

Repos were

developed by U.S. Treasury security dealers to provide an alternative source of
funds to finance their security positions.

financing
funds

—mainly

—were

Parties initially providing this

financial institutions, nonfinancial corporations and pension

attracted to these arrangements because they provided a ready means

to invest money on a short-term basis in great safety.

Over the years the repo market has grown and developed in a number of
ways.

Dealers now use the market as the principal financing source for their

positions.

Indeed, the types of securities used in this method of financing


Federal Reserve Bank of St. Louis

29

have expanded to include federally sponsored agency issues, government-guaranteed mortgage-backed securities, negotiable CDs of banks, bankers' acceptances

Dealers also have become important intermediaries in

and other securities.

the market, arranging repos with one set of customers and reverse repos with

others.

These "matched book" transactions, which transfer funds from economic

units with a surplus to those with

a

shortage, now substantially exceed the

volume of repos dealers arrange to finance their own positions.
Repurchase agreements initially were arranged on an overnight (or
over-the-weekend) basis, and this remains the predominant maturity of such
contracts.

In recent years, however,

have had longer contract periods
some cases apparently

5

a

sizable volume of such transactions

— ordinarily

or 6 months.

periods of

1

to 3 months, but in

The contracts, therefore, are now being

used to satisfy borrowing and investing strategies designed to achieve longer-

run objectives as well as for the day-to-day management of funds.

Thrift institutions and other financial firms with GNMA security

portfolios have been using repos and particularly term repos in recent years
as a means of obtaining funds to meet short-term liquidity needs.

Such trans-

actions are sometimes arranged in the form of classic repo agreements
is,

a

— that

GNMA with a given pool number (which identifies the specific pool of

mortgages from which payments of principal and interest are passed through
to the security holder) is sold to a dealer under an agreement which specifies

that a GNMA security with the same pool number will be repurchased on
date.

a

later

Recently, an alternative form of repo agreement has been developed that

is commonly referred to as a "dollar price repo."


Federal Reserve Bank of St. Louis

Under these contracts, it is

30

agreed that when the thrift repurchases from the dealer, the dealer need not
and in practice usually does not

those originally sold to him.

— sell

back GNMAs with the same pool number as

Depending on contract terms, he may redeliver any

GNMA issue that has the same coupon as those originally sold or alternatively
that provides the same yield to maturity (adjusted for the terms of the repo).

This new type of agreement was developed because dealers ordinarily

resold securities they acquired under conventional repo agreements (perhaps on
an outright basis, perhaps under repo with no requirement to return the same

security) and often found it difficult to obtain GNMAs with the same pool number when it came time to redeliver to the thrift institution.

In addition the

dollar price repo fits well with the arrangements by which GNMAs are traded on
both a cash and forward delivery basis.

A dealer will generally quote bid and

asked prices for GNMAs with a given coupon for delivery immediately and on

various forward dates.

(The forward quotes are for GNMAs with a given coupon

rate but no pool number is specified.)

Thus, in entering into a dollar price

repo, the thrift sells GNMAs to the dealer at the dealer's quoted bid price
for immediate delivery and simultaneously buys (repurchases) GNMAs for delivery
in a future month at the dealer's asked price.

The difference between the

immediate bid price paid by the dealer and the forward asked price ultimately
paid by the thrift in effect represents the amount of interest paid by the
thrift for the use of funds over the period until delivery is made under the

forward contract.

There are issues raised with regard to the accounting treatment of a
dollar price repo relating to whether the investor is required to book a gain


Federal Reserve Bank of St. Louis

-

or loss on the transaction. 6/

31

The thrift institutions' exposure to interest

rate risk under such agreements, however, is essentially the same as under a

classic repo; under either alternative the capital loss incurred if interest
rates rise would be essentially the same. 7/

With the expansion of repo trading in recent years, the greatly
increased number of repo customers and the introduction of term contracts,
a

number of problem cases have developed in which one contracting party was

unable to fulfill the terms of the contract.

Partly for this reason, many

of the people interviewed as part of this study indicated that participants

have been applying tighter standards in arranging repo contracts.

These

traders have made greater efforts to ensure that securities involved in the

transaction are initially valued at market and that their value exceeds the
amount of money exchanged.

They have also included provisions in repo agree-

ments requiring the borrowing party to increase the amount of collateral in
the event of erosion in the value of the securities.

The borrowing party,

6/

These transactions raise the obvious issue whether they should be viewed
just as regular repos, i.e., accounted for as loans, or instead as outright
This question is imporsales of securities followed by outright purchases.
tant, of course, because it raises the further issue whether a loss should
be shown by the institution when the price it receives when selling is below
the book value of the security.
Or if a loss is not booked, there is the
question of how the transactions should be reflected on the balance sheet
While there are arguments that can be made on both
of the institution.
sides of this question, the Federal Home Loan Bank Board has given approval
for S&Ls to treat these transactions as repos, so long as the GNMAs (re)purchased for forward delivery have the same coupon as those sold for immediate
delivery.

IJ

The prices of GNMAs with the same coupon but different underlying pools do
not necessarily move in exact unison with a given change in the general
level of rates.
Thus, the gain (or loss) from these alternative positions
could differ somewhat.


Federal Reserve Bank of St. Louis

32

of course, assumes the risk that the securities may not be returned, which

would prove costly if securities prices rise.

Government-Sponsored Agency Securities
Instruments and Method of Issuance
The sponsored federal agencies finance their operations principally

through the sale of debt instruments in the open market.

The Farm Credit

Agencies (FCA) account for 35 percent of this total; Federal National Mortgage Association (FNMA) 32 percent; and the Federal Home Loan Banks (FHLB)
33 percent.

8^/

In 1979,

the sponsored agencies issued on a gross basis $117

billion of debt to rollover maturing debt and raise new money.

This resulted

in a net increase in indebtedness of $25-1/2 billion for the year.

Of the

total volume of securities sold, 36 percent was issued with an original matu-

rity of less than one year, 60 percent with maturities of

1

to 10 years,

and

4 percent with maturities greater than 10 years.

Each of the sponsored agencies employs
debt.

a

fiscal agent to market its

The fiscal agents maintain close contacts with the financial community

and carefully monitor developments and conditions in financial markets.

Based

on market conditions and consultations with dealers in the selling groups, the

fiscal agents decide on the size, price, maturity and timing of a new debt

offering.

These decisions are subject to approval by the agency involved, and,

because of law or custom, to clearance by the U.S. Treasury.

Intermediate- and

longer-term securities are offered through large, nationwide selling groups of

8^/

Debt issued and guaranteed by the Federal Home Loan Mortgage Corporation,
a wholly owned subsidiary of the Federal Home Loan Bank System, is discussed
in a separate section below.


Federal Reserve Bank of St. Louis

-

dealers and commercial banks.

33

-

For sales of short-term discount notes, the

agencies rely on a few major money center dealers who continually make a market in agency securities.

Distribution of sponsored agency issues is accomplished in
period.

The time between announcement of

terras

the selling group runs no more than a few days.

a short

and allotments to members of

Following the allotments,

dealers are expected to distribute the issues to final investors in a short
time

— in

the course of a week or two.

Indeed, dealers are expected to have a

major share of their allotments presold, and they are either precluded from
taking allotments for their own account or are carefully controlled in the
amount that they take.

All of the issuing agencies carefully monitor the

activities of their dealers and have the option, if given cause, to terminate
an agreement at any time.

Trading Activity
Sponsored agency securities generally are traded actively in secondary markets.
in 1979.

Average daily trading volume in all issues was above $2.5 billion

These transactions are almost entirely arranged on either a cash deli-

very or regular delivery basis.

A few transactions have somewhat longer delayed

delivery dates, but in few if any cases is the time span longer than a week.

Ownership

Ownership of federal agency securities is widely dispersed, with
commercial banks holding the largest share of the total.

Sizable amounts are

also held by all other major types of financial institutions, by nonfinancial

corporations and by the general funds, pension and retirement funds of states


Federal Reserve Bank of St. Louis

34

and localities.

The Federal Reserve also is authorized to purchase these secu-

rities in the course of its open market operations and currently holds outright
about $8.2 billion.

Certain Treasury trust funds also hold

a

small proportion.

Government-Guaranteed Securities
GNMA Pass-Through Certificates
Government National Mortgage Association pass-through certificates
(GNMAs) provide their holders with an interest in the income stream from spe-

cific pools of government-guaranteed (mainly FHA/VA single family) mortgages

bearing the same interest rate and with the same maturity.

The security holders

receive pass-through payments of interest and principal made on the mortgages.
The instruments have stated maturities equal to those on the underlying mort-

gages, usually 25 to 30 years.

Because of prepayments, most of the mortgages

are repaid in a much shorter period; thus the principal amount outstanding on

pass-through certificates is repaid at an accelerated rate, especially in the
initial years.

By convention based on experience, yields on new securities

are quoted on a 12-year maturity basis.

While all the mortgages in the pools

backing the securities are guaranteed by the federal government, the attractiveness of GNMAs is enhanced by a further guarantee which commits the full faith
and credit of the United States government for the timely payment of interest

and principal.

Issuers and Dealers

While authorized and guaranteed by GNMA, GNMA pass-throughs are currently issued by about 900 private firms that originate mortgages.

About two-

thirds of these firms are mortgage bankers; commercial banks and savings and


Federal Reserve Bank of St. Louis

-

35

loan associations account for most of the remainder.

Originators sometimes

place newly issued securities directly with final investors, but the great

proportion are sold to dealers who then resell them to final investors.

There

are approximately 20 major dealer firms that account for most of the distribution and trading of GNMAs, but it is estimated that about 60 firms over the

country make a market in these securities.

Investors

Thrift institutions were by far the largest investors in GNMA passthroughs when they were first issued in 1970.

In recent years, however,

investor base for GNMAs has been broadened substantially.

the

Mutual savings banks,

commercial banks, pension funds, and state and local governments have become
important acquirers of these instruments.

In addition,

viduals each hold significant amounts.

is

It

credit unions and indi-

now estimated by GNMA that about

75 percent of the total issues outstanding (about $85 billion)

are held by

lenders other than S&Ls.

Origination and Trading Arrangements

GNMA securities are traded on a regular delivery basis (for the GNMA
market this generally implies delivery specified within 30 days) 9/

delayed delivery or forward basis.

and on a

The former involves trades of outstanding

issues as well as sales of newly issued pass-throughs.

Trading on a forward

basis (between issuers and dealers, among dealers, and between dealers and

9/

The length of "regular delivery" time is longer for GNMA than for other
securities because of technical factors associated with the collection
and pass-through of principal and interest.


Federal Reserve Bank of St. Louis

36

investors) Involves the purchase and sale of securities for delivery often
or 4 months in the future and in some cases as much as a year or more.

3

There

are two types of forwards, those calling for mandatory delivery on a specified

forward date and those with an optional delivery before a specified date (standThe trading volume in forward contracts, particularly mandatory delivery

bys).

contracts, is substantially greater than that which occurs on a regular delivery
basis.

Most of this trading occurs among the dealer firms, but permanent inves-

tors and mortgage originators also trade forward contracts in efforts to improve

yields on portfolio positions or in some cases to profit from expected movements
in market prices

Trading on both a regular delivery and forward delivery basis is done
on an "over-the-counter" basis with dealers standing ready to add to their position (or sell from their position) at quoted bid and asked prices.

Tradition-

ally, a dealer that contracts to buy GNMAs from one dealer on a forward basis

and contracts to resell them to another on the same basis has, on the settlement

date of these contracts, taken delivery of the obligation from one and made

delivery to the other.

In many cases, of course, there is a long series of

matching forward trades each of which requires physical delivery of the security
to complete the transaction.

Recently a clearing corporation has been established

to faclliate the completion of transactions.

The corporation now clears a

proportion of its members' trades by matching long and short positions of
each member in a given contract and then requesting that a check or securities
be delivered to make up the difference. 10 /

10 /

For additional discussion of the clearing corporation see page 67 of
Appendix C.


Federal Reserve Bank of St. Louis

37

Mortgage production cycle and the management of interest rate risk

.

While accurate statistics are not available on the total volume of trading
activity in GNMA securities, it was estimated by some participants interviewed
in connection with this study that the average volume of trades per business
As noted above, a large proportion occurs

day might run to about $2.5 billion.

in the form of transactions for forward delivery.

Such heavy forward trading

in the over-the-counter market for fixed income securities is esentially con-

fined to the market for mortgage-backed securities.

It is thus appropriate to

focus on the basic reasons for this trading process in order to provide back-

ground for discussion in later chapters.

There are fundamental economic reasons for forward transactions in

GNMA securities.

Mortgage loan commitments, extending months into the future,

are essential to the financing of real estate.

Contracts for the sale of

existing properties usually require buyers to secure mortgage commitments from
lenders several months prior to the time the property is transferred and the

mortgage loan is closed.

Advance commitments also are essential for the con-

struction and sale of new properties.

Before making a construction loan,

institutions ordinarily require developers to arrange commitments for per-

manent mortgage financing; in fact, the permanent mortgage commitment usually
The production periods

forms the basis for the construction loan commitment.
for single-family structures typically range between

periods as long as a year are not uncommon

— and

3

and 6 months

— although

the production periods for

multifamily structures are even longer.
Commitments may specify
committed at

a

a

rate of interest, or the funds may be

rate to be determined at a time of loan closing.


Federal Reserve Bank of St. Louis

While take-

38

down of the funds by the buyer is optional under these arrangements, the mortgage

originator is firmly committed to provide funds.

Thus, buyers may walk away from

the contract if interest rates fall relative to rates specified in the contract.

The loan originator, on the other hand, when committed to provide funds at a
specified rate, must do so even if mortgage rates have risen well above this
level.

Those committing to make mortgages, in effect, enter into a kind of
forward agreement with a builder or with a buyer of a home or other properties.

The committing party then must decide whether to "carry" this commitment risk
without hedge or to enter into an agreement in which another party agrees to

buy the mortgage at the time it is made.

Some parties that commit to make

mortgages are also mortgage investors (such as thrift institutions) who will

ordinarily take these loans into their own portfolio.

Accounting conventions

allow institutions to enter mortgages so acquired at par on their books, even
if at the time of closing they technically have a market value below par because

interest rates have risen above the rate specified in the mortgage.

Given that

the institution can generally also count on cash flow to make the mortgage, it
is,

in a sense, screened from the interest rate risk associated with entering

into forward mortgage commitments.

A substantial volume of mortgage commitments,

however, are also originated by mortgage bankers

—who

their prospective cash flow

manently.

—-or

by thrifts in excess of

do not intend to hold them in portfolio per-

In these cases, originators must decide whether to remain exposed

to the risk of loss if market rates rise (relative to a commitment rate) or the

opportunity to profit if rates should fall, or to hedge their exposure to rate
fluctuation.


Federal Reserve Bank of St. Louis

The originator has traditionally obtained such a hedge by arranging

39

to sell the mortgage once its has been consummated at a specified price to a

final investor.

From this perspective it can be seen that the forward market for GNMAs
is the

natural outgrowth of the mortgage production cycle.

A mortgage originator

who has committed to make a large block of FHA or VA mortgages or who expects to
enter into commitments to make such loans over the near future may sell GNMA

securities for forward delivery to a dealer rather than sell these mortgages

directly (for forward delivery) to a lending institution.
In addition to selling forward to hedge against the interest rate

risk associated with fixed rate commitments, mortgage originators also incur
similar risks when they are in the process of accumulating FHA/VA mortgages to
be placed in a pool to back a GNMA security.

Mortgage bankers and other origi-

nators finance these mortgages by borrowing on a short-term basis and thus are

exposed to the risk that interest rates may rise over the assembly period,
causing a decline in the value of mortgages in the inventory.

A forward sale

of GNMA securities provides a hedge against this risk by locking in a certain
price to be received.

Alternative to selling GNMAs forward for mandatory delivery, mortgage originators also can sell forward on an optional delivery basis.

In these

"standby" agreements, dealers obtain a fee for agreeing to purchase a given
volume of GNMAs at a given yield at a specified future date, if the securities
are tendered to the dealer.

(These standby agreements are essentially the same

type of commitment FNMA sells in its auction of contracts for delivery (at the

option of the buyer) of whole FHA/VA mortgages.)

The dealers, in turn, depending

upon their willingness and ability to carry interest rate risk, will lay off all
or a part of this risk by making similar standby agreements with various kinds of


Federal Reserve Bank of St. Louis

40 -

financial firms.

For investors who have the financial resources and sophistica-

tion to understand the nature of such agreements and their risk exposure, and to

negotiate attractive terms

— in

the form of fees, specified interest rate, etc.

issuance of standbys can be a sound, potentially profitable activity that facilitates the mortgage production and distribution process.

Interest rate risk associated with mortgage production and distribution
also can be managed by taking positions in the futures markets for GNMAs.

11/

For example, an originator accumulating a pool of mortgages can sell (go "short"
in) a futures contract,

a

position in which he is assured of receiving a known

price for delivering a given volume of GNMA securities on a future date.

Thus,

he is hedged against the risk that mortgage rates may rise above the rates on

the mortgages he holds in portfolio or above the rates at which he is committed
to make mortgages.

He may choose ultimately to deliver these securities,

receiving the price which he "locked in" with his futures contract.

Typically,

however, he will close out his contract position sometime before it matures.

can achieve such a closeout by buying in the same contract.

He

Such an approach

provides a good hedge, because if mortgage rates rise over the holding period,
the price of the futures contract would fall. Thus, he would be able to buy his

"offsetting" position at a price below that at which he initially sold the contract; and the profits earned from trading in futures would offset the losses

incurred in producing mortgages.

11/

As in the over-the-counter forward market,

—

There are presently four contract markets two on the Chicago Board of
Trade and one each on the Commodity Exchange and American Commodity
Exchange. Three of these trade agreements call for delivery of GNMA
securities of given yield on specified future dates. The fourth calls
for delivery of a Collateralized Depository Receipt (CDR), an instrument which gives its holder a claim on GNMA securities held in safekeeping by the depository.


Federal Reserve Bank of St. Louis

41

many participants in the futures markets assume positions in futures that are
not covered by offsetting positions in mortgages.

Such traders generally are

attempting to profit from expected interest rate changes.
The futures market offers several advantages relative to the for-

ward market, including the reduction in credit risk which results because the

exchange stands behind every contract.
the forward market more attractive.

But many participants continue to find

An important consideration is the ability

to make purchases precisely tailored to the amount of securities one wishes to

sell or to buy in the forward market, while trades in futures are for standard-

ized blocks.

Another is that while futures contracts are based on GNMA securi-

ties bearing a given coupon interest rate, delivery under these contracts can

be made with any GNMA security, with the delivery price of securities with

various coupons adjusted by a standard formula to provide investment yields

equivalent to that on GNMAs with the base coupon rate.

The problem with this

arrangement is that GNMAs with different coupons do not trade in the cash

market with the same yield to maturity.

Instead, market forces generally set

yields on high coupon GNMAs at levels that are higher than those set on lower
coupon GNMAs.

(High coupon issues are subject to more rapid repayment; also

the return on low coupon issues that trade at prices below par is partly in
the form of capital gains that are taxed at relatively low rates by the federal

government.) The effect of this disparity in yields is to make the cost to

a

— less

short of acquiring high coupon issues

— to

than the cost of low coupon issues.

Thus, shorts generally deliver high coupon

issues.

fulfill delivery obligations

Correspondingly, the longs who take delivery of high coupon issues


Federal Reserve Bank of St. Louis

42

receive securities that have a lower market value than lower coupon issues.
Still another feature is that the most actively traded contract specifies that

delivery will ordinarily be in the form of a collateralized depository receipt
(CDR)

—which

is

backed by a pool of mortgages held in trust by the depository

rather than actual GNMA securities.
Finally, until recently margin requirements were not imposed on for-

ward transactions and apparently are still not on the majority of trades, while
the futures market requires posting of an initial margin and margin maintenance.

While this latter provision offers the clear advantage of virtually assuring
that the other party to the contract will fulfill his contractual obligations,
it presents the disadvantage of tying up limited capital of mortgage bankers.

Those operating with highly leveraged positions, the typical condition of the
mortgage banker, find this particularly a problem.

The placement of initial

margin is not a great burden because this presently can be met by pledging
liquid assets or by submitting an irrevocable letter of credit from a commercial
bank.

Futures markets, however, require participants to put up cash when the

market moves against a position, and this can create a serious liquidity strain
during periods

t>f

sharp changes in interest rates.

FHLMC-Guaranteed Mortgage Pass-Through Securities
Characteristics of Instruments

The mortgage pass-through securities programs operated by the Federal
Home Loan Mortgage Corporation (generally referred to as Freddie Mac) were established after the GNMA program and are designed to further develop the secondary


Federal Reserve Bank of St. Louis

-

markets for conventional mortgages

GNMA program.

—a

43

-

component of the market not touched by the

Cumulative issuance of FHLMC-guaranteed securities remains sub-

stantially below the volume of GNMA issues (roughly $18 billion vs. $100 billion

although issue volume has increased substantially in recent years.

for GNMA),

These securities carry only the guarantee of the Federal Home Loan Mortgage

Corporation rather than the full faith and credit guarantee of the federal
government which is imparted with a GNMA guarantee.

Freddie Mac purchases residential mortgages from originators

marily members of the FHLB System
through certificates. 12/

— financing

— pri-

them by sale of mortgage pass-

In its mortgage purchase programs,

the corpora-

tion conducts weekly auctions of mandatory delivery commitments to purchase

conventional home mortgages.

Once a month, it also conducts an auction in

which it sells "puts" or standby commitments to bidders which are similar to
those offered by FNMA in its biweekly auction program.

The mortgages acquired

under these programs are pooled into groups, and FHLMC issues Guaranteed Mort-

gage Certificates (GMC) or Mortgage Participation Certificates (PCs) against
these pools.

The former is a "bond-like" instrument in that it pays interest

twice annually, while payments of principal are passed through once a year.

latter is

a

The

pass-through instrument with cash-flow features similar to GNMAs

Investors
As with GNMA securities, the program has successfully attracted funds
to the mortgage market from nontraditional

12/

lenders in this market.

FHLMC esti-

FHLMC also raises some money by participating in the issuance of consolidated obligations of members of the Federal Home Loan Bank System.


Federal Reserve Bank of St. Louis

44

mates that all but about 20 percent of its GMCs and PCs are held outside savings
and loan associations by institutional investor groups ranging from commercial

banks and their trust departments to public pension funds.

Individuals and

credit unions also own a small portion of the total.

Origination and Trading
In recent years, FHLMC has placed issues of PCs with selected secu-

rities dealers (at present 14 major firms) which distribute them to investors.
CMC issues are marketed through the FHLB System Office of Finance which sells

them through the dealer group utilized for issues of FRLB System debt.

Thus,

this marketing arrangement gives FHLMC closer control over the initial distri-

bution of its securities than GNMA has.

GNMA is, of course, able to impose

controls indirectly by setting down guidelines regarding the terms on which

mortgage originators issue GNMAs and the types of dealers with whom they deal.
The Freddie Mac program also must adapt to the underlying reality of
the mortgage production cycle.

As noted above, its commitments to acquire

mortgages generally are made well in advance of the date that mortgages are
actually delivered.

To minimize the corporation's exposure to interest rate

risk, it sells its pass-through instruments on a forward basis, with the

forward time often 3 to 4 months in the future but sometimes extending as
long as one year.
Also, as with GNMAs, there is very active secondary market trading
in Freddie Mac securities.

Yet to be issued securities are effectively resold

many times in the forward market.
relatively actively.


Federal Reserve Bank of St. Louis

Already issued Freddie Mac issues also trade

To date, transactions in Freddie Macs are not cleared

-

45

through the MBSCC, though it is reported that this is under active consideration.

Other Government-Guaranteed Securities
In addition to mortgage-backed securities that are guaranteed by GNMA

or by FHLMC, there are several large government guarantee program that are de-

signed to increase the availability of credit to targeted borrowers.

While the

Federal Financing Bank purchases a large volume of guaranteed obligations each
year, a growing volume is also being sold to private investors.

Guaranteed Loans
Guaranteed obligations that are purchased by private investors are of
two broad types

— loans

and bonds.

Guaranteed loans traditionally have been par-

tially guaranteed (usually 90 percent) and have been originated, serviced and
held by commercial banks.

In the raid-1970s, however,

liberalization of guaran-

tees encouraged the development of secondary markets for the guaranteed portions

of the loans.

Currently the most active non-housing related loan guarantee programs
are the Small Business Administration's business loan program, the Farmers Home

Administration's business and industrial loan program, and the National Oceanic
and Atmospheric Administration's fishing vessel program.

Legal opinions have

been obtained from the Comptroller General for each of these programs which permit the guarantees to be passed through to the secondary investor, regardless
of fraud or mismanagement on the part of the servicer of the loan.
of unqualified guarantees to the secondary holders,


Federal Reserve Bank of St. Louis

The extension

together with the splitting

46

of the guaranteed and nonguaranteed portions in the case of the SBA and FmHA

90-10 programs, has permitted significant secondary marketing of the guaranteed
portions.

FMHA, SBA and NCAA loans are not fungible and, under current law,
the guarantee does not extend to the holder of a certificate that represents a

participation in

a

to size, maturity,

pool of guaranteed loans.

Each loan has discrete terms as

fixed or variable interest rate, and amortization schedule.

The guaranteeing agency oversees the origination of each loan and the original
sale of the guaranteed portion in the secondary market.
In large part, the guaranteed loan market is a private placement

market in which the loan originator sells the guaranteed portion to a securities dealer and the dealer resells the loan to an investor.

The largest cus-

tomers are pension funds, life insurance companies, and retirement plans for

high income professionals who hold rather than trade the obligations.

The

discrete loan terms are taken into consideration in pricing each piece, and
the absence of homogeneity among the loans restricts trading.

Several dealers

have become active in placing guaranteed loans with investors, and they "make

markets" in the loans in that, to provide their customers with liquidity, they
stand ready to repurchase obligations from their customers and resell them.

The Economic Development Administration in the Department of Commerce
and the Federal Aviation Administration have 90-10 programs under which loans

are being financed.

While neither of the programs provides a secondary guarantee

now, each is working on the legal changes that would be required to provide the

secondary guarantee.


Federal Reserve Bank of St. Louis

EDA had $0.9 billion of guaranteed loans outstanding at

-

47

-

the end of fiscal year 1979 and is projected to have $3.4 billion out at the

end of fiscal year 1981.

The FAA has expanded authority to guarantee aircraft

loans, and its outstanding guarantees are projected to increase to $1.0 billion
in fiscal year 1981 from $0.2 billion at the end of fiscal year 1979.

Guaranteed Bonds

Maritime Administration (MarAd)

.

MarAd Title XI ship financing bonds

are usually sold to the public through underwriters, although smaller issues

often are privately placed.

billion.)

(The current volume outstanding is about $5.7

Pension funds and life insurance companies are major purchasers,

and hold rather than trade the obligations.

While securities dealers make

markets in the obligations to fill their customers' liquidity needs, there
is no active secondary market.

HUD guarantees short-term subsidized low-income public housing and
makes renewal project notes which are sold in the tax-exempt market.

The notes

are auctioned publicly in volumes of around $1 billion and are actively traded
in the secondary market.

The Market for Securities Issued by GovernmentSponsored International Organizations

During the twelve months ending in September 1979, $8.5 billion were
borrowed in the international capital markets by government-sponsored international organizations.

Although 10 institutions issued international securities

during the year, two organizations

— the

International Bank for Reconstruction

and Development (commonly known as the World Bank) and the European Investment

Bank

— accounted

for 75 percent of the volume of new debt.

The primary purpose

of most government -sponsored international organizations is to promote the


Federal Reserve Bank of St. Louis

- 48

economic development of member countries by making loans to governments or to

private enterprises.
The international bond issues of international organizations fall
into two categories:

Euro- and foreign bond issues.

A Euro-bond issue is

underwritten and sold in markets outside of the country whose currency is used
to denominate the security.

A foreign bond issue, on the other hand, is under-

written and sold in a single national market in the currency of the country in
which the market is located.

During the twelve months ending in September 1979,

two-thirds of the international bond issues of international organizations consisted of foreign bonds.

The United States is an important market for the sale of these securities.

Of the $1.9 billion of foreign bonds issued by international organiza-

tions during the third quarter of 1979, about 17 percent ($325 million) was

marketed in the United States.

None of these securities is directly guaranteed

by the United States government, but some of the international organiations can
call upon the United States if necessary to contribute a stated amount of capital
for the institution's support.

During the 12 months ending in September 1979, the original maturities of the foreign bonds issued by international organizations ranged from
to 25 years; the original maturities of their Euro-bond issues ranged from

3

1

to 20 years.

Compared to the $48.3 billion of borrowing by domestic government
sponsored agencies and mortgage pools during the 12 months ending in September
1979, the market for securities issued by government sponsored international

organizations is relatively inactive.


Federal Reserve Bank of St. Louis

-

49

-

APPENDIX A
U.S. TREASURY SECURITIES

Growth and Composition of Federal Debt During the 1970s
Over the decade of the 1970s, the U.S. Treasury was faced with the
task of financing massive budget deficits, particularly over the second half
of the period, and an additional large volume of funds was needed by the Treasury in order to finance the lending activities of the Federal Financing Bank.
As a result, as may be seen in table 1, the Treasury's net debt to the public
increased $380 billion during the 1970s, raising the total amount of debt held
outside agencies of the federal government by nearly 2-1/2 times.
Of the growth in publicly held debt over the 1970-1979 period, about
$80 billion (21 percent) was issued in nonmarketable form. \J As can be seen
in the table, the increase in nonmarketable debt was about evenly split among
its three main components
savings bonds sold primarily to individuals, special
issues to foreign official institutions, and "arbitrage" bonds issued to state
and local governments. 2/ The growth of foreign special issues took place primarily in the three-year period 1971 to 1973, while growth of state and local
arbitrage bonds was concentrated primarily in the years 1976 to 1978.
The outstanding amount of the three types of nonmarke tables, it might be noted, has
declined since the end of 1979, with savings bonds dropping $5.6 billion during
the first four months of this year.

—

As may also be seen in table 1, marketable debt held by the public
grew $300 billion during the 1970s. About two-thirds of this increase was in
the form of notes and bonds, which are issued with original maturity from one
year to generally no more than 30 years, while the other one-third was in the
Most
form of Treasury bills, which have original maturity of one year or less.
of the growth in Treasury bills occurred in the early 1970s, and this development together with the normal "aging" of outstanding debt resulted in a sharp
decline in the average maturity of the marketable debt held by the public.
In early 1976, when the average maturity of the Treasury debt fell to
low of 2-years 5-months, the Treasury became concerned that a further erosion
in the maturity of its outstanding debt might create serious problems in managing
the debt.
The Treasury therefore shifted toward issuance of longer-term securities, and over the four years 1976 to 1979, notes and bonds accounted for over
a

1/

In addition to the nonmarketable securities issued to the public (and shown
in the table), another $103 billion of nonmarketable Treasury debt was sold
to the government investment accounts and trust funds during the 1970s.

2/

Many state and local borrowers chose to refund in advance outstanding issues
In order to conform
that had been sold earlier at higher interest rates.
to certain tax regulations, these issuers reinvested the proceeds of their
refundings in special nonmarketable Treasury securities ("arbitrage issues").


Federal Reserve Bank of St. Louis


Federal Reserve Bank of St. Louis

-

Table

50

1

U.S. TREASURY DEBT HELD BY THE PUBLIC
(Billions of dollars, end of calendar years)

51

90 percent of the increase in the total volume of
Because of this change in the composition of debt
of publicly-held marketable debt rose to 3- years
the same level that prevailed at the beginning of

publicly-held debt outstanding.
issuance, the average maturity
9-months at the end of 1979,
the decade.

Ownership of Marketable Treasury Debt
The Federal Reserve is the largest holder of marketable Treasury debt,
with 23 percent of the total at the end of 1979.
(See table 2.)
Foreigners
primarily foreign official institutions increased their holdings of marketable
Treasury debt dramatically during the 1970s, largely as the result of efforts to
support a steadily weakening dollar.
These two sectors together absorbed about
one-half of the net increase of marketable Treasury debt during the decade.
Among private domestic holders, commercial banks have traditionally been by far
the largest, although their holdings have declined somewhat since the end of
Other major holders of the debt,
1976, in both relative and absolute terms.
in descending order of importance, include state and local governments, individuals, corporations, and insurance companies.

—

Importance of the Treasury Market for its Participants
The size and depth of the market for Treasury securities facilitates
execution of a myriad of private trading and investment decisions each day and
permits the United States government to finance quickly and efficiently its
activities even in times of financial or economic stress.
The market for
Treasury debt also plays a crucial role in the implementation of the Federal
Reserve System's monetary policy.
The Manager of the System's Open Market
Account buys and sells U.S. government securities on a temporary or permanent
basis to affect the volume of reserves in the banking system.
Federal Reserve
System payment for securities purchased add to bank reserves, while reserves
are extinguished when firms pay for the securities sold by the System Account.
The size and liquidity of the Treasury market permit these operations to be
executed typically without advance notice, thus adding considerably to the
flexibility of monetary policy actions undertaken to manage the money supply.

The Process of Selling Marketable Treasury Issues
In the last few years the Treasury has, with but a few exceptions,
Three- and 6-month Treasury bills
sold its marketable debt through auctions.
are auctioned each Monday and 52-week bills are auctioned every four weeks.
Special "cash management" bills with maturities from a few days to several
months are sold from time to time to bridge temporary low points in the Treasury's cash balance.
The announcements of these auctions state the amount of
Competitive
bills to be sold and the deadline for the submission of bids.
bidders must specify the amount and price of the bills for which they are


Federal Reserve Bank of St. Louis


Federal Reserve Bank of St. Louis

52

Table 2
OWNERSHIP OF MARKETABLE TREASURY DEBT
(Billions of dollars, end of calendar years)

- 53

bidding. 3/ The Treasury also permits noncompetitive tenders without specification of price for amounts up to $500,000.
These tenders are awarded in full
by the Treasury.
The Treasury then fills the competitive tenders beginning
with those at the highest price until the entire amount of bills announced
have been sold.
Noncompetitive bidders pay the average auction price as determined by the competitive bidders, while each of the successful competitive
bidders receives bills at the price specified on their tenders.
The minimum
denomination for all Treasury bills is $10,000.
The Treasury's sales of notes and bonds have also been placed on a
fairly regular schedule.
In 1973, the Treasury began to sell 2-year notes at
specifically designated times once each quarter, and since 1975, 2-year notes
have been offered regularly in the latter part of each month. With the success
of the 2-year note cycle, the Treasury began issuing on a regular basis 4-year
notes in the last month of each quarter (in 1975) and 5-year notes or 15-year
bonds in the first month of each quarter (in early 1976).
More recently, the
Treasury has been issuing an intermediate-term note about 5-1/2 years in
maturity early in the last month of each quarter.

—

—

In addition to the regularization of financing activity that has been
accomplished by the establishment of the note cycles, the Treasury has standardThe Treasury usually
ized the mix of securities in its mid-quarter refundings.
offers a package of three securities in each of these operations a note with
maturity around 3 years, another note in the 7- to 10-year range, and a longterm bond.

—

Coupon auctions are similar to those for bills. Bidding is usually
done on a yield basis that is, bids are submitted in terms of a yield to
maturity.
Once the average yield for the auction is determined, the Treasury
places a coupon on the issue that is slightly above the average yield, so the
Noncompetitive tenders for
security is priced at a slight discount from par.
The minimum
notes and bonds may be submitted in amounts up to $1 million.
denomination for coupons is usually $1,000, except for notes with less than
4 years to maturity.

—

Trading and Delivery Practices
A very large number of institutions participate actively in the market
At the heart of this market, however, is a relatively
small group of firms, located primarily in New York City, that are referred to
These dealers presently about three dozen in number
as "primary" dealers.
generally bid for and are awarded a sizable portion of the securities offered
The dealers then redistribute the debt to
by the Treasury in each auction.
investoi s.
for Treasury secuiities.

—

3/

The incicase in value from
The price io opcci fied as a pOLOciitagc of par.
the original purchase price to par at maturity represents the investor's
interest return.


Federal Reserve Bank of St. Louis

- 54 -

The dealers also maintain an active secondary market for Treasury
securities.
They stand ready to buy and sell issues at stated prices (by
Such
making bid and offer quotes) to their customers and to other dealers.
transactions are made for their own account with the objective of obtaining a
profit by selling securities at prices higher than those paid for the securities.
(Dealers do not charge commissions.) Dealers also profit if the
interest earned on securities they own is greater than the interest they pay
on the funds borrowed to finance those securities.
The dealers' trading activity recently has been about equally split
between trades with other dealers and brokers and with customers (see table 3).
These brokers deal
The bulk of the interdealer trading is through brokers.
only with the primary dealers.
The brokers do not make markets or hold securities in inventory but merely reflect the bids and offers dealers give them.
In return for putting buyers and sellers together, they are paid a commission.
The great value to dealers of the brokers is that the latter provide rapid
access to other dealers.
Because the broker does not reveal the identity of
the dealer on the other side of the trade, he provides anonymity for the dealers
who do not wish to reveal their activity to another dealer.
Some brokers display bid and offered quotes on closed circuit television screens placed in
dealers' trading rooms.
Dealers who wish to buy or sell at these prices call
the broker to effect a transaction.
Some brokers communicate bids and offers
by telephone only.

Institutional investors make up the vast bulk of nondealer participants in the Treasury and agency securities market.
Because the absence of
credit risk and the unusual liquidity of such investments attract these investors. Treasury securities are sold at and trade at yields that are below those
on all other taxable securities.
Commercial banks are an important participant,
although their share of dealers' trading volume has fallen from about one-third
in the early part of the 1970s to about 15 percent.
The market for Treasury and agency securities is an over-the-counter
market in which practically all trades are negotiated over the telephone by the
buyer and seller.
The parties must agree upon the particular security, the
price, the amount, and the delivery date.

Trades in Treasury securities generally are delivered and settled on
the same day or the next business day.
However, when securities that have not
been issued are traded (when-issued or WI trading), delivery takes place on the
date of issuance (the date on which payment for the securities is made).
The
time interval between trading and delivery can be as much as two weeks.
In
the case of Treasury bills, WI trading generally begins once the Treasury has
announced the date and size of an auction.
For example, the Treasury usually
announces the terms of its weekly 3- and 6-month bill auctions (held on Monday)
on the Tuesday afternoon preceding the auction.
Since payment is made on the
Thursday following the auction, a WI trade in bills could call for delivery up
to 6 or 7 business days in the future.


Federal Reserve Bank of St. Louis

55

-

Table 3
REPORTING DEALERS IN TREASURY SECURITIES
TRADING ACTIVITY BY
BY TYPE OF CUSTOMER
(Millions of dollars, daily average, par value)
1977

1978

1979

10,838

10,285

13,182

1,267

1,135

1,448

3,709

3,838

5,171

Commercial banks

2,295

1,804

1,905

All other

3,568

3,508

4,658

Total

U.S. government securities

dealers

U.S. government securities

brokers

Source:

Federal Reserve Bulletin.


Federal Reserve Bank of St. Louis

-

56

The Treasury has placed restrictions on trading of coupon issues
before auctions (participants are not allowed to submit a bid in a particular
coupon auction if they have already made trades in that security) and therefore most WI trading in coupons takes place between the time of the auction
and the payment date.
In some cases, the time betwee" auction and issuance
date might be nearly two weeks.

Delivery and safekeeping of securities is, for the most part, handled
by the computerized book entry system and the wire-transfer system provided by
the Federal Reserve System.

Dealer Financing and the RP Market

Dealers rely heavily on repurchase agreements (RPs) to finance their
holdings of securities; that is, they sell a security with an agreement to
repurchase the security on a specified date a few days or weeks hence.
The
dealer pays the investor an agreed-upon rate of interest on this "loan." It
is increasingly the custom for the investor to obtain some margin by lending
the dealer an amount of funds that is somewhat less than the market value of
the securities involved.
Nonbank dealers may also use collateral loans with
banks to finance their inventories of securities, while dealer departments of
banks may also use funds obtained from the parent bank to carry securities in
position.
Dealers also arrange reverse RPs; that is, they buy securities from
another party who agrees to repurchase the securities at a later date.
The
dealer receives an agreed-upon rate of interest on this loan.
The dealer can
do two things with the securities obtained in this fashion.
One is to sell
the securities short in the hope of buying them back at a lower price when it
is time to terminate the reverse RP.
In essence, this is a maneuver designed
to profit from price declines and is one way in which dealers try to make their
overall position conform to their outlook on interest rates.
The dealer firms can also place the securities out under an RP and
try to pay less interest on the RP than they earn on the reverse RP.
In this
case, the dealer is acting as a financial intermediary, transferring funds
from those who wish to lend money for short periods of time to those who wish
to borrow.
Dealers frequently call this their "matched book" operation. When
they match the amounts and maturities of their RPs and reverse RPs exactly,
they are not exposed to any interest rate risk, although they are exposed to
credit risk in the event that one party (or both) cannot perform their part
of the bargain.
In 1979, exactly matched transactions of this sort by the
dealers reporting to the Federal Reserve Bank of New York amounted to $13.8
billion on a daily average basis. When the maturities do not match exactly,
the dealer is exposed to interest rate risk.
For example, a one-week reverse
RP balanced against 7 overnight RPs of the same dollar amount could turn out
to be a losing proposition if overnight RP rates rise rapidly over the week.


Federal Reserve Bank of St. Louis

57

In 1979 dealers arranged a daily average o^ $15,3 billion of RPs and $13.3
billion of reverse RPs (in addition to exactly matched transactions). Much
of these, of course, were established to finance securities held in position
or to finance short positions.

Treasury Futures Market
Dealers have also been active in the interest rate futures market.
These markets, which are located on organized commodity exchanges, have uniform contracts calling for delivery of a specific amount of a particular secuThe most active
rity on a designated date in the future at a specific price.
trading in futures occurs in contracts for 3-month Treasury bills, long-term
Treasury bonds, and GNMA securities.
The prices of these contracts are determined by the interplay of buying and selling activity on the floor of the
exchanges where the contracts are traded.
In these commodity exchanges, at the end of each day the exchange
clearing house interposes itself between buyer and seller, and becomes a seller
In turn the clearing house will
to every buyer and a buyer to every seller.
collect margin from its members on each contract they entered into, and the
members in turn obtain margin from their customers. At present, the minimum
initial customer margin on the most active contracts generally ranges from
$1,500 per $1 million contract in 3-month bills to $2,500 per $100,000 conEach day the clearing house marks to market its
tract in bonds and GNMAs.
contract with clearing members to take account of gains or losses resulting
Thus, if a contract is held until delivery,
from price changes that day.
all interim losses or gains will have already been reflected in the margin
account.
Only a small percentage of contracts is held until delivery, however, with most closed out earlier.

Dealers may at times use interest rate futures contracts to hedge
against market risk
for example, selling bill futures contracts as a hedge
against the Treasury bills they hold in position in anticipation of customer
orders.
Dealers also act as "arbitragers," by going long in a futures contract calling for delivery on one date and short in a contract for delivery
on another date.
The hope in these positionings is to profit from interest
rate disparities.

—

Securities dealers constitute the single most active group in the
According to the most recent CFTC survey of
interest rate futures markets.
positions in the three most active contracts, commercial traders held only
The remainder was held by
about one-fifth to one-third of those positions.
futures exchange members and individuals, either singly or grouped together
in commodity pools.


Federal Reserve Bank of St. Louis

-

58

-

APPENDIX B
GOVERNMENT SPONSORED AGENCY SECURITIES

Government or federally sponsored agencies are organizations which
Their
were established by the federal government but are now privately owned.
primary function is the channeling of credit and technical support to the
housing and agricultural sectors. U.S. Treasury capital was repaid by the
agencies when they became private and currently the Treasury neither provides
financial support nor guarantees their securities.
However, the sponsored
agencies do still have emergency backstops at the Treasury; and the federal
government maintains a measure of control over them by appointing some of
their directors, setting debt limits, and approving the terms and timing of

With the exception of the Federal Home Loan Mortgage Corporation
(FHLMC) and the Student Loan Marketing Association (SLMA) which were established in the early 1970s, the sponsored agencies have existed in one form or
another for at least several decades.
The Banks for Cooperatives (BC) and the
Federal National Mortgage Association (FNMA) were all established during the
1930s, while the Federal Land Banks (FLB) and the Federal Intermediate Credit
Banks (FICB) have an even longer history.
The FLB, FICB, and BC, which are
under the overall supervision of the Farm Credit Association and together are
called the Federal Farm Credit Banks, serve the agricultural sector whereas
FNMA, FHLB, and FHLMC assist housing.

Discussion in the following sections will review the financing activities of FNMA, FHLB, and the Federal Farm Credit Banking System.
The activities
of the FHLMC are discussed separately in Appendix D.
SLMA will not be reviewed
because the guaranteed student loans acquired by this agency are financed solely
by debt issued to the Federal Financing Bank.

Description of the Agencies
The twelve Federal Land Banks, the oldest of the sponsored agencies,
were created in 1917 pursuant to the Federal Farm Loan Act of 1916. While
most of the original stock was government owned, there has been no government
capital in the banks since 1947.
Since that date the banks have been completely
owned by the Federal Land Bank Associations which in turn are owned by farmers
and ranchers who belong to the associations.
The FLB are authorized to make
mortgage loans in rural areas with maturities of from 5 to 40 years.
The loans
are extended for such purposes as the purchase of homes, real estate, equipment
and livestock, and the refinancing of existing debt.
The twelve Federal Intermediate Credit Banks, whose regions coincide
with those of the FLB and the BC, were established under the Agriculture Credit
Act of 1923.
Their function is the provision of short- and intermediate-term
credit to farmers, ranchers, and commercial fishermen primarily for their marketing needs.
Federal government holdings in the FICB ended in 1968 and the
banks are now entirely owned by some 430 local production credit associations.


Federal Reserve Bank of St. Louis

59

The association members are the borrowers who must use a specified percentage
of their loans to purchase stock in the lending association.
The FICB do not
themselves make loans to individuals but, rather, lend to and discount paper
for the production credit associations and financial institutions which do
provide financing to farmers, ranchers, rural homeowners, owners of farmrelated businesses, and commercial fishermen.
The third group of sponsored agencies serving the agricultural
community, the Banks for Cooperatives, is composed of a central bank and 12
regional banks.
Like the Farm Credit Administration which supervises all
three groups, the EC came into being pursuant to the Farm Credit Act of 1933.
Entirely owned by borrowing cooperatives since the end of 1968, the BC lend
funds to agricultural and fishing cooperatives which provide various kinds of
services such as marketing and processing to their members.
The principal
function of the central bank is to participate in large loans originated by
the regional banks which exceed the legal lending capacity limits of the individual banks.

Prior to 1975, each of the three sets of Federal Farm Credit Banks
financed their activities by issuing their own respective consolidated bond
obligations.
Owing to the maturity of their assets, the Federal Intermediate
Credit Banks and the Banks for Cooperatives sold primarily bond obligations
maturing in less than one year, while the Federal Land Banks sold bonds with
a maturity mainly in the 1- to 6-year range.
Starting in 1975, the Federal
Farm Credit Banks began to sell discount notes that were the consolidated
obligations of all 37 banks in the system.
The discount notes are issued
with maturities up to 270 days.
After some experimenting with offerings of
systemwide bond obligations, the Federal Farm Credit Banks began in January
Currently,
1979 to raise money exclusively by issuing systemwide obligations.
all debt obligations issued by the Federal Farm Credit Banks are the joint
obligations of the 37 banks.
As of the end of 1979, the total amount of outstanding marketable
debt of all the Federal Farm Credit Banks was $52.5 billion.
Of this total,
notes with an average maturity of
$3.2 billion was in the form of discount
about 32 days.
The remaining $49.3 billion of outstanding bonds had an average
maturity of 2-year s 4-months.
The breakdown of outstanding obligations for
the three sets of banks was $28,3 billion for the Federal Land Banks, $16.5
billion for the Federal Intermediate Credit Banks, and $7.7 billion for the
Banks for Cooperatives.
Slightly more than 40 percent of bonds now outstanding are in the form of systemwide obligations.

The twelve Federal Home Loan Banks
the oldest of the sponsored
housing agencies, were established in 1932, a time when many home financing
institutions were in difficulty.
The primary function of the banks is to
provide loans for member savings institutions engaged in residential mortgage
financing.
While the banks have been privately owned by these savings institutions since 1951, they remain subject to the policies and supervision of the


Federal Reserve Bank of St. Louis

,

60

-

Federal Home Loan Bank Board, an independent agency in the executive branch of
the federal government.
To provide credit to their members, the FHLB jointly
issue medium- and long-term consolidated obligations of various maturities.
At the end of December 1979, $27.7 billion of FHLB medium- and long-term debt
was outstanding.
To meet short-term needs the banks also sell discount notes,
and at the end of the fourth quarter 1979, $5.4 billion of these notes were
outstanding.
The Federal National Mortgage Association was originated in 1939,
was rechartered in 1954, and then was divided into two separate corporations
in 1968.
These two entities are the now privately owned FNMA which conducts
secondary mortgage market operations 1/ and the Government National Mortgage
Association (GNMA) which remained in the Department of Housing and Urban
Development and assumed special assistance functions which aid certain kinds
of housing.
(See Appendix C for a discussion of GNMA.)

FNMA was initially established to provide a secondary market for FHAinsured mortgages and 10 years later, in 1948, was also authorized to purchase
and sell VA-guaranteed mortgages.
FNMA's activities were restricted to these
segments of the market until the Emergency Home Finance Act of 1970 empowered
it to deal in conventional mortgages as well.
FNMA is by far the largest of
the housing sponsored agency borrowers with outstanding debt of almost $50
billion at the end of 1979.
(This excludes about $700 million directly placed
with state and local governments.) The bulk of FNMA's outstanding debt is in
the form of medium- and long-term debentures though it also has liabilities of
about $7 billion in short-term discount notes.
In addition, FNMA has issued
a small amount of GNMA-guaranteed mortgage-backed bonds, though no such securities have been offered recently.

Characteristics and Structure of Agency Debt
Securities issued by federally sponsored agencies are, with a few
minor exceptions, not guaranteed by the United States. 2/ Regardless of the
absence of direct government guarantees, agency securities are considered to
be almost as credit worthy as the securities of the U.S. Treasury.
The high
regard with which the market views the credit of the agencies exists largely
because the agencies were created by the Congress and the market believes
that the integrity of the agencies is linked to that of the federal government.

_1/

In its secondary market operations FNMA conducts a bi-weekly auction of commitments to purchase mortgages on 1- to 4-family houses.
It employs more
individually tailored techniques for its larger project mortgage purchases.

Ij

The exceptions are several FHLMC and FNMA issues which are guaranteed by
GNMA.


Federal Reserve Bank of St. Louis

61

-

For this reason agency securities are considered to be close substitutes for
Treasury securities in investors' portfolios.

Agency securities bear semi-annual coupons with the exception of
short-term discount notes. Minimum denominations vary but some issues are
available in $1,000 denominations and almost all can be purchased in $10,000
denominations. Most new offerings are available only in the form of a bookentry on the records of the Federal Reserve Banks but many outstanding issues
are in bearer form.
Agency securities ordinarily yield a bit more than Treasury securities of comparable maturity because they are not direct obligations of the
United States and because the market for these securities is not as broad as
the market for Treasury securities.
The difference or spread between yields
response
on agencies and Treasuries of similar maturity varies in large part
When the agencies are borrowing heavto the relative supply in each market.
ily while the Treasury is less active, the yield spread can be expected to
widen.
Another important determinant in the spread is the prevailing degree
In periods of tightness investors value
of tightness in the credit markets.
more highly the liquidity of Treasury securities and consequently yield spreads
Spreads averaged below 30 basis points in
against agencies tend to widen.
1979, but in March 1980, a time of extremely tight market conditions, they
In the early 1970s, when the long-term
climbed to as high as 100 basis points.
agency market was less developed, spreads between longer-term maturities were
often well in excess of 100 basis points.
Agency securities of short-term
This usually occurs
maturity sometimes yield less than Treasury securities.
when the available supply in the agency market is thin.

m

With regard to the timing and maturities of new bond offerings, the
farm credit agencies marketed 16 consolidated systerawide bond issues in 1979
monthly offerings of 6- and 9-month bonds and quarterly issues of medium-term
bonds.
Both the FHLB and FNMA restricted their borrowings to the medium-term
The bulk
area of 1- to 10-year maturities during the last two calendar years.
FNMA made seven trips to
of these offerings was in the 2- to 7-year range.
the market in 1978 and eight in 1979 while the FHLB sold five new issues in
1978 and six in 1979.

Federally sponsored agency securities are lawful investments. As
such, they may be accepted as security for all fiduciary, trust and public
funds, including Treasury tax and loan accounts, the investment or deposit
Agency
of which is under the authority of any officer of the United States.
securities are eligible for Federal Reserve Bank open market purchases and as
Also, they are
collateral for Federal Reserve Bank advances to member banks.
eligible for purchase by national banks without restriction and for investment
by federally chartered savings and loan associations and federally-chartered
credit unions.


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OWNERSHIP OF AGENCY MARKET SECURITIES BY HOLDER
AS OF DECEMBER 1979
Billions
of dollars
U.S. government accounts and
Federal Reserve Banks

Commercial banks

Mutual savings banks
Savings and loan associations

Life insurance companies
Fire, casualty and marine

insurance companies

Nonfinancial corporations
State and local governments

General funds

Pension and retirement funds
All other investors


Federal Reserve Bank of St. Louis

8.9

Percent
of total

63

-

Because of the low credit risk associated with agency securities
they enjoy wide legal acceptability for institutional investors and their
ownership is diverse. The following table shows the major holders of sponsored agency securities based on the Treasury Survey of Ownership at the end
of 1979.
According to the survey, the major holders were commercial banks
with 18-1/2 percent, state and local governments with 6-1/2 percent, U.S.
government accounts and the Federal Reserve Banks which also held 6 percent,
and "all other investors" with 58 percent.
In the period since year-end 1977,
the major changes have been a rise in the "all other investors" share from 51
percent to 58 percent coupled with a 4 percentage point drop in the share
owned by U.S. government accounts and the Federal Reserve Banks and a one
percentage point decline in commercial banks' share.

While the Congress authorized the Federal Reserve System to deal
in both federal and sponsored agency securities in 1966, the System confined
its transactions to repurchase agreements (RPs) rather than to outright operations in agency securities until 1971.
Until that time the agency market was
not considered to have developed to a point where the System could conduct
outright operations of a meaningful size without dominating the market. By
1971 the System reached the judgment that the agency market had developed to
the point where outright transactions could be made without causing market
distortions. The first purchases were effected in September of that year.
The Federal Open Market Committee (FOMC) established certain criteria for
open market operations in these securities. These guidelines were designed
to limit the System's impact on the agency market by setting ceilings on the
share of any one issue that the System could hold and establishing a minimum
size for issues that the System could purchase.
Over the next few years the
System expanded the use of agency securities in open market operations, though
Starting in February
in recent years the growth of its holdings has slowed.
1977, System transactions were restricted to those agencies that cannot borrow
from the Federal Financing Bank. Thus, open market operations in agency debt
are now limited to sponsored agency securities.

Marketing Techn iques a n d Trading Character;istics
The main technique utilized by the sponsored agencies in marketing
their new debt entails the use of a fiscal agent who offers the securities
through a large nationwide selling group of dealers and commercial banks.
Under the selling group technique, the agency employs a fiscal agent who maintains close contact with the financial community.
(In the case of FHLB issues
the Office of Finance of the FHLB Board serves this fiscal agency function.)
Based on market conditions and subject to approval by the agency, the fiscal
agent determines the size, price, maturity, and offering date of a new issue
and engages a group of securities dealers to sell the issue to investors.
(Either by law or by custom the agencies also clear new issues with the
Treasury.


Federal Reserve Bank of St. Louis

64 -

Selling groups for most new securities are large, usually numbering
in the hundreds, and their members are chosen for their ability to distribute
securities. The fiscal agent will usually advise members of the selling group
as well as the general public of the terms of a pending sale a few days before
The market is generally aware of a pending sale some time
the offering date.
before, however, because most agency financing is on a regular schedule and
agency cash needs can be estimated to some degree by the public. When the
terms are known the selling group will canvass the market to uncover investor
Interest. The assessment of market demand gained through the selling group
enables the fiscal agent to determine an offering yield which will satisfy
both Investors and the agency's need for an economical source of funds. The
fiscal agent's determination of an offering yield (Issues are usually sold at
par) is announced the day before the offering date.
On the offering date the
fiscal agent apportions a share of the issue to each selling group member
taking account of each member's past performance as well as the current magnitude of their customers' interest.
Each member receives a commission for
distributing the securities. Payment for the securities is usually due a week
or two after the offering date.
Securities are therefore sold on a "when-issued'
basis in a primary offering.
Selling groups for short-term discount notes are
smaller in size and usually include major money center dealers who continually
make a market in an agency's discount notes.
The secondary market for agency securities is mainly created by the
same group of dealers who are mocst active in the market for U.S. Treasury securities.
Transactions in agency securities are usually settled the next day.
Forvard transactions in agency securities are not common, although when-issued
trading for a period of one or two weeks is necessary for the distribution of
new issues. Futures markets for agency securities do not presently exist. The
following table presents data on agency debt outstanding in the markets at the
end of 1979.

The volume of trading activity in agency securities has grown considerably over the years, indicating a broadening market In which investors can
conduct transactions easily and efficiently.
Over the 15-year period from 1962
to 1977 the volume of trading activity increased from less than $100 million
to about $1 billion.
Average daily volume has continued to expand since that
time, climbing well above $2.5 billion in 1979.
During the recent interval
from 1977 through 1979 the most notable increase in transactions has been in
agency securities with maturities of one year or less.

This active market has resulted in narrow spreads between a dealer's
buying and selling prices; major dealers ordinarily quote their offering rate
from 2/32 to 8/32 above their bid price. While a dealer may quote wider spreads
for a smaller, long-outstanding issue for which the market has become less
active, even such issues are readily marketable and a market price can be determined.
Quotations for outstanding agency securities are published daily by many
dealers, and the financial press, as well as many other newspapers, print agency
quotations daily.


Federal Reserve Bank of St. Louis

"

65

Table

2

FEDERALLY SPONSORED CREDIT AGENCY DEBT OUTSTANDING
(As of Dec. 31, 1979 - millions of dollars)
Agency

Notes

Bonds

Federal Home Loan Bank Board

5,619

27,711

33,330

Federal National Mortgage Assoc.

6,392

39,900

46,292

Federal Farm Credit Banks:
Consolidated Obligations
Federal Land Banks
Federal Intermediate Credit Banks
Banks for Cooperatives

3,259

116,834

132,104

TOTAL


Federal Reserve Bank of St. Louis

15,270

Total

-

66

-

APPENDIX C
GNMA GUARANTEED MORTGAGE -BACKED SECURITIES

The Government National Mortgage Association (GNMA) was established
in 1968 through amendment to the National Housing Act.
Set up as a government
corporation within the U.S. Department of Housing and Urban Development, GNMA
administers two major types of mortgage support programs.
Through its Special
Assistance Function (SAF), which was inherited from the Federal National Mortgage Association (FNMA) when that agency was converted to a privately owned
corporation in 1968, GNMA carries out a number of interest rate subsidy programs designed to provide support for specific types of housing.
Secondly,
GNMA administers the Mortgage-Backed Securities (MBS) Program, which was
designed to increase liquidity in the secondary mortgage market and attract
new private sources of funds into residential loans. Under the MBS program,
GNMA guarantees the timely payment of principal and interest on passthrough
securities that are issued by private financial institutions and are based
on pools of government-underwritten residential mortgages that are originated

by private lenders.

Formation of the Mortgage Pools
The mortgage pools backing issues of GNMA-guaranteed securities consist primarily of FHA-insured and VA-guaranteed home loans and Farmers Home
Administration home loans. Other types of government-underwritten mortgages
also have been pooled in limited amounts:
FHA-insured multifamily construction loans, FHA-insured long-term multifamily mortgages, and FHA-insured and
VA-guaranteed mobile home loans (table 1).
The minimum pool size is $1 million for home mortgages and $500
thousand for multifamily and mobile home loans.
Mortgages making up a pool
must be uniform with respect to type of dwelling and coupon interest rate,
and the loans must be less than one year old. 1/ The home mortgages have a
maximum maturity of 30 years, whereas the multifamily mortgages may run as
long as 40 years.
The pools of government-underwritten loans backing issues of GNMAs
ordinarily are formed by private mortgage originators without the involvement
of GNMA's own funds.
In some cases, however, the mortgage pools
have been
made up of FHA/VA loans sold by GNMA loans that GNMA previously had acquired
under its Special Assistance Function programs in connection with the singlefamily "tandem plans." In these cases, the mortgages were sold back to the
originators who then assembled the mortgage pools, issued the GNMA-guaranteed
securities, and placed them with the syndicates of security dealers that bid
the highest prices in the MBS auctions conducted by GNMA.
GNMA has not pur-

—

\J

There are exceptions for the mobile home loan program.


Federal Reserve Bank of St. Louis

-

67

Table 1
GNMA-GUARANTEED PASSTHROUOI SECURITIES BY TYPE OF POOL
(December 31, 1979)


Federal Reserve Bank of St. Louis

-

68 -

chased mortgages under the tandem plan since 1976. Ij In the event that the
single-family tandem plan is resurrected to help limit cyclical downswings
In residential mortgage activity, this link between the SAF and MBS programs
may reappear.

Before GNMA-guaranteed securities are Issued, the mortgages assembled in the pools to back them are removed from the balance sheets of the
originating institutions and are placed in trust with a GNMA-approved custoThe custodian examines the documents, cerdian (usually a commercial bank).
tifies their authenticity, and holds them for safekeeping; these documents,
and pajrments of mortgage principal and interest received by GNMA issuers but
not yet passed through to investors, represent GNMA's collateral for the guarantee.

3/

Characteristics of the GNMA-Guaranteed Certificates

A GNMA-guaranteed passthrough certificate is a claim on a share of
The
the income from a specific pool of government-underwritten mortgages.
certificates are issued by private institutions that originate the mortgages
and assemble the pools.
The originator/issuer generally continues to service
the mortgages in the pools, collecting principal and interest pajnnents from
mortgagors and passing payments through to the holders of the securities.
GNMA guarantees that the issuers will maintain payments of principal and
interest from the mortgages to holders of the securities on a timely basis.
The GNMA guarantee of issuer performance is backed by the full faith and
credit of the U.S. government. GNMA has unlimited authority to borrow from
the Treasury to meet its obligations under the guarantee.
The GNMA-guaranteed certificates currently being issued are passthrough securities that are "fully modified" in the sense that scheduled
monthly payments of principal and interest from mortgages in the pool are
provided to the holder of the security, whether or not collected by the
mortgage servicer, plus a pro rata share of any unscheduled recoveries of

Ij

GNMA purchased $6.9 billion of single-family FHA/VA mortgages under these
tandem programs between November 1971 and September 1976, and resold $4.9
billion of the loans during 1975-76 to syndicates of security dealers
through auctions of mortgage-backed securities.
The remainder were sold
by GNMA through whole-loan auctions, and they generally were declared by
GNMA to be eligible for pooling.

V

In addition to the mortgage documents, the custodian holds an unrecorded
assignment in favor of GNMA.


Federal Reserve Bank of St. Louis

69

-

principal. 4^/ Sales of mortgaged property are the most important cause of
prepayment prior to contract maturity, but refinancings and foreclosures also
can be significant factors.
Thus, the cash flow to investors may vary from
month to month depending on the distribution of terminations for mortgages
in the pool.

GNMAs that represent shares in pools of 30-year FHA/VA home loans
generally are characterized by participants in the market as securities with
expected lives of 12 years. ^/ The 12-year life assumption is based upon
termination experience with FIlA-insured loans accumulated over many years.
This experience suggests that, on average, half of the mortgages in a pool
will be terminated by the twelfth year.
The coupon rate on a GNMA single-family security is set 50 basis
points below the contract rate on the mortgages in the pool, and this contract rate ordinarily is equal to the FHA/VA ceiling rate prevailing at the
time the pool is formed.
The servicer of the mortgages receives 44 basis
points and GNMA receives a guarantee fee of 6 basis points. The 44-point
servicing charge is 6-1/2 basis points higher than that typically earned by
servicers of whole FHA/VA loans. This extra Income compensates the GNMA
servicer for administrative costs and for ensuring timely payment of principal and interest to the security holders, whether or not received from the
mortgagors.
The minimum denomination for a newly issued GNM- guaranteed passthrough security is $25,000; beyond this minimum, GNMAs are available in
increments of $5,000.
Securities representing shares in pools of mortgages
that are partly paid off, of course, will havr -.orrespondingly smaller amounts
Moreover, some securities dealers have organized GNMA
of unpaid balances.
mutual funds or unit investment trusts, with individual shares priced at
$1,000.

GNMA-guaranteed certificates are issued only in registered form.
However, the certificates are fully transferable and assignable; that is,
they may be endorsed by the owners and assigned to other investors without
reregistration.
In these cases, of course, the cash flow from the mortgage
pool continues to flow to the registered holder.

kj

Some straight passthroughs were issued when the GNMA program first started,
but almost all outstanding GNMAs are now fully modified.

V

Yields on securities issued against pools of 40-year multifamlly mortgages
usually are quoted on the basis of prepayment in 20 years.


Federal Reserve Bank of St. Louis

70

Participants in the GNMA Market
Issuers
GNMA has specified a number of eligibility requirements
Issuers must be FHAfor issuers of GNMA-guaranteed passthrough securities.
mortgage servicers. GNMA
approved mortgage lenders and approved by FNMA as
also has established net worth requirements for issuers. Until October 1979,
the minimum required net worth was $100,000 and the requirement could range
only up to $250,000; within this range, the requirement depended on the type
(single-family, multifamily, etc.) and the amount of securities issued. Under
regulations implemented In October 1979, the net worth requirement is related
For example,
to the type and amount of securities issued, with no set maximum.
an issuer of single-family GNMAs must have net worth of $100,000 plus one percent of the amount of securities outstanding in excess of $5 million but less
than $20 million, plus 0.2 percent of any additional securities outstanding in
excess of $20 million.
.

The major issuers of GNMA-guaranteed securities are mortgage companies, which originate the bulk of government-underwritten home loans (more
than 80 percent in 1979). More than 900 institutions have issued GNMAs, and
nearly two-thirds of the issuers have been mortgage companies most others
have been depositary institutions (table 2). Moreover, issue volume has been
concentrated among a relatively small number of large institutions. The fifty
largest issuers, (47 of which are mortgage companies) have accounted for nearly
half of the total volume of GNMA issues.

—

In the early days of the GNMA securities program, the
Investors
nonbank thrift institutions (S&Ls and mutual savings banks) were the major
investors in GNMAs; in 1971, these institutions held nearly 70 percent of
outstanding GNMAs. By the mid-1970s, the thrifts still held nearly half the
volume of GNMAs outstanding, although diversified investors were entering the
market in increasing numbers. Yields on GNMAs increased sharply relative to
yields on Treasury and corporate securities in 1974 as the thrift institutions substantially reduced their purchase of GNMA securities in response to
contracting deposit flows, and the large yield advantage helped overcome conceptual problems that had discouraged participation by some types of instituAfter the cyclical trough in 1975, the range of investors particitions.
pating in the GNMA market broadened markedly.
.

As can be seen in table 3, by the end of 1979 holdings of the nonbank thrift institutions accounted for only about one-fourth of all outstanding
GNMAs; the remainder was spread among every major category of investor. As
the thrift institution share of the market declined in recent years, the shares
A notable exception has been credit
of most other types of Investors rose.
unions, where the share dwindled from nearly 7 percent in 1971 to about 2 perInvestment by private individuals has remained between one and
cent in 1979.
two percent of the total since the Inception of the program.


Federal Reserve Bank of St. Louis

71

-

Table 2
ISSUERS OF GNMA-GUARANTEED PASSTHROUOI SECURITIES BY TYPE OF INSTITUTION
(December 31, 1979)


Federal Reserve Bank of St. Louis

72 -

Table 3
PERCENT DISTRIBUTION OF HOLDINGS OF GNMA-GUARANTEED PASSTHROUGH
SECURITIES BY TYPE OF INVESTOR
(1979 month ended)

Investor groups

Mutual savings banks
Commercial banks
Savings and loan associations

Public retirement/pension funds

Private retirement/pension funds

Mortgage bankers
Securities brokers/dealers
Nominees

Corporations /partnerships

Private individuals
Credit unions
Life insurance companies

Other insurance companies
State & local govt. gen. funds

Fiduciary - individual

Fiduciary - institutional
Others

Terminated issues

Percentage
Total issued


Federal Reserve Bank of St. Louis

October

73

—

While the participation of pension and retirement funds major
investor targets of the program^ has increased, only ahout one-eighth of
outstanding GNMAs are registered in the names of private (nonlnsured) and
Some portion of
state and local government pension and retirement funds.
the large block of GNMAs registered in the name of nominees apparently
represents investment by pension and trust funds, but the amounts Involved
are unknown.
The figures for commercial banks include securities held in
their trust departments also an unknown quantity.

—

—

Institutions of all sizes have been attracted to GNMAs because of
favorable yields and the high degrees of quality and liquidity.
Federally
guaranteed mortgage passthrough securities (primarily GNMAs) account for
roughly three percent of the total assets of S&Ls in all size groups (table
At credit unions, some GNMAs are held by institutions in all but the
4).
smallest size groups (those with total assets under $100 thousand), but GNMAs
account for more than three percent of total assets only in the largest size
group (table 4). Only about 350 of the nearly 11,000 federally Insured
credit unions with total assets under $1 million held GNMAs at the end of
1978.

Brokers and dealers
Most firms making markets in GNMAs are members of the Mortgage-Backed Securities Association now a division of the
Public Securities Association. 6^/ The association was established In 1972
to further development of the secondary market in GNMAs, and there currently
are about 75 members of the group, including a number of major securities
firms and commercial banks.
A broker/dealer need not be a member of this
group In order to trade GNMAs, and there are an estimated 20 nonmeraber firms
currently active in the GNMA market.
.

—

Some transactions are arranged by firms serving merely as brokers
In most cases, however, the firms act as dealers
between buyers and sellers.
The major
in GNMAs, buying and selling securities on their own accounts.
dealers are in the market continuously, making it possible for buyers and
sellers to take or dispose of positions in GNMAs without significant delay.
Over-the-counter trading conditions prevail in the dealer market; transactions
take place on a negotiated basis and contract terms are not standardized.

Distribution and Trading of GNMAs

New issues and the dealer market . An institution considering issuance of GNMAs against pools of FHA, VA, or FmHA mortgages it has acquired or

6/

The group originally was called the GNMA Mortgage-Backed Securities Dealers
Association. The name was changed twice to the Mortgage-Backed Securities
Dealers Association and then to the Mortgage-Backed Securities Association
and the group recently merged with PSA.


Federal Reserve Bank of St. Louis

—

-

74

Table 4
GNMA-GUARANTEED PASSTHROUGH SECURITIES HELD BY SAVINGS AND LOANS
AND CREDIT UNIONS BY SIZE OF INSTITUTION
December 31, 1978
(Dollar amounts in thousands)


Federal Reserve Bank of St. Louis

75

-

plans to acquire must apply to GNMA for commitments to guarantee.
GNMA commitments are available. In amounts up to the net worth limits discussed earlier to authorized Issuers, regardless of market conditions, at a fixed fee
that does not vary with the amount of the commitment.
The GNMA commitments
are good for at least one year (they may be extended an additional 60 days),
and they provide for pooling of loans bearing any FHA/VA celling rate In effect
during the commitment period.

Receipt of the GNMA commitment does not obligate the mortgage originator to Issue GNMAs.
Indeed, a mortgage originator that has obtained a GNMA
commitment to guarantee and is accumulating an inventory of FHA/VA/FmHA mortgages may market the mortgages in a number of ways. He may commit to sell new
issues of GNMAs to dealers in the forward cash market under a "mandatory" delivery contract. IJ Alternatively, the originator may decide to wait until he
has assembled a group of mortgages; then he may sell blocks of whole loans to
investors (such as S&Ls or life insurance companies) or place them in pools
and issue GNtlAs for immediate delivery to private investors or to securities
dealers.
During the "assembly" period, the originator may cover the risk of
price fluctuation on mortgage Inventory by obtaining optional-delivery or
"standby" purchase commitments from GNMA dealers or from FNMA, or through a
hedge in the GNMA futures market. ZJ And in the cases where interest rates
have risen relative to rates on mortgages accumulated in inventory, the originator may find it profitable to deliver mortgages to FNMA or to sell GNMAs
In recent
to dealers under optional-delivery commitments obtained earlier.
years, mortgage companies have marketed most of the government-underwritten
loans they originate either by issuing GNMA certificates or by selling whole
loans to FNMA.
Forward prices for mandatory future delivery of new issues of GNMAs
(those with coupons 50 basis points below the current or recent FHA/VA celling)
are published by some dealers.
The deferred-delivery prices generally are
lower than the immediate-delivery prices for GNMAs when long-terra Interest
Thus if a mortgage company utilizes forward
rates are above short-term rates.
commitments at the dealers, it forfeits some or all of the warehousing profits
that are derived while assembling the pool of mortgages in a positive-carry

IJ

If delivery fails to be made under a mandatory delivery contract, the mortgage company is liable for any loss sustained by the buyer due to nondelivery.

8/

Four-month standby commitments may be obtained from FNMA through the biweekly
Free Market System commitment auctions or through FNMA's 12-raonth convertible
standby commitment program.


Federal Reserve Bank of St. Louis

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76

market. JJ On those occasions when the term structure is inverted and there
is a negative-carry, mortgage companies incur losses on mortgage warehousing
and deferred-delivery prices available at dealers usually rise above immediatedelivery prices for GNMAs.
As the volume of trading in GNMAs has grown and the resale risk
assumed by dealers has declined, spreads between bid and asked prices on new
issues have fallen from more than 1 percentage point in the early days of the
program to as little as 1/32 of a point at least under normal market condiThe price spread for new issues generally is the same for immediate
tions.
delivery and for mandatory delivery in the forward market. Moreover, dealers
ordinarily have not required mortgage companies to post margin to secure forward contracts.

—

Mandatory commitments for delayed delivery of new issues of GNMAs
protect issuers against price declines during the period required to assemble
the mortgage pools, but these contracts also prevent them from taking advanOptional-delivery or "standby" purchase commitments
tage of price increases.
eliminate the disadvantage of mandatory commitments for mortgage bankers in
periods of rising securities prices. 10/ To obtain this greater flexibility,
the mortgage banker must pay a fee to the party agreeing to "stand by."
The GNMA dealers make markets in optional-delivery or standby contracts providing for delivery up to a year or more later. The optional-dellvery standby commitment issued by the GNMA dealer is, in essence, a "put"
option handled in an informal, over-the-counter options market. The fee paid
So is the "striking
by the mortgage banker to the dealer is negotiated.
price," the price at which a GNMA with a specified coupon can be sold to the
dealer upon the exercise of the standby commitment. A dealer issuing a standby may decide to reduce his risk exposure by obtaining a similar commitment
from an investing institution to which he pays the bulk of the standby fee
In periods of rising interest rates, the
received from the mortgage company.
cost of standbys at the dealers can increase considerably since the issuer of
the standby (dealer or investor) is more likely to receive delivery of GNMAs
priced below the market.
At FNMA, on the other hand, fees for standby commitments are constant regardless of market conditions.

—

9/

The cost-of-carry element the difference between long- and short-term
interest rates usually dominates the pattern of forward-delivery prices,
Thus, the differbut interest rate expectations also can have an effect.
ence between immediate and forward delivery prices does not necessarily
match the net gain or loss on mortgage warehousing.

10/

Standby commitment agreements generally specify that the seller must give
At that point, the commitment
30 to 60 days notice of intent to deliver.
becomes mandatory.

—


Federal Reserve Bank of St. Louis

77

In the forward market (mandatory or optional), contracts between
mortgage companies and securities dealers generally include an equivalentyield clause that permits delivery of GNMAs issued against pools of mortgages
bearing either the current FHA/VA ceiling rate or other ceiling rates that
might be established during the life of the contract.
Standard conversion
factors, based upon the assumption of 30-year term and prepayment in 12 years
for all coupons (in the case of securities issued against pools of home mortgages), establish delivery prices for various coupons that will produce yields
"equivalent" to those agreed upon for the current coupon. 11 /

Delayed-delivery contracts generally also specify that the securities delivered cannot be priced higher than par.
This "par cap" reflects the
reluctance of Investors to absorb capital losses that accrue as premium securities approach maturity.
It also protects dealers and investors against the
possibility of outright losses that could occur on premium securities in the
event of rapid prepayment of mortgages in the pools, and it limits the dollar
outlay required of buyers that had committed to purchase a given amount of
GNMAs (par value). 12 / On the other hand, the par cap can create complications
for mortgage companies when the FHA/VA ceiling is increased; mortgages originated under the higher ceiling might have to be priced below market to meet a
commitment to deliver GNMAs under an "equivalent" yield contract. Under such
conditions, of course, the mortgage companies may buy the lower-coupon FHA/VA
mortgages or GNMAs in the market to meet the commitments.
Investors often buy GNMAs for immediate delivery in the cash market.
Some investors also buy GNMAs under mandatory-delivery arrangements in the forward cash market as a way of locking in asset yields at some margin over their
anticipated costs of funds; such forward pricing of mortgage investments has
been regarded as a legitimate form of hedging by the regulators of depositary
Some also may issue standby commitments to
Institutions, such as the FHLBB.
buy in the future, receiving front-end fees in return. The demand for forward
delivery commitments by GNMA issuers, however, need not be met by the supply
Speculators, who accept interest
of commitments issued by permanent investors.
rate risk in the hope of making profits from changes in the market, provide
Moreover, secua bridge between mortgage companies and mortgage investors.
rities dealers may take substantial positions on their own accounts.
An organized futures market in GNMAThe GNMA futures market
guaranteed securities has been in operation at the Chicago Board of Trade
since late 1975, providing ways of hedging against Interest rate changes for
.

11 /

As discussed below, actual market prices for various GNMA coupons may
differ from the prices generated by this equivalent-yield formula.

12 /

Rapid paydowns of premium securities can occur if market Interest rates
decline and the high-rate mortgages in the pools are refinanced by the
borrowers.


Federal Reserve Bank of St. Louis

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78

GNMA issuers, investors and dealers. Actual delivery is generally not made
on the futures market, because positions usually are offset before the futures
contracts expire.

Mortgage bankers may sell GNMA futures contracts as a temporary
This "short hedge" tends to balance
substitute for a sale in the cash market.
the risk of a long position in the cash market associated with the accumulation
of mortgage inventory for later sale; losses incurred in the cash market when
mortgage prices are falling should be approximately offset by gains realized
on the futures contracts when the mortgage banker closes out its futures market
position by buying back the contract at a profit (if mortgage prices are rising,
the situation Is reversed).
On the other hand, companies committing to sell
GNMAs in the forward market may simultaneously secure a "long hedge" in the
Indeed,
futures market by buying an equivalent amount of futures contracts.
any institution committed to buy or sell GNMAs in the forward market may hedge
this position by taking a position in the futures market equal to and opposite
from its forward market position.
Hedging in the futures market involves some costs, such as brokerage commissions and opportunity costs associated with initial and maintenance
margin requirements. 13 / Moreover, many mortgage companies hesitate to use
the futures market because they prefer to hold open the possibility of capital
gains on mortgage inventory while limiting the possibility of capital losses
through use of optional-delivery standby commitments (from FNMA or from GNMA
dealers).
Some mortgage companies also had been deterred by complications
surrounding the delivery instrument known as a collateral depositary receipt
(CDR), formerly called a due bill, which was developed by the Chicago Board
of Trade. 14 /
In 1978, the American Commodities Exchange developed a GNMA
futures contract allowing for settlement of short positions via delivery of
actual GNMA certificates, and the Chicago Board of Trade subsequently added a
similar contract. The CBOT's original GNMA contract market, however, remains
by far the largest GNMA futures market.
Secondary market trading of GNMAs . About $48 billion of GNMAs were
reregistered in 1979 (table 5). Moreover, dealers estimate that the actual
volume of secondary market trading was substantially larger (perhaps by a factor of 10) due to trades involving assignment but not registration primarily
among the securities dealers. Until recently there was no central clearing
house, and most transactions in GNMAs have been settled by individual dealers,
either by delivery or by pair-off s and difference checks to settle trades.

—

13 /

The broker charges a "round turn" commission to sell and then buy a futures
contract.

14 /

Under this delivery system, the mortgage banker had to maintain a collateral
pool of GNMAs to back his CDRs until they were surrendered.


Federal Reserve Bank of St. Louis

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-

Table 5
GMMA-GUARANTEED PASSTHROUGH SECURITIES TRANSFERRED IN SECONDARY MARKET
(Millions of dollars)

Month


Federal Reserve Bank of St. Louis

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80

Yields on the higher-coupon securities traded in the secondary markets usually are higher than those on the lower-coupon securities (under the
standard 12-year average life assumption). There apparently are two reasons
for this difference.
First, higher coupon issues have shorter expected maturites because there is a higher probability of early prepayment of the mortgages in the pools than there is for the mortgages in the low-coupon pools.
Second, the price and yield pattern may also partly reflect tax considerations.
The ratable share of discount income obtained by acquiring a newly issued GNMA
at a discount from par must be reported to the Internal Revenue Service as
ordinary income.
But recoveries of price discounts on seasoned issues acquired
in the secondary market— which arise because market interest rates decrease
Thus,
after issuance are considered to be capital gains for tax purposes.
for investors with marginal income tax rates above the tax rates for capital
gains, deeply discounted Issues will be relatively attractive, ceteris paribus.
The favorable tax status of low-coupon GNMAs is an important factor in the
determination of yield spreads among GNMAs with various coupons, in view of
the important role of taxable institutions in this market.

—

Repurchase agreements . Securities dealers enter into repurchase
and reverse-repurchase agreements in GNMAs.
From the dealer's perspective, a
repurchase agreement involves a sale of GNMAs for immediate delivery and a commitment to buy back an equivalent amount of the securities at a future date at
the same price, plus a sum of money that yields a prearranged rate of interest
over the period of the contract; for dealers, this is basically a financing
transaction or borrowing. A reverse repo, on the other hand, involves the
purchase of securities by a dealer and a commitment to sell back an equivalent
amount of the securities at a specified price on a specified future date; an
agreed-upon interest rate is earned by the dealer over the life of the contract, and for financial reporting the transaction is treated as a receivable
collateralized by the security purchased.
Some major dealers advertise bid and asked interest rates for terms
of 30, 60, and 90 days on repos, identifying an interest rate spread generally
around 1/2 percentage point. However, as in other components of the market,
practices are not standardized.
Initial margins (in the form of price markdowns) may or may not be required, and the repurchase agreement may or may not
be "marked" to the market in the event of price fluctuations.
The securities
may be re-registered, but it is customary to keep the securities in the name
of the original owner during the period of time they are pledged as collateral
under a repurchase agreement. However, in some cases the security "repurchased"
may not be the same security that was sold.
In the case of such "money" repos,
collateral substitution is allowed and yield maintenance and par cap provisions are involved.

From an investor's perspective, a reverse repo with a dealer is a
method of turning securities held in portfolio into cash for a short period at
interest rates that may be favorable, relative to other short-term interest
rates available in the raarket. An investor may do a repurchase agreement to


Federal Reserve Bank of St. Louis

81

raise short-term funds without actually liquidating his assets.
For some
institutions, such as S&Ls
this can be an important mechanism for raising
cash without taking losses when GNMA prices are depressed.
,

The MBS Clearing Corporation
In 1979, the MBS Clearing Corporation was established to offer services providing risk reduction and settlement
the GNMA forward market.
Mortgage bankers,
cost savings to firms active
The list of participants
investors, and dealers may participate.
early
1980 is shown in table 6.
.

m

m

On each day, MBSCC, utilizing the Midwest Clearing Corporation as
facilities manager, produces two reports for each participant a "Purchase
and Sales Report" and an "Open Commitment Report." The P & S Report lists
all pertinent information on each trade entered the previous day and serves
This Report elimias a formal comparison and confirmation of each trade.
nates the need for the exchange of commitment letters by both parties to a

—

trade.

The Open Commitment Report is a detailed listing of all forward
The
trade commitments that have been entered and have not yet been settled.
It is
Report provides participants with a surveillance tool for open trades.
from information contained in this Report that MBSCC calculates a daily markto-the-market for each participant.
Each participant is required to post
directly with MBSCC, or through an approved bank, a letter of credit, cash or
qualified securities in an amount equal to 100 percent of any debit margin
balance.
This must be done within twenty-four hours after notice from MBSCC.

Settlement cost savings for participants result from MBSCC's ability
trades each settlement month into a substantially fewer number of balance
order deliveries than a firm would achieve by pairing off open trades with
another firm.
MBSCC routinely nets over 90 percent of all trades while firmto-firm pair-offs normally net only 50 to 60 percent.
to net


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Table 6
PARTICIPANTS IN THE MBS CLEARING CORPORATION

ACLI Government Securities
Bach

Cantor Fitzgerald Agency
COMARK
Countrywide Funding
Dean Witter Reynolds

First Boston
Gar ban Ltd.

Goldman Sachs*
Hilliard Farber

JPC Brokers

Kidder Peabody
Loeb Rhoades

Merrill Lynch
MKI Government Securities

Neuberger Herman

Oppenheimer
Paine Webber

Salomon Brothers
S. E. First National Bank*

Thompson McKlnnon

*

Applied for participation.

Source:


Federal Reserve Bank of St. Louis

MBS Clearing Corporation.

83

APPENDIX D
FHLMC MORTGAGE-BACKED SECURITIES

The Federal Home Loan Mortgage Corporation (FHLMC) was created as
corporate instrumentality of the United States under Title III of the Emergency Home Finance Act of 1970. The corporation is owned by the Federal Home
Loan Banks and the Board of Directors consists of the three members of the
Federal Home Loan Bank Board.
a

FHLMC was established primarily to develop secondary markets in
conventional (nonfederally insured or guaranteed) residential mortgages.
FHLMC has carried out its statutory responsibilities by purchasing residential
mortgages primarily from members of the Federal Home Loan Bank System and by
In recent years, FHLMC has
reselling mortgage assets out of its portfolio.
marketed its mortgages mainly through sales of mortgage passthrough securities
that it both issues and guarantees.
The economic objectives of the FHLMC mortgage passthrough securities
programs are generally the same as the goals of the GNMA program increased
liquidity in secondary mortgage markets and a broader investor base for residential mortgages.
In the early days of the FHLMC programs, emphasis was
placed on regional redistribution of mortgage funds within the S&L industry;
FHLMC sought to purchase mortgages from S&Ls in capital deficit areas and to
In recent
sell mortgage-backed securities to S&Ls in capital surplus areas. 1/
years, FHLMC has added to this capital redistribution goal a second obiective
of attracting new sources of funds into the conventional residential mortgage
markets

—

Since its creation in 1970, FHLMC has utilized a variety of mortgage
purchase and sale programs.
Originally, FHLMC bought both government-underwritten and conventional residential mortgages (and participations in conventional mortgages) through an open-window system at advertised prices, and
financed its activities out of its original $100 million in capital and by
issuing debt.
FHLMC has borrowed in debt markets primarily through the
Federal Home Loan Bank System (short-term discount notes and consolidated
FHLB obligations), and has issued a limited number of bonds guaranteed by
GNMA.

FHLMC began to sell mortgages out of its portfolio in 1971 by
issuing mortgage passthrough securities.
FHLMC in 1975 designed a second
type of passthrough securities to appeal to investors that prefer the cashflow features of bonds rather than mortgages. 2/
In recent years, the cor-

1/

the maior type of FHLMC-guaranteed oassthrough certificate
classified as a mortgage asset by SfiLs and mutual savings banks
for federal tax purposes.

As with GNMAs

,

raav be

2/

This type of security may not be classified as a mortgage asset by S&Ls
and mutual savings banks for federal tax purposes.


Federal Reserve Bank of St. Louis

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84

—

poration has raised most of its funds more than three-fourths in 1978 and
1979 through sales of mortgage passthroughs
In 1977, FHLMC abandoned the
open-window system for purchasing conventional home mortgages and inaugurated
an auction system designed to provide more competitive market prices to mortgage originators and to allow FHLMC to more closely control the volume of
mortgage purchases. Also in 1977, FHLMC contracted with a group of securities dealers to participate in the retail of its major types of passthrough
security, and to make secondary markets in the instrument.

—

.

Characteristics of Mortgage Pools and Pass-Through Securities
The mortgage pools backing issues of FHLMC-guaranteed securities
consist of conventional residential first mortgages (whole loans and participations) acquired by FHLMC primarily from members of the FHLB System through
its various mortgage-purchase programs. 3/
The pooled mortgages are largely
newly originated loans (less than one year old), although up to 20 percent of
the cumulative aggregate principal balance of all conventional mortgages purchased by FHLMC can be seasoned loans. 4/ Each pool, when formed, generally
has an aggregate unpaid principal balance ranging from $100 to $200 million
and comprised of from 2,000 to 5,000 residential mortgages.
At least 95 percent of the aggregate principal balance of the pool must consist of home mortgages (1- to 4-family), with the balance made up of multifamily mortgages.
Not more than 2-1/2 percent of the home mortgages in a pool may be flexiblepayment loans. At present, FHLMC purchases conventional residential mortgages
with loan-to-value ratios exceeding 80 percent only if the principal amount
in excess of 75 percent of the appraised value of the mortgage property is
covered by private mortgage insurance.

FHLMC issues passthrough securities against the assembled pools
of mortgages and the originators of the mortgages continue to service them.
FHLMC issues two types of securities against the mortgage pools Mortgage
Participation Certificates (PCs) and Guaranteed Mortgage Certificates (GMCs).
Both types represent undivided interests in pools of mortgages, but the cash
flow patterns are different.
As with GNMAs, the FHLMC PCs entitle holders
of the securities to monthly payments of interest on the underlying mortgages;

—

"hj

Originally, FHLMC could buy mortgages only from federally insured depositary institutions, and those insured depositary institutions that were not
part of the FHLB System had to pay a nonmember fee when selling mortgages
to FHLMC.
In 1978 FHLMC was authorized to buy from mortgage companies,
although these institutions also must pay a nonmember fee.
In practice,
most mortgage sales to FHLMC are from S&Ls.

4/

As of June 1979, seasoned loans (more than one year old) represented less
than 5 percent of all conventional mortgages purchased by FHLMC.


Federal Reserve Bank of St. Louis

- 85

-

scheduled payments of principal and mortgage prepayments are also oassed
through on a pro rata basis. 5/ The GMCs, first offered in l"??"!, pay
interest semiannually, return minimum scheduled principal amounts once a
year, and give holders the option of selling the certificates back to
They were designed for instiFHLMC in either 15, 20 or 25 years at par.
tutional investors that dislike the uncertain cash flow features of PCs
GMCs account for
and prefer semiannual rather than monthly remittances.
about one-eighth of the dollar amount of all passthrough securities issued
and guaranteed by FHLMC.

FHLMC PCs and GMCs are both issued in minimum denominations of
Yields on the PCs are
$100,000 and have maximum maturities of 30 years.
quoted on the basis of 12-year average lives. 6/ The maximum average
weighted life of a CMC has ranged between 8.3 and 10.8 years, considering
The price at which FHLMC
the repurchase and minimum repayment provisions.
offers the securities depends on the coupon rates and current market conditions and in recent years the certificate rates have varied in increments
FHLMC PCs and GMCs are available only
of one-quarter of one percent. 7/
in fully registered form and are readily transferable.
The timely payments of interest and full pajmient of all principal
FHLMC PCs and GMCs are guaranteed by FHLMC; the securities are not guaranon
teed by the United States or by the Federal Home Loan Banks, and they do not
constitute debt obligations of the U.S. or any FHLB. FHLMC's contingent
liability is offset by a like amount of mortgage loans underlying the PCs and
GMCs,
In addition, FHLMC maintains a reserve for management fees and guaranEven though FHLMC passthrough securities are not guaranteed by the full
tees.
faith and credit of the federal government, the yield on FHLMC PCs ordinarily
This typical
exceeds that on GNMA passthroughs by only about 35 basis points.
yield relationship suggests that the investment community believes the FHLB
System, or even the Treasury, might come to the aid of FHLMC if necessary to
maintain payments on the securities.

5/

Shares of prepayment fees on the mortgages also are passed through to
Since FHA- and VA-underwritten mortgages do not
the securities holders.
have prepayment penalties, prepayment fees are not a factor in the GNMAguaranteed securities market.

6/

The limited experience of FHLMC suggests that the average life of a PC
actually will be less than 12 years, and internal FHLMC decisions are
based on the assumption that the average life is between 6 and 8 years.

7/

FHLMC prefers to set the certificate rate on a passthrough security below
However, when market interest
the net yield on all mortgages in the pool.
In these cases, FHLMC
rates are rising sharply, this may not be possible.
retains ownership of a portion of the mortgage pool and transmits interest
received on this portion to the security holder to maintain payment at the
certificate rate.


Federal Reserve Bank of St. Louis

86

Participants in the FHLMC Mark et
Issuer
FHLMC is both the issuer and the guarantor of its mortgage
Since FHLMC seeks to maintain only a modest mortgage
passthrough securities.
portfolio, the volume of issues is determined primarily by the scope of its
mortgage purchase programs. The volume of mortgage purchases depends partly
on overall mortgage market conditions, but FHLMC can control purchase volume
by varying the proportions of bids accepted in its auctions of mortgage purchase commitments. FHLMC has a limited capacity in terms of resources necessary to underwrite mortgages and administer the programs, and thus the Corporation sets limits on its level of operations.
.

Investors
During the first half of the 1970s, virtually all of
the FHLMC passthrough securities were bought and held by members of the
In recent years, however,
Federal Home Loan Bank System (primarily S&Ls).
In 1979,
participation by diversified institutions has expanded greatly.
institutions other than S&Ls purchased nearly 80 percent of the PCs issued
by FHLMC (table 1). The GMCs have appealed to bond portfolio managers from
the start, and the thrift institutions have bought only minor amounts of
these securi t ies
.

Credit unions and individuals have purchased only minor amounts of
FHLMC passthrough securities, perhaps because of the large minimum denominaOn the other hand, bank trust departments, insurance companies, and
tions.
pension and retirement funds have been major investors in recent years.

Deale rs. Prior to 1977, FHLMC marketed the PCs directly to invesHowtors, and the Corporation still maintains a small retail sales force.
ever, in January 1977 FHLMC contracted with a group of major securities
dealers to participate in the retail distribution of the PCs; the FHLMCapproved group currently consists of 13 New York securities dealers and
The GMCs are marketed by the FHLBB Office
the Bank of America (table 2).
of Finance through a special dealer group that they have formed.
FHLMC has established certain standards and procedures for its
selling group of dealers. FHLMC evaluates all dealer applicants by reviewing
audited financial statements to assure adequate net worth and by analyzing
Moreover, the sales
the operations and internal management of the dealers.
control staff of FHLMC periodically conducts on-site compliance audits of
each firm to verify reported sales activity and to ensure fair pricing.
Certain activities are prohibited by FHLMC, such as purchasing optionaldelivery PCs for the dealer's own account ("positioning") or real lowing any
part of the dealer's sales concession to the purchaser ("customer-directed
give-ups"). 8/

8/ Sales concessions are discussed on page 8,


Federal Reserve Bank of St. Louis

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Table 1
PURCHASES OF NEW ISSUES OF FHLMC PCs
(Percentage distributions)

Type of investor
Savings and loans

Credit unions
Bank portfolios

Bank trust
Savings banks
Public pension funds

Private pension funds

Investment companies
Insurance companies
State and local government funds

Individuals
Dealer positions
Other


Federal Reserve Bank of St. Louis

1978

88 -

Table 2
MEMBERS OF FHLMC PCs DEALER GROUP
(May 1980)

Bache Halsey Stuart Shields, Inc.

New York, New York

Bank of America

San Francisco, California

New York, New York

Becker, Inc.

A.

G.

E.

F. Hut ton & Co.,

Dillon Read

St

Inc.

Co., Inc.

New York, New York
New York, New York

First Boston Corporation

New York, New York

First Pennco Securities, Inc.

New York, New York

Goldman, Sachs & Co.

New York, New York

Kidder Peabody

New York, New York

&

Co., Inc.

Lehman Government Securities, Inc.

New York, New York

Merrill Lynch Government
Securities, Inc.

New York, New York

Paine Webber Jackson & Curtis, Inc.

New York, New York

Salomon Brothers

New York, New York

Shearson Loeb Rhoades, Inc.

New York, New York

Source:

Federal Home Loan Mortgage Corporation.


Federal Reserve Bank of St. Louis

-

89

Distribution and Trading of FHLMC Securities
The GMCs are not sold on a regular basis (there were 4 Issues in
1979), and issues are forthcoming only when FHLMC determines that market
All transactions are on an
conditions favor issuance of this security.
Immediate and mandatory delivery basis. There is no forward market for
these securities and secondary market liquidity is quite limited.

Sales of PCs are conducted by FHLMC on a continuous basis and new
issues are sold in a variety of ways to the securities dealers that particiSales are made under mandatory and optional
pate in retail distribution.
delivery programs, and agreements may call for delivery on either an immediate or a delayed delivery basis.
To reduce Its risks, FHLMC generally
attempts to tailor its PC sales volume to correspond to the volume it has
generated or expects to generate under its major conventional mortgage purchase programs. FHLMC currently conducts weekly auctions of mortgage purchase commitments providing for mandatory delivery within 60 days, and
once a month conducts an auction for optional forward commitment contracts.

Under mandatory delivery contracts, dealers commit to purchase
from FHLMC a specified principal amount of PCs on a given date between 7
Under optional delivery contracts, the
and 150 days from the trade date.
dealer commits to buy up to a specified amount of PCs for delivery any time
within a specified period; currently the commitment periods are 140 and 270
days. Neither a mandatory delivery contract nor an optional delivery contract may be assigned or transferred by a purchaser without the prior written consent of FHLMC.
FHLMC presently allows a sales concession to dealers involved in
the retail distribution of PCs, in an amount no greater than 0.25 percent
of the purchase price of the securities sold to the dealers; the dealers,
in turn, are expected to place the issues with investors at the sales price.
In the case of optional-delivery sales contracts, FHLMC pays the customer
standby fees-not more than 1 percent for the 270-day program.

FHLMC does not require members of its PC dealer group to post
The Corporation's retail sales force,
Initial or maintenance margins.
however, retains the right to require a good faith deposit of up to 5
percent of the unpaid principal balance of the PC on the trade date.
About half of the 14 dealers that distribute new issues of PCs reportedly
are requiring maintenance margin (between trade and settlement dates) in
forward contracts with some of their customers.
FHLMC maintains a secondary market for PCs, quoting bid prices
for the repurchase of PCs and offering prices for currently issued PCs as
well as PCs it has repurchased.
Since 1977, securities dealers also have
made secondary markets for PCs, and FHLMC has encouraged trading at the
dealers; FHLMC s bid prices for repurchase may be below bid prices at


Federal Reserve Bank of St. Louis

90 -

securities dealers making a market in PCs, and FHLMC s offering prices
for resales may be higher than the offering prices at the dealers.
Members of the PC dealer selling group report that secondary market trading
in PCs amounted to more than $20 billion during 1979.
Spreads between bid
and asked prices at dealers generally are 1/8 point for recently issued
at

'

securities and ordinarily range between 1/4 and 1/2 point for more seasoned
issues, although the size of spreads depends on overall market conditions.

FHLMC PCs are used as collateral in repurchase (or reverse repurchase) agreements between investors and dealers, or between two financial
institutions.
FHLMC has pointed out that these agreeements are solely
between two private parties and the Corporation is not obligated in any
way to either party.


Federal Reserve Bank of St. Louis

91

APPENDIX E
GOVERNMENT GUARANTEED SECURITIES
(OTHER THAN MORTGAGE -BACKED SECURITIES)

All federally guaranteed loans and bonds that currently are sold in
the private capital markets are discussed below, except GNMA and FHLMC mortgageThe latter are reviewed in detail in Appendices C and D.
backed securities.
Federal loan guarantees assure lenders that the government will pay
all or part of principal and interest on a loan in the event of a default by
the borrower.
The use of loan guarantees was initiated on a large scale in
The loan guarantee
the U.S. during the 1930's to assist purchases of homes.
concept was expanded in the 1950's and 1960's to assist marginal borrowers
such as small businesses, students and low income families, who were unable
to obtain credit or who could obtain credit only at high cost.
In the 1970'
loan guarantees became widely used to supplement budget outlays to achieve
various other public policy objectives.
The Federal Housing Administration single-family mortgage Insurance
program was one of the earliest and remains the most successful of the guaranPrior to its establishment, most home mortgages had low loan-totee programs.
value ratios, matured in 5 or 6 years and provided for "balloon payments" of
principal at maturity.
This arrangement triggered a large number of foreclosures and bankruptcies during the Depression and caused private lenders
The FHA mortgage insurance program
to back away from the mortgage market.
It
was initiated in 1934 to fill this important gap in credit availability.
assured private lenders that they could safely make long-term, low downpayment mortgage loans at reasonable interest rates.

The FHA mortgage insurance program is operated on an actuarily sound
basis; FHA charges insurance premiums which are high enough to cover probable
losses and operating expenses.
The government pools the risk of a number of
small loans, and borrowers as a group bear the risks through insurance premiums.

With the experience of a successful FHA insurance program, federal
policjmiakers expanded the loan guarantee concept in the 1950 's and 1960 's to
provide credit assistance for higher risk borrowers in order to achieve socially
desired goals.
Similar to loans guaranteed under the FHA mortgage insurance
program, most of the guaranteed loans in this period were small and were financed
by institutional investors, largely banks, insurance companies and pension funds.
An example of the higher risk programs is the urban renewal program which was
established in the Housing Act of 1954 to assist residents of urban renewal areas,
whose record of creditworthiness had not been established, to obtain credit on
properties whose future value was in doubt.
Other higher risk programs include
the Small Business Administration business loan guarantee program, which was
established in 1953 to assist smaller, often thinly capitalized entrepreneurs.
The Federal Ship Mortgage insurance program, which was established in 1938, was
simplified and expanded in 1953 as part of larger efforts to assist the U.S.
.shipping industry.
The Guaranteed Student Loan Program was established in
1965 to assist low- and moderate-income students in obtaining funds for postsecondary education.

Federal Reserve Bank of St. Louis

92

Loan guarantees took on a new dimension in the late 1960 's and the
1970's when federal guarantees were substituted on a large scale for direct
Such programs
federal loans and other program outlays in the federal budget.
include the substitution of loan guarantees for below market interest rate
direct loans to REA electric cooperatives, the use of loan guarantees for big
projects such as those to promote energy self-sufficiency, and guarantees for
special situations such as Chrysler and railroad restructuring. At the time
the number of guarantees was expanding, the creativity of federal program
managers and private market participants was being applied to establish secondary markets for guaranteed loans, such as FHA and VA-backed mortgages and SBAs,
which traditionally had been held largely by the loan originator.

A large number of relatively small direct and federally guaranteed
debt issues that resulted from the proliferation of guarantee programs caused
market congestion and serious Federal debt management problems in the early
1970 's.
The Federal Financing Bank was established under legislation enacted
in 1973 (P.L. 92-224, 12 Q.S.C. 2281 et seq .) to centralize and better coordinate the timing and terms of sales of obligations that were issued, sold or
guaranteed by federal agencies and to reduce the costs of federal and federallyassisted borrowing from the public.
Under current FFB policy, the FFB borrows
solely from the Treasury and uses the proceeds to purchase direct obligations
of federal agencies and obligations that are fully guaranteed as to principal
and Interest by a federal agency.
The FFB is a corporate instrumentality of
the U.S. and is under the supervision of the Treasury Department.
To date, FFB policy has been to purchase obligations on original
issue, rather than entering the market to purchase outstanding obligations.
Thus, there remain outstanding balances of loans that were guaranteed to private holders prior to the time the program came into the FFB.
An example is
loans guaranteed by the Department of Defense under the foreign military sales
program.
Outstanding loans that are in private hands are in repayment status,
and private holdings are declining.
As a broad indication of the size of the universe of federallyguaranteed obligations outstanding in the market, table 1 presents data on
federally-guaranteed obligations that were held by private investors on
September 30, 1979.
This table Includes private holdings of obligations that
were issued under programs, such as Department of Defense foreign military
sales guarantees, that currently are financed solely by the FFB.
The table
does not Include guarantees of loans, such as those guaranteed by NASA under
its space shuttle development program, for which there was no private market
financing on September 30, 1979.

A narrower view of the size of the government-guaranteed market is
presented in table 2, which excludes obligations Issued under programs that
currently are financed through the FFB. Table 2 presents summary information
on obligations that are guaranteed and financed currently In the capital marIt also provides a judgmental estimate of trading activity that is
kets.


Federal Reserve Bank of St. Louis

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Table 1
OWNERSHIP OF FEDERALLY GUARANTIED LOANS AND BONDS
September 30, 1979

Agency and program

Holdings of federal entities
Privately
Spons.
Other
held
federal 2/ agency 3/

Total

FFB

appropriated to the President
Foreign military sales
Agency for International Dev.
worldwide housing guarantees
Overseas Private Investment Corp.
Callable capital of international
dev. banks

1/

F unds

Agriculture Department
Farmers Home Administration
Commodity Credit Export guarantees
Rural Electrification

5,670

5,271
760
56

760
92

36

11,545

11,545

37,078
136
7,535

31,080

5,802

196

136

385

7,150

Commerce Department

883

883

Administration
Maritime Administration

106
5,703

106
5,703

Education
Guaranteed student loans
Other education

8,302
1,305

Economic Development Admin.
National Oceanic & Atmospheric

1,239

7,063

Energy

Geothermal resources
Health and Human Services
Health programs

Medical facilities
Housing and Urban Development
Low-income project notes and
bonds
Urban renewal notes and bonds
New communities debentures

Mortgage Insurance
Federal Housing Admin.
Veterans Administration

Subtotal
Less GNMA pools of FHA/VA
FHA/VA outside of GNMA pools

Continued on next page.

Federal Reserve Bank of St. Louis

14

14

167
1,321

77

160

15,050
466

5

141

38

110,051
89,158

199,209
70,558
128,651

3,105 5/

35,251 6/

90,295

-

Table

1

94

(continued)

Holdings of federal entities

Agency and program

Transporation
Rail program 7/
Washington Metro Authority
FAA aircraft loan guarantees
Treasury
New York City

8^/

Independent Agencie s
Export -Import Bank
General Services Administration
Small Business Administration
Business loans
Lease and surety bond
Lease guarantees
Disaster loans
Pollution control bonds
(tax-exempt)


Federal Reserve Bank of St. Louis

95 -

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Federal Reserve Bank of St. Louis

-

96

based on the type of obligations and on discussions with program agency officials and market pjarticipants.
Currently, there is no centralized survey of
the dollar volume of transactions in these obligations.

Guaranteed obligations can be classified into three general groups:
(1) bond-type obligations that are financed in the market on original issue
and which are traded in a secondary market; (2) loans that are originated and
serviced by one entity and sold to another investor in the secondary market;
Innovations
and (3) loans that are originated and held by the originator.
initiated by market participants and the guarantee agencies have encouraged
sales of the guaranteed portion of partially-guaranteed loans into the secondary market in order to provide liquidity for the obligations and to increase
the availability of credit for agency programs.
The guaranteed obligations
which comprise the major share of the market are described below.

HUD Projects
Of all guarantee programs, only HUD project notes and bonds and
Maritime Administration guaranteed securities are currently sold through
public offerings and are issued in a standard denomination.
The Department
of Housing and Urban Development guarantees tax-exempt notes and bonds that
are issued by approximately 3,000 local public housing finance authorities
for low-income housing projects.
The obligations are fully secured by HUD
annual contributions contracts, under which HUD pays principal and interest
on the obligations of the HFAs (42 U.S.C.
HUD also has authority
1437c).
to loan up to 100% of development, acquisition and rehabilitation costs to
the HFAs in the event obligations are not sold in the market (42 U.S.C.
HUD has back-up authority to borrow from the Secretary of the Trea1437b).
sury, so that timely pa5mient is assured.

HUD project notes are designed to provide for short-term financing
during a project construction period. While the program allows for long-term
bonds to be guaranteed to provide permanent financing, no long-term HUD project bonds have been issued since 1974.
Thus there has been a large build-up
in the amount of short-term financing that is being rolled over each year.
The President's Budget for FY 1981 calls for FFB purchases of long-term HUDguaranteed project bonds; to date the FFB has not purchased any.
HUD project notes are bellwether issues in the tax-exempt market,
and are actively traded.
They are sold to the public in regularly scheduled
monthly auctions of approximately $1 billion in which bidders compete for
the notes of specific issuers.
Usually, banks and securities dealers form
syndicate groups to bid on particular issues, and the notes subsequently are
distributed to investors.
The auction occurs approximately 1 month prior to
the delivery date of the securities.


Federal Reserve Bank of St. Louis

97

Title XI Ship Financing
The Maritime Administration fully guarantees 6-month to 40-year
securities that are issued in the market by qualified American shipowners
under the Merchant Marine Act of 1936, as amended (46 U.S.C. 1271 et seq .).
MarAd guarantees short-term obligations maturing in 6 months to 1 year to
accommodate construction or renovation period financing needs. The shortterm obligations can be refinanced in separate transactions in the form of
longer-term sinking fund debentures to provide for permanent financing.
MarAd also guarantees long-term financing for shippers who have utilized
unguaranteed loans during the construction period.
The long-term sinking
fund debentures are redeemed at par on a lottery basis in predetermined
amounts on specified dates over the maturity period.

Title XIs usually are sold to the public through underwriters,
although smaller issues often are privately placed through investment bankers
who act as agent and charge a fee.
The terras of all sales of MarAd Title
Pricing
XIs on original issue must be approved by the Treasury Department.
usually takes into consideration current yields on marketable U.S. Treasury
issues with similar maturities.
Pricing of the Title XIs is usually done
one week prior to the issue date, but can be done as much as one month prior
to delivery of obligations.

Pension funds and life insurance companies, which hold rather than
Dealers who
trade the obligations, comprise the major share of the market.
distribute the bonds on original issue also make markets in the obligations
Individual participation
in order to provide liquidity for their customers.
in the MarAd Title XI market is practically nonexistent, with the exception
of retirement funds of high-income professionals.

Small Business Loans
The second category of Federal guarantee programs in table 2
includes those in which the originator sells the whole loan or the guaranteed
portion of the loan in the secondary market and usually retains the responsiBy far the most Important of the guarbility for servicing the whole loan.
anteed loans in this category are the fully-guaranteed portions of SBA business loans that are partially guaranteed on origination (SBA 90-lOs).

Section 7 of the Small Business Act (15 U.S.C. 636) authorizes SBA
to participate in loans to qualified small businesses, on an immediate or
The general
deferred basis, for up to 90% of the principal and interest.
powers in Section 5(b) of the Act (15 U.S.C. 634(b)) have been interpreted
in legal opinions by the SBA, the Attorney General and the Comptroller General
to authorize SBA to pledge the full faith and credit of the U.S. to repayment
of the fully guaranteed portion of a loan, whether it is held by the loan


Federal Reserve Bank of St. Louis

- 98

The SBA does not under current law,
originator or a secondary investor.
however, have authority to guarantee participation certificates in pools of
SBA guaranteed loans.
The SBA pledges that, in the event it is called upon
by the holder to make good on its guarantee, it will draw on revolving funds
authorized under the Act and seek additional appropriations if necessary.

The overwhelming share of SBA-guaranteed loans and of guaranteed
loans that are sold in the secondary market are small business loans guaranteed under section 7(a).
Those loans generally mature in up to 10 years,
with monthly amortization of principal and interest over the term of the
loan (other amortization schedules can be agreed upon) and no prepayment
penalty.
The average loan size is $110,000 while the maximum loan guarantee
is $500,000 to any one borrower.
There are $7.6 billion of guaranteed small
business loans outstanding at the end of fiscal year 1979. About 15 to 20
percent of the $3.1 billion of new loans estimated to be guaranteed in the
current fiscal year are expected to be sold in the secondary market.

The Interest rate on an SBA-guaranteed business loan can be fixed
or variable.
The interest rate on a fixed rate loan is set for the term of
the loan at a maximum of the commercial bank prime rate at the time the loan
is disbursed, plus 1/2 of 1 percentage point.
The maximum allowable on variable rate loans is the base rate (usually the prime rate) plus 2-1/4 points
for loans maturing in 7 years or less or 2-3/4 points for loans maturing in
more than 7 years. The rate on a variable rate loan can change only at the
end of each 3-month period following the date the loan is disbursed, and is
based on the commercial bank prime rate at the end of the period.
SBA regulations permit lenders to require guaranteed borrowers to pay the 1-time, 1
percentage point SBA guarantee fee when the loan is disbursed.
Both fixed
rate and variable rate loans are sold in the secondary market.

Repayment schedules on SBA guaranteed business loans are negotiated
between the lender and the borrower, but generally provide for monthly payments of principal and interest. The level debt service and the level installment methods of repajraient are most often used.
Level debt service is the most
popular and provides for equal monthly pajnnents, like a home mortgage, with
each payment applied first to interest and the rest to principal.
The level
installment method provides for equal monthly installments of principal plus
interest on the remaining balance.
Commercial banks are originators of practically all small business
loans, with about 800 banks participating actively in the program.
SBA also
licenses small business lending companies, which are regulated by state banking
commissions, to make SBA guaranteed loans in geographical areas where the SBA
believes support of other lenders is inadequate.
In January 1980, SBA for the
first time authorized a finance company which relies on the commercial paper
and bond markets for its financing, to become a lender in the Section 7 program.
The finance company plans to sell the guaranteed portion of its loan
production through dealers in U.S. government securities.


Federal Reserve Bank of St. Louis

99

SBA has promoted the development of a secondary market in the fullyguaranteed portion of small business loans, in order to increase the flow of
The secondary market was made posfunds available to guaranteed borrowers.
sible in 1974, when SBA obtained a Comptroller General's opinion stating no
objection to SBA purchases of the guaranteed portion of loans from innocent
holders even when the borrower has not gone into default, regardless of any
The secondary holder is in a somefraud or misrepresentation by the lender.
what better position to collect from SBA than the originator, since the originator's ability to collect is conditioned on its performance as servicer.
In 1979, SBA contracted with a fiscal and transfer agent to act as
custodian of the documents behind the guaranteed portion of the small business
loan, to issue one certificate per loan, to maintain a central registry of
holders of record of certificates, and act as a central receiving and paying
SBA guarantees that the fiscal and
agent.
The agent is not a market maker.
Loans
through payments from the borrower or SBA.
transfer agent will pass
initiation of the certificate system can be
that were outstanding prior to
converted into certificates, at the request of the purchaser, upon execution
of an agreement with the lender/servicer and SBA.

The guaranteed portions of SBA business loans are sold by the originator to a regional or national securities dealer, while the originator
The interest
holds the nonguaranteed portion and services the whole loan.
rate that the SBA-guaranteed borrower pays is substantially higher than the
yield to the secondary market investor who purchases the guaranteed portion
of the loan.
In lieu of paying a premium on the loan, which would adjust
the yield to current market yields and which would be at risk in the event
of prepayment of the loan, the investor usually pays a small premium and
The fee is repays a monthly fee to the originator/servicer of the loan.
tained by the servicer who receives loan payments from the borrower and
passes them through to the investor.

The combination of the face interest rate on the loan, plus the
servicing fee raises substantially the originator/servicer 's yield on its
invested capital. With a 15% interest rate on the loan and 1% servicing
fee, for example, the gross return on invested capital would be roughly 24%
(15% on the 10% unguaranteed portion, plus 1% on the 90% guaranteed portion).
The originator often sells the guaranteed portion as much as 30
days in advance of the loan closing date.
Contracts for sales of the guaranteed portion usually include an escape clause to provide for the event that
the loan is not funded or an SBA guarantee could not be obtained in time for
the schedule closing date.
Unlike forward sales of GNMA passthroughs other
guaranteed SBA loans usually are not substituted to fill the commitment to
deliver a guaranteed portion of an SBA loan.
This absence of substitutions
reflects the discrete terms of each guaranteed loan and the unwillingness of
investors to buy obligations of particular businesses or types of businesses.


Federal Reserve Bank of St. Louis

,

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100 -

The SBA has proposed legislation that would permit pooling of the
giiaranteed portions of several loans (including old outstanding loans) and
Cursales of participation certificates, which would be guaranteed by SBA.
smaller denomination
rently, the guaranteed loans are not divisible into
pieces, and each SBA guaranteed loan certificate is backed by documents for
a specific small business loan.

The SBA does not have centralized recordkeeping system for outstanding SBA-guaranteed loans, which would provide up-to-date information on
Thus, there are no data,
the unpaid principal balance of guaranteed loans.
which would be analogous to the GNMA pool factors, for the investor to check
prior to purchasing an SBA-guaranteed loan in the secondary market. The SBA
guarantees the correctness of the principal amount of a loan only on the date
of disbursement.
It does not guarantee the correctness of information on current principal balances over the loan amortization period, and the investor's
most reliable source of that information is the originator of the loan.
The secondary market for SBA-guaranteed loans is focussed mainly on
insurance companies and pension funds, which are attracted by the high yield
and safety of the instruments.
The SBAs are also attractive investments for
deposit-type institutions since they can be used to meet most pledging requirements.
There is little participation by individuals.
While the buyers of SBAs
usually hold them, dealers that distribute SBAs make markets to provide their
customers with liquidity.
Generally, SBA guaranteed loans are priced taking
into consideration current trading in GNMA pass-through securities whose
amortization schedules are similar to SBAs.

Farmers Home Business and Industrial Loans
The Farmers Home Administration guarantees 90% of the outstanding
principal and accrued interest on rural business and industrial loans under
the Rural Development Act of 1972 (7 U.S.C. 1932(a)).
Guaranteed business
and industrial loans outstanding totaled $1.5 billion at the end of fiscal
year 1979.
The FmHA B&I loan guarantee program is designed to promote business
and employment in areas with less than 50,000 population.
Unlike the requirements of the SBA business loan guarantee program, borrowers need not demonstrate an inability to obtain credit without a guarantee and there is no
statutory or regulatory maximum on the size of loans guaranteed for any one
borrower. Whereas the average size of an SBA guaranteed loan is $110,000,
FmHA B&I loans average around $500,000.
The interest rate on a B&I loan is negotiated between the lender
and the borrower, can be fixed or variable, and is not subject to any maximum.
Different interest rates can be set on guaranteed and the nonguaranteed


Federal Reserve Bank of St. Louis

- 101

Maximum maturities are 7 years for operating loans, the shorter
portions.
of 15 years or useful life for equipment loans, and 30 years for real estate.
One all-purpose loan can be made, so long as the amortization schedule accomUsually payments of principal
modates the maximum maturity for each purpose.
and interest are made monthly in level installments, but other terms can be
arranged

Nearly all B&I loans are sold into the secondary market, Famiers
Home requires the originator/servicer to hold only 5 percent of the loan;
On original sale in the secondthat is, half of the nonguaranteed portion.
ary market the guaranteed portion of a B&I loan can be divided into up to 10
notes, each of which is guaranteed by FmHA and each of which can have a sepaSubsequent divisions of guaranteed
rate interest rate and maturity schedule.
notes are not guaranteed, nor would certificates representing participations
The nonguaranteed portion can be
in a pool of FmHA B&I loans be guaranteed.
sold in the form of only one note.
Sales of the guaranteed portions of B&I loans in the secondary
market are similar to secondary market sales of SBAs , except that the FmHA
has not contracted with a fiscal and transfer agent to facilitate trading
and recordkeeping.
FmHA does not have centralized data on the outstanding
balances of particular loans, so that the best source of that information
is the originator/servicer.

AID Worldwide Housing
The Agency for International Development fully guarantees loans,
which are held by investors in the United States, to finance housing projects in developing countries as part of the U.S. Foreign Assistance Program
Since its beginning in the 1960s, more than $1.2
(22 U.S.C. 2181 et seq .).
billion of loans have been authorized for 137 projects in 36 countries and
to 3 regional institutions.
At the end of fiscal year 1979, there were $760
million of A. I.D. guaranteed housing loans outstanding.

Lenders under the A. I.D. program must be U.S. entities.
A. I.D.
assists prospective borrowers in soliciting bids from a wide range of investors by publishing a notice of each A. I.D. guaranteed investment opportunity
in the Federal Register and by mailing notices to interested firms and individuals.
The interest rate on A. I.D. guaranteed loans is a maximum of 1 percentage point above the then current FHA ceiling rate for similar domestic
loans.
A. I.D. charges a 1-point guarantee fee on the unpaid principal amount
and the investor can charge a 1-point commitment fee up front.

While A. I.D. requires amortization of principal over the life of
the loan, A. I.D. permits the parties to contract for a grace period of up to
10 years on the repayment of principal.
The maximum maturity period for any


Federal Reserve Bank of St. Louis

-

giiaranteed loan is 30 years.
out penalty.

102

Prepayments on guaranteed loans are made with-

A.I.D. has contracted with a fiscal agent to collect all loan payA.I.D. has
ments from borrowers and pass them through to holders of record.
had a longstanding arrangement under which District Federal Home Loan Banks,
notably of Boston and New York, have originated A.I.D. guaranteed housing
loans and have sold participations in those loans to savings and loan associations.
The A.I.D. fiscal agent does not make distributions of loan repayments to subsequent holders; these distributions are made by the FHLB that
originated the loan.
In a recent development, A.I.D. has contracted in two separate transactions to guarantee loans originated by large commercial banks.
These banks
sell participations in the guaranteed loans to secondary holders, mostly
savings and loans, and pass through loan payments on a pro rata basis.
A.I.D.
is a party to each note that is executed with a secondary market investor by
the commercial bank originator, thus guaranteeing the secondary holder.
There
is no minimum denomination for the notes.
The guarantee does not extend to
subsequent holders.

NOAA Fishing Vessels
The National Marine Fisheries Service of the National Oceanographic
and Atmospheric Administration, U.S. Department of Commerce, fully guarantees
loans for fishing vessels that are owned by U.S. citizens. While statutory
authority for fishing vessel loan guarantees is under Title XI of the Merchant
Marine Act of 1936, as amended (46 U.S.C. 1271-1280), the fishing vessel guarantee program is administered separately from the MarAd Federal Ship Financing
program (50 C.F.R. 255).

NOAA has the authority to guarantee interim construction loans and
long-term loans, but currently only guarantees the long-term permanent financing for new, reconstructed or reconditioned fishing vessels.
NOAA issues
commitments to guarantee the permanent financing at the beginning of a fishing
vessel construction, reconstruction or reconditioning project. When a vessel
is delivered, the proceeds of the guaranteed loan are used to repay unguaranteed interim financing.
Several securities dealers currently are active in assisting owners
obtain financing packages which include arranging unguaranteed interim
financing and placing the long-term guaranteed obligations with investors. A
typical package could include short-term financing by a commercial bank and
placement of the long-term debt with a pension fund.
Pension funds comprise
a large proportion of the market for this paper, while savings and loans.
Production Credit Associations and bank trust departments are also investors.
to


Federal Reserve Bank of St. Louis

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103

The maximum maturity of fishing vessel loans generally is 20 years
There is no maximum dollar amount
or the useful life, whichever is shorter.
of loans that can be guaranteed; the average size is around $300,000.
The
interest rate on the guaranteed loan is negotiated between borrower and lender,
and is not subject to any ceiling.
The guaranteed obligation is in the form
of a promissory note that represents the whole loan; NOAA does not permit the
loans to be divided into smaller pieces.
In addition, regulations require
NOAA approval before the guaranteed obligations can be assigned.

Loans Held By Originator

The third category of guaranteed loans which are financed currently
in the private markets includes those that usually are held by the originator.
This category includes fully-guaranteed student loans, which can be sold as
whole loans to other lenders whose ability to provide for servicing has been
approved by the Department of Education. The extremely large amount of servicing required for a guaranteed student loan, especially when it is in repayment status, limits the investment appeal of this paper.
Commercial banks
originate the majority of student loans, though originations by tax-exempt
state and local student loan funding enities have been growing in recent

The Student Loan Marketing Association was established as an offbudget federally sponsored agency in 1972 to be a secondary market for guarSLMA holds practically all of the student loans it
anteed student loans.
purchases and finances its activities by borrowing solely through the Federal
Financing Bank.
SLMA borrowings are guaranteed by the Department of Education.

years.

The buy-and-hold category also Includes the economic development
loan guarantee program of the Economic Development Administration and the aircraft loan guarantee program of the Federal Aviation Administration.
Each of
these programs guarantees 90% of principal and Interest on loans.
Unlike the
SBA and FmHA 90-10 programs, however, neither EDA nor FAA guarantees extend to
a secondary holder.


Federal Reserve Bank of St. Louis

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CHAPTER IV

REVIEW OF CASES OF ABUSIVE TRADING PRACTICES IN MARKETS FOR
GOVERNMENT RELATED SECURITIES AND OF REGULATORY MEASURES TO REDUCE SUCH PROBLEMS

The federal securities laws apply, among other things, to the original distribution of securities, and the trading of already issued securities.

The Securities Act of 1933 ("1933 Act") seeks to ensure effective disclosure
in the original distribution of corporate securities by mandating that specific

documents be given to investors and filed with the Securities and Exchange Com-

mission ("SEC"). 1/ To complement this system of specifically mandated disclosures by issuers, the 1933 Act has a broad anti-fraud provision. Section 17(a),

which applies to the offer or sale of any security, whether or not subject to
the Act's registration requirements.

The trading of already issued securities is generally covered by the

Securities Exchange Act of 1934 ("1934 Act"), which contains provisions on both
the disclosure of information and the substantive conduct of broker-dealers as

well as other participants in the securities markets.

Like the 1933 Act, the

1934 Act has a general anti-fraud provision. Section 10(b), which applies to
the purchase or sale of any security by any person.

At the same time, the

1934 Act establishes specific standards of conduct and prophylactic measures

through a combination of self-regulation and direct rulemaking by the SEC.

Congress charged the securities exchanges in 1934 and the National Association
of Securities Dealers ("NASD") in 1938

zations ("SROs") Ij

—with

— referred

to as self-regulatory organi-

the primary responsibilities for the conduct of

y

Sections

Ij

Other SROs include the Municipal Securities Rulemaking Board and registered
clearing agencies.


Federal Reserve Bank of St. Louis

5

and 10 of the 1933 Act.

105

their respective members.

supervision.

But the authority of SROs is subject to the SEC's

For example, under Section 19(b) of the 1934 Act, SROs must file

all proposed rule changes with the SEC, which must take affirmative action to

approve or disapprove most such proposed rule changes. 3/
19(d) of the 1934 Act,

And, under Section

the SEC is authorized to review any final disciplinary

sanction imposed by an SRO upon a member.

Moreover, Congress empowered the

SEC to engage in direct rulemaking with respect to various trading practices,

such as short-selling, kj and various aspects of broker-dealer operations like

financial responsibility. 5/

Although government related securities are subject to the aforementioned anti-fraud provisions of the 1933 Act and the 1934 Act, the majority of
the Acts'

requirements do not apply to such securities.

The 1933 Act exempts

government related securities from the registration requirements of that Act. 6/
Similarly, the 1934 Act effectively exempts broker-dealers trading solely in

government related securities from most SRO and SEC rules governing the conduct
of securities trading.

The dealer registration provisions of the 1934 Act,

for

example, allow unregistered dealers to trade in these exempted securities; 7/
and the recordkeeping provisions are applicable only to registered brokers,

3^/

See also Section 19(c) of the 1934 Act.

4/

Section 10(a) of the 1934 Act.

5/

Section 15(c)(3) of the 1934 Act.

6/

Section 3(a)(2) of the 1933 Act.

TJ

See Section 15(a)(1) of the 1934 Act, together with that Act's definition of "exempted security" in Section 3(a) (12).


Federal Reserve Bank of St. Louis

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106

dealers, municipal securities dealers, and certain other specified persons.

8^/

As mentioned above, 9/ Congress exempted government related securities

from most of the regulatory provisions of the federal securities laws largely

because of the federal guarantee of interest and principal.

However, no

government guarantee can protect against the risk of substantial price swings
and attendant liquidity impairment resulting from sharp changes in interest

rates.

This risk is most pronounced in the market for mortgage-backed securi-

ties, which are long-term obligations commonly bought or sold for delivery

four to six months into the future without any margin requirement.

Moreover,

a number of other factors have added to the potential for problems in government

related securities, especially relating to forward trading in mortgage-backed
securities:
(1)

the significant changes in the economic environment for
government related securities;

(2)

a marked increase in the volume of government related
securities sold to the public;

(3)

smaller, less sophisticated institutions and individuals
increasing their participation in these markets; and

(4)

a substantial number of new and relatively small dealers
participating in the government related markets.

Of course, problems have not materialized in a large proportion
of the trades in government related securities.

As indicated above,

10/

the trading markets for such securities involve approximately $300 to $500

8/

Section 17(a)(1) of the 1934 Act.

^/

See Chapter II, supra

10 /

See Chapters II and III, supra.


Federal Reserve Bank of St. Louis

.

107

billion on an annual basis. And, while precise statistics are not available,
it appears that the great

majority of these trades have been conducted in an

open, honest manner by investors, dealers and issuers. Nevertheless, there have

recently been a disturbing number of reported cases involving serious abuses
in the trading of government related securities. Most of these cases involve

mortgage-backed securities

—most

importantly GNMA securities and to a lesser

extent FHLMC securities.

Below we summarize the major abuses that have occurred in the trading
markets for government related securities during the past five years.

In the

light of these abuses, we then review the regulatory measures imposed on regis-

tered broker-dealers trading in non-exempted securities and the possible appli-

cation of such measures to trading in government related securities, and the

regulatory measures voluntarily adopted by certain dealers trading in government related securities.

Extent of Abuses

During the last five years, the SEC has instituted a number of enforcement proceedings and investigations involving government related securities.

Appendix A presents summaries of 28 such cases and investigations.

These include

the SEC proceedings that have been completed during the last five years, and

other proceedings and investigations for which a substantial amount of information
is available.

Not included are other SEC investigatory proceedings at preliminary

stages of development.

Moreover, the press has recently issued reports on at

least four other government related securities cases involving significant sums.


Federal Reserve Bank of St. Louis

\

108 -

While some of the 28 cases in the Appendix involve a variety of securities and different types of abuses, the cases can be grouped into several

major categories.

Of the 28 cases, 23 involve primarily government related

mortgage-backed securities, two cases involve other government related securities, and three cases involve Treasury securities.

Of the 23 cases concerning

government related mortgage-backed securities, 16 primarily involve overcommit-

ments in connection with forward transactions, three principally involve misuse
of customer funds or securities, and the remaining four involve various problems
such as churning, adjusted trading, and interpositioning.

Of the 16 overcommit-

ment cases, investors became over-committed at least in part because of questionable sales practices of dealers in seven, investors became overcommitted as a

result of their own speculation in three, and dealers themselves became over-

extended or suffered related financial problems in six cases.

Unregistered dealers were the main cause of the problems in 10 of the
cases;

in nine cases dealers registered with the SEC were involved in abusive

conduct.

Four cases involved both registered dealers and unregistered affiliates.

The problems in the remaining cases were caused by a mortgage banker, a financial

officer of

a

university, and others.

While no firm figures concerning the total

losses resulting from the 28 cases are available, it is estimated that those

incurred by customers of dealers trading in GNMAs were $70-94 million while

dealers absorbed an additional $15 to $17 million in losses.

To the extent

that further breakdowns can be made, it appears that between $53 million and
$77 million of losses have occurred in cases involving unregistered broker-

dealers, while between $7 and $14 million of losses have occurred in cases

involving registered broker-dealers.


Federal Reserve Bank of St. Louis

109

In addition, the press has recently reported at least four other cases

involving significant losses in connection with GNMA forward commitments.

These

cases involve two savings and loan associations, a mortgage banker, and a govern-

mental jurisdiction.

One savings and loan with assets of about $233 million has

filed suit against 11 brokerage firms alleging, among other things, that the

brokerage firms sold it "hundreds of millions of dollars" in "grossly unsuitable"

GNMA forward transactions.

11 /

The Federal Savings

&

Loan Insurance Corporation

("FSLIC"), in order to protect $175 million in customer deposits, recently took

over another savings & loan that was unable to meet its extensive GNMA forward

commitments.

The FSLIC has already paid almost $80 million for GNMA forward

commitments, and the savings and loan still has outstanding commitments to
buy $500 million in GNMAs

mid-1981. 12/

— almost

three times its total deposits

— through

In the third case, a county fund refused to take delivery of

$20 million in GNMA forwards, thus avoiding a $3 million loss, and sued its

former treasurer and a broker-dealer to recover $5.5 million in losses allegedly

suffered as a result of unauthorized and illegal trades. 13/

And, a mortgage

banker with extensive GNMA forward and futures commitments is engaged in litigation with at least

3

broker-dealers over several million dollars allegedly lost

as a result of speculative activity in these markets by several of the mortgage

banker's principals. 14/

n/

Wall Street Letter, Feb. 25, 1980, at

W

Wall St. J. March 26, 1980 at 16.

12/

Business Week, March 10, 1980, at 44.

14/

See, e.g., Barrons, Nov. 12, 1979 at 4.


Federal Reserve Bank of St. Louis

1.

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110

Furthermore, interviews with state regulators and federal agencies 15/

I

indicate that there have been many other instances in which financial institutions have suffered significant losses in trading government related securities.

These problems have typically occurred at small banks, savings and loan associations, and credit unions.

While the sharp increase in interest rates in recent

years has contributed greatly to liquidity problems, a substantial number of such

institutions have lost large sums, relative to their resources, in transactions
that were ill-suited to their financial positions and needs.

The most common

cause of these problems has been the acceptance of relatively large forward com-

mitments for mortgage-backed government related securities without full appreciation of the risks associated with increases in interest rates.

Sharp or high-

pressure sales practices by certain dealers have contributed to these problems
in the first instance;

then in many cases complex financing and accounting

schemes have been used in attempts to cover-up the difficulties and
postpone

recognition of the losses.
Below is a review of the major categories of abuses revealed by
the SEC
cases in Appendix A.

Citations, by case number, to Appendix A are provided where

appropriate for illustration.

In a number of cases more than one abuse was present,

so some cases are cited in several categories.

This review also draws upon the afores

mentioned interviews with various government regulators and
market participants.
Overcommitments
The most dangerous problem to date in the market for
mortgage-backed,

government related securities has been

15_/

the.

assumption of large forward delivery

See Appendix B for a list of the persons, firms, and
agencies interviewed
connection with this report.

m


Federal Reserve Bank of St. Louis

Ill

commitments by institutions and individuals without sufficient assets to enter
into such risks.

In some cases, over-commitments by relatively unsophisticated

sales
investors have been encouraged by dealers, frequently through the use of
tactics like those described below.

In other instances, however, apparently

sophisticated investors such as mortgage bankers have made conscious decisions
and have assumed
to speculate in government related mortgage-backed securities

patently excessive positions while concealing the full extent of their commit-

For example, one mortgage banker speculating

ments from the dealers involved.

commitments
in GNMA forwards told each of 10 to 12 dealers that it had made no
with any other dealer or was dealing with only one or two other dealers.

In

fact the mortgage banker, which had a net worth of approximately $2 million,

had substantial commitments with each of the 10 to 12 dealers, had commitments

exceeding $50 million with each of three, and had acquired net "long" commitments of over $350 million coming due over the following five months.
e.g., cases

1,

4, 8, 9,

10,

11,

19,

(See,

21, 25, 26.)

In several cases, dealers themselves have become over-committed, and
this has led to their bankruptcy, with accompanying defaults on their commitments
to customers and to other dealers.

In other cases, customer defaults led to

serious financial problems for the dealers that had sold the forward commitments.
(See,

e.g., cases 2, 4, 7, 13, 14, 17, 19, 28).

A fundamental factor conducive to the over-commitment problems experienced in government related mortgage-backed securities has been the absence of

margin requirements.

The lack of such restrictions has allowed excessive leveraging

and speculation in forward commitments for these securities.


Federal Reserve Bank of St. Louis

Likewise, the absence

112

-

of such restrictions has enabled investors to use repurchase agreements as a

device to "pyramid" holdings

— that

is,

an original investment in government

related securities serves as collateral for an entire series of additional

purchases by the same investor.

In either case, a significant rise in interest

rates can create large unrealized losses on the transactions. (See, e.g., cases
2, 4,

9,

14,

19, 21.)

Sales and Trading Practices

Unsuitable recommendations and transactions .

Closely related to the

problem of over-commitments is the problem of dealers making recommendations
to their customers that are unsuitable in view of the interest rate risks asso-

ciated with the trading of government related securities and the financial circumstances and objectives of the investors.

involved forward commitments

— either

In most cases, unsuitable transactions

mandatory or "stand-by"

— to

purchase GNMAs.

The investors have often been small institutions such as banks, savings and loans,
other thrift institutions, and credit unions, but other entities such as universities, local governmental units, and individuals have also participated in clearly

unsuitable transactions.

All of the regulatory agencies interviewed in connection

with this study agreed that unsuitable recommendations and sales have been a major
factor behind the problems in forward trading of government-guaranteed securities.
(See,

e.g., cases 1, 4, 11, 13, 14, 15, 19, 25).

Among the examples described in Appendix A, one dealer sold forward

commitments to purchase $5 million worth of GNMAs to a credit union with total
assets of only $1 million and sold $21 million in commitments to a bank with
total assets of $11 million. In another case, a salesman placed well over a

million dollars worth of GNMA forward commitments in the account of an individual


Federal Reserve Bank of St. Louis

113 -

who had a very small net worth and who had asked to be informed inmiediately if

losses reached $2,500. (See, e.g., cases 4, 7; cf. case 10.)

High-pressure sales methods and inadequate disclosure

.

Many of the

unsuitable transactions and positions evident in government related securities
have resulted from use of high-pressure sales tactics and inadequate disclosures
by dealers and salesmen.

These sales methods have been used with respect to both

individuals and small, institutional investors.

Polished presentations stressing

large returns, with little or no initial cash expenditure, have commonly been made,
in some cases through "cold calls" to persons or institutions listed in directories

but otherwise unknown by the salesman.

Moreover, certain dealers have misrepre-

sented their own financial conditions to prospective investors, and one unregistered government securities dealer falsely held itself out as registered, a member
of the NASD, and insured by the Securities Investor Protection Corporation.
e.g., cases 4,

10,

(See,

13.)

Some salesmen have omitted information that repeated GNMA trades in a

customer's account can substantially reduce or eliminate the return that could

otherwise be expected. There are also cases in which dealers, in selling forward
commitments, have neglected to mention the large losses that investors can sustain
on these forward commitments if interest rates change.

In some cases, salesmen have

even extended assurances that buyers would not have to take delivery of the subject

GNMAs but could sell the contract at a profit at the settlement date,

purchase, or extend the commitment.

finance the

Other salesmen have also told financial

institutions that they could increase their current reported earnings by taking
into current income fees from writing stand-by commitments, even though this

constitutes a questionable or improper accounting practice and even though


Federal Reserve Bank of St. Louis

114

such commitments entail major risks.

(See, e.g., cases 4, 7, 13, 14, 21,

22, 25.)

Pricing, churning, unauthorized sales, delayed settlements .

Certain

salesmen and dealers have also engaged in other questionable sales
practices in

government related securities trading.

In some cases dealers have charged exces-

sive mark-ups and mark-downs or excessive and unexplained
interest charges on

customer accounts.

And, at least in a few instances, dealers have engaged in

churning of customer accounts, thereby inflating their own
profits and commissions at the customers' expense.

In other cases dealers and salesmen have

carried out purchases and sales for customer accounts
without customer authorization, sometimes utilizing false or misleading
confirmations in the process.
In at least one other case, it appears that the
settlement dates on cash pur-

chases of GNMAs by individual customers were delayed,
which may have resulted
in customers losing one or two months of principal
and interest payments on the

securities they purchased.

(See,

e.g., cases 1, 4, 8, 9, 15, 18, 20, 21, 25.)

Disguising Losses and Overcommitment s
After losses and over-commitments have been incurred
in connection with
government related securities trading, some dealers
and investors have engaged in
other transactions that, together with associated
accounting practices, served to

disguise either existing losses or the inability
of an entity to carry out its
contractual commitments.

One practice used for these purposes
is "adjusted trading,'

in which an investor, typically a financial
institution, sells securities to a dealer
at a price above the current market and
agrees to purchase other securities at
a

similarly inflated price either concurrently with
the sale or at a future date.


Federal Reserve Bank of St. Louis

115 -

The effect of these transactions is to inflate the book value of the investor's

portfolio and similarly inflate its current earnings or reduce its reported
losses.

One bank and its holding company, for example, engaged in three types

of "adjusted trading" in several varieties of government related and securities
to hide substantial trading losses.

possible by the cooperation of

a

These falsely reported transactions were made

dealer bank and two other dealers.

Savings and

loans, credit unions, trust companies, banks, and even governmental entities have

made use of transactions of this sort to hide a variety of losses.

(See,

e.g.,

cases 6, 10, 16, 21, 22.)

Repurchase agreements and reverse repurchase agreements 16/ of government related securities have also been used for the purposes of disguising losses
or covering a purchaser's inability to pay for securities it had agreed to buy.

Such arrangements have been especially common in connection with GNMA forward

commitments that show substantial losses to the purchasers at the time of settlement.

In a few instances, dealers have represented to their customers at the time

they entered into forward contracts that they could relieve them of any potential

losses at settlement by arranging repurchase or reverse repurchase transactions
on favorable terms.

(See,

e.g., cases 4, 14, 21; cf. case 9).

Misuse of Customer Funds and Securities
Several of the cases in Appendix A reveal misuse by dealers of customer
funds or securities in connection with the trading of government related securities.
In some of these cases, unregistered dealers sold or hypothecated securities that

16 /

See the discussion at pages 24-27, supra, explaining the nature and operation
of repurchase and reverse repurchase agreements.


Federal Reserve Bank of St. Louis

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116 -

belonged to their customers or lenders, causing losses to the customers and
lenders when the dealers became insolvent.

In other cases,

unregistered dealers

have used newly received funds from investors to finance their commitments to
purchase or repurchase securities from other investors.
10,

13,

14,

17,

(See,

e.g., cases 3, 7,

26).

In several other known cases, dealers have persuaded customers to enter

into claimed "repurchase agreements" or other forward transactions in which there

were actually no underlying securities.

Accordingly, while denominated "repur-

chase agreements" or "standby with pair-off" trades, these transactions were in
fact unsecured loans to the dealers.

In some instances,

these commitments were

subsequently rolled-over and enlarged, all without any collateral being established.

Two known cases involved the use of false confirmations to further con-

vince the customers that the fictitious repurchase agreements or forwards were
genuine.

(See,

e.g., cases 3, 10, 12,

13,

14).

Training and Supervision

Investigations in several cases have revealed serious inadequacies in
the training and supervision of salesmen by dealers.

In one case,

an unregistered

dealer developed a large business in government related securities using at least
15 salesmen with no prior experience in those securities.

Nevertheless, the dealer

firm provided no meaningful rules, guidelines, or training in fair and appropriate
sales practices.

What little instruction the firm did supply encouraged the sales-

men to employ trading practices, such as churning of accounts, designed to inflate
firm profits and salesmen's commissions at the expense of the customers.

cases 4, 7, 21).


Federal Reserve Bank of St. Louis

(See,

e.g.,

117

-

Industry observers have indicated that major shortcomings in both
training and firm supervision of sales practices have been chronic at some

unregistered dealers. These shortcomings are especially serious where salesmen
are given high commission rates and therefore have a heightened incentive to

employ high-pressure sales methods and to make inadequate disclosure to customers.
In fact, compensation to individual salesmen as high as 40% to 45% of the total

firm commissions or markups on their sales have been utilized in government

securities firms, and salesmen at certain firms have achieved extremely large
earnings from these commissions.

In the case cited in the preceding paragraph,

at least 10 salesmen at an unregistered dealer each earned over $40,000 in net

commissions during a single month. (See, e.g., cases 4, 10, 13, 15).

Recordkeeping
Finally, investigations of

shortcomings in recordkeeping.

a

number of dealers have revealed major

In various individual cases, dealer records

have been so deficient as to (1) render impossible an assessment of a firm's

financial position over substantial periods of time by an accounting firm sub-

sequently retained by the firm's receiver;

(2) make it impossible for a firm to

calculate its ovm capital position; (3) fail to indicate whether a firm acted as
principal or agent in certain customer purchases that were not completed because
of defaults by the initial selling party;

(4)

leave doubt whether certain trades

subsequently disclaimed by customers were in fact authorized or unauthorized; or
(5)

leave doubt as to whether or not a firm actually purchased the government

related securities it had represented would underlie the investment packages it
sold to investors.


Federal Reserve Bank of St. Louis

(See, e.g., cases 2, 7, 9, 12, 17, 20, 23).

118

Possible Regulatory Measures
The SEC and the SROs have applied various types of regulatory measures
to reduce the incidence of trading abuses with respect to non-exempted securi-

ties.

Although these requirements generally do not apply to government related

securities, some dealers in such securities have implemented, on a voluntary
basis, similar measures.

Moreover, in the course of the interviews and discus-

sions for this study, these and other measures have been suggested as desirable
or appropriate in connection with the trading of government related securities.
In the following pages we describe major categories of regulatory measures and

their possible application to the markets for government related securities.
These measures, if in place at the time, would have likely deterred or reduced
the incidence of abuse outlined above, although these measures would of
course
not have totally eliminated fraud or deceit.

17/

Standards of Financial Responsibility
Standards of financial responsibility are imposed on registered brokers
and dealers by the SEC, the Federal Reserve Board, and SROs.
at least three-fold:

(1)

Their purposes are

ensuring that brokers and dealers are financially sound

and that they operate in such a way as to protect their assets
and the funds and

l]_l

The following discussion is written in terms of applicability
to "dealers,"
which term refers to both broker-dealers registered with the
SEC pursuant'
to Section 15(b) of the 1934 Act and bank municipal
securities dealers
registered pursuant to Section 15B(a) of the 1934 Act ("bank
dealers").
The rules applicable to municipal securities brokers and
municipal securities dealers are established by the Municipal Securities
Rulemaking Board
(the MSRB ) and unless otherwise noted herein, are
applicable to bank
dealers.
Some of the SEC's rules are also applicable to bank
dealers in
municipal securities. Certain aspects of regulation of bank
dealers as
discussed herein, are performed by the Comptroller of the
Currency the
Board of Governors of the Federal Reserve System, and
the Federal Deposit
Insurance Corporation (the "federal bank regulatory authorities")


Federal Reserve Bank of St. Louis

-

119 -

use of credit
securities held by them for customers; (2) preventing excessive

promoting stability in the
for speculative purchases of securities and thereby
customers
securities markets and in the nation's economy; and (3) protecting
from becoming financially over-committed. 18 /

Margins.

Margin requirements establish a minimum amount of cash or

purchase of
securities that must be deposited or maintained as collateral in the
open contracts
securities on credit, or must be posted as deposits by parties to
to ensure performance of their commitments.

margin and maintenance margin.

I9_l

There are two types of margin: initial

Initial margin requirements provide that the

of the
purchaser of securities must pay or deposit at least a certain percentage

amount of
purchase price of the securities. 20/ Maintenance margin refers to the

~

18/

19/

Commission 423
See, e.g., Don D. Anderson & Co. v. Securities and Exchange
Uet capital); S. Rep. No. 792, 73d Cong. 2d
F72d~8iTr'816 (10th Cir. 1970)
Sess. 3 (1934) (margin).
,

Section 7 of the 1934 Act grants the Federal Reserve Board (the "FRB")
requirements
the authority to set both initial and maintenance margin
FRB establishes initial margin reThe
for non-exempted securities.
quirements, but has chosen not to impose maintenance margin except with
It has issued the following
See 12 CFR 220. 8(j).
respect to options.
by Brokers and Dealers (Regularegulations concerning margin: Credit
tion T), Credit by Banks for the Purpose of Purchasing or Carrying
Registered Stock (Regulation U), Securities Credit by Persons Other
than Banks, Brokers, or Dealers (Regulation G), and Rules Governing
Borrowers Who Obtain Securities Credit (Regulation X).
Municipal securities are exempted securities for the purposes of Section
municipal securities are
7 and, therefore, bank dealers' transactions in
not subject to the FRB margin rules.

20/

Regulation T allows broker-dealers to extend the allowable amount of
overcredit on exchange-listed securities and certain securities traded
cannot extend
Broker-dealers
the-counter (OTC margin securities).
on OTC securities that are not OTC margin securities.
credit


Federal Reserve Bank of St. Louis

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120

I
money or securities required to be maintained in the account of a customer who
has purchased securities on margin.

Under these requirements, the amount of

cash or securities collateralizing the loan or securing the commitment must be

maintained at a certain level, llj

As the market value of a security fluctuates,

the dealer, for example, must "mark-to-market" the security and either credit the

customer's account for the excess margin or require an additional maintenance

margin payment.

In the event the customer fails to respond to this "margin call"

with an additional margin payment, the dealer is obligated to sell all or part of
the collateral or the security and, after deducting any amount due the dealer, to

remit any remaining proceeds of the sale to the customer.
Net capital

.

The SEC's net capital rule establishes minimum amounts of

liquidity that must be maintained by dealers registered with the SEC. 22 /

It is

designed primarily to ensure that firms have sufficient liquidity at all times
to cover their current indebtedness to all customers, and are therefore able to

satisfy customers' claims for cash or securities.

The term "net capital" means

net worth of a dealer (i.e.) assets less liabilities) less illiquid assets, and
less a discount from the market value of the securities in the account of the

dealer ("haircut"), plus certain subordinated liabilities.

21 /

Maintenance margin rules are set by exchanges and other self-regulatory
organizations.
See, e.g.. Rule 431, NYSE Guide (CCH) 12431; Rule 12.3 CBOE
Guide (CCH) 12373.

22 /

Rule 15c3-l; 17 CFR 240.15c3-l. The financial safety and soundness of
federally chartered or federally insured bank dealers are subject to
regulation by federal bank regulatory authorities; accordingly, bank
dealers are not subject to the SEC's net capital requirements.


Federal Reserve Bank of St. Louis

121 -

Reserve, segregation, and hypothecation requirements

.

An SEC rule

establishes reserve and segregation requirements for registered dealers which
(1)

limit the use of customers'

funds by dealers in their business, and (2)

require dealers to obtain and maintain physical possession or control of all
fully paid and excess margin securities carried in the accounts of customers. 23/
The rule also requires a dealer to deposit that portion of the customer funds

held by it and not used in connection with other customers' accounts in a
special reserve bank account for the exclusive benefit of customers. 24/

A

separate rule limits the circumstances under which dealers may hypothecate

customer securities. 25 /

These rules are designed to safeguard customers'

funds and securities and prevent unsound use of customers' assets by ensuring
that such funds and assets are deployed in safe areas of the broker-dealer's

business.

Securities Investor Protection Corporation

.

In 1970, Congress estab-

lished the Securities Investor Protection Corporation ("SIPC").

With certain

limited exceptions, all brokers and dealers registered pursuant to Section 15(b)
of the 1934 Act are required to be members of SIPC. In the event that the SEC or
an SRO determines that a SIPC member subject to its regulation is in or approaching financial difficulty, it is required to notify SIPC immediately.

If SIPC

determines that the member has failed or is in danger of failing to meet its

23/

Rule 15c3-3, 17 CFR 240.15c3-3.

24/

Rule 15c3-3(e), 17 CFR 240.15c3-3(e)

25/

Rule 8c-l, 17 CFR 240.8c-l.


Federal Reserve Bank of St. Louis

122

obligations to customers, and certain other conditions exist, 26 / it may apply
to federal court for a decree to appoint a trustee to distribute any customer

cash and securities held by the member to the customers.

A special SIPC fund

supported by member assessments exists to allow prompt payment of these funds
and securities, subject to certain dollar limitations.

Application to government-guaranteed securities .

Of the various

regulatory measures that have been proposed for the trading of government
related securities, margin requirements for forward commitments in mortgage-

backed securities seem to be the most needed.

Two principal benefits could

be expected from margin requirements in forward trading of such securities.

First, depending on the details of the requirements, they would protect dealers
and other forward market participants against losses should the parties with

which they have contracted prove unable or unwilling to fulfill their commitments.

Second, by requiring at least some initial commitment of capital and

additional payments to cover unrealized losses from market movements, margin

requirements would discourage overcommitments and lend added financial stability
to all market participants.

Margin requirements would have precluded many of the overcommitment
problems, discussed above, in forward trading of government related mortgage-

backed securities. The vast majority of the serious over-commitments in this
area have apparently resulted from the ability of investors to speculate without any initial cost, and to suffer increasing losses without having to make

proportionate deposits.

26 /

These circumstances include non-compliance with applicable requirements
under the 1934 Act, SEC rules, or rules of any SRO with respect to financial
responsibility or hypothecation of customers securities.
See Section 5(a)(2),
Securities Investor Protection Act of 1970, 15 U.S.C. 78aaa5(a)(2).


Federal Reserve Bank of St. Louis

123

Recognizing the probable efficacy of margin requirements in forward
transactions respecting mortgage-backed securities, several major dealers have
already begun voluntarily to demand margin payments from most customers entering
into forward commitments with them.

In addition, GNMA, PSA Self-Regulation, Inc.,

and the MBS Clearing Corporation have all implemented or proposed margin-related

requirements and guidelines for forward trading.

Likewise, there was near unani-

mity among the industry representatives, regulators, investors, and other persons
interviewed that at least some form of maintenance margin requirements should be
applied to forward trading in government related mortgage-backed securities. 27/
In this regard, however, several persons expressed the view that margin requirements

should not be applied to mortgage bankers in the normal issuance process for GNMAs

A number of technical questions will confront any attempt to impose margin

requirements with respect to government related securities.

These include (1) whether

dealers should be required to post, as well as to demand, such payments with respect
to their forward commitments;

(2) whether exemptions should be recognized for commit-

ments that are hedged in some manner;

(3)

if so, what sort of hedging should qualify,

and what types of market participants should be able to take advantage of such exemptions;

(4)

in what forms will margin be allowed to be posted

ties, or letters of credit;

— cash,

(5) what entities should hold the

pledged securi-

margin payments for

various classes of transactions; and (6) whether a clearing facility should be

established to facilitate compliance with margin requirements. 28/

The successful

application of mandatory margin requirements in other segments of the securities

e.g.. Rule 431(c)(2), NYSE Guide (CCH)

27/

See,

28/

See discussion in chapter VI, infra.


Federal Reserve Bank of St. Louis

1

2431.

-

124 -

markets suggests that these questions can be resolved satisfactorily.

In

addition, the stock exchanges impose maintenance margin requirements on their

members with respect to purchases of exempted securities on credit.
In addition to margin requirements, net capital and segregation require-

ments have been suggested for dealers.

By requiring a conservative financial

structure and full coverage of firm liabilities by qualifying assets, the net
capital rule attempts to guarantee that subject dealers will be able to satisfy
their customer obligations at all times.

And, there seems to be little doubt that

the net capital rule is reasonably effective in promoting the financial soundness

and responsibility of dealers in non-exempted securities.

Nevertheless, trading

in government related securities is different in certain respects from trading in

corporate securities. 29 / Accordingly, careful consideration is needed to determine
what requirements in the area of net capital would be appropriate for dealers in

government related securities.
Several of the cases described in Appendix A involved misuse by government

securities dealers of customer funds or securities

— e.g.,

selling or hypothecating

customer securities or using customer funds in the dealer's operations.

As applied

to trading in non-exempted securities, requirements exist that seem to be reasonably

effective in protecting customer-owned assets.

Reserve and segregation requirements

could be devised that would provide increased protection for customer-owned assets

held by government related securities dealers.

In one of the cases described in

Appendix A, such requirements were applied with respect to customers' government

29 /

For example, the characteristics of government securities trading may make
it possible for dealers to hedge their commitments effectively in ways that
are not effective or reliable for other types of securities.


Federal Reserve Bank of St. Louis

125 -

related securities accounts and played a substantial role in preventing customer
losses despite the dealer's insolvency.

(See case 7.)

It may also be appropriate to require non-bank government securities

dealers to join SIPC.

Such a requirement would protect smaller investors from

losses occasioned by dealer insolvencies 30/ and help to preclude any loss of

public confidence in the government related securities markets.

The costs of SIPC

membership represent a sharing by securities dealers of the risk of investor injury,
and are now relatively small. 31 /

Standards of Fair Practice

Many investors deal with securities dealers from

a

position of unequal

knowledge and understanding of relevant investment information.

To protect

investors from overreaching and unfair practices by dealers, the SEC and the
SROs have prescribed several categories of "fair practice" rules, which generally

require dealers to treat investors in accordance with "just and equitable principles of trade." 32/

Confirmations and disclosure

.

Several "fair practice" rules require

dealers to disclose to investors information important to an understanding of their

30 /

It is important to note, however, that SIPC ensures only $100,000 in securities claims, including up to $40,000 in cash per customer at a member firm.

Government related securities transactions frequently involve amounts much
SIPC is supporting the introduction of legislation which
greater than this.
would raise the amount of coverage to $500,000, including up to $100,000 in
cash.
S. 1076, 96th Cong., 2d Sess. (1980).
31/

Each SIPC member was required to pay an assessment equal to one-eighth of
one percent of its gross securities revenues at the time the SIPC fund
was established.
The SIPC fund currently approximates $190,000,000
and is supported by assessments on members not to exceed $150 per annum.

32 /

See, e.g.. Rules of Fair Practice, Article III, Section 1, NASD Manual
(CCH) 1 2151.


Federal Reserve Bank of St. Louis

126

For example, SEC and SRO rules require confirmations

securities transactions.

of transactions, including those in exempted securities, to be sent to customers

on or before settlement of a transaction disclosing, among other things, the price
and identity of the securities bought or sold, the dealer's capacity (principal
or agent) in the transaction, and the commissions charged by the dealer when acting
in an agency capacity. 33/

Such requirements protect investors by providing them

with disclosure of the terms on which their money and securities are being handled
and the charges they are incurring.

They also protect both dealers and investors

by minimizing the chances of repeated unauthorized trades and creating a record
the parties can refer to in case of subsequent disagreements.

Other SEC and SRO

rules serving similar investor protection purposes require dealers to disclose

interest rates in credit arrangements; 34 / and to disseminate to customers audited

balance sheets reflecting the dealer's financial condition 35/ and account state-

ments showing a customer's security and money positions. 36/
Suitability.

Suitability rules seek to protect both the customer and the

dealer by discouraging customer transactions that are inappropriate in view of the

33/

See Rule lOb-10, 17 CFR 240.10b-10; Rules of Fair Practice, Art. Ill, Sec. 12
NASD Manual (CCH) 1 2162; Rule 9.11, CBOE Guide (CCH) 1 2311.
See Rule G-15,
MSRB Manual (CCH) 1 3571, for more detailed confirmation requirements.

34/

Bank dealers which extend credit are
See Rule lOb-16, 17 CFR 240.10b-16.
subject to the disclosure provisions of the Truth-in-Lending Act, 15 U.S.C.
1601 et seq.

35^/

See Rule 17a-5, 17 CFR 240.17a-5; Rule 9.13, CBOE Guide (CCH) 12313.
Bank dealers are subject to the reporting requirements of the federal
bank regulatory agencies.

36/

See Rule 9.12, CBOE Guide (CCH)


Federal Reserve Bank of St. Louis

1

2312.

f

127

customer's financial situation and investment objectives.

Such rules typically

prohibit dealers from recommending, and in some cases executing, 37/ securities

transactions unless the dealer reasonably believes that the transaction is suitable
for the customer in light of a customer's financial resources, investment objec-

tives and needs.

One SRO rule requires the subject dealers to make suitability

determinations upon the basis of relevant information, if any, proffered by a
customer. 38/ Stricter rules impose an affirmative duty on dealers to inquire into
the investment objectives and financial situation of customers before making a

suitability determination. 39/ Perhaps the most stringent SRO suitability rule
forbids subject dealers from recommending a transaction unless they reasonably

believe that the customer, in addition to being financially suited to the transaction, has sufficient knowledge and experience in financial matters to evaluate
the risks of the transaction. 40/

Closely allied to suitability rules are "know your customer" rules,
which affirmatively require dealers to inquire about facts such as

a

customer's

occupation, investment objectives, and financial situation, i.e., information

relevant to

a

suitability determination. 41/ In addition to serving as

a

fundamental

37/

See Rule 15c2-5,

38 /

See Rules of Fair Practice, Art.

39/

See Rule 15blO-3, 17 CFR 240.15bl0-3; Rule 15c2-5, 17 CFR 240.15c2-5;
Rule 9.9, CBOE Guide (CCH) 1 2309; Rule G-19, MSRB Manual (CCH) 1 3591.

40/

See Rule 9.9, CBOE Guide

41/

See Rule 15blO-6, 17 CFR 240.15bl0-6; Rule 9.7(b), CBOE Guide (CCH) 1 2307;
Rule 405, 2 NYSE Guide (CCH) 1 2405.
Bank dealers are subject to the
suitability rules of the MSRB, which include similiar provisions.


Federal Reserve Bank of St. Louis

17

CFR 240.15c2-5.

1

Ill,

Sec.

2,

NASD Manual (CCH)

1

2152.

2309.

-

128

-

protection for customers who rely on the judgment and expertise of dealers,
"know your customer" rules provide protection to dealers who might otherwise
execute transactions for customers financially unable to fulfill their contractual obligations.
Fair pricing

.

To ensure that customers are not charged excessive

prices or brokerage commissions, SROs have prescribed rules that require dealers,

when acting as principals, to buy from or sell to customers at fair prices; and
when acting as agents, to charge customers fair commissions. 42 / Fair prices and
commissions are determined by factors such as market conditions at the time of the
transaction, the total amount of the transaction, expenses involved in effecting
or executing the transaction, the value of the services rendered, and the dealer's

best judgment of the fair market value of the traded securities at the time of the

transaction.

Trading authorization and churning

.

Another important objective of the

fair practice rules is to ensure that dealers do not execute trades for customer

accounts outside the scope of the authority given by the customer.

Accordingly,

SRO rules (1) prohibit dealers from exercising any discretionary trading power in
a customer's account without prior written authorization from the customer, 43/
(2)

require that supervisory persons approve in writing discretionary account

transactions, 44 / (3) mandate frequent review of discretionary accounts to prevent

irregularities and abuses, 45 / and (4) require the recording of all purchase and

42 /

See Rules of Fair Practice, Art. Ill, Sec. 4, NASD Manual (CCH)
G-30, MSRB Manual (CCH) 1 3646.

43 /

Rules of Fair Practice, Art. Ill, Sec. 15, NASD Manual (CCH) 12165; Rule G-26,
MSRB Manual (CCH) 1 3626; Rule 9.10(a), CBOE Guide (CCH) 1 2310.

44/

See Rule G-26(c), MSRB Manual (CCH)

45/

Id.


Federal Reserve Bank of St. Louis

5

3676.

1

2154; Rule

129

sale orders, regardless of execution. 46/

In addition, SEC and SRO rules

expressly prohibit dealers from churning customer accounts, i.e., from causing
trading activity that is excessive in size or frequency in view of the financial

resources and character of a customer's account. 47/

Application to government related securities

.

Next to rules on finan-

cial responsibility, rules of fair practice could well be the most important to

reduce the incidence of abuses in the market for government related securities.

Although much of the trading volume in this market still consists of transactions

between large sophisticated institutions, small less sophisticated investors are
now participating in the forward markets for mortgage-backed securities.

These

investors stand at a significant informational disadvantage relative to securities

professionals and are in the greatest need of effective "fair practice" protections.
If effectively enforced in government related securities trading, "fair

practice" rules like those applicable to non-exerapted securities probably could
have deterred or reduced the incidence of many of the trading abuses discussed in

Appendix A.
of abuse.

Of course it is impossible to eliminate, by rule, every possibility
But a number of these rules proscribe, in relatively specific terms,

the precise abuses that have arisen in a number of cases.

Consistent with this

view, industry representatives seem to favor extension of "fair practice" precepts
to the government related markets.

The leading association of dealers in mortgage-

46/

See Rule 15cl-7, 17 CFR 240.15cl-7; Rules of Fair Practice, Art. Ill, Sec.
15, NASD Manual (CCH) 1 2165; Rule G-19(b), MSRB Manual (CCH) 1 3591; Rule
9.10(c) CBOE Guide (CCH) 1 2310.

47^/

See Rule 17a-3, 17 CFR 240.17a-3 Rules of Fair Practice, Art. Til, Sec. 21,
NASD Manual (CCH) 1 2171; Rule G-8, MSRB Manual (CCH) 1 3536.


Federal Reserve Bank of St. Louis

130 -

backed securities has approved certain "fair practice" rules for trading by its

members.

In addition,

a number of government securities dealers,

including

several of the largest dealers which deal with many of the most sophisticated

institutional customers, have already implemented, on a voluntary basis, guidelines, mechanisms, or procedures that resemble some of the principal "fair

practice" rules.

Suitability rules, in particular, would address an important problem
area in the trading of government related securities.

There are a number

of instances when small institutions and individuals have engaged in unsuitable

transactions in government related securities.

Any kind of significant suita-

bility and know your customer requirements, especially if implemented with procedures such as credit checks, would have prevented some of these problems.

Moreover, the great majority of industry representatives we spoke with, as well
as most of the governmental agencies, believe that appropriate suitability rules

can be formulated and should be applied to trading in government related mortgage-

backed securities.

The leading association of mortgage-backed securities dealers

has proposed specific suitability requirements, and several dealers in such secu-

rities have implemented suitability requirements on their own initiative. 48 /

Standards of Competency and Integrity and Supervision Requirements

Competency and qualifications . To ensure that investors are served by
competent and honest securities professionals, SEC and SRO rules prescribe minimum

competency requirements for securities dealers.

48 /

These rules require certain

We note, however, that formulation and application of suitability rules with
respect to institutional investors, which constitute a large percentage of
the purchasers of government related securities, can raise issues not generally
encountered with respect to suitability rules respecting individual investors.


Federal Reserve Bank of St. Louis

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employees of dealers to pass minimum competency examinations before being deemed

qualified for employment. 49/ In addition, some SROs require the principals of
dealer firms to pass

specific examination to assure that they are sufficiently

a

competent to handle supervisory responsibilities, 50/ and require securities salesmen to complete training courses 51/ and apprenticeships 52/ before transacting

business with the public.

Integrity and disqualification.

To promote integrity among securities

dealers, SEC and SRO rules prescribe disqualification procedures for dealers and

their associated persons who have been expelled or suspended from SRO membership,
have willfully violated any provisions of the securities laws, or have committed

Hiring and termination procedures prescribed

other enumerated infractions. 53 /

for registered dealers are designed to identify dishonest salesmen by requiring

hiring firms to make inquiries into the previous employment records and reputations of prospective employees 54 / and to file notices with SROs when salespersons
leave,

specifying the reasons for departure and disclosing whether the salespersons

were the subject of any major complaints. 55/

49/

See Rule 15b8-l, 17 CFR 240.15b8-l; Rule G-3, MSRB Manual (CCH) ^ 3511; Rule
Rule 345.15, 2 NYSE Guide (CCH) 1 2345.
9.3, CBOE Guide (CCH) 1 2303.

50/

See Rule G-3(d), MSRB Manual (CCH)
Examination, NASD Manual 1 1102A.

21./

See Rule 9.3, CBOE Guide (CCH)

yy

See Rule G-3(h), MSRB Manual

52/

See Sections 3(a)(39), 15(b)(4), 15(b)(6), 15B(a)(2), 15B(c)(2) of the 1934
Act; Rule 15b8-2, 17 CFR 240.15b8-2; Rule 345(d), 2 NYSE Guide (CCH) 1 2345;
Rule G-4, MSRB Manual (CCH) \ 3516.

'bkj

See Rule 345.18, 2 NYSE Guide (CCH)
Sec. 27, NASD Manual (CCH) 112177.

_55/

See Rule 345.13,


Federal Reserve Bank of St. Louis

2

1

3511;

1

Schedule C, Details of Qualification

2302; Rule 345.15,

(CCH)

NYSE Guide (CCH)

2

NYSE Guide (CCH)

1

2345.

3511.

H

1

2345; Rules of Fair Practice Art.

1

2345; Rule 9.3, CBOE Guide (CCH)

Ill,

\

2303.

- 132 -

Supervision.

Strict supervisory rules have also been prescribed to

assure that sales personnel and other associated persons of dealers perform their
duties without violating the securities laws or SRO standards of conduct.

These

rules typically require dealers (a) to appoint firm officials to supervise the

securities activities of all persons associated with the firm; (b) to establish,
maintain, and enforce written procedures to assure compliance with broker-dealer

supervisory responsibilities; and (c) to designate a firm official to review

supervisory activities of supervisors and inspect each business office of the
dealer to ensure that the written procedures are enforced. 56/

Application to government related securities .

As indicated above, there

have been several notable examples of incompetence and dishonesty on the part of

certain dealers in government related securities, and equally notable examples
of inadequate training and supervision of salesmen by such firms.

Implementation

of meaningful standards of training, qualification, and supervision would discourage

situations in which major departures from reasonable standards are widespread within
a firm and are continuing in nature.

In addition,

state securities regulators and

other persons familiar with past abuses in municipal securities trading have emphasized that a number of past violators in the now-regulated municipal securities
area are currently active in government related securities.

56 /

Accordingly, employee

See Rule 15bl0-4, 17 CFR 240.15bl0-4; Rules of Fair Practice, Art. Ill, Sec.
27, NASD Manual (CCH) H 2177; Rule G-27, MSRB Guide (CCH) K 3631; See Rules
342 and 405, 2 NYSE Guide (CCH)
2342, 2405, and Rule 9.8 CBOE Guide (CCH)
H 2308, for much briefer supervisory rules.


Federal Reserve Bank of St. Louis

n

133

-

reviews, background checks, and other mechanisms to identify persons previously

disqualified from associating with dealers would be helpful in improving the
integrity of the trading markets in government related securities.
Of course, the majority of government securities dealers now appear to
be observing reasonable standards of competence, training, and supervision on a

voluntary basis.

Likewise, the leading association of mortgage-backed securities

dealers has proposed rules which are designed to improve training and supervision

requirements for its members. 57/

Because of its concern with abuses in the markets

for mortgage-backed securities, GNMA supports the imposition of competency, integrity,

and supervision standards; and so do the regulatory authorities interviewed for

this study.

Nevertheless, no formal rules in this area legally bind firms dealing

exclusively in government related securities, and the presence of even a relatively
small group of less capable and less scrupulous firms and salesmen in the industry

poses a potential threat to less sophisticated individual and small institutional

investors

Dealer Registration
Securities dealers may not engage in an interstate business in nonexerapted
securities or be members of SROs without complying with the SEC's registration requirements. 58 /

Initially, these requirements serve to implement the qualification require-

ments and serve an important identification function since, prior to registration

57/

See Chapter V, infra.

58/

See Section 13(a)(1), and Section 15B(a)(l) of the 1934 Act.
6(c)(1), and 15A(g)(l) of the 1934 Act.


Federal Reserve Bank of St. Louis

See also Sections

134 -

with the SEC or joining an SRO, a dealer must file an application disclosing
specific information, 59/ and must meet prescribed standards of competence,

operational capability and financial responsibility. 60 / Thereafter, the regis-

tration requirements allow the SEC and SROs to monitor broker-dealer compliance
with the applicable regulatory requirements, including the bookkeeping and record-

keeping provisions, 61 / the rules calling for the filing of periodic financial
reports, 62/ and the financial responsibility rules.

Registration requirements

also play an important role in connection with the SEC's statutory disqualification

authority and rules, which provide for the denial or revocation of a dealer's

registration for failure to comply with SEC or SRO rules and standards. 63 /

Application to government related securities

.

Mandatory government

securities dealer registration is an essential condition for assuring compliance
with most of the regulatory measures that might be applied to trading of government

related securities.

Without mandatory registration, regulatory authorities would

encounter great difficulties in keeping track of dealers and in developing systems
to monitor and ensure compliance.

A number of the industry experts interviewed in

59/

See Rule 15bl-l, 17 CFR 240.15bl-l; Rule 345.11, 2 NYSE Guide (CCH) 5 2345;
Rule 9.3, CBOE Guide (CCH) 1 2302. See also Rule 15Ba2-l, 17 CFR 240.15Ba2-l
(bank dealer registration).

60/

Rule 15b8-l, 17 CFR 240.15b8-l; Rule G-3, MSRB Guide (CCH)

61/

See note 69 & accompanying text infra .

62 /

See notes 70-71 & accompanying text infra

63/

See Sections 15(b)(1), 15(b)(4), and 15B(a)((2) and (c)(2) of the 1934 Act;
£f. Sections 3(a)(39), 6(1)93)A, 15A(g) (3) (a) , and 19(h) of the Act; Rule
15b8-2, 17 CFR 240.15b8-2; Rule 345, 2 NYSE Guide (CCH) t 2345.


Federal Reserve Bank of St. Louis

1

3511.

.

135

connection with this study expressly indicated the desirability of universal
registration requirements for dealers in government related mortgage-backed
securities.

In addition, absent such requirements, new means would have to be

developed to implement standards of competence and integrity and to impose

disciplinary sanctions if these measures were imposed on dealers in these
securities.

There is no assurance that such new means would be as efficient

or effective as the systems based on mandatory registration.

Books and Records
SEC and SRO rules require registered dealers to maintain accurate books
and records on, among other things, all purchases and sales of securities; copies

of confirmations of all purchases and sales; all assets and liabilities of a firm;

cash and margin accounts of customers; securities in transfer; dividends and interest received; securities and money borrowed and loaned;
or delivered;

securities not received

long and short positions in securities; brokerage orders and instruc-

tions for purchases and sales (regardless of execution); repurchase agreements;

employment questionaires for associated individuals; and customer complaints. 64 /

Related rules and statutory provisions also require dealers to designate

a

firm

official to assure maintenance and preservation of records, 65 / and provide for
the right of inspection by an SRO or the SEC at any reasonable time. 66/

64/

See Rule 17a-3, 17 CFR 240.17a-3 Rules of Fair Practice, Art. Ill, Sec. 21,
NASD Manual (CCH) 1 2171; Rule G-8, MSRB Manual (CCH) 1 3536.

65^/

See Rule G-10, MSRB Manual (CCH)

66/

InspecSee Section 17(a) of the 1934 Act; Rule G-9, MSRB Manual (CCH) 1 3541.
tion of bank dealers is done by the federal bank regulatory authorities.


Federal Reserve Bank of St. Louis

1

3546.

-

136

Application to government related securities .

As indicated above,

serious deficiencies in recordkeeping practices have been evident in some of
the recent cases described, and these deficiencies made it difficult for the
firms to assess accurately their own capital positions or to guide their business

operations.

Appropriate recordkeeping would obviously have prevented problems

due to these deficiencies.

Moreover, enforcement of most of the regulatory

measures discussed above (e.g., margin, net capital) would require the maintenance of at least some standardized types of records.

Reporting, Compliance, and Enforcement

A variety of mechanisms have been developed to achieve

a

high level

of compliance with the regulatory measures applicable to registered securities

dealers.

Reporting and early warning systems .

To find violations of financial

responsibility and other related rules at an early stage, the SEC has developed a
reporting and early warning system based largely on mandatory reporting by dealers.
The reporting and early warning system ensures that current information on each

dealer is available to the SEC and provides a mechanism for SEC action in the
event a dealer fails to conform to the rules.

Dealers that carry customer accounts are required to prepare reports
monthly, quarterly, and annually and to file them with the SEC. 67 / The annual

reports must be certified by an independent public accountant and must be furnished
to all customers. 68 / In addition, when a dealer fails to comply with the SEC's

67/

Rule 17a-5(a), 17 CFR 240.17a-5(a)
reporting requirements.

68/

Rule 17a-5(c), 17 CFR 240.17a-5(c)


Federal Reserve Bank of St. Louis

.

Bank dealers are not subject to these

137

-

reserve and segregation requirements or net capital rule or fails to keep its
books and records current according to the SEC's recordkeeping rule, the dealer
must provide immediate notice to the SEC, and must file special reports with the
SEC for a specified period of time, 69/ until it demonstrates its ability to

comply with applicable rules.
Compliance:

enforcement .

Inspections, disciplinary proceedings, oversight, and

Aside from the reporting and early warning systems, the task of

ensuring compliance with the rules applicable to registered brokers and dealers
is performed by a two-tiered system in which

(1)

the SROs are delegated govern-

mental-type powers and responsibilities to enforce compliance by their respective
members, and (2) the SEC performs both an oversight role to ensure that the SROs
carry out their responsibilities effectively and fairly, and a supplemental

enforcement role.
SROs seek to enforce compliance with the federal securities laws and

their own rules primarily through inspections and disciplinary proceedings.

SRO

rules and procedures provide for inspection of all members within certain time
periods. 70 /

A system of market surveillance operated by the SROs supplements

these inspections.

Disciplinary sanctions are imposed on members or persons

associated with members by SROs for violations of the 1934 Act or SEC or SRO
rules. 71/

69 /

Rule 17a-ll, 17 CFR 17a-ll. The rule also requires a self-regulatory organization to give immediate notice to the SEC in the event it discovers a violation
of any of the rules by a member.

70 /

See , e.g., MSRB Rule G-16 (requires inspection of municipal securities brokers
and municipal securities dealers once every two years).

71 /

An SROs sanctions may include, for example, censure, suspension of up to five
years, expulsion, or fines of up to $25,000 for a member or $100,000 for a
member firm.


Federal Reserve Bank of St. Louis

138

The SEC, in its oversight role, reviews the performance of the SROs
through oversight inspections of member firms and of the SROs themselves.

The

SEC itself also inspects firms registered with the SEC that are not members of
an SRO.

Under the 1934 Act, inspection and compliance authority for bank dealers

is allocated to the federal bank regulatory agencies.

The SEC also has the authority

to inspect these entities, after notice and consultation with the appropriate

regulatory agency.

Finally, the SEC has administrative enforcement authority over

all persons registered with it 72 / and may institute injunctive actions in the

federal courts to enforce compliance with the securities laws by persons not so

registered.

Application to government related securities .

A number of the cases

described in Appendix A involved widespread and continuing abuses that may have
been caught by inspections or possibly prevented if the entities had been subject
to a regulatory program and had been inspected, although some abuses would no doubt

persist under any possible compliance system.

Reporting and early warning are par-

ticularly efficient mechanisms for monitoring and encouraging compliance with those
financial and operating requirements that, in themselves, require regulated firms
to perform analyses and tabulations of internal information.

help assure that books, records, and reports are accurate.

Audit requirements

Inspections not only

provide further assurance of such accuracy but also furnish a principal method of

encouraging and monitoring compliance with a broad range of substantive requirements.

72 /

This includes broker-dealers, municipal securities dealers, registered securities information processors, and SROs.


Federal Reserve Bank of St. Louis

139

The existing reporting, compliance, and enforcement system for

registered dealers seems to be reasonably effective. Its flexibility, moreover, has recently been demonstrated by the application of this system to
the municipal securities markets. Absent some measures analogous to those

employed in this existing system, there would seem to be no assurance that
any substantive regulatory requirements that might be imposed on the trading

of government related securities would actually be followed.


Federal Reserve Bank of St. Louis

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140

-

APPENDIX
SEC INVESTIGATIONS OF CASES OF ABUSIVE TRADING PRACTICES

The following factual accounts, based upon the results of actual

lawsuits, investigations, and inquiries, present examples of problenjs and
abuses in the trading of government and government related securities.

Although we believe that the accounts accurately present the major facets
of the respective cases, particular facts in some of the cases may be sub-

ject to dispute.

The names of parties and other identifying characteristics

in the cases have been omitted to prevent the disclosure of nonpublic or

sensitive information.


Federal Reserve Bank of St. Louis

141

Case #

1

In this early administrative proceeding, unsuitable transactions
were entered into by a large registered broker-dealer for the account of a
major public university. The broker-dealer also churned the account and failed
to reflect the account's transactions properly on its books and records.

The subject transactions involved government securities, including
forward commitments executed in 1974 to purchase GNMAs. The university had
sought low risk investments for its investment account of approximately $1.5
million. Nevertheless, its account acquired commitments exceeding $3 million,
and sustained losses of nearly $1 million.

These unsuitable trades had been handled by only one of the brokerdealer's registered representatives. The SEC brought an administrative proceeding against the broker-dealer and accepted a settlement which included
findings of a failure to supervise the registered representative involved.
In addition, the broker-dealer agreed to take remedial steps to prevent recurrence of these activities, including written approval of manager prior to
execution of GNMA forward commitments in excess of specified amount and the
institution of procedures for the early detection of excessive trading activity
by account executives.
The registered broker-dealer reached a settlement with
the university in which it agreed to share the losses that had been sustained
and pay approximately $400,000 to the university, resulting in a net loss
to the university of approximately $600,000.

Case #2

B Corporation was an unregistered dealer in government-issued and
government guaranteed securities with offices in the Midwest and in New York
City.
B engaged in repurchase agreements and reverse repurchase agreements
with respect to these securities with various entities, includiag corporations,
banks, and state and local governments. B filed a voluntary petition of bankruptcy in late-1975.

B accumulated a portfolio of well over a billion dollars worth of securities, primarily Treasury securities, by buying the securities and immediately
putting them out on repurchase agreements during a period when repo rates were
lower than the rates on government securities.
As long as the rate of return
exceeded B's cost of financing the purchase of the securities,
on the securities
B profited on the arbitrage between the two rates, and used these profits


Federal Reserve Bank of St. Louis

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142

i
When interest rates
to build an extensive pyramid of government securities.
unexpectedly rose, however, causing the cost of borrowing to rise and the
market price of B's government securities inventory to drop, B experienced
severe financial problems. During a two-week period in mid-1975, B defaulted
on several repurchase agreements.
Although B was insolvent during this period,
it continued to operate, and entered into at least one additional repurchase
agreement.
B's financial problems were exacerbated by its failure to maintain
complete and accurate books and records. Its recordkeeping relied in large
part on uncorrelated purchase and sales confirmations, some of which were
maintained in chronological order while others were ordered according to other
systems.
Accordingly, these confirmations provided no useful system for checking
daily transactions. Further, B's logs of transactions failed to reflect accurately
all of its securities transactions, and, for its final year of operations, B
failed to maintain various journals and ledgers.

Althcngh B did large amounts of business with its major customers, it
failed on several occasions to honor their requests for its financial statements.
These financials would have revealed the company's precarious position. Moreover,
when B turned its books and records over to a bankruptcy receiver, these documents
were so incomplete and disorganized that the receiver had to engage an accounting
firm to attempt to determine B's position with regard to its open repurchase
and reverse repurchase agreements.
The books were in such bad condition, however,
that the accountant was unable to express an opinion on the company's financial
condition for any period during 1975.
Papers filed in the bankruptcy proceedings indicate that B's liabilities exceeded its assets by $19 million. While the total amount of losses
resulting from B's defaults is not known, two repo customers reported losses
totalling $2.4 - 2.8 million.

I

I
Case # 3

G was incorporated in 1973 and shortly thereafter began doing business as an unregistered broker-dealer in government and municipal securities.
G ceased its municipal securities business in 1975 when the Securities Acts
Amendments of 1975 became effective, thereby requiring registration with the
SEC of municipal securities broker-dealers.
From 1975 through 1977, G engaged
in the purchase and sale of securities issued by the U.S. Treasury, and sponsored federal agencies, and mortgage-backed securities guaranteed by GNMA.


Federal Reserve Bank of St. Louis

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143

In early 1976, G began selling GNMA certificates and Treasury securities under agreements to repurchase.
Over the course of the next eighteen
months, G solicited and entered into 27 separate fraudulent repo transactions,
generally with small banks and savings and loan associations.
It solicited
customers by representing that it was acting as agent for a bank, and would
pay interest generally 1% higher than the prevailing federal funds rate.
Customers were assured that the investment was sound because it was guaranteed
by the federal government.
G instructed customers to wire funds to several banks at which G had
No securities were ever delivered to customers; rather, customers
accounts.
were told that they would be sent safekeeping receipts indicating that the
securities purchased were deposited in third party banks. No such receipts
In fact, G's own records indicate that
were ever received by customers.
it never owned or acquired the securities covered by the repo transactions.

Generally, when repo transactions fell due, G would engage in various
practices to delay as long as possible the repurchasing of the securities. For
example, it would:
(1) issue confirmations extending the repo date without
authorization, (2) claim that a foul-up in the wire transfer procedure had delayed repayment, or (3) write checks it knew would be returned for insufficient
funds.

These practices resulted in G's failure to meet repurchase obligations
totalling over $1 million.

Case #4

H, an unregistered broker-dealer involved exclusively in trading
government-guaranteed and government-issued securities from its inception in1974 until mid-1977 when it ceased doing business, was a wholly owned subsidiary
of a registered broker-dealer that went out of business as a result of net
capital problems attributable to the unregistered dealer.

More than 60% of H's business involved forward transactions in GNMA
mortgage-backed securities with national and state banks, credit unions, and
savings and loan associations. The balance of its business was in other government securities. H employed approximately 30 salesmen who were given territorial
areas throughout the country in which to solicit institutional customers over
the telephone.


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were steadily
H had tremendous success in late 1976 when GNMA prices
accounts and often trading over 350 million
rising, carrying approximately 250
million, and during
a day!' The firm's profit for December, 1976, was $1.7
each earned net commissions of over c40,000.
that single month 10 of the salesmen
At that time
In early 1977, however, GNMA prices turned downward.
purchase GNMA securities totalling more than
H's customers were committed to
half of
$400 million from the firm, with settlement dates through the first
these transactions, H had to sell
When certain customers disclaimed
1977.
their securities at a loss, leaving its customers still owing $8.1 million
on their commitments and leaving H short approximately $4 million on its commitments to dealers. H instituted, or planned to institute, law suits against
31 institutional customers who had disclaimed transactions, but most of the
customers disclaiming transactions alleged that H engaged in unauthorized

transactions or had misrepresented or omitted material information concerning
Tn addition, some customers
the risks attendant to GNMA forward trading.
whom the salesmen had dealt lacked authority
indicated that the individuals with
Four suits were also filed against H alleging
to bind the institutions.
violations of the securities laws and common law fraud.
In the following three months, representatives of the dealers to whom H
owed money attempted to work out a plan to permit H to continue operating, under
certain restrictions, in an effort to reduce the outstanding indebtedness. H,
It
however, was unable to generate sufficient business to meet its overhead.
owing to its customers
ceased doing business in mid-1977, leaving $4 million
and dealers.

There appear to have been numerous causes of the aforementioned problems,
including principally agressive sales practices which led to customers becoming
over-committed in connection with GNMA forward transactions, and then refusing
H failed to train its salesmen or
to take delivery when interest rates rose.
Of the salesmen
to exercise any meaningful supervision or control over them.
employed by H, at least 15 had either no experience in the sale of government
securities or experience limited to municipal securities. Despite this lack of
of experience, H established no rules or guidelines concerning suitability, trade
authorization, or the mark-ups, mark-downs, or spreads charged on transactions.
Salesmen were permitted to engage in transactions of any size without authorization from principals. While one of the principals conducted a "training
program," it laid little stress on trading procedures and regulation, but
emphasized (1) that customers were not required to commit any capital at the
time they purchased GNMA commitments and (2) that the firm was therefore justified
in reducing customer profits and keeping as much profit as possible for itself.
Supervisors also impressed upon salesmen that they could earn commissions only
The relatively
only by causing active trading in their customers' accounts.
high 40% commission rate obviously contributed to the salesmen's incentives
to engage in excessive trading.
As a general practice, the salesmen used high-pressure, "boiler-room"
sales techniques in soliciting customers, and misstated and omitted to state


Federal Reserve Bank of St. Louis

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many material facts ia connection with these solicitations. Using aggressive
and persistent presentations in telephor^e contacts with banks, savings & loans,
and credit unions, the salesmen emphasized that quick profits could be made
in trading GNMAs and that such profits could be made without risk and without
committing funds, because no tu.rgin was required.
In some cases they told
customers that delivery would not have to be taken because the securities
could be sold at a profit prior to delivery.
Customers were also told that,
in the event delivery had to be taken, H would arrange reverse repurchase
agreements as a means of extending credit.
In this manner, customers who
could not afford to accept delivery of GNMA securities were induced to trade
in such contracts withou^ being informed of the risks inherent in reverse
Indicative of the resulting over-commitments, one credit
repo agreements.
union with total assets of under $1 million was committed to purchase $5 million
worth of securities, and a bank with $11 million in total assets was committed
to purchase $21 million in securities.

Once a cusitomer had purchased commitments for GNMA's, the salesman
would seek authorization to commence trading on a discretionary basis for
Even where authorization was not received, salesmen
the customer's account.
nevertheless sometimes bought and sold GNMA securities for the customer's
account and then, in an effort to obtain such authorization, sent confirmations,
or "wooden tickets," notifying the customer of its profit.
In the rising market that existed during the final quarter of 1976,
the salesmen engaged in trading practices that enabled them and the firm to
reap enormous profits while reducing customers' profits.
The fact that the
customers were continuously realizing profits apparently prevented them from
discovering these unconscionable practices. For example, notwithstanding the
rising market, the salesmen frequently repurchased customer commitments as
soon as there was a small profit in an account, e.g
1/32 or 2/32 of a point,
and then had the firm resell the commitment to another customer.
Some of these
repurchases were effected without authorization, while in other cases the
firm had apparently convinced the customers to give it trading discretion.
The salesmen generated enormous profits by engaging in excessive mark-up and
mark-down practices in connection with these riskless principal transactions.
For instance, a salesman would obtain the price at which H could sell a security
to a third party and then determine the price it would pay i'cs customer for
the security, often making the purchase at a price substantially below the
market.
.

,

Finally, the salesmen in some cases allowed, or even encouraged,
the opening of "sham" accounts, where individuals acting under the guise of
an institution or corporation traded GNMA securities for their own accounts.
For example, one salesman persuaded two individuals with limited means to
form corporations to trade GNMAs.
These individuals traded over $185 million
of GNMA securities, resulting in substantial losses.


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Case # 5

iit'I

I'
was formerly ii.t office ma^^ger for a large registered brokerdealer.
J and K were registered representatives in the same office.
I, J and
K also owned one corporation and one partnership that traded in government
securities.

Using information obtained from the broker-dealer, 1, J, and K
schemed to interposition their corporation between the registered broker-dealer
and outside broker-dealers to make proiits in government securities trades.
They concealed this from the broker-dealer by the use of the government bond
trading department of a l<2rge national bank. Beginning in late 1973, J arranged
for the corporation to open a bank account aud bond trading account at the
national bank. All contacts with the bank were made through one of its vice
presidents, who worked in its government bond trading department.
This vice
president was a long-time friend of J. For 2 1/2 years thereafter, numerous
trades of government bonds were carried out among the broker-dealer, the
interpositioned corporation, the bank's bond department, and outside parties.
J, who did most of the government securities business in the brokerdealer's office, determined each morning at what prices the broker-dealer's
government bond traders in New York would sell certain bonds and related this
information to I, K and the bank's vice-president. With this information aud
the aid of the bank's vice president, purchase prices were obtained from
outside
dealers.
The bank's vice president, with 1, J, and K, would then cause the
bank to place orders through the broker-dealer to buy bonds at prices at
which
the broker-dealer was willing to sell.
Once the trade was made, the vice president would execute a sale to an interpositioned corporation at or
near the
purchase price from the broker-dealer.
Simultaneously, the vice president
would execute another trade with the corporation buying the government
securities
back at a higher price.
He would then sell the bonds out to the outside dealers.

Thus, profits which, but for the interpositioning, would
have gone
to the broker-dealer or to outside purchasers were diverted
through the bank's
bond department to companies owned by I, J, and K.
These three aien also made
commissions from the broker-dealer on the orders of bonds the bank
placed
through them.
In a two and one-half year period, I, J, and K made
over ISO
interpositioned trades and over $268,000 in profits

I

When the scheme was discovered in mid-1976, I and the vice
president
were fired. J and K also left the broker-dealer in mid-1976.


Federal Reserve Bank of St. Louis

I

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147

-

In 1977, the SEC instituted an administrative proceeding against
and K.
In a subsequent settlement, I and J were barred from associaI, J
tion with any broker or dealer, and K was suspended for three months from
any association with any broker or dealer and received a further nine months
suspension from any association other than in a supervised capacity. No
administrative action could be taken against the bank vice president.

Case #6

N Corporation was a holding company which owned four banking subsidiaries and had a class of securities that were registered with the SEC pursuant
Bank M, the largest of these
to Section 12(g) of the Securities Exchange Act.
subsidiaries, failed in October, 1975.
Bank M accounted for most of the assets
of N Corporation, and its failure led to the collapse of N as well.

In early 1973, in an effort to avoid recognizing an $805,000 loss
suffered in connection with short sales of government securities, M engaged
in "adjusted trading" of U.S. Treasury and government-guaranteed securities.
Adjusted trading is the practice of pairing purchases and sales of securities
at a price in excess of the current market price.

Three basic methods of adjusted trading were employed. First, the
bank sold securities to a registered broker-dealer at prices from three to
The
four points above the market and subject to oral repurchase agreements.
bank repurchased these securities at similarly inflated prices in the following
month.
The bank treated these transactions as outright sales and separate
purchases of securities.
The bank's second method of adjusted trading was bond swaps, in which
the bank would sell securities to a dealer at the current market price plus a
one to four point premium and, later the same day, purchase different securities
from the same dealer at the market price plus the same one to four point
premium.
Bank M engaged in these swaps with both a large national bank
and a second registered broker-dealer.
The national bank had established
adjusted trading and allowed trades to take place
no staff guidelines on
at premiums of three to four points over the market.
The registered brokeradjusted trading, although supervisory personnel within
dealer also permitted
the broker-dealer prohibited premiums of any more than about one point over
market, which approximated a day's range of trading.
As a result of these
swaps. Bank M avoided showing losses of over $250,000.


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Bank M' s third method of adjusted trading involved the "sale" of $4
million of securities to an unregistered municipal securities dealer at prices
more than three points above the market. This sale, executed through a separate
broker acting as agent for the dealer, nominally occurred at the market, but
Bank M then charged the dealer's account $124,000, which constituted the
In return, Bank M agreed to purchase about $8 million
dealer's overpayment.
of municipal securities from the dealer at a price 1 1/2 points above the
As a
market, thereby reimbursing it for the $124,000 loss it had incurred.
avoided showing losses of over $100,000.
result of this transaction, Bank M
As a result of these adjusted trading practices, the published financials
The trades
of Holding Company N understated its 1973 losses by about 19%.
securities inventory
also caused the overstatement of the value of Bank M' s

by about $400,000.

Case #

7

was a registered broker-dealer which had offices in two cities.
was a member of the NASD, and its primary business was trading in municipal
and government securities.

began trading GNMAs in 1978. In mid-1978, one of O's salesmen,
without authorization, agreed to take a $4 million position in forward commitments to purchase GNMAs with a broker-dealer in New York. At that time,
had only nominal net capital.
Interest rates moved up in the following two
months and
sustained large losses which more than wiped out its capital.
O's difficulties in this period were compounded by problems it experienced in introducing a computerized recordkeeping system and by O's failure
to maintain a manual backup system.
These recordkeeping deficiencies were
so serious that
was unable to compute its capital position at the time the
large forward position was assumed.
It also appears that
engaged in unsuitable and fraudulent transactions in the account of one of its individual customers.
This customer was
a mechanic with limited formal education and a net worth of only a few thousand
dollars.
promised to alert him whenever his losses exceeded $2,500.
Nevertheless, one of O's salesmen used this customer's account to purchase millions
of dollars worth of GNMA forwards, while .assuring the customer that he would
never have to take delivery on the certificates, and would only make money
on changes in interest rates.


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continuing
The SEC learned of O's net capital problems and its
The SEC
a result of a routine NASD inspection.
operations while insolvent as
its chairman
obtained injunctions against further violations against 0, and
in receivership and administrative proceedings
was placed
and president.
None of O's customers
may also be instituted in connection with the same facts.
collapse, although
sustained financial losses as a result of the firm's financial
failure to honor
other dealers lost more than $300,000 as a result of O's
favorable outcome for O's customers resulted
The
its forward commitments.
financial condition by the NASD
in part from the prompt discovery of its poor
O's observance of the reserve and segregation
and the SEC and in part from
bank account
requirements under which customer funds were held in a separate
for their exclusive benefit.

Case #

8

of Q, a
Government Securities, Inc. is an unregistered affiliate
organized in 1973 to deal exclusively
P was
large registered broker-dealer.
registration with
aovernment securities and is, accordingly, exempt from
in
outside of New York City are serthe^SEC. Nevertheless, all of P's accounts
have established specialized
viced by registered representatives of Q. P and Q
particular types of government
rules for determining which entity handles
securities transactions for their customers.
P

in government
In late 1976, R, an account executive specializing
accounts at P for two
securities employed by Q, opened and began servicing
pension^^fund of one of
medium-sized mid-western cities and a police and fire
engage in arbitrage
was to
the cities. The purpose of the new accounts
arbitrage strategy
in United States Treasury securities. R's
transactions
it on the market
involved borrowing a Treasury Note through P and selling
from this sale were used
Simultaneously, the proceeds
(the short position).
Treasury Note of the same denomination with a different
to purchase another
The only funds that
maturity date and interest rate (the long position).
transfers representing
changed hands between P and the customer were wire
the differences in prices between the two notes.

securities whose
The arbitrage position was established by selecting
"normal" historical
their
yield to maturity appeared to be out of line with
while
security whose yield appeared to be low was sold short
relationship. A
yield was purchased
than its historical
a security with a current yield higher
would return
R expected that the yield of the securities
for the long position.
profit by liquidating
account could then
to their "normal" levels, and that the
- i.e. selling the long position and buying in the short position.
the arbitrage
paired on opposite sides of
Securities with similar maturity dates were usually
With this arrangement.
position.
the arbitrage, creating a partially hedged


Federal Reserve Bank of St. Louis

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also have an
market factors that caused one security to increase in value would
resulting in little over-all effect
off-setting effect on the other security,
on the account.

On R's recommendation, the cities and the pension fund engaged in
arbitrage trading th-roughout the first half of 1977. None of them had engaged
in arbitrage before, however, and they were not fully aware of the risks
The primary risk is that the yield of the
involved in an arbitrage str-^Cegy.
In
securities involvt-d may not move back to their historical relationship.
on closing out the position.
this event, the customer may recognize a loss
R apparantly did not fully disclose this market risk to the cities.^ In addition,
he failed to explain the borrowing charges assessed by P in connection with
the arbitrage transactions.
first, the transactions engaged by the cities and the fund were
successful, and they recognized aggregate gains of nearly $170,000 in the
Gradually, however, R began recommending transactions
first several monthK.
which resulted in larger and larger open positions and wider disparities beThis strategy increased
tween the maturity dates involved in the arbitrages.
could be realized if the market did not
the possibility that a large loss
In addition, the transactions were not arbitrages in the
move as predicted.
same sense the earlier activities were because the partially hedged position
which resulted from choosing securities with similar maturities was gone.
R also failed to disclose the special risks inherent in this new strategy.
At

3y mid-1977, the two small cities and the pension fund taken together
Beginning about that time,
had open positions of well over $300 million.
the market for Treasury securities failed to move as predicted, and losses reSince the three entities each had large
sulted in a number of the arbitrages.
arbitrage positions, even small market movements caused large paper losses.
By June 30, 1977, the three had sustained paper losses of over $670,000.

V

The cities' fiscal years ended on June 30, 1977, and they wished to
close their accounts to recognize any gains. To avoid having to close the
accounts and report losses to the cities, R devised a scheme whereby Q wired
funds to each of the cities and the cities wired back approximately equal
amounts the next day. R also prepared and mailed ficticious confirmation slips
from P showing closing and reopening of the cities' open positions in the
arbitrages. The prices shown on the confirmations were not market prices,
In fact, no transbut prices that would show no gain or loss to the cities.
actions had occurred and the accounts remained open. 2/ The actual losses
By this
were not discovered until August, 1977, during one of P's audits.
time, further losses had occurred in the accounts.

1/

Between January and September, 1977, R effected over 20 arbitrages for
the accounts of each of the cities. He also earned $90,000 in commissions
during this period.

2/

An investment manager for one of the cities knew it had a potential
loss in its open positions and knew the June 30 "trades" were done
away from the market. He approved the deal to give R time to remedy
the sutuation.


Federal Reserve Bank of St. Louis

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As a result of R' s arbitrage strategy, the accounts of the cities and
the pension fund showed net losses of $1,300,000.
As
Q assumed these losses.
a result of SEC enforcement proceedings against R and Q and judicial settlement of these proceedings, Q instituted new procedures to (1) prevent use of
false confirmations, (2) require additional approvals for fund transfers to
avoid occurences such as the June 30 sham transaction, (3) provide for disclosure
of borrowing charges, (4) require approval of all arbitrage accounts, and
R was barred
(5) implement a periodic review procedure for P's accounts.
from association with a broker or dealer for five years, and one of Q's supervisors agreed to undergo retraining.

Case #9

From 1976 until late 1977, the portfolio manager of a state university,
who was charged with the responsibility of investing university funds in short-terra
highly liquid government securities, used the university's account to accrue
financial benefits totaling approximately $1.3 million for himself and a group
of friends and business associates through trading fees generated by transactions
Despite the university's conservative
in government-guaranteed securities.
investment objectives, and without disclosure to the university, the portfolio
manager engaged in a highly speculative, leveraged trading program. This program
involved the trading of GNMAs on a forward basis as well as when-issued trading of
sponsored agency securities.
After becoming over-extended on these forward
commitments the portfolio manager engaged in reverse repurchase agreements to
Through the use of reverse repos,
fund delivery of the securities purchased.
the portfolio manager was able to "pyramid" the university's investments, i.e.,
borrow money against securities owned to purchase additional securities. This
strategy resulted in university commitments exceeding $250 million at a time
when its assets available for investment were only about $60 million. Published
accounts have estimated losses to the university of about $17 million.
While the portfolio manager often dealt directly with New York government
securities dealers, he placed many of these transactions through broker-dealers
The
owned by friends and associates, or that employed friends and associates.
portfolio manager himself was a part-owner of one such broker-dealer. One of
those broker-dealers was registered with the SEC, while two others were not.
In each instance the university was the sole, or at least the primary, customer
These broker-dealers charged the university
of the broker-dealer or the salesman.
excessive mark-ups and commissions, and failed to disclose that they were also
being compensated, at market rates, by the other party to the trade.


Federal Reserve Bank of St. Louis

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-

The university has not honored some of its outstanding commitments,
resulting in suits for damages totalling approximately $1 million by two brokerdealers.
One of the broker-dealers involved in the scheme is currently in
receivership.

Case # 10

R was organized in 1977, was registered with the SEC as a brokerIt operated a municipal and government
dealer, and was a member of the NASD.
S was a wholly-owned subsidiary of R's parent and was
securities business.
S was incorporated sepaorganized as an unregistered broker-dealer in 1978.
rately of R, which had been losing money, apparently so that the government
securities business could be conducted with less government regulation, including
operating outside the net capital rule.

The trading practices used by the two firms in the sale of government-guaranteed securities, primarily GNMAs and FHLMCs, were similar and
were carried out by R until S commenced doing business and continued the practices.
The trading room was operated as a "boiler room," and telephone calls
frequently small financial institutions
were made to potential customers
such as credit unions, banks, and savings and loans
using sources such
as bank directories and savings and loan directories.
"Cold calls" to various
types of potential customers resulted in a substantial number of sales.
Salesmen
for the firms were paid a commission of 40% of the firm's profits on each sale
once the trades were settled.
Sales were made without regard to the suitability
of the purchase for the customer; salesmen made no inquiry of a customer'
liabilities or net worth or other investment commitments. In a number of
instances, customers of R and S entered into forward commitments for GNMAs
and FHLMCs well in excess of the assets they had available to purchase the
securities when the commitments became due.
For example, a credit union with
a net worth of $2.5 million was committed to take delivery of $5.5 million
of government guaranteed securities within a month's time and had $11 million
of additional commitments coming due in the following four months.

—

—

To enable some customers to avoid recognition of some losses they had
incurred in their transactions, R and S entered into adjusted trades with
these customers, purchasing the securities from them several points above
the market, and selling other forward commitments to the customers at prices


Federal Reserve Bank of St. Louis

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153

-

Some salesmen testified that they thought
also several points above the market.
as long as the mark-ups did not exceed 5 points.
sach trades were permissible
To insure that the customers would honor these further commitments, the firms
sometimes required "margin money" in amounts sufficient to cover R' s losses
o;i tht^ adjusted trades.

V

Existing customers of R were not informed when S was organized, even
though many of their accounts were transferred to the new entity. Neither
these customers nor new ones were told that S was not registered with the
The same
Commission, was not an NASD member, and was not insured by SIPC.
the business was operated out
salesmen continued to deal with the customers,
of the same office, and, although separate books were kept reflecting the
government and municipal business, the firms' salesmen were not even sure
which entity paid them.
In part because of accounting requirements, S recognized substantial
Its accountant required it to "book" losses
losses in its adjusted trading.
resulting from adjusted trading immediately, but would not allow it to recognize
the gain from the forward commitment sold to the customer until settlement.
over $600,000.
As a result, by the end of 1978 it had a negative net worth of
Despite this insolvency, it continued doing business.

Through much of 1978, R and S borrowed money from a southern city
through a series of repurchase agreements covering government guaranteed secuIn late 1978, S, while insolvent, began using funds borrowed from
rities.
collateral.
the city in its operations without maintaining the securities as
to the city
In a practice termed "bucketing," it sent false confirmations
purporting to show purchases of the collateralizing securities when in fact
In late 1978 and early 1979, the amount of uncolno such purchases were made.
lateralized funds was approximately $1.4 million. During this period, the
management of the firm changed, and the $1.4 million was thereafter returned
Included in this money, however, was approximately $500,000
to the city.
of margin money of a credit union.
The changed management also refused to allow any more adjusted trading,
balance sheet
and attempted to remove all the losses it had accumulated on its
trading by instituting a system of "swaps", which effecthrough the adjusted
The customers agreed
tively closed out certain open positions for customers.
R' s management had represented that the losses which had
to such "swaps" because
have to
been encountered and were hidden through the adjusted trading would not
In fact, the losses were recognized at this time,
oe recognized by the customers.

3/

"

One customer, a credit union, deposited over $60,000 of margin money
A second payment of $446,156.77 was made in November
in May 1978,
Between $450,000 and $500,000 of this money was never returned
1978.
to the credit union.


Federal Reserve Bank of St. Louis

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154 -

One customer recognized a loss of $1.4 million and also lost about $500,000 in
margin mon';:y which xvas not returned. Two other credit unions recognized losses
of over $20,000 each.

Three
A permanent injunction was entered against S in early 1979.
of that firm's salesmen and its manager have been barred from the industry.
Administrative proceedings are pending against R and certain other persons.

Case #11

Company U is a no-load, open-end management investment company registered with the SEC under the Investment Company Act of 1940. U's investment
objective is to provide current income to shareholders primarily through purchasing securities which are obligations of or guaranteed by the U.S. Government.
In 1977 and 1978, the majority of U's portfolio consisted of GNMA certificates
and other government guaranteed loans.

Broker T has been a registered broker-dealer and investment advisor
since 1973. T shares offices with U and advises U on its investments. In addition, T and U have had at least two common officer-directors, including a
comjuon president, and these two individuals were primarily responsible for the
selection, purchase, and sale of U's portfolio investments, including GNMAs.

A Commission inspection of U under the Investment Company Act revealed
that commencing in 1977, U traded GNMA forwards and standby s and entered into
reverse repos. By December 31, 1977, U had over $42 million in GNMA commitment
in its portfolio, while its total assets other than these commitments were
~
"
only $46 million. In its prospectus and advertisements to its existing and
potential investors, U extolled the safety of its investments, stressing that
the U.S. Government guaranteed them all.
It did not apprise these investors
of the risks inherent in forward contracts, standbys, and reverse repos; namely,
the speculation in interest rates and the possibility of having to purchase
GNMAs at a loss or when the company might not have sufficient funds to cover
the purchase.
In addition, U's financial statements understated the amounts
of GNMA commitments held.
U's massive GNMA commitments came to the attention of U's board of
directors in early 1978.
(Under the Investment Company Act, 40% of U's directors
were required to be independent of the company and its advisor.) The Board
instructed the common officers of T and U to cease issuing commitments for
GNMA forwards, and the Board further required those officers to execute an


Federal Reserve Bank of St. Louis

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indemnification agreement to U for losses it may have on $20 million in commitments as a quid pro quo for continuance of T's advisory contract with U.
Pursuant to the indemnification agreement, the common officers reimbursed U
for $700,000 in commitments losses.
An additional $90,000 loss remains unreimbursed. Subsequent SEC proceedings resulted in additional monetary and nonmonetary relief.

Case #12

W, an independent unregistered broker-dealer, was organized in late
1977.
During 1979 it raised at least $6.5 million from investors by purporting
to enter into "repurchase agreements" on guaranteed student loans ("GSL's").
Apparently, however, W did not have GSL's as collateral, and it defaulted upon
$4,500,000 in payments on these "repurchase agreements," and issued over
$1,000,000 worth of dishonored checks in connection with two of these agreements.

W engaged in these transactions with credit unions, S & L's, banks,
insurance companies, and other institutional investors.
It represented that
the GSL's were to be held by third parties or by the broker-dealer for the
purchasers. However, the broker-dealer, after receiving funds from the customer,
failed to produce the securities, even when requested.
At this time it is
unknown whether any securities were ever produced for any customer.

W told investors to whom it purportedly sold GSL's, among other things,
that these securities were safe investments and were guaranteed by the Office
of Education of HEW. W also told investors that it was in sound financial
condition and would be able to repurchase the securities.
State authorities as well as the SEC have taken action against the
broker-dealer and its principals. A receiver was appointed in the SEC action,
and the company is presently in bankruptcy proceedings.
Several private lawsuits
are also pending.
Because no meaningful records have yet been located, it is unclear how many institutions or other investors suffered losses.
The total amount
of the losses is also unclear, although it apparently exceeds $4,500,000.


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Case #13

X, an unregistered government securities dealer, was affiliated with
registered municipal securities broker-dealer. The two firms were controlled
by one individual and shared offices, managetnent and sales staff, but maintained
separate books and records. X is presently insolvent and has filed a petition
for bankruptcy.
As a result of X's past trading activities, small banks, credit
unions, and over 40 individuals may ultimately suffer losses exceeding $8
million.
a

,

X's financial collapse and the resulting losses to its customers appear
been the result of a Ponzi-like scheme furthered by misrepresentations
and omissions of material facts concerning both the nature of the investment
packages it was offering to the public and the firm's financial condition.
Beginning in early 1978, X engaged in selling GNMA securities to customers on
a stand-by basis.
Stand-bys are essentially put options
the dealer pays
the customer a fee for agreeing to "stand by" to purchase a specified amount
of securities at a certain yield if the dealer exercises his option to sell
the securities.
By mid-1977, X had paid stand-by fees totalling $7 million.
In order to pay these fees, X obtained funds from other customers through the
use of "stand-by with pair-off" transactions.
Pursuant to these transactions,
X would purport to sell GNMA securities to the customer for forward delivery
and, at the same time, would execute a stand-by commitment to repurchase the
securities at a higher price on the settlement date. X would require payment
of a stand-by commitment fee from the customer on the trade date.
Customers
were promised a return of 11-13% on their investments.
This return consisted
of the difference between (a) the price at which the customer would resell
the securities to X, and (b) the amount paid by the customer for the securities
plus the firm's stand-by commitment fee.
to have

—

X, however, did not tell investors they were entering into "standby
with pair-off" transactions; rather it told investors that their funds were
being invested in existing GNMA securities, and that these investments were
fully collateralized, were segregated from other customers' funds, and were
guaranteed by the federal government. X further stated that these securities
were being held in safekeeping by a bank and that the securities could be
sold at any time prior to settlement date.
In fact, however, X did not purchase
any GNMA securities for customers with whom it entered into "stand-by with
pair-off" transactions, and no such securities were held in banks on behalf
of the investors.
These transactions were merely unsecured loans to X. X used
the funds to pay stand-by commitment fees it owed to customers; pay fees to
other customers to induce them to enter into stand-by commitments at above-market
prices; repay with interest the funds owed to other "stand-by with pair-off"
customers whose settlement dates had arrived; pay "finder's fees" to persons
who referred customers to X; pay "management fees" to its registered affiliate;
and pay its expenses, including the extremely high commissions it paid its
salesmen.
In addition, a substantial part of this money was retained as "profit,"
and X apparently also used some of these funds to invest for its own account.


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157

-

In addition to the misrepresentations and omissions concerning the
nature of the investment packages it was offering, X misled its customers with
false statements concerning its financial situation aad its status as a brokerdealer.
In response to requests for information concerning its financial condition, X provided customers with a combined financial statement for it and
its registered municipal securities affiliate, which was in far better financial
condition than X. This statement served to conceal X's precarious financial
situation. Moreover, the cover page of the financial statement contained the
legend "Member Securities Investor Protection Corporation - National Association
of Securities Dealers, Inc." X, however, was not a member of either SIPC or
the NASD.

By raid-1979, X's financial condition had become desperate.
In July August the firm had a negative net worth of between $150,000 and $300,000.
It
continued to conduct business in this condition for several months, with the
exception of a one-month period when the firm ceased operating because it
did not meet the minimum net worth requirements of the state under whose laws
State and federal enforcement actions, and a declaration
it was organized.
of bankruptcy, followed in late 1979. According to the most recently available
financial information, X presently has about 165 open trades with about 75
different customers. These customers include credit unions, banks, savings
and loan associations, trust accounts, and individuals.
The firm's contractual
obligations through February 1981 include repaying its "stand-by with pair-off"
customers about $11.4 million in principal and about $1.4 million in accrued
interest.
At this point, it is unclear what the ultimate losses occasioned
by x's activities will be, but based on information X has filed with the bankruptcy
court, they will evidently exceed $8 million.
X contends that the stand-by with pair-off contracts were legitimate
hedge transactions, and that its financial difficulties were caused by defaults
on GNMA forward commitments by a New York broker-dealer and a large investor.
X apparently had purchase and sale agreements with the broker-dealer covering
delivery of $321 million in GNMA securities in 1979 and 1980. X charges that
the New York firm unjustifiably repudiated these agreements in September, 1979.
These claims are currently the subject of private litigation.
It appears that two principals and several salesmen of X may currently
be continuing X's activities at a newly formed, unregistered broker-dealer

establishment.


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-

Case #14

Y was an unregistered government securities dealer, affiliated with
registered municipal securilies broker-dealer. From mid-1977 to mid-1979,
Y sold hundreds of millions of dollars of delayed delivery contracts in government
to a variety of customers, including small
securities, principally GNMAs
banks, S & L's, trust companies, and a substantial number of individuals.
Many of these contracts called for settlement beyond six months in the future.
The unregistered dealer generally attempted to cover its future delivery obligations by purchasing delayed delivery contracts from primary government securities
dealers in amounts and yields sufficient to protect it from risk due to market
fluctuations.
a

,

Problems arose with this hedging strategy, however, because contrac

;

for settlement longer than 6 months in the future are generally not available
Accordingly, Y employed
from issuers or other government securities dealers.
In practice this meant that when it
a strategy known as a "rolling hedge".
sold a delayed delivery contract of greater than 6 months duration, Y would
purchase a contract in the same principal amount and yield but with a settlement
date of 6 months or less. When the settlement date on this purchase arrived,
Y would pay for the contract, immediately sell it, and use the proceeds (plus
or minus an additional capital contribution, depending on the market) to purchase
a second contract of a duration, yield, and principal amount chosen to cover
its outstanding obligation.
However, even when final settlement dates on
purchases and sales were perfectly matched, maintaining the rolling hedge
required very large temporary investments of capital in a declining market
and, because of its thin capitalization in relation to its outstanding obligations,
Y found itself with severe cash flow problems.
For example, the rolling hedge
itself consumed additional funds of nearly $7,000,000 during one four month
period in late 1978. This would have forced Y to cease doing business if
it had not employed several questionable or fraudulent business practices de-

scribed below.
Y's cash flow problems were exacerbated by "coupon conversion losses"
it experienced as a result of its business strategy. Y frequently engaged
in repo transactions
using GNMA collateral to raise short term working
capital.
In many instances it repurchased a similar, but not identical, security
at the repo termination date.
In several instances, a coupon rate change occurred
in the GNMA market between the time of sale and repurchase, making it difficult
for Y to obtain securities with the same coupon as the original collateral.
A similar problem occurred with the rolling hedge strategy described above,

—

since there were coupon rate changes between the time Y sold standbys or forward
commitments and the time it rolled over the standbys or forwards it had purchased
to hedge its sales.
For tax and other reasons, some customers refused delivery


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-

of GNMA's with coupon rates different than those they had contracted for, even
This forced Y to pay premiums for GNMA's
though they offered the same yields.
satisfactory to its customers since they vere no longer readily available in the
market place. During 1979, these "coupon conversion" losses totaller' .learly
$3,000,000.

The traders at most of Y's small institutional customers were unsophisticated with respect to the government securities market.
At least two of Y's
customers cancelled several trades for delayed delivery and standby contracts
during the declining market of early 1979
one of the institutions claiming
that salesmen failed to disclose the risk factors associated with trading in
GNMA forward commitments and standbys. Also, Y sold forward commitments of over
$12,000,000 to one trust company which thereafter cancelled the contract and
subsequently went bankrupt. Y absorbed a loss of almost $500,000 in connection
with these transactions.

—

In late 1978, when Y's cash position became critical, it began selling
standbys without purchasing similar standbys to hedge its position.
In doing
this it gained working capital since it realized the entire standby fee without
having to pay a substantial portion of that fee to hedge its position.
In effect,
however, the dealer was betting that the GNMA market would rise so that its customers would not exercise their standbys, and it was exposing itself to a risk
In fact, the
of substantial loss in the event the market continued to decline.
latter situation occurred, and Y lost in excess of $2 million in these transactions,
By early 1979, Y's financial situation deteriorated to the point where
it engaged in outright fraudulent repo transactions to obtain the necessary capital
to stay in business.
On several occasions it approached two of its customers,
a privately held trust and a publicly owned insurance company, and convinced them
to "purchase" GNMA securities in repo transactions from unidentified "customers"
of Y.
The two purchasing customers paid a total of $4,200,000 in margins in the

They were
alleged repo of $157,000,000 of GNMA's during the first half of 1979.
induced to enter this transaction by the offer of a very attractive 26-28% annual
In fact, however, there were no selling "customers"
return on their investment.
In effect, the trust and the insurance company unwittingly
and no underlying GNMA.
made unsecured loans to Y, which was able to cover the deception for several months
by paying the "purchasers" the profit due from the "repos" and inducing them to
The true situation, however, could
take part in larger and larger transactions.
be hidden because Y's financial condition deteriorated to such a point
not long
that it could no longer maintain this facade.
In
and revealed
be unable to
the only way

late May, 1979, Y approached the trust and the insurance company
It convinced these customers that it would
its fraudulent activity.
continue in business without additional working capital and that
they could recoup their losses was to infuse an additional $5,100,000


Federal Reserve Bank of St. Louis

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160

The
to be reppid when Y's extensive hedge position began unwinding in late 1979.
right to review Y's finances
customers acquiesced L.ut demanded and received the
In late summer, 1979, Y was unable to repay
Slid oversee its future operations.
The customers converted their debt positions to equity and replaced
the loans.
Y's officers and directors. Y's apparent net worth, as of August 31, 1979, was

negative in the amount of about $6,500,000.

Case

#15

A now-defunct registered broker-dealer, W, with offices located in
several southern cities, was primarily engaged in the business of buying and
selling GNMAs but also engaged in an occasional municipal bond transaction.
In September, 1979, the SEC determined, based upon information received
from the NASD and a subsequent examination of the broker-dealer's books and
records, that the broker-dealer was in violation of the net capital and bookkeeping
requirements of the federal securities laws.
It appeared that the broker-dealer
owed its customers approximately $1 million for their credit balances and did
not have funds available to pay them.
The broker-dealer had apparently been
operating with a net capital deficiency for at least several weeks and had
effected about 80 customer transactions during that period. Although the cause
of the financial collapse is unclear, it appears that a major part of the problem
was that interest rates rose rapidly causing the value of its government
securities inventory to plummet.

W engaged in forward transactions in GNMA for its own account, and
sold GNMAs to customers, including many retired persons, on a cash basis.
W'
salesmen, who were paid commissions as high as 45%, appear to have made misrepresentations to some customers regarding, among other things, the risks associated
with GNMA transactions and the fact that the monthly pass-throughs represent a
return of principal as well as interest, and therefore decline over time.
There
also appear to have been problems concerning timely payment of principal and
interest.
A SIPC trustee has been appointed and liquidation is proceeding.
SIPC
has already paid approximately $3 million in connection v/ith this case, but it
may recover a portion of this expenditure from W' s assets.


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Case # 16

AA is a registered broker-dealer that during the period discussed
herein engaged almost exclusively in municipal securities. In 1971, a small
national bank with deposits of $70 million and equity of between $4 and
4 1/2 million, opened an account with AA.
During 1974 and 1975, adjusted
trades were made between AA and the bank. Adjusted trades are transactions
at prices above the market which are designed to cover up or defer losses
on portfolio securities.
To hide such losses in its investment portfolio,
GNMA certificates and municipal securities owned by the bank were sold to AA
at prices adjusted as much as 30% above the market, and in related transactions
the bank purchased new investment securities from AA also at prices above the
market.
During 1975, trades with the bank resulted in profits to AA of over
The bank cear.ed doing business with AA in 1975 at the insistence of
$600,000.
the Comptroller of the Currency.

Losses to the bank on the transactions from 1973 through 1977 total
at least $700,000 and there is an additional $1 million in unrealized losses
on securities not yet liquidated as of mid-1979.
In mid-1979, the SEC, through settlement with the principals, censured
AA for its activities with the bank and imposed administrative sanctions
against 4 of AA's principals.

Case # 17

BB is an unregistered broker-dealer engaged in transactions in U.S.
It is affiliated, and shares offices
government issued and guaranteed securities.
with a registered broker-dealer.
and personnel,
In late 1978, BB defaulted on its reverse repo agreement to deliver a $1
million GNMA certificate to a savings & loan company ("S & L"). The S & L inquired
about the status of this GNMA and about a separate $1 million government guaranteed
State of Israel bond held by BB on another reverse repo and found that BB had
hypothecated both securities to other lenders and was unable to redeem them.
On the same day, BB defaulted on a loan secured by a government security held
by a registered broker-dealer. This broker-dealer then recalculated its secured
position as lender to BB in many repos and reverse repos and a few days later
BB could not
demanded additional security under the terms of its agreements.
meet this demand and, three days later, BB filed for reorganization under the
Bankruptcy Act.


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162

An inspection of BB and its affiliate indicated major irregularities
and -pparent customer lo.<ises in BB's operations, but few if any major irregularities aiv' no customer losses in the operations of its registered broker-dealer
affiliatft.
BB utilized a simplistic and often unreliable recordkeeping system.
EB also distributed false, unaudited financial statements which did not reveal
its precarious financial condition.
In contrast, BB's registered ef filiate
took great, efforts to ensure that its books and records provided an accurate
basis for NASD FOCUS reports, and thus achieved a far aore accurate and complete
recordkeeping system than that of BB.
In one category of ix-i:egularities, BB had failed to pass through
rannthly payments on GNMA securities held by BB for safekeeping or on repo

or reverse repo agreements. Seven financial institutions and three broker-cealers
were thus deprived of three months of pass-through payments on these securities,
or about $240,000.
In a second major category, BB hypothecated many securities
that were held by it but were owned by or committed to customers or other dealers.
In twenty-five reverse repos, BB had lent about $11,000,000 and had then pledged
or repoed the same certificates as security on loans to itself from ultimate
lenders in an aggregate amount of about $16,000,000.
(BB had also pledged some
customer securities that it was simply holding for safekeeping.) The difference
of nearly $5 million was deposited in BB's general operating account and exhausted
on operating or other expenses. BB's customers were not advised of this use
of their securities nor the possibility that BB would be unable to redeem the
securities or return them to the customers.
BB was declared bankrupt in raid-1979.
Schedules compiled by the
trustee in bankruptcy in early 1980, indicate losses of approximately $15
million to financial institutions and other broker-dealers who dealt with BB.
Some creditors were allowed to liquidate the assets they held for BB against
their claims. As a result, they were included as defendants in suits filed by
11 of BB's numerous remaining creditors,

BB's creditors include banks, credit unions, pension funds, savings
and loan associations, generally with assets of less than $30 million, and
individuals. Their claims further illustrate the practices BB engaged in.
For example, one New York S & L filed a civil action alleging that, beginning
in early 1977, BB borrowed about $3.5 million from it, pledging as collateral
five GNMA certificates and that BB either repledged the GNMAs or disposed
of them in violation of the agreement.
These certificates were never delivered
to the S & L. Likewise, an S & L in Texas claims that BB or its agent wrongfully
sold a $300,000 GNMA certificate that was delivered as collateral and not in
a sale.
Finally, a registered broker-dealer claims BB defaulted on its purchases
of GNMAs for forward delivery.

BB's affiliate, a registered broker-dealer, also went bankrupt,
chiefly due to guarantees given on BB's transactions and not due to any sales
improprieties of its own.


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-

Case # 18

CC, an unregistered broker-dealer firm, has been engaged in the
purchase and sale of U.S. government-guaranteed securities since its its inception in February, 1976. CC is an affiliate of a registered municipal securities
broker-dealer. CC and its registered affiliate shared the same 12 salesmen
but kept separate books and records.

In early 1977 the SEC received information from the Comptroller of
the Currency and other sources indicating that the unregistered broker-dealer
may have committed violations of the federal securities laws in connection
with the sale of GNMA securities to a national bank.
The information indicated
possible violations which included unauthorized trading, a failure to disclose
adequately the potential risks in certain GNMA transactions, and excessive
mark-ups and mark-downs. There was no indication of any irregularities by
the registered affiliate.
CC has vigorously opposed enforcement of subpoenas
issued in the SEC' s investigation, and it is currently appealing a subpoena
enforcement order of a federal district court.

Case #19

A mortgage banker and its predecessor firms have been FHA and VA
approved lenders since 1971. The mortgage banker originated GNMA modified
pass through certificates from early 1975 until mid - 1979, and it had more
than 20 offices nationwide. The current president, chief executive officer
and principal shareholder of the mortgage banker is an individual who has
been in control of the firm since 1974 and is responsible for placing in
the secondary market the mortgages originated by the firm.
,

During the period from early 1975 until mid-1979, the mortgage
banker originated VA and FHA loans primarily on single family residences,
pooled these loans, applied to GNMA for certification, and, after receiving
GNMA certification, sold these loans. The mortgage banker would continue
to service the loans which it had sold, receiving servicing income of .44
In 1978, the mortgage
percent of the total amount of mortgages serviced.
banker's servicing income was nearly $2,000,000 and its total GNMA servicing
pool was nearly $600,000,000.


Federal Reserve Bank of St. Louis

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164

By 1978, the mortgage banker was originating and closing approximately $30 million a month in home loans. Lacking the capital to operate
at this volume, it utilized "warehousing" credit arangeraents with approximately
twelve banks throughout the United States. The warehouse banks required
the mortgage banker to provide them with written commitments evidencing^
that it had received commitments for future delivery of the GNMA certificates.
In this way, the bankers were protected from adverse interest rate changes.

The process of selling forward commitments in GNMAs or selling
"short" is commonly used by mortgage bankers to "lock in" an interest rate.
The mortgage banker normally sold "short" its future production and went
"long", or purchased forward commitments, only to pair off certain short
positions to take advantage of upswings in the market. Beginning in early
1979, however, the mortgage banker began to speculate in the GNMA forward
market.
Over a period of approximately 3 months, the mortgage banker entered
The size of the positions
into forward commitraents with 12 securities dealers.
taken by the mortgage banker were greatly in excess of the normal hedging
activity and the "net" position the mortgage banker held was a long position
obligating it to take delivery rather than a short hedging position.

During a two month period in early 1979, the mortgage banker's net
position ranged from $180 million to over $350 million long. With $75 million
in GNMA settlements coming due in mid-April, the mortgage banker called a
meeting with the customer-dealers and told them it could not honor its commitraents.
The customer-dealers, although attempting to minimize their losses,
Of this amount, approximately
incurred losses of approximately $5.2 million.
$3 million was repaid pursuant to the terms of a settlement between 11 of
the customer-dealers and the mortgage banker.
In addition, during this period, the mortgage banker was receiving
the proceeds from the sale of GNMA' s and failing to remit them promptly to
When the banks learned of this failure to honor its
its warehousing banks.
commitments and foreclosed on the loans pledged as collateral, they discovered
The mortgage banker subsequently
they were approximately $8.6 million short.
agreed to pay the banks this entire amount pursuant to the terras of a settlement

agreement. 4/

4/

The large losses suffered by the banks were partially a result of
misrepresentations that loans would be paid promptly upon receipt
of payment of a GNMA certificate, and partially due to lack of
diligence on the part of the banks in ensuring that they were
properly collateralized and that the mortgage banker promptly paid
them.
In addition, new GNMA regulations, effective April, 1979,
required banks to release any security interest on loans for GNMA
pools at the time the certificates are issued.


Federal Reserve Bank of St. Louis

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The mortgage banker was able to obtain such a large net long position
First, although it was "long" with 12 seperate
in the market for three reasons.
dealers, it falsely represented to each dealer that it was long only with
that dealer, and was net short because it had short positions with other
dealers.
It also represented it was buying from only one or two other dealers.
Second, the mortgage banker and its CEO were viewed by all the dealers as
sophisticated investors, both because the mortgage banker had a servicing portfolio of nearly $600 million in GNMA mortgages, and because the CEO had apparently
made money in speculating in GNMA' s in the past. Third, the absence of a mark-tomarket or margin maintenance requirement allowed the mortgage banker to acquire
a large position without posting any funds or having any limit imposed on it.
As a result of these three factors, a number of firms sold large amounts of
forward commitments to the mortgage banker that would otherwise appear unsuitable,
resulting in the latter' s having, on the date of its defaults, forward commitments
When these commitments
to buy GNMAs from customer-dealers totaling $75 million.
started coming due for settlement, the mortgage banker was unable to "pair them
off", did not have sufficient funds for settlement, and defaulted.

Prior to the actual default by the mortgage banker, it had attempted
unsuccessfully to enter into reverse repurchase agreements with a number of the
dealers in order to roll over the contracts due for settlement. After the
default, the proceeds from the sale of the mortgage banker's servicing contracts
netted about $7.1 million and the mortgage banker was therefore able to pay
its banks lOOZ of their losses, and its dealers, 65Z.
In May, 1979, GNMA revoked the mortgage banker's issuer/servicer status.
Nevertheless, the mortgage banker continues to originate^FHA and VA loans and is
selling them to one customer that is creating GNMA pools.

Case # 20

DD has been a registered broker-dealer since 1975 and is primarily
in the sale of government and municipal securities.
It has
engaged
salesmen and 190 active customers. A substantial portion of DD's
nineteen
business has consisted of the offer and sale of forward commitments to purchase
GNMA securities. DD stopped selling GNMA forwards in February, 1979, because of
a declining market and net capital problems, but has resumed as of January,
1980.
In early 1979, three savings and loan associations and a bank that had
traded with DD charged that one of its salesmen had executed unauthorised trades


Federal Reserve Bank of St. Louis

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of GNMA forwards for their accounts.
At that time the four customers' accounts
already showed unrealized losses of approximately $400,000 on GNMA forward
transactions involving commitments of $13 million. Although it received written
notice of the customers' intention not to honor these GNMA contracts, DD failed
to deduct the unrealized losses from net capital as required by rules promulgated
under the Securities Exchange Act. DD also failed to take the other required
deductions in computing its net capital.
DD's net capital deficiencies were discovered shortly after the customers' notices as a result of a complaint one of the customers filed with the
SEC, and an SEC inspection conducted immediately thereafter.
When informed of
deficiencies amounting to $703,755, DD immediately ceased conducting business.
It then entered into an agreement with a primary dealer whereby the dealer assumed
the obligation for the $13 million in GNMA forwards in consideration of future
underwriting revenues. This assignment remedied the net capital deficiencies and
DD resumed business shortly thereafter. None of the four customers lost money
on the apparently unauthorized transactions, since DD assumed the losses. The
salesman is no longer employed by DD.
It should be noted that the four customers had been trading GNMA forwards for two or three years and apparently understood the market. They had
also made repeated transactions with the salesman accused of the unauthorized
trading.
In disclaiming the subject transactions, the customers pointed to
the fact that they did not sign the authorization forms usually sent out by
DD on such trades. The salesman, however, claims that these transactions were
orally authorized by the banks and that the banks repudiated the trades because
of the drop in the market at the time.
It is also noteworthy, however, that
DD had been having net capital problems for some time and that it was only
pursuant to a previous settlement agreement with the SEC that DD subjected
its government securities transactions to the requirements imposed on its
registered broker-dealer activities.

case #21

A registered broker-dealer and certain of its unregistered affiliate
dealers transacted business in GNMA forwards and other government issued
and guaranteed securities for forward delivery primarily with small and medium
sized credit unions and savings and loan associations.
The dealers' salesmen
were, for the most part, inadequately trained and lacked experience in the


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167

-

financial
securities field. These salesmen generally did not inquire as to the
They represented
instututions.
condition or investment objectives of these
margin deposit or
that profits were virtually certain to be earned with no
They often neglected to
cash payment, or the necessity of taking delivery.
the secumention, or misrepresented, the market and credit risks inherent
in these securities, often
Portfolio managers invested heavily
rities offered.
trading limits of
well beyond their financial ability to fund or beyond in-house
union, at one point, had
For example, one small federal credit
the dealer.
total assets.
amount of commitments in these securities equal to 3/4 of its
an

m

When interest rates began to rise, these institutions, fearing large
turned for relief
losses and the inability to fund securities at settlement,
One technique
salesmen.
dealers'
to various techniques suggested to them by the
Under this approach,
used by over a dozen customers was adjusted fee trading.
forward delivery at
one of the dealers would buy back a security sold for
then current market,
the original contract price, i.e., a price above the
the customer another
and simultaneously sold (sometimes from a short position)
an amount equal
security for forward delivery at a price over the market by
The customer was also required
to the loss involved in the original contract.
cushion its loss on the
to pay an additional charge which the dealer used to
Several salesmen advised their customers to post the loss
original contact.
the loss at
mark-up and charge on their books as an asset, thus deferring
By then, salesmen
least until the settlement date for the second commitment.
these amounts.
told their customers, prices would rebound enough to cover
continued to decline and some institutions lost thousands
Unfortunately, prices
prices lower than
of dollars in charges when securities were liquidated at
Confirmations sent by the dealer to its customers seem
their original cost.
transaction by indicating that
to have masked the economic substance of the
extended at the original contract price.
settlement had simply been
the

Investors also started transacting reverse repos with the dealers
insufficient funds to
when they found themselves with a market loss or with
The investor would receive the coupon
pay for securities at the delivery date.
fee to the
interest on the security sold to the dealer and pay a financing
were rolled over, market value of
As interest rates rose and repos
dealer.
exceeded the coupon
the securities continued to decline and the fee often
associations found themselves
As a result, several savings and loan
rate.
borrowing limitations.
with* large losses and sometimes in violation of FHLBB
at a price higher than
The dealers also seem to have sold these securities
the prevailing market in a number of cases.

Although it is difficult to quantify losses at this time, a subin excess
stantial number of institutions have realized or unrealized losses
of $50^000, a few with losses of at least $250,000.


Federal Reserve Bank of St. Louis

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Case #22

An unregistered affiliate of a registered broker-dealer seeras to have
engaged in adjusted trading with certain of its customers. These customers,
savings and loan associations and credit unions, had purchased GNMAs and
Federal Home Loan Mortgage Corporation Participation Certificates (PCs)
for forward delivery and had significant losses resulting from a decline
in the market price.
Some of these customers were induced to purchase these
In this
forwards because of the payment of "up-front" money by the dealer.
case, the affiliate, often at the customer's request, would pay one point
(1% of the principal amount of the transaction) to its customer shortly
after the trade date and raise the price of the security by one point over
the current market price.
The customer then booked as income some or all
of the "up-front" fee, even though the customer sometimes liquidated its
obligation at a loss before settlement date. The recognition of "up front"
payments apparently materially increased customer income.
The affiliate was also involved in questionable or improper activity
in connection with sales of forward commitments where no money initially
changed hands.
In some instances, customers incurred unrealized losses
because of a decline in market price and the affiliate, at or about the
settlement date, confirmed the buy-back of the securities at the original
higher price which the customer had agreed to pay.
Simultaneously, the
affiliate either "sold short" or "long" to the the same customer forwards
or securities with the same principal amount and coupon, which it purchased
in the market, at the lower market price, with a future settlement
date.
The affiliate confirmed sale of such securities at the higher
original transaction price to the customer for later settlement. This
type of transaction required the customer to pay a raark-to-market fee
to the affiliate, which was disguised as an advance payment on the new
contract, instead of being shown as a loss.
Often the customers were
unaware of these "adjustments"; rather, they believed that they were just
extending their settlement dates.
In addition, one customer of the affiliate apparently sustained
additional losses when it over-extended itself by entering into reverse
repos with the affiliate's unregistered parent.

Millions in realized and unrealized losses were incurred by the
customers of the affiliate and its parent.


Federal Reserve Bank of St. Louis

I

4

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Case # 23

Three complaints have recently been filed concerning an unregistered
government securities affiliate of a registered broker-dealer. A federal agency,
which had responsibility for administering certain trust funds, was a customer of
The agency purchased, in November of 1978, approxithe unregistered affiliate.
mately $760,000 worth of FMHA loans from that firm but never received the supIn February, 1979, a bank in Mississippi and a federal
porting documentation.
credit union in Pennsylvania purchased approximately $150,000 and $200,000,
respectively, of these same securities and likewise never received any supporting
documentation.

Upon initial inquiry, it seems that the unregistered affiliate purchased
the loans for its own account from an issuing bank in Florida and resold them to the
complaining customers. The customers wired their money to the firm's account at
a New York bank, but the issuing bank filed for bankruptcy during this period and
did not deliver the notes to the unregistered affiliate. To escape liability on
the sales contracts with its customers, the unregistered affiliate is now claiming
that it acted as agent for the customers and not as principal.

While the facts of the case are not clear, it appears that the unregistered affiliate may have been over-extended in GNMA commitments and was thereIt is also
fore unable to meet its commitments when the issuing bank defaulted.
by the unregistered
worth noting that the acknowledgments and confirmations sent
affiliate gave no indication of whether the dealer was acting as principal
or agent in the purchases although confirmations for transactions in non-exempt
securities are required to contain this information. Confirmation rules
applicable to non-exempt securities require the dealer to state his status
in the transaction.
The total amount of funds involved in the three complaints is $1,100,000.
At this time it is not known whether other customers were affected or what
On December 21, 1979, the unregistered affiliate
the ultimate losses will be.
filed for bankruptcy.


Federal Reserve Bank of St. Louis

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Case # 24

NN is a small regional broker-dealer, a NASD member, and not a member
of any exchange, although it clears through a member firm. Since 1975, NN
has specialized in publicly traded municipal and other government bonds.
From January 1976 until October 1976, NN acquired approximately
$2 million of Tennessee Valley Authority ("TVA") Bonds and sold them to more
than 300 customers. NN actively marketed these bonds by means of newspaper
and radio advertisements.
Most sales transactions were conducted by the
phone.
Neither NN, nor its registered principals, ever informed their
Shortly thereafter,
customers that these TVA bonds were callable.
customers lost approximately $73,400 when TVA exercised its redemption
clause.
Thus customers lost the difference between the premium price they
paid and the lower redemption price.

V

Seventy-five percent of NN' s new business was generated by its advertising program. NN ran about four or five newspaper advertisements per week.
During the summer of 1976, NN advertised certain energy related revenue
bonds as being "guaranteed by a U. S. Government Agency," when no such government
guarantee existed. Finally, NN ran advertisements giving false yields on
Government Services Administration Bonds. Apparently, no losses to customers
resulted from these activities.
In early 1977, the NASD filed a complaint against NN and its two
registered principals. They were found guilty of fair practice violations
regarding NN's advertising activities. All respondents were censured, one
principal was suspended for three years, and the other principal was barred
from being a registered principal and fined $5,000.
A subsequent SEC administrative proceeding was based on NN's lack of disclosure of pertinent information
on the TVA bonds and inaccurate advertising on the GSA bonds.
The SEC suspended
the firm and its principals for various periods of time, required new supervisory
procedures, especially regarding advertisements, and required the firm and
the principals to disgorge to the bond purchasers profits made on these
transactions.

5J

Bonds are callable when the issuer reserves the right to redeem the
bonds prior to maturity. Such a provision may require the issuer to
pay some amount over par, the amount over par being referred to as
premium.
In this case, TVA paid 106.3 on redemption.
During the period
of the sales campaign, NN was selling these bonds at a premium greater
than 106.3.


Federal Reserve Bank of St. Louis

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171

-

Case # 25

Two employees of a region?! office of a major registered broker-dealer
apparently engaged in unsuitable trades, churning, misrepresentation and a
fraudulent course of conduct in GNMA transactions. The investors involved
were generally unsophisticated and included an elderly retired school teacher
who was allegedly strongly encouraged by the registered representative into
opening a margin account and making purchases in, among others, G^TMAs. Apparently
as a result of active trading in her account, the value of her portfolio declined
from over $200,000 to about $28,000 in one year's time.
In addition, the second employee, a vice-president at the same regional
office, apparantly encouraged a second investor to buy a $1 million GNMA
after falsely saying that he had already purchased it for the investor's
account.
The salesman seems to have made made certain misrepresentations to
the investor and failed to state other material matters, including the cost
of the security, his interest costs and the commission charge of $16,534.
This
investor is claiming a loss of $120,000 since April, 1978, and has filed an
action against the registered representative and the broker-dealer.
A third investor, a retired contractor, was seeking a risk-free investment with a 9% or better return. The registered representative reportedly told
the investor that a purchase of certain GNMAs could yield a 19% return, made
misrepresentations as to the costs the investor would incur on his margin account,
and gave the investor unauthorized and misleading sales literature. Subsequently,
the investor, contrary to the registered representative's advice, sold at a
loss of approximately $60,000.

A fourth investor, an elderly businessman who had just sold his business
upon retirement, invested $9,911,000 in GNMAs for his and his wife's trust
accounts.
The registered representative told him that such a purchase could
19-21% return and was risk free.
yield a
This investor lost over $2.6 million
Total losses aggregate $3 million.
in 15 months.

Case # 26

MM is a family-controlled corporation approved as a trust company in
As a trust company, it is supervised by a state banking commission.
Its
primary business is the investment of funds deposited by the public. MM also
functions as a trust company for individuals and businesses.
The company is now
insolvent, having filed a voluntary petition for bankruptcy in December, 1978.
1964.


Federal Reserve Bank of St. Louis

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MM solicited deposits from the public and issued certificates of
In its sales literature, MM acknowledged that
deposit and passbook accounts.
its deposits were not iasured by the Federal Deposit Insurance Corporation but
represented that its depositors had comparable security because it had a fidelity
bond which protected against losses from embezzlement, and because it engaged only
in the safest possible investments. MM received $7 million in deposits from 850
In addition,
investors, most of whom have incomes in the $20,000 - $30,000 range.
individuals who were attracted by the
a large number of investors were retired
advertised safety of MM' s investments.
Contrary to its representations, however, MM used these funds for
speculative investments in GNMA forward commitments and other securities.
In addition, some of this money was apparently diverted to the accounts of
insiders.
Its total assets now amount to $5.2 million, but a significant portion
In addition to the
of this amount is pledged for financial transactions.
money it owes investors, MM has outstanding commitments totalling $14 million
in connection with GNMA forward transactions.

Although the state banking commissioner, in May 1977, prohibited all
state trust companies from trading GNMA forwards, MM continued to participate
in this market. h_l In late 1978, MM had open transactions involving $7 million
worth of GNMA forwards and $7 million of Treasury securities with a registered
New York broker-dealer. MM, however, could not afford to pay for these securities,
and on settlement date, entered into reverse repurchase agreements with the
broker-dealer.
After the banking commissioner discovered $1.4 million in losses
in connection with these transactions, MM directed another government securities
dealer to sell the $7 million in GNMA's, but did not inform the dealer that these
securities were collateral being held by the New York broker-dealer in connection
with the repurchase agreements. The $7 million in Treasury notes were apparently
sold by another dealer. MM attempted to conceal these losses by manipulating the
entries on its uncertified financial statements.
In November and December 1978,
in an apparent attempt to recoup its losses, MM purchased about $14 million in
GNMA forwards. At the end of December, however, MM filed for bankruptcy, and has
defaulted on these transactions. These defaults resulted in a losses of more than
a half million dollars to several dealers, one of which was already experiencing
severe cash flow problems and is now the subject of an SEC enforcement action.
It appears that MM's depositors will lose approximately $4 million as a result of
its insolvency.

hj

MM claims that it never received the letter which the banking commmissioner
mailed to inform it of the new prohibition on GNMA trading.


Federal Reserve Bank of St. Louis

173

Case # 27

JJ is a credit union formed in 1976 to function as a central credit
union for several small credit unions. JJ acts primarily as a "reserve bank"
for the member credit unions by investing their excess funds and by providing
short term loans during periods of heavy demand by its members.
In early 1977,
during a period of rapid growth, JJ hired a new president and investment manager,
who began to invest heavily in GNMA forwards and other government-guaranteed
securities through three registered broker-dealers. At two of the firms, JJ's
trades were routed through separate, unregistered affiliates of those registered
broker-dealers which dealt only in government securities.

JJ's new manager instituted an aggressive "trading strategy," which
was designed to take advantage of daily shifts in market prices, and which
frequently involved buying and selling the same security several times in
In addition, the manager purchased large amounts of GNMA and
the same day.
FHLMC forward commitments anticipating that increased member deposits would
enable JJ to take delivery of these securities on their settlement dates.

Credit union member deposits did not grow as quickly as anticipated,
however, and when interest rates began to rise, JJ had commitments to take
delivery of large amounts of securities several points above market, but was
without sufficient funds to take delivery. In order to postpone delivery of
these securities, JJ entered into a series of reverse repo agreements, including
dollar price reverse repurchase agreements, Ij with its dealers, hoping that
(1) interest rates would fall and it would be able to resell the securities
at a gain or at a smaller loss, or (2) increased member deposits would enable
it to take delivery and hold the securities in inventory.
This strategy failed
because interest rates remained high and member deposits did not increase
sufficiently. As a result, state banking authorities had to step in with additional funds to prevent JJ from defaulting on obligations of $5 million coming
due in October, 1979, and $18 million coming due in November, 1979.
JJ recognized
a loss of $1.8 million as a result of these forward commitments.

7/

Under these dollar price reverse repurchase agreements, the credit union
would fund the purchase of securities by selling them back to the dealers
on settlement date and agreeing to repurchase securities with an equivalent
yield on a date in the future. The lending dealer could sell or otherwise
dispose of the securities it purchased from the credit union, and then
was required to obtain securities with an equivalent yield to resell
to the credit union upon maturity of the repurchase agreement.


Federal Reserve Bank of St. Louis

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174

-

In the course of its trading in governraent-guarantsed securities,
JJ was dealing with three different dealers, and was doing considerable business
with two of them. The dealers contend that JJ and its manager were sophisticated
investors, pointing out that JJ had been successful in day trading and th^t,
although it incurred losses from its heavy forward commitments, everyone who
had forward commitments in government-guaranteed securities took losses when
the interest rates continued to rise.
Nevertheless, the sale of forward commitments to JJ may have been unsuitable for that entity. Further, although one of
the dealers required JJ to maintain securities with it in a margin account, the
others did not. Thus, as a practical matter, there was no limit on the amount of
forward commitments on which JJ could be obligated. Despite JJ's very rapid
growth, it was still overcommi tted to purchase securities in the forward market.
Substantial forward commitments such as these exposed the credit union to
undue market risk, notwithstanding the apparent sophistication of JJ's manager.

Case #28

An unregistered broker-dealer was created in late 1978 with approximately $4.5 million in capital to deal in government and government-guaranteed
securities in a so-called matched book. 8^/ During its short existence, the
partnership engaged primarily in GNl'IA repurchase ("repo") and reverse repurchase
("reverse repo") agreements. The partnership consisted of three largely
passive partners who provided most of its capital and one active partner
who conducted trading and managed operations. Within a year of its inception,
the firm did business with hundreds of both sophisticated and unsophisticated
investors, including a state, a political subdivision, banks from South Carolina
to New York, savings and loan associations, and mortgage bankers.

Approximately six months after the firm was formed, the active partner,
apparently without the knowledge of the others, opened the first of three trading
accounts for himself under fictitious names. His apparent purpose was to enable
himself to trade without having to provide any capital.
Six months later the
firm declared bankruptcy. These losses were apparently attributable, at least

8/

In a matched book, a dealer, acting for its own account, engages in an
equal number of purchases and sales of the same securities, thereby limiting its risk and the amount of capital required.
Profits are derived
chiefly from the spread between the purchase and sale prices and from
the differences between the interest rates.


Federal Reserve Bank of St. Louis

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175

in part, to the three nominee accounts and to unsecured loans made by the brokerdealer to its partners.

Based on a very preliminary information, it appears that the active
partner purchased large quantities of securities without sufficient funds with
In addition it appears that
the expectation that interest rates would go down.
the other partners learned of the firm's large trading losses approximately
two months before the declaration of bankruptcy, but nevertheless allowed the
firm's employees to continue making new commitments during this period.

When the firm declared bankruptcy, it had commitments of approximately
When the firm declared
$130 million dollars in repo and reverse repo agreements.
bankruptcy, its liabilities exceeded its assets by $11.5 million.
It is impossible to determine who will eventually suffer the losses, but there were approximately 40 persons which had open positions with the firm when it declared bankruptcy, including registered dealers, unregistered dealers, local governments,
and savings and loans associations.


Federal Reserve Bank of St. Louis

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-

CHAPTER V
REVIEW OF RECENT ACTIONS BY FEDERAL REGULATORS AND
INDUSTRY PARTICIPANTS TO REDUCE ABUSIVE TRADING PRACTICES
In response to the problems that developed in markets for federally

guaranteed mortgage-backed securities, regulators of financial institutions
have issued guidelines for investment activity in these securities, particularly activities in futures,

forward and standby agreements to acquire these

These guidelines principally involve revised accounting pro-

securities.

cedures, margin maintenance requirements, and restrictions on taking positions in delayed delivery contracts.

The National Credit Union Administration has introduced stringent

regulations applicable to all federally chartered credit unions.

The rules

prohibit credit unions from dealing in standbys and forward transactions of
more than 120 days.

Further, the rules define permissible reourchase agree-

ments and reverse repurchase agreements.

Credit unions must also mark for-

ward positions to market on their financial statements.
The Federal Home Loan Bank Board introduced rules in 1979 limiting

forward positions to a specified percentage of assets.

They also announced

overtrading (adjusted trading) and recordkeeping regulations.
The Comptroller of the Currency, Federal Deposit Insurance Corporation, and Federal Reserve, the three agencies which supervise the nation's

commercial banks, announced a joint policy statement near the end of 1979.
The agencies set forth a number of precautionary rules which are designed
to confine

bank activity in forward and standby contract activities to safe

and sound banking practice.

Included was a rule describing how mark-to-market

requirements are to be apolied.


Federal Reserve Bank of St. Louis

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-

GNMA (hud) has required issuers of its securities to observe prudent business practice rules since October 1977,

including instituting cer-

tain internal management controls and applying net capital requirements.

GNMA

has also recently introduced regulations applicable to issuers pertaining to
suitability, raark-to-market

,

and margin requirements for GNMA forward trans-

actions.

The problems in trading government-guaranteed securities also
prompted attention from several other agencies including the SEC, Treasury,
and Federal Reserve.

A number of the problems involved violations of the

anti-fraud provisions of the securities laws and in some of these instances
the SEC was able to bring its enforcement powers to bear on the individuals

and entities involved once the violations had occurred and were discovered.

The Treasury and its fiscal agent, the Federal Reserve Bank of New York,

have also increased their surveillance, mainly through the primary dealers
that make markets in U.S. government securities.

Some states also have

statutes or regulations that govern trading of government-related securities
by persons within their jurisdictions.

Moreover, some individual dealers

have taken initiatives and independently applied more stringent regulations
on their activities.

The sections which follow discuss the various initia-

tives taken by government agencies and private participants in greater detail.

Surveil 1 ance by the Federal Reserve and Treasury

While markets for U.S. government securities have traditionally
been exempt from formal regulation, the Federal Reserve System and the

Treasury Department, both with vital interests in maintaining a healthy


Federal Reserve Bank of St. Louis

178

government securities, have exercised an active surveil-

market for U.S.
lance role.

A prime interest, of course, has been maintenance of a market

which facilitates the efficient financing of the government's activities.
Secondly, this

is

the market

in

which national monetary policy

is

executed

and which uniquely enables the U.S. to manage its monetary activities.

Thirdly, the Treasury securities market is the corneratone of the U.S.

capital markets and its health is vital to the effective functioning of
the credit markets in the U.S.

The Federal Reserve and the Treasury have assigned day-to-day
responsibility for the surveillance activities to the System Account

Manager for Domestic Operations located in the Federal Reserve Bank of New
York.

The surveillance activities of the Federal Reserve Bank of New York

focus on the approximately three dozen primary dealers in government secu-

rities, through which the Federal Reserve typically conducts open market

operations.

Dealers that have a trading relationship with the Federal

Reserve or who aspire to this relationship are required to report daily
their positions and volume of transactions in Treasury, government-related

mortgage-backed securities, and federal agency securities; with supplementary
reports on a weekly and semi-monthly basis.

These reports also include for-

ward commitments in GNMA securities covering a broad range of maturities.

Reporting dealers also submit data on their financial status every month.
Apparently as a matter of prudence, many investors will do business only
with dealers that are on the Federal Reserve's reporting list, which provides
strong incentive for dealers to seek qualification as reporting primary


Federal Reserve Bank of St. Louis

179

-

During 1979 this group of dealers reported average daily trans-

dealers.

actions in U.S. government securities of $13.2 billion and an additional
$2.7 billion in Federal agency securities.

There are no data available on

the total amount of government securities traded elsewhere.

The position and trading volume reports provide the Federal Reserve

with basic information on supply and demand conditions in the markets for the
securities on which they require reports and on dealers' exposure to market
risks.

Because the dealers provide daily information with virtually no lag,

the Federal Reserve can spot significant changes in a dealer's position on a

timely basis.

The dealer reporting system was established on a comprehensive basis
in

1960.

The reporting system was revised this year to adapt it to the changes

that have occurred in the market.

Reporting of forward, future and optional

delivery transactions in U.S. Treasury securities was introduced or improved,

permitting the monitoring of such activity to be more precise.

Unusual or

outsize activity in forward commitments of standbys will now be more evident,
and it will be possible to undertake follow-up discussion or corrective action,
if needed,

in a more timely way.

More useful information on repurchase agree-

ments and reverse repurchase agreements with respect to these securities
is

now requested.

In addition,

the reports continue to show positions in

major security types and maturities.

The volume of transactions is reported

for each security type and maturity and by broad categories of customer type.

The Federal Reserve Bank of New York also asks dealers to submit
an informal monthly financial report which indicates their profit or loss


Federal Reserve Bank of St. Louis

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180

A more comprehensive annual report drawn to Federal Reserve

from operation.

speciEications

also submitted.

is

This financial information provides a

good measure of the health of members of this important industry.

Dealers

are judged on their ability to carry the positions to which they are com-

mitted, and potentially unsound positions are discussed with dealers.

The Federal Reserve's large scale daily market activity also contributes significantly to its surveillance program, because it provides

additional information on the operation of the market.

This participation

reveals not only how the market arranges transactions, but the relative

efficiency of delivery and accounting practices, the methods of resolvirjg,.

,;.

problems and misunderstandings, and the reasons underlying existing market
practices.

'

•

>

:

'

•,.

:•

/

,.i

••

«

:

,

-i

•

tn addition to the dealer reporting process and on-going involveraentr.
in the market,

the Reserve Bank holds three or four meetings daily with indi-

vidual dealer firms at the Reserve Bank.

Senior officials, traders, and sales

people of the dealer firm informally discuss their views of the market,

latest

trends in the industry, and developments within their firms, as well as infor-

mation they have obtained from customers.

Telephone contact with traders

routinely takes place throughout the day and is another important means of

communication and source of information.
Visits to dealers to observe their operations are also an integral
part of surveillance by the Federal Reserve.

While such visits are not

intended to be audits, they do include a review of the systems dealers use
to prepare their reports to the Federal Reserve.


Federal Reserve Bank of St. Louis

The visits also provide

<.

181

additional information about the characteristics of each dealer's operations,
practices, and trading techniques.

Re gulatory Act ions of the C ompt roller, the Federal Reserve, and the FDIC
On November 15, 1979, the three federal bank regulatory agencies

issued a joint policy statement that set out precautionary rules and specific

guidelines for commercial banks and mutual savings banks engaging in financial futures and forward contracts, including standbys,

agency (including GNMA) securities. 1/

January

1,

1980,

for Treasury and

The statement became effective

and all requirements except the accounting guidelines were

applicable to contracts outstanding at that time as well as to subsequent
contracts.

The accounting guidelines in the statement were applicable only

to those contracts entered into after January

1.

Comments on the action

were invited, and the Interagency Coordinating Committee revised the guidelines somewhat in response to comments received.

The joint statement was in two parts.

The first provided "precau-

tionary rules" for banks engaging in futures, forward, and standby contracts.

The rules set down the general guideline that safe and sound banking practices should be followed.

To fulfill this objective, banks should avoid

unreasonably large transactions that are not related to the bank's business
needs, and such contracts should decrease, rather than increase,

rate exposure.

\J

interest

Limits on the size of contracts should be set and enforced

See Pol icy Statement Concerning Forward Place ment oy Delated Deliver y
Interest Rate Futures Contract s~"(44 F.'r. 68033, November 28,
revised March 20, 19807^
1979;

Cont'ract's and


Federal Reserve Bank of St. Louis

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182

Standby contracts calling for settlement

by the bank's board of directors.

in excess of 150 days would be viewed by the agencies as being inappropriate

for banks and should not be issued by banks except

in special circumstances.

The second part of the statement of the banking agencies provided
specific guidelines for the internal control of banks engaging in futures,
forward, or standby transactions and for the accounting of such transactions.

The guidelines require,

for example,

that a bank's board of directors endorse

specific written policies in authorizing these transactions.

A key guideline,

and the one generating the most comment, concerned valuation requirements:
".

.

,

all open positions should be reviewed and market values determined at

least monthly (or more often, depending on the volume and magnitude of posi-

tions), regardless of whether the bank is required to deposit margin in conIn addition, banks were given the option of

nection with a given contract."

marking futures and forward contracts at either market value or the lower of
cost or market.

delivered under

Whichever option
a

is

selected should also apply to securities

contract, and the accounting method should not conflict with

the procedures followed for these contracts held in the bank's trading depart-

ment.

Moreover, because of the nature of forward and standby contracts, any

loss on these open contracts should be recognized, at least monthly, on the

basis of the lower cost or market value.

The statement exempts mortgage banking activities from the accounting guidelines since the accounting profession has already instituted appro-

priate accounting procedures for these activities.
In mortgage banking operations,


Federal Reserve Bank of St. Louis

(AICPA Position No. 74-12),

financial contracts tend to be used in a more

183

-

traditional hedging of inventory fashion which is not inconsistent with the

regulatory agencies' view concerning what constitutes appropriate banking
practices.

Regulati ons of th e Fe deral Home Loan Bank Boa rd
The Federal Home Loan Bank Board regulations regarding forward com-

mitments of all FSLIC-insured institutions became effective June

1,

1979 (12

The rules were promulgated to curb the speculation in mortgage-

CFR 563).

backed securities which had resulted in large losses for some savings and
loans.

The FHLBB regulations permit S&Ls to book mortgage-backed securities
at cost,

and presently do not require them to mark open forward commitments to

market for accounting purposes during the commitment period.

The current regu-

lations define a forward commitment to be a firm or optional contract to buy

securities in 30 or more days after the contract date.
worth under

5

Institutions with net

percent of assets can have outstanding forward commitments of up

to 10 percent of assets, while those with net worth over

5

percent of assets

are permitted to carry forward commitments up to 15 percent of assets.

The

rules also generally require forward activity to be conducted on a prudent

basis and allow the FHLBB to prohibit forward trading for individual S&Ls

unable to fund commitments when due.

Another provision, aimed at adjusted trading, prohibits S&Ls from
selling a forward commitment or security under an agreement to purchase another
forward commitment or security at a price other than actual market price.
This adjusted trading provision does not address repurchase agreements, which


Federal Reserve Bank of St. Louis

184

are viewed as involving borrowings, not purchases of securities.

The FHLBB

regulations specify that repurchase agreements are to be treated as purchases
and sales in cases where the securities purchased and sold are substantially

dissimilar.

Moreover, to eliminate the practice of avoiding recognition of

losses by extending a previously established settlement date, the FHLBB re-

quires profit or loss related to disposal or modification of a forward com-

mitment on or before the settlement date to be recognized at the time of the
disposal or modification.

Under current regulations, fees received for firm or optional
commitments are to be recorded according to "generally accepted accounting

principles."

On January 26, 1979, the Financial Accounting Standards Board

Board of the AICPA approved release of an "Auditing and Accounting Guide for
Savings and Loan Associations."

The guide provides that commitment fees

related to forward transactions should be deferred and amortized over the combined commitment and loan period to the extent that such fees exceed under-

writing costs.

The FHLBB regulations require the minutes of the board of directors
of each S&L to include the names, duties, and limits of authority of the insti-

tution's personnel that are authorized to engage in forward commitment trans-

actions for the S&L's account.

The minutes must also list the brokerage firms

with which authorized S&L personnel can conduct forward activity and the dollar
limits of transactions with each firm.

A record must also be kept of the type

(firm or standby) of each contract; the commitment date; amount, rate, price
to be paid at settlement;


Federal Reserve Bank of St. Louis

market price at date of commitment; settlement date;

V

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185

commitment fees received; date and manner of disposal; sales price and market
value at disposal if disposition is made on or prior to settlement date other
than through funding; and the seller's identity and confirmation.
tion,

In addi-

S&Ls must be able at all times to document their ability to fund all

outstanding forward commitments when due.

Regulations of the Nat ional Credit Union Admini strat ion
The National Credit Union Administration has authority to regulate
the investment activities of credit unions under Section 107 of the Credit

Union Act (12 USC 1757).
1979 (12 CFR 703.3),

NCUA published its current regulations on July 20,

providing the most stringent rules of any of the federal

financial institution regulators regarding delayed delivery contracts and

repurchase agreements.

The rules apply only to federally chartered credit

unions and not to federally insured State-chartered institutions.

NCUA relies

on individual State supervisory agencies to regulate the institutions in their

jurisdiction, under NCUA scrutiny.

Subject to approval by NCUA on a case-by-case basis, the July 1979

regulations permit credit unions to enter into forward commitments to purchase
securities when delivery is to be made up to 120 days from the trade date,
stating that such transactions "will assist in the sale of mortgage loans
secured by real estate and will not subject federal credit unions to undue or

excessive market risk."

A credit union can enter into a forward contract to

purchase securities only if it has a written cash-flow projection verifying
its ability to buy the security.

contract to sell

a


Federal Reserve Bank of St. Louis

security unless

A credit union cannot enter into a forward
it

has that security in its portfolio.

All

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186

forward agreements must be settled in cash on the settlement date and cannot
be extended or rolled over into new contracts that would extend the settlement
date.

Credit unions are prohibited from engaging in short sales and in trans-

actions in the futures markets.

A credit union cannot sell its real estate

loans under a standby commitment. 2/

An NCUA Interpretive Policy and Policy Statement dated August 23,
1979,

requires credit unions, in cases where a contract calls for delivery in

more than 30 days, to mark the securities to the lower of cost or market value
on the settlement day.

In addition,

it

requires such contracts to be similarly

marked and footnoted in financial Statements that are prepared during the
period when the forward contract is outstanding.

The regulations distinguish between "loan-type" and "investment-type"
repurchase agreements, because the Credit Union Act (12 USC 1757(5)) provides
that federal credit unions can make loans only to their members, other credit

unions, and credit union organizations, at an interest rate not to exceed

percent per month.

Ij

1

In order to qualify as an investment-type repurchase

When it proposed the investment rules on October 17, 1978, NCUA would have
prohibited credit unions from entering into any agreements to purchase or
sell securities with deliveries in excess of 5 days from the trade date,
but, on final promulgation of the rules, NCUA (1) replaced the absolute
prohibition on forward trades with restrictions that allow forward trading
subject to the above described limitations and (2) in order to accommodate
the usual new issue cycle of Treasury and agency securities other than
mortgage-related issues, changed its definition of immediate delivery to
encompass a period of up to 30 days after the trade date. The earlier 5day definition for cash sales, together with the prohibition on forward
purchases, would have nearly eliminated credit unions as investors in
Treasury and Federal agency securities on original issue, since the "when
issued" period between the sale and issue date for these securities
usually involves a somewhat longer period.


Federal Reserve Bank of St. Louis

I

187

the credit union or its agent that purchases the security under an

agreeraent,

agreement to resell must take physical possession of the security.

There can

be no restriction on the transfer of the security purchased by the credit union

and it is not required to deliver an identical security upon resale.

The pur-

pose of investment-type repurchase agreements is to earn a specified rate of

interest for a short period, not to exceed the 120-day limit on forward agreeraents.

':«'5 ^, t^

«!•

5i jC

%/!/»

tti

^'-

.J i» ^i*-;-i

-i

r* -^

'•

Reverse repurchase agreements are subject to the general limitations
that credit union borrowing cannot exceed 50 percent of paid-in and unimpaired

capital and surplus, and that the amount of funds obtained by means of a
single reverse repurchase agreement for investment is limited to a maximum of
10 fiefcerit of paid-in arid

unimpaired capital and surplus.

The rules prevent

credit unions from putting short-term securities out on repurchase agreeraent
to finance a purchase of long-term securities.

Investments made with funds

obtained through a reverse repurchase agreement or securities collateralizing
the transaction must have a maturity date no later than the repurchase date.

GNMA Regulations of Issuers of Mo r tgage-Ba ck ed Secur ities

GNMA has authority under Section 306(g) of the National Housing Act
(12 use

1716 et seq.) to regulate the business practices of issuers of secu-

rities that

it

guarantees.

The GNMA Mortgage-Backed Securities Guide governs

the specific terms of issuance and guarantee of GNMA mortgage-backed securities, and since late 1977 it has prescribed prudent business practices for GNMA

issuers.

The prudent business practice rules require issuers to establish pro-

cedures to assess the financial integrity of securities dealers and investors


Federal Reserve Bank of St. Louis

188

with whom they conduct transactions.

The rules also require issuers to estab-

lish internal management controls to assure coordination of commitment activities,

to avoid excessive forward commitments,

and to assure competence and

integrity of its staff.

GNMA did not mandate specific rules for issuers to use in assessing
the financial soundness of securities dealers and investors,

the following procedures:

but

it did suggest

(1) review of financial statements and assessment of

the adequacy of dealers' and investors' capital;
the dealer or investor firm;

(2) checking of references on

(3) review of a general resolution of the govern-

ing body of the dealer or investor, naming individuals who are authorized to

conduct GNMA transactions;

(4) recording terms and conditions of commitments;

and (5) familiarization with the trading practices encouraged by the securities

industry and review of whether individual dealer firms follow those practices.
The internal management controls required by GNMA include (1) written

designation of persons responsible for marketing GNMA securities; (2) restriction of authority to designated persons to enter into mortgage-backed securities

commitments on behalf of the issuer;
for at least one year,

(3) keeping records of each transaction

including the type of security to be delivered, date,

dollar amount, coupon rate and price, a notation of whether delivery is mandatory, and the name of the firm and individual with whom the commitment was
made.

The issuer's net position must also be calculated and recorded at least

once per week.

Under GNMA rules issuers must be prepared to report on demand to
GNMA.
dom,

Each month GNMA makes a written demand on 25 issuers, selected at ranfor evidence of compliance with the prudent business practice require-


Federal Reserve Bank of St. Louis

189

raents.

In addition, GNMA has contracted with the Federal National Mortg^ige

Association to conduct on-site visits with issuers in order to assure; compliance with GNMA rules.

Each issuer is visited approximately once every two

years
In October 1979, GNMA issued regulations that tied issuers' required

minimum net worth to (1) the amount of mortgage-backed securities that the mortgage banker has outstanding and (2) the amount of its commitments for guarantees

obtained from GNMA.
inant type of GNMAs

An issuer of modified pass-through securities, the predom-

—must

have a net worth of at least $100,000.

That amount

grows with increases in the amount of securities that the issuer has outstanding
or in production.

There is no upper limit on the requirement.

The .GNMA Mortgage-Backed, Securities Guide states that issuers must

hold their required net worth in assets acceptable to GNMA.

Rather than list-

ing the assets that are acceptable and thus limiting them, the Guide lists

exclusions.

The Guide states, "acceptable assets exclude such intangibles as

goodwill, copyrights, organization expenses,

franchises, etc., and may exclude

certain other assets of doubtful economic value as determined by GNMA."
On June 11, 1980 GNMA published regulations that require all issuers
of GNMA guaranteed mortgage-backed securities to mark certain forward contracts
to market and to post maintenance margin deposits in one of the following forms:

cash, unmatured, negotiable debt obligations issued or guaranteed by the U.S.

government or agency thereof and irrevocable, unconditional letters of credit

with an independent financial institution.
mark-to-raarket accounting procedures.


Federal Reserve Bank of St. Louis

They also require issuers to use

Both parties must mark-to-raarket at

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190

least once a week from the trade date until settlement date.

The regulations

in forward
also include a "suitability rule" to help assure that issuers engage

transactions in a manner that does not impair their capital or their ability
to service outstanding GNMA securities.

The proposed maintenance margin requirement runs both ways and
restricts issuers to transacting forward contracts with dealers and investors
that are willing to post maintenance margin deposits weekly in cash (or any
of the other acceptable forms listed above).

The required margin payments

must be 100 percent of any unrealized loss on the difference between the current market price and the contract price.

The requirement applies, with cer-

tain exceptions, to all forward purchases of GNMA securities by an issuer (as
well as those to be obtained under repurchase agreements and standbys) with

delivery scheduled more than 30 days after the contract date.
however, is particularly important.

One exception,

The proposed margin requirement does

not apply to the issuer/seller if he is acting in the normal course of GNMA

production, i.e. a 150-day production cycle.

The GNMA issuef will, however,

still be required to obtain margin maintenance from the securities dealer or

investor on the other side of the forward contract.

The regulation also requires GNMA issuers to post maintenance margin
deposits with respect to forward contracts that involve forward purchases of

GNMA securities which are to be "paired off" against forward contracts to sell
GNMAs, if the GNMA issuer's production of mortgages proves insufficient in size
to cover forward sales contracts on a delivery date.

This also applies to cases

where an issuer purchases GNMAs forward to deliver against a standby commitment


Federal Reserve Bank of St. Louis

191

under which

t>ie

-

mortgage banker has the option to deliver.

These "pair off"

and standby transactions are not uncommon in a time of risi"? interest rates

and waning demand for Bfortgages.

The above regulations, excluding mark-to-market require'nents, are
effective July 14, 1980.

The mark-to-raarket provisions become effective

September 11, 1980.

State Regulatory Actions

Two possible general approaches are evident in state regulation applicable to the markets for government-related securities.

First, some state secu-

rities, or "blue sky," commissions regulate dealer activity in government-guar-

anteed securities either by imposing upon dealers in those securities the same

regulatory system applicable to other securities dealers, or by adopting specific provisions that are designed to address problems peculiar to government-

guaranteed securities dealers.

Such state regulation of dealers is generally

modeled after federal regulation, although it varies in scope and stringency.
Second, some states impose limits on the extent to which certain classes of

investors subject to regulation may purchase government-related securities.
It appears that

few of the state agencies charged with the regulation of such

investors, e.g., state insurance departments or departments of banking, have

taken specific actions to prevent abuses in the the government-guaranteed

securities market. 3/

3/

An appendix is attached that contains a survey of the regulatory responses
of seven st^ites to devs-^lopments in the government-guaranteed securities
markets.


Federal Reserve Bank of St. Louis

192

-

Industry Self-Regulatory_Ef£orts

Mortgage-backed securities dealers organized during the first half
of 1978 to lead the securities industry in efforts to develop an industry

self-regulatory program with respect to trading in GNMA securities.

The GNMA

Mortgage-Backed Securities Dealers Association (founded in 1972) developed a
proposal to create a self-regulatory organization, the Mortgage-Backed Dealers

Association (now the Mortgage-Backed Securities Association ("MBSA")), for
banks, securities firms,

securities. 4/

and mortgage bankers dealing in mortgage-backed

The MBSA was intended to adopt rules and regulations to

establish (1) standards of ethical conduct and fair practice,

(2)

uniform

industry practice with respect to delivery, clearance, and processing of
trades,

(3) recordkeeping and financial responsibility procedures,

codes of arbitration and member discipline.

In October 1978,

and (4)

the MBSA sub-

mitted its draft articles of incorporation, bylaws, and rules and regulations
to the Department of Justice for review under its business review procedure.

5/

In addition to the efforts of the MBSA to create a self-regulatory

organization during 1978, the Public Securities Association (a national trade

4/

the members of the GNMA Mortgage-Backed Securities Dealers
approved, in principle, a proposal to establish the MBSA.
At
Association
Public Securities Association (the "PSA") indicated its
that time, the
support for the MBSA proposal. The Government Guaranteed Loan Dealers
Association prior to its merger with the PSA, had also considered the
adoption of a code of conduct for its members.

5/

A "business review" request is a request for an expression of enforcement
The Department evaluates such requests only with respect to
intention.
the application of the Sherman and Clayton Acts.
In responding to a business review request, the Department will either indicate that it would not
take antitrust action, or decline to so state.
The Department may review
its decision if the original circumstances change.
See 28 CFR §50.6.

In July 1978,


Federal Reserve Bank of St. Louis

193

-

association established in 1977 to reoresent broker-dealers and banks
iirderwri te

,

traHe

,

ag;encv securities)

and sell municipal, "nited States e;overnment

,

("hat

and Federal

examined the need for and the feasibility of establishing

an induFtrv self-regulatory mechanism for mortgage-backed securities dealers,
and,

to the

extent necessary, dealers in other exempted securities.

In

October 1978, PSA's board of directors authorized its staff to organize an
independent non-profit corporation, affiliated with PSA but with its own

separate membership, governing body, and rules, as a self-regulatory body for
brokers and dealers in government and federal agency securities.

The MBSA

encouraged its members to support the efforts of the PSA in this effort. 6/
In January 1979, PSA held informational meetings, attended by reore-

sentatives of several interested federal regulatory agencies and by member"= of
the securities industrv,

in which the elements of a proposed industry-sponsored

self-regulatory body, PSA Governments, Inc., were described.
that the essential task of PSA Governments, Inc.

of conduct

for members effecting transactions

PSA indicated

would be to develop standards

in GNMA securities,

and to consi-

der substantive rulemaking in several areas, including those identified in the

6_/

1^79, the MRSA and PSA Self-Regulation, Inc
(PSA-SRi) issued a
statement designating PSA-SRI as the organization responsible for
implementing a self-regulatory system for dealers in government mortgagebacked securities.
Shortly after tiiat announcement, MBSA urged its member
firms dealing in mortgage-backed securities to consider joining PSA-SRI.
Currently, MBSA functions as a trade organization for the mortgage-backed
securities industry, but does not engage in rulemaking.
In January 1980,
MHSA with '^SA-SRI was advanced so that the industry
a proposal to merge
could speak vrith "one voice" on all matters of concern to it.
In August

joint


Federal Reserve Bank of St. Louis

,

-

194

Shriver Report, which had recently been released.

At

those meetings, PRA indi-

cated that it believed an important factor in the success of any industrv-sponsored self-regulatory system would be the formal endorsement of that organi-

zation by federal agencies, including GNMA and the Treasury, and it therefore
solicited comments in advance from all interested persons on the proposed rules
to be developed by the new association.

In May 1979,

PSA announced the forma-

tion of PSA Self-Regulation, Inc. ("PSA-SRI"), an independent corporation, to
adopt "rules of business conduct" applicable to brokers, dealers, and bank

dealers in government mortgage-backed and government -guaranteed securities. Ij
In June 1979,

the Justice Department responded to the MBSAs October

1978, business review request. 8/

In its response,

the Department noted the

public purpose to be served by a self-regulatory organization which might mini-

mize the Dotential for abuse in the mortgage-backed securities markets, referenced the types of abuses in the GNMA market which had already come to light,
and generally commented favorably on the MBSA's proposed rules and regulations
"as an effort

to

minimize unfair and unethical practices and to make uniform

7/

Membership in the self-regulatory organization is open to any broker,
dealer, or bank engaged in the business of effecting transactions in
government mortgage-backed or government-guaranteed loan securities.
PSA-SRI generates its revenues from membership dues. PSA, the parent
trade organization, currently provides staff resources and facilities
to PSA-SRI.

8/

Letter to Victor S. Friedman, Esq., from Donald J. Flexner, Acting
Assistant Attorney General, Antitrust Division, dated June 25, 1979
("Flexner" letter).


Federal Reserve Bank of St. Louis

195

-

trading practices in the TTtortgas;e-backed securities market." Nevertheless,

because of the uniform maintenance margin provision in the proposed rules,
which the Department viewed as potentially anti-comoetitive

,

the Department

declined to state that it would not challenge implementation of the proposal
as

a

violation of the Sherman Act.
Specifically, the proposed MBSA rules relating to uniform industry

practice contained provisions which would establish uniform maintenance margin procedures for members entering into contracts for the sale of mortgage-

backed securities calling for settlement more than four months after the contract date.

In discussing the draft provision,

the Department stated that an

agreement to impose uniform margin requirements on all parties to

a

contract

for sale, regardless of individual consideration of "credit worthiness and

credit needs," might raise antitrust problems, since such an agreement would

eliminate the ability of association members to compete for customers by foregoing margin or setting lower margin requirements. 9/

The Department stated

that a "uniform and agreed-upon market maintenance requirement does not appear

essential" to achieve either the general objectives of the MBSA, or to achieve
the more specific goals of making customers aware of the "speculative nature"

of delayed delivery contracts and ensuring that parties are able to perform

their obligations under such contracts.

9/

Flexner letter, at


Federal Reserve Bank of St. Louis

4,

-

In early July 1979,

196

PSA-SRI solicited comment on its initial pro-

posed rules from members of the public, the securities industry, and several

interested federal agencies, including the SEC, the Treasury"^ and the FRB.
The proposed rules of PSA-SRI, to a great extent, incorporated the self-regu-

latory proposal of the MBSA, and, accordingly, the general areas of substantive rulemaking by the two industry-sponsored groups are similar in scope and

purpose.

The PSA-SRI proposed rules relating to transactions in mortgage-backed

securities,

like those of the MBSA, included a series of definitional rules;

recordkeeping requirements; uniform standards for processing, clearance, and
settlement of transactions; a code of fair practice which included suitability
and supervision guidelines;

financial responsibility procedures; and codes of

of arbitration and member discipline.

Because of the Justice Department's

position, expressed in its business review letter, with respect to the antitrust implications of the MBSA's uniform margin requirements, the PSA-SRI

'

proposed rule concerning financial responsibility did not impose uniform

margin and "mark-to-market" requirements, but instead provided margin-related
guidelines for members. 10/

10/

The PSA-SRI rule would have required a member to adopt and maintain
"written procedures for determining the risk limits it will extend and
lengths of settlement it will permit on various types of transactions
involving mortgage-backed securities for any customer or dealer" (Art. IV,
Rule 401).
In the event a member determined not to obtain margin from a
customer in an amount at least equal to any adverse change in market
value with respect to delayed-delivery or stand-by contracts, the member
would be required to designate an officer to review such determination
weekly (Art. IV, Rule 402).


Federal Reserve Bank of St. Louis

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197

-

The Treasury coordinated an interagency response to the initial PSA-

SRI proposal.

11/

The SFX staff conveyed its comments by letter.

12/

Both

groups of commentators identified similar concerns with respect to the proposed rules, including the desirability of uniform margin provisions and the
need for a more detailed suitability rule.

The SEC also emphasized the impor-

tance of specific professional qualification requirements and strengthened
sujjervisory procedures.

Shortly after receiving comments from interested federal agencies
on the proposal, PSA-SRI circulated revised proposed rules which reflected

certain recommendations of those agencies.
it

PSA-SRI determined, however, that

could not propose mandatory margin requirements until potential antitrust

problems could be resolved.
PSA-SRI adopted rules relating to transactions in mortgage-backed

securities on January

1,

1980.

13/

The rules establish requirements govern-

11/

An interagency response to the proposed rules was communicated to representatives of PSA-SRI at a meeting on September 17, 1979.
The response
represented the views of the staffs of the Treasury, GNMA, Comptroller of
PSA-SRI did not submit its proposed
the Currency, the FRB, and FHLMC.
rules to the Justice Department for review.

12/

Letter to Roger Klein, Executive Director, PSA, from Douglas Scarf f.
Associate Director, Division of Market Regulation, dated September 14,
1979.

13/

The terra "mortgage-backed security" is defined in Art. I, Rule 103.16 to
mean "all participation interests in pools of mortgage loans issued or
guaranteed by instrumentalities of the United States government, including
without limitation, pass-through and modified pass-through certificates
guaranteed by GNMA and Mortgage Participation Certificates and Guaranteed
Mortgage Certificates issued by FHLMC. The term shall also include all
commitments or arrangements to purchase or sell such securities including
repurchase agreements, reverse repurchase agreements, and stand-by contracts but excludes all contracts for future delivery and options on
mortgage-backed securities executed on a contract market."


Federal Reserve Bank of St. Louis

198

-

ing transactions in mortgage-backed securities between members of PSA-SRI or

between a member and

a

customer or person who is not

a

member.

The rules,

substantially similar to the proposed rules described earlier, include
general principles and definitions, operations and recordkeeping requirements, a code of fair practice which contains suitability and supervisory

procedures, financial responsibility requirements in the form of marginrelated guidelines for members, and an arbitration code. 14/

PSA-SRI

's

effort to organize quickly an effective self-regulatory

organization for dealers in mortgage-backed securities has encountered a

number of difficulties.

One of the most serious problems in attracting full

industry support for PSA-SRI 15/ appears to be the limitations under the antitrust laws on PSA-SRI

's

ability to draft uniform margin rules.

The rules

adopted by PSA-SRI encourage individual firms to establish their own prudent

constraints on risk by, among other things, evaluating the need for margin

requirements on a customer-by-customer basis and by designating an officer to

review certain credit determinations on a weekly basis.

Because the rules do

14 /

Although the membership has approved the rules package in principle,
certain important rules will become effective at an unspecified future
date, including those concerning supervisory procedures, a uniform disclosure of risk statement (Art. Ill, Rules 307 and 308), and a code of
arbitration (Art. V, Rule 501).
In addition, a disciplinary proceedings
code which would establish procedures for handling complaints against
members has not yet been developed.

15 /

Of the approximately 60-80 active dealers in government-guaranteed
mortgage-backed securities, 31 have ioined PSA-SRI to date. MBSA, the
industry trade group, has approximately 40 members, 25% of which are
active dealers, with the remainder consisting of mortgage bankers and

other market participants.


Federal Reserve Bank of St. Louis

199

-

not impose uniform margin or mark-to-market requirements,

it

appears that cer-

tain industry participants may believe that PSA-SRI's self-regulatory efforts
are not sufficient to deal with problems in the forward markets that result

from an absence of controls designed (1) to decrease speculation by limiting
the

leverage available to customers and (2) to reduce the risks associated

with forward trading by enabling market participants to monitor their potential gains and losses.

16/

In addition to difficulties concerning uniform

margin requirements, other antitrust considerations have hindered PSA-SRI's
efforts.

MBSA proposed rules, the Justice

In commenting on the earlier

Department expressed concern that several rules (including those relating
to member disciplinary proceedings) when read together "could be construed
as

prohibiting members from dealing with non-members who fail to follow the

Association's standard of conduct."

Any provisions encouraging

a

"refusal

to deal" by members with non-members would be inconsistent with the antitrust
In order to avoid such criticism,

laws.

organization which intends

to

develop

a

PSA-SRI is a voluntary membership

disciplinary code separate from its

rules.

Without an effective system to enforce industry-wide adherence to
certain standards of ethical conduct, such as suitability and disclosure of
risk procedures, it is uncertain whether PSA-SRI can reduce sufficiently

16/

PSA-SRI has stated that "[iln our view, it is unfortunate that the implications of the antitrust laws have precluded any industry attempt to
achieve financial responsibility of market participants through a unifonn
market maintenance requirement." Letter to the Hon. Paul A. Volcker,
Chairman, FRB, from Roger D. Shay, Chairman, PSA-SRI (Jan. 21, 1980).


Federal Reserve Bank of St. Louis

200

-

certain types of serious problems including abusive sales practices, which

have arisen in the GNMA market.

In addition,

the lack of uniform margin

requirements, which several regulatory agencies as well as certain industry

members agree would be essential to effective self-regulation, has seriously
reduced PSA-SRI's ability to deal with nroblems related to overspeculation
and credit risk in the forward market

for government -guaranteed mortgage-

backed securities.
Recently, PSA-SRI has directed its attention toward developing a
federal legislative proposal to deal with abuses in the government securities markets.
to the extent

markets


Federal Reserve Bank of St. Louis

PSA-SRI has indicated that it favors federal involvement only

necessary to address abuses in the mortgage-backed securities

-

201

-

APPENDIX
STATE REGULATORY ACTIONS

The following pages provide a brief survey of the regulatory
responses of seven states to developments in the government-related secuIt is based on discussions with state personnel and
rities markets.
The
other available information concerning state regulatory activities.
states, Arkansas, California, Florida, Illinois, New York, Tennessee, and
Texas, were selected because prior contacts indicated that certain of them
had adopted or were considering special regulations concerning the government-related securities market, contact had already been established with
certain of their officials, or their size suggested that problems associated with the market might exist and that there might be an awareness
For this reason, the rec^ulatory patof and reaction to those problems.
tern in these states may be atypical and, more extensive and detailed than
in other states.

"Blue Sky" Laws and Dealer Regulation

Government-related securities are themselves exempt from "blue
Nevertheless,
registration in each of the seven states surveyed.
sky"
which government-related securities dealers may
except in those states in
be excluded from the definition of "broker-dealer" or "dealer", 1/ even
dealers participating exclusively in sales of government -related securities must register as dealers and comply with pertinent state regulations.
Enforcement of such requirements depends upon the resources and policies
of the blue sky commission involved.
In general, the states surveyed have enacted laws or relevant
state agencies had adopted regulations that were modeled, although usually
For example,
in a partial and fragmentary manner, after SEC regulations.
most of the states surveyed have adopted net capital and recordkeeping
requirements.
States, however, do not appear to have adopted general
explicit suitability requirements of the sort adopted by self-regulating
organizations (SROs).

1/

California law excludes banks, trust companies and loan associations from
its definition of "broker-dealers." The Florida statute excludes properly
state-authorized banks, trust companies and "wholesalers" from its definition of "dealer." New York excludes persons selling solely to any bank,
corporation, savings institution, trust company, insurance company, investment company (registered under the Investment Company Act of 1940), pension
or profit-sharing trust or "other financial institution or institutional
buyer" from its definition of "dealer." In addition, Texas excludes dealers
selling exclusively t'^ institutions, such as savings and loans, banks, and
ircurance companies.


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-

Arkansas, Florida, and Tennessee have each adopted some regulations applicable to government-E^uaranteed securities dealers.
Florida
recodified its blue sky regulations during 1979 and adoDted only one provision covering government-guaranteed securities dealers; that provision
allows those dealers to maintain a minimum net capital of 625,000, rather
than the amount of capital that would be required by the SEC's capital
rule.
Tennessee imposes a higher minimum net capital requirement upon
dealers who trade exclusively in government -related securities than upon
other dealers.
Arkansas imposes extensive net capital requirements on all
dealers, but treats GNMAs favorably, by including forward commitments to
purchase such securities in the calculation of aggregate indebtedness only
under certain conditions.
In addition, Arkansas deems adjusted trading,
excessive markups, and interpositioning to be unfair, misleading, and
unethical practices and, as such, grounds for suspension or revocation
of the registration of a broker-dealer or its agent.

Regulations of Investors
Statutes in every jurisdication surveyed deem government -guaranteed securities to be permissible investments under state fiduciary law.
The commonly regulated institutions likely to be participants in the markets for regulated institutions likely to be participants in the markets
for government-related securities include commercial banks, thrift institutions, insurance companies, and credit unions.
The response of the
various state agencies having jurisdication over such institutions to
conditions in government-related securities markets has varied.

Banks and Thrift Institutions

Generally, state regulators do not impose any limitations on commercial bank investments in government-guaranteed securities. The regulators
of banks and thrift institutions in the states surveyed apparently have considered rulemaking unnecessary, in part because institutions whose deposits
are insured by federal agencies are bound bv those agencies' guidelines
with respect to trading in government-related securities.
It also appears
that some state regulators are inclined to follow and enforce guidelines
promulgated by federal regulators, such as the Office of the Comptroller of
the Currency and the Federal Deposit Insurance Corporation ("FDIC").
For
example, one official indicated that, although no formal rulemaking had
occurred in his state, if the question of investing by thrift institutions
in forwards and other speculative instruments arose, the state would probably respond by following the guidelines and policies of the FDIC and the
Federal Home Loan Bank Board (FHLBB).


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Some other state regulators have taken more specific actions.
The
New York Banking Department has issued a letter to banks under its iurisdiction warning those institutions about the speculative nature of forward
trading in securities, particularly GNMAs and enumerating some drawbacks
In the letter the Superintendent of the Department
to such investments.
recommended banks engaging in forward trading institute a regular internal
reporting system so that the banks' officials are fully informed of the
The Tennessee State Banking Commission has proinstitutions' commitments.
posed a rule that would prohibit all bank trading in forwards by deeming
such trading to be an "unsafe and unsound" practice, and an official of
that state's Insurance Department indicated that it intends to adopt rules
modeled after those promulgated by the FHLBB. The Arkansas State Bank
Department has issued warnings to state banks declaring that trading in
mortgage futures on a speculative basis is an unsafe and unsound banking
practice.
In addition, the Arkansas Securities Department has issued a
letter notifying thrift institutions that speculation in government-related
securities, including futures, forwards, standbvs, and reverse repos, would
The Texas Banking Commission has
be considered "unsafe and unsound."
adopted no rules or regulations limiting commercial bank participation in
the government-guaranteed securities markets. We understand, however, that
it has rendered advice on an ad hoc basis to banks in its iurisdiction that
were experiencing problems. A similar course of action has been followed
The Texas Savings and Loan Department
with regard to thrift institutions.
indicated that it generallv had endorsed FHLBB rules and guidelines to
deter speculation in standbys by thrift institutions.

Credit Unions
State regulators of state-chartered credit unions also recognized
the the problems that have arisen in trading of government-related securiThe Illinois Department of Financial Institutions has proposed a rule
ties.
that would prohibit credit unions from selling securities short, trading on
margin, investing in futures and forwards, and participating in adjusted
trades.
Another state agency anticipates that it will adopt regulations
modeled after those of the National Credit Union Administration. Two state
The Arkanagencies have have issued letters regarding speculative trading.
credit unions under its adminsas Securities Commission issued a letter to
istration declaring speculation in government-guaranteed securities, including
futures, forwards, standbys, and reverse repos, to be an "unsafe and unsound"
practice, while the Texas Credit Union Department has admonished its credit
unions, in light of heavy losses experienced by two Texas credit unions in
GNMA forwards, to avoid speculative forward trading.

Although two states, Tennessee and Texas, indicated that credit
unions there have experienced difficulties in the GNMA market, the consensus
among other state officials surveved was that preventive activities appear to


Federal Reserve Bank of St. Louis

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sufficient, since credit unions under their regulation lacked sufficient
capital to consider speculating in the government-guaranteed securities markets or were aware of abuses because of NCUA rules and guidelines.
be

Insurance Companies
None of the state insurance regulators surveyed has adopted anv
regulations specifically tailored to curb abuses in government -related securities.
Nevertheless, agencies in two states, California and Florida, have
barred investments in futures and forwards through interpretation of existing
statutes.
In those states the law requires the assets of an insurance comoanv
to be held in the comoany's account and any interest or dividends on such
assets must be to the exclusive benefit of the insurance company.
Since
physical delivery of the instruments underlying futures and forwards is
delayed for a substantial period after a trade, California and Florida prohibit these investments.


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CHAPTER VI
FEDERAL REGULATION OF BROKERS AND DEALERS IN GOVERNMENT RELATED SECURITIES:
ANALYSIS, CONCLUSIONS AND RECOMMENDATIONS

This chanter addresses

a

variety of considerations hearing on whether

federal regulation should be extended to dealers in jjovernTnent guaranteed and

other related securities and, if so, what specific kinds of regulation are
needed.

In particular,

it

first reviews estimates of the losses suffered by

investors, primarily in exempted mortgage-backed securities, in cases where
abusive trading practices were present.

The need for and potential costs of

regulation of dealers designed to prevent similar problems in the future are
then considered in

light of the measures recently adopted by GNMA and financial

institution regulatory agencies.

Based on the conclusion that additional regu-

lation of the market for mortgage-backed securities is needed, the discussion

then turns to an examination of (1) the role and imnlement at ion of margin rules
and whether they would by themselves be a sufficient
(2) what other types

form of regulation, and

of regulatorv measures mav be appropriate.

The discussion concludes that the problems inherent in forward trading
of GNMA and FHLMC mortgage-backed securities warrant creation of a flexible regu-

latory system for dealers engaged in forward trading in these securities.

trading is presently exempt from most of the federal securities laws.

Such

The system

proposed has been designed to permit extension of regulation to other sectors of
the government guaranteed and related securities markets.

The participants in

the study have concluded that at this time the extension of regulation to mar-

kets for other government related securities is unnecessary and not warranted
by the evidence.


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206

Estimates of Investment Losses and Regulatory Costs
In deciding whether federal regulation of brokers and dealers should
be extended, it is appropriate to attempt an assessment of the losses that

have been incurred by market participants in cases where abusive practices

were present and to compare those losses with the costs that would be incurred
if a regulatory framework were established to address these abuses.

The avail-

able information permits only rough estimates of the measurable costs and potential benefits of regulation.

With regard to losses, it should be noted that the cases reviewed in
.the

SEC.

Appendix to Chapter IV are only those that have been investigated by the
There have been other complaints filed that have not been included because

sufficient information is not available.

Moreover, these cases do not reflect

fully the losses that have been recorded by many other financial institutions,
nor do they include several other cases that have recently been given coverage
in the national press.

On the other side, a simple addition of losses in cases

where abusive practices were present may overstate such losses.

In five of the

cases in the Appendix, there has been at least a partial payback of initial
losses by the dealers or other parties Involved.

Further, a large share of

the losses in certain cases is attributable to a combination of overextended

positions and rapid changes in interest rates, which have fluctuated sharply
in recent years.

If Interest rates had remained stable or moved in the opposite

direction, the ultimate financial effects on the investors in many of these
cases might have been quite different.


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- 207 -

Similar uncertainties also impede an accurate assessment of the

potential costs of regulation.

The study staff was unable to assess the poten-

tial indirect costs of regulation, nor was it able to determine the precise

costs to dealers of compliance with possible regulatory requirements.

Also,

regulatory costs would depend, to some degree, on the number of market sectors
to be brought under the mantle of regulation and the kind of regulation that is

introduced.

Despite the above mentioned problems, presenting the available esti-

mates of losses and measurable regulatory costs serves a purpose.

The Appendix

to this Chapter contains a discussion of the losses in cases where abusive prac-

tices were a factor and presents available information on some of the measur-

able costs of regulation in the municipal securities market, the most closely
analogous market.

However, the study participants are not basing their conclu-

sion that regulation of this market is needed or appropriate on a mechanical

evaluation of monetary cost/benefit data.

Indeed, the imprecise and incomplete

nature of much of the data does not justify placing much reliance on such data
in making a decision.

Instead, the study participants believe that the case for regulation
is justified on broader grounds.

In particular, because of the programs of

government agencies and sponsored agencies involved in these markets, the study

participants believe that maintenance of the efficiency and integrity of the
markets for these agencies' securities is a decisive benefit, even if regulation could not be justified on a strict comparison of the monetary cost of

regulation with the reduction of direct monetary loss to participants.

The

number and continuing nature of problems which have occurred in the forward


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208

markets for mortgage-backed securities seem sufficient to justify such regulation.

Recent Changes in the Regulatory Context
The assessment of losses contained in this study is based on past

experience with trading abuses.

Recent changes in the market context may have

reduced the potential for abusive practices and problems.

While a disturbing

number of problems in the GNMA market have recently been reported in the press,

many of these problems result from transactions which occurred in late 1978
or earlier, and there may be less likelihood that investors will become so

involved in the future.

There is greater awareness now of the high risks

involved in forward trading, a point which the recent sharp fluctuation in the
prices of fixed income securities has dramatically reinforced.

Thus, investors

and issuers may now be somewhat less susceptible to the blandishments of unscru-

pulous salesmen than in the past. 1/ Greater care, spawned by past abuses, may
also characterize the operations of dealer firms that might be tempted to engage
in unsound practices. 2/
in abusive practices,
a result,

In

many of the maior cases in which dealers engaged

they also ended up suffering serious financial losses.

As

dealers may have become more wary of doing business with the potentially

irresponsible investor who might walk away from an unfavorable commitment.

Ij

It might be noted, however, that while investors that trade in these securities on a continuing basis gain a first-hand appreciation of the risks such
trading can entail, sporadic or one-time investors may be less likely to
have gained such knowledge.

2/

In some cases in which abusive practices were a factor in investor losses,
the investor may have contributed to the abusive practices by misleading
dealers as to its financial position.


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209

It should also be clear from Chapter V's discussion of the various

actions taken by federal agencies that the institutions regulated by these
agencies are now more constrained in their trading of these securities than
they were in the past.

These new rules and regulations do not, of course,

ensure that further abuses will not arise, since no system of regulation can

eliminate all abuses.

However, it seems likely that these actions have reduced

the likelihood that these regulated institutions will engage in speculative

transactions of the type that can lead to large losses if the market moves
adversely.

Despite these hopeful signs, the potential for losses still appears
to be unacceptably large.

For example, individuals have become more active in

certain sectors of the government related securities markets in recent years.
They, as well as some classes of institutional investors, are not subject to
the guidance and protection of the recent regulations promulgated by various

financial institution regulators and discussed in Chapter V.

More importantly, many of the conditions responsible for the problems
In the forward markets for government related securities continue to exist.

For example, it remains possible to assume large positions in GNMA securities

with long delayed delivery dates without being required to provide either
Initial margin or maintenance margin when the market moves against that position.

Some dealer firms have voluntarily imposed margin requirements on their

customers, but many firms have not established any such requirements.

Moreover,

given the Justice Department's ruling inhibiting proposals to establish standard

margin requirements without government sanction, it is clear that voluntary


Federal Reserve Bank of St. Louis

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efforts by Individual firms in the industry are bound to be quite disparate in
stringency.

Thus it Is likely that many firms, including those most inclined

to "cut corners" and otherwise employ less than sound and suitable practices,

might impose lax and ineffective requirements, if they impose any at all.
Also, given the competitive disadvantages that may accrue to firms adopting

stringent margin standards, it is possible that many reputable dealers might
decide to impose looser standards.
In addition, dealers in government related securities are not subject
to the "fair practice" rules, financial responsibility rules, and recordkeeping

and qualification requirements that are applicable to other types of securities
dealers.

These rules directly address many of the types of abuses discussed in

Chapter IV.

Furthermore, the absence of registration requirements for these

dealers makes effective enforcement of even the anti-fraud rules difficult with
respect to their principals and associated persons.

Finally, since many of the

problems evident in trading of government related securities have originated

with abusive sales practices by dealers, regulation aimed solely at investors
may fall to address a sizeable portion of these problems.

While the prospects for similar abuse today are reduced from what
they were when many of the problems described in Chapter IV originated, there

remains a possibility that future losses could still exceed limits thought

tolerable by market participants and the public at large.

It is reasoning

along these lines that underlies the positions expressed by GNMA, by various
federal regulatory agencies, and by the major dealer associations and a number
of individual dealer firms that reasonable regulatory measures should be imposed


Federal Reserve Bank of St. Louis

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-

with respect to trading in the forward market for GNMA and FHLMC mortgagebacked securities.

These agencies and organizations generally believe that

dealer regulation would complement the measures already taken by financial

regulatory agencies, but there exists a wide range of views about the form
and scope of any such regulatory system.

After extensive consideration, the participants in this study agree
that, with regard to forward transactions in GNMA and FHLMC mortgage-backed

securities, problems and abuses have been serious and not infrequent, and the

measures taken thus far address only part of the practices responsible for
these problems.

Accordingly, we believe that a framework should be established

for implementing appropriate regulatory measures.

In establishing a regulatory framework one must choose among a broad

spectrum of possible approaches.

Initially, it is necessary to decide whether

the regulatory structure should be designed to deal only with the problems in

forward markets for GNMA and FHLMC mortgage-backed securities or whether a

structure should be established which is flexible enough to deal with any future
problems in related areas in a relatively expeditious manner.

One must then

determine whether the system should be designed to meet only the major source
of problems (the lack of initial and maintenance margins in forward transactions
in GNMAs and FHLMCs) or whether a more comprehensive system should be imposed to

meet other problems as well.

Finally, a decision must be made as to who will

establish rules and be responsible for their enforcement.

One could adopt an

approach relying almost exclusively on the private sector, with only minimal

governmental oversight.


Federal Reserve Bank of St. Louis

Alternatively, one could rely exclusively on a govern-

212

mental agency to establish and enforce rules.
ing on input

An intermediate position, rely-

from the industry but with a fairly active governmental oversight

role, could also be adopted.

Finally, the role to be played by those agencies

or organizations that already regulate other aspects of the business of parti-

cipants in the market must also be considered.
In addition to considering the desirability of rules designed to

eliminate unsound or unfair practices, one must also consider the appropriateness of providing for the adoption of rules designed to improve the functioning
of the market.

Proposals calling for uniform market practices and encouraging

the establishment of clearing facilities are designed primarily to mandate more

efficient operation of the market and are only indirectly related to the preven-

tion of abuses or unsound practices.

Types of Securities Needing Regulation

Regulation of trading in currently exempted securities appears necessary at this time only in the case of forward trading in GNMA and FHLMC mortgage-

backed securities.

The study participants do not believe that the evidence of

past abuses compiled in the study demonstrates a present need for regulation of

markets for any other types of government related securities.
it should be

In this regard,

noted that the eight cases reviewed in the Appendix to Chapter IV

pertaining to these other types of government related securities essentiallv
exhaust the instances of trading abuses in these instruments known by any of
the agencies

in this study group,

a

generalization that holds not only for the

past five years but also for preceding years.

Losses in these cases were much

smaller than the corresponding losses in GNMA guaranteed mortgage-backed secu-


Federal Reserve Bank of St. Louis

?13

-

rities alone, and the frequency of abuses in relation to trading volume was

much lower in some of these securities, particularly Treasury securities, than
in GNMA securities.

The much smaller incidence of trading abuses by dealers and investors
in markets for other types of government related securities stems mainly from
the fact that trading for long forward delivery rarely occurs in the markets
for these other securities; there is, accordingly,

less opportunity for over-

extension and less risk of default by the other party to the transaction.
For example,

_3/

transactions in outstanding Treasury securities are almost all on

a same-day or next-day delivery basis; when-issued trading may take place

for

The Treasury bans all pre-auction trading in Treasury coupon

about two weeks.

securities by market participants who bid in the Treasury auction of the underlying security.

It should also be

noted that the great preponderance of trading

in Treasury securities is done by primary dealers that are subiect to surveillance by the Treasury and Federal Reserve.

While the cases involving abuses in other markets have been few and
the losses incurred in these cases relatively small, the study participants

believe that it may be appropriate to establish a regulatory system which,
after careful consideration of the impact of regulation, could be extended

administratively to cover additional markets.

3/

This may be of special

In the area of repurchase agreements, which are utilized in connection with
some of these other securities, some dealers have apparently recently implemented more careful standards and procedures and thus may be more alert to
avoiding problems such as failing to obtain collateral before funds are
transferred.
In addition, repurchase transactions are not, in themselves,
inherently leveraged or speculative in character.


Federal Reserve Bank of St. Louis

214

importance if there are any significant increases in the volume of sales of

particular government guaranteed securities in the market.

Such a system

could respond swiftly in the event that abusive practices begin to occur
in those markets which have heretofore been nearly free of abuse.

Also, the

potential for a quick regulatory response may in itself be sufficient to
deter abuses.
Accordingly, while the participants in this study recommend a system
of regulation in the forward market for mortgage-backed securities, it would
be appropriate to provide an administrative mechanism v^ich permits extending
at least some regulatory measures to the cash market for GNMA and FHLMC mort-

gage-backed securities 4/ as well as to markets for other government related
securities other than Treasury securities if the incidence of problems and
abuses increased substantially in these other areas.

What Kind o f Regulation is Needed ?

Assuming that any regulatory scheme is limited to the appropriate
types of securities, the next question is what types of regulatory measures
are needed:

i.e., whether the full range of possible regulatory measures

discussed in Chapter IV is needed or whether more limited measures would
provide sufficient protection to market participants.

In particular,

it

seems worthwhile to explore whether expanded federal involvement should be

limited to establishing and overseeing the imposition of margin requirements
for forward trading in mortgage-backed securities.

kj

In some cases, effective regulation of forward trading may require regulation of cash transactions of dealers engaged in forward trading.


Federal Reserve Bank of St. Louis

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215

A review of cases discussed in Chapter IV makes clear that most
instances of large losses have occurred because investors assumed unsuitably
large forward positions and failed to close out these positions quickly as
losses increased.

Thus, the most important regulatory objective should be

to discourage the assumption of overcommitted positions, ensure that losses

suffered in connection with forward positions are promptly recognized by the
investors and dealers involved, and establish procedures to protect customers,
dealers, and other market participants from losses occasioned by defaults.
As discussed in Chapter IV, well chosen margin requirements would

largely achieve this regulatory objective, and their imposition already has

wide support in the industry. 5J

They would protect forward market partici-

pants against losses that can result from other parties' defaults on forward
contracts.

They would also discourage over-commitments, bring incipient

losses forcefully and promptly to investors' attention, and lend added financial stability to dealers and to the markets.

At the same time, however,

the

discussion in Chapter IV recognizes that regulatory imposition of margin
requirements for government related securities raises significant technical
questions.

These questions include:

what types of securities, traders, and

transactions should be subject to the margin rules; what body should be
charged with formulating the margin rules; the role of initial versus maintenance margins in the system; the manner in which margin payments should be

made and held; and what reduction, if any, of margin payment obligations

5/

See page 103, supra.


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should be recognized in connection with commitments that are hedged or off-set
by other commitments, bj

While these technical questions are formidable, the participants in
this study believe that the need for mandatory margin requirements for forward

transactions in GNMA and FHLMC mortgage-backed securities is sufficiently com-

pelling to mandate their development by an appropriate combination of industry
self-regulation, public participation, and regulatory oversight.

With respect

to the body which should establish the rules, we note that the primary purposes

of margin rules in the forward market would be regulatory rather than economic
i.e., to reduce the likelihood of over-commitments and defaults, rather than to

regulate the use of credit in the economy.

Accordingly, the primary responsi-

bility for setting these rules should be left to an appropriate self-regulatory
organization subject to governmental oversight, with residual powers to set

margins also granted to some other governmental body.

We believe that the

other technical questions and details concerning the margin requirements could
also best be resolved in a similar manner.
In this connection, we have given special consideration to whether

legislation establishing a regulatory system should also establish mechanisms
such as clearing agencies to facilitate implementation and enforcement of mar-

gin requirements.

Such mechanisms might provide substantial regulatory advan-

tages, both in terms of effective enforcement of the requirements and in reducing
the cost and inconvenience market participants might encounter in complying with

with them.

For example, in addition to facilitating efficient settlement of

6/ Id.


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217

trades, a clearing agency might implement margin rules by (1) notifying its

participants (presumably mostly securities dealers) of their margin payment

obligations on

a

daily basis, (2) monitoring their compliance with those

obligations, (3) acting as a third-party escrow agent to hold the deposits,
and (4) taking into account a participant's hedged or off-setting commitments
to the extent that these might reduce the participant's required margin pay-

ments.

Depending on its structure and powers,

a

clearing agency might also

perform a market monitoring function, gathering information on market activity
and perhaps identifying instances of overcommitments.

After extensive review, we believe that the major advantages of
clearing agencies can be realized through voluntary use of these mechanisms,
without legislatively mandating their creation or use.

That is, appropriate

participation in a clearing agency could be an acceptable method for a dealer
or other market participant to comply with margin requirements, but dealers

would not be required to belong to a clearing agency or process any class of

transactions through a clearing agency.

This voluntary approach has the advan-

tage of allowing market forces and voluntary industry action to determine what

transactions can be economically processed through

a

clearing agency.

At the

same time, however, we believe that provision should be made for registration
and appropriate oversight of any such agencies that may be

formed in order to

assure that they operate fairly, efficiently, and safely, and that they produce
the regulatory benefits that can reasonably be expected of them.

7/

7/

After experience with the operation of clearing agencies for government
related securities in the context of regulation in that area, it might be
appropriate to encourage, or even require, inclusion of particular types
of transactions in some type of central clearing or information processing
system.


Federal Reserve Bank of St. Louis

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218

Since margin requirements would achieve a primary regulatory objective, one must consider whether they would constitute a sufficient regulatory

system in themselves or whether provision should be made for the possible
application of other regulatory measures to the trading of government related

mortgage-backed securities.

The study participants have concluded that other

measures are required, but believe that the determination of the specific
measures

to

be

adopted may best be left to a self-regulatory organization or

oversight body after appropriate inquiry into industry conditions.

The cases

reviewed in Chapter IV reveal a number of problems which it might be desirable
to

address by other regulatory measures.

five categories:

These measures can be grouped into

(1) "fair practice" rules

and other requirements);

(2)

(including suitability, disclosure,

competency and qualification requirements; (3)

financial responsibility rules;

(4) registration, recordkeeping and reporting

requirements; and (5) disciplinary and enforcement mechanisms.
Based on the information in Chapter IV, we believe that some of the

regulatory measures discussed there may be appropriate, in addition to margin
requirements, for application at this time to GNMA and FHLMC mortgage-backed
In this regard, cost and enforcement-oriented considerations are

securities.

pertinent.

Effective implementation and enforcement of margin requirements for

forward trades might require dealer registration, implementation of mandatory

recordkeeping provisions for dealers, and a program of dealer surveillance and

Assuming the existence of such a system, which might rely on

inspections.

existing federal agencies and SROs, the incremental cost of devising and enforcing
additional regulatory measures, such as those described in Chapter IV, should
be manageable


Federal Reserve Bank of St. Louis

.

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219

Many of the regulatory measures discussed in Chapter IV can be iustified as good business practices for broker-dealers.

If measures have already

been adopted by significant parts of the industry, they should, of course, be
given priority consideration in the formulation of any system of broker-dealer

regulation for forward transactions in GNMA and FHLMC mortgage-backed securities.

Rather than imposing any of these rules legislatively, however, we

think it generally preferable to allow a self-regulatory organization and
oversight body to make the initial determination of the benefits and burdens
of possible rules in these areas.

Accordingly, we believe that the regulatory

structure should include a self-regulatory organization subject to governmental
oversight, and, further, that this organization, the oversight body, and, where
appropriate, existing administrative agencies, should be given the authority
to establish regulatory requirements not only with respect
in the other areas discussed in Chapter IV.

to margins but also

This approach would allow adoption

of a range of regulatory measures that could minimize, to the extent possible,
the range of abuses experienced thus far; at the same time,

it would allocate

most responsibility for judgments of the advantages and disadvantages of potential regulatory measures to knowledgeable personnel who would have the advantage
of appropriate industry input.

Recommended Regulatory Structure

After extensive consideration of possible regulatory structures, we
have concluded that a desirable framework would use as a model the system cur-

rently in place for the municipal securities markets, but with several significant modifications.


Federal Reserve Bank of St. Louis

This system appears to be a relevant model since there

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220

seem to be certain structural similarities between the two segments of the
industry. 8/

In addition,

the system was recently created but has now been

in operation for several years, and its use as a model

efficiencies.

may involve certain

The principal differences between the proposed system for

government related securities and the existing system for municipal securities
reflect the inherent differences between forward markets and cash markets, as

well as the interest of the federal government in the markets for government
related securities and the role of many of those securities as instruments of

national monetary policy.
As detailed below, the primary rulemaking authority for government

related securities trading should be allocated to a new rulemaking board (the
"Board") composed primarily of industry representatives.

We believe that the

name which would be most descriptive of the activities of the Board would be
the Federal Mortgage-Backed Securities Rulemaking Board.

However, if trading

in other government related securities which are not mortgage-backed securities

were brought within the regulatory authority of the Board, it might be appropriate
at

some future date to change the name of the Board to reflect any change in

the scope of its rulemaking authority.

8/

One of the most important similarities is the presence of entities
already subject to a regulatory structure in both markets. When the
regulatory system for the municipal securities markets was established,
concern with the possible impact of imposing an additional inspection
and enforcement structure on banks and registered broker-dealers was
an important factor in the decision to make use of established structures
Other similarities are the importance of
to perform these functions.
institutional investors, the predominance of dealer rather than agency
markets, and the absence of a transaction reporting system.


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-

Because of differences between dealers which are securities firms
and dealers which are banks, it seems appropriate that each group be represented.

Consideration should also be given to including on the Board persons

not associated with dealers.

Such a Board would be a self-regulatory organiza-

tion ("SRO"), and like existing SRO's would exercise its rulemaking authority

subject to oversight by a governmental body.

The study participants believe

that, in view of the broad responsibilities of the Board for assuring the integrity

of the market for government related securities and the implications of develop-

ments in this market for securities markets in general, this oversight group
should be a "Council" composed of the Secretary of the Treasury, the Chairman
of the Federal Reserve Board, and the Chairman of the SEC, or their respective

designees.

With respect to rules for mortgage-backed securities, the views

of the Secretary of HUD and of GNMA and FHLMC will be sought by the Council

and given full consideration in its deliberations.
At the present time it does not appear that the Council will need a

separate staff or budget.

It would instead utilize the staffs of the three

agencies whose representatives would serve on the Council.

The proposed

regulatory structure should require registration of brokers and dealers (both
referred to herein as "dealers") effecting transactions in those types of

government-related securities that are subject to regulation.

Primary examina-

tion and enforcement authority over registered dealers should be allocated

among regulatory agencies and organizations already performing similar functions

with respect to bank and nonbank dealers.

In addition, the proposed regulatory

structure should provide for the registration and oversight of clearing agencies
for government related securities.


Federal Reserve Bank of St. Louis

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-

Scope of Regulation

The proposed new system would regulate the market for forward transactions In GNMAs and FHLMCs, the class of government related securities with
the most active forward trading and the area where abuses have been most

evident in the past.

In order to allow the regulatory system to respond to

changes in trading practices, the oversight Council should be authorized to

specify the transactions which will be considered forward transactions subject to regulation.

Because of the interrelationships between forward transactions and
cash transactions, it might be necessary, in order to regulate the forward

market effectively, to extend regulation to cover transactions in the cash

market by dealers who are active in the forward market.

The Board should be

given authority to extend its rules to transactions in the cash market in such
cases, but only if the oversight Council unanimously approves such an extension

after finding that the extension to the cash market is necessary or appropriate
for effective regulation of the forward market.

In order to allow the regulatory system to address new problems
old problems in new areas

—without

— or

the need for new legislation, the oversight

Council should be authorized to bring additional types of government related
securities within the system of regulation.

9^/

(GNMAs and FHLMCs and any other

government related securities that are brought within the system are hereafter

V

Government related securities would not include securities issued directly
by the Treasury.


Federal Reserve Bank of St. Louis

223

referred to as "designated securities.")

Any extension of regulation to cover

trading in additional government related securities should be made only on the

unanimous vote of the Council.

In addition, agencies whose activities would

be affected by any proposed extension of regulation should be consulted by the

Council prior to approval of any extension of regulation. 10/

The regulatory system should require all currently unregistered
securities dealers that trade in designated securities to register with the
Council.

This function, initially, would be delegated to the SEC.

Because

banks currently act as dealers in these securities (as they do in municipal

securities), the system should apply to bank, as well as nonbank, dealers.
11 /

In order to avoid undue regulatory burdens for already registered bank

dealers, any registration requirements for banks should be designed to permit

them to fit together with those for municipal securities dealers, which permit registration of the whole bank, or a separately identifiable department
or division of the bank, at the bank's option. 12/

10 /

As is the case with issuers of municipal securities, issuers or guarantors
of government related securities would not be subject to regulation under
the proposed system, although regulation of such entities by other governmental bodies could continue. For example, GNMA could continue to set
requirements for the business and operations of Issuers of securities
guaranteed by GNMA.

11 /

As in the case of municipal securities, banks that limit their activities
with respect to designated securities to agency transactions would not be
required to register. Dealers already subject to regulation because of
their nonexempted securities activities would be deemed to be registered
and subject to the new requirements applicable to their government-related
securities activities.

12^/

See Sections 3(a)(30) and 15B(b)(2)(H) of the 1934 Act. Accordingly, for
banks able to conduct both their municipal and their government related
securities business in one department, as is commonly the case, that
department, rather than the entire bank, would be subject to dealer
registration.


Federal Reserve Bank of St. Louis

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Rulemaking Responsibilities
The Board should have primary rulemaking authority over dealers in

designated securities.

It should not be a voluntary membership entity; all

such dealers should be subject to its rules.

In order to increase industry

involvement in the organization and to facilitate use of "businessman's
judgment" in developing standards, 13 / the Board should be composed primarily
of representatives of bank and nonbank dealers.

The Board should be given both specific and general rulemaking power.
One area of specific rulemaking authority which the study participants believe
is essential is the formulation and imposition of margin requirements for

transactions in designated securities. 14/

This rulemaking authority, like

other rulemaking authority of the Board, would be subject to approval by the
Council.

In order to permit prompt governmental response to serious specula-

tive problems in the market, the Council should be given emergency power to

impose or change margin requirements on an expedited basis.

13 /

See., e.g.. Report of the Sen. Comm. on Banking, Housing, and Urban Affairs
to Accompany S. 249, S. Rep. No. 94-75, 94th Cong., 1st Sess., 46-47 (1975).
It would also be important to include representatives of persons not associated with the securities industry.
So long as the major part of the Board's
activities involve regulation of markets for mortgage-backed securities,
including a mortgage banker on the Board would also be appropriate.

14/

We do not anticipate that the initial margin requirements for forward contracts would even approach the 50% range of the margin requirements for
present purchases of stock.
Indeed, they might be as small as a few percent. However, the study participants believe the Board should consult
with the Federal Reserve Board to ensure that it concurs in any changes
in margin requirements.
In any event, we recommend that the Federal
Reserve Board be given the power to set its own margin requirements, which,
if exercised, would supersede the Board's or other applicable margin
requirements.


Federal Reserve Bank of St. Louis

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225

The Board should also be given rulemaking authority with respect to
fair practice standards (including rules pertaining to prevention of fraudulent and manipulative acts and practices and to suitability, supervision, and

customer confirmation requirements), professional qualification and competency
requirements, recordkeeping, financial responsibility and uniform practice
requirements. 15 /

To increase regulatory efficiency and prevent unnecessary

costs or burdens on securities professionals, the Board's statutory mandate

should also specify that, to the extent feasible, certain of the Board's
rules should be similar to those already applicable to brokers, dealers, and

municipal securities dealers.

For example, the Board's recordkeeping rules

could be coordinated with other applicable recordkeeping requirements in
order to avoid burdensome or duplicative requirements for dealers that do

business in government related and other types of securities.
The Board would exercise its rulemaking authority subject to the

oversight of the Council, which would evaluate Board rules. 16 /

In addition

to its authority to approve or disapprove Board rules, the Council should be

given the power to abrogate, add to, or delete from the rules of the Board.
The Council should be required to consult with GNMA and FHLMC and other

agencies when markets for securities which those agencies issue or guarantee

15/

In addition, the Board should be required to establish fair procedures
concerning the election of members, and to adopt rules providiiig for
the administration of the Board and for a fee structure applicable to
government related securities professionals.

16 /

Meaningful governmental oversight over an SRO's activities would appear
to be necessary and sufficient to justify antitrust immunity for the
SRO.
See Gordon v. New York Stock Exchange, Inc ., 422 U.S. 659, 685
(1975); United States v. National Association of Securities Dealers,
Inc ., 422 U.S. 694 (1975); Silver v. New York Stock Exchange, Inc. , 373
U.S. 341 (1963).


Federal Reserve Bank of St. Louis

226

might be affected by any proposed rule, before taking final action with
respect to such rule.
The Council should also be given authority under certain provisions
of the 1934 Act to make rules governing dealers trading in designated securities.

This authority should include control over the dealer registration

process and authority to make rules governing registration of dealers;

recordkeeping; and financial responsibility.

This authority should include

broad emergency powers to ensure that the Council could deal swiftly and

effectively with sudden developments.

It is expected that the Council,

in

its rulemaking activity, will rely heavily on the expertise of the SEC and

other agencies and, in appropriate circumstances, may delegate its rulemaking
In addition, the Council should be required to take into account

authority.

the needs of the SEC in carrying out its enforcement responsibilities.

Other entities might also be given specific types of rulemaking

authority with respect to dealers in government related securities.

The

SEC will retain general antifraud rulemaking authority it presently exercises

over exempt securities.

The SEC also would retain its present rulemaking

powers with respect to Integrated securities firms which trade both government
related securities and corporate and/or municipal securities.

The bank regu-

latory agencies should also retain their existing authority under banking laws
to make rules governing the government related securities activities of banks

in the areas of recordkeeping, reporting, financial responsibility and safe

and sound banking practices.


Federal Reserve Bank of St. Louis

The Federal Reserve Board would be given resi-

227

-

dual margin rulemaking authority with respect to designated government related

securities.

Nonbank dealers should also be required to become members and

subject to the requirements of the Securities Investor Protection Corporation
("SIPC").

Because SIPC's fund Is now at the statutorily required level of

$150 million, SIPC has reduced assessments on members to a flat fee of $25
per year.

The study participants believe that, in fairness to those broker-

dealers whose payments to SIPC have built up the SIPC fund, the new class of

dealers required to join SIPC should be required to pay a higher fee for a
period of time.

SIPC has suggested that a fee of 1/4% of gross revenues for

While SIPC's existing statutory authority

three years would be appropriate.

would permit imposing a separate assessment on the new class of members, both
SIPC and the study participants believe that Congressional direction to SIPC
»

to Impose siich a fee would be appropriate.

Uniform Practice Rules and Clearing
In addition to providing the Board authority to establish uniform

practices and standard requirements for dealers' activities in clearing,
processing, and settling transactions, the statutory provisions should

provide for registration and rulemaking oversight by the Council of one
or more clearing agencies for government related securities.

The Council

should be given authority to delegate its responsibilities over clearing

agencies, and because of the SEC's expertise in this area we believe that
this should be given to the SEC.

The formation of, and participation in,

such clearing agencies should be voluntary; as noted previously in this


Federal Reserve Bank of St. Louis

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228

-

Report, at least one such agency Is already processing transactions In GNMA

(Clearing agencies not only can facilitate the clearance and

forwards.

settlement processes but can also assist dealers and other market partlcipiants in complying with margin requirements.

recordkeeping and monitoring functions.)

They might also perform

The rules of clearing agencies for

government related securities, like those of other clearing agencies, should
be subject to approval by the appropriate oversight agency (either the Council
or an agency to which the Council has delegated its authority), which agency

should also be able to abrogate, add to, or delete from the rules of the clearing agency.

To allow reasonable freedom of action for such clearing agencies,

the Board's uniform practice rules should be required,

to the extent feasible,

to foster cooperation and coordination with entities engaged in clearing,

settling and facilitating transactions in government related securities •r

Inspection and Enforcement
Inspection and enforcement authority for dealers In designated securities should be allocated in the same fashion as for municipal securities pro-

fessionals, with additional responsibilities given to national securities
exchanges.

Under such an allocation, the NASD and the exchanges, the federal

bank regulatory agencies, and the SEC would conduct compliance examinations
and institute enforcement actions.

Such a division of responsibilities would

minimize costs, avoid unnecessary additional compliance burdens, and utilize
existing examination procedures, examination cycles and training programs.

further advantage of this arrangement would be that, for many dealers, regulation of their government related securities activities could be achieved


Federal Reserve Bank of St. Louis

A

229

-

with a minimum of disruption to their business operations that might otherwise result from additional and separate examinations.
As is the case for municipal securities professionals, the SEC

should be given authority to inspect and institute enforcement proceedings
for both bank and non-bank dealers in order to assure a comprehensive system
of regulation.

In addition to the type of notification and consultation

requirements applicable to SEC enforcement actions Involving banks dealing
in municipal securities, the SEC should be required to consult with the

Council before bringing enforcement proceedings against government related
securities dealers for violations of the rules of the Board or the Council.
The Council should be responsible for oversight of the Board to

ensure that it is carrying out its statutory responsibilities.

Clearing

agencies for government related securities should be made subject to the
same system of compliance and enforcement currently existing for clearing

agencies registered with the SEC.
In view of the foregoing recommendations the study participants

have drafted proposed legislation to establish a framework for supervised

self-regulation in the markets for forward trading of federally guaranteed
mortgage-backed securities.

Appendix B to the Chapter.


Federal Reserve Bank of St. Louis

This legislative proposal is set forth as

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230

-

APPENDIX A

DISCUSSION OF LOSSES AND COSTS OF REGULATION

This appendix contains a discussion of the losses Incurred in the
reviewed In Chapter IV and various other estimates of losses Incurred
cases
primarily In the market for GNMA securities. It should be noted that while
abusive trading practices were present In each case, no estimate is made of
At
the portion of the losses attributable solely to the abusive practices.
the same time that these investors were suffering losses, other investors
who had made Investments in fixed Income securities which could be considered
prudent at the time may also have suffered losses because of unusually large
fluctuations in interest rates.

The discussion of potential costs of regulation is an attempt to
present the Information that is available.
It is not to be taken as a comprehensive estimate of the total cost of any proposed regulatory system.
Many of the cost figures cited are simply rough estimates and should not
be viewed as reliable indications of the cost of any proposed regulatory
system.

Losses
To the extent they can be estimated, the aggregate monetary losses
for the cases reviewed in the Appendix to Chapter IV amount to between $85
and $111 million. Loss estimates for the 16 SEC proceedings total between
$45 and $59 million.
The estimates for the 12 pending SEC investigations
total between $A1 and $53 million.

In the cases summarized In the Appendix to Chapter IV, losses to
broker-dealers amounted to approximately $15 to $17 million IJ and losses
to investors (Including banks, credit unions, and individuals) amounted to
approximately $70 to $94 million. 2/ While these losses were primarily
Incurred by the immediate parties to the transactions, the overcommitments
and defaults by Investors and dealers at times also affected the financial
position of remote investors and dealers. In what might be called secondary
For example, in one case, it appears that defaults by
or indirect effects.
customers of one dealer led to the dealer's involvency and inability to
In another case, dealer overfulfill its commitments to other dealers.
commitments and misuse of customer funds led to substantial losses to the

1/

2J

Of this range, $3 million has been reimbursed by the mortgage banker
involved in one of the transactions
Of this range, $2.8 million has been reimbursed by the registered brokerdealers Involved in 4 of the cases, and $8.6 million has been reimbursed
in one other case through joint action by a mortgage banker and an interested governmental agency.


Federal Reserve Bank of St. Louis

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-

dealer's customers and other broker-dealers. This case also resulted in the
bankruptcy of the dealer's registered affiliate, as well as the dealer's own
bankruptcy.
3/

Total losses exceed the amounts involved
noted in Chapter IV, four instances of substantial
GNMA mortgage backed securities have been reported
the beginning of 1980.
Overextended positions and
appear to have been contributing factors in all of
mated losses in these cases have not been included
losses in this Appendix or in Chapter IV. 4/

in these SEC cases.
As
losses by investors in
in the news media since

improper trading practices
these losses. The estiin the tabulations of

Moreover, other information points to additional instances of
problems and abuses.
For example, the National Credit Union Administration
("NCUA") estimates that, at year end 1978, credit unions had unrealized
losses of over $200 million on over $700 million of what the NCUA has
termed "speculative" purchases primarily of GNMA's, although a few other
types of government related securities were also involved.
These purchases
consisted of well over $200 million of forward commitments and also of purchases of GNMA's which were being financed under reverse repurchase agreements. The NCUA has also indicated that the possible insolvency and liquidation of 12 credit unions due to losses primarily in GNMA mortgage-backed
securities transactions was averted as a result of $8 million in loans made
by NCUA.
All of the transactions involved in these instances were entered
into prior to the adoption of new rules by NCUA designed to limit speculative trading by credit unions.

Other federal agencies also have reported significant losses by
The Comptroller of the
the entities under their regulatory jurisdiction.
Currency reported that, by the beginning of 1980, its bank examiners had
discovered approximately 40 cases of trading abuses and unsuitable speculative investment practices by national banks, though no cumulative cost
Other bank regulatory agencies also noted cases
estimate was available.
of abusive practices, mainly in the form of unsuitable speculation by banks
Likewise, the
in GNMA forward contracts, discovered by their examiners.
Federal Home Loan Bank Board has indicated that perhaps about 100 of its
institutions had experienced problem situations due to overcojnmitments or
improper accounting procedures with respect to government related securities.

Beyond these monetary losses, abuses in the trading of government
related securities may also impose other economic costs on the society in
general and on the markets for these securities in particular.
If the

TJ

The registered affiliate went bankrupt because of its guarantee of certain
of the unregistered dealer's transactions, not because of trading practices
on the part of the registered affiliate.

4/

See page 89, supra.


Federal Reserve Bank of St. Louis

232

integrity of the markets for these securities becomes questionable because
of the practices of certain participants in the market, investor confidence
and dealers' willingness to participate in these markets will be reduced.
If investors and dealers were to avoid these markets, thereby reducing demand
and trading activity, market interest rates on government related securities
In the case of mortgage-backed securities, such a move by inveswould rise.
Indeed GNMA
tors could result in an increased cost of mortgage origination.
administer government related securiand some other government agencies that
ties programs, or contemplate initiating such programs, are concerned that
continued abuses in the trading of their, or other, government related securities might seriously impair market acceptance of their securities.

Costs of Regulation

A wide variety of possible regulatory systems might be employed
The measurable costs of these possible
to implement regulatory measures.
regulatory systems are impossible to estimate accurately, but some impression
can be gained of relative magnitude by reviewing the costs involved in the
recently imposed regulation of the municipal securities market.
Intangible
costs, such as the possibility of increased dealer spreads and a reduction
in market liquidity, are even more difficult to measure, and no effort has
been made to quantify estimates of such costs.
Some data have been collected and seem appropriate for examination.
Government related securities, like municipal securities prior to the enactment
of the 1975 Amendments, generally are subject only to the anti-fraud provisions
of the federal securities laws.
Moreover, the regulations imposed on municipal
securities dealers involved nearly the full range of measures (except for initial and maintenance margins) that might be adopted if a comprehensive system
of regulation were selected for GNMA and FHLMC mortgage backed securities. 5/
In examining the costs arising from establishment of a regulatory
system for the municipal securities markets, it is helpful, but not conclusive,
to consider two main categories: administrative agency costs and dealer costs.

Administrative Agency Costs
The MSRB, the rulemaking body for municipal transactions, in fiscal
year 1976 (the first full year of its existence), had expenses of $704,584

bj

Costs would depend to some degree on the extent to which various
sectors of the government related securities markets were brought under
regulation.


Federal Reserve Bank of St. Louis

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233

-

reflecting expenditures for salaries, meetings, travel, etc.
In fiscal year
1979, MSRB expenses were $866,323, a small increase over the start-up year. 6/
The NASD, in its role as inspection and enforcement agency for its
member firms with respect to MSRB rules, expanded its existing programs and
initiated others to deal with its new responsibilities in the municipal securities area. As a result of the 1975 Amendments, the NASD added 46 examiners
to its nationwide field staff at a cost of approximately $600,000 in order to
provide additional regulatory coverage for the approximately 650 existing municipal securities firms which were then NASD members and over 200 municipal
securities firms subsequently admitted to membership in the NASD. Each muniThis inspeccipal securities firm member is inspected annually by the NASD.
Ij
Allocation of the
tion encompasses all aspects of the dealer's business.
$600,000 among the more than 200 new firms results in a per-finn figure in the
This is roughly comparable to the NASD's overall per-firm
range of $3,000.
inspection costs. For calendar year 1978 (the latest figures available), the
NASD spent approximately $10.6 million for on-site inspection and review of
its 2,813 members, 8/ or about $3,800 per member. 9/

6/

The MSRB obtains its funds from municipal securities brokers and dealers.
Most of its revenues are generated by an underwriting assessment which in
the MSRB' 8 first year was five cents per $1,000 of the par value of all
new issue municipal securities (other than short-term notes) purchased by
or through these firms.
By late 1977, the underwriting fee was reduced to
one cent per $1,000 because the prior assessment produced a surplus. We
understand that the MSRB intends to raise this fee to two cents per $1,000
when that surplus is exhausted. In addition, each municipal securities
broker municipal securities dealer that registers with the SEC is required
to pay to the MSRB an initial fee of $100 and an annual fee of $100.

7/

There are approximately 646 municipal securities firms that are members of
the NASD and are also members of exchanges, and for certain exchange member
firms the exchanges have usually been designated to perform the financial
inspections, while the NASD continues its routine inspections of their operations.

8/

9_/

On the revenue side, 44 percent of NASD's revenues ($8.8 million) for fiscal
year 1979 came from assessments on member firms: $300 per year/per firm, $5
per person, and an assessment on gross income from nonmunicipal securities
transactions equaling .25 percent and .21 percent for municipal securities
income.
In addition, NASD charges an initial membership fee of $500 per firm.
These fees support the NASD's activities with respect to both corporate and
municipal securities.
It may be noted that over half of NASD firms have no
municipal business; and of the approximately 1,250 firms that do transact
some municipal business, a large number do relatively little continuing municipal business.

Little additional expense was incurred by the SEC as a result of regulation
in the municipal securities area, primarily because of its role in this area
is limited principally to oversight of MSRB and NASD activities and to enforcement activities, some of which have been carried out under the antifraud
rules with or without additonal regulation in this market sector.


Federal Reserve Bank of St. Louis

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234

Of the 333 banks that registered with the SEC as municipal securities dealers, 229 are national banks inspected by the Comptroller of the
Currency; 49 are state banks in the Federal Reserve System inspected by that
agency; and 55 are state nonmember banks inspected by the FDIC.
These bank
regulators have experienced some additional costs because of the extra training of inspectors and the extension of bank inspections to check compliance
with MSRB requirements. 10/ However, most inspections of municipal securities

activities can coincide with regular bank inspections.

Dealer Costs

From the viewpoint of individual dealers, the MSRB and NASD fees and
survey completed in May 1978 by the MSRB suggested that municipal securities
dealers (both bank and nonbank dealers) expended, on the average, approximately $33,000 per firm in start-up costs, although the data from this survey
do not appear to be complete or definitive. 11/ The best judgment as to the
allocation of this expense was that it represented primarily (1) the salary
of a "compliance officer," or someone who took the time to learn about the new
MSRB rules in order to ensure that the firm was in compliance; and (2) changes
in recordkeeping in order to conform to the new MSRB requirements.
Of course,
some firms had very few changes to make in their compliance procedures or
recordkeeping while others needed, or desired, to institute new systems.
It is not entirely clear whether the estimates of dealer costs provided by the MSRB provide a full indication of all the costs that typical
dealers in municipal securities incurred in connection with municipal securities regulation or whether the municipal experience can be assumed to be fully
representative of the costs that would be involved in regulating trading in
government related securities. Based on recent informal conversations by
officials of PSA with a few large municipal securities dealers, it appears
that some of the largest individual dealers incurred start-up costs that substantially exceeded the average reported alone.

10/

The FDIC estimates that in 1979 its added costs for municipal inspections
totalled $22,000, an average of $400 per firm. However, this per firm
average cost may be the lowest average cost for the three bank regulatory
agencies, since the municipal securities dealer-banks under the FDIC's
jurisdiction are among the smallest of the dealer-banks.
Also, attempting
to extrapolate average inspection costs from the municipal market to the
market for GNMA and FHLMC securities may be difficult because the average
size of GNMA and FHLMC dealers is believed to be larger than the average
size of dealer-banks in the municipal market.

11/

The MSRB received responses from only about 1/3 of the firms to which it
sent questionnaires.
It is impossible to determine whether the firms that
replied to the survey had a disproportionately higher or lower cost than
those that did not respond.


Federal Reserve Bank of St. Louis

235

No comparable survey data on continuing annual dealer costs are availMSRB and NASD officials believe that continuing annual dealer costs are
comparable to, or smaller than, the start-up costs.
In our interviews, these
officials pointed to recordkeeping requirements and the cost of a compliance
officer as constituting the main ongoing costs. They emphasized that, in their
opinion, the "fair practice" rules of the MSRB are sound business principles and
should not impose substantial new costs on firms.
Officials of both the MSRB
and the NASD also stressed that the new scheme for municipal securities regulation has resulted in certain cost savings to broker-dealers.
For example,
standardized settlement and clearance procedures for municipal transactions have
increased efficiency and certainty in the market place and have decreased the
number of disputes. When disputes do arise, arbitration procedures can help to
reduce court costs and delays.
able.

In reviewing the above discussion of costs associated with regulation
of the municipal securities market, it should be noted that three factors may
tend to lessen the cost of regulation of government related securities relative
First, there are currently only about 60 to
to that for municipal securities.
80 firms (including approximately 25 banks) actively dealing in GNMA and FHLMC
mortgage-backed securities. By contrast, within a year after the enactment of
the 1975 Amendments, approximately 310 bank municipal securities dealers and
Second, of these
232 broker-dealers were required to register with the SEC.
For these firms,
60 to 80 firms, some are already registered with the SEC.
any additional regulatory requirements should not be extensive since their
recordkeeping and compliance procedures are already in place. Third, inspections are already being conducted by bank regulators or the NASD with respect
to all the bank dealers and some of the non-bank dealers in government related
securities because of these dealers' activities in the corporate or municipal
securities markets. Most of the regulators interviewed for this study believed
that the changes needed to expand inspections to include the government securities activities of these dealers would not be extensive.

On the other hand, one factor might tend to increase the per-firm
of regulation.
costs
It seems a certainty that, if regulation is to be extended
trading in GNMA and FHLMC mortgage-backed securities, inito delayed-delivery
tial and maintenance margin requirements, which do not exist in the regulatory
system for municipal securities, will be imposed and the costs of enforcing and
complying with these regulations could be significant. The additional capital
required of dealers, investors, and mortgage bankers because of initial and
maintenance margin requirements will also be an additional cost to the market.
Further, aside from any regulatory costs imposed on the firms subjected to
regulation, there are also potential indirect costs to the markets in the form
In particular, if some of the less active
of regulatory barriers to entry.
dealers were to find the added costs of regulation too burdensome, they might
decide to cease doing business in that market, conceivably reducing the competitive performance of the market. The added costs to the market arising from
regulation might also cause a shift of activity from the regulated market to
unregulated areas.


Federal Reserve Bank of St. Louis

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236

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APPENDIX B
GOVERNMENT RELATED SECURITIES ACT OF 1980

To provide greater protection for investors in government-related securities, and for other purposes.

Be it enacted by the Senate and House of
Representatives of the United States of America in Congress
assembled
TITLE I

—

SECTION

1.

Short Title and Relationship to Securities
Exchange Act of 1934
.

(a) This Act may be cited as the "Government-Related
Securities Act of 1980."
(b) Except as otherwise provided in the GovernmentRelated Securities Act of 1980, the provisions of the
Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.
apply as if all provisions of this Act constituted an
amendment to, and were included as a section of, such Act.

SECTION

2.

Necessity for Regulation

.

Transactions in government-related securities, as
commonly conducted, are affected with a national public
interest which makes it necessary to provide for control of
such transactions and of matters and practices related
thereto, to require appropriate reports, to remove
impediments to and perfect a national system for the
clearance and settlement of government-related securities
transactions and to impose requirements necessary to make
such regulation effective, in order to protect investors,
the national credit, the national banking system, and to
ensure the maintenance' of fair and honest markets in such
securities
SECTION

3.

Definitions and Application

.

(a) When used in the Government-Related Securities Act
of 1980, unless the context otherwise requires

—

(1) The term "1980 Act" means the provisions of the
Government-Related Securities Act of 1980.

(2) The term "government-related securities" means
those securities designated in accordance with section 3(b)
of the 1980 Act.


Federal Reserve Bank of St. Louis

237

(3) The terms "government-related securities broker"
and "government-related securities dealer" have the same
meaning as those terms have in the Securities Exchange Act
of 1934.

(4) The term "government-related securities clearing
agency" means a clearing agency (as that term is defined in
section 3(a) (23) of the Securities Exchange Act of 1934)
that functions as such in connection with transactions in
government-related securities.
(5)

The term "appropriate regulatory agency"

—

(A) when used with respect to the Federal MortgageBacked Securities Rulemaking Board, means the GovernmentRelated Securities Oversight Council;
(B) when used with respect to all other persons, is
defined in section 3(a) (34) of the Securities Exchange Act
of 1934.
(6) The term "interested agency" means any governmental
issuer or guarantor of government-related securities or
securities proposed to be designated as government-related
securities that notifies the Government-Related Securities
Oversight Council and the Federal Mortgage-Backed Securities
Rulemaking Board that such issuer or guarantor requests to
be consulted in accordance with the requirements of this
title.

(b)(1) Mortgage-backed securities guaranteed by the
Government National Mortgage Association and mortgage-backed
securities that are issued or guaranteed by the Federal Home
Loan Mortgage Corporation are hereby designated as
government-related securities:
Provided, however, That
transactions other than forward transactions in such
securities shall not be regulated under, nor subject to the
provisions of, sections 5, 7, 8, 9(b) and 10 of the 1980 Act
or section 7 of the Securities Exchange Act of 1934, and
shall be deemed to be transactions in "exempted securities"
for purposes of this title, notwithstanding the provisions
of Section 3(a) (12) of the Securities Exchange Act of 1934
under which government-related securities are deemed not to
be exempted securities for purposes of that Act, unless the
Government-Related Securities Oversight Council (hereinafter
in 1980 Act referred to as the "Council"), by rule,
determines that regulation of such transactions is necessary
or appropriate in the public interest, for the protection of
investors, or for the orderly regulation of forward
transactions. Any rule adopted under this subsection shall
require approval by all members of the Council.


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(2) As it deems necessary or appropriate in the public
interest or for the protection of investors, the Council,
with the approval of all of its members, may by rule
designate as government-related securities additional
obligations of, or obligations guaranteed as to principal or
interest by, any agency, corporation, or instrumentality of
the United States or in which the United States has a direct
or indirect interest, except that the Council shall have no
authority to designate as government-related securities any
securities issued by the United States Department of the
Treasury.
(3) The Council, by rule, shall define the term
"forward transactions."

(c) The authority of the Federal Mortgage-Backed
Securities Rulemaking Board to regulate transactions in
securities guaranteed by the Government National Mortgage
Association and issued or guaranteed by the Federal Home
Loan Mortgage Corporation shall be limited to forward
transactions, as that term is defined by the Council;
Provided, however. That to the extent necessary or
appropriate for the orderly regulation of forward transactions, such regulation, with the unanimous approval of the
Council, may be extended to other transactions in such
government-related securities effected by brokers, dealers,
and public securities dealers which engage in forward
transactions in the same securities:
Provided, however.
That nothing in this subsection shall limit the authority of
the Council to extend the scope of the authority of the
Federal Mortgage-Backed Securities Rulemaking Board under
the procedures set forth in subsection (b).
(d) No provision of this title shall apply to, or be
deemed to include, any agency, corporation, or instrumentality of the United States or in which the United States has
a direct or indirect interest, or any officer, agent, or
employee of any such agency, corporation, or instrumentality
acting in the course of his official duty as such, unless
such provision makes specific reference to such agency,
corporation or instrumentality, or to an "interested agency"
as defined in Section 3(a)(6) of the 1980 Act.


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SECTION

4.

Government-Related Securities
Oversight Council.

(a) There is hereby established a Government-Related
Securities Oversight Council to be composed of the Secretary
of the Treasury or his designee, the Chairman of the Board
of Governors of the Federal Reserve System or his designee,
and the Chairman of the Securities and Exchange Commission
The members of the Council shall choose a
or his designee.
chairman from among themselves.

(b) The Council shall have no separate staff, but shall
utilize such personnel of, and consultants to, the
Department of the Treasury, the Board of Governors of the
Federal Reserve System, and the Securities and Exchange
Commission as are assigned to the Council by such agencies.
(c) Except for the functions performed in subsections
3(b) and 3(c) of the 1980 Act, the Council shall have the
authority to delegate, by published order or rule, any of
its functions to the Department of the Treasury, the Board
of Governors of the Federal Reserve System, the Securities
and Exchange Commission, any employee of any such agency
assigned to the Council, or to an individual member of the
Council or his designee, including functions with respect to

hearing, determining, ordering, certifying, reporting,
rulemaking, or otherwise acting as to any work, business, or
Provided, however. That nothing herein contained
matter:
shall be deemed to supersede the provisions of section 7(a)
of the Administrative Procedure Act of 1946 (5 U.S.C. 556).
The Council may, in its discretion, by published order or
rule, withdraw delegated authority or any portion thereof,
including authority delegated pursuant to subsection (d) of
this section.
(d) With respect to the provisions in sections 5 and 8
of the 1980 Act applicable to brokers, dealers, and public
securities dealers, and the provisions in sections 7, 8, and
9 of the 1980 Act applicable to clearing agencies, the
Council is directed, within thirty days of the enactment of
the 1980 Act, to delegate its authority to the Securities
and Exchange Commission.
(e) With respect to the delegation of any of its
functions other than rulemaking, the Council shall retain a
discretionary right to review the action of any person,
office, division, or agency, upon its own initiative or upon


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petition of any aggrieved person in such action, within such
time and in such manner as the Council by rule, shall
Provided, however. That the vote of one member
prescribe:
of the Council shall be sufficient to bring any such action
before the Council for review.
SECTION

5.

Registration of Government-Related
Securities Brokers and GovernmentRelated Securities Dealers
.

(a)(1) It shall be unlawful for any government-related
securities broker or government-related securities dealer
(other than a broker, dealer, or public securities dealer
registered as such with the Securities and Exchange
Commission) to make use of the mails or any means or
instrumentality of interstate commerce to effect any
transaction in, or to induce or attempt to induce the
purchase or sale of, any government-related security unless
such government-related securities broker or governmentrelated securities dealer is registered in accordance with
subsection (b) of this section.
(2) Any provision of the 1980 Act (other than
subsection (a)(1) of this section) which prohibits any act,
practice, or course of business if the mails or any means or
instrumentality of interstate commerce is used in connection
therewith shall also prohibit any such act, practice, or
course of business by any broker, dealer, or public
securities dealer registered pursuant to this section or
section 15 of the Securities Exchange Act of 1934, or any
person acting on behalf of such broker, dealer, or public
securities dealer, irrespective of any use of the mails or
any means or instrumentality of interstate commerce in
connection therewith.
(3) The Council, by rule or order, upon its own motion
or upon application, may conditionally or unconditionally
exempt any broker, dealer, or public securities dealer or
class of brokers, dealers, or public securities dealers from
any provision of this section or any rule of the Federal
Mortgage-Backed Securities Rulemaking Board if the Council
deems such exemption consistent with the public interest,
the protection of investors, and the purposes of this
title.


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-

(b)(1) A government-related securities broker or
government-related securities dealer may be registered by
filing with the Council an application for registration in
such form and containing such information and documents
concerning such government-related securities broker or
government-related securities dealer and any persons
associated with such government-related securities broker or
government-related securities dealer as the Council
by
rule, may prescribe as necessary or appropriate in the
public interest or for the protection of investors. Within
forty-five days of the date of the filing of such
application (or v/ithin such longer period as to which the
applicant consents), the Council shall
,

—

(A)

by order grant registration, or

(B) institute proceedings to determine whether
Such proceedings shall
registration should be denied.
include notice of the grounds for denial under
consideration and opportunity for hearing and shall be
concluded within one hundred twenty days of the date of
At the
the filing of the application for registration.
conclusion of such proceedings, the Council, by order,
The Council may
shall grant or deny such registration.
extend the time for conclusion of such proceedings for
up to ninety days if it finds good cause for such
extension and publishes its reasons for so finding or
for such longer period as to which the applicant
consents.

The Council shall grant such registration if the Council
finds that the requirements of this section are satisfied.
The Council shall deny such registration if it does not make
such a finding or if it finds that if the applicant were so
registered, its registration would be subject to suspension
or revocation under paragraph (4) of subsection 15(b) of the
Securities Exchange Act of 1934.
An application for registration of a governmentrelated securities broker or government-related securities
dealer to be formed or organized may be made by a governmentrelated securities broker or government-related securities
dealer to which the government-related securities broker
or government-related securities dealer to be formed or
Such application, in such
organized is to be the successor.
form as the Council, by rule, may prescribe, shall contain
such information and documents concerning the applicant, the
(2)


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successor, and any persons associated with the applicant or
successor, as the Council, by rule, may prescribe as
necessary or appropriate in the public interest or for the
protection of investors. The grant or denial of registration to such an applicant shall be in accordance with the
procedures set forth in paragraph (1) of this subsection. If
the Council grants such registration, the registration shall
terminate on the forty-fifth day after the effective date
thereof, unless prior thereto the successor shall,
in accordance with such rules and regulations as the Council
may prescribe, adopt the application for registration as its
own.
Any registered government-related securities broker or
government-related securities dealer may, upon such terms
and conditions as the Council deems necessary or appropriate
in the public interest or for the protection of investors,
withdraw from registration by filing a written notice of
withdrawal with the Council.
If the Council finds that any
registered government-related securities broker or governmentrelated securities dealer is no longer in existence or has
ceased to do business as a government- related securities
broker or government-related securities dealer, the Council,
by order, shall cancel the registration of such governmentrelated securities broker or government-related securities
dealer.

SECTION

6.

Federal Mortgage-Backed Securities
Rulemaking Board
.

(a)(1) Not later than one hundred twenty days after the
date of enactment of the 1980 Act, the Council shall
establish a Federal Mortgage-Backed Securities Rulemaking
Board (hereinafter in the 1980 Act referred to as the
"FMSRB").
(A) The FMSRB shall be composed initially of seven
members appointed by the Council, after consultation with
the Securities and Exchange Commission, the Comptroller of
the Currency, the Board of Governors of the Federal Reserve
System, the Board of Directors of the Federal Deposit
Insurance Corporation, the National Credit Union Administration Board, the Federal Home Loan Bank Board, the Government
National Mortgage Association, and the Federal Home Loan
Mortgage Corporation, and shall perform the duties set forth
in this section.
The initial members of the FMSRB shall
serve as members for a term of two years, and shall


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consist of at least two individuals who are not associated
with the government-related securities industry (at least
one of whom is representative of investors in governmentrelated securities) and at least four individuals who are
associated with and representative of government-related
securities brokers and bank and non-bank government-related
securities dealers.
(B) The Council, by rule, may as it deems appropriate
increase the number of members of the FMSRB and specify the
nature of their affiliations, in order to assure fair
representation of government-related securities brokers and
government-related securities dealers who trade in newly
designated government-related securities, as well as persons
(including investors) interested in such newly designated
government-related securities. The Council, by rule, may as
it deems appropriate rename the FMSRB to reflect newly
designated government-related securities.

(C) Prior to the expiration of the terms of office of
the initial members of the FMSRB, an election shall be held
under rules adopted by the FMSRB (pursuant to subsection
(a)(2)(C) of this section) of the members to succeed such
initial members.
(2) The FMSRB shall propose and adopt rules to effect
purposes of the 1980 Act with respect to transactions in
the
government-related securities effected by brokers,
dealers, and public securities dealers. (Such rules are
hereinafter collectively referred to in this section as
"rules of the FMSRB.") The rules of the FMSRB, as a
minimum, shall:

(A) as the FMSRB deems necessary or appropriate in
order to preserve the financial integrity of the
markets for government-related securities, regulate the
amount of deposit that may be initially required and
subsequently maintained in connection with the
purchase, sale, or carrying of any government-related
Such rules and regulations may make
security.
appropriate provision with respect to the type of
deposit or collateral which may be furnished; the
carrying of undermargined accounts for limited periods
and under specified conditions; the withdrawal of funds
or securities; the substitution or additional purchase
of securities; the transfer of accounts from one lender


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to another; special or different nargin requirements
for delayed deliveries, short sales, and arbitrage
transactions; the bases and methods to be used in
calculating loans, and margins and market prices; and
similar administrative adjustments and details.
In
developing any such requirements the FMSRB shall
consult with the Board of Governors of the Federal
Reserve System with respect to the impact and
appropriateness of any proposed requirements.
(B) if the FMSRB deems it appropriate, with respect
to the rules adopted pursuant to this section 6,
classify securities, types of securities transactions,
persons, applications, reports, and other matters, and
prescribe greater, lesser, or different standards with
respect to such different classes.
(C) establish fair procedures for the nomination
and election of members of the FMSRB and assure fair
representation in such nominations and elections of
government-related securities brokers and government-related securities dealers.
Such rules shall
provide that the membership of the FMSRB shall at all
times be apportioned in the manner set forth in
subsection (a)(1) and any rule thereunder, and that the
public representatives shall be subject to approval by
the Council to assure that no one of them is associated
with the government-related securities industry, and
that at least one is representative of investors in
government-related securities.
Such rules shall also
specify the term members shall serve.
(D) provide for the operation and administration of
the FMSRB, including the selection of a Chairman from
among the members of the FMSRB, the compensation of the
members of the FMSRB, and the appointment and
compensation of such employees, attorneys, and
consultants as may be necessary or appropriate to carry
out the FMSRB's functions under this section.

(E) provide that each government-related securities
broker and each government-related securities dealer
shall pay to the FMSRB such reasonable fees and charges
as may be necessary or appropriate to defray the costs
and expenses of operating and administering the FMSRB.
Such rules shall specify the amount of such fees and
charges.


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(F) prescribe records to be made and kept by
government-related securities brokers and governmentrelated securities dealers and the periods for which
such records shall be preserved:
Provided, however,
That, in order to avoid undue regulatory burdens for
government-related securities brokers and governnieni:related securities dealers, any such requirements rhall
be, to the extent feasible, similar to the requirements
for records to be made, kept, and preserved by brokers,
dealers, and municipal securities dealers.
(G) provide for the periodic examination in
accordance with subsection (c)(1) of this section of
government-related securities brokers and governmentrelated securities dealers to determine compliance with
applicable provisions of this title, the rules and
regulations thereunder, and the rules of the FMSRB.
Such rules shall specify the minimum scope and
frequency of such periodic examinations and shall be
designed to avoid unnecessary regulatory duplication or
undue regulatory burdens for any such government-related
securities broker or government-related securities
dealer by, to the extent possible, coordinating
examination requirements with those established for
municipal securities brokers and municipal securities
dealers by the Municipal Securities Rulemaking Board.

be designed to prevent fraudulent and manipulative acts and practices, to promote just and
equitable principles of trade, to foster cooperation
(H)

and coordination with persons engaged in regulating,
clearing, settling, processing information with respect
to, and facilitating transactions in securities, to
remove impediments to and perfect the mechanism of a
free and open market in government-related securities,
and, in general, to protect investors and the public
interest; and not be designed to permit unfair
discrimination between customers, issuers, guarantors,
government-related securities brokers, or government-related securities dealers, to fix minimum
profits, to impose any schedule or fix rates of commissions, allowances, discounts, or other fees to be
charged by government-related securities brokers or


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-

government-related securities dealers, to regulate by
virtue of any authority conferred by the 1980 Act
matters not related to the purposes of the 1980 Act
with respect to government-related securities or the
administration of the FMSRB, or to impose any burden on
competition not necessary or appropriate in furtherance
of the purposes of the 1980 Act.
(I) if the FMSRB deems appropriate, specify
activities, in addition to those included in section
3(a) (42) of the Securities Exchange Act of 1934 which
the FMSRB determines are integral to the conduct of
business as a government-related securities dealer, and
require those activities to be conducted within any
separately identifiable department or division,
(J) if the FMSRB deems appropriate, provide that no
government- related securities broker or
government-related securities dealer shall effect any
transaction in, or induce or attempt to induce the
purchase or sale of, any government-related security
unless such government-related securities broker or
government-related securities dealer meets such
standards of operational capability and such government-related securities broker or government-related
securities dealer and every natural person associated
with such government-related securities broker or
government-related securities dealer meet such
standards of training, experience, competence, and such
other qualifications as the FMSRB finds necessary or
appropriate in the public interest or for the protection of investors.
In connection with the
definition and application of such standards the FMSRB

may


Federal Reserve Bank of St. Louis

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(i) appropriately classify government-related
securities brokers and government-related securities' dealers (taking into account relevant
matters, including types of business done, nature
of securities other than government-related securities sold, and character of business
organization) , and persons associated with
government-related securities brokers and
government-related secjjrities dealers;

(ii) specify that all or any portion of such
standards shall be applicable to any such class;

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(iii) require persons in any such class to pass
tests administered in accordance with subsection
(c)(1) of this section; and
(iv) provide that persons in any such class
other than government-related securities brokers
and government-related securities dealers and
partners, officers, and supervisory employees of
government-related securities brokers or
government-related securities dealers, may be
qualified solely on the basis of compliance with
such standards of training and such other
qualifications as the FMSRB finds appropriate.
(K) if the FMSRB deems appropriate, include
provisions governing the form and content of quotations
relating to government-related securities which may be
distributed or published by any government-related
securities broker, government-related securities
dealer, or person associated with such a governmentrelated securities broker or government-related securities dealer, and the persons to whom such quotations
may be supplied.
Such rules relating to quotations
shall be designed to produce fair and informative
quotations, to prevent fictitious or misleading
quotations, and to promote orderly procedures for
collecting, distributing, and publishing quotations.

(L) if the FMSRB deems appropriate, provide for the
arbitration of claims, disputes, and controversies
relating to transactions in government-related securities:
Provided, however. That no person other than a
government-related securities broker, government-related
securities dealer, or person associated with such a
government-related securities broker or governmentrelated securities dealer may be compelled to submit to
such arbitration except at his instance and in
accordance with section 29 of the Securities Exchange
Act of 1934.
(b) The FMSRB is not authorized under this title to
require any issuer or guarantor of government-related
securities, directly or indirectly through a governmentrelated securities broker or government-related securities
dealer or otherwise, to furnish to the FMSRB or to a
purchaser or prospective purchaser of such securities any


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application, report, document, or information with respect
Provided, however. That the
to such issuer or guarantor:
FMSRB may require government-related securities brokers and
government-related securities dealers to furnish to the
FMSRB or purchasers or prospective purchasers of
government-related securities applications, reports,
documents, and information with respect to the issuer or
guarantor thereof which are generally available from a
source other than such issuer or guarantor.
(c)(1) Tests required pursuant to subsection (a)(2)(J)
of this section shall be administered by or on behalf
of and periodic examinations pursuant to subsection (a)(2)
(G) of this section shall be conducted by
(iii)

—

(A) a registered securities association or
national securities exchange, in the case of
government-related securities brokers and
government-related securities dealers who are
members of such association or exchange; and

a

(B) the appropriate regulatory agency for any
government-related securities broker or
government-related securities dealer, in the case
of all other government-related securities brokers
and government-related securities dealers.
(2) An appropriate regulatory agency, registered
securities association, or national securities exchange
shall make a report of any examination conducted pursuant to
subsection (a)(2)(G) of this section and, upon request,
shall promptly furnish the Securities and Exchange
Commission or the Council a copy thereftf and any data
supplied to it in connection with such examination.
Subject
to such limitations as the Council, by rule, determines to
be necessary or appropriate in the public interest or for
the protection of investors, the Council shall, upon
request, make available to the FMSRB a copy of any report of
an examination of a government-related securities broker or
government-related securities dealer furnished to the
Council pursuant to this paragraph.


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(d) Uo government-related securities broker or
government-related securities dealer registered pursuant to
section 5 of the 1980 Act shall make use of the mails or any
means or instrumentality of interstate commerce to effect
any transaction in, or to induce or attempt to induce the
purchase or sale of, any government-related security
FMSRB
in contravention of such rules and regulations as the
public
shall prescribe as necessary or appropriate in the
interest or for the protection of investors to provide
safeguards with respect to the financial responsibility and
related practices of such government-related securities
brokers and government-related securities dealers including,
but not limited to, the acceptance of custody and use of
customers' securities, and the carrying and use of
Such rules and
customers' deposits or credit balances.
regulations shall require the maintenance of reserves with
respect to customers' deposits or credit balances, as
determined by such rules and regulations.

No broker, dealer, or public securities dealer
shall make use of the mails or any means or instrumentality
to
of interstate commerce to effect any transaction in, or
induce or attempt to induce the purchase or sale of, any
government-related security in contravention of any rule of
the FMSRB.
(e)

The Council is authorized, by order, if in its
opinion such action is necessary or appropriate in the
public interest, for the protection of investors, or otherwise in furtherance of the purposes of the 1980 Act, to
remove from office or censure any member or employee of the
FMSRB, who, the Council finds, on the record after notice
any
and opportunity for hearing, has willfully (A) violated
rules and regulations
provision of this title, the
thereunder, or the rules of the FMSRB, or (B) abused his
authority.
(f)

file with each agency enumerated in
section 3(a) (34) of the Securities Exchange Act of 1934 and
with every interested agency as defined in Section 3(a)(6)
filed
of the 1980 Act copies of every proposed rule change
9(a) of the 1980 Act.
with the Council pursuant to section
(g)

The FMSRB shall

(h)(1) The FMSRB shall make and keep for prescribed
periods such records, furnish such copies thereof, and make
and disseminate such reports, as the Council, by rule.


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prescribes as necessary or appropriate in the public
interest, for the protection of investors, or otherwise
furtherance of the purposes of the 1980 Act.

in

(2) All records of the FMSRB are subject at any tine,
or frou time to tine, to such reasonable, periodic, special,
or other exarainations by representatives of the Council as
the Council deems necessary or appropriate in the public
interest, for the protection of investors, or otherwise in
furtherance of the purposes of the 1900 Act.

SECTION

7.

Government-Related Securities Clearing
Agencies
.

(a)(1) With respect to government-related securities,
the Congress adopts the findings in section 17A of the
Securities Exchange Act of 1934 and, in addition, finds that
(A) transactions in government-related securities,
particularly transactions entered into on a delayed
delivery or optional delivery basis, may pose serious
financial risks prior to settlement for underwriters,
buyers, and sellers of such securities, place
substantial demands on banks and the national banking
system, and affect the national credit;
(B) availability of information with respect to the
volume of transactions in and value of unsettled
obligations with respect to government-related
securities is desirable to assure the fairness,
orderliness, efficiency, and integrity of the markets
for government-related securities; and

(C) a comprehensive system for the clearance and
settlement of transactions in government- related
securities would provide an efficient and effective
means of .reducing risks associated with unsettled
obligations in government-related securities, and
strengthening the markets for government-related securities.
(2) The Council, the Securities and Exchange Commission,
the Secretary of the Treasury, the Board of Governors of the
Federal Reserve System, the Federal Home Loan Bank Board,


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the National Credit Union Administration Board, the
Comptroller of the Currency, the Board of Directors of the
Federal Deposit Insurance Corporation, and each agency,
corporation, or instrumentality of the United States or in
which the United States has a direct or indirect interest
and which is an issuer or guarantor of government-related
securities are directed, therefore, having due regard for
their various and unique responsibilities with respect to
financing programs supported by, issuance of, operation of
the market for, and sales practices associated with
government-related securities, to use their respective
authorities in a coordinated and cooperative manner to
encourage and facilitate the establishment, to the extent
feasible, of a comprehensive system for clearance and
settlement of government-related securities suitable for use
by all persons directly involved in the issuance,
underwriting, sale and purchase of government-related
securities.
(b)(1) Except as otherwise provided in this section, it
shall be unlawful for any clearing agency, unless registered
in accordance with this subsection or in accordance with
section 17A of the Securities Exchange Act of 1934, directly
or indirectly, to make use of the mails or any means or
instrumentality of interstate commerce to perform the
functions of a clearing agency with respect to any government-related security. The Council, by rule or order, upon
its own motion or upon application, may conditionally or
unconditionally exempt any clearing agency or governmentrelated security or any class of clearing agencies or
government-related securities from any provisions of this
section or the rules or regulations thereunder, if the
Council finds that such exemption is consistent with the
public interest, the protection of investors, and the
purposes of this section, including the prompt and accurate
clearance and settlement of government-related securities
transactions and the safeguarding of government-related
securities and funds.
(2) A government-related securities clearing agency may
registered under the terms and conditions hereinafter
be
provided in this subsection, by filing with the Council an
application for registration in such form as the Council, by
rule, may prescribe containing the rules of the clearing


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agency and such other information and documents as the
Council, by rule, may prescribe as necessary or appropriate
in the public interest or for the prompt and accurate
clearance and settlement of government-related securities
transact ions
(c)(1) The Council shall, upon filing of an application
for registration as a government-related securities clearing
agency, publish notice of the filing and afford interested
persons an opportunity to submit written data, views, and
arguments concerning such application. Within ninety days
of the date of publication of such notice (or within such
longer period as to which the applicant consents), the
Council shall
(A)

by order grant such registration, or

(B) institute proceedings to determine whether
registration should be denied.
Such proceedings shall
include notice of the grounds for denial under
consideration and opportunity for hearing and shall be
concluded within one hundred eighty days of the date
of publication of notice of the filing of the
application for registration. At the conclusion of
such proceedings the Council, by order, shall grant or
deny such registration.
The Council may extend the
time for conclusion of such proceedings for up to
ninety days if it finds good cause for such extension
and publishes its reasons for so finding or for such
longer period as to which the applicant consents.

The Council shall grant such registration if it finds that
the requirements of the 1980 Act and the rules and
regulations thereunder with respect to the applicant are
satisfied.
The Council shall deny such registration if it
does not make such finding.
(2) A government-related securities clearing agency
shall not be registered unless the Council determines that

(A) Such clearing agency is so organized and has
the capacity to be able to facilitate the prompt and
accurate clearance and settlement of securities
transactions for which it is responsible, to safeguard
securities and funds in its custody or control or for


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which it is responsible, to comply with the provisions
of the 1980 Act and the rules and regulations
thereunder, to enforce (subject to any rule or order of
the Securities and Exchange Cofrimission pursuant to
section 17(d) or 19(g)(2) of the Securities Exchange
Act of 1934) compliance by its participants with the
rules of the clearing agency, and to carry out the
purposes of this section.
(B) Subject to the provisions of paragraph
17A(b){4) of the Securities Exchange Act of 1934, the
rules of the clearing agency provide that any (i)
broker or dealer registered with the Council or the
Securities and Exchange Commission, (ii) other clearing
agency registered with the Council or with the
Securities and Exchange Commission, (iii) registered
investment company, (iv) bank, (v) insurance company,
or (vi) other person or class of persons as the Council
by rule, may from time to time designate as appropriate
to the development of a national system for the prompt
and accurate clearance and settlement of governmentrelated securities transactions may become a participant in such clearing agency.

(C) The rules of the clearing agency assure a fair
representation of its shareholders (or members) and
participants in the selection of its directors and
(The Council may
administration of its affairs.
determine that the representation of participants is
fair if they are afforded a reasonable opportunity to
acquire voting stock of the clearing agency, directly
or indirectly, in reasonable proportion to their use of
such clearing agency.
(D) The rules of the clearing agency provide for
the equitable allocation of reasonable dues, fees, and
other charges among its participants.


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-

(E) The rules of the clearing agency do not impose
any schedule of prices, or fix rates or other fees, for
services rendered by its participants.

(F) The rules of the clearing agency are designed
to promote the prompt and accurate clearance and
settlement of government-related securities
transactions, to assure the safeguarding of securities
and funds which are in the custody or control of the
clearing agency or for which it is responsible, to

foster cooperation and coordination with persons
engaged in the clearance and settlement of securities
transactions, and, in general, to protect investors and
the public interest; and are not designed to permit
unfair discrimination in the admission of participants
or among participants in the use of the clearing
agency, or to regulate by virtue of any authority
conferred by this title matters not related to the
purposes of this section or the administration of the
clearing agency.
(G) The rules of the clearing agency provide that
(subject to any rule or order of the Securities and
Exchange Commission pursuant to section 17(d) or
19(g)(2) of the Securities Exchange Act of 1934) its
participants shall be appropriately disciplined for
violation of any provision of the rules of the clearing
agency by expulsion, suspension, limitation of
activities, functions, and operations, fine, censure,
or any other fitting sanction.

(H) The rules of the clearing agency are in
accordance with the provisions of paragraph 17A(b)(5)
of the Securities Exchange Act of 1934 and, in general,
provide a fair procedure with respect to the
disciplining of participants, the denial of
participation to any person seeking participation
therein, and the prohibition or limitation by the
clearing agency of any person with respect to access to
services offered by the clearing agency.
(I) The rules of the clearing agency do not impose
any burden on competition not necessary or appropirate
in furtherance of the purposes of this title.
(3) With respect to an application for registration
pursuant to this section filed by a government-related
securities clearing, agency


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-

(A) The Council shall not grant registration prior
to the sixtieth day after the date of publication of
notice of the filing of such application unlefes the
appropriate regulatory agency for such clearing agency
has notified the Council of such appropriate regulatory
agency's determination that such clearing agency is so
organized and has the capacity to be able to safeguard
securities and funds in its custody or control or for
which it is responsible and that the rules of such
clearing agency are designed to assure the safeguarding
of such securities and funds.
(B) The Council shall institute proceedings in
accordance with paragraph (1)(B) of this subsection to
determine whether registration should be denied if the
appropriate regulatory agency for such clearing agency
notifies the Council within sixty days of the date of
publication of notice of the filing of such application
of such appropriate regulatory agency's (i) determination that such clearing agency may not be so organized
or have the capacity to be able to safeguard securities
or funds in its custody or control or for which it is
responsible or that the rules of such clearing agency
may not be designed to assure the safeguarding of such
securities and funds and (ii) reasons for such
determination.
(C) The Council shall deny registration if the
appropriate regulatory agency for such clearing agency
notifies the Council prior to the conclusion of
proceedings instituted in accordance with paragraph
(1)(B) of this subsection of such appropriate
regulatory agency's (i) determination that such
clearing agency is not so organized or does not have
the capacity to be able to safeguard securities or
funds in its custody or control or for which it is
responsible or that the rules of such clearing agency
are not designed to assure the safeguarding of such
securities or funds and (ii) reasons for such
determination.

(4) A government-related securities clearing agency
may, upon such terms and conditions as the Council, by rule,
deems necessary or appropriate in the public interest or for
the protection of investors, withdraw from registration by
If
filing a written notice of withdrawal with the Council.


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finds that any such clearing agency is no longer
existence or has ceased to do business in the capacity
in
specified in its application for registration, the Council,
by order, shall cancel its registration.
the Council

(d) No clearing agency registered pursuant to this
section shall, directly or indirectly, engage in any
activity as clearing agency in contravention of such rules
and regulations (A) as the Council may prescribe as
necessary or appropriate in the public interest, for the
protection of investors, or otherwise in furtherance of the
purposes of this title, or (B) as the appropriate regulatory
agency for such clearing agency may prescribe as necessary
or appropriate for the safeguarding of securities and funds.

(e)(1) The appropriate regulatory agency for a
government-related securities clearing agency shall file
with the Council notice of the commencement of any
proceeding and a copy of any order entered by such
appropriate regulatory agency against such clearing agency.
(2) The appropriate regulatory agency for a government-related securities clearing agency shall notify the
Council and make a report of any examination conducted by it
of such clearing agency, and, upon request, furnish to the
Council a copy of such report and any data supplied to it in
connection with such examination.

SECTION

8.

Recordkeeping and Reporting

.

(a)(1) Every government-related securities broker,
government-related securities dealer, and government-related
securities clearing agency registered with the Council shall
make and keep for prescribed periods such records, furnish
such copies thereof, and make and disseminate such reports
as the Council, by rule, prescribes as necessary or
appropriate in the public interest, for the protection of
investors, or otherwise in furtherance of the purposes of

this title.
(2) Every such clearing agency shall also make and keep
for prescribed periods such records, furnish such copies
thereof, and make and disseminate such reports, as the


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appropriate regulatory agency for such clearing agency, by
the
rule, prescribes as necessary or appropriate for
funds in the custody or
safeguarding of securities and
control of such clearing agency or for which it is
responsi ble

Everv government-related securities broker and
qovernment-reiated securities dealer (other than a bank)
shall annually file with the Securities and Exchange
for
Commission a balance sheet and income statement which,
hundred twenty days after
any fiscal year beginning one
enactment of the 1980 Act, shall be certified by an
or
independent public accountant, prepared on a calendar
financial statements
fiscal year basis, and such other
certified) and
(which shall, as the Council specifies, be
condition as the
information concerning its financial
(b)

SECTION

9.

in

Oversight of the FMSRB and GovernmentRelated Securities Clearing Agencies.

securities
(a)(1) The FMSRB and every government-related
Council, in accordance
clearing agency shall file with the
copies of any
with such rules as the Council may prescribe,
addition to , or
proposed rule or any proposed change in,
(hereinafter in
deletion from the rules of such organization "proposed rule
as a
this subsection collectively referred to
statement of the
change") accompanied by a concise general
The Council
change.
basis and purpose of such proposed rule
change. Publish
shall, upon the filing of any proposed rule
substance of the
notice thereof together with the terms of
subjects and
proposed rule change or a description of the
interested Persons
The Council shall give
issues involved.
arguments
to submit written data, views, and
an opportunity
consult with
concerning such proposed rule change and shall 3(a)(6) of
in section
all interested agencies, as defined
concerning the advisability of approving the
the 1980 Act,
No proposed rule change shall take
proposed rule change.
otherwise permitted
Sf?e?t unless approved by the Council or subsection.
this
in accordance with the provisions of


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VJithin thirty-five days of the date of publication
of notice of the filing of a proposed rule change in
accordance with paragraph (1) of this subsection, or within
such longer period as the Council may designate up to ninety
days of such date if it finds such longer period to be
appropriate and publishes its reasons for so finding or as
to which the FMSRB or government-related securities clearing
(2)

agency consents, the Council shall
(A)

—

by order approve such proposed rule change, or

institute proceedings to determine whether the
Such
proposed rule change should be disapproved.
notice of the grounds for
proceedings shall include
disapproval under consideration and opportunity for
hearing and be concluded within sixty days of the date
At
of publication of notice instituting proceedings.
proceedings the Council, by
the conclusion of such
order, shall approve or disapprove such proposed rule
The Council may extend the time for conclusion
change.
of such proceedings for up to sixty days if it finds
good cause for such extension and publishes its reasons
for so finding or for such longer period as to which
the FMSRB or government-related securities clearing
agency consents.
(B)

The Council shall approve a proposed rule change of the
FMSRB or a government-related securities clearing agency if
it finds that such proposed rule change is consistent with
the requirements of this title and the rules and regulations
The Council
thereunder applicable to such organization.
shall disapprove such a proposed rule change if it does not
The Council shall not approve any
make such finding.
proposed rule change prior to the thirtieth day after the
date of publication of notice of the filing thereof, unless
the Council finds good cause for so doing and publishes its
reasons for so finding.
(3) (A) Notwithstanding the provisions of paragraph (2)
of this subsection, a proposed rule change may take effect
upon filing with the Council if designated by the FMSRB or

government-related securities clearing agency as (i) constituting a stated policy, practice, or interpretation with
respect to the meaning, administration, or enforcement of an
existing rule of such organization, (ii) establishing or


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-

changing a due, fee, or other charge inposed by the
organization, or (iii) concerned solely with the
administration of the organization or other matters which
the Council, by rule, consistent with the public interest
and the purposes of this subsection, may specify as without
the provisions of such paragraph (2).
(B) Notwithstanding any other provision of this
subsection, a proposed rule change may be put into effect
summarily if it appears to the Council that such action is
necessary for the protection of investors, the maintenance
of fair and orderly markets, or the safeguarding of
securities or funds. Any proposed rule change so put into
effect shall be filed promptly thereafter in accordance with
the provisions of paragraph (1) of this subsection.

(C) Any proposed rule change of the FMSRB or a
government-related securities clearing agency which has
taken effect pursuant to subparagraph (A) or (B) of this
paragraph may be enforced to the extent it is not
inconsistent with the provisions of this title, the rules
and regulations thereunder, and applicable Federal and State
law.
At any time within sixty days of the date of filing of
such a proposed rule change in accordance with the
provisions of paragraph (1) of this subsection, the Council
summarily may abrogate the change in the rules of the
organi zation made thereby and require that the proposed rule
change be refiled in accordance with the provisions of
paragraph (1) of this subsection and reviewed in accordance
with the provisions of paragraph (2) of this subsection, if
it appears to the Council that such action is necessary or
appropriate in the public interest, for the protection of
investors, or otherwise in furtherance of the purposes of
this title.
Council action pursuant to the preceding
sentence shall not affect the validity or force of the rule
change during the period it was in effect and shall not be
reviewable under section 10 of the 1980 Act nor deemed to be
"final agency action" for purposes of 5 U.S.C. 704.


Federal Reserve Bank of St. Louis

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(b) The Council, by rule, may abrogate, add to, and
delete from (hereinafter in this subsection collectively
referred to as "amend") the rules of the FMSRB or the rules
of a government-related securities clearing agency (insofar as they relate to government-related securities) as the
Council deems necessary or appropriate to insure the fair
administration of the FMSRB or such government-related
securities clearing agency, to conform its rules to the
requirements of this title and the rules and regulations
thereunder applicable to it, or otherwise in furtherance of
the purposes of this title, in accordance with the
procedures set forth in subsection 19(c) of the Securities
Exchange Act of 1934, substituting the term "Council" for
each reference therein to the "Commission".
For purposes of
this subsection, the FMSRB and any government-related securities clearing agency shall each be deemed to be a
"self-regulatory organization" as that term is used in
section 19(c) of the Securities Exchange Act of 1934.

SECTION 10.

Rules, Regulations, and Orders

.

(a) The Council shall have the power to make such rules
and regulations as may be necessary or appropriate to
implement the provisions of the 1980 Act for which it is
responsible or for the execution of the functions vested in
it by the 1980 Act, and may, for such purposes, classify

persons, government-related securities, transactions,
statements, applications, reports, and other matters within
its jurisdiction, and prescribe greater, lesser, or
different requirements for different classes thereof. No
provision of the 1980 Act imposing any liability shall apply
to any act done or omitted in good faith in conformity with
a rule, regulation, or order of the Council or any
government-related securities clearing agency,
notwithstanding that such rule, regulation, or order may
thereafter be amended or rescinded or determined by judicial
or other authority to be invalid for any reason.
(b) The Council, in making rules and regulations
pursuant to any provisions of the 1980 Act, shall consult
with all interested agencies concerning the impact of any
proposed rule or regulation on the markets for their
respective securities and shall also consider among other
matters the impact any such rule or regulation would have on
competition.
The Council shall not adopt any such rule or


Federal Reserve Bank of St. Louis


Federal Reserve Bank of St. Louis

262

Any action taken or directed to be taken
such securities.
by the Council pursuant to this subsection shall expire at
the end of ninety days, or such shorter period as
established by the Council.

SECTION 11.

Annual Reports

.

(a)(1) The Council shall roake an annual report to the
Congress on its work for the preceding year, and shall
include in each such report whatever information, data, and
recommendations for further legislation it considers
advisable with regard to matters within its jurisdiction
under the 1980 Act.
(2) The Council shall include in its annual report to
the Congress for each fiscal year a summary of its oversight activities under the 1980 Act with respect to the
FMSRB, including a description of any examination of the
FMSRB conducted as part of such activities, any material
recommendation presented as part of such activities to the
FMSRB for changes in its organization or rules, and any
action by the FMSRB in response to any such recommendation.
(3)

The Council shall also include in its annual report

to the Congress for each fiscal year

—

(A) a statement and analysis of the expenses and
operations of the FMSRB in connection with the
performance of its responsibilities under the 1980 Act,
for which purpose data pertaining to such expenses and
operations shall be made available by the FMSRB to the
Council at its request; and
(B) a statement detailingits administration of the
Freedom of Inform'ation Act, 5 U.S.C. 552, including a
copy of the report filed pursuant to subsection (d) of
such section.

SECTION 12.

Court Reviews of Orders and Rules

.

(a) A person aggrieved by a final order of the
Council entered pursuant to this title may obtain a review
of the order in the United States Court of Appeals for the


Federal Reserve Bank of St. Louis

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263

circuit in which he resides or has his principal place of
business, or, for the District of Columbia Circuit, by
filing in such court, within sixty days after the entry of
such order, a written petition requesting that the order be
modified or set aside in whole or in part. A copy of the
petition shall be transmitted forthwith by the clerk of the
court to any member of the Council, or an officer designated
by the Council for that purpose.
Thereupon the Council
shall file in the court the record on which the order
complained of is entered, as provided in the Federal Rules
of Appellate Procedure, 28 U.S.C. 2112.
On the filing of
the petition, the court has jurisdiction, which becomes
exclusive on the filing of the record, to affirm or modify
and enforce or to set aside the order, in whole or in part.
No objection to the order of the Council shall be considered
by the court unless such objection shall have been urged
before the Council.
The findings of the Council as to the
facts, if supported by substantial evidence, are conclusive.
If either party applies to the court for leave to adduce
additional evidence and shows to the satisfaction of the
court that such additional evidence is material and that
there were reasonable grounds for failure to adduce it
before the Council, the court may remand the case to the
Council for further proceedings, in \r7hatever manner and on
whatever conditions the court considers appropriate. The
Council may modify its findings as to the facts, by reason
of the additional evidence so taken, and it shall file such
modified or new findings, which, if supported by substantial
evidence, shall be conclusive, and its recommendation, if
any, for the modification or setting aside of the original
order.
The judgment and decree of the court, affirming,
modifying, and enforcing or setting aside, in whole or in
part, any such order of the Council, shall be final, subject
to review by the Supreme Court of the United States upon
certiorari or certification as provided in sections 239 and
240 of the Judicial Code, 28 U.S.C. 346, 347, as amended.
The commencement of proceedings under subsection
(a) shall not, unless specifically ordered by the court,
operate as a stay of the Council's order.
(b)

SECTION 13.

Application of the Commodity Exchange
Act.

No action taken pursuant to the provisions of the 1980
Act and no action of a government-related securities


Federal Reserve Bank of St. Louis

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264

clearing agency shall be considered to create a contract
market, or other board of trade, exchange or market, as
those terms are used in the Commodity Exchange Act, as
amended, 7 U.S.C. 1 et seq.

TITLE

II

—

SECTION 1. Section 3 of the Securities Exchange Act of
1934 (15 U.S.C. 78c) is amended as follows:
(1) Paragraph (12) of subsection (a) thereof is amended
by inserting the following directly preceding the reference
to "any interest or participation in any common trust
fund":

"(12) The term 'exempted security' or 'exempted
securities' includes securities which are direct obligations
of, or obligations guaranteed as to principal or interest
by, the United States; such securities issued or guaranteed
by corporations in which the United States has a direct or
indirect interest as shall be designated for exemption by
the Secretary of the Treasury as necessary or appropriate in
the public interest or for the protection of investors:
Provided, however. That government-related securities, as
defined in section 3(a) (43) of this title, shall not be
deemed to be 'exempted securities' for purposes of sections
15 (except subsections (a), (b)(9), (b)(ll), (c)(2), (c)(3),
(c)(5), and (c)(6) thereof), and 1 5A (except subsections
(b)(6), (b)(ll), and (g)(3) thereof) of this title
municipal securities as defined in section 3(a) (29) of this
title: Provided, however. That municipal securities shall
not be deemed to be 'exempted securities' for purposes of
sections 15, 15A (except subsections (b)(6), (b)(ll), and
(g)(3) thereof), and 17A of this title;"
;

Underl ining indicates additions to the Securities
Exchange Act of 1934; M indicates deletions.


Federal Reserve Bank of St. Louis

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(2)

265

Paragraph (26) of subsection

(a)

thereof is amended

to read as follows:

"(26) The term 'self-regulatory organization' means any
national securities exchange, registered securities
association or registered clearing agency, or (solely for
purposes of sections 19(b), 19(c), and 23(b) of this title)
the Municipal Securities Rulemaking Board established by
section 15B of this title or (solely for purposes of
sections 17(d), 19(d), 19(e), 19(f), 19(g), and 19(h)) a
clearing agency registered pursuant to section 7 of the
Government-Related Securities Act of 1980."
,

(3)

Paragraph (30) of subsection

(a)

thereof is amended

to read as follows:
"(30) The term 'municipal securities dealer' means^
public securities dealer engaged in the business of buying
and selling municipal securities for his own account,
through a broker or otherwise..".
(4)

Paragraph (32) of subsection

(a)

thereof is amended

to read as follows:
"(32) The term 'person associated with a public
securities dealer' when used with respect to a public
securities dealer which is a bank or a division or
department of a bank means any person directly engaged in
the management, direction, supervision, or performance of
any of the public securities dealer's activities with
respect to municipal securities or government-related
securities , and any person directly or indirectly
controlling such activities or controlled by the public
securities dealer in connection with such activities.".
<

Subparagraph (A) of paragraph (34) of subsection
(a) thereof is amended by striking each reference to the
term "municipal securities dealer" and inserting in lieu
thereof the term "public securities dealer",
(5)

(6) Subparagraphs (B) and (C) of paragraph (39) of
subsection (a) thereof are amended by striking each
reference to the term "municipal securities dealer" and
inserting in lieu thereof the term "public securities
dealer".


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Subsection (a) is further amended by adding at the
(7)
end thereof the following new paragraphs:
"(41) The term 'public securities dealer' means any
person (including a separately identifiable department or
division of a bank) engaged in the business of buying and
selling municipal securities or govern me nt-related
securities for his own account, through a broker or
otherwise, but does not include

—

"(A) any person insofar as he buys or sells such
securities for his own account, either individually or
in some fiduciary capacity, but not as a part of a
regular business; or
"(B) a bank, unless the bank is engaged in the
business of buying and selling municipal securities or
government-related securities for its own account
other than in a fiduciary capacity, through a broker or
otherwise;
Provided, however. That if the bank is
engaged in such business through a separately
identifiable department or division (as defined in
section 3(a) (42) of this title) the department or
division and not the bank itself shall be deemed to be
the public securities dealer.

"(42) The term 'separately identifiable department or
division', as that term is used in subsection 3(a) (41) of
this title, means that unit of a bank which

—

"(A) conducts the trading, sales, and operations
activities of the bank relating to the conduct of its
business as a public securities dealer, and
"(B) is organized and administered to permit
independent examination, periodic inspection, and
enforcement of applicable provisions of this titTe, the
rules and regulations thereunder, the rules of the
Municipal Securities Rulemaking Board, and the rules of
the Federal Mortgage-Backed Securities Rulemaking
Board. A separately identifiable department or
division of a bank may be engaged in activities other
than those relating to municipal securities or
government-related securities.


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267

"(43) The term 'government-related securities' means
those securities subject to regulation under the GovernmentRelated Securities Act of 2980
.

"(44) The term 'government-related securities dealer'
means a public securities dealer engaged in the business of
buying and selling government-related securities for his own
account through a broker or otherwise.
y

"(45) The term 'government-related securities
broker' means a broker engaged in the business of effecting
transactions in government-related securities for the
account of others
"(46) The term registered
when used with respect to
broker, dealer public securities dealer^ or clearing
a
agency means registered with the Commission unless otherwise
indicated "
^

'

'

^

.

(8)

Subsection

(c)

thereof is amended to read as

follows
(c) No provision of this title shall apply to, or be
deemed to include, any agency, corporation, or
instrumentality of^the United States or in which the United
States has a direct or indirect interest or any officer,
agent, or employee of any such. agency, corporation, or
instrumental ity acting in the course of his official duty as
such, unless such provision makes specific reference to suchy.
agency, corporation, or instrumentality.
,

(9)

Subsection

(d)

thereof is amended to read as

follows
"(d) No issuer of municipal securities or officer or
employee thereof acting in the course of his official duties
as such shall be deemed to be a 'broker', 'dealer', or
'publ ic securities dealer' solely by reason of buying,
selling, or effecting transactions in the issuer's
securi ties ."

SECTION
of 1934
(1)

(15

2.
Section 6(b) of the Securities Exchange Act
U.S.C. 78f(b)) is amended as follows:

Paragraph

follows


Federal Reserve Bank of St. Louis

(1)

thereof is amended to read as

268

Such exchange is so organized and has the
capacity to be able to carry out the purposes of this title
and to comply, and (subject to any rule or order of the
Commission pursuant to section 17(d) or 19(g)(2) of this
title) to enforce compliance by its members and persons
associated vrith its members, with the provisions of this
title, the rules and regulations thereunder, the rules of
the Federal Mortgage-Backed Securities Rulemaking Board, and
the rules of the exchange.".
"(1)

(2)

Paragraph (6) thereof

is

amended to read as

follows
"(6) The rules of the exchange provide that (subject to
any rule or order of the Commission pursuant to section
17(d) or 19(g)(2) of this title) its members and persons
associated with its members shall be appropriately
disciplined for violation of the provisions of this title,
the rules or regulations thereunder, the rules of the
Federal Mortgage-Backed Securities Rulemaking Board, or the
rules of the exchange, by expulsion, suspension, limitation
of activities, functions, and operations, fine, censure,
being suspended or barred from being associated with a
member, or any other fitting sanction.".

SECTION 3.
1934 (15 U.S.C.

Section
7

8g)

(1) Paragraphs
reads as follows:

is
(a)

7 of the Securities Exchange Act of
amended as follows:

through (d) thereof are amended to

"(a) For the purpose of preventing the excessive use of
credit for the purchase or carrying of securities and to
preserve the financial integrity of the markets for
government-related securities t'he Board of Governors of the
Federal Reserve System shall, prior to October 1, 1934 and
from time to time thereafter, prescribe rules and regulations with respect to the amount of credit that may be
initially extended and subsequently maintained on any
security (other than an exempted security) and, if it is
deemed necessary by the Board of Governors of the Federal
Reserve System


Federal Reserve Bank of St. Louis

,

269

-

Securities Rulemaking Board or of the Government -Related
Securities Oversight Council that is inconsistent therewith
For the initial extension of credit on any security other
than a government-related security such rules and
regulations shall be based upon the following standard: An
amount not greater than whichever is the higher of

.

,

(1) 55 per centum of the current market price of
the security, or

(2) 100 per centum o£ the lowest market price of
the security during the preceding thirty-six calendar
months, but not more than 75 per centum of the current

market price.
Should the Board of Governors of the Federal Reserve
System determine that it is necessary for it to prescribe
requirements with respect to the initial or subsequent maintenance of a deposit in connection with the purchase, sale,
or carrying of a government-related security, such rules and
regulations shall require such amount as the Board of
Governors of the Federal Reserve System shall deem necessary
in order to further the purposes of this title
Such rules
and regulations may make appropriate provision with respect
to the carrying of undermarg ined accounts for limited
periods and under specified conditions; the withdrawal of
funds or securities; the substitution or additional
purchases of securities; the transfer of accounts from one
lender to another; special or different margin requirements
for delayed deliveries, short sales, arbitrage transactions,
and securities to which paragraph (2) of this subsection
does not apply; the bases and the methods to be used in
calculating loans, and margins and market prices; and
For the
similar administrative adjustments and details.
purposes of paragraph (2) of this subsection, until July 1,
1936, the lowest price at which security has sold on or
after July 1, 1933, shall be considered as the lowest price
at which such security has sold during the preceding
thirty-six calendar months.
.

"(b) Notwithstanding the provisions of subsection (a)
of this section, the Board of Governors of the Federal
Reserve System, may, from time to time, with respect to all
or specified securities or transactions, or classes of
securities, or classes of transactions, by such rules and
regulations (1) prescribe such lower margin requirements for


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the initial extension or maintenance of credit as it deens
necessary or appropriate for the accominodation of connerce
and industry, having due regard to the general credit
situation of the country, and (2) prescribe such higher
margin requirements for the initial extension or maintenance
of credit as it may deem necessary or appropriate to prevent
the excessive use of credit to finance transactions in
securities or to preserve the financial integrity of the
markets for government-related securities
.

"(c) It shall be unlawful for any member of a national
securities exchange or any broker, dealer, or governmentrelated securities dealer directly or indirectly to extend
or maintain credit or arrange for the extension or
maintenance of credit to or for any customer-,

(1) On any security (other than an exempted
security)
in contravention of the rules and
regulations which the Board of Governors of the Federal
Reserve System shall prescribe under subsections (a)
and (b) of this section.
,

(2) Without collateral or on any collateral other
than securities, except in accordance with such rules
and regulations as the Board of Governors of the
Federal Reserve System may prescribe (A) to permit
under specified conditions and for a limited period any
such member, broker, dealer, or government-related
securities dealer to maintain a credit initially
extended in conformity with the rules and regulations
of the Board of Governors of the Federal Reserve
System, and (B) to permit the extension or maintenance
of credit in cases where the extension or maintenance
of credit is not for the purpose of purchasing or
carrying securities or of evading or circumventing the
provisions of par'agraph (1) of this subsection."

"(d) It shall be unlawful for any person not subject to
subsection (c) of this section to extend or maintain credit
or to arrange for the extension or maintenance of credit for
the purpose of purchasing or carrying any security, in
contravention of such rules and regulations as the Board of
Governors of the Federal Reserve System shall prescribe to
prevent the excessive use of credit for the purchasing or
carrying of or trading in securities or to preserve the


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-

financial integrity of the markets for government-related
secur 1 ties in circumvention of the other provisions of this
section.
Such rules and regulations may impose upon all
extensions of credit and deposit requi rementSyi^or the
purpose of purchasing or carrying secur i ties uimi tat ions
similar to those imposed upon members, brokers, dealers, or
government-related securities dealers by subsection (c) of
this section and the rules and regulations thereunder.
This
subsection and the rules and regulations thereunder shall
not apply (A) to a loan made by a person not in the ordinary
course of his business, (B) to a loan on an exempted
security, (C) to a loan to a dealer to aid in the financing
of the distribution of securities to customers not through
the medium of a national securities exchange, (D) to an
extension of credit by a bank on a security other than an
equity security or a government-related security or (E) to
such other loans as the Board of Governors of the Federal
Reserve System shall, by such rules and regulations as it
may deem necessary or appropriate in the public interest or
for the protection of investors, exempt, either
unconditionally or upon specified terms and conditions or
for stated periods, from the operation of this subsection
and the rules and regulations thereunder."
(2) Subparagraph (B) of paragraph (2) of subsection
thereof is amended to read as follows:

(f)

"(B) The term "United States security" means
a
i
security (other than an exempted security) issued by a
person incorporated under the laws of any State, or whose
a
principal place of business is within a State, and i i
government-related security ."
(

(

SECTION
of 1934

4.

)

Section 15 of the Securities Exchange Act
78o) is amended as follows:

(15 U.S.C.

(1) The caption thereof is amended to read as follows:
"REGISTRATION AND REGULATION OF BROKERS, DEALERS, AND PUBLIC
SECURITIES DEALERS"
.

(2)

Paragraph (1) of subsection

(a)

thereof is amended

to read as follows:
"(1) It shall be unlawful for any broker or dealer
which is either a person other than a natural person or


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a

272

natural person not associated with a broker or dealer which
is a person other than a natural person (other than such a
broker or dealer whose business is exclusively intrastate
and who does not make use of any facility of a national
securities exchange) or for any public securities dealer to
make use of the mails or any means or instrumentality of
interstate commerce to effect any transaction in, or to
induce or attempt to induce the purchase or sale of, any
security (other than an exempted security or commercial
paper, bankers' acceptances, or commercial bills) unless
such broker, dealer, or public securities dealer is
registered in accordance with subsection (b) of this
section.".
(3) Subsection (a) thereof is further amended by
striking paragraph (2) and inserting the following as
paragraphs (2) and (3):

"(2) Any provision of this title (other than section 5
or subsection (a)(1) of this section) which prohibits any
act, practice, or course o€ business if the mails or any
means or instrumentality of interstate commerce is used in
connection therewith shall also prohibit any such act,
practice, or course of business by any registered broker,
dealer, or public securities dealer or any person acting on
behalf of such broker, dealer, or public securities dealer ,
irrespective of any use of the mails or any means or
instrumentality of interstate commerce in connection

therewith.
"(3) The Commission, by rule or order, upon its own
motion or upon application, may conditionally or
unconditionally exempt any broker, dealer, or public
securities dealer or qlass of brokers, dealers, or public
securities dealers from any provision of this section, or
any rule of the Municipal Securities Rulemaking Board TT
the Commission deems such exemption consistent with the
public interest, the protection of investors, and the
purposes of this title .".
,

(4) That part of paragraph (1) which precedes the dash
and subparagraph (A) of paragraph (2) of subsection (b)
thereof are amended to read as follows:

"(1) A broker, dealer, or public securities dealer may
be registered by filing with the Commission an application
for registration in such fcrrm and contai^ning such informa-


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tion and documents concerning such broker, dealer, or public
securities dealer and any persons associated with such
broker, dealer, or public securities dealer as the Commission, by rule, may prescribe as necessary or appropriate in
the public interest or for the protection of investors.
Within forty-five days of the date of the filing of such
application (or within such longer period as to which the
applicant consents), the Commission shall

—

"(2) (A) An application for registration of a broker,
dealer, or public securities dealer to be formed or
organized may be made by a broker, dealer, or public securities dealer to which the broker, dealer, or public securities dealer to be formed or organized is to be the
successor.
Such application, in such form as the
Commission, by rule, may prescribe, shall contain such
information and documents concerning the applicant, the
successor, and any persons associated with the applicant or
the successor, as the Commission, by rule, may prescribe as
necessary or appropriate in the public interest or for the
protection of investors. The grant or denial of registration to such an applicant shall be in accordance with the
procedures set forth in paragraph (1) of this subsection. If
the Commission grants such registration, the registration
shall terminate on the forty-fifth day after the effective
date thereof, unless prior thereto the successor shall,
in accordance with such rules and regulations as the
Commission may prescribe, adopt the application for
registration as its own.".
(5) Subsection (b) thereof is further amended by
striking paragraph (3), and redesignating subparagraph
paragraph (2) as paragraph (3).

(6)

Redesignated paragraph

(3)

is

(C)

amended to read as

follows
"(3) Within six months of the date of the granting of
registration pursuant to this section or section 5 of the
Government-Related Securities Act of 1980 to a broker or
dealer, the Commission, or upon the authorization and
direction of the Commission, a registered securities


Federal Reserve Bank of St. Louis

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274

association or national securities exchange of which such
broker or dealer is a member, shall conduct an inspection of
the broker or dealer to determine whether it is operating in
conformity with the provisions of this title and the rules
Provided, however. That the
and regulations thereunder:
Commission may delay such inspection of any class of brokers
or dealers for a period not to exceed six months".
(7) That part of paragraph (4) which precedes the dash,
subsection (ii) of subparagraph (B), subparagraphs (C) and
(D)
that part of subparagraph (E) which precedes the dash,
and subparagraph (F) of paragraph (4) of subsection (b)
thereof are amended to read as follows:
,

"(4) The Commission, by order, shall censure, place
limitations on the activities, functions, or operations of,
suspend for a period not exceeding twelve months, or revoke
the registration with the Commission or with the GovernmentRelated Securities Oversight Council of any broker, dealer,
or public securities dealer if it finds, on the record after
notice and opportunity for hearing, that such censure,
placing of limitations, suspension, or revocation is in the
public interest and that such broker, dealer, or public
securities dealer whether prior or subsequent to becoming
such, or any person associated with such broker, dealer, or
public securities dealer, whether prior or subsequent to
becoming so associated
,

—

"{B)(ii) arises out of the conduct of the
business of a broker, dealer, publ ic securities dealer,
investment adviser, bank, insurance company, or
fiduciary;

"(C) is permanently or temporarily enjoined by
order, judgment, or decree of any court of competent
jurisdiction from acting as an investment adviser,
underwriter, broker, dealer, or public securities
dealer, or as an affiliated person or employee of any
investment company, bank, or insurance company, or from
engaging in or continuing any conduct or practice in
connection with any such activity, or in connection
with the purchase or sale of any security.


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275

"(D) has willfully violated any provision of the
Securities Act of 1933, the Investment Advisers Act of
1940, the Investment Company Act of 1940, this title,
the rules or regulations under any of such statutes,
the rules of the Municipal Securities Rulemaking Board,
or the rules of the Federal Mortgage-Backed Securities
Rulemaking Board, or is unable to comply with any such
prov ision.

"(E) has willfully aided, abetted, counseled,
commanded, induced, or procured the violation by any
other person of any provision of the Securities Act of
1933, the Investment Advisers Act of 1940, the Investment Company Act of 1940, this title, the rules or regulations under any of such statutes, the rules of the
Municipal Securities Rulemaking Board, or the rules of
the Federal Mortgage-Backed Securities Rulemaking
Board or has failed reasonably to supervise, with a
view to preventing violations of the provisions of such
statutes, rules, and regulations, another person who
commits such a violation, if such other person is
subject to his supervision.
For the purposes of this
subparagraph (E) no person shall be deemed to have
failed reasonably to supervise any other person, if -,

"(F) is subject to an ordeiy^entered pursuant to
paragraph (6) or 7 of this subsection (b) barring or
suspending the right of such person to be associated
with a broker, dealer, or public securities dealer.
(

(8) Paragraphs (5) and (6) of subsection (b) thereof
are amended to read as follows:

"(5) Pending final determination whether any
registration under this subsection or under section 5 of the
Government-Related Securities Act of 1980 shall be revoked,
the Commission, by order, may suspend such registration, if
such suspension appears to the Commission, after notice and
opportunity for hearing, to be necessary or appropriate in
Any
the public interest or for the protection of investors.


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-

registered broker, dealer, or public securities dealer nay,
upon such terms and conditions as the Comrr, ission deems
necessary or appropriate in the public interest or for the
protection of investors, withdraw from registration by
filing a written notice of withdrawal with the Commission.
If the Commission finds that any registered broker, dealer,
or public securities dealer is no longer in existence or has
ceased to do business as a broker, dealer, or public
securities dealer , the Commission, by order, shall cancel
the registration of such broker, dealer, or public
securities dealer. ".
"(6) The Commission, by order, shall censure or place
limitations on the activities or functions of any person
associated, or seeking to become associated, with a broker,
dealer, or public securities dealer or suspend for a period
not exceeding twelve months or bar any such person from
being associated with a broker, dealer, or public securities
dealer if the Commission finds, on the record after notice
and opportunity for hearing, that such censure, placing of
limitations, suspension, or bar is in the public interest
and that such person has committed or omitted any act or
omission enumerated in subparagraph (A), (D), or (E) of
paragraph (4) of this subsection, has been convicted of any
offense specified in subparagraph (B) of said paragraph (4)
within ten years of the commencement of the proceedings
under this paragraph, or is enjoined from any action,
conduct, or practice specified in subparagraph (C) of said
paragraph (4).
It shall be unlawful for any person as to
whonyian order entered pursuant to this paragraph or pursuant
to paragraph (7) suspending or barring him from being
associated with a broker, dealer, or public securities
dealer is in effect willfully to become, or to be,
associated with a broker, dealer, or public securities
dealer without the consent of thp Commission, and it shall
be unlawful for any broker, dealer, or public securities
dealer to permit such a person to become, or remain, a
person associated with him without the consent of the
Commission, if such broker, dealer, or public securities
dealer knew, or in the exercise of reasonable care should
have known, of such order.".
,

(9) S.ubsection (b) thereof is further amended by
redesignating paragraphs (7), (8), (9), and (10) as
paragraphs (9), (10), (11), and (12), respectively, and by
inserting the following as paragraphs (7) and (8):


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-

"(~) With respect to any publ ic securities dealer for
which the Commission is not the appropriate regulatory
agency, the appropriate regulatory agency for such publ ic
securities dealer may sanction any such publ ic securities
dealer in the manner and for the reasons specified in
paragraph (4 of this subsection and any person associated
with such publ ic securities dealer in the manner and for the
reasons specified in paragraph (6) of this subsection.
In
addition, such appropriate regulatory agency may, in
accordance with section 8 of the Federal Deposit Insurance
Act (12 U.S.C. 1818), enforce compliance by such public
securities dealer or any person associated with such publ ic
securities dealer with the provisions of this section,
section s 1 5B and 17 of this title, the provisions of the
Government-Related Securities Act of 1980, any rule or
regulation under any such provision the rules of the
Municipal Securities Rulemaking Board, the rules of the
Federal Mortgage-Backed Securities Rulemaking Board, and the
rules of the Commission pertaining to publ ic securities
dealers, persons associated with publ ic securities dealers,
and transactions in municipal securities and governmentrelated securities
For purposes of the preceding sentence,
any violation of any such provision shall constitute
adequate basis for the issuance of any order under section
8(b) or 8(c) of the Federal Deposit Insurance Act, and the
customers of any such publ ic securities dealer shall be
deemed to be 'depositors' as that term is used in
section 8(c) of that Act.
Nothing in this paragraph shall
be construed to affect in any way the powers of such
appropriate regulatory agency to proceed against such public
securities dealer under any other provision of law.
,

.

"(8)(A) The Commission, prior to the entry of an order
of investigation, or oommencement of any proceedings,
against any publ ic securities dealer, or person associated
with any publ ic securities deader, for which the Commission
is not the appropriate regulatory agency, for violation of
any provision of^ section 15 or 15B of this title, any rule
or regulation unaer any such section, any provision of the
Government-Related Securities Act of 1980, any rule or
regulation under any such provision, any rule of the
Municipal Securities Rulemaking Board, or any rule of the
Federal Mortgage-Backed Securities Rulemaking Board, shall
(i) give notice to the appropriate regulatory agency for


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-

such publ ic securities dealer of the identity of such public
securities dealer or person associated with such public
securities dealer and the nature of and basis for such
proposed action, and (ii) consult with such appropriate
regulatory agency concerning the effect of such proposed
action on sound banking practices and the feasibility and
desirability of coordinating such action with any proceeding
or proposed proceeding by such appropriate regulatory agency
against such publ ic securities dealer or associated person.
"(B) The appropriate regulatory agency for a publ ic
securities dealer (if other than the Commission), prior to
the entry of an order of investigation, or commencement of
any proceedings, against such publ ic securities dealer or
person associated with such public securities dealer, for
violation of any provision of this section, section 7 or
section 15B of this title, the rules of the Municipal
Securities Rulemaking Board, the rules of the
Federal Mortgage-Backed Securities Rulemaking Board, or the
rules or regulations of the Commission or the Board of
Governors of the Federal Reserve' System pertaining to public
securities dealers, persons associated with publ ic
securities dealers, or transactions in municipal securities
or government-related securities shall (i) give notice to
the Commission of the identity of such public securities
dealer or person associated with such public securities
dealer and the nature of and basis for such proposed action,
and (ii) consult with the Commission concerning the effect
of such proposed action on the protection of investors and
the feasibility and desirability of coordinating such action
with any proceeding or proposed proceeding by the Commission
against such public securities dealer or associated person.
"(C) Prior to


Federal Reserve Bank of St. Louis

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consult


Federal Reserve Bank of St. Louis

280

(2)

Paragraph

(7)

of subsection (b)

thereof is amended

to read as follows:
"(7) The rules of the association provide that (subject
to any rule or order of the Commission pursuant to section
17(d) or 19(g)(2) of this title) its members and persons
associated with its members shall be appropriately
disciplined for violation of any provision of this title,
the rules or regulations thereunder, the rules of the
Municipal Securities Rulemaking Board, the rules of the
Federal Mortgage-Backed Securities Rulemaking Board, or the
rules of the association, by expulsion, suspension,
limitation of activities, functions, and operations, fine,
censure, being suspended or barred from being associated
with a member, or any other fitting sanction.".
(3) Paragraphs (2) and (3) of subsection
are amended to read as follows:

(e)

thereof

"(2) For the purposes of this subsection, the term
'nonmember professional' shall include (A) with respect to
transactions in securities other than municipal securities
and government-related securities
any registered broker or
dealer who is not a member of any registered securities
association, except such a broker or dealer who deals
exclusively in commercial paper, bankers' acceptances, and
commercial bills, and (B) with respect to transactions in
municipal securities and government-related securities ,
any public securities dealer (other than a bank or division
or department of a bank) who is not a member of any
registered securities association and any municipal
securities broker or government-related securities broker
who is not a member of any such association.
,

"(3) Nothing in this subsection shall be so construed
or applied as to prevent (A) any member of a registered
securities association from granting to any other member of
any registered securities association any dealer's discount,
allowance, commission, or special terms, in connection with
the purchase or sale of securities, or (B) any member of a
registered securities association or any public securities
dealer which is a bank or a division or department of a bank
from granting to any member of any registered securities
association or any such public securities dealer any
dealer's discount, allowance, commission, or special terms
in connection with the purchase or sale of municipal


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281

securities or government-related securities;
Provided,
however. That the granting of any such discount, allowance,
commission, or special terms in connection with the purchase
or sale of municipal securities shall be subject to rules of
the Municipal Securities Rulemaking Board adopted pursuant
to section 15B(a) (2 (K of this title.".
)

(4) Subparagraph (B) of paragraph
thereof is amended to read as follows:

(1)

of subsection (h)

"(B) the specific provisions of this title, the rules
or regulations thereunder, the rules of the Municipal
Securities Rulemaking Board, the rules of the
Federal Mortgage-Backed Securities Rulemaking Board, or the
rules of the association which any such act or practice, or
omission to act, is deemed to violate; and".

Section 15B of the Securities Exchange Act
SECTION 6.
of 1934 (15 U.S.C. 780-4) is amended:
(1) by striking subsection (a) and redesignating
subsections (b), (c), and (d) thereof as subsections (a),
b) , and (c) , respectively;
(

(2) by striking oat "subsection (b)(2)(B) of this
section" in the last sentence of redesignated subsection
(a)(1), and inserting in lieu thereof "paragraph
(a) (2)(B)";
(3) by striking out that part of paragraph (2) of
redesignated subsection (a) which precedes the colon and
inserting in lieu thereof the following:

"(2) The Board shall propose and adopt rules to effect
purposes of this title with respect to transactions in
the
municipal securities effected by brokers, dealers, and
(Such rules are hereinafter
public securities dealers.
referred to in this sectio n as 'rules of the
collectively
n
The rules of the Board, as a minimum, shall:'"
Board'.)

by striking out "(c)(7)" in paragraph (2)(A)(iii)
of redesignated subsection (a) and inserting in lieu of
thereof "(b) (2)";
(4)


Federal Reserve Bank of St. Louis

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(5) by striking out subparagraph (C) of paragraph (2) of
redesignated subsection (a) thereof and inserting in lieu
thereof the following:

"(C) be designed to prevent fraudulent and manipulative
acts and practices, to promote just and equitable principles
of trade, to foster cooperation and coordination with
persons engaged in regulating, clearing, settling,
processing information with respect to, and facilitating
transactions in municipal securities, to remove impediments
to and perfect the mechanism of a free and open market in
municipal securities, and, in general, to protect investors
and the public interest; and not be designed to permit
unfair discrimination between customers, issuers, municipal
securities brokers, or municipal securities dealers, to fix
minimum profits, to impose any schedule or fix rates of
commissions, allowances, discounts, or other fees to be
charged by municipal securities brokers or municipal
securities dealers, to regulate by virtue of any authority
conferred by this title matters not related to the purposes
of this title with respect to municipal securities or the
administration of the Board, or to impose any burden on
competition not necessary or appropriate in furtherance of
the purposes of this title.";
(6) by striking out "(c)(7)" in subparagraph (E) of
paragraph (2) of redesignated subsection (a) thereof and
inserting in lieu thereof "(b)(2)";
(7) by striking out subparagraph (H) of paragraph (2)
of redesignated subsection (a) and inserting in lieu thereof
the following:

"(H) if the Board deems appropriate, specify activities
in addition to those included in section 3(a) (42) of this

title which the Board determines are integral to the conduct
of business as a municipal securities dealer, and require
those activities to be conducted within any separately
identifiable department or division." ;
(8)

by striking out paragraphs

(2),

(3),

(4),

(5),

and

(6) of redesignated subsection (b) and by redesignating
paragraphs (7) and (8) thereof as paragraphs (2) and (3),
respectively;


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-

(9) by striking out each reference to the term
municipal securities dealer" in paragraph (1) of
redesignated subsection (b) thereof and inserting in lieu
thereof the term "public securities dealer";
II

by striking out "subsection (b) 2 A) ii i " and
subsection (b)(2)(E)" in redesignated subsection (b)(2) and
inserting in lieu thereof "subsection (a) 2 A) iii " and
"subsection (a)(2)(E)", respectively.
)

(10)

(

)

(

(

)

(

(

n

SECTION
of 1934

7.

)

Section 17 of the Securities Exchange Act
78q) is amended as follows:

(15 U.S.C.

(1) Subsections (a) and (c) thereof are amended by
striking each reference to the term "municipal securities
dealer" and inserting in lieu thereof the term "public
securities dealer," and subsection (b) thereof is amended to
read as follows:

"(b) All records of persons described in subsection (a)
of this section and all records of persons registered
pursuant to sections 5 and 7 of the Government-Related
Securities Act of 1980 are subject at any time, or from time
to time, to such reasonable periodic, special, or other
examinations by representatives of the Commission and the
appropriate regulatory agency for such persons as the
Commission or the appropriate regulatory agency for such
persons deems necessary or appropriate in the public
interest, for the protection of investors, or otherwise in
Provided,
furtherance of the purposes of this title:
however. That the Commission shall, prior to conducting any
such examination of a^clearing agency, /^transfer agent, or a
public securities dealer for which it is not the appropriate
regulatory agency, give notice to the appropriate regulatory
agency for such clearing agency, transfer agent, or public
securities dealer of such proposed examination and consult
with such appropriate regulatory agency concerning the
feasibility and desirability of coordinating such examinations with examinations conducted by such appropriate
regulatory agency with a view to avoiding unnecessary
regulatory duplication or undue regulatory burdens for such
clearing agency, transfer agent, or public securities
Nothing in the proviso to the preceding sentence
dealer.
shall be construed to impair or limit (other than by the


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284

-

requirement of prior consultation) the power of the
Commission under this subsection to examine any clearing
agency, transfer agent, or public securities dealer or to
affect in any way the power of the Commission under any
other provision of this title or otherwise to inspect,
examine, or investigate any such clearing agency, transfer
agent, or public securities dealer.",
(2) Subparagraph (A) of paragraph (1) of subsection
thereof is amended to read as follows:

(d)

"(A) with respect to any person v^o is a member of
or participant in more than one self-regulatory
organization, relieve any such self-regulatory
organization of any responsibility under this title (i)
to receive regulatory reports from such person, (ii) to
examine such person for compliance, or to enforce
compliance by such person, with specified provisions of
this title, the rules and regulations thereunder, the
rules of the Federal Mortgage-Backed Securities Rulemaking Board , and its own rules, or (iii) to carry out
other specified regulatory functions with respect to
such person, and".
(3)

Subsection (f)(1)(A) thereof

is

amended to read as

follows:
"(f)(1) Every national securities exchange, member
thereof, registered securities association, broker, dealer,
public securities dealer, registered transfer agent,
registered clearing agency, participant therein, member of
the Federal Reserve System, and bank whose deposits are
insured by the Federal Deposit Insurance Corporation shall —
"(A) report to the Commission or other person
designated by the Commission such information about
missing, lost, counterfeit, or stolen securities, in
such form and within such time as the Commission, by
rule, determines is necessary or appropriate in the
public interest or for the protection of investors;
such information shall be available on request for a
reasonable fee, to any such exchange, member,
association, broker, dealer, public securities dealer,
transfer agent, clearing agency, participant.


Federal Reserve Bank of St. Louis

285

member of the Federal Reserve System, or insured bank,
and such other persons as the Commission, by rule,
designates; and".
SECTION 8.
Section 17A of the Securities Exchange Act
of 1934 (15 U.S.C. 78q-l) is amended as follows:
(1) Paragraphs (4), (5), and (6) of subsection
thereof are amended to read as follows:

(b)

" 4
A )^ A clearing agency registered pursuant to this
section or section 7 of the Government-Related Securities
Act of 1980 may, and in cases in which the Commission, by
order, directs as appropriate in the public interest shall,
deny participation to any person subject to a statutory
d isqualif ication. A Any such clearing agency shall file
notice with the Commission not less than thirty days prior
to admitting any person to participation, if the clearing
agency knew, or in the exercise of reasonable care should
have known, that such person was subject to a statutory
disqualification. The notice shall be in such form and
contain such information as the Commission, by rule, may
prescribe as necessary or appropriate in the public interest
or for the protection of investors,
(

)

(

" (B)yvA clearing agency registered pursuant to this
section or section 7 of the Government-Related Securities
Act of 1980 may deny participation to, or condition the
participation of, any person if such person does not meet
such standards of financial responsibility, operational
capability, experience, and competence as are prescribed
by the rules of the clearing agency. ^ Such clearing agency
may examine and verify the qualifications of an applicant to
be a participant in accordance with procedures established
by the rules of the clearing agency.

"(5) (A) In any proceeding by a^^clearing agency
registered pursuant to this section or section 7 of the
Government-Related Securities Act of 1980 to determine
whether a participant should be disciplined (other than a
summary proceeding pursuant to subparagraph (C) of this
paragraph) , the clearing agency shall bring specific
charges, notify such participant of, and give him an
opportunity to defend against such charges, and keep a


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record.
A determination by the clearing agency to impose a
disciplinary sanction shall be supported by a statement
setting forth

—

(i) any act or practice in which such participant has been found to have engaged, or which such
participant has been found to have omitted;

(ii) the specific provisions of the rules of the
clearing agency which any such act or practice, or
ommission to act, is deemed to violate; and

(iii)

the sanction imposed and the reasons

therefor,
"(B) In any proceeding by a clearing agency registered
pursuant to this section or section 7 of the GovernmentRelated Securities Act of 1980 to determine whether a person
shall be denied participation or prohibited or limited with
respect to access to services offered by the clearing
agency, the clearing agency shall notify such person of, and
give him an opportunity to be heard upon, the specific
grounds for denial or prohibition or limitation under
consideration and keep a record. A determination by the
clearing agency to deny participation or prohibit or limit a
person with respect to access to services offered by the
clearing agency shall be supported by a statement setting
forth the specific grounds on which the denial or
prohibition or limitation is based.

"(C) A clearing agency registered pursuant to this section
or section 7 of the Government-Related Securities Act of
1980 may summarily suspend and close the accounts of a participant who (i) has been and is expelled or suspended from
any self-regulatory organization, (ii) is in default of any
delivery of funds or securities to the clearing agency, or
(iii) is in such financial or operating difficulty that the


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clearing agency determines and so notifies the appropriate
regulatory agency for sucli participant that such suspension
and closing of accounts are necessary for the protection of
the clearing agency, its participants, creditors, or
investors.
A participant so summarily suspended shall be
proi.iptly afforded an opportunity for a hearing by the
clearing agency in accordance with the provisions of
subparagraph (A) of this paragraph. The appropriate
regulatory agency for such participant, by order, may stay
any such summary suspension on its own motion or upon
application by any person aggrieved thereby, if such
appropriate regulatory agency uetermines summarily or after
notice and opportunity for hearing (which hearing may
consist solely of the submission of affidavits or
presentation of oral arguments) tliat such stay is consistent
with the public interest and the protection of investors.
No clearing agency registered pursuant to this
6
section or section 7 of the Government-Related Securities
Act o f 1980 shall prohibit or limit access by any person to
services offered by any participant therein."
"

(

)

(2) Paragraph (2) of subsection
to read as follows:

(d)

thereof is amended

"(2) With respect to any clearing agency or transfer
agent for which the Commission is not the appropriate
regulatory agency, the appropriate regulatory agency for
such clearing agency or transfer agent may, in accordance
with section 8 of the Federal Deposit Insurance Act (12
U.S.C. 1818), enforce compliance by such clearing agency or
transfer agent with the provisions of this section, sections
17 and 19 of this title, the rules and regulations
thereunder, the Government-Related Securities Act of 1980,
For purposes of
and the rules and regulations tnereunder.
the preceding sentence, any violation of any such provision
shall constitute adequate basis for the issuance of an order
under section 8(b) or 8(c) of the Federal Deposit Insurance
Act, and the participants in any such clearing agency and


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the persons doing business v.'ith any such transfer agent
shall be deemed to be "depositors" as that terra is used
section 8(c) of that Act.",

SECTION
of 1934

9.

Section

(15 U.S.C.

78s)

19

of

ttie

in

Securities Exchange Act
follows:

is araended as

(1) Subparagraph (A) of paragraph (1) of subsection
thereof is amended to read as follows:

(e)

"(A) if the appropriate regulatory agency for such
member, participant, or person associated with a member
finds that such raeiober, participant, or person
associated with a member has engaged in such acts or
practices, or has omitted such acts, as the
self- regulatory organization has found him to have
engaged in or omitted, that such acts or practices, or
omissions to act, are in violation of such provisions
of this title, the rules or regulations thereunder, the
rules of the Federal Mortgage-Backed Securities Rulemaking Board, the rules of the self-regulatory
organization, or, in the case of a registered
securities association, the rules of the Municipal
Securities Rulemaking Board as have been specified in
the determination of the self-regulatory organization,
and that such provisions are, and were applied in a
manner, consistent with the purposes of this title,
such appropriate regulatory agency, by order, shall so
declare and, as appropriate, affirm the sanction
imposed by the self-regulatory organization, modify the
sanction in accordance with paragraph (2) of this
subsection, or remand to the self-regulatory
organization for further proceedings; or".
(2) Subparagraphs (A) and (B) of paragraph (1) of
subsection (g) thereof are amended to read as follows:

"(g)(1)(A) in the case of a national securities
exchange, with such provisions and the provisions of
the rules of the Federal Mortgage-Backed Securities
Rulemaking Board by its members and persons associated
wit!: its members;
"(B) in the case of a registered securities
association, with such provisions, the provisions of
the rules of the Federal Mortgage-Backed Securities


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Ruleiriakiny Board

289

and the provisions of the rules of
the Municipal Securities Rulemakin<j Board by its
members and persons associated vv^ith its rnerabers; and."
(3)

,

Paragraph (2) of subsection

(g)

thereof is amended

to read as follows:
"(2) The Coiarnission, by rule, consistent with the
public interest, the protection of investors, and the other
purposes of this title, may relieve any self-regulatory
organization of any responsibility uuuer this title to
enforce compliance v;ith any specified provision of this
title, the rules or regulations thereunder or the rules of
the Federal Mortgage-Backed Securities Rulemaking Board by
any member of such organization or person associated with
such a member, or any class of such members or persons
associated with a member."
(4) Subparagraphs (A) and (B) of paragraph (1) of
subsection (h) thereof are amended to read as follows:

"(h)(1)(A) in the case of a national securities
exchange, with any such provision or any provision of the
rules of the Federal Mortgage-Backed Securities Rulemaking
Board by a member thereof or a person associated v/ith a
member thereof;
"(B)

in

the case of a registered securities

association, with any such provision, any provision of the
rules of the Federal Mortgage-Backed Securities Rulemaking
Board or any provision of the rules of the Municipal
Securities Rulemaking Board by a member thereof or a person
associated with a member thereof; or".

Subparagraphs (A) and (B) of paragraph (2) of
subsection (h) thereof are amended to read as follows:
(5)

in the case of a national securities exchange, any
provision of the Securities Act of 1^33, the Investment
Advisers Act of 1940, the Investment Company Act of 1940,

"(A)


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290

this title, the rules or regulations under any of such
statutes or the rule s of the Federal Mortgage-Backed Securities Rulemaking Board;
"(B) in the case of a registered securities
association, any provision of the Securities Act of 1933,
the Investiaent Advisers Act of 1940, the Investraent Company
Act of 1940, this title, the rules or regulations under any
of such statutes, the rules of the Municipal Securities
Rulemaking Board or the rule s of the Federal Mortgage-Backed
Securities Rulemaking Board; or".
(6) Subparagraphs (A) and (B) of paragraph (3) of
subsection (h) thereof are amended to read as follows:

"(h)(3)(A) in the case of a national securities
exchange, any provision of the Securities Act of 1933, the
Investment Advisers Act of 1940, the Investment Company Act
of 1940, this title, the rules or regulations under any of
such statutes or the rules of the Federal Mortgage-Backed
Securities Rulemaking Board; or
"(B) in the case of a registered securities
association, any provision of the Securities Act of 1933,
the Investment Advisers Act of 1940, the Investment Company
Act of 1940, this title, the rules or regulations under any
of such statutes, the rules of the Municipal Securities
Rulemaking Board or the rules of the Federal Mortgage-Backed
Securities Rulemaking Board. "
(7) Subparagraphs (A) and (B) of paragraph (4) of
subsection (h) thereof are amended to read as follows:

"(h)(4)(A) in the case of a national securities
exchange, with any such provision or any provision of the
rules of the Federal Mortgage-Backed Securities Rulemaking
Board by any member or person associated with a member;
"(B) in the case of a registered securities
association, with any such provision, any provision of the
rules of the Federal Mortgage-Backed Securities Rulemaking
Board, or any provision of the rules of the Municipal
Securities Rulemaking Board by any member or person
associated with a member; or".


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SECTION 10.
of 1934

(15

Section 21 of the Securities Exchange Act
U.S.C. 78u) is amended as follows:

(1) Subsections (a), (d), and (e) thereof are araended
to insert "or the rules of the Federal Mortgage-Backed
Securities Rulemaking Board," directly follov/ing each
reference to the "rules of the Municipal Securities
Rulemaking Board".

(2)

Subsection

(g)

thereof is amended to read as

follows:
"(g) Notwithstanding the provisions of section 1407(a)
of title 28, United States Code, or any other provision of
law, no action for equitable relief instituted by the
Commission pursuant to the securities laws shall be
consolidated or coordinated with other actions not brought
by the Commission, even though such other actions may
involve common questions of fact, unless such consolidation
is consented co by the Commission.
Tlie term "securities
laws" as used herein includes the Securities Act of 1933 (15
U.S.C. 77 et seq.), the Securities Exchange Act of 1934 (15
U.S.C. 78a et seq.), the Public Utility Holding Company Act
of 1935 (15 U.S.C. 79a et seq.), the Trust Indenture Act of
1939 (15 U.S.C. 77aaa et seq.), the Investment Company Act
of 1940 (15 U.S.C. 80a-l et seq.), the Investment Advisers
Act of 1940 (15 U.S.C. 80b-l et seq.), the Securities
Investor Protection Act of 1970 (15 U.S.C. 78aaa et seq),
and the Government-Related Securities Act of 1980 (15
U.S.C.
et seq. ."
)

.

Section 23 of the Securities Exchange Act
SECTION 11.
of 1934 (15 U.S.C. 78w^ is amended as follows:
(1)

Paragraph

(1)

of subsection (a)

thereof is amended

to read as follows:

"(a)(1) The Commission, the Board of Governors of the
Federal Reserve System, and the other agencies enumerated in
section 3(a) (34) of this title shall each have power to make
such rules and regulations as may be necessary or
appropriate to implement the provisions of this title for
which they are responsible or for the execution of the


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functions vested in them by this title, and may for such
purposes classify persons, securities, transactions,
statements, applications, reports, and other matters within
their respective jurisdictions, and prescribe greater,
lesser, or different requirements for different classes
thereof. No provision of this title imposing any liability
shall apply to any act done or omitted in yood faith in
conformity with a rule, regulation, or order of the
Commission, the Board of Governors of the Federal Reserve
System, other agency enumerated in section 3(a) (34) of this
title, the Government-Related Securities Oversight Council,
any self-regulatory organization, notwithstanding that such
rule, regulation, or order may thereafter be amended or
rescinded or determined by judicial or other authority to be
invalid for any reason."
(2) Paragraph (3) and subparagraph (G) of paragraph (4)
of subsection (b) thereof are amended by striking each
reference to the term "municipal securities dealer" and
inserting in lieu thereof the term "public securities
dealer"

Section 28(b) of the Securities Exchange
SECTION 12.
Act of 1934 (15 U.S.C. 78bb(b)) is amended to read as
follows:
"(b) Nothing in this title shall be construed to modify
existing law with regard to the binding effect (1) on any
member of or participant in any self-regulatory organization
of any action taken by the authorities of such organization
to settle disputes between its members or participants, (2)
on any municipal securities dealer or municipal securities
broker of any action taken pursuant to a procedure
established by the Municipal Securities Rulemaking Board to
settle disputes between municipal securities dealers and
municipal securities brokers, (3) on any government-related
securities dealer or government-related securities broker of
any action taken pursuant to a procedure established by the
Federal Mortgage-Backed Securities Rulemaking Board to
settle disputes between government-related securities
dealers and government-related securities brokers* or (4) of
any action described in paragraph (1) , (2) , or (3) on any
person who has agreed to be bound thereby.".


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TITLE III

SECTION 1.
That part of subparagraph (A) of paragraph
of subsection (a) of section 3 of the Securities
Investor Protection Act of 1970 (15 U.S.C. 78ccc) (the "SIPC
Act") which precedes the dash is amended to read as
(2)

follows:

~

"(a)(2)(A) Members of SIPC
SIPC shall be a
membership corporation the members of which shall be all
persons registered under section 15(b) of the 1934 Act or
under section 5 of the Government-Related Securities Act of
1980 as brokers or dealers, other than --".
4

SECTION 2.
Paragraph (2) of subsection (c) of section
of the SIPC Act (15 U.S.C. 78ddd) is amended to read as

follows

—

"(2) General Assessment Authority
SIPC shall, by
bylaw, impose upon its members such assessments as, after
consultation with self-regulatory organizations, SIPC may
deem necessary and appropriate to establish and maintain the
fund and to repay any borrowings by SIPC.
Any assessments
so made shall be in conformity with contractual obligations
made by SIPC in connection with any borrowing incurred by
SIPC.
Subject to paragraph (3) and subsection (d)(1)(A),
any such assessment upon the members, or any one or more
classes thereof, including any class of members registered
under section 5 of the Government-Related Securities Act of
1980 may, in whole or in part, be based upon or measured by
(A) the amount of their gross revenues from the securities
the
business, or (B) all or any of the following factors:
revenues from the
amount or composition of their gross
securities business, the amount or composition of their
gross revenues from the business in government-related
securities as that term is defined in section 3(a) (43) of
the 1934 Act, the number or dollar volume of transactions
effected by them, the number of customer accounts maintained
by them or the amounts of cash and securities in such
accounts, their net capital, the nature of their activities
(whether in the securities business or otherwise) and the
consequent risks, or other relevant factors.".
,


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This Act shall become effective on the date
SECTION 3.
Sections 5
of its enactment except as hereinafter provided.
Act of 1980, the
and 7 of the Government-Related Securities
amendments made by this Act to sections 3(a) (12), 6(b),
15(a), ISA, 19(e), (g) and (h) of the Securities Exchange
Act of 1934, and the amendments made by this Act to the
Securities Investor Protection Act of 1970 shall become
effective one hundred twenty days after the date of
enactment of this Act.


Federal Reserve Bank of St. Louis


Federal Reserve Bank of St. Louis


Federal Reserve Bank of St. Louis

U.S.

TREASURY LIBRARY

10109835