Investment in Exchangeable Collateralized Mortgage Obligations

AGENCY:

National Credit Union Administration.

ACTION:

Proposed rule with request for comments.

SUMMARY:

The National Credit Union Administration (NCUA) proposes to amend its regulations regarding investment in collateralized mortgage obligations (CMOs). Currently, NCUA regulations prohibit federal credit unions (FCUs) and certain corporate credit unions from investing in stripped mortgage backed securities (SMBS) and exchangeable CMOs that represent interests in one or more SMBS. NCUA has safety and soundness concerns with direct investment in SMBS, but recognizes that some exchangeable CMOs representing interests in one or more SMBS may be safe investments for credit unions. This proposed rule will authorize all FCUs and corporate credit unions to invest in exchangeable CMOs representing interests in one or more SMBS subject to certain safety and soundness limitations. This proposed rule also contains miscellaneous technical corrections and clarifying amendments to NCUA's Investment and Deposit Activities rule and Corporate Credit Unions rule.

DATES:

Comments must be received on or before April 2, 2004.

ADDRESSES:

Direct comments to Becky Baker, Secretary of the Board. Mail or hand-deliver comments to: National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428. You are encouraged to fax comments to (703) 518-6319, or e-mail comments to regcomments@NCUA.gov instead of mailing or hand-delivering them. Whatever method you choose, please send comments by one method only.

FOR FURTHER INFORMATION CONTACT:

Steve Sherrod, Senior Investment Officer, Office of Strategic Program Support and Planning (OSPSP) at the above address or telephone (703) 518-6620; Kim Iverson, Senior Investment Officer, Office of Strategic Program Support and Planning, at the above address or telephone (703) 518-6620; George Curtis, Corporate Program Specialist, Office of Corporate Credit Unions at the above address or telephone (703) 518-6640; or Paul Peterson, Staff Attorney, Office of General Counsel, at the above address or telephone (703) 518-6555.

SUPPLEMENTARY INFORMATION:

A. Exchangeable Collateralized Mortgage Obligations

The Federal Credit Union Act permits FCUs and corporate credit unions to purchase mortgage related securities (MRS) subject to such regulations as the NCUA Board may prescribe. 12 U.S.C. 1757(15)(B). NCUA regulations generally permit the purchase of CMOs, a multi-class MRS, but not if the CMO is a stripped mortgage backed security (SMBS). 12 CFR 703.14(d) and 703.16(e); 704.5(c)(5) and (h)(4). SMBS, including interest-only CMOs (IOs) and principal-only CMOs (POs) are, when purchased individually, highly volatile and risky investments. For example, in a declining interest rate environment, such as that experienced over the last few years, the value of an IO can drop precipitously in a short time period. Accordingly, individual SMBS are generally not suitable investments for most credit unions.

Currently, many CMO issues contain one or more classes of exchangeable CMOs. An exchangeable CMO represents a beneficial ownership interest in a combination of two or more underlying CMOs, and the owner may pay a fee and take delivery of the underlying CMOs. In many cases, these underlying CMOs include IOs and POs.

Because NCUA regulations prohibit investment in SMBS, the regulations also prohibit investment in an exchangeable CMO that represents an interest in one or more IOs or POs. Certain exchangeable CMOs representing IOs or POs, however, do not carry the risk or raise the same safety and soundness concerns associated with direct investment in an SMBS. For example, an exchangeable CMO might represent ownership in two securities: (1) An interest-bearing CMO (i.e., a non-SMBS CMO) with a coupon of 5.0 percent and (2) a SMBS in the form of an IO representing 0.5 percent interest on the interest-bearing CMO. See RCR class PA from Federal National Mortgage Association (Fannie Mae) Prospectus Supplement 2001-73. As indicated in the Prospectus Supplement for this particular combination, the notional principal of the underlying IO is not large relative to the principal of the underlying interest-bearing CMO and will decline at the same rate as the principal on the interest-bearing CMO. As a result, the risks associated with this combination more closely resemble the risks associated with the underlying interest-bearing CMO than the risks associated with the IO or any other SMBS.

This proposed rule, if adopted, will authorize FCUs and corporate credit unions to invest in an exchangeable CMO representing interests in one or more IOs or POs if the exchangeable CMO meets certain conditions.

One condition concerns the rate of amortization of the underlying IOs and POs. Specifically, for an exchangeable CMO representing one or more IOs, the notional principal of each IO must decline at the same rate as the principal on one or more non-IO CMOs included in the combination. For an exchangeable CMO representing one or more POs, the principal of each PO must decline at the same rate as the notional principal of one or more IOs included in the combination or at the same rate as the principal on one or more interest-bearing CMOs included in the combination. This requirement helps mitigate the risk associated with the IO and PO SMBS.

Each exchangeable CMO has an offering circular, which includes the final prospectus and all supplements to that prospectus, that contains performance characteristics for the exchangeable CMO and its various underlying CMOs. One set of tables, labeled as “decrement” or “declining balance” tables, displays the remaining principal (or, for IOs, the notional principal) balance on each CMO at periodic intervals following issuance, assuming certain principal repayment speeds for the mortgage pool as a whole. The Board believes that the principal, or notional principal, of two underlying CMOs will decline at the same rate only if the two CMOs share the same decrement or declining balance table. The rule text also requires this condition be satisfied throughout the life of the investment, so that a credit union may not exercise a call option, or other embedded option, that causes the exchangeable CMO to fail this condition after purchase.

The amortization condition discussed above helps mitigate risk, but by itself will not ensure that an exchangeable CMO representing interests in underlying SMBS does not perform like a stand-alone SMBS. For example, an issuer might fashion an exchangeable CMO that represents ownership in two securities: (1) An interest-bearing CMO and (2) an IO, but with the notional principal of the IO much larger than the principal of the interest-bearing CMO. Even assuming the notional principal on the IO declines at the same rate as the principal on the interest-bearing CMO, the exchangeable CMO representing these two interests will still have the substantive risk characteristics of the underlying IO.

Accordingly, the Board finds it necessary to add another condition: that, at the time of purchase, the ratio of the market price to the remaining principal balance is between .8 and 1.2, meaning that the discount or premium of the market price to par must be less than 20 points. In the Board's view, if an exchangeable CMO is priced at a premium of 20% or more to the remaining principal balance due on the CMO at the time of purchase, or its “par,” the CMO has substantially the same risk characteristics as an IO. Similarly, if an exchangeable CMO is priced at a discount of 20% or more to par, it has substantially the same risk characteristics as a PO. “Remaining principal balance” refers to the actual principal remaining to be paid, not notional principal.

The proposed rule also states that credit unions may not exercise the right to exchange an exchangeable CMO if it represents an interest in one or more impermissible SMBS. Corporate credit unions with part I or part II Expanded Authorities may exercise the exchange function if the resulting SMBS are all permissible under those authorities.

This proposed rule also adds a definition of collateralized mortgage obligation to part 703 of NCUA's rules and regulations. This definition parallels the definition found in NCUA's corporate rule. 12 CFR 704.2.

B. Technical Corrections and Minor Changes

The Board also proposes to make several technical corrections and other minor changes to parts 703 and 704.

1. Investment and Deposit Activities (Part 703)

The Board proposes to modify the definitions of put and call in § 703.2. Puts and calls are parallel devices, with a put giving the holder the option to sell, and a call giving the holder an option to buy, a security under certain conditions. The proposed definitions reflect this relationship more closely. The Board also proposes to modify the definition of put to clarify that the exercise of a put need only be during a fixed time period rather than, as currently stated, “at any time until the stated expiration date.”

Section 703.2 defines “custodial agreement” and limits such agreements to those where one party agrees to exercise ordinary care in the safekeeping of securities. The term “custodial agreement” only appears in § 703.9(a), and that section references a “written custodial agreement that requires the safekeeper to exercise, at least, ordinary care.” Accordingly, the use of “ordinary care” in the definition of custodial agreement is redundant and the Board proposes to eliminate it.

The Board wishes to amend the current definition of derivative in part 703. The Board intends that the term derivative mean any derivative instrument that, under generally accepted accounting principles (GAAP), must be recognized as an asset or liability in the statement of financial condition and be valued at fair market value. Currently, FASB Statement No. 133 (FAS 133), as amended and interpreted, discusses the accounting treatment of derivative instruments, which include certain financial contracts and other contracts that meet conditions specified in FAS 133. Stand-alone interest rate swaps, options, swaptions, and futures, for example, are derivative instruments under FAS 133 that must be recognized as assets or liabilities and valued at fair market value and so are considered to be derivatives for purposes of parts 703 and 704. In contrast, embedded options that are not required under GAAP to be accounted for separately from the host contract are not derivatives for purposes of parts 703 and 704.

Sections 703.8(b)(3) and 703.9(d) employ the term “nationally-recognized statistical rating agencies.” The Board proposes to replace this term with the more commonly used “nationally-recognized statistical rating organizations.”

Section 703.14(g) allows for the purchase, subject to certain conditions, of European financial options contracts to fund the payment of dividends on member share certificates. One condition in paragraph (g)(4) requires that “[t]he options' expiration dates coincide with the maturity date of the share certificate.” The Board proposes a change to allow these options to expire “no later than the maturity date of the share certificate.” This change will provide more flexibility in the use of options.

In § 703.14(g)(13), the Board proposes to replace the word “it” with “its.”

2. Corporate Credit Unions (Part 704)

In § 704.2, the Board proposes to amend the definitions of “small business related security” and “weighted average life” to make them identical to the definitions of those terms in § 703.2. Also, the Board proposes to revise § 704.8(a)(4) by changing the phrase “interest rate risk simulation tests” to “interest rate sensitivity analysis requirements.” Section 704.8(a)(4) cross-references § 704.8(d) which uses the phrase “interest rate sensitivity analysis requirements.” The Board also proposes to add a definition of “derivatives” to part 704. The proposed part 704 definition is identical to the amended definition proposed for part 703 and discussed above.

Regulatory Procedures

Regulatory Flexibility Act

The Regulatory Flexibility Act requires NCUA to prepare an analysis to describe any significant economic impact a proposed rule may have on a substantial number of small credit unions (those under $10 million in assets). This proposed rule expands the investment authority granted to FCUs and corporate credit unions. The proposed amendments will not have a significant economic impact on a substantial number of small credit unions and, therefore, a regulatory flexibility analysis is not required.

Paperwork Reduction Act

NCUA has determined that the final rule would not increase paperwork requirements under the Paperwork Reduction Act of 1995 and regulations of the Office of Management and Budget.

Executive Order 13132

Executive Order 13132 encourages independent regulatory agencies to consider the impact of their actions on state and local interests. In adherence to fundamental federalism principles, NCUA, an independent regulatory agency as defined in 44 U.S.C. 3502(5), voluntarily complies with the executive order. The proposed rule would not have substantial direct effects on the states, on the connection between the national government and the states, or on the distribution of power and responsibilities among the various levels of government. NCUA has determined that this proposed rule does not constitute a policy that has federalism implications for purposes of the executive order.

The Treasury and General Government Appropriations Act, 1999—Assessment of Federal Regulations and Policies on Families

The NCUA has determined that this proposed rule would not affect family well-being within the meaning of section 654 of the Treasury and General Government Appropriations Act, 1999, Pub. L. 105-277, 112 Stat. 2681 (1998).

Small Business Regulatory Enforcement Fairness Act

The Small Business Regulatory Enforcement Act of 1996 (Pub. L. 104-121) provides generally for congressional review of agency rules. A reporting requirement is triggered in instances where NCUA issues a final rule as defined by section 551 of the Administrative Procedure Act. 5 U.S.C. 551. The Office of Management and Budget has determined that this rule is not a major rule for purposes of the Small Business Regulatory Enforcement Fairness Act of 1996.

List of Subjects

12 CFR Part 703

• Credit unions
• Investments

12 CFR Part 704

• Corporate credit unions
• Reporting and recordkeeping requirements

For the reasons stated in the preamble, NCUA proposes to amend 12 CFR part 703 and 12 CFR part 704 as follows:

PART 703—INVESTMENT AND DEPOSIT ACTIVITIES

1. The authority citation for part 703 continues to read as follows:

Authority: 12 U.S.C. 1757(7), 1757(8), 1757(15).

2. Amend § 703.2 to revise the definitions of Call, Custodial Agreement, Derivatives, and Put, and add definitions of Collateralized Mortgage Obligation and Exchangeable Collateralized Mortgage Obligation, as follows:

PART 704—CORPORATE CREDIT UNIONS

7. The authority citation for part 704 continues to read as follows:

Authority: 12 U.S.C. 1762, 1766(a), 1781, and 1789.

8. Amend § 704.2 to add definitions of Derivatives and Exchangeable collateralized mortgage obligation, and to revise the definitions of Small business related security and Weighted average life, as follows: