[Federal Register Volume 64, Number 103 (Friday, May 28, 1999)]
[Rules and Regulations]
[Pages 28884-28900]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-13622]
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FARM CREDIT ADMINISTRATION
12 CFR Part 615
RIN 3052-AB76
Funding and Fiscal Affairs, Loan Policies and Operations, and
Funding Operations; Investment Management
AGENCY: Farm Credit Administration.
ACTION: Final rule.
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SUMMARY: The Farm Credit Administration (FCA) adopts final investment
management regulations that help Farm Credit System (System or FCS)
banks and associations respond to rapid and continual changes in
financial markets and instruments. The final regulations:
Expand the list of high-quality investments that System
banks and associations can purchase;
Provide more flexibility to use comprehensive analytical
techniques to manage risks at the portfolio or institutional level;
Strengthen our requirements for sound investment
management practices; and
Streamline the requirements for investments in mortgage
securities issued or guaranteed by the Federal Agricultural Mortgage
Corporation (Farmer Mac).
EFFECTIVE DATE: These regulations will become effective 30 days after
they are published in the Federal Register during which either one or
both houses of Congress are in session. We will publish a notice of the
effective date in the Federal Register.
FOR FURTHER INFORMATION CONTACT: Laurie A. Rea, Senior Policy Analyst,
Office of Policy Analysis, Farm Credit Administration, McLean, VA
22102-5090, (703) 883-4498; or Richard Katz, Senior Attorney, Office of
General Counsel, Farm Credit Administration, McLean, VA 22102-5090,
(703) 883-4020, TDD (703) 883-4444.
SUPPLEMENTARY INFORMATION:
I. Background
System banks may purchase eligible investments for the purpose of
[[Page 28885]]
maintaining a liquidity reserve, managing interest rate risk, and
investing surplus funds. Farm Credit associations have authority to
hold eligible investments to manage short-term surplus funds and reduce
interest rate risk, subject to the approval of their funding banks.
Eligible investments help FCS banks and associations to control
risks that result from their operations as single-industry agricultural
lenders. On June 18, 1998, we proposed revisions to our investment
management regulations.
The proposal balanced our desire to institute a disciplined
investment management framework with the System's desire for more
flexibility to respond to changing market conditions and advances in
risk management and securities valuation.\1\
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\1\ See 63 FR 33281.
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We proposed two fundamental changes to the existing investment
regulations. First, we established guidelines for implementing an
effective oversight and risk management process for investment
activities. Second, our proposal expanded the list of eligible
investments, and it relaxed or repealed many of the restrictions on
investments that we previously authorized. For instance, we proposed to
expand System bank and association investment authority to include a
broader array of money market instruments, mortgage securities, and
asset-backed securities.
Our proposal also balanced the System's need for greater
flexibility regarding investments with essential safety and soundness
controls, such as credit rating and diversification standards.
Furthermore, our proposal continued to limit non-agricultural
investments to 30 percent of each bank's total outstanding loans.
Overview of the Comments
The Presidents Finance Committee (PFC) for Farm Credit System
banks, The Bond Market Association, and Farmer Mac commented on the
proposed rule. All eight FCS banks fully supported the PFC's comments.
The PFC's letter identified over 20 separate issues concerning
investment management and eligible investments that the PFC asked us to
address in the final rule. The Bond Market Association, which
represents securities firms and investment banks that underwrite and
trade debt securities, supported many of the System's positions on
eligible investments. Farmer Mac's comments focused primarily on the
different regulatory treatment of its mortgage securities and the
Federal National Mortgage Association (Fannie Mae) and the Federal Home
Loan Mortgage Corporation (Freddie Mac).
Separately, we published a notice in the Federal Register that
asked the public to identify existing FCA regulations and policies that
impose unnecessary regulatory burdens on FCS institutions.\2\ CoBank
ACB and four Farm Credit associations asked us to reduce regulatory
burden on the System by repealing or revising provisions in the
existing investment regulations that pertain to the liquidity reserve
requirement, association investments and the portfolio limit on Farmer
Mac mortgage securities. We address these regulatory burden comments in
the final investment rule.
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\2\ See 63 FR 44176 (Aug. 18, 1998); 63 FR 64013 (Nov. 18,
1998).
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We respond to these comments by making several substantive changes
to the proposed investment management regulations and by rewriting the
regulations so they are easier to understand. In addition, we also
address commenters' questions and requests for clarification in the
preamble.
II. Investment Activities of Associations and Service Corporations
We received several comments and questions about the investment
authorities of associations, both in response to the proposed
investment rule and our regulatory burden initiative. The PFC asked us
to confirm that funding banks still retain the responsibility to review
and approve the investments of their affiliated associations. In
response to our regulatory burden initiative, three associations stated
that the Farm Credit Act of 1971, as amended (Act) does not require the
degree of bank oversight that redesignated Sec. 615.5142 imposes on
association investment activities. These associations suggested that
funding banks should rely on the General Financing Agreements (GFA) to
oversee the investment activities of their affiliated associations.
We modified final Secs. 615.5131, 615.5133, 615.5140, 615.5141,
615.5142, and 615.5143 to confirm the existing investment authorities
of associations and clarify that associations that elect to hold
investments are expressly subject to regulations governing investment
management, eligible investments, stress tests, and divestiture.
Redesignated Sec. 615.5142 continues to authorize associations to
acquire eligible investments that are listed in Sec. 615.5140, with the
approval of their funding banks, for the purposes of reducing interest
rate risk and investing surplus funds. The final rule also retains the
existing requirement that each System bank annually review the
investment portfolio of every association that it funds.
Final Sec. 615.5142 implements sections 2.2(10) and 2.12(18) of the
Act, which require each funding bank to supervise and approve the
investment activities of its affiliated associations. In response to
comments that focused on the scope of bank supervision of association
investments, we note that a number of satisfactory methods exist for
System banks to oversee association investment activities under our
regulatory framework. A bank may take an active role in advising and
approving an association's investment decisions and strategies. For
example, banks may provide research, analytical or advisory services
that help associations to manage their investment portfolios.
Alternatively, as suggested by three association commenters, the GFA
can be an appropriate tool for funding banks to oversee the investment
activities of their affiliated associations.
Bank oversight does not absolve an association's board and managers
of their fiduciary duties to manage investments in a safe and sound
manner. The fiduciary responsibilities of association boards of
directors obligate them to develop appropriate investment management
policies and practices to manage the credit, market, liquidity, and
operational risks associated with investment activities. Additionally,
it is incumbent upon each association's investment managers to fully
understand the risks of its investments and make independent and
objective evaluations of investments prior to purchase.
We incorporated explicit references to associations into final
Sec. 615.5133 to acknowledge the existing responsibility of
associations to effectively manage their investments. We recognize,
however, that associations have historically maintained few or no
investments in non-agricultural financial instruments. The few
associations that maintain investment portfolios hold primarily money
market instruments and municipal securities. Therefore, the final
regulation requires an association's board of directors to develop
investment policies that are commensurate with its institution's
investment activities.
An association's investment policies should be appropriate for the
size, risk characteristics, and complexity of the association's
investment portfolio and should be based on an association's unique
circumstances, risk tolerances, and objectives. Associations must
[[Page 28886]]
comply with all the requirements in Sec. 615.5133 if the level or type
of their investments could expose their capital to material loss.
However, an association's board does not need to develop an investment
policy if it elects not to hold non-agricultural investments authorized
under Sec. 615.5140.
Final Sec. 615.5140, which lists eligible investments, is modified
to clarify that it applies to associations. As noted earlier,
associations already have the authority under redesignated
Sec. 615.5142 to hold eligible investments that are listed in
Sec. 615.5140. This revision more accurately reflects the scope of this
regulation.
We take this opportunity to reiterate our long-standing position
that service corporations, organized under section 4.25 of the Act, are
subject to the investment regulations in subpart E of part 615.
Although we have noted on past occasions that Sec. 611.1136 of this
chapter applies these investment regulations to both incorporated and
unincorporated service organizations, questions about this issue have
remained. Final Sec. 615.5131(m) resolves this matter by expressly
subjecting FCS service corporations that hold investments to these
regulations. Service corporations that hold no investments are not
required to develop investment policies or comply with Sec. 615.5133.
III. Investment Management
We proposed significant changes to Sec. 615.5133, which governs
investment management practices and internal controls in the FCS. Our
objective was to strengthen this regulation so each System institution
would follow certain fundamental practices that enable its board and
management to fully understand and effectively manage risks in its
investment portfolio. An effective risk management process for
investments requires financial institutions to establish: (1) Policies;
(2) risk limits; (3) a mechanism for identifying, measuring, and
reporting risk exposures; and, (4) a system of internal controls. As a
result, the proposed rule required each Farm Credit board of directors
to adopt policies that establish risk parameters and guide the
decisions of investment managers. More specifically, we required board
policies to establish objective criteria so investment managers can
prudently manage credit, market, liquidity, and operational risks.
Additionally, proposed Sec. 615.5133 established other controls that
help prevent loss, such as:
Clear delegation of responsibilities and authorities to
investment managers;
Separation of duties;
Timely and effective security valuation practices; and,
Routine reports on investment performance.
A. Requests for Change
Only the PFC commented on proposed Sec. 615.5133. Although the PFC
supported the FCA's approach, it requested changes to three provisions
of proposed Sec. 615.5133. In response, we revised two of these
regulations so they advance our safety and soundness objectives without
placing unnecessary burden on the FCS. We resolved the PFC's third
concern with a preamble explanation rather than a regulatory change. In
addition to the two substantive amendments described above, we
reorganized and rewrote this regulation so it is easier to understand
and use.
1. Limits on Transactions With Each Securities Firm
The PFC asked us to eliminate the provision in proposed
Sec. 615.5133(a)(1)(ii) that requires investment policies to ``set
limits on the amounts and types of transactions that the bank shall
execute with authorized securities firms.'' \3\ The PFC believes that
this requirement is overly burdensome because the risk of loss from
purchase and sale transactions with securities firms is negligible. The
commenter also opined that this provision reduces the System's
flexibility to trade with the securities firm that provides the best
terms and execution for investment transactions.
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\3\ The term ``securities firms'' in the final rule and this
preamble collectively refers to brokers, dealers, and investment
banks.
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The PFC persuaded us that some of the requirements in proposed
Sec. 615.5133(a)(1)(ii) might have inadvertently reduced the System's
flexibility in executing transactions with various securities firms.
However, we continue to believe that each System institution must
carefully select and properly manage its relationships with securities
firms as part of its efforts to manage credit risk associated with
settlements on securities transactions. Thus, we respond to the PFC's
concerns by revising the regulation so that the necessary safety and
soundness constraints do not unreasonably hinder business
relationships. In addition, this revision offers System institutions
greater flexibility to trade with the securities firms of their choice.
Specifically, final and redesignated Sec. 615.5133(c)(1)(ii) no
longer obligates the board of directors to set specific limits on the
amount and types of transactions that its institution executes with
authorized securities firms. Instead, the final regulation requires
System institutions to buy and sell eligible investments with more than
one securities firm. As a result, the final rule still requires System
institutions to diversify their exposure to credit risk from brokers,
dealers, and investment bankers.
Nevertheless, final and redesignated Sec. 615.5133(c)(1)(ii) still
requires board policies to establish the criteria that investment
managers will use to select securities firms. We have also retained the
regulatory provisions that require each board of directors to:
Annually review its criteria for selecting securities
firms; and
Determine whether its existing relationships with various
securities firms should continue.
2. Reporting Investment Performance to the Board
The PFC expressed concern about a provision in proposed
Sec. 615.5133(e) that requires investment managers to report quarterly
to the board on the performance and risk of ``each'' investment in the
portfolio. According to the PFC, many FCS banks hold several hundred
individual securities in sizeable investment portfolios. Under these
circumstances, reporting to the board on every single investment is
cumbersome and meaningful board review is difficult. The PFC suggests
the reports to the board should summarize the risks associated with
investment activities and address compliance with investment policies,
objectives, risk limits, and regulatory requirements. The commenter
further suggests that managers should report on individual investments
only in exceptional circumstances.
We revise this provision to address the PFC's concern. Final and
redesignated Sec. 615.5133(g) requires management to report each
quarter to its board of directors or a committee thereof on the
performance and risk of each class of investments and the entire
investment portfolio. Additionally, the final rule continues to require
the report to identify all gains and losses that the institution incurs
during the quarter on individual securities sold before maturity. We
retained a reporting requirement on individual securities because it
provides the board important and accurate information relating to the
performance of investments and investment activity in general.
This new approach requires investment portfolio managers to provide
System boards of directors
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accurate, concise, meaningful, and timely information on the
performance and risk of their institution's investments. This
information helps the board to understand the risks inherent in the
investment portfolio and oversee the investment activities of
investment managers. We believe this revision removes burdensome
reporting requirements from the final regulation while simultaneously
promoting safe and sound investment management practices in the FCS. We
have made no other modification to redesignated Sec. 615.5133(g).
3. Securities Valuations
The only comment on securities valuation was from the PFC. The PFC
asked us to delete proposed Sec. 615.5133(d)(1), which requires System
institutions to verify with an independent source the value of any
security (other than a new issue) that they purchase or sell. The PFC
interprets proposed Sec. 615.5133(d)(1) as requiring FCS institutions
to solicit a second bid for all securities from a competing broker,
dealer, or other intermediary. The PFC warns that this requirement
would undermine the good reputation of the System and cause its
business relationships with securities firms to quickly deteriorate. As
a result, the FCS would ultimately pay higher prices for securities and
obtain lower yields.
We observe that nothing in the proposed regulation or preamble
would require bids on investments from parties who compete with the
seller, purchaser, counterparty, or other intermediary to a specific
transaction. Instead, our regulation requires System banks,
associations, and service corporations to verify the value of a
security with an independent source. As the preamble to the proposed
regulation notes, ``independent verification of a price can be as
simple as obtaining a price from an industry recognized information
provider.'' The same preamble passage also states that ``although price
quotes from information providers are not actual market prices, they
confirm whether the broker's price is reasonable.'' \4\ This regulatory
provision allows System institutions to independently verify the price
of a security with an on-line market reporting service, such as
Bloomberg, Telerate, or Reuters. Additionally, the regulation provides
sufficient flexibility for System institutions to use internal
valuation models to verify the reasonableness of prices that they pay
or receive for securities. Moreover, independent verification of
securities prices is a fundamental component of safe and sound
investment management, and ensures that FCS institutions understand the
value of their investments at purchase and sale.
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\4\ See 63 FR 33284 (June 18, 1998).
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In view of these considerations, we conclude that the requirement
for independent verification of securities prices is appropriate and
should be retained in the final regulation. We also made several
stylistic changes to the securities valuation requirements, which we
redesignated as final Sec. 615.5133(f)(1).
B. Other Comments and Questions on Investment Management
We offer the following responses to requests for clarification on
proposed Sec. 615.5133 and additional guidance regarding investment
management.
1. Are the FCA Regulations Consistent With the Federal Financial
Institutions Examination Council's Policy on Investment Activities?
Yes. We confirm that Sec. 615.5133 is consistent with the Federal
Financial Institutions Examination Council's (FFIEC) ``Supervisory
Policy Statement on Investment Securities and End-User Derivatives
Activities'' (Policy Statement).\5\ We used the FFIEC's Policy
Statement as a benchmark for developing this regulation. In our
opinion, the FFIEC's guidance to other federally regulated financial
institutions on sound investment management practices is suitable for
the FCS. We encourage System institutions to refer to the FFIEC's
Policy Statement when they devise, implement, and review policies that
govern their investment management practices pursuant to Sec. 615.5133.
Additionally, FCS institutions should refer to our policy statement on
interest rate risk management (FCA-PS-74) for further guidance on
managing market risks.\6\
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\5\ See 63 FR 20191 (Apr. 23, 1998).
\6\ See 63 FR 69285 (Dec. 10, 1998).
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2. What Are the Responsibilities of Boards of Directors?
In general, the board of directors of any association or service
corporation that holds eligible investments and every bank is
responsible for establishing written investment policies that are
appropriate for the size, types, and risk characteristics of its
investments. Investment policies are a critical aspect of effective
risk management and should set appropriate limits on exposure to
credit, market, and liquidity risks. We emphasize that investment
policies of each Farm Credit bank and any association or service
corporation with significant investments should embody the following
key elements.
Investment Objectives. A general explanation of the board's
investment objectives, expectations, and performance goals is necessary
to guide investment managers.
Risk Tolerance. Risk tolerance should be based on the strength of
each institution's capital position and its ability to measure and
manage risk. Additionally, risk limits should be consistent with
broader business strategies and institutional objectives. Risk
tolerance can be expressed through several parameters: duration,
convexity, sector distribution, yield curve distribution, credit
quality, risk-adjusted return, portfolio size, total return volatility,
or value-at-risk.\7\ Each institution should use a combination of
parameters to appropriately limit its exposure to credit and market
risk.
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\7\ Generically, duration is a measure of a bond or portfolio's
price sensitivity to a change in interest rates. Convexity measures
the rate of change in duration with respect to a change in interest
rates. A sector refers to a broad class of investments with similar
characteristics or industry classification. Yield curve distribution
refers to the distribution of the portfolio's investments in short-
term, intermediate, or long-term investments. Value-at-risk is a
methodology used to measure market risk in an investment portfolio.
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Asset Allocation. The board's asset allocation policy should ensure
appropriate diversification within the various asset classes, as well
as across the entire investment portfolio.\8\ Final Sec. 615.5140
eliminates the portfolio limits on many eligible investments, and
therefore, we expect each bank, association, and service corporation to
establish its own asset allocation guidelines. Investment parameters
may include points where the investment portfolio should be reallocated
or rebalanced to bring it back in line with the board's strategic asset
allocation goals.
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\8\ Asset allocation is generally defined as the allocation of
your investment portfolio across major asset classes, such as United
States Treasury, corporate, mortgage or asset-backed securities.
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Asset Selection. The investment policy should identify the risk
characteristics (e.g., credit quality, price sensitivity, maturity,
marketability or liquidity, maximum premiums or discounts, etc.) of
investments that are suitable for inclusion in the investment
portfolio.
Derivatives. Derivative instruments can be used to hedge risk,
leverage a position or otherwise modify the risk profile of an
investment portfolio. The board's investment policy should address the
application of derivatives
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within the portfolio and set appropriate limits on the use of
derivatives.
Controls and Reporting Requirements. The investment policy should
describe the duties and responsibilities of the investment manager(s),
set the delegation of authorities, outline any prohibited investments
or activities, and specify the content and frequency of reports to the
board on investment activities.
3. What Analysis Must Management Perform on Individual Investments
Prior to Purchase and on an Ongoing Basis?
Not all investment instruments need an extensive pre-purchase or
post-purchase analysis. Non-complex instruments that have minimal price
sensitivity need little or no pre-purchase analysis. Final and
redesignated Sec. 615.5133(f) (previously proposed Sec. 615.5133(d)(3))
generally requires System banks to perform an analysis of the credit
and market risks on investments prior to purchase and on an ongoing
basis. The primary objective of this provision is to ensure that
management understands the risks and cashflow characteristics of any
investment that it purchases. The board's investment policy should
fully address the extent of the pre-purchase analysis that management
needs to perform for various classes of instruments. For example, the
policy should specifically indicate which stress tests in Sec. 615.5141
should be performed on various types of mortgage securities.
For investments that have unusual, leveraged, or highly variable
cashflows, it is especially important for investment managers to
exercise diligence and thoroughness in making investment decisions.
Managers should have a reasonable and adequate basis, supported by
appropriate analysis for their investment decisions, and maintain
adequate documentation. The analysis should describe the basic risk
characteristics of the investment and include a balanced discussion of
risks involved in purchasing the investment. In preparing the analysis,
investment managers should consider the current rate of return or
yield, expected total return, annual income, the degree of uncertainty
associated with the cashflows, the investment's marketability or
liquidity, as well as its credit and market risks.
4. What Investment Management Approach Does the FCA Prefer?
The PFC asked us to clarify when we expect System institutions to
manage their investments on an individual, portfolio or institutional
basis. The appropriate level of risk management depends on the
complexity of instruments and the size of your investment portfolio. A
System institution may need to analyze risk on an individual,
portfolio, and institutional level. As appropriate, stress testing
should be performed on individual investments, the investment portfolio
or the entire institution. Additionally, other risk management
techniques, such as total return analysis or value-at-risk, may be used
to effectively manage risk exposures.
When a new investment position is likely to significantly alter the
risk profile of an institution, management should complete an analysis
of the potential effects on the portfolio and the entire institution
prior to purchasing the investment. Although investors have
traditionally looked at investments one at a time, modern portfolio
theory suggests that investors should look at the effect of individual
investments on the entire portfolio. Often, investments that seem
acceptable on an individual basis have a significant exposure to a
single risk factor on a cumulative basis. Conversely, under the
portfolio approach, financial institutions may hold individual
investments that are fairly risky, if the risks are offset by other
investments or derivative instruments. As a result, the portfolio
approach allows investment managers to achieve higher returns while
maintaining overall portfolio risk at a reasonable level.
System institutions should tailor their investment management
approach to meet their needs based on the type and level of their
investment activities and unique risk profile. Regardless of the
approach taken, each Farm Credit bank, association, and service
corporation should ensure that it is able to effectively measure,
monitor, and control the credit, market, liquidity, and operational
risks stemming from its investment activities. This requires an
understanding of the source and degree of the institution's risk
exposures and how these risk exposures may change under differing
economic scenarios.
III. Eligible Investments
A. Overview
System banks may purchase and hold the eligible investments listed
in Sec. 615.5140 to maintain liquidity reserves, manage interest rate
risk, and invest surplus short-term funds. Similarly, redesignated
Sec. 615.5142 (formerly Sec. 615.5141) authorizes FCS associations to
hold eligible investments listed in Sec. 615.5140 to invest surplus
funds and reduce interest rate risk. Only investments that can be
promptly converted into cash without significant loss are suitable for
achieving these objectives. For this reason, the eligible investments
listed in Sec. 615.5140 generally have short terms to maturity and high
credit ratings from nationally recognized statistical rating
organizations (NRSROs). Furthermore, all eligible investments are
either traded in active secondary markets or are valuable as
collateral.
We proposed to amend Sec. 615.5140 so System banks and associations
could purchase and hold a broader array of high-quality and liquid
investments. As a result, the proposed regulations expanded the list of
eligible investments and relaxed or repealed certain restrictions in
Sec. 615.5140. These revisions reflect changes in the financial markets
and help fulfill our objective of developing a regulatory framework
that can more readily accommodate innovations in financial products and
analytical tools.
Two commenters, the PFC and The Bond Market Association, generally
supported our proposal to amend Sec. 615.5140. The commenters also
asked us to approve other instruments that would offer higher yields
and further diversify the investment portfolios of System institutions.
As we explain in greater detail below, we incorporated many of the
commenters' suggestions into final Sec. 615.5140. In addition, as part
of our efforts to write regulations that are easier to understand and
use, we converted most of Sec. 615.5140 into a chart.
We received no comments on proposed Sec. 615.5140(a)(1), (a)(3),
(a)(7), and (a)(8), which respectively authorize FCS banks and
associations to invest in:
Securities that are issued or guaranteed by the United
States, its agencies, or instrumentalities;
Obligations of international and multilateral development
banks;
Corporate debt obligations; and
Shares of investment companies that register under the
Investment Company Act of 1940 (e.g., money market mutual funds).
Accordingly, we made no substantive changes to Sec. 615.5140(a)(1),
(a)(3), (a)(7), and (a)(8).
State and Municipal Securities
Existing Sec. 615.5140(a)(10) authorizes System banks and
associations to invest in the general obligations of State and
municipal governments. We proposed to redesignate this provision as
Sec. 615.5140(a)(2) without significant change. However, we added a
definition of ``general obligation of a State or political
subdivision'' to Sec. 615.5131 to
[[Page 28889]]
codify our recent guidance on bonds guaranteed by the full faith and
credit of a State or local government.\9\ We rewrote the definition to
make it clear and we now adopt Secs. 615.5140(a)(2) and 615.5131(e) as
final regulations.
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\9\ See FCA BL-038, ``Guidance Relating to Investment
Activities,'' Nov. 26, 1997).
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Prior to this rulemaking, System banks requested authority to
invest in revenue bonds. Revenue bonds are not supported by the
taxation powers of the obligor, and are repayable from fee income and
other sources of revenue. We requested input on how the final
regulation could authorize investments in revenue bonds while limiting
risks to System institutions. More specifically, we solicited comments
on how the final regulation could establish:
Criteria for determining which revenue bonds meet the
investment purposes in Sec. 615.5132; and
Appropriate limits on the amount of these investments.
We received only one comment concerning municipal securities. The
PFC suggested that all highly rated revenue bonds should be eligible
investments. The PFC believes that highly rated revenue bonds are
suitable for meeting liquidity and interest rate risk management
objectives.
Municipal revenue bonds may provide FCS banks and associations with
another suitable investment to diversify their portfolios. The universe
of municipal revenue bonds is diverse and some, but not all, of these
instruments are actively traded in established secondary markets.
Although the full faith and credit of a governmental entity with
taxation powers does not back municipal revenue bonds, these
instruments usually enjoy an implicit guarantee of the State
government. For these reasons, we add municipal revenue bonds as
eligible investments, subject to certain safety and soundness controls.
Final Sec. 615.5140(a)(2) authorizes FCS banks and associations to
invest in municipal revenue bonds that are rated in the highest
investment rating category by an NRSRO and mature within 5 years or
less. The final regulation requires the investing System bank or
association to document, at the time of purchase, that the particular
issue is actively traded in an established secondary market.
Additionally, these investments are subject to a 15-percent portfolio
limit. We also added a conforming definition of ``revenue bonds'' to
final Sec. 615.5131.
C. Money Market Instruments
We proposed several changes to the provisions in Sec. 615.5140 that
authorize FCS banks and associations to invest in money market
instruments. Under our proposal, all money market instruments were
grouped together into a single regulatory provision,
Sec. 615.5140(a)(4). We proposed to repeal existing limitations on the
amounts of negotiable certificates of deposit, Federal funds (Fed
Funds), bankers acceptances, and prime commercial paper that each FCS
institution can hold in its investment portfolio. We also added
Eurodollar time deposits and master notes to the list of eligible money
market investments.
Only the PFC commented on proposed Sec. 615.5140(a)(4). The
commenter asked us to: (1) Repeal the ``callable'' requirement for Term
Federal Funds; and (2) clarify the credit rating requirements for
repurchase agreements and master notes.
1. Term Federal Funds
From the commenter's perspective, our insistence that System
institutions invest only in negotiable Term Fed Funds is inconsistent
with our approach toward Eurodollar time deposits. The PFC pointed out
that proposed Sec. 615.5140(a)(4) granted System institutions new
authority to invest in non-negotiable Eurodollar time deposits, which
are very similar to Term Fed Funds in terms of credit, liquidity, and
market risks. The PFC asserts that Term Fed Funds do not need a
``callable'' feature to make them liquid because our regulation already
requires them to maintain a high credit rating and mature within 100
days. Thus, the PFC urges us to delete the provision in
Sec. 615.5140(a)(4)(i) that requires all Term Fed Funds to be
``callable.''
The PFC persuaded us that highly rated Term Fed Funds that mature
within 100 days are suitable investments, even if they are not
``callable.'' Thus, we amended this provision so final
Sec. 615.5140(a)(4) no longer requires System banks and associations to
invest only in ``callable'' Term Fed funds.\10\ This change will
provide System institutions with additional flexibility to invest with
counterparties that do not offer ``callable'' features on Term Fed
Funds.
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\10\ In the final regulations, Term Fed Funds are defined as
having a maturity between 2 and 100 business days.
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In addition, the final regulations apply consistent treatment of
investments in Term Fed Funds and Eurodollar time deposits. Final
Sec. 615.5140 subjects non-callable Term Fed Funds to the same 20-
percent portfolio limit as Eurodollar time deposits. From a safety and
soundness perspective, this portfolio limit is necessary to limit the
amount of non-negotiable instruments that are held in bank and
association investment portfolios. The final regulation continues to
place no portfolio limit on the amount of ``continuously callable''
Term Fed Funds that FCS banks and associations can hold. Like
Eurodollar time deposits, non-callable Term Fed Funds must also be
invested at depository institutions with the highest short-term credit
rating from an NRSRO.
2. Response to Comments on Credit Ratings
a. When are short-term or long-term credit ratings appropriate for
the collateral securing repurchase agreements? Final
Sec. 615.5140(a)(4) allows System banks and associations to invest in
repurchase agreements that are backed either by: (1) Eligible
investments; or (2) other marketable securities that are rated in the
highest credit rating category by an NRSRO. The type of collateral
should determine whether a short-term or a long-term credit rating is
appropriate. System banks and associations may use an equivalent long-
term rating if it is the only credit rating available for a short-term
financial instrument held as collateral in a repurchase agreement.
b. Are long-term credit ratings appropriate when no short-term
ratings are available for counterparties to master note agreements?
Yes. We recognize that certain institutions that are counterparties to
master note agreements may only have long-term credit ratings from an
NRSRO. When short-term credit ratings are unavailable, System
institutions may use an equivalent long-term rating to determine if the
money market instrument is eligible under our regulations. For example,
we consider an ``A-1'' short-term rating from Standard and Poor's (S&P)
to be the equivalent to a ``AA'' or higher long-term S&P rating.
D. Mortgage Securities
1. Overview
We proposed significant changes to the authority of FCS
institutions to invest in mortgage securities. The proposal expanded
the list of eligible investments to include certain non-agency mortgage
securities and stripped mortgage-backed securities (SMBS). We proposed
these amendments to grant FCS banks and associations more options for
managing risks and diversifying their portfolios.
Both the PFC and The Bond Market Association suggested additional
revisions to the regulation, and asked us
[[Page 28890]]
several questions about the proposed requirements. They recommend that
we grant FCS banks and associations authority to invest in: (1)
Mortgage securities that are rated within the two highest rating
categories by an NRSRO, (2) multifamily mortgage securities, and (3)
non-agency commercial mortgage-backed securities (CMBS). In response to
these comments, we revised Sec. 615.5140(a)(5) so System banks and
associations can invest in a broader array of mortgage securities.
2. Credit Ratings
Both the PFC and The Bond Market Association asked us to authorize
investments in mortgage securities that are rated in the ``two''
highest (rather than only the highest) credit rating categories of an
NRSRO. The commenters assert that investment grade mortgage securities
in general have exhibited a remarkable credit performance history. Over
the past 20 years, few mortgage security issues have experienced
credit-related problems. Furthermore, the two highest credit ratings
would correspond with the criteria in the Secondary Mortgage Market
Enhancement Act of 1984.\11\
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\11\ See Pub. L. 98-440, 98 Stat. 1689 (Oct. 3, 1984).
---------------------------------------------------------------------------
After carefully considering the commenters' input and weighing the
potential risks, we did not adopt the suggestion to lower the credit
rating for mortgage securities. There is an ample assortment of
mortgage securities in the highest investment credit rating category
that System banks and associations can use for liquidity, cash and
interest rate risk management. We believe the final regulation
maintains the high credit quality of System investments without
depriving System institutions of any significant opportunity to invest
in mortgage securities.
3. Mortgage Securities that are Issued or Guaranteed by the United
States
We made a technical correction to the provision that allows FCS
banks and associations to invest in mortgage securities that are issued
or fully guaranteed by the United States. Our proposal omitted language
in the former regulations that authorize investment in securities that
are backed by mortgages that are guaranteed as to both principal and
interest by the full faith and credit of the United States. Final
Sec. 615.5140(a)(5) allows System banks and associations to invest in
mortgage securities that are:
Issued or guaranteed by the Government National Mortgage
Association (GNMA); or
Secured by mortgages that are guaranteed as to both
principal and interest by the full faith and credit of the United
States.
This provision extends to mortgage securities issued by the Small
Business Administration (SBA) or other Federal government agencies if
the full faith and credit of the United States back the principal and
interest payment of the underlying mortgages. All mortgage securities
that System banks and associations purchase under Sec. 615.5140(a)(5)
must comply with the stress-testing requirements in Sec. 615.5141.
4. Agency Mortgage Securities
We made no changes to FCS institutions' authorities to invest in
residential mortgage securities that are:
Issued by Fannie Mae and the Freddie Mac; or
Issued under a private label but are collateralized by
Fannie Mae or Freddie Mac mortgage-backed securities.
System banks, however, suggested that we add Fannie Mae Delegated
Underwriting and Servicing (DUS) bonds to the list of eligible
investments. Fannie Mae DUS bonds are mortgage securities backed by
multifamily mortgage loans. They carry the Fannie Mae guarantee on the
timely payment of principal and interest. They also have low prepayment
risk due to yield maintenance agreements, prepayment lockouts, and
prepayment fees. We agree that agency mortgage securities backed by
multifamily loans are suitable investments for FCS institutions.
Therefore, we amended the definition of ``mortgage securities'' in
Sec. 615.5131(i) to clarify that FCS banks and associations have the
authority to invest in Fannie Mae DUS bonds and other mortgage
securities on multifamily residential properties that are issued or
guaranteed by Federal agencies and instrumentalities. Agency mortgage
securities that are secured by multifamily loans must meet the stress-
testing requirements of Sec. 615.5141.
5. Portfolio Limits on Fannie Mae and Freddie Mac Mortgage Securities
Two commenters, the PFC and The Bond Market Association, asserted
that the 50-percent portfolio limit on Fannie Mae and Freddie Mac
mortgage securities is overly restrictive and unprecedented. According
to these commenters, the credit risk on these securities is almost non-
existent and no other financial regulatory agency places any
restrictions on the amount of these securities.
After a thorough evaluation of these comments, we decided not to
eliminate the portfolio limit on Fannie Mae and Freddie Mac mortgage
securities. We believe that regulatory portfolio limits enhance safety
and soundness by promoting diversification of System investment
portfolios and curtailing investments in securities that may exhibit
considerable interest rate risk. The final regulation greatly expands
the types of mortgage securities that are eligible investments. Under
the circumstances, we believe portfolio limits are an appropriate
regulatory tool for controlling the System's market risk exposure from
these instruments.
We did, however, make one important modification to the proposed
portfolio limits in response to the commenters' concerns. Under the
final regulations, the 50-percent limit on agency mortgage securities
is now separate from the 15-percent limit on non-agency residential and
commercial mortgage securities. The new portfolio limits accommodate
the System's desire for greater opportunities to invest in mortgage
securities.
We emphasize that the board and management of each System bank,
association, or service corporation are responsible for establishing
exposure limits on all types of mortgage securities. Regulatory
portfolio limits on certain mortgage securities do not absolve an
institution's board or management of its responsibility to set limits
based on its unique risk-bearing capacity, management capabilities, and
objectives. Moreover, the board of directors of each System bank or
association has a fiduciary duty to maintain a well-diversified
investment portfolio to reduce the risk of substantial loss. We also
expect FCS banks and associations to diversify their investments within
each major asset class.
6. Non-Agency Mortgage Securities
Our proposal would authorize System institutions to invest in
mortgage securities that are offered by private entities.\12\ Under the
proposal, only the highest rated privately issued securities that are
collateralized by qualifying residential mortgages meeting the
collateral requirements of the Secondary Mortgage Market Enhancement
Act of 1984 (SMMEA), would be eligible investments.\13\ SMMEA
securities must generally be secured by a first lien on
[[Page 28891]]
a single parcel of real estate (residential or mixed residential
commercial structure) and originated by a qualifying financial
institution.\14\ Our proposal required System banks and associations to
subject these mortgage securities to a stress test under Sec. 615.5141
prior to purchase.
---------------------------------------------------------------------------
\12\ See proposed Sec. 615.5140(a)(5)(ii).
\13\ The proposed rule allows investments in mortgage securities
that are offered and sold pursuant to section 4(5) of the Securities
Act of 1933, 15 U.S.C. 77d(5) or are residential mortgage-related
securities within the meaning of section 3(a)(41) of the Securities
Exchange Act of 1934, 15 U.S.C. 78c(a)(41).
\14\ See SMMEA amended section 3(a)(41) of the Securities
Exchange Act of 1934.
---------------------------------------------------------------------------
System banks requested additional authority to invest in mortgage
securities that are collateralized by mortgages on commercial
properties, such as apartment buildings, shopping centers, office
buildings, and hotels. CMBS typically have yield maintenance provisions
or other features that provide greater prepayment protection to
investors than residential mortgage securities.\15\ However, CMBS are
more difficult to analyze in terms of credit risk. The structure of
CMBS securities can vary widely and the more unique structures may
contain additional risks that need to be thoroughly evaluated. The CMBS
market is relatively young and has recently experienced liquidity
problems.
---------------------------------------------------------------------------
\15\ ``CMBS'' refers only to non-mortgage securities on
commercial real estate. This term does not cover Fannie Mae mortgage
securities on mixed residential and commercial properties or
mortgage securities on commercial real estate that the SBA issues or
guarantees.
---------------------------------------------------------------------------
On balance, we conclude CMBS with appropriate safety and soundness
controls may help Farm Credit banks achieve greater portfolio
diversification and risk-adjusted returns. We, therefore, authorized
investments in CMBS that are rated in the highest credit rating
category by an NRSRO and supported by no less than 100 mortgage loans
that are geographically dispersed. Additionally, no single obligor can
be the mortgagor on more than 5 percent of the loans in the entire
mortgage pool. The final regulation subjects CMBS to the same portfolio
cap as non-agency mortgage securities. As a result, the combined
investment in CMBS and non-agency mortgage securities cannot exceed 15
percent of the total investment portfolio.
Prudent investment practices require investment managers to fully
understand the cashflow characteristics and price sensitivity of CMBS
investments. Thus, we require System institutions to subject CMBS
investments to stress testing in accordance with Sec. 615.5141.
Furthermore, System banks should rely on evaluation methodologies that
take into account all the risk elements in CMBS investments. In this
regard, we stress the importance of making an independent and critical
evaluation of the security's credit and liquidity risks prior to
purchase, and on an ongoing basis.
7. Other Mortgage-Derivative Products
The FCA proposed to repeal existing Secs. 615.5131(r) and (s),
615.5140(a)(2)(v), and certain provisions in Sec. 615.5174(c) that
explicitly ban investments in SMBS and inverse floating-rate debt
classes. We concluded that the explicit regulatory ban on certain
mortgage-derivative products (MDP) is unnecessary because all mortgage
securities are subject to stress-testing requirements. We received no
comments regarding these proposed changes, and therefore adopt this
provision as a final rule.
However, certain MDP (such as SMBS) may pose substantial risks to
the System institutions, and, therefore we take this opportunity to
reiterate the importance of effective risk management and to provide
additional guidance. Although we recognize that MDP can be useful tools
for reducing interest rate risk, certain MDP are risky because their
prices may be subject to substantial fluctuations. Successful risk
management of these instruments requires a thorough understanding of
the principles that govern the pricing of these instruments. The degree
of price sensitivity that a mortgage security exhibits to changes in
market interest rates is influenced by its unique characteristics. A
System institution should determine whether a particular mortgage
security meets its risk management objectives by using analytical
techniques and methodologies that effectively evaluate how interest
rate changes will affect prepayments and cashflows of the instrument.
Investment managers must have a reasonable basis for making
investments in MDP that exhibit significant price sensitivity and
maintain appropriate records to support their investment decisions. In
general, the FCA would view it as an unsafe and unsound practice for
FCS banks and associations to hold highly price-sensitive MDPs, such as
interest-only or principal-only SMBS, for any purpose other than to
reduce specific interest rate risks. Managers must document, prior to
purchase and each quarter thereafter, that the MDP is reducing the
interest rate risk of a designated group of assets or liabilities and
the interest rate risk of the institution.
E. Asset-Backed Securities
1. An Overview of Our Proposal and Summary of Comments
Our proposal expanded the collateral for eligible asset-backed
securities (ABS) to include student loans, manufactured housing loans,
wholesale dealer automobile loans, equipment loans and home equity
loans. Under these regulations, securities collateralized by home
equity loans qualify as ABS, not mortgage securities. Proposed
Sec. 615.5140(a)(6) specified that the weighted average life (WAL) for
all eligible ABS could not exceed 5 years and the final maturity could
not exceed 7 years. We further proposed that all eligible ABS achieve
the highest credit rating from an NRSRO, and we suggested a 20-percent
portfolio cap on these investments. We also solicited your comments on
how we could develop a more flexible regulatory framework that could
effectively respond to new innovations in the ABS market.
The PFC and The Bond Market Association responded to our proposal
on ABS. They asked us to revise the provisions in proposed
Sec. 615.5140(a)(6) relating to ABS maturity, collateral, and credit
rating requirements and the portfolio limit. In response, we made
several modifications to these proposed provisions, which are explained
below.
2. Final Maturity
The PFC and The Bond Market Association advised us that the
combination of a 5-year WAL and a final maturity of 7 years would
effectively prevent System banks and associations from investing in
some of the most liquid segments of the ABS markets. As a result, both
commenters asked us to omit the provision that establishes a final
maturity for ABS from final Sec. 615.5140(a)(6).
We conclude that the commenters' suggestion has merit. Generally,
the WAL is the average amount of time required for each dollar of
invested principal to be repaid, based on the cashflow structure of an
ABS and an assumed level of prepayments. In contrast, the final
maturity of an ABS refers to the date that the final principal payment
on the underlying collateral is due. Nearly all ABS are priced and
traded on the basis of their WAL. We agree that the 7-year final
maturity restriction in the proposed rule would have effectively
foreclosed the System's ability to invest in ABS that are backed by
certain types of collateral, especially manufactured housing and home
equity loans. Therefore, the final rule does not
[[Page 28892]]
impose a maximum final maturity on ABS.
3. Adjustable Rate ABS
The PFC also asked us to modify the maturity guidelines for
adjustable rate ABS so that they are more consistent with the criteria
for adjustable rate mortgage securities. The preamble to the proposed
rule noted that repricing frequency, periodic life caps, and the
underlying index are important determinants of how a floating rate ABS
performs and its interest rate risk profile.\16\ Although the PFC
generally agreed with this statement, it pointed out that the maturity
(whether defined as WAL, expected final or legal final maturity) will
not provide much insight into the interest rate risk profile of the
instrument. The PFC also noted that these securities have minimal price
sensitivity and interest rate risk because most adjustable rate ABS:
(1) Frequently reprice off a recognized index; (2) are uncapped; or (3)
have very high lifetime interest rate caps. We agree and we have
modified the regulations to address these concerns. Under the final
regulations, the expected WAL on eligible ABS must not exceed:
---------------------------------------------------------------------------
\16\ See 63 FR 33281, 33289 (June 18, 1998).
---------------------------------------------------------------------------
Five (5) years for a fixed rate security or floating rate
security at its contractual interest rate cap;
Seven (7) years for a floating rate security without a cap
or floating rate security that remains below its contractual interest
rate cap.
4. Collateral and Credit Ratings
The PFC suggests that final Sec. 615.5140(a)(6) authorizes System
banks to invest in any ABS that is rated in the two highest credit
rating categories by an NRSRO once a liquid market is established. The
PFC believes that its suggestion would expand the System's
opportunities to invest in the ABS market while preventing System banks
and associations from acquiring individual securities that are
illiquid. The PFC asserts that a high credit rating is indicative of
whether an ABS is liquid. The commenter supports its position by
pointing out that the secondary market for ABS is now larger than the
secondary market for Collateralized Mortgage Obligations (CMOs). If we
adopted this approach, the final regulation would not restrict the
types of collateral that back eligible ABS.
We did not incorporate the PFC's suggestion into final
Sec. 615.5140(a)(6). This regulation allows System banks and
associations to invest in most ABS that are available in the financial
markets. Although the ABS market now outpaces the CMO market, the
secondary market for ABS issues secured by other types of collateral is
more limited. The PFC acknowledges in its comment letter that its
suggestion may not necessarily be a reliable gauge of liquidity in ABS
markets. Final Sec. 615.5140(a)(6) provides System institutions ample
opportunities to invest in highly rated, fixed-income ABS that offer
stable cashflows. Furthermore, the FCA will consider approval of other
types of ABS on a case-by-case basis under final Sec. 615.5140(e).
5. Portfolio Limit
We did not incorporate The Bond Market Association's suggestion to
increase the portfolio limit on ABS from 20 to 50 percent. The ABS
market primarily developed during a period of prolonged economic
growth, and, for the most part, the performance of the ABS market has
not been tested under significant economic stress. For this reason, we
are reluctant to increase the System's exposure to ABS investments at
this time.
Separately, System institutions asked us to explain how
Sec. 615.5140 applies to senior ABS that are secured by student loans
the United States Department of Education conditionally guarantees.
These securities are backed by loans that are conditionally guaranteed
by the United States Department of Education through a program that
reinsures the guarantees of loans by State and nonprofit agencies. The
portion of the security that the United States Department of Education
does not conditionally guarantee must be counted toward the 20-percent
ABS limit. The portfolio limit does not apply to the portion of the
security that the United States guarantees. This treatment is
consistent with our approach of placing no portfolio restrictions on
investments in obligations that are insured or guaranteed by the United
States or its agencies. Obligations that are insured or guaranteed by
the United States or its agencies are authorized under
Sec. 615.5140(a)(1).
F. Approval Process for Other Investments
We solicited comments on how final Sec. 615.5140 could permit FCS
banks and associations to invest in highly rated marketable securities
that are not expressly authorized by Sec. 615.5140 without requiring
FCA approval. System banks suggested that the FCA should pursue a more
general and broader approach to risk management and establish a set of
price volatility guidelines that could be applied to all types of
investments. After considering this suggestion, we concluded, for the
reasons explained below, that this suggestion is not an effective
replacement for the prior approval requirement in Sec. 615.5140.
We make no changes in our process for approving investments not
listed in Sec. 615.5140 for several reasons. We designed final
regulations that would grant FCS banks more flexibility to manage risk
in accordance with their own unique risk tolerance and objectives. For
example, FCS institutions now have the option under Sec. 615.5141 to
establish their own internal price volatility guidelines for mortgage
securities. Furthermore, the final regulations expand the list of
eligible investments and remove or relax regulatory restrictions on
other authorized investments. Together, these amendments provide each
FCS bank with a broader selection of investments so it can establish a
well diversified investment portfolio that will enable it to maintain a
liquidity reserve, invest surplus funds, and manage interest rate
risks. Similarly, Sec. 615.5133 places the primary responsibility for
identifying, measuring, and managing risk with each System institution.
This provision allows each FCS institution to set its own risk
tolerance levels based on its unique circumstances.
Furthermore, establishing a single set of price volatility
guidelines that applies to all types of investments and all System
banks and associations is inconsistent with our new regulatory
approach. We believe we can achieve our safety and soundness objectives
by placing greater emphasis on effective investment and risk management
practices within the System. Therefore, the final regulations continue
to require System institutions to seek our approval before they
purchase investments not listed in Sec. 615.5140.
G. Equity Investments
CoBank, ACB, responded to our initiative on regulatory burden by
suggesting that we amend Sec. 615.5140 so FCS banks could hold equity
investments in borrowers and other third parties who form strategic
alliances to serve System customers. These types of investments further
the System's mission to finance agriculture and rural communities, but
usually they are not suitable for managing liquidity and market risks
at System institutions. We plan to initiate a rulemaking in the future
that will address the authority of FCS banks and associations to hold
equity investments that are related to their agricultural credit
mission.
[[Page 28893]]
Accordingly, we will address CoBank's request at that time.
IV. Stress Testing for Mortgage Securities
We adopt the requirements for stress testing mortgage securities in
Sec. 615.5141 as a final regulation without substantive amendment.
However, we did receive several questions and comments regarding stress
testing that require a response.
Prior to this rulemaking, FCS banks requested technical
modifications to our existing regulatory stress tests. System banks
subsequently requested that we repeal the regulatory stress tests after
the FFIEC rescinded a policy statement that required depository
institutions to stress test mortgage-derivative products.\17\ System
banks commented that the FCA should make its regulatory approach
consistent with the FFIEC's new policy. In response, we proposed
significant changes to existing requirements for evaluating the price
sensitivity of mortgage securities and determining their suitability.
We, however, did not propose to rescind the stress-testing requirement
for mortgage securities.
---------------------------------------------------------------------------
\17\ See 63 FR 20191 (Apr. 23, 1998).
---------------------------------------------------------------------------
We concluded that stress testing is an essential risk management
practice for several reasons. Although credit risk on highly rated
mortgage securities is minimal, mortgage securities may expose
investors to significant interest rate risk. Since borrowers may prepay
their mortgages, investors may not receive the expected cashflows and
returns on these securities. Additionally, numerous factors influence
the cashflow pattern and price sensitivity of mortgage securities.
Prepayments on these securities are affected by the spread between
market rates and the actual interest rates of mortgages in the pool,
the path of interest rates, and the unpaid balances and remaining terms
to maturity on the mortgage collateral. The price behavior of a
mortgage security also depends on whether the security was purchased at
a premium or at a discount. As a result of these factors, we concluded
that each System institution needs to employ appropriate analytical
techniques and methodologies to measure and evaluate interest rate risk
inherent in mortgage securities. More specifically, prudent risk
management practices require every System institution to examine the
performance of each mortgage security under a wide array of possible
interest rate scenarios.
Our proposal allowed each System institution to accomplish this
performance analysis by choosing between two options for stress testing
mortgage securities. Under the first option, an FCS institution could
continue to use a modified version of the existing three-pronged stress
test in Sec. 615.5141(a). The three tests include an average life test,
an average life sensitivity test, and a price sensitivity test.
The Bond Market Association suggested that we eliminate the
standardized stress tests in Sec. 615.5141(a) because a risk management
program that requires a financial institution to identify, measure,
monitor, and control risk on an institutional or portfolio level is
more effective than a pass/fail test for individual instruments.
However, we elect to retain the three-pronged stress test in
Sec. 615.5141(a) as a viable option for System institutions. Our
reasoning for this decision stems from our concerns about additional
resources, costs, and expertise associated with more comprehensive
analytical techniques needed to effectively manage risk at the
portfolio or institutional level. From a historical perspective, the
tests in Sec. 615.5141(a) successfully protected Farm Credit banks from
significant losses in certain mortgage products. By requiring the pre-
purchase and quarterly price sensitivity analysis, System banks were
better able to understand the risks associated with their investments.
Under the second stress-testing option, proposed Sec. 615.5141(b)
allowed the use of alternative stress test criteria and methodologies
to evaluate the price sensitivity of mortgage securities. We proposed
this alternative because new risk management techniques better enable
investors to measure interest rate risks in complex mortgage
securities. We also emphasized that alternate stress tests must be able
to measure the price sensitivity of mortgage instruments over different
interest rate and yield curve scenarios. Furthermore, the methodology
must be commensurate with the complexity of the instrument's structure
and cashflows. For example, a pre-purchase analysis should show the
effect of an immediate and parallel shift in the yield curve of plus
and minus 100, 200, and 300 basis points. An instrument's complexity
determines whether the risk analysis should encompass a wider range of
scenarios, including non-parallel changes in the yield curve. A
comprehensive analysis may also take into consideration other relevant
factors. Most importantly, the methodology that each System bank or
association uses to evaluate an instrument's suitability must be able
to determine that a particular mortgage security:
Meets the objectives and risk limits in its investment
policies; and
Does not expose the capital and earnings of the
institution to excessive risk.
We received one comment from the PFC on proposed Sec. 615.5141(b).
The PFC requested clarification on whether the board or the management
of each FCS bank and association is responsible for establishing the
risk parameters of alternate stress tests. If the board elects to use
alternative stress tests as permitted under Sec. 615.5141(b) to gauge
market risk in mortgage securities, it must also assume responsibility
for establishing the risk parameters for the stress test.
In further response to the PFC, we reaffirm that Sec. 615.5141(b)
is consistent with the guidance in the FFIEC's policy statement
regarding stress testing mortgage securities. Our new approach, which
we now adopt as a final regulation, enables System banks and
associations to rely on more comprehensive analytical techniques that
enhance their risk management. Our regulations no longer prevent System
banks and associations from holding mortgage securities solely on the
basis that they exhibit significant price sensitivity. The final
regulation affords FCS banks and associations the latitude to consider
a number of factors when evaluating a mortgage security's suitability.
For example, System banks and associations may consider interest rate
volatility, changes in credit spreads, an instrument's total return or
whether the instrument reduces the overall risk in the investment
portfolio or throughout the institution.
The PFC inquired whether derivative hedge transactions could be
considered when determining whether a mortgage security is an eligible
investment. We confirm that FCS institutions may consider the effect of
derivative hedge transactions on the price sensitivity of instruments
as part of their evaluation of whether a particular mortgage security
is a suitable investment under either Sec. 615.5141(a) or (b).
V. Farmer Mac Mortgage Securities
1. Our Proposal
We proposed technical amendments to Sec. 615.5174, which authorizes
FCS banks and associations to invest in mortgage securities that are
issued or guaranteed by Farmer Mac. Basically, we intended to revise
Sec. 615.5174 so it conforms to amendments in subpart E of part 615.
More specifically, these technical amendments would:
[[Page 28894]]
Delete cross-references to the former definitions of
``mortgage-backed securities,'' ``collateralized mortgage
obligations,'' ``Real Estate Mortgage Investment Conduits,'' and
``adjustable rate mortgages'' in Sec. 615.5131; and
Repeal existing Sec. 615.5174(c), which prohibits FCS
banks and associations from investing in Farmer Mac stripped mortgage-
backed securities.
2. Summary of Comments
Two commenters requested substantive revisions to Sec. 615.5174.
Farmer Mac asked us to amend our regulations to equalize the regulatory
treatment of mortgage securities of Farmer Mac, Fannie Mae, and Freddie
Mac. Farmer Mac asserts that our original justification for according
Farmer Mac mortgage securities a different regulatory treatment than
Fannie Mae and Freddie Mac mortgage securities is no longer valid.
Farmer Mac points out that 2 years after we adopted existing
Sec. 615.5174, Congress enacted the Farm Credit System Reform Act of
1996 \18\ (1996 Act), which repealed several statutory provisions that
distinguished its mortgage securities from those of Fannie Mae and
Freddie Mac. As a result of these statutory changes, Farmer Mac asserts
that the spreads of Farmer Mac mortgage securities are now close to
those on comparable Fannie Mae and Freddie Mac products. For these
reasons, Farmer Mac believes that the mortgage securities of all three
GSEs expose investors to approximately the same risk of loss and should
be treated in a similar fashion.
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\18\ Pub. L. 104-105, 110 Stat. 162 (Feb. 10, 1996).
---------------------------------------------------------------------------
The jointly managed Central Coast Production Credit Association/
Federal Land Credit Association (Central Coast) responded to our notice
on regulatory burden by encouraging us to repeal the 20-percent
portfolio limit on Farmer Mac mortgage securities in existing
Sec. 615.5174(a). As the commenter notes, we enacted this portfolio
limit in 1993, when the Act required System banks and associations to
guarantee 10 percent of Farmer Mac mortgage securities through either a
cash reserve or a subordinated participation interest in the underlying
loans. The associations assert that the original safety and soundness
rationale for the 20-percent portfolio limit no longer exists because
Farmer Mac now has the authority both to issue mortgage securities and
to fully guarantee principal and interest payments to investors.
3. Response to Comments
We acknowledge that the 1996 Act granted Farmer Mac many of the
same powers that Fannie Mae and Freddie Mac have to issue and guarantee
mortgage securities. These statutory amendments profoundly changed
Farmer Mac's business operations and the market for its securities. We
agree that the 1996 Act has rendered many provisions of existing
Sec. 615.5174 obsolete, and for this reason, this regulation requires
more than technical and conforming amendments.
4. Final Regulation
We have fashioned a final regulation that balances the interests of
both Farmer Mac and other System institutions. We recognized Farmer
Mac's new statutory powers and market realities by repealing all
obsolete provisions in Sec. 615.5174. The final regulation responds to
Farmer Mac's request for comparable treatment with Fannie Mae and
Freddie Mac by applying the investment management provisions of final
Sec. 615.5133(b) and (c) and the stress test requirements of final
Sec. 615.5141 to Farmer Mac mortgage securities. In the same context,
final Sec. 615.5174 focuses on issues that are unique to investments by
FCS banks and associations in Farmer Mac mortgage securities. In
addition, the final regulation allows System banks and associations
more latitude to manage their credit risks through investments in
Farmer Mac securities.
Final Sec. 615.5174(a) continues to authorize System banks and
associations to invest in mortgage securities that are issued or
guaranteed as to principal and interest by Farmer Mac. This provision
specifically allows System banks and associations to purchase and hold
Farmer Mac securities for the purposes of: (1) Managing credit and
interest rate risk; and (2) furthering their mission to finance
agriculture. Certain Farmer Mac mortgage securities may help System
banks and associations to manage interest rate risk exposures in their
portfolios. Additionally, System banks and associations can use these
mortgage securities for cashflow management because Farmer Mac
guarantees that investors will receive timely payment of principal and
interest.
We added explicit references to associations to final Sec. 615.5174
to clarify the scope of this regulation. Because redesignated
Sec. 615.5142 contained a redundant authorization for FCS associations
to purchase and hold Farmer Mac mortgage securities, we deleted the
reference to Sec. 615.5174 in redesignated Sec. 615.5142.
System banks and associations can still acquire subordinated
participation interests in Farmer Mac pools, although title VII of the
Act no longer requires them to do so. Investments by System banks and
associations in subordinate Farmer Mac securities are also subject to
regulations in part 614 of this chapter.
In response to Central Coast's request, we modified the portfolio
cap in this regulation. Farmer Mac mortgage securities can be used to
diversify the credit risk exposure in FCS bank and association
agricultural loans and further their important mission objectives.
Therefore, final Sec. 615.5174 allows System banks and associations to
hold Farmer Mac mortgage securities in an amount that is equal to their
total outstanding loans.
We note that System banks must not count Farmer Mac mortgage
securities as part of their total outstanding loans when they calculate
their 30-percent portfolio limit for liquid investments under
Sec. 615.5132. Our reason for this treatment is that Farmer Mac
mortgage securities are not considered loans of System banks and
associations.
Final Sec. 615.5174(b) covers the responsibilities of boards and
senior management for overseeing investments in Farmer Mac securities.
This provision requires each Farm Credit bank and association board of
directors to adopt written policies that will govern their investments
in Farmer Mac securities. Final Sec. 615.5174(b) closely parallels
similar provisions in Sec. 615.5133 that guide investment management
practices for non-agricultural investments.
Final Sec. 615.5174(c) also closely follows similar provisions in
Sec. 615.5133. This provision requires banks and associations to
establish policies that identify the types and quantity of Farmer Mac
securities they will hold to achieve their objectives and set credit,
market, and liquidity risk limits. Under final Sec. 615.5174(c)(2), the
board's policy must establish specific criteria for managing credit
risk by establishing product and geographic diversification
requirements for investments in Farmer Mac mortgage securities. Final
Sec. 615.5174(c)(3) requires the board's policies to address how the
market risk of Farmer Mac mortgage securities affects the institution's
capital and earnings.
Under final Sec. 615.5174(c)(4), board policies must indicate
liquidity risk tolerance levels. Risk preferences may be based on the
liquidity characteristics of the types of Farmer Mac securities you
wish to select for your portfolio and your institutional objectives. We
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recognize that if your objective is to hold Farmer Mac securities until
maturity, liquidity risk is less important. Additionally, the final
regulations prohibit Farm Credit banks from holding Farmer Mac mortgage
securities in the liquidity reserve they maintain under Sec. 615.5134.
Our concern over concentration risk led us to develop this provision.
For example, if the System had real or perceived credit problems due to
a crisis in the agricultural economy and could not access the market at
reasonable rates, those same economic factors may also adversely affect
the price and liquidity of Farmer Mac securities.
Lastly, final Sec. 615.5174(d) requires System banks and
associations to perform stress tests in accordance with final
Sec. 615.5141 to measure market risks in these securities.
VI. Liquidity Reserve
We received no comment on our proposal to repeal a provision in
existing Sec. 615.5134(b) which requires System banks to segregate
investments in the liquidity reserve from investments that are held for
other purposes under Sec. 615.5132. This amendment provides FCS banks
with greater flexibility to decide how to best use their investments to
manage risk exposure.
In response to our initiative on regulatory burden, CoBank, ACB,
stated that the ``burdensome liquidity reserve requirement calculations
should be simplified.'' The commenter did not offer any suggestions for
simplifying the liquidity reserve requirement in Sec. 615.5134.
The liquidity reserve requirement for System banks is calculated
using a basic formula. The liquidity reserve requirement ensures that
FCS banks have a pool of liquid investments to fund their operations
for approximately 15 days if their access to the capital markets
becomes impeded. We believe the significance of maintaining an ample
supply of liquid funds outweighs any burdens created by the liquidity
reserve calculation process. Thus, we made no changes to the liquidity
reserve calculation at this time.
List of Subjects in 12 CFR Part 615
Accounting, Agriculture, Banks, banking, Government securities,
Investments, Rural areas.
For the reasons stated in the preamble, part 615 of chapter VI,
title 12 of the Code of Federal Regulations is amended to read as
follows:
PART 615--FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS,
AND FUNDING OPERATIONS
1. The authority citation for part 615 continues to read as
follows:
Authority: Secs. 1.5, 1.7, 1.10, 1.11, 1.12, 2.2, 2.3, 2.4, 2.5,
2.12, 3.1, 3.7, 3.11, 3.25, 4.3, 4.3A, 4.9, 4.14B, 4.25, 5.9, 5.17,
6.20, 6.26, 8.0, 8.3, 8.4, 8.6, 8.7, 8.8, 8.10, 8.12 of the Farm
Credit Act (12 U.S.C. 2013, 2015, 2018, 2019, 2020, 2073, 2074,
2075, 2076, 2093, 2122, 2128, 2132, 2146, 2154, 2154a, 2160, 2202b,
2211, 2243, 2252, 2278b, 2278b-6, 2279aa, 2279aa-3, 2279aa-4,
2279aa-6, 2279aa-7, 2279aa-8, 2279aa-10, 2279aa-12); sec. 301(a) of
Pub. L. 100-233, 101 Stat. 1568, 1608.
Subpart E--Investment Management
2. Section 615.5131 is revised to read as follows:
Sec. 615.5131 Definitions.
For purposes of this subpart, the following definitions apply:
(a) Asset-backed securities (ABS) mean investment securities that
provide for ownership of a fractional undivided interest or collateral
interests in specific assets of a trust that are sold and traded in the
capital markets. For the purposes of this subpart, ABS exclude mortgage
securities that are defined in Sec. 615.5131(i).
(b) Bank means a Farm Credit Bank, agricultural credit bank, or
bank for cooperatives.
(c) Eurodollar time deposit means a non-negotiable deposit
denominated in United States dollars and issued by an overseas branch
of a United States bank or by a foreign bank outside the United States.
(d) Final maturity means the last date on which the remaining
principal amount of a security is due and payable (matures) to the
registered owner. It does not mean the call date, the expected average
life, the duration, or the weighted average maturity.
(e) General obligations of a State or political subdivision means:
(1) The full faith and credit obligations of a State, the District
of Columbia, the Commonwealth of Puerto Rico, a territory or possession
of the United States, or a political subdivision thereof that possesses
general powers of taxation, including property taxation; or
(2) An obligation that is unconditionally guaranteed by an obligor
possessing general powers of taxation, including property taxation.
(f) Liquid investments are assets that can be promptly converted
into cash without significant loss to the investor. In the money
market, a security is liquid if the spread between its bid and ask
price is narrow and a reasonable amount can be sold at those prices.
(g) Loans are defined by Sec. 621.2(f) of this chapter and they are
calculated quarterly (as of the last day of March, June, September, and
December) by using the average daily balance of loans during the
quarter.
(h) Market risk means the risk to the financial condition of your
institution because the value of your holdings may decline if interest
rates or market prices change. Exposure to market risk is measured by
assessing the effect of changing rates and prices on either the
earnings or economic value of an individual instrument, a portfolio, or
the entire institution.
(i) Mortgage securities means securities that are either:
(1) Pass-through securities or participation certificates that
represent ownership of a fractional undivided interest in a specified
pool of residential (excluding home equity loans), multifamily or
commercial mortgages, or
(2) A multiclass security (including collateralized mortgage
obligations and real estate mortgage investment conduits) that is
backed by a pool of residential, multifamily or commercial real estate
mortgages, pass-through mortgage securities, or other multiclass
mortgage securities.
(j) Nationally Recognized Statistical Rating Organization (NRSRO)
means a rating organization that the Securities and Exchange Commission
recognizes as an NRSRO.
(k) Revenue bond means an obligation of a municipal government that
finances a specific project or enterprise but it is not a full faith
and credit obligation. The obligor pays a portion of the revenue
generated by the project or enterprise to the bondholders.
(l) Weighted average life (WAL) means the average time until the
investor receives the principal on a security, weighted by the size of
each principal payment and calculated under specified prepayment
assumptions.
(m) You means a Farm Credit bank, association, or service
corporation.
3. Section 615.5133 is revised to read as follows:
Sec. 615.5133 Investment management.
(a) Responsibilities of Board of Directors. Your board must adopt
written policies for managing your investment activities. Your board of
directors must also ensure that management complies with these policies
and that appropriate internal controls are in place to prevent loss.
Annually, the board of directors must
[[Page 28896]]
review these investment policies and make any changes that are needed.
(b) Investment policies. Your board's written investment policies
must address the purposes and objectives of investments, risk
tolerance, delegations of authority, and reporting requirements.
Investment policies must be appropriate for the size, types, and risk
characteristics of your investments.
(c) Risk tolerance. Your investment policies must establish risk
limits and diversification requirements for the various classes of
eligible investments and for the entire investment portfolio. These
policies must ensure that you maintain appropriate diversification of
your investment portfolio. Risk limits must be based on your
institutional objectives, capital position, and risk tolerance. Your
policies must identify the types and quantity of investments that you
will hold to achieve your objectives and control credit, market,
liquidity, and operational risks. The policy of any association or
service corporation that holds significant investments and each bank
must establish risk limits for the following four types of risk.
(1) Credit risk. Investment policies must establish:
(i) Credit quality standards, limits on counterparty risk, and risk
diversification standards that limit concentrations based on a single
or related counterparty(ies), a geographical area, industries or
obligations with similar characteristics.
(ii) Criteria for selecting brokers, dealers, and investment
bankers (collectively, securities firms). You must buy and sell
eligible investments with more than one securities firm. As part of
your annual review of your investment policies, your board of directors
must review the criteria for selecting securities firms and determine
whether to continue your existing relationships with them.
(iii) Collateral margin requirements on repurchase agreements.
(2) Market risk. Investment policies must set market risk limits
for specific types of investments, the investment portfolio, or your
institution. Your board of directors must establish market risk limits
in accordance with these regulations and our other policies.
(3) Liquidity risk. Investment policies must describe the liquidity
characteristics of eligible investments that you will hold to meet your
liquidity needs and institutional objectives.
(4) Operational risk. Investment policies must address operational
risks, including delegations of authority and internal controls in
accordance with paragraphs (d) and (e) of this section.
(d) Delegation of authority. All delegations of authority to
specified personnel or committees must state the extent of management's
authority and responsibilities for investments.
(e) Internal controls. You must:
(1) Establish appropriate internal controls to detect and prevent
loss, fraud, embezzlement, conflicts of interest, and unauthorized
investments.
(2) Establish and maintain a separation of duties and supervision
between personnel who execute investment transactions and personnel who
approve, revaluate, and oversee investments.
(3) Maintain management information systems that are appropriate
for the level and complexity of your investment activities.
(f) Securities valuation.
(1) Before you purchase a security, you must evaluate its credit
quality and its price sensitivity to changes in market interest rates.
You must also verify the value of a security that you plan to purchase,
other than a new issue, with a source that is independent of the
broker, dealer, counterparty or other intermediary to the transaction.
(2) You must determine the fair market value of each security in
your portfolio and the fair market value of your whole investment
portfolio at least monthly. You must also evaluate the credit quality
and price sensitivity to change in market interest rates of all
investments that you hold on an ongoing basis.
(3) Before you sell a security, you must verify its value with a
source that is independent of the broker, dealer, counterparty, or
other intermediary to the transaction.
(g) Reports to the board. Each quarter, management must report to
the board of directors or a board committee on the performance and risk
of each class of investments and the entire investment portfolio. These
reports must identify all gains and losses that you incur during the
quarter on individual securities that you sold before maturity. Reports
must also identify potential risk exposure to changes in market
interest rates and other factors that may affect the value of your
bank's investment holdings. Management's report must discuss how
investments affect your bank's overall financial condition and must
evaluate whether the performance of the investment portfolio
effectively achieves the board's objectives. Any deviations from the
board's policies must be specifically identified in the report.
4. Section 615.5134 is amended by revising paragraph (b) to read as
follows:
Sec. 615.5134 Liquidity reserve requirement.
* * * * *
(b) All investments that the bank holds for the purpose of meeting
the liquidity reserve requirement of this section must be free of lien.
* * * * *
5. Section 615.5140 is revised to read as follows:
Sec. 615.5140 Eligible investments.
(a) You may hold only the following types of investments listed in
the Investment Eligibility Criteria Table. These investments must be
denominated in United States dollars.
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(b) Rating of foreign countries. Whenever the obligor or issuer of
an eligible investment is located outside the United States, the host
country must maintain the highest sovereign rating for political and
economic stability by an NRSRO.
(c) Marketable securities. All eligible investments, except money
market instruments, must be marketable. An eligible investment is
marketable if you can sell it quickly at a price that closely reflects
its fair value in an active and universally recognized secondary
market.
(d) Obligor limits.
(1) You may not invest more than 20 percent of your total capital
in eligible investments issued by any single institution, issuer, or
obligor. This obligor limit does not apply to obligations, including
mortgage securities, that are issued or guaranteed as to interest and
principal by the United States, its agencies, instrumentalities, or
corporations.
(2) Obligor limits for your holdings in an investment company You
must count securities that you hold through an investment company
towards the obligor limit of this section unless the investment
company's holdings of the security of any one issuer do not exceed five
(5) percent of the investment company's total portfolio.
(e) Other investments approved by the FCA. You may purchase and
hold other investments that we approve. Your request for our approval
must explain the risk characteristics of the investment and your
purpose and objectives for making the investment.
Secs. 615.5141 through 615.5143 [Redesignated]
6. Sections 615.5141, 615.5142, and 615.5143 are redesignated as
Secs. 615.5142, 615.5143, and 615.5144, respectively, and a new
Sec. 615.5141 is added to read as follows:
Sec. 615.5141 Stress tests for mortgage securities.
Mortgage securities are not eligible investments unless they pass a
stress test. You must perform stress tests to determine how interest
rate changes will affect the cashflow and price of each mortgage
security that you purchase and hold, except for adjustable rate
securities that reprice at intervals of 12 months or less and are tied
to an index. You must also use stress tests to gauge how interest rate
fluctuations on mortgage securities affect your institution's capital
and earnings. You may conduct the stress tests as described in either
paragraph (a) or (b) of this section.
(a) Mortgage securities must comply with the following three tests
at the time of purchase and each following quarter:
(1) Average Life Test. The expected WAL of the instrument does not
exceed 5 years.
(2) Average Life Sensitivity Test. The expected WAL does not extend
for more than 2 years, assuming an immediate and sustained parallel
shift in the yield curve of plus 300 basis points, nor shorten for more
than 3 years, assuming an immediate and sustained parallel shift in the
yield curve of minus 300 basis points.
(3) Price Sensitivity Test. The estimated change in price is not
more than thirteen (13) percent due to an immediate and sustained
parallel shift in the yield curve of plus or minus 300 basis points.
(4) Exemption. A floating rate mortgage security is subject only to
the price sensitivity test in paragraph (a)(3) of this section if at
the time of purchase and each quarter thereafter it bears a rate of
interest that is below its contractual cap.
(b) You may use an alternative stress test to evaluate the price
sensitivity of your mortgage securities. An alternative stress test
must be able to measure the price sensitivity of mortgage instruments
over different interest rate/yield curve scenarios. The methodology
that you use to analyze mortgage securities must be appropriate for the
complexity of the instrument's structure and cashflows. Prior to
purchase and each quarter thereafter, you must use the stress test to
determine that the risk in the mortgage security is within the risk
limits of your board's investment policies. The stress test must enable
you to determine at the time of purchase and each subsequent quarter
that the mortgage security does not expose your capital or earnings to
excessive risks.
(c) You must rely on verifiable information to support all your
assumptions, including prepayment and interest rate volatility
assumptions, when you apply the stress tests in either paragraph (a) or
(b) of this section. You must document the basis for all assumptions
that you use to evaluate the security and its underlying mortgages. You
must also document all subsequent changes in your assumptions. If at
any time after purchase, a mortgage security no longer complies with
requirements in this section, you must divest it in accordance with
Sec. 615.5143.
7. Newly designated Sec. 615.5142 is revised to read as follows:
Sec. 615.5142 Association investments.
An association may hold eligible investments listed in
Sec. 615.5140, with the approval of its funding bank, for the purposes
of reducing interest rate risk and managing surplus short-term funds.
Each bank must review annually the investment portfolio of every
association that it funds.
8. Newly designated Sec. 615.5143 is revised to read as follows:
Sec. 615.5143 Disposal of ineligible investments.
You must dispose of an ineligible investment within 6 months unless
we approve, in writing, a plan that authorizes you to divest the
instrument over a longer period of time. An acceptable divestiture plan
must require you to dispose of the ineligible investment as quickly as
possible without substantial financial loss. Until you actually dispose
of the ineligible investment, the managers of your investment portfolio
must report at least quarterly to your board of directors about the
status and performance of the ineligible instrument, the reasons why it
remains ineligible, and the managers' progress in disposing of the
investment.
Subpart F--Property and Other Investments
9. Section 615.5174 is revised to read as follows:
Sec. 615.5174 Farmer Mac securities.
(a) General authority. You may purchase and hold mortgage
securities that are issued or guaranteed as to both principal and
interest by the Federal Agricultural Mortgage Corporation (Farmer Mac
securities). You may purchase and hold Farmer Mac securities for the
purposes of managing credit and interest rate risks, and furthering
your mission to finance agriculture. The total value of your Farmer Mac
securities cannot exceed your total outstanding loans, as defined by
Sec. 615.5131(g).
(b) Board and management responsibilities. Your board of directors
must adopt written policies that will govern your investments in Farmer
Mac securities. All delegations of authority to specified personnel or
committees must state the extent of management's authority and
responsibilities for managing your investments in Farmer Mac
securities. The board of directors must also ensure that appropriate
internal controls are in place to prevent loss, in accordance with
Sec. 615.5133(e). Management must submit quarterly reports to the board
of directors on the performance of all investments in Farmer Mac
securities. Annually, your board of directors must review these
policies and the performance of your
[[Page 28900]]
Farmer Mac securities and make any changes that are needed.
(c) Policies. Your board of directors must establish investment
policies for Farmer Mac securities that include your:
(1) Objectives for holding Farmer Mac securities.
(2) Credit risk parameters including:
(i) The quantities and types of Farmer Mac mortgage securities that
are collateralized by qualified agricultural mortgages, rural home
loans, and loans guaranteed by the Farm Service Agency.
(ii) Product and geographic diversification for the loans that
underlie the security; and
(iii) Minimum pool size, minimum number of loans in each pool, and
maximum allowable premiums or discounts on these securities.
(3) Liquidity risk tolerance and the liquidity characteristics of
Farmer Mac securities that are suitable to meet your institutional
objectives. A bank may not include Farmer Mac mortgage securities in
the liquidity reserve maintained to comply with Sec. 615.5134.
(4) Market risk limits based on the effects that the Farmer Mac
securities have on your capital and earnings.
(d) Stress Test. You must perform stress tests on mortgage
securities that are issued or guaranteed by Farmer Mac in accordance
with the requirements of Sec. 615.5141(b) and (c). If a Farmer Mac
security fails a stress test, you must divest it as required by
Sec. 615.5143.
Dated: May 13, 1999.
Vivian Portis,
Secretary, Farm Credit Administration Board.
[FR Doc. 99-13622 Filed 5-27-99; 8:45 am]
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