[Federal Register Volume 59, Number 90 (Wednesday, May 11, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-11341]
[[Page Unknown]]
[Federal Register: May 11, 1994]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-34017; File No. SR-PTC-92-16]
Self-Regulatory Organizations; Participants Trust Company; Order
Approving on a Temporary Basis a Proposed Rule Change Relating to
Margin Levels for Collateralized Mortgage Obligations
May 5, 1994.
On December 28, 1992, the Participants Trust Company (``PTC'')
filed with the Securities and Exchange Commission (``Commission'') a
proposed rule change (File No. SR-PTC-92-16) pursuant to section
19(b)(1) of the Securities Exchange Act of 1934 (``Act'')\1\ relating
to the establishment of margin levels on Collateralized Mortgage
Obligations (``CMO security'' or ``CMO'') currently eligible for
deposit or which may become eligible for deposit at PTC. Notice of the
proposal appeared in the Federal Register on February 7, 1994.\2\ No
comments were received. For the reasons discussed below, the Commission
is approving the proposed rule change on a temporary basis, until April
30, 1995.
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\1\U.S.C. 78s(b)(1).
\2\Securities Exchange Act Release No. 33546 (January 31, 1994),
59 FR 5646.
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I. Description
PTC's proposal establishes a method of computing the percentages to
be deducted from the market value of certain securities (``haircut'')
to determine how those securities should be valued for purposes of
participants' Net Free Equity.\3\ The securities in question are CMO
securities\4\ which are eligible for deposit or which may become
eligible for deposit at PTC. Currently, the only such securities are
Real Estate Mortgage Investment Conduits (``REMIC'') issued by the U.S.
Department of Veterans Affairs (``VA REMIC'').\5\
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\3\Net Free Equity is calculated as the sum of: (1) The cash
balance in the account; (2) the market value of securities in the
account, less the appropriate haircut for such securities
(``Applicable Percentage''); and (3) the value of all Supplemental
Processing Collateral; minus (4) Reserve on Gain on transfers made
that day. Supplemental Processing Collateral includes the following:
(1) The value of optional deposits to the participants fund
allocated to that account (optional deposits to the participants
fund are deposits that exceed the minimum deposit required pursuant
to PTC's rules and procedures); and (2) 20% of the mandatory
deposits to the participants fund for the Master Account (mandatory
deposits to the participants fund are minimum deposits required to
be deposited into such fund pursuant to PTC's rules and procedures).
Reserve on Gain means: (1) The contract value credited to the cash
balance of a delivering participant or limited purpose participant
over the market value of securities credited to the transfer account
associated with the account of the receiving participant; or (2) the
market value of securities credited to the transfer account
associated with the account of a receiving participant over the
contract value credited to the cash balance of the delivering
participant or limited purpose participant. PTC Rules, Article I,
Rule I.
\4\A CMO is a multiple-class mortgage cash flow security. As
such, a CMO redirects the cash flow from an underlying standard
mortgage-backed security (``MBS''), such as a Government National
Mortgage Association (``GNMA'') security, and allows the CMO issuer
to create classes, or tranches, with many different interest rates,
average lives, prepayment sensitivities, final maturities, and
payment priorities.
\5\VA REMICs are securities for which the full and timely
payment of principal and interest is guaranteed by the United States
Department of Veterans Affairs and backed up the full faith and
credit of the United States government. The Commission approved VA
REMICs as eligible for deposit at PTC in Securities Exchange Act
Release Nos. 30792 (June 10, 1992), 57 FR 27495, and 31914 (February
24, 1993) 58 FR 12295.
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Under PTC's rules, the Applicable Percentage\6\ of the market value
of securities is used in computing a participant's Net Free Equity.
PTC's rules require participants to maintain Net Free Equity of zero or
greater in each of their agency, pledgee transfer, and proprietary
accounts in order for transactions to be processed.\7\ PTC has the
right to borrow against or liquidate those assets that comprise the Net
Free Equity computations in those accounts in the event that the
participant responsible for one or more of those accounts fails to pay
the account debit balance at the end of the day. By including only a
portion of the market value of securities in Net Free Equity, i.e., the
Applicable Percentage, PTC attempts to limit the risk caused by
fluctuations in the market value of securities in those accounts. In
computing Net Free Equity, PTC deducts 5% from the market value of GNMA
Single-Family securities, and higher levels for GNMA Project,
Construction, and Mobile Home Securities to reflect their reduced
liquidity.\8\
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\6\``Applicable Percentage'' means that percentage of the market
value of securities that is included in the computation of Net Free
Equity. The Applicable Percentage is determined by deducting certain
percentages (i.e., margin) from the market value of securities. See
also definition of Net Free Equity, supra note 3.
\7\PTC Article II, Rule 13.
\8\Securities Exchange Act Release No. 33840 (March 31, 1994),
59 FR 16672.
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Unlike GNMAs, CMOs are structured as a series of tranches or
classes, each of which represents a separate security with unique
characteristics, such as differing payment schedules and price
volatility. In addition, there is a lack of historical price data for
CMOs, in contrast to GNMA securities. Consequently, PTC has chosen to
rely on a model developed by the Asset Backed Securities Group/Trepp
(``Trepp'') that uses the yield on an underlying Treasury security to
predict the potential movement and prepayment risk of a corresponding
CMO tranche when subjected to a rise or fall in interest rates.
Currently, PTC's model assumes a 50 basis point upward movement in the
underlying Treasury securities for CMO tranches which exhibit positive
effective duration (i.e., rise in value with falling interest rates).
For CMO tranches which exhibit negative effective duration (i.e.,
decline in value with falling interest rate), the model assumes a 50
basis point downward move in the underlying Treasury security.\9\
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\9\See letter from Leopold S. Rassnick, dated March 21, 1994,
supra note 5. When first proposed, PTC's methodology calculated
margins by assuming a change in prepayment speeds based on a
sustained change in interest rates, applying the largest historic
two-day movement in the yield of the underlying Treasury security as
the applicable interest rate change. Thus, a 35 basis point upward
move in the underlying Treasury securities for CMO tranches which
exhibit positive effective duration; and a 50 basis point downward
move in the underlying Treasury securities for CMO tranches which
exhibit negative effective duration. See letter from Michael D.
Frieband, dated August 17, 1993, supra note 5. PTC has since
modified its methodology, which will now rely on a 50 basis point
upward move in underlying Treasury securities for tranches
exhibiting positive effective duration for purposes of calculating
margin. Given the dearth of historical prices for CMOs, using a 50
basis point upward move in Treasury securities should generate more
conservative margins. See letter from Leopold S. Rassnick, dated
March 21, 1994, supra note 5.
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Rather than assigning a uniform Applicable Percentage for all CMO
securities, PTC takes into account the unique characteristics of each
CMO tranche.\10\ Each CMO tranche is subjected to a stress test to
determine its response to yield changes, thereby allowing PTC to assign
each tranche an appropriate margin. PTC's management will establish the
margin based on the stated analysis as each CMO tranche is deposited at
PTC. Nevertheless, PTC has represented that the minimum margin level
for any CMO product will be 5%.\11\
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\10\This represents a departure from PTC's past practice of
assigning a specific percentage margin for each type of security
that is eligible for deposit at PTC. For example, for GNMA Project
Loan, Project Note, Construction Loan, and Mobile Home Securities,
PTC established margin levels of 10%, 10%, 12%, and 20%,
respectively. Securities Exchange Act Release No. 33840, supra note
8.
\11\See letter from Leopold S. Rassnick, dated March 17, 1994,
supra note 5. Margins on CMO securities which cannot be modeled by
an independent pricing source will be set at 100%. See letter from
Leopold S. Rassnick, dated January 12, 1993, supra note 5.
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II. Discussion
The Commission believes that PTC's proposed rule change is
consistent with section 17A of the Act, and, specifically, with
sections 17A(b)(3) (A) and (F).\12\ Those sections require a clearing
agency to be organized, and its rules be designed, to promote the
prompt and accurate clearance and settlement of securities transactions
and to assure the safeguarding of securities and funds which are in its
custody or control or for which it is responsible. The Commission is
approving PTC's proposal until April 30, 1995, to allow PTC to gain
more experience with CMO securities.
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\12\15 U.S.C. 78q-1(b)(3) (A) and (F).
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In 1992, the Commission approved a PTC proposal to make certain VA
REMIC securities, guaranteed by the U.S. government, eligible for
deposit at PTC pursuant to PTC Article I, Rule 2.\13\ The approval ran
through December 31, 1992, to coincide with the expiration of the
legislation authorizing the issuance of VA REMICs.\14\ In 1993,
legislation extending the VA's authority to issue REMICs through
December 31, 1995 was enacted.\15\ In light of the extension, the
Commission approved a PTC proposal allowing it on a permanent basis to
designate VA REMICs depository eligible, as long as they continue to be
guaranteed by the U.S. government.\16\
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\13\See Securities Exchange Act Release No. 30792, supra note 5.
\14\38 U.S.C. 3720h(1) and (2), as amended by P.L. 102-291,
enacted on May 20, 1992.
\15\38 U.S.C. 3720h(1) and (2), as amended by P.L 102-547,
enacted on October 28, 1992.
\16\See Securities Exchange Act Release No. 31914, supra note 5.
Should the VA's authority to issue securities with a U.S. government
guarantee cease, any VA securities in PTC at that time shall remain
depository eligible. Id.
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PTC has relied on Trepp as its vendor for VA REMIC prices and has
used Trepp's model to determine margin for such securities. Trepp was
established in 1979 and created the first independent CMO pricing
service in 1988. Currently, Trepp provides pricing and analytical
services to more than 500 institutions, including 23 of the 25 largest
bank trust departments.\17\
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\17\Letter from Michael D. Frieband, dated March 4, 1994, supra
note 5.
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Because each CMO tranche has unique characteristics, Trepp models
each security to determine its value. The information required to model
each tranche of a CMO is derived from that CMO's prospectus, including
the characteristics and principal payment priorities of each tranche,
initial price and interest rate, and remaining principal balances and
prepayment assumptions used to derive the cash flows and initial
spread.\18\
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\18\Id.
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Initially, PTC gauges the accuracy of these models by comparing the
cash flows and other data calculated by the model to the information
provided by the underwriter in the issuer summary report and the
prospectus. In addition, the accuracy of the model is tested on an
ongoing basis by comparing its valuations to those of the underwriter,
and by using available factor information to verify the remaining
principal balance of each security with those calculated by its
corresponding model.\19\
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\19\Id.
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PTC's model is an example of a static cash flow yield model, as
distinguished from an option-adjusted spread (``OAS'') model. Static
cash flow and OAS models differ primarily in their handling of future
interest rate and prepayment scenarios. A static cash flow yield
analysis uses an interest rate/prepayment scenario which relies on
current market conditions. This reliance creates two limitations.
First, it might not measure accurately reinvestment risk caused by an
investor's inability to reinvest periodic payments at a rate equal to
the yield on the security. Second, such a model does not value the
embedded option representing a mortgagee's ability to prepay, which can
be a factor in determining the value of a particular CMO tranche.\20\
It is the option to prepay which causes OAS models generally to be
considered more accurate than static cash flow models. However, the
enhanced accuracy of OAS models comes at a cost; such models are more
complex and computer intensive than those relying on a static cash flow
analysis. According to PTC, there are no daily price vendors that
provide bulk prices for CMOs using an OAS model.\21\
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\20\Id.
\21\Id.
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Each CMO tranche is subjected to a stress test, the purpose of
which is to observe the effect of an upward and downward movement of 50
basis points in the underlying Treasury yield of each CMO tranche.\22\
Because the volatility of a CMO tranche is primarily a function of the
level of interest rates, PTC has stated it will recalculate margins
whenever the Treasury yield curve has changed by 100 basis points from
the time of original issue or last margin recalculation. PTC has also
stated that securities whose attributes warrant it shall have their
margins reevaluated quarterly.\23\
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\22\Id; letter from Leopold S. Rassnick, dated March 21, 1994,
supra note 5.
\23\Letter from Michael D. Frieband, dated March 4, 1994, supra
note 5. PTC has yet to delineate the CMO attributes that would
warrant quarterly reevaluation. See infra note 29.
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In order to facilitate daily pricing and margin evaluations, PTC
intends to acquire Trepp's CMO pricing model. Currently, PTC receives a
price tape from Trepp daily no later than 5 p.m. and meets regularly
with representatives from Trepp regarding its pricing service.
Nevertheless, as the volume of CMOs deposited at PTC increases, the on-
site availability of the Trepp model should provide PTC with additional
safeguards.\24\
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\24\Letter from Michael D. Frieband, dated March 4, 1994, supra
note 5.
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PTC's proposed methodology requires its model to predict accurately
the market price of CMOs. Thus far, PTC's experience has been limited
to comparing the predicted versus actual transation price of VA
REMICs.\25\ The data indicate that PTC's model has been reasonably
accurate in predicting actual prices.\26\ However, VA REMICs represent
the most stable of CMOs given that VA mortgages are assumable, and
therefore less subject to prepayment risk. Moreover, the structures of
the VA REMICs so far issued and on deposit at PTC have not been
particularly complicated.
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\25\VA REMICs are the only CMOs currently depository eligible at
PTC.
\26\See letter from Michael D. Frieband, dated August 17, 1993,
supra note 5.
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Another concern raised by the proposed methodology relates to the
prepayment projections on which it relies. The prepayment projections
volunteered by twelve firms are averaged, but whether such quotes are
executable is not considered. This may affect the accuracy of the
prepayment speeds used to arrive at a market price for CMOs. Without
accurate prepayment data, the predicted price might lag behind the
market's true price by up to 30-45 days, when each agency issuing
mortgage pass-through securities releases the actual prepayment factors
\27\ and settlement occurs. The interest rate volatilities of the
underlying Treasuries from which the CMOs are priced can change 50-75
basis points over the course of 30-45 days. In part to address this
concern, PTC has determined to use fifty basis points for purposes of
running the stress test to establish margin.\28\
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\27\A factor represents the fractional share of the original
principal that remains in a given pool of mortgages comprising a
mortgage pass-through security (e.g., a factor of .7 indicates that
70% of a pool's principal remains).
\28\See letter from Leopold S. Rassnick, dated March 21, 1994,
supra note 5.
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The Commission believes that in granting PTC temporary approval of
its CMO pricing methodology until April 30, 1995, PTC will be afforded
an opportunity to gain experience with its methodology. In addition,
the temporary approval period will allow PTC to take steps to address
any concerns which exist with respect to its methodology.\29\
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\29\PTC has represented that it will provide the following
information to the Commission prior to the expiration of the
temporary approval period:
(1) PTC will explain what criteria it uses in identifying
certain CMO tranches as more volatile and/or risky than other
tranches. PTC will recalculate margin for any tranche whenever the
Treasury yield curve has changed by 100 basis points from the time
of original issue or last recalculation; however, until it
establishes clear standards, PTC will reevaluate margins for all
tranches at least twice a year, in addition to reevaluating selected
tranches quarterly;
(2) PTC will consider using a model other than its present
modelling vendor to conduct the stress test (or serve as the present
vendor's back up), as opposed to relying on a single vendor both for
the stress test and as a source of daily pricing;
(3) PTC will address the treatment of non-par issuances, which
tend to be more sensitive to changes in interest rates than other
CMOs;
(4) PTC will explain the method by which its present modelling
source aligns a CMO with a referenced Treasury maturity; and
(5) PTC has stated its intention to modify its systems software
to make automated price comparisons possible, and PTC will expedite
the automation of its comparison of predicted versus actual CMO
transation price data.
See letter from Leopold S. Rassnick, Vice President, General
Counsel, and Secretary, PTC, to Francois Mazur, Staff Attorney,
Division, Commission, dated May 3, 1994.
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The Commission believes that granting PTC temporary approval of its
proposal for one year should allow it sufficient time to address the
issues raised above. PTC's current CMO margining methodology should
help ensure that CMO margins will be established that take into account
the unique characteristics of each CMO tranche, and that PTC's reliance
on a daily pricing source will provide it with timely price
information. The resulting margins will afford PTC protection should it
be necessary for PTC to borrow against or liquidate these assets.
III. Conclusion
For the reasons stated above, the Commission finds that PTC's
proposal is consistent with section 17A of the Act.
It Is Therefore Ordered, Pursuant to section 19(b)(2) of the
Act,\30\ that PTC's proposed rule change (SR-PTC-92-16) be, and hereby
is, approved on a temporary basis until April 30, 1995.
\30\15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.
Margaet H. McFarland,
Deputy Secretary.
[FR Doc. 94-11341 Filed 5-10-94; 8:45 am]
BILLING CODE 8010-01-M
