[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]


-----------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \1\U.S.C. 78s(b)(1).
    \2\Securities Exchange Act Release No. 33546 (January 31, 1994), 
59 FR 5646.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    \12\15 U.S.C. 78q-1(b)(3) (A) and (F).
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \17\Letter from Michael D. Frieband, dated March 4, 1994, supra 
note 5.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \18\Id.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \19\Id.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \20\Id.
    \21\Id.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \24\Letter from Michael D. Frieband, dated March 4, 1994, supra 
note 5.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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).
---------------------------------------------------------------------------

    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