[Federal Register Volume 60, Number 229 (Wednesday, November 29, 1995)]
[Proposed Rules]
[Pages 61219-61232]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-28705]



 ========================================================================
 Proposed Rules
                                                 Federal Register
 ________________________________________________________________________
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 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
 
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 

  Federal Register / Vol. 60, No. 229 / Wednesday, November 29, 1995 / 
Proposed Rules  

[[Page 61219]]


NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Part 703


Investment and Deposit Activities

AGENCY: National Credit Union Administration (NCUA).

ACTION: Proposed rule.

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SUMMARY: The regulation governing the investment and deposit activities 
of natural person credit unions was last revised effective July 30, 
1993. Recent events and significant changes in the investment products 
available in the marketplace have prompted a review of the rules 
regarding credit unions' investment and deposit activities. The 
proposed regulation clarifies a number of areas, adds restrictions on 
some securities which have been determined to be too risky for credit 
unions, broadens authority in certain areas, and requires that a credit 
union's staff and board of directors fully understand the potential 
risk characteristics of its investment options.

DATES: Comments must be received on or before March 28, 1996.

ADDRESSES: Comments should be directed to Becky Baker, Secretary of the 
Board. Mail or hand-deliver comments to: National Credit Union 
Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428. Fax 
comments to (703) 518-6319. Post comments on NCUA's electronic bulletin 
board by dialing (703) 518-6480. Please send comments by one method 
only.

FOR FURTHER INFORMATION CONTACT: David M. Marquis, Director, Office of 
Examination and Insurance, (703) 518-6360, or Daniel Gordon, Senior 
Investment Officer, (703) 518-6620, or at the above address.

SUPPLEMENTARY INFORMATION:

Background

    The Federal Credit Union Act (the Act) permits federal credit 
unions to purchase investments that, in general, have little default 
risk (e.g., securities of the U.S. Treasury, government agencies, and 
government-sponsored enterprises). However, rapid changes in financial 
markets have altered the once simple characteristics of many of these 
investments. The innovations have increased the potential interest 
rate, market, and liquidity risk of credit union investments, putting a 
greater burden on credit union board to understand and manage such 
risks.
    To estimate credit union understanding of investment risks, NCUA 
conducted a study of approximately 300 credit unions with investments 
in collateralized mortgage obligations (CMOs) and Real Estate Mortgage 
Investment Conduits (REMICs)\1\ in excess of capital. The study 
revealed that management in more than a third of the credit unions did 
not understand the risks of CMOs, that more than a quarter of the 
credit unions were taking unacceptable risks, and that almost half did 
not have acceptable asset-liability management policies. From this and 
other evidence, NCUA concluded that investment policies with well-
defined parameters and enhanced monitoring and reporting of investment 
risks are needed to strengthen credit union investment risk management.

    \1\Hereafter, in this supplementary information section, ``CMO'' 
means ``CMOs and REMICs.''
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    The proposed rule recognizes that credit union investment risk is 
largely interest rate, rather than credit (default) risk, and that a 
regulation designed to prohibit particular securities can fail to 
reflect the changing financial environment. It is based on the belief 
that the responsibility for making investment decisions rests with the 
credit union board, not NCUA, and that credit unions which assume more 
potential risk should meet higher standards.
    The proposed rule allows a credit union to operate on one of three 
levels. At the most conservative level, a credit union could invest in 
fully-insured certificates of deposit (CDs) and shares and deposits in 
corporate credit unions. If limited to these investments, the credit 
union would not be required to approve CMO prepayment models, conduct 
CMO testing, develop a divestiture plan for failed CMOs, establish a 
trading policy, report on trading activities, prepare a monthly report 
showing the fair value of each investment, calculate the impact on its 
portfolio of a 300 basis point parallel shift in interest rates, obtain 
independent valuations of each investment, or evaluate credit risk.
    At the next level, a credit union could invest in potentially more 
risky securities in an amount up to capital and would have to comply 
with most of the proposed rule's policy and reporting requirements. 
However, it would not be required to evaluate the impact on its 
portfolio of a 300 basis point shift in rates.
    Finally, at the most sophisticated level, a credit union investing 
in potentially more risky securities in an amount exceeding capital 
would be subject to all of the policy and reporting requirements, 
including calculating the impact of a 300 basis point shift in rates.
    NCUA sought input from various sources during the process of 
revising Part 703. In six ``focus group'' meetings, NCUA staff met with 
board members, CEOs, and CFOs of credit unions of various sizes and 
with representatives of trade organizations. The focus groups provided 
valuable input on the proposed rule. As a result of the meetings, a 
number of changes were made, including the following: (1) Clarification 
was provided that the knowledge and skills of individuals making 
investment decisions could be documented in position descriptions 
instead of being set out in the investment policy; (2) The amount of 
information required to be provided in the monthly investment report 
was reduced, and provision was made for an investment or asset-
liability management committee, rather than the board, to receive the 
full report; (3) Selling broker-dealers were permitted to provide 
monthly valuations of securities, and some discretionary investment 
authority was permitted to be delegated to an outside party; and (4) 
Time periods for notifying NCUA of nonconforming investments and 
preparing a divestiture plan were expanded.

Section 703.1  Scope

    The proposed rule deletes some sentences in the Scope section, as 
unnecessary. In addition, it adds the provision that Part 703 does not 
apply to corporate credit unions. Corporate credit unions are subject 
to the same laws and rules as natural person credit 

[[Page 61220]]
unions, except where those laws and rules are inconsistent with Part 
704 of the NCUA regulations, 12 CFR Part 704, which specifically 
governs corporate credit unions. Although Part 704 contains a detailed 
investment section, it does not cover all aspects of corporate credit 
union investment activities. Accordingly, corporate credit unions are 
subject to certain provisions of Part 703. This occasionally has caused 
confusion, however, as it is not always clear when a general law or 
rule is ``inconsistent'' with Part 704. Part 704 is currently being 
revised, and plans are for it to incorporate all of the applicable NCUA 
rules governing investment activities, even if this means duplicating 
portions of Part 703. Therefore, proposed Section 703.1 clarifies that 
Part 703 is not applicable to corporate credit unions.

Section 703.2  Definitions

    NCUA is proposing to add a number of new definitions, to redefine 
certain already-defined terms, and to delete several definitions.
    The proposed rule treats amortizing securities and securities with 
embedded options as investments that have the potential to present 
significant interest rate risk. The proposed rule does not prohibit 
credit unions from purchasing such investments, but it does subject a 
credit union holding these and other potentially risky investments in 
an amount greater than capital to additional measures of interest rate 
risk. To ensure consistency, the proposed rule provides definitions of 
``amortizing security'' and ``embedded option.''
    The proposed rule substitutes the term ``custodial agreement'' for 
the current regulation's ``bailment for hire contract,'' using an 
almost identical definition. Based on questions that have been 
received, it appears that the current term may no longer widely be 
used.
    The dollar amount of capital is used as a threshold in a number of 
places in the proposed rule. Therefore, a definition of capital has 
been provided. The allowance for loan losses is excluded from capital 
for the purposes of Part 703 since the balance in this account has 
already been allocated to specific loan losses and is not available to 
absorb investment losses. Capital for the purpose of determining CAMEL 
ratios includes the allowance for loan losses.
    The proposed rule discusses securities in terms of fair value 
rather than market price to conform to guidance in recent statements of 
the Financial Accounting Standards Board (FASB). Market price is the 
best evidence of fair value; if a market price is not available, fair 
value may be estimated based on the market price of a security with 
similar characteristics or on valuation techniques, including 
calculating the present value of estimated future cash flows using an 
appropriate discount rate, option pricing, or matrix pricing.
    ``Industry-recognized information provider'' refers to an entity 
which provides information regarding investments, but which is not, for 
instance, a broker or dealer. An example of such an entity is 
Bloomberg, L.P., an electronic service which provides market 
information to subscribers, who must lease a specialized terminal to 
access the information. Other examples are the Wall Street Journal and 
other bona fide newspapers, news magazines, or business or financial 
publications or electronic services of general and regular circulation.
    The proposed rule provides separate definitions for ``investment'' 
and ``security,'' as the terms are not used interchangeably. 
``Investment'' is a broad category that includes securities, deposits, 
and shares in credit unions.
    The proposed rule simplifies the definition of ``repurchase 
transaction,'' because the current definition has proved confusing. The 
safekeeping element of the current definition has been moved to 
proposed section 703.3(b)(8).
    The term ``counterparty'' in the proposed definition of ``reverse 
repurchase transaction'' has been substituted for ``purchaser'' in the 
current definition. This reflects current market terminology.
    The proposed rule deletes some sentences in the definitions of 
``standby commitment'' and ``stripped mortgage-backed security,'' as 
being unnecessarily detailed.
    Definitions are provided for the following new terms used in the 
proposed rule: ``business day,'' ``commercial mortgage related 
security,'' ``delivery versus payment,'' ``interest rate swap,'' 
``investment characteristic,'' ``maturity,'' ``mortgage related 
security,'' ``mortgage servicing,'' ``municipal security,'' 
``official,'' ``option,'' ``pair-off transaction,'' ``parallel shift,'' 
``prepayment model,'' ``regular-way settlement,'' ``securities loan,'' 
``small business related security,'' ``street name,'' ``total return,'' 
``U.S. government agency,'' ``U.S. government-sponsored enterprise,'' 
and ``when issued trading.''
    The proposed rule deletes the following definitions, as the terms 
are no longer used: ``cash forward agreement'' and ``maturity date.''

Section 703.3  Investment Policies and Practices

Policies

    Section 703.3(a) of the proposed rule requires that the board of a 
federal credit union establish written investment policies consistent 
with the Federal Credit Union Act, the NCUA Rules and Regulations 
governing investments, and other applicable laws and regulations. The 
policy must address the purposes and objectives of the credit union's 
investment activities. The policy must provide a clear statement of the 
credit union's investment goals. A credit union's primary goals may be 
to minimize risk, provide liquidity, and generate a reasonable rate of 
return. The emphasis placed on each goal will vary based on individual 
credit union constraints or needs.
    The policy must also list authorized investments for the credit 
union, by issuer and characteristics. Characteristics of an investment 
include its maturity, index, cap, floor, coupon rate, coupon formula, 
index, call provision, and average life. For example, a policy 
statement may authorize investments issued or guaranteed by the U.S. 
Treasury, the Federal Home Loan Mortgage Corporation, and the Federal 
National Mortgage Association. The policy statement could also 
stipulate that no investment may have a maturity of more than 5 years, 
or that only investments with a fixed coupon, or those indexed, without 
caps, to 3-month LIBOR or the 3-month Treasury rate, will be permitted. 
The complexity of amortizing securities may cause the board to exclude 
any securities or deposits with amortizing cash flows.
    The policy is also required to address interest rate risk 
management. A credit union's interest rate risk management policy 
should be related to its existing and potential cost of funds. In 
addition, for credit unions holding securities with potential interest 
rate risk, the policy may state that total return or average price 
cannot vary by more than a certain percentage of capital for a specific 
parallel shift in interest rates. The policy may state that capital 
should not be permitted to decline below a specific minimum level when 
the portfolio is subjected to a particular interest rate shock. 
Consistent with NCUA's intent to place more responsibility with credit 
union boards, the proposed rule does not specify particular limits. The 
policy should be tailored to a credit union's activity level and 
portfolio sophistication. Less complex 

[[Page 61221]]
institutions will have a less complicated policy statement.
    The board must also develop prudent concentration limits for all 
investments, including deposits in Section 107(8) institutions and 
shares and deposits in corporate credit unions. Concentrations can 
result from single or related issuers, lack of geographical 
distribution, holdings of obligations with similar characteristics, 
such as mortgage-backed bonds, zero coupon bonds, and bonds linked to 
the same index, holdings of bonds having the same trustee, and holdings 
of securitized loans having the same originator, packager, or 
guarantor. Concentrations can increase a credit union's vulnerability 
to unforeseen market, credit, and liquidity risks. Each credit union 
must evaluate concentration risk in relation to its financial condition 
and its ability to analyze the risks of all investments.
    Of all securities available in recent years, credit unions have 
purchased more inappropriate CMOs than they have any other type of 
instrument. For this reason, NCUA has decided to retain specific 
testing requirements for CMOs. These are set forth at proposed section 
703.4(e). To control the ``cherry picking'' that has accompanied such 
testing (selecting the prepayment model that will allow a particular 
CMO to pass the tests), the proposed rule requires potential purchasers 
of CMOs to identify in their investment policies the specific 
prepayment models that will be used in the tests. Each credit union has 
the flexibility to choose the prepayment models it believes are the 
best measures of potential risk, as long as the models are reasonable 
and supportable.
    Liquidity risk is the risk that a credit union will have 
insufficient liquid assets to meet immediate cash demands. The board 
must assess the potential for such demands, document how it arrived at 
this assessment, and establish a liquidity policy that will enable it 
to meet the demands. A credit union may use either a simple estimate, 
based upon the history of prior cash flows, or a more sophisticated 
approach.
    Credit risk is the risk of default. The board must establish a 
policy to manage this risk, if the credit union entertains any. While 
it is not impermissible to rely on credit ratings, boards should be 
aware that ratings may fail to timely reflect a creditor's 
deteriorating ability to repay its obligations. A credit union without 
the ability to fully evaluate credit risk may choose to limit its 
investments to those that are fully guaranteed or insured by the U.S. 
government and its agencies.
    The board has the fiduciary responsibility to ensure that any 
person authorized to make investment decisions has the knowledge and 
experience necessary to carry out this function. The proposed rule 
requires that the board establish criteria for such persons, either in 
the investment policy or by approving appropriate position 
descriptions.
    The proposed rule requires that the policy statement indicate 
approved broker-dealers and limits on the amounts and types of 
transactions for each broker. Although the rule does not require that 
the credit union approve more than one broker-dealer, reliance on a 
single individual or firm could be disadvantageous to the credit union. 
A credit union might choose to approve one broker-dealer for the full 
range of its investment activities and another for only certain of the 
investments authorized by policy. For example, the credit union may 
permit one broker, with more limited knowledge, to sell to the credit 
union only Treasury securities with less than 1 year maturity, while 
permitting another, with more knowledge and ability, to sell longer 
term securities or securities with embedded options issued by U.S. 
government agencies, as well as Treasury securities. The details for 
these authorizations should be established by policy.
    The proposed rule expands the requirements for credit union 
policies regarding the safekeeping of investments. The policy statement 
should include the amount and type of investments that can be safekept. 
The proposed rule does not require more than one safekeeping agent. 
Thus, all of a credit union's investments may be held by one safekeeper 
if this authorization is set forth in the policy statement.
    Most credit unions do not engage in trading, because it requires a 
great deal of sophistication, market knowledge, and strong controls. 
Credit unions that choose to enhance their income through this method 
may do so, provided they have established appropriate policies and 
controls.

Practices

    In addition to expanding the requirements for the establishment of 
investment policies, the proposed rule requires that credit unions 
follow certain practices designed to ensure that officials and 
employees involved with investment activities have adequate information 
regarding investments to make appropriate decisions to manage and 
control risk.
    Section 703.3(b)(1) of the proposed regulation requires that a 
federal credit union classify its securities as held-to-maturity, 
available-for-sale, or trading, in accordance with generally accepted 
accounting principles (GAAP) and consistent with the federal credit 
union's documented intent and ability regarding the security. Deposits 
and shares in Section 107(8) institutions and corporate credit unions 
are not securities and therefore are not subject to these 
classifications.
    It is NCUA's view that a credit union should not hold an investment 
unless its board of directors, chief financial officer, investment 
committee, and investment manager understand the risks reflected in the 
policy statement. Proposed Section 703.3(b)(2)(a) requires that any 
official or employee of a federal credit union who has discretionary 
investment authority be able to demonstrate an understanding of the 
risk characteristics of investments and investment transactions under 
that authority. The board must recognize its responsibilities in this 
area. Directors must be able to fully understand the risks associated 
with investment products that are authorized by policy. While not a 
specific requirement, NCUA recommends that in credit unions with more 
sophisticated portfolios, one or more board members serve on the asset-
liability management and/or investment committees.
    The NCUA examiner may request that individuals with investment 
authority demonstrate their understanding of that authority. If they 
are not able to do so, the credit union may be required to alter its 
policy statement or take other appropriate action.
    To ensure the board maintains control over the credit union's 
investment activities, proposed Section 703.3(b)(2)(B) establishes a 
general prohibition against delegating discretionary control of 
investment authority to an outside party. However, proposed Section 
703.3(b)(2)(C) allows a credit union to delegate such control to an 
investment advisor who is registered with the Securities and Exchange 
Commission under the Investment Advisers Act of 1940. Registration 
imposes a number of requirements designed to ensure that an adviser 
acts in the client's best interest. Nevertheless, to ensure that the 
transactions being made by the adviser are consistent with the credit 
union's policies and objectives, a credit union must establish 
specific, detailed parameters and reporting procedures when delegating 
investment authority.
    Proposed Section 703.3(b)(2)(D) limits the total of a credit 
union's delegation of investment authority and investment in mutual 
funds and other investment companies to 100 percent of capital. 

[[Page 61222]]

    Proposed Section 703.3(b)(3) requires that the board be notified 
when an investment has fallen outside board-approved policy parameters. 
For instance, if the credit union has established a minimum issuer 
credit rating of B, and during the course of holding an investment, the 
issuer's rating falls to B/C, the board must be notified and some 
decision regarding the investment or policy made and documented in the 
minutes.
    Proposed Section 703.3(b)(4) addresses the reporting of interest 
rate risk. It requires a federal credit union to prepare a monthly 
report showing the characteristics of each investment in the portfolio 
and the net increase or decrease in the fair value or total return of 
each security, and the portfolio, in sufficient detail to ensure that 
all of the securities, and the portfolio as a whole, remain within 
board policy. The change in fair value of held-to-maturity securities 
must be included because losses from such securities reflect future 
losses of income. Where the credit union has an active asset-liability 
management or investment committee, the report may be provided to such 
committee, with a summary to the board. Where the credit union does not 
have such a committee, the full report must be provided to the board.
    A credit union that chooses to keep all of its investments in CDs 
and corporate credit union shares and deposits would not be required to 
price these investments and therefore would not be subject to this 
reporting requirement. Only those credit unions that have marketable 
securities would be required to report this information. Credit unions 
that purchase securities with greater potential risk may have 
additional reporting requirements.
    Section 703.3(b)(4)(ii)(C) sets forth the securities that NCUA has 
determined represent greater potential risk. They are: (1) Securities 
that amortize; (2) securities with embedded options; (3) securities 
with maturities greater than 3 years; and (4) securities where contract 
rates are related to more than one index or are inversely related to, 
or multiples of, an index. If the total of securities that have any one 
of these characteristics is greater than capital, proposed Section 
703.3(b)(4)(iii) requires that the credit union calculate the potential 
impact, on the fair value and/or total return of each security in the 
portfolio and the portfolio as a whole, of parallel shifts of plus and 
minus 300 basis points. The purpose of this analysis is to determine 
the impact of potential shifts in interest rates on the credit union's 
future capital position. Current investment decisions must be made in 
the context of this analysis. Credit unions that do not want to conduct 
this analysis can restrict the total of these potentially risky 
investments to less than capital. For purposes of this rule, adjustable 
rate securities with a final maturity of 3 years or more are considered 
securities which represent greater potential risk.
    This interest rate shock test reflects a trade-off between ensuring 
a credit union board's full awareness of the risks of its portfolio and 
reducing the burden on small and medium-sized credit unions. The rule 
could have included long-term CDs and term investments in corporate 
credit unions in the list of investments that trigger the test, since 
such investments can present a high degree of interest rate risk. The 
rule also could have required a credit union holding even one of the 
triggering securities to subject its portfolio to a 300 basis point 
shock, because of the potential for greater interest rate risk. The 
rule also could have required more complex interest rate tests. Since 
financial markets do not change in parallel shifts, a 300 basis point 
parallel shift is inadequate to truly evaluate potential risk. More 
accurate tests would consider factors such as twists in the yield 
curve, lags, changes in volatility, the reinvestment rate of cash 
flows, and institutional factors affecting prepayment patterns. 
Finally, NCUA could have required credit unions to subject their entire 
balance sheets, including loans and shares, to an interest rate shock 
test, since testing only the investment portfolio yields an incomplete 
picture of the interest rate risk on a credit union's balance sheet. 
The NCUA Board determined, however, that more complex or additional 
tests would be too burdensome for small and medium-sized credit unions. 
However, it is NCUA's judgment that holders of large portfolios of more 
complex securities cannot manage interest rate risk adequately without 
conducting additional testing, and examiners will anticipate that 
additional evaluations be done.
    NCUA is proposing to permit credit unions the choice of using 
either changes in the fair value or total return to establish risk 
parameters and assess return. Changes in fair value can provide an 
approximation of risk exposure and return. However, credit unions may 
prefer to calculate and report total return since it is a more 
comprehensive measure. Managers with more sophisticated portfolios will 
likely calculate total return. The method used for calculating total 
return should be documented for review purposes.
    A credit union should always compare prices among broker-dealers 
for similar securities. In some instances, the price a credit union has 
paid or received for a security has been significantly different from 
the market price because the credit union conducted transactions with 
only one broker, who knew that the credit union was not verifying the 
price with another source. Proposed Section 703.3(b)(5)(i) requires 
that prior to purchase or sale a credit union obtain a price quote from 
a second broker or from an industry-recognized information provider. 
The information provider can be a pricing service or simply a newspaper 
with a financial section. These latter sources provide only indicative 
prices, however, and generally are not sufficient to ensure the credit 
union has received the best price quote. Where a credit union wishes to 
purchase a security that cannot be competitively priced, it should 
obtain a price on a comparable security. It is understood that the 
prices received from broker-dealers will generally not be in writing; 
however, the credit union should maintain documentation of who was 
called, the date and time of the call, and the quoted price or spread 
to the relevant Treasury security.
    Proposed Section 703.3(b)(5)(ii) requires a monthly review of the 
fair value of each security in a credit union's portfolio. This 
information is generally provided by broker-dealers or safekeepers. 
Although such information may not be as accurate as a real bid, the 
NCUA Board recognizes that obtaining real bids on a monthly basis is 
impractical and burdensome. To ensure some independent verification of 
these prices, however, Section 703.3(b)(5)(iii) requires that at least 
semiannually the credit union obtain a price on each security from 
another broker or an industry-recognized information provider. A credit 
union may eliminate the burden of valuing securities by restricting its 
portfolio to CDs and shares and deposits in corporate credit unions. In 
addition, a credit union can lessen its burden of valuing securities by 
restricting its portfolio to securities whose market prices are readily 
available.
    Proposed Section 703.3(b)(6) provides that credit unions must 
perform credit analyses of issuing entities unless the investment is 
issued or fully guaranteed by the U.S. government or its agencies or 
enterprises or is insured by the Federal Deposit Insurance Corporation 
or NCUA. The NCUA Board recognizes that it is often difficult for 
credit unions to perform a detailed credit analysis. Therefore, the 
proposed rule establishes a minimum issuer rating for financial 
institutions of B/C (or equivalent) or 

[[Page 61223]]
better. Credit unions should ensure that the rating is the issuer 
rating and not the issue rating. The issuer rating takes into 
consideration the entire operation, while an issue rating will take 
into consideration any credit supports accompanying an instrument.
    Credit unions are not necessarily excused from performing their 
own, independent credit analyses. Credit ratings are slow to adjust to 
rapid changes in the financial viability of an issuer. The extent of 
the credit analysis necessary is dependent upon the amount of the 
investment in relation to the credit union's total investments and 
capital. An analysis should include, at a minimum, a review of ratings 
and financial trends, including the capital to asset ratio, earnings, 
and loan losses.
    Credit unions should perform a credit analysis for investments 
above the insured amount in financial institutions that are not rated, 
including corporate credit unions. The NCUA Board specifically seeks 
comment on the issue of performing credit analyses on corporate credit 
unions.
    NCUA has observed substantial problems with broker-dealers. While 
most of the decisions on the choice of a broker-dealer should be left 
to the credit union's board, a minimum level of analysis should be 
conducted prior to selection. Section 703.3(b)(7) of the proposed rule 
requires that, at the least, the broker-dealer be a Section 107(8) 
institution or registered with the Securities and Exchange Commission 
(SEC). There will be many unscrupulous brokers who satisfy this 
requirement but still should not be used by credit unions. However, the 
requirement will exclude some brokers who sell only CDs and are not 
required to register with the SEC. The proposed rule also requires that 
credit unions also conduct an analysis of the financial condition and 
reputation of the broker-dealer and sales representative.
    Section 703.3(b)(8) addresses safekeeping. For control purposes, 
the proposed rule requires that securities be maintained independently 
of the broker. This is a change from the current regulation, which 
requires that only securities involved in repurchase transactions be 
held by an independent third party.
    There have been some problems in recent years with the failure of 
some brokers, and credit unions have been required to devote 
substantial resources to recover securities from some safekeepers. 
Because of the potential that some safekeepers may not be appropriate, 
this section requires that the credit union review an independent 
audited statement for the safekeeper.
    NCUA is also proposing that the purchase and sale of investments be 
``delivery versus payment.'' This method of settlement guarantees that 
the investment will not be paid for until it is received by the 
safekeeping institution.
    Trading policies and practices are not specifically addressed in 
the current regulation. According to the latest call report data, very 
few credit unions engage in trading activities. Activity in this area 
could increase, however, and if not properly controlled, could pose a 
significant risk. The details, in proposed section 703.3(b)(9), are 
from Letter to Credit Unions No. 89, dated April 1987. NCUA has 
determined that, for convenience, these requirements should be included 
in the regulation.
    Proposed Section 703.3(b)(10) requires that documentation be 
maintained through the examination and audit cycles. There have been 
instances where credit unions failed to maintain enough documentation 
for the examiner/auditor to properly analyze the security or determine 
the relationship of the investment decisions to the credit union's 
policies. Credit unions must maintain sufficient information to 
demonstrate that they have exercised prudent judgment in making 
investment decisions.

Section 703.4  Authorized Activities

    Current Section 703.4(a) permits a credit union to contract for the 
purchase or sale of a security provided that the delivery of a security 
is to be made within 30 days from the trade date. This accommodates the 
settlement of U.S. government and agency securities. Section 703.4(b) 
permits a credit union to enter into a cash forward agreement to 
purchase or sell a security provided that the period from the trade 
date to the settlement date does not exceed 120 days. If the credit 
union is the purchaser, it must have written cash flow projections 
evidencing its ability to purchase the security. This was designed to 
accommodate the settlement of mortgage-backed securities. NCUA is 
proposing to delete these specific time frames and simply provide for a 
credit union to contract for the purchase or sale of a security 
provided that delivery of the security is by ``regular-way'' 
settlement.
    The current regulation has created some problems distinguishing 
between regular delivery and forward commitments. The proposed 
regulation will permit a credit union to contract for the purchase of a 
security no matter when it settles, as long as the settlement date is 
within the normal time frame for that type of security. Currently, 
regular-way settlement for Treasury securities is the next business day 
after the trade date and for agency securities and secondary market 
mortgage-backed securities is the third business day. For new mortgage-
backed securities, regular-way settlement can be considerably longer. 
Under the proposed rule, where delivery of an investment extends beyond 
regular-way settlement, the investment will be considered an 
unauthorized forward commitment.
    The NCUA Board notes that proposed section 703.5(c) prohibits when 
issued trading. This is not intended to prohibit a credit union from 
contracting to purchase securities in the period between the 
announcement of an offering and the issuance of the securities. Rather, 
it is designed to prohibit a credit union from contracting to purchase 
securities during that time and then selling those securities before 
settlement. NCUA specifically seeks comment on how the removal of the 
authority for credit unions to enter into cash forward agreements and 
engage in when issued trading affects the ability of credit unions to 
enter into certain transactions, such as dollar rolls, which have been 
permitted for credit unions.
    Proposed section 703.4(b) simplifies the language authorizing 
credit union investment in repurchase transactions. Repurchase 
transactions can be viewed as relatively safe secured borrowing and 
lending. However, credit unions can incur losses on such investments if 
they do not exercise proper care in controlling and valuing their 
collateral. Repurchase transactions may be considered unsecured 
transactions if the purchaser does not take the appropriate steps to 
perfect an interest in the collateral. Credit unions should review NCUA 
Interpretive Ruling and Policy Statement (IRPS) 85-2 for a detailed 
discussion of the controls that should be followed when engaging in 
repurchase transactions.
    Section 703.4(j) of the current regulation provides that a federal 
credit union may invest in a mutual fund, provided that the investment 
and investment transactions of the funds are legally permissible for 
federal credit unions under the Act and NCUA regulations. Proposed 
section 703.4(d) broadens this authority by permitting investment in an 
investment company which is registered with the Securities and Exchange 
Commission under the Investment Company Act of 1940. A mutual fund is 
the most common type of registered investment company, but credit 
unions have been authorized by opinion letter to invest in other types, 
such as money market mutual funds and 

[[Page 61224]]
unit investment trusts. The regulatory language has been changed to 
clarify that these other types are permissible investments for credit 
unions.
    The proposed rule retains the requirement that the investments and 
investment transactions of the investment company must be permissible 
for credit unions and clarifies that this limitation must be set out in 
the company's prospectus and/or statement of additional information. 
For several years, NCUA has struggled with how much detail a 
prospectus/statement must contain in order for a credit union to 
determine that the investments and transactions are permissible for 
credit unions. Last year, NCUA issued Letter to Credit Unions No. 155, 
which attempted to provide guidance in this area for investments in 
mutual funds.
    The Letter stated that NCUA was taking the position that a credit 
union could invest in a mutual fund ``only when the prospectus 
indicates that the fund's authority is strictly limited to investments 
and investment transactions that are legal for federal credit unions.'' 
The Letter provided the example of a fund authorized to purchase CMOs, 
without restriction; it stated that the fund would be an impermissible 
investment for credit unions because the prospectus/statement would 
have to declare that only CMOs passing the HRST could be purchased. The 
Letter was intended to set forth the position that statements about a 
fund being ``a legal investment for federal credit unions'' or ``legal 
under the Federal Credit Union Act and NCUA Rules and Regulations'' 
were insufficient. A prospectus/statement of additional information was 
to set forth the specific investments and investment transactions 
authorized for the fund, in sufficient detail that credit unions and 
examiners could see that fund management clearly understood the limits 
of credit union investment authority and that the activities of the 
fund were within that authority.
    The Letter has led to more questions concerning the level of detail 
required in a prospectus, such as, for example, whether a prospectus 
must address the actions a fund will take if a CMO fails the stress 
tests upon retesting. Since it is not NCUA's intent that a mutual fund 
prospectus recite all of Part 703, and it is difficult to draw a line 
about what must be specifically included, the proposed rule provides 
that one method of establishing that a fund is a permissible investment 
for federal credit unions is for the prospectus simply to assert that 
the fund is ``a legal investment for federal credit unions'' or ``legal 
under the Federal Credit Union Act and NCUA Rules and Regulations.'' A 
credit union that has invested in a mutual fund should monitor the 
activities of the fund to determine that they do not exceed the limits 
of credit union authority. The NCUA Board specifically requests 
comments on this issue. To the extent that a provision of Letter 155 is 
inconsistent with this rule, that provision would be superseded by this 
rule.
    Section 704.4(e) of the proposed rule addresses the high risk 
securities test (HRST) for CMOs. The most significant change is the 
application of the entire test to variable as well as fixed rate CMOs. 
A number of credit unions have been unaware of the risks associated 
with variable rate CMOs. They owned securities linked to lagging market 
indexes, frequently the 11th District Cost of Funds (COFI) . The 
weighted average lives of these securities extended 20 years or more 
following the last interest rate increase, and the securities suffered 
substantial price deterioration. Under the proposed regulation, both 
variable rate and fixed rate CMOs would be subject to all three tests. 
However, credit unions should still be aware of the limitations of the 
HRST, particularly as applied to variable rate securities based on 
lagging indexes. When testing a variable rate CMO, the credit union 
must be aware that a ``thumbs up'' on the HRST may not mean it passes 
the tests imposed by this rule. The credit union must review the 
results of each part of the test (average life, average life 
sensitivity, and price sensitivity) to ensure compliance.
    There has been some confusion regarding the applicability of the 
current regulation when a CMO has passed the HRST for one prepayment 
model, but failed for another. NCUA does not want to specify which of 
the prepayment models a credit union must use to evaluate the risks 
associated with the CMO. However, as discussed earlier, the proposed 
rule requires that the credit union board specify, in its policy 
statement, an approved list of prepayment models that will be used when 
purchasing or retesting a CMO. At the time of purchase, a CMO will be 
required to pass the HRST for all the prepayment models listed in the 
policy statement. At any subsequent retesting date, the CMO must pass 
the HRST for the majority of the prepayment models specified in the 
policy statement and used in the purchase decision.
    This provides a credit union's board of directors with several 
options: (1) Where the policy specified the use of the median 
prepayment estimate alone, the subsequent failure of the HRST upon 
retest, using the same median, would make the security impermissible. 
(2) Where the policy specified three specific prepayment models, for 
example, the CMO could fail the HRST for one prepayment model and still 
be held by the credit union. Where five prepayment models were 
specified, the CMO could fail two and still be held. (3) Where the 
policy specified the use of a median prepayment model in addition to 
proprietary models, the CMO would not be subject to divestiture unless 
it failed a majority of the prepayment models used rather than the 
median alone.
    A majority cannot be interpreted as half of the prepayment models. 
If the credit union specifies only two prepayment models in its policy 
statement, then the CMO must pass the HRST for both prepayment models 
if the security is to remain in the portfolio and not be subject to the 
divestiture requirement of proposed Section 703.7.
    Proposed Section 703.4(f) addresses federal credit union 
investments in corporate credit union capital shares and deposits. In a 
slight rewording of the current rule, it provides that such investments 
are permissible except where the NCUA Board has provided notice that 
the corporate credit union is not operating in compliance with the NCUA 
regulations governing corporate credit unions. This should address 
concerns regarding investing credit unions' knowledge of corporate 
compliance. The proposed rule also limits credit union investment in 
the capital shares of a corporate credit union to a total of one 
percent of the investing credit union's assets, due to the potential 
risk associated with such investments. Membership capital share 
deposits, as defined in Section 704.2 of the NCUA Rules and 
Regulations, 12 CFR 704.2, are currently the only type of capital 
shares corporate credit unions are authorized to offer. The NCUA Board 
specifically requests comment regarding the appropriateness of this one 
percent limit.
    Proposed section 703.4(g) establishes minimum credit ratings for 
municipal bonds. Credit unions would be limited to purchasing bonds 
rated in one of the two highest rating categories by at least one 
nationally recognized statistical rating organization. In the existing 
rule there is no limitation on credit quality, exposing credit unions 
to potentially unacceptable risk.
    The prior rule was silent as to the types of indexes to which 
variable rate instruments could be tied. The proposed rule limits 
permissible indexes to those tied to domestic interest rates only. 
There is no correlation between a credit 

[[Page 61225]]
union's cost of funds and, for instance, foreign currencies or equity 
prices.
    This will prohibit credit unions from purchasing investments linked 
to the Standard & Poor's 500 and other equity indexes, either as 
speculative investments or to match against Individual Retirement 
Accounts (IRAs) offered to members. NCUA recognizes that this may 
present a hardship to credit unions who wish to offer such accounts; 
however, the potential risk associated with credit unions purchasing 
investments that are not linked to interest rates supports this 
restriction. NCUA considered requiring a credit union to match equity-
linked investments to shares but rejected this alternative because of 
the difficulty of ensuring that such investments were actually matched 
in this manner.

Section 703.5  Prohibitions.

    The proposed rule adds prohibitions against purchasing or selling 
option and interest rate swap contracts and engaging in pair off 
transactions. These activities all have been prohibited by opinion 
letter. The proposed rule also prohibits the purchase of stripped 
mortgage-backed securities and CMO residuals. Currently, credit unions 
are permitted to purchase these securities for hedging purposes. NCUA 
has found that credit unions holding these securities generally have 
been unable to demonstrate that they were using them as a hedge. The 
high risk of these securities justifies their prohibition. The Board 
notes, however, that a CMO with the characteristics of a stripped 
mortgage-backed security is permissible if it meets the CMO stress 
tests in this regulation. The proposed prohibition against when issued 
trading is discussed above, in conjunction with cash forward 
agreements.
    The Riegle Community Development and Regulatory Improvement Act of 
1994 amended the definition of ``mortgage related security,'' as 
defined in Section 3(a)(41) of the Securities and Exchange Act of 1934, 
to include securities backed by commercial mortgages. Federal credit 
unions are authorized to invest in mortgage related securities pursuant 
to section 107(15)(B) of the Act. Thus, the Riegle Act provided 
statutory authority for federal credit union investment in securities 
backed by commercial mortgages. However, it is NCUA's view that this 
authority is not self-implementing, that is, it requires action of the 
NCUA Board to become effective. This proposed rule would clarify that 
credit unions are not permitted to invest in commercial mortgage 
related securities. The NCUA Board is declining to implement the 
statutory authority at this time because the market for these 
securities is undeveloped, and the potential timing of cash flows from 
these securities is not widely disseminated.
    In addition to amending the definition of mortgage related 
security, the Riegle Act amended the Act by adding section 107(15)(C), 
which provides the statutory authority for federal credit unions to 
invest in small business related securities as defined in Section 
3(a)(53) of the Securities and Exchange Act of 1934. These are 
privately issued securities backed by loans to small businesses. Again, 
this statutory authority is not self-implementing, and the proposed 
rule clarifies that credit unions are not permitted to invest in these 
types of securities. As with commercial mortgage related securities, 
the market for small business related securities is undeveloped. The 
NCUA Board notes that this does not prohibit credit unions from 
purchasing investments in securities issued or guaranteed by the Small 
Business Administration.
    The proposed rule also clarifies that credit unions may not 
purchase mortgage servicing rights directly, as there is no express or 
incidental authority for such purchase. This prohibition does not 
affect the right of a credit union to retain servicing rights of loans 
that are sold, whether the loans have been made by the credit union or 
purchased to complete a pool for sale or pledge on the secondary 
market.

Section 703.6  Pledging Securities

    Proposed section 703.6 establishes a new section which addresses 
the pledging of securities. Although a reverse repurchase transaction 
can be characterized as a sale and repurchase of securities, it is 
considered a secured borrowing for purposes of the proposed rule. The 
proposed rule clarifies the authority of federal credit unions to 
participate in securities lending and subjects securities lending and 
collateralized borrowing to several provisions which currently apply 
only to reverse repurchase transactions.
    A credit union engaging in reverse repurchase transactions and 
securities lending must ensure that it has adequately investigated the 
financial stability and character of any counterparty with which it 
deals. IRPS 85-2, discussed above in the context of repurchase 
transactions, sets out the controls that should be followed when 
engaging in reverse repurchase transactions. These controls should also 
be followed when lending securities.

Section 703.7  Divestiture Requirements

    The NCUA Board is proposing to codify specific divestiture 
requirements for investments which do not meet the requirements of the 
proposed rule. When an investment is downgraded below the minimum 
credit requirements of proposed sections 703.3(b)(6)(ii) and 703.4(g), 
or fails the HRST, proposed Section 703.7 requires that the credit 
union either sell the investment or develop a plan that supports the 
intention to hold it. While awaiting response from the regional 
director to a proposed plan to hold a downgraded or failed investment, 
a credit union must continue to manage and monitor the investment as 
required by this part. NCUA retains the right to require immediate 
divestiture when an investment constitutes a significant threat to the 
continued sound operation of the credit union. To the extent that a 
requirement of Letter to Credit Unions No. 169 is inconsistent with 
this rule, it would be superseded by this rule.

Section 703.8  Prohibited Fees

    The language in proposed section 703.8 is currently found at 
Section 703.5(l). No changes were made, but the material has been put 
into a separate section to ensure that it is not overlooked. It should 
be noted that the prohibition against committee members receiving 
pecuniary consideration in the making of investments means that a 
broker-dealer or consultant may not serve as a voting member of an 
investment or asset-liability management committee. It should also be 
noted that this provision does not exclude credit union employees 
involved in making investments or deposits from receiving salary for 
those activities.

Section 703.9  Grandfather Provisions

    The NCUA Board anticipates that any final rule addressing Part 703 
will be made effective 30 days after it is published in the Federal 
Register. The proposed rule provides that credit unions holding 
investments that will become impermissible when the final rule takes 
effect will be allowed to continue holding those investments. The 
proposed rule also sets out grandfather provisions that have been 
established in conjunction with prior regulatory changes.

Regulatory Procedures

Regulatory Flexibility Act

    The NCUA Board certifies that the proposed rule, if made final, 
will not have a significant economic impact on 

[[Page 61226]]
small credit unions (those under $1 million in assets).
    Such credit unions generally do not purchase potentially risky 
investments and hence would not be subject to the majority of the 
policy and reporting requirements of the proposed rule. Accordingly, a 
regulatory flexibility analysis is not required.

Paperwork Reduction Act

    NCUA has determined that several requirements of the proposed rule 
constitute collections of information under the Paperwork Reduction 
Act. The requirements are: (1) To establish a written investment 
policy; (2) to perform an annual review of the written investment 
policy; (3) to provide notification to the federal credit union's board 
of directors of investments that do not fall within the guidelines of 
the established policy; (4) to prepare a written report of investments 
monthly; (5) to obtain price quotes on securities prior to purchase or 
sale; (6) to complete and document a monthly review of the fair value 
of each security; (7) to obtain a semiannual independent assessment of 
the fair value of securities held; (8) to complete a credit analysis of 
the issuing entity prior to purchasing an investment if the principal 
and interest is not fully guaranteed by the U.S. government, its 
agencies, or enterprises or is not fully insured by NCUA or the FDIC; 
(9) to obtain individual confirmation statements for each investment 
purchased or sold; (10) to obtain and reconcile a monthly statement of 
investments held in safekeeping; (11) to prepare a monthly written 
report of the fair value and/or total return at the trade date of all 
trading securities and purchase and sale transactions and the resulting 
gain or loss on an individual basis; (12) to complete and document the 
retesting of CMOs on a quarterly basis; (13) to provide written notice 
to the Regional Director of CMOs that fail the High Risk Security Test; 
and (14) to prepare and provide to the Regional Director a written 
divestiture plan if the federal credit union does not immediately sell 
the failed CMO.
    It is NCUA's view that the time a federal credit union spends 
developing a responsible and reasonable policy, notifying the federal 
credit union's board of directors of investments that do not fall 
within the guidelines of the established policy, obtaining individual 
confirmation statements for each investment purchased or sold, and 
obtaining and reconciling a monthly statement of investments held in 
safekeeping are not burdens created by this regulation, but rather are 
usual and customary practices in the normal operations of a federal 
credit union. The paperwork burdens created by this rule are the 
remaining requirements outlined above.
    NCUA estimates that it should take an average of 2.5 hours to 
review the investment policy annually and 2 hours per month to prepare 
the written report of investments. Since this requirement applies to 
all 7,400 federal credit unions, 196,100 burden hours would be required 
to comply with these two requirements. NCUA estimates that 370 federal 
credit unions would have to comply with the requirement to report 
investments that fall outside board policy after purchase. It is 
expected that this would take 15 minutes per year, resulting in a total 
of 92.5 burden hours. NCUA estimates that 5,624 federal credit unions 
would be required to obtain price quotes prior to the purchase or sale 
of securities, projected to take 2 hours per year, to review the fair 
value of each security monthly, projected to take 12 hours per year, 
and to independently assess the fair value of its securities 
semiannually, projected to take 2 hours per year. The burden for these 
requirements totals 89,984 hours. NCUA estimates that 705 federal 
credit unions would be required to complete a credit analysis. It is 
estimated that this analysis would take 25 hours, resulting in a total 
of 17,625 burden hours. NCUA estimates that 74 federal credit unions 
would be required to prepare a written report of the trading account 
activity, an activity that is expected to take 12 hours per year, 
imposing a total burden of 888 hours. NCUA estimates that 1,850 federal 
credit unions would have to comply with the quarterly retesting of 
CMOs. It is projected that this requirement would take a credit union 2 
hours per year to perform, making to total burden 3,700 hours. NCUA 
estimates that 370 federal credit unions would be required to prepare 
written notices and divestiture plans regarding downgraded or failed 
investments. It is expected that a notice and plan would take 3 hours, 
making a total burden of 1,110 hours. In total, the burden created by 
the proposed rule is 309,499.5 hours. A significant portion of the 
paperwork required by the proposed rule is already being completed by 
credit unions. It is NCUA's view that the additional requirements are 
necessary in order for a credit union to understand the risks presented 
by a substantial portion of its balance sheet.
    The Paperwork Reduction Act of 1995 and regulations of the Office 
of Management and Budget (OMB) require that the public be provided an 
opportunity to comment on information collection requirements, 
including an agency's estimate of the burden of the collection of 
information.
    The NCUA Board invites comment on: (1) Whether the collection of 
the information is necessary for the proper performance of the 
functions of NCUA, including whether the information will have 
practical utility; (2) the accuracy of NCUA's estimate of the burden of 
the collection of information; (3) ways to enhance the quality, 
utility, and clarity of the information to be collected; and (4) ways 
to minimize the burden of collection of information. Send comments to 
Attn: Milo Sunderhauf, OMB Reports Management Branch, New Executive 
Office Building, Rm. 10202, Washington, DC 20530. Comments should be 
postmarked by January 29, 1996.

Executive Order 12612

    Executive Order 12612 requires NCUA to consider the effect of its 
actions on state interests. Since the proposed rule applies only to 
federal credit unions, it has no effect on state interests.

List of Subjects in 12 CFR Part 703

    Credit unions, Investments.

    By the National Credit Union Administration Board on November 
16, 1995.
Becky Baker,
Secretary of the Board.

    For the reasons set forth in the preamble, NCUA proposes to revise 
12 CFR Part 703 to read as follows:

PART 703--INVESTMENT AND DEPOSIT ACTIVITIES

Sec.
703.1  Scope.
703.2  Definitions.
703.3  Investment policies and practices.
703.4  Authorized activities.
703.5  Prohibitions.
703.6  Pledging securities.
703.7  Divestiture requirements.
703.8  Prohibited fees.
703.9  Grandfather provisions.

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


Sec. 703.1  Scope.

    Sections 107(7), 107(8) and 107(15) of the Federal Credit Union Act 
(``Act''), 12 U.S.C. 1757(7), 1757(8), 1757(15), set forth those 
securities, deposits, and other obligations in which federal credit 
unions may invest. This part interprets several of the provisions of 
Sections 107(7), 107(8), and 107(15)(B) and (C). This part does not 
apply to: investments in loans to members and related activities, which 
are governed by Secs. 701.21, 701.22, and 701.23 of this chapter; the 
purchase of real estate-secured loans pursuant to Section 

[[Page 61227]]
107(15)(A) of the Act, which is governed by Sec. 701.23 of this 
chapter; investment in credit union service organizations, which is 
governed by Sec. 701.27 of this chapter; investment in fixed assets, 
which is governed by Sec. 701.36 of this chapter; or investments by 
corporate credit unions, which is governed by part 704 of this chapter.


Sec. 703.2  Definitions.

    Adjusted trading means any method or transaction used to defer a 
loss whereby a federal credit union sells a security to a counterparty 
at a price above its current fair value and simultaneously purchases or 
commits to purchase from the counterparty another security at a price 
above its current fair value.
    Amortizing security means a security where the principal is reduced 
by contractual payments.
    Average life means the weighted average time to principal repayment 
with the amount of the principal paydowns (both scheduled and 
unscheduled) as the weights.
    Bankers' acceptance means a time draft that is drawn on and 
accepted by a bank, and that represents an irrevocable obligation of 
the bank.
    Business day means a day other than a Saturday, Sunday, or federal 
holiday.-
    Capital means the total of all undivided earnings, regular 
reserves, other reserves (excluding the allowance for loan losses), net 
income, and accumulated unrealized gains (losses) on available-for-sale 
securities.
    Collateralized mortgage obligation (CMO) means a multi-class bond 
issue collateralized by whole loan mortgages or mortgage-backed 
securities.
    Commercial mortgage related security means a mortgage related 
security where the mortgages are secured by real estate upon which is 
located a commercial structure.
    Corporate credit union means a credit union that meets the 
definition of ``corporate credit union'' contained in part 704 of this 
chapter.
    Custodial agreement means a contract whereby a third party, for a 
fee, agrees to exercise ordinary care in protecting the securities held 
in safekeeping for its customers.
    Delivery versus payment, in the context of the purchase and sale of 
securities, means that payment for a security occurs simultaneously 
with its delivery.
    Embedded option means a characteristic of an investment which gives 
the issuer or the holder of the investment the right to change features 
such as rate and principal payment schedule. Embedded options include, 
but are not limited to, caps, floors, calls, and prepayment provisions. 
These options can result in the principal and/or interest cash flows of 
an investment varying in response to changes in interest rates.
    Eurodollar deposit means a deposit in a foreign branch of a United 
States depository institution.-
    Facility means the home office of a federal credit union or any 
suboffice thereof, including, but not necessarily limited to, credit 
union service center, wire service, telephonic station, or mechanical 
teller station.
    Fair value means the price at which a security can be bought or 
sold in a current, arms length transaction between willing parties, 
other than in a forced or liquidation sale.
    Federal funds transaction means a transaction among depository 
institutions involving the transfer of immediately available funds 
resulting from credits to deposit balances at Federal Reserve banks or 
from credits to new or existing deposit balances due from a 
correspondent depository institution.
    Futures contract means a contract for the future delivery of 
commodities, including certain government securities, sold on 
commodities exchanges.
    Immediate family member means a spouse or other family member 
living in the same household.
    Index means an interest rate which is regularly reported in a 
publication or electronic service of national circulation.
    Industry-recognized information provider means an organization 
which obtains compensation by providing information to investors and 
receives no compensation for the purchase or sale of investments.
    Interest rate swap means a contract to exchange streams of interest 
payments based upon a specified dollar amount at specified dates in the 
future.
    Investment means any security, obligation, account, deposit, or 
other item authorized for purchase by a federal credit union under 
Sections 107(7), 107(8), or 107(15)(B) or (C) of the Federal Credit 
Union Act, or this part, other than loans to members.-
    Investment characteristic means a feature of an investment such as 
its maturity, index, cap, floor, coupon rate, coupon formula, index, 
call provision, or average life.
    Maturity means the date the last principal amount of a security is 
scheduled to come due and shall not mean the call date or the average 
life of the security.
    Mortgage related security means a security as defined in Section 
3(a)(41) of the Securities and Exchange Act of 1934, i.e., a privately-
issued security backed by mortgages secured by real estate upon which 
is located a dwelling, mixed residential and commercial structure, 
residential manufactured home, or commercial structure.
    Mortgage servicing means performing tasks to protect a mortgage 
investment, including collecting the installment payments, managing the 
escrow accounts, monitoring and dealing with delinquencies, and 
overseeing foreclosures and payoffs.
    Municipal security means a security as defined in Section 107(7)(K) 
of the Act.
    Official means any member of the board of directors, credit 
committee, or supervisory committee.
    Option means a contract which provides the right, but not the 
obligation, to buy or sell a security at a fixed price on or before a 
specified date in the future.
    Pair-off transaction means a security purchase transaction that is 
closed or sold at, or prior to, the settlement date.
    Parallel shift means an equal basis point change at every point 
along a given yield curve.
    Prepayment model means a reasonable and supportable forecast of 
mortgage prepayments in alternative interest rate scenarios. Models are 
available from securities broker-dealers and industry-recognized 
information providers. These models are used in tests to forecast the 
weighted average life, change in weighted average life, and price 
sensitivity of CMOs/REMICs and mortgage-backed securities.
    Real estate mortgage investment conduit (REMIC) means a nontaxable 
entity formed for the sole purpose of holding a fixed pool of mortgages 
secured by an interest in real property and issuing multiple classes of 
interests in the underlying mortgages.
    Regular-way settlement means delivery of a security from a seller 
to a buyer within the specified number of days established for that 
type of security. For example, regular-way settlement for transactions 
in U.S. government securities is one business day after the trade date 
and in agency securities is three business days after the trade date.
    Repurchase transaction means a transaction in which a federal 
credit union agrees to purchase a security from a counterparty and to 
resell the same or any identical security to that counterparty at a 
specified future date and at a specified price.
    Residual interest means the remainder cash flows from a CMO/REMIC, 
or other mortgage-backed security transaction, 

[[Page 61228]]
after payments due bondholders and trust administrative expenses have 
been satisfied.
    Reverse repurchase transaction means a transaction in which a 
federal credit union agrees to sell a security to a counterparty and to 
repurchase the same or any identical security from that counterparty at 
a specified future date and at a specified price.
    Section 107(8) institution means an institution in which a federal 
credit union is authorized to make deposits pursuant to Section 107(8) 
of the Act, i.e., an institution that is insured by the Federal Deposit 
Insurance Corporation or is a state bank, trust company or mutual 
savings bank operating in accordance with the laws of a state in which 
the federal credit union maintains a facility.
    Securities loan means a transaction in which a federal credit union 
agrees to lend a security to a counterparty.
    Security means a share, participation, or other interest in 
property or in an enterprise of the issuer or an obligation of the 
issuer that:
    (1) Either is represented by an instrument issued in bearer or 
registered form or, if not represented by an instrument, is registered 
in books maintained to record transfers by or on behalf of the issuer;
    (2) Is of a type commonly dealt in on securities exchanges or 
markets or, when represented by an instrument, is commonly recognized 
in any area in which it is issued or dealt in as a medium for 
investment; and
    (3) Either is one of a class or series or by its terms is divisible 
into a class or series of shares, participations, interests, or 
obligations.
    Senior management employee means the credit union's chief executive 
officer (typically this individual holds the title of President or 
Treasurer/Manager), any assistant chief executive officers (e.g., 
Assistant President, Vice President, or Assistant Treasurer/Manager) 
and the chief financial officer (Comptroller).
    Settlement date means the date originally agreed to by a federal 
credit union and a vendor for settlement of the purchase or sale of a 
security.
    Short sale means the sale of a security not owned by the seller.
    Small business related security means a security as defined in 
Section 3(a)(53) of the Securities and Exchange Act of 1934, i.e., a 
security, rated in one of the four highest rating categories by a 
nationally recognized statistical rating organization, that represents 
ownership of one or more promissory notes or leases of personal 
property which evidence the obligation of a small business concern. It 
does not mean a security issued or guaranteed by the Small Business 
Administration.
    Standby commitment means a commitment to either buy or sell a 
security, on or before a future date, at a predetermined price. The 
seller of the commitment is required to either accept delivery of a 
security (in the case of a commitment to buy) or make delivery of a 
security (in the case of a commitment to sell), in either case, at the 
option of the buyer of the commitment.
    Street name, for a security, means registered in the name of a 
broker-dealer. Customer-owned securities held by a safekeeper normally 
are registered in street name to facilitate transfer when the security 
is sold. The customer remains the beneficial owner of the security.
    Stripped mortgage-backed security means a security that represents 
either the principal- or interest-only portion of the cash flows of an 
underlying pool of mortgages or mortgage-backed securities.
    Total return means, for a specific holding period, the sum of 
interest and principal payments, the income earned on the reinvestment 
of these cash flows, and the change in fair value.
    Trade date means the date a federal credit union originally agrees, 
orally or in writing, to purchase or sell a security.
    U.S. government agency means an instrumentality of the U.S. 
government, including the Commodity Credit Corporation, the Export-
Import Bank, the Federal Farm Credit Bank, the Farm Credit System 
Financial Assistance Corporation, the Federal Financing Bank, the 
Federal Housing Administration, the Financing Corporation, the 
Government National Mortgage Association, the Maritime Administration, 
the Overseas Private Investment Corporation, the Resolution Funding 
Corporation, the Small Business Administration, the Tennessee Valley 
Authority, and the Veterans Administration. -
    U.S. government-sponsored enterprise means an entity originally 
established or chartered by the federal government to serve public 
purposes specified by the U.S. Congress but whose obligations are not 
explicitly guaranteed by the full faith and credit of the U.S. 
government. Such enterprises include the Federal Home Loan Mortgage 
Corporation, the Federal National Mortgage Association, and the Student 
Loan Marketing Association. -
    When issued trading means the buying and selling of securities in 
the period between the announcement of an offering and the issuance and 
payment date of the securities.
    Yankee dollar deposit means a deposit in a United States branch of 
a foreign bank licensed to do business in the state in which it is 
located, or a deposit in a state-chartered, foreign controlled bank.
    Zero coupon bond means a debt obligation that makes no periodic 
interest payments but instead is sold at a discount from its face 
value. The holder of a zero coupon bond realizes the rate of return 
through the gradual appreciation of the security, which is redeemed at 
face value on a specified maturity date.


Sec. 703.3  Investment policies and practices.

    (a) The board of directors of each federal credit union shall 
establish written investment policies consistent with the Act, this 
part, and other applicable laws and regulations, and review them at 
least annually. At a minimum, the policies shall address the following:
    (1) Purposes and objectives of the credit union's investment 
activities;
    (2) Authorized investments, by issuer and characteristics;
    (3) Interest rate risk management, if not addressed in the credit 
union's asset-liability management policies;--
    (4) Concentration limits;
    (5) Approved CMO/REMIC prepayment models, subject to the 
requirements of Sec. 703.4(e)(3);
    (6) Liquidity risk management, if not addressed in the credit 
union's asset-liability management policies;
    (7) Credit risk management, if applicable, including approved 
issuers, or criteria for issuers, and limits on the amounts that may be 
invested with each issuer;-
    (8) Persons to whom investment authority has been delegated, the 
knowledge and experience required of such persons, and the extent of 
their authority. This requirement may be met by the board's approval of 
position descriptions which address the same criteria;
    (9) Approved securities broker-dealers and limits on the amounts 
and types of transactions to be executed with each broker-dealer. 
Limits to be considered should include safekeeping arrangements, 
repurchase transactions, securities lending and borrowing, other 
transactions with credit risk, and total credit risk with an individual 
broker-dealer;
    (10) Approved safekeeping entities and limits on the amounts and 
types of investments that may be safekept with each entity; and
    (11) Trading policies, if the credit union engages in trading, 
including persons who have purchase and sale 

[[Page 61229]]
authority, trading account size limitations, allocation of cash flow to 
trading accounts, stop loss or sale provisions, dollar size limitations 
of specific types, quantity and maturity to be purchased, limits on the 
length of time an investment may be inventoried in the trading account, 
appropriate segregation of duties, and other internal controls. -
    (b) Federal credit unions must comply with the following investment 
practices:
    (1) Reporting. A federal credit union must classify a security as 
held-to- maturity, available-for-sale, or trading, in accordance with 
generally accepted accounting principles (GAAP) and consistent with the 
federal credit union's documented intent and ability regarding the 
security.
    (2) Investment authority.  (i) Any official or employee of a 
federal credit union who has discretionary investment authority must be 
able to demonstrate an understanding of the risk characteristics of 
investments and investment transactions under that authority. Only 
officials, employees, and members of a federal credit union may be 
voting members of the credit union's investment and/or asset-liability 
management committees. The ultimate responsibility for supervising a 
federal credit union's investment activities rests with the board of 
directors.
    (ii) Except as provided in paragraphs (b)(2)(iii) through (v) of 
this section, a federal credit union must retain discretionary control 
over the purchase and sale of investments and may not delegate such 
control to a person other than an official or employee of the credit 
union. Control is not considered delegated when a federal credit union 
is required to authorize a recommended purchase or sale transaction 
prior to its execution and the federal credit union, in practice, 
reviews such recommendations and authorizes such transactions. -
    (iii) A federal credit union may delegate discretionary control of 
its investment portfolio, within established parameters, to a person 
other than an official or employee of the credit union, provided that 
the person is an investment adviser registered with the Securities and 
Exchange Commission under the Investment Advisers Act of 1940 (15 
U.S.C. 80b). A federal credit union is prohibited from compensating an 
investment adviser on a per transaction basis or based on capital 
gains, capital appreciation, net income, performance relative to an 
index, or any other incentive basis.
    (iv) The aggregate of a federal credit union's delegation of 
investment control, under paragraph (b)(2)(iii) of this section, and 
investment in investment companies, under Sec. 703.4(d), is limited to 
100 percent of capital at time of delegation and/or purchase.
    (v) When a credit union has delegated discretionary investment 
control, it no longer has the ability to control its own securities, 
and all holdings for which such control has been delegated must be 
reported as available-for-sale. --
    (3) Investments outside board policy. The board of directors of a 
federal credit union must be notified as soon as possible, but no later 
than the next regularly scheduled board meeting, of any investment 
which falls outside of board policy after purchase. Board action 
regarding the investment must be documented in the minutes of the board 
meeting. -
    (4) Interest rate risk. (i) In the management of interest rate 
risk, a federal credit union must use a process that is commensurate 
with the scope, size, and complexity of the risk assumed. Market 
factors and characteristics of an investment which affect risk 
exposures must be evaluated prior to purchase and adequately measured, 
monitored, and controlled while the investment is held in the 
portfolio.
    (ii) At least monthly, a federal credit union must prepare a 
written report setting forth:
    (A) As applicable, the characteristics of each investment in the 
portfolio;
    (B) The net increase or decrease in the fair value or total return 
of each security since the date of purchase and for the last month, 
with summary information on the whole portfolio for the last month;
    (C) The sum of the fair values of all fixed and variable rate 
securities that have one or more of the following characteristics:
    (1) Amortizing features;
    (2) Embedded options;
    (3) Maturities greater than 3 years; or
    (4) Contract rates that are related to more than one index or are 
inversely related to, or multiples of, an index. -
    (iii) Where the amount calculated in paragraph (b)(4)(ii)(C) of 
this section is greater than the federal credit union's capital, the 
report described in paragraph (b)(4)(ii) of this section must provide a 
reasonable and supportable estimate of:
    (A) The potential impact on the fair value and/or total return of 
each security in the portfolio and the portfolio as a whole, in 
percentage and dollar terms, of an immediate and sustained parallel 
shift in market interest rates of plus and minus 300 basis points; and
    (B) The potential impact on capital, in percentage and dollar 
terms, of the dollar value calculated in paragraph (b)(4)(iii)(A) of 
this section.
    (iv) Where a federal credit union does not have an asset-liability 
management or investment committee, each member of the board of 
directors must receive a copy of the report described in paragraphs 
(b)(4)(ii) and (iii) of this section. Where a federal credit union has 
such a committee, each member of the committee must receive a copy of 
the report, and each member of the board of directors must receive a 
summary of the information contained therein.
    (5) Valuation of securities. (i) Prior to purchasing or selling a 
security, a federal credit union must obtain and document, on the trade 
date, either:
    (A) Price quotes for the security, or a security with substantially 
similar characteristics, from at least two securities broker-dealers; 
or
    (B) A price quote on the security from an industry-recognized 
information provider.
    (ii) At least monthly, a federal credit union must review and 
document the fair value of each security held in portfolio.
    (iii) At least semiannually, a federal credit union must obtain and 
document an independent assessment of the fair value of each security 
held in portfolio. This may be accomplished by obtaining either:
    (A) At least one timely price quote on the security, or a security 
with substantially similar characteristics, from a securities broker-
dealer other than the one from which it was purchased; or
    (B) A price quote on the security from an industry-recognized 
information provider.--
    (6) Credit risk. (i) A federal credit union must conduct and 
document a credit analysis of the issuing entity prior to purchasing an 
investment and must update such analysis at least semiannually as long 
as the investment is held in portfolio. At a minimum, this analysis 
should consist of a review of the investment's prospectus and, if 
rated, its credit rating.
    (ii) If an issuer is a financial institution which is rated by a 
nationally recognized statistical rating organization, it must have an 
issuer rating of B/C (or equivalent) or higher.
    (iii) The requirements of paragraphs (b)(6)(i) and (ii) of this 
section do not apply in the case of investments that are:
    (A) Issued or fully guaranteed as to principal and interest by the 
U.S. government, U.S. government agencies, 

[[Page 61230]]
or U.S. government-sponsored enterprises; or -
    (B) Fully insured (including accumulated interest) by the National 
Credit Union Administration or the Federal Deposit Insurance 
Corporation.
    (7) Securities broker-dealers. (i) A federal credit union may 
transact business with a securities broker-dealer provided that such 
broker-dealer either is registered with the Securities and Exchange 
Commission under the Securities Exchange Act of 1934 (15 U.S.C. 78a et 
seq.) or is a bank whose broker-dealer activities are regulated by a 
federal financial institution regulatory agency.
    (ii) In determining whether to transact business with a securities 
broker- dealer, a federal credit union must consider the following 
factors:
    (A) The ability of the broker-dealer and its subsidiaries or 
affiliates to fulfill commitments as evidenced by capital strength, 
liquidity, and operating results. This evidence should be gathered from 
current financial data, annual reports, credit reports, and other 
sources of financial information.
    (B) The broker-dealer's general reputation for financial stability 
and fair and honest dealings with customers. Other depository 
institutions that are past or current customers of the broker-dealer 
should be contacted.
    (C) Information available from state or federal securities 
regulators and securities industry self-regulatory organizations, such 
as the National Association of Securities Dealers, about any formal 
enforcement actions against the broker-dealer, its affiliates, or 
associated personnel.
    (D) The background of any broker-dealer's sales representative upon 
whose advice the credit union may rely to determine his or her 
experience or expertise.
    (iii) A federal credit union must review the audited financial 
condition of approved broker-dealers at least annually.
    (8) Control of investments. (i) A federal credit union's purchased 
investments and repurchase collateral must be in the credit union's 
possession, recorded as owned by the credit union through the Federal 
Reserve Book-Entry System, or held by a board-approved safekeeper under 
a written custodial agreement.
    (ii) A federal credit union must obtain an individual confirmation 
statement for each investment purchased or sold.-
    (iii) A federal credit union may not leave purchased investments 
and repurchase collateral in safekeeping with the selling broker-
dealer, except that where the broker-dealer is a bank or corporate 
credit union, the investments or collateral may be safekept in a 
separately identifiable department or division of the bank or corporate 
credit union.
    (iv) A credit union must receive a safekeeping receipt for each 
investment held in safekeeping. An investment may be held in street 
name, provided that the credit union and/or the safekeeper maintain 
documentation establishing that the credit union is the beneficial 
owner of the investment.
    (v) A federal credit union must obtain and reconcile monthly a 
statement of purchased investments and repurchase collateral held in 
safekeeping and must review the financial condition of approved 
safekeepers at least annually.
    (vi) All purchases and sales of investments must be delivery versus 
payment.
    (9) Trading. (i) Any federal credit union engaging in trading must 
be able to demonstrate that it has sufficient resources, knowledge, 
systems, and procedures to handle the risks of such activity.
    (ii) At least monthly, the board of directors or board-appointed 
investment committee must be provided a written report setting forth 
the fair value and/or total return at the trade date of all trading 
securities and purchase and sale transactions and the resulting gain or 
loss on an individual basis.
    (iii) Any security purchased for trading purposes must be recorded 
at fair value on the trade date.
    (10) Documentation. Documentation regarding an investment 
transaction must be maintained as long as the investment is held and 
until the documentation has been both audited and examined. At a 
minimum, documentation should include, where appropriate, credit 
ratings, bids and prices for periodic updates, a prospectus or 
description of the security from an industry-recognized information 
provider, and all the tests and reports required by the federal credit 
union's investment policy and this part. Documentation used in 
approving a broker-dealer or safekeeper must be maintained as long as 
the broker-dealer or safekeeper is on a federal credit union's approved 
list and until it has been both audited and examined.


Sec. 703.4  Authorized activities.

    (a) Contracting for securities. A federal credit union may contract 
for the purchase or sale of a security provided that the delivery of 
the security is by regular-way settlement.
    (b) Repurchase transactions. A federal credit union may enter into 
a repurchase transaction provided the collateral securing the 
transaction is a permissible investment for federal credit unions and 
the transaction is priced to reflect accrued interest, the risk of the 
securities, and the term of the transaction.
    (c) Federal funds transactions. A federal credit union may sell 
federal funds to Section 107(8) institutions and credit unions, 
provided that the interest or other consideration received from the 
financial institution is at the market rate for federal funds 
transactions.
    (d) Investment companies. (1) A federal credit union may invest in 
an investment company, such as a mutual fund or unit investment trust, 
which is registered with the Securities and Exchange Commission under 
the Investment Company Act of 1940 (15 U.S.C. 80a), provided that the 
portfolio of such management company is restricted by its investment 
policy, changeable only if authorized by shareholder vote, solely to 
investments and investment transactions that are permissible for 
federal credit unions.
    (2) An investment company's investment policy is established by its 
prospectus and any statement of additional information incorporated 
therein.
    (3) For the purposes of this part, an investment company's 
portfolio is deemed to be restricted solely to investments and 
investment transactions that are permissible for federal credit unions 
when its investment policy states that the investments and investment 
transactions of the company are limited to those authorized for federal 
credit unions under the Federal Credit Union Act and National Credit 
Union Administration Rules, Regulations, and Interpretive Ruling and 
Policy Statements.
    (4) The federal credit union must, periodically, obtain a summary 
of the portfolio of the investment company to ensure consistency with 
the Federal Credit Union Act and this part.
    (5) The aggregate of a federal credit union's investment in 
investment companies, under this paragraph (d), and delegation of 
investment control, under Sec. 703.3(b)(2), is limited to 100 percent 
of capital at time of purchase and/or delegation.
    (e) CMOs/REMICs. (1) A federal credit union may invest in or hold a 
fixed or variable rate CMO/REMIC only if it meets all of the following 
tests:
    (i) Average life test. The CMO/REMIC has an estimated average life 
of 10 years or less.
    (ii) Average life sensitivity test. The estimated average life of 
the CMO/REMIC extends by 4 years or less, 

[[Page 61231]]
assuming an immediate and sustained parallel shift in interest rates of 
up to and including plus 300 basis points, and shortens by 6 years or 
less, assuming an immediate and sustained parallel shift in interest 
rates of up to and including minus 300 basis points.
    (iii) Price sensitivity test. The estimated change in the price of 
the CMO/REMIC is 17 percent or less, as a result of an immediate and 
sustained parallel shift in interest rates of up to and including plus 
and minus 300 basis points.
    (2) The three tests contained in paragraph (e)(1) of this section 
shall apply at the time of purchase and on any subsequent date, based 
on market prices, interest rates, and estimated prepayments at the time 
of testing. CMOs/REMICs must be retested at least quarterly, more 
frequently if market or business conditions dictate.
    (3) Before a federal credit union may invest in a CMO/REMIC, the 
board of directors must set forth, in its investment policy, the method 
by which the credit union will obtain the prepayment estimates 
necessary to conduct the tests contained in paragraph (e)(1) of this 
section. In its policy, the board must state whether the credit union 
will use either a median prepayment estimate or individual prepayment 
models, one of which may be the median estimate. Only one method may be 
selected; once selected, it is the only method that may be used when 
testing a CMO/REMIC. If the board elects to use individual prepayment 
models, it must identify specific models, with a minimum of two. If a 
median prepayment estimate is used, it must be obtained from an 
industry-recognized information provider. At purchase, the median 
estimate must be based on at least 5 prepayment models. At retesting, 
the median estimate must be based on at least 2 prepayment models. If 
individual prepayment models are used, estimates must be obtained from 
all of the prepayment models identified in the federal credit union's 
investment policy. One of the individual prepayment models may be the 
median prepayment estimate from an industry-recognized information 
provider. At purchase, a CMO/REMIC must pass the tests for each 
prepayment model used. At retesting, the CMO/REMIC must pass the tests 
for a majority of the prepayment models used at the time of purchase.
    (f) Corporate credit unions. A federal credit union may purchase 
shares or deposits in a corporate credit union, except where the NCUA 
Board has provided notice that the corporate credit union is not 
operating in compliance with part 704 of this chapter. A federal credit 
union's purchase of corporate credit union capital shares, as defined 
in part 704 of this chapter, is limited to one percent of the investing 
credit union's assets.
    (g) Municipal securities. A federal credit union may purchase and 
hold a municipal security only if it has been rated in one of the two 
highest rating categories by at least one nationally recognized 
statistical rating organization.
    (h) Variable rate investments. The index of any variable rate 
investment must be tied to domestic interest rates and not, for 
example, to foreign currencies, foreign interest rates, or domestic or 
foreign commodity or equity prices. For purposes of this part, the U.S. 
dollar-denominated London Interbank Offered Rate (LIBOR) is considered 
a domestic interest rate.
    (i) Yankee dollars, eurodollars, and bankers' acceptances. A 
federal credit union may invest in yankee dollar deposits in a Section 
107(8) institution, in eurodollar deposits in a branch of a Section 
107(8) institution, and in bankers' acceptances issued by a Section 
107(8) institution.


Sec. 703.5  Prohibitions

    A federal credit union is prohibited from:
    (a) Purchasing or selling a standby commitment or an option 
contract, except as permitted under Sec. 701.21(i) of this chapter;
    (b) Purchasing or selling futures or interest rate swap contracts;-
-
    (c) Engaging in pair-off transactions, adjusted trading, when 
issued trading, or short sales;
    (d) Purchasing stripped mortgage backed securities, residual 
interests in CMOs/REMICs, mortgage servicing rights, commercial 
mortgage related securities, or small business related securities; and
    (e) Purchasing a zero coupon investment with a maturity date that 
is more than 10 years from the settlement date.


Sec. 703.6  Pledging securities.

    (a) Permissible activities. A federal credit union may pledge 
securities through reverse repurchase transactions, securities loans, 
and collateralized borrowing, and receive in exchange cash, other 
securities, and/or a fee.
    (b) Limitations. (1) A federal credit union may enter into a 
transaction described in paragraph (a) of this section provided that 
the transaction is priced to reflect accrued interest, the risk of the 
securities, and the terms of the transaction.
    (2) Cash obtained in a transaction described in paragraph (a) of 
this section is subject to the borrowing limit specified in Section 
107(9) of the Act.
    (3) Any investment purchased with cash obtained in a transaction 
described in paragraph (a) of this section must be a permissible 
investment for federal credit unions and must mature no later than the 
maturity of the transaction.
    (4) Any security received in a transaction described in paragraph 
(a) of this section must be a permissible investment for federal credit 
unions.


Sec. 703.7  Divestiture requirements.

    (a) Any federal credit union in possession of an investment that 
fails a requirement of this part, either because it has been downgraded 
below a minimum rating by the same rating agency used when it was 
purchased or because it is a CMO/REMIC that does not meet one of the 
tests set forth at Sec. 703.4(e) upon retesting, must, within 30 days 
of the date of the failure, provide written notice of the failure to 
the board of directors and the appropriate regional director, except 
that notification to the regional director is not required if the 
investment matures within 90 days.
    (b) If the federal credit union does not sell the failed investment 
within 30 days of the date of the failure, it must provide to the 
regional director, within 60 days of the written notice, a written plan 
to hold the investment. The regional director, however, has the 
authority to require the written plan within a shorter timer period or 
require immediate divestiture if serious safety and soundness concerns 
are present. The plan must address:
    (1) The investment's characteristics and risks;
    (2) The process to obtain and adequately evaluate the investment's 
market pricing, cash flows, and risk;
    (3) How the investment fits into the credit union's asset liability 
management strategy;
    (4) The impact that either holding or selling the investment will 
have on the federal credit union's earnings, liquidity and capital in 
different interest rate environments; and
    (5) The likelihood that the investment may again pass the 
requirements of this part.
    (c) Except where serious safety and soundness concerns are present, 
the federal credit union is not required to sell the investment until 
it receives a written response to the plan described in paragraph (b) 
of this section from the regional director. 

[[Page 61232]]



Sec. 703.8  Prohibited fees.

    (a) A federal credit union's officials, senior management 
employees, and immediate family members of such individuals, may not 
receive pecuniary consideration in connection with the making of an 
investment by the federal credit union. The prohibition contained in 
this subsection also applies to any employee not otherwise covered if 
the employee is directly involved in investments or deposits unless the 
board of directors determines that the employee's involvement does not 
present a conflict of interest.
    (b) All transactions with business associates or family members not 
specifically prohibited by paragraph (a) of this section must be 
conducted at arm's length and in the interest of the credit union.


Sec. 703.9  Grandfather provisions.

    (a) Subject to safety and soundness considerations, a federal 
credit union's authority to hold an investment is governed by the 
regulations in effect at the time of purchase. Past regulations 
governing certain investments are described in paragraphs (b) through 
(d) of this section.
    (b) Subject to safety and soundness considerations, a federal 
credit union may hold a fixed-rate CMO/REMIC purchased:
    (1) Before December 2, 1991;
    (2) On or after December 2, 1991, but before July 30, 1993, if its 
average life does not extend or shorten by more than 6 years if 
interest rates rise or fall 300 basis points; or
    (3) On or after December 2, 1991, but before the effective date of 
the final regulation, if for the purpose of reducing interest rate 
risk.
    (c) Subject to safety and soundness considerations, a federal 
credit union may hold a variable-rate CMO/REMIC purchased:
    (1) Before December 2, 1991;
    (2) On or after December 2, 1991, but before July 30, 1993, if:
    (i) The interest rate is reset at least annually;
    (ii) The maximum allowable interest rate on the instrument is at 
least 300 basis points above the interest rate of the instrument at the 
time of purchase; and
    (iii) The interest rate of the instrument varies directly (not 
inversely) with the index upon which it is based and is not reset as a 
multiple of the change in the related index; or
    (3) On or after July 30, 1993, but before the effective date of 
this regulation, if:
    (i) The interest rate is reset at least annually;
    (ii) The maximum allowable interest rate on the instrument is at 
least 300 basis points above the interest rate of the instrument at the 
time of purchase; and
    (iii) The interest rate of the instrument varies directly (not 
inversely) with the index upon which it is based and is not reset as a 
multiple of the change in the related index; and
    (iv) The estimated change in its price is 17 percent or less, due 
to an immediate and sustained parallel shift in the yield curve of plus 
or minus 300 basis points.
    (d) Subject to safety and soundness considerations, a federal 
credit union may hold a CMO/REMIC residual, SMBS, or zero coupon 
security with a maturity greater than 10 years, if the investment was 
purchased:
    (1) Before December 2, 1991; or
    (2) On or after December 2, 1991, but before the effective date of 
the final regulation, if for the purpose of reducing interest rate 
risk.
    (e) All grandfathered investments are subject to the reporting and 
risk management requirements of Sec. 703.3.

[FR Doc. 95-28705 Filed 11-28-95; 8:45 am]
BILLING CODE 7535-01-P