[Federal Register Volume 64, Number 103 (Friday, May 28, 1999)]
[Rules and Regulations]
[Pages 28884-28900]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-13622]


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FARM CREDIT ADMINISTRATION

12 CFR Part 615

RIN 3052-AB76


Funding and Fiscal Affairs, Loan Policies and Operations, and 
Funding Operations; Investment Management

AGENCY: Farm Credit Administration.

ACTION: Final rule.

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SUMMARY: The Farm Credit Administration (FCA) adopts final investment 
management regulations that help Farm Credit System (System or FCS) 
banks and associations respond to rapid and continual changes in 
financial markets and instruments. The final regulations:
     Expand the list of high-quality investments that System 
banks and associations can purchase;
     Provide more flexibility to use comprehensive analytical 
techniques to manage risks at the portfolio or institutional level;
     Strengthen our requirements for sound investment 
management practices; and
     Streamline the requirements for investments in mortgage 
securities issued or guaranteed by the Federal Agricultural Mortgage 
Corporation (Farmer Mac).

EFFECTIVE DATE: These regulations will become effective 30 days after 
they are published in the Federal Register during which either one or 
both houses of Congress are in session. We will publish a notice of the 
effective date in the Federal Register.

FOR FURTHER INFORMATION CONTACT: Laurie A. Rea, Senior Policy Analyst, 
Office of Policy Analysis, Farm Credit Administration, McLean, VA 
22102-5090, (703) 883-4498; or Richard Katz, Senior Attorney, Office of 
General Counsel, Farm Credit Administration, McLean, VA 22102-5090, 
(703) 883-4020, TDD (703) 883-4444.

SUPPLEMENTARY INFORMATION:

I. Background

    System banks may purchase eligible investments for the purpose of

[[Page 28885]]

maintaining a liquidity reserve, managing interest rate risk, and 
investing surplus funds. Farm Credit associations have authority to 
hold eligible investments to manage short-term surplus funds and reduce 
interest rate risk, subject to the approval of their funding banks.
    Eligible investments help FCS banks and associations to control 
risks that result from their operations as single-industry agricultural 
lenders. On June 18, 1998, we proposed revisions to our investment 
management regulations.
    The proposal balanced our desire to institute a disciplined 
investment management framework with the System's desire for more 
flexibility to respond to changing market conditions and advances in 
risk management and securities valuation.\1\
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    \1\ See 63 FR 33281.
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    We proposed two fundamental changes to the existing investment 
regulations. First, we established guidelines for implementing an 
effective oversight and risk management process for investment 
activities. Second, our proposal expanded the list of eligible 
investments, and it relaxed or repealed many of the restrictions on 
investments that we previously authorized. For instance, we proposed to 
expand System bank and association investment authority to include a 
broader array of money market instruments, mortgage securities, and 
asset-backed securities.
    Our proposal also balanced the System's need for greater 
flexibility regarding investments with essential safety and soundness 
controls, such as credit rating and diversification standards. 
Furthermore, our proposal continued to limit non-agricultural 
investments to 30 percent of each bank's total outstanding loans.

Overview of the Comments

    The Presidents Finance Committee (PFC) for Farm Credit System 
banks, The Bond Market Association, and Farmer Mac commented on the 
proposed rule. All eight FCS banks fully supported the PFC's comments. 
The PFC's letter identified over 20 separate issues concerning 
investment management and eligible investments that the PFC asked us to 
address in the final rule. The Bond Market Association, which 
represents securities firms and investment banks that underwrite and 
trade debt securities, supported many of the System's positions on 
eligible investments. Farmer Mac's comments focused primarily on the 
different regulatory treatment of its mortgage securities and the 
Federal National Mortgage Association (Fannie Mae) and the Federal Home 
Loan Mortgage Corporation (Freddie Mac).
    Separately, we published a notice in the Federal Register that 
asked the public to identify existing FCA regulations and policies that 
impose unnecessary regulatory burdens on FCS institutions.\2\ CoBank 
ACB and four Farm Credit associations asked us to reduce regulatory 
burden on the System by repealing or revising provisions in the 
existing investment regulations that pertain to the liquidity reserve 
requirement, association investments and the portfolio limit on Farmer 
Mac mortgage securities. We address these regulatory burden comments in 
the final investment rule.
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    \2\ See 63 FR 44176 (Aug. 18, 1998); 63 FR 64013 (Nov. 18, 
1998).
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    We respond to these comments by making several substantive changes 
to the proposed investment management regulations and by rewriting the 
regulations so they are easier to understand. In addition, we also 
address commenters' questions and requests for clarification in the 
preamble.

II. Investment Activities of Associations and Service Corporations

    We received several comments and questions about the investment 
authorities of associations, both in response to the proposed 
investment rule and our regulatory burden initiative. The PFC asked us 
to confirm that funding banks still retain the responsibility to review 
and approve the investments of their affiliated associations. In 
response to our regulatory burden initiative, three associations stated 
that the Farm Credit Act of 1971, as amended (Act) does not require the 
degree of bank oversight that redesignated Sec. 615.5142 imposes on 
association investment activities. These associations suggested that 
funding banks should rely on the General Financing Agreements (GFA) to 
oversee the investment activities of their affiliated associations.
    We modified final Secs. 615.5131, 615.5133, 615.5140, 615.5141, 
615.5142, and 615.5143 to confirm the existing investment authorities 
of associations and clarify that associations that elect to hold 
investments are expressly subject to regulations governing investment 
management, eligible investments, stress tests, and divestiture.
    Redesignated Sec. 615.5142 continues to authorize associations to 
acquire eligible investments that are listed in Sec. 615.5140, with the 
approval of their funding banks, for the purposes of reducing interest 
rate risk and investing surplus funds. The final rule also retains the 
existing requirement that each System bank annually review the 
investment portfolio of every association that it funds.
    Final Sec. 615.5142 implements sections 2.2(10) and 2.12(18) of the 
Act, which require each funding bank to supervise and approve the 
investment activities of its affiliated associations. In response to 
comments that focused on the scope of bank supervision of association 
investments, we note that a number of satisfactory methods exist for 
System banks to oversee association investment activities under our 
regulatory framework. A bank may take an active role in advising and 
approving an association's investment decisions and strategies. For 
example, banks may provide research, analytical or advisory services 
that help associations to manage their investment portfolios. 
Alternatively, as suggested by three association commenters, the GFA 
can be an appropriate tool for funding banks to oversee the investment 
activities of their affiliated associations.
    Bank oversight does not absolve an association's board and managers 
of their fiduciary duties to manage investments in a safe and sound 
manner. The fiduciary responsibilities of association boards of 
directors obligate them to develop appropriate investment management 
policies and practices to manage the credit, market, liquidity, and 
operational risks associated with investment activities. Additionally, 
it is incumbent upon each association's investment managers to fully 
understand the risks of its investments and make independent and 
objective evaluations of investments prior to purchase.
    We incorporated explicit references to associations into final 
Sec. 615.5133 to acknowledge the existing responsibility of 
associations to effectively manage their investments. We recognize, 
however, that associations have historically maintained few or no 
investments in non-agricultural financial instruments. The few 
associations that maintain investment portfolios hold primarily money 
market instruments and municipal securities. Therefore, the final 
regulation requires an association's board of directors to develop 
investment policies that are commensurate with its institution's 
investment activities.
    An association's investment policies should be appropriate for the 
size, risk characteristics, and complexity of the association's 
investment portfolio and should be based on an association's unique 
circumstances, risk tolerances, and objectives. Associations must

[[Page 28886]]

comply with all the requirements in Sec. 615.5133 if the level or type 
of their investments could expose their capital to material loss. 
However, an association's board does not need to develop an investment 
policy if it elects not to hold non-agricultural investments authorized 
under Sec. 615.5140.
    Final Sec. 615.5140, which lists eligible investments, is modified 
to clarify that it applies to associations. As noted earlier, 
associations already have the authority under redesignated 
Sec. 615.5142 to hold eligible investments that are listed in 
Sec. 615.5140. This revision more accurately reflects the scope of this 
regulation.
    We take this opportunity to reiterate our long-standing position 
that service corporations, organized under section 4.25 of the Act, are 
subject to the investment regulations in subpart E of part 615. 
Although we have noted on past occasions that Sec. 611.1136 of this 
chapter applies these investment regulations to both incorporated and 
unincorporated service organizations, questions about this issue have 
remained. Final Sec. 615.5131(m) resolves this matter by expressly 
subjecting FCS service corporations that hold investments to these 
regulations. Service corporations that hold no investments are not 
required to develop investment policies or comply with Sec. 615.5133.

III. Investment Management

    We proposed significant changes to Sec. 615.5133, which governs 
investment management practices and internal controls in the FCS. Our 
objective was to strengthen this regulation so each System institution 
would follow certain fundamental practices that enable its board and 
management to fully understand and effectively manage risks in its 
investment portfolio. An effective risk management process for 
investments requires financial institutions to establish: (1) Policies; 
(2) risk limits; (3) a mechanism for identifying, measuring, and 
reporting risk exposures; and, (4) a system of internal controls. As a 
result, the proposed rule required each Farm Credit board of directors 
to adopt policies that establish risk parameters and guide the 
decisions of investment managers. More specifically, we required board 
policies to establish objective criteria so investment managers can 
prudently manage credit, market, liquidity, and operational risks. 
Additionally, proposed Sec. 615.5133 established other controls that 
help prevent loss, such as:
     Clear delegation of responsibilities and authorities to 
investment managers;
     Separation of duties;
     Timely and effective security valuation practices; and,
     Routine reports on investment performance.

A. Requests for Change

    Only the PFC commented on proposed Sec. 615.5133. Although the PFC 
supported the FCA's approach, it requested changes to three provisions 
of proposed Sec. 615.5133. In response, we revised two of these 
regulations so they advance our safety and soundness objectives without 
placing unnecessary burden on the FCS. We resolved the PFC's third 
concern with a preamble explanation rather than a regulatory change. In 
addition to the two substantive amendments described above, we 
reorganized and rewrote this regulation so it is easier to understand 
and use.
1. Limits on Transactions With Each Securities Firm
    The PFC asked us to eliminate the provision in proposed 
Sec. 615.5133(a)(1)(ii) that requires investment policies to ``set 
limits on the amounts and types of transactions that the bank shall 
execute with authorized securities firms.'' \3\ The PFC believes that 
this requirement is overly burdensome because the risk of loss from 
purchase and sale transactions with securities firms is negligible. The 
commenter also opined that this provision reduces the System's 
flexibility to trade with the securities firm that provides the best 
terms and execution for investment transactions.
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    \3\ The term ``securities firms'' in the final rule and this 
preamble collectively refers to brokers, dealers, and investment 
banks.
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    The PFC persuaded us that some of the requirements in proposed 
Sec. 615.5133(a)(1)(ii) might have inadvertently reduced the System's 
flexibility in executing transactions with various securities firms. 
However, we continue to believe that each System institution must 
carefully select and properly manage its relationships with securities 
firms as part of its efforts to manage credit risk associated with 
settlements on securities transactions. Thus, we respond to the PFC's 
concerns by revising the regulation so that the necessary safety and 
soundness constraints do not unreasonably hinder business 
relationships. In addition, this revision offers System institutions 
greater flexibility to trade with the securities firms of their choice.
    Specifically, final and redesignated Sec. 615.5133(c)(1)(ii) no 
longer obligates the board of directors to set specific limits on the 
amount and types of transactions that its institution executes with 
authorized securities firms. Instead, the final regulation requires 
System institutions to buy and sell eligible investments with more than 
one securities firm. As a result, the final rule still requires System 
institutions to diversify their exposure to credit risk from brokers, 
dealers, and investment bankers.
    Nevertheless, final and redesignated Sec. 615.5133(c)(1)(ii) still 
requires board policies to establish the criteria that investment 
managers will use to select securities firms. We have also retained the 
regulatory provisions that require each board of directors to:
     Annually review its criteria for selecting securities 
firms; and
     Determine whether its existing relationships with various 
securities firms should continue.
2. Reporting Investment Performance to the Board
    The PFC expressed concern about a provision in proposed 
Sec. 615.5133(e) that requires investment managers to report quarterly 
to the board on the performance and risk of ``each'' investment in the 
portfolio. According to the PFC, many FCS banks hold several hundred 
individual securities in sizeable investment portfolios. Under these 
circumstances, reporting to the board on every single investment is 
cumbersome and meaningful board review is difficult. The PFC suggests 
the reports to the board should summarize the risks associated with 
investment activities and address compliance with investment policies, 
objectives, risk limits, and regulatory requirements. The commenter 
further suggests that managers should report on individual investments 
only in exceptional circumstances.
    We revise this provision to address the PFC's concern. Final and 
redesignated Sec. 615.5133(g) requires management to report each 
quarter to its board of directors or a committee thereof on the 
performance and risk of each class of investments and the entire 
investment portfolio. Additionally, the final rule continues to require 
the report to identify all gains and losses that the institution incurs 
during the quarter on individual securities sold before maturity. We 
retained a reporting requirement on individual securities because it 
provides the board important and accurate information relating to the 
performance of investments and investment activity in general.
    This new approach requires investment portfolio managers to provide 
System boards of directors

[[Page 28887]]

accurate, concise, meaningful, and timely information on the 
performance and risk of their institution's investments. This 
information helps the board to understand the risks inherent in the 
investment portfolio and oversee the investment activities of 
investment managers. We believe this revision removes burdensome 
reporting requirements from the final regulation while simultaneously 
promoting safe and sound investment management practices in the FCS. We 
have made no other modification to redesignated Sec. 615.5133(g).
3. Securities Valuations
    The only comment on securities valuation was from the PFC. The PFC 
asked us to delete proposed Sec. 615.5133(d)(1), which requires System 
institutions to verify with an independent source the value of any 
security (other than a new issue) that they purchase or sell. The PFC 
interprets proposed Sec. 615.5133(d)(1) as requiring FCS institutions 
to solicit a second bid for all securities from a competing broker, 
dealer, or other intermediary. The PFC warns that this requirement 
would undermine the good reputation of the System and cause its 
business relationships with securities firms to quickly deteriorate. As 
a result, the FCS would ultimately pay higher prices for securities and 
obtain lower yields.
    We observe that nothing in the proposed regulation or preamble 
would require bids on investments from parties who compete with the 
seller, purchaser, counterparty, or other intermediary to a specific 
transaction. Instead, our regulation requires System banks, 
associations, and service corporations to verify the value of a 
security with an independent source. As the preamble to the proposed 
regulation notes, ``independent verification of a price can be as 
simple as obtaining a price from an industry recognized information 
provider.'' The same preamble passage also states that ``although price 
quotes from information providers are not actual market prices, they 
confirm whether the broker's price is reasonable.'' \4\ This regulatory 
provision allows System institutions to independently verify the price 
of a security with an on-line market reporting service, such as 
Bloomberg, Telerate, or Reuters. Additionally, the regulation provides 
sufficient flexibility for System institutions to use internal 
valuation models to verify the reasonableness of prices that they pay 
or receive for securities. Moreover, independent verification of 
securities prices is a fundamental component of safe and sound 
investment management, and ensures that FCS institutions understand the 
value of their investments at purchase and sale.
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    \4\ See 63 FR 33284 (June 18, 1998).
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    In view of these considerations, we conclude that the requirement 
for independent verification of securities prices is appropriate and 
should be retained in the final regulation. We also made several 
stylistic changes to the securities valuation requirements, which we 
redesignated as final Sec. 615.5133(f)(1).

B. Other Comments and Questions on Investment Management

    We offer the following responses to requests for clarification on 
proposed Sec. 615.5133 and additional guidance regarding investment 
management.
1. Are the FCA Regulations Consistent With the Federal Financial 
Institutions Examination Council's Policy on Investment Activities?
    Yes. We confirm that Sec. 615.5133 is consistent with the Federal 
Financial Institutions Examination Council's (FFIEC) ``Supervisory 
Policy Statement on Investment Securities and End-User Derivatives 
Activities'' (Policy Statement).\5\ We used the FFIEC's Policy 
Statement as a benchmark for developing this regulation. In our 
opinion, the FFIEC's guidance to other federally regulated financial 
institutions on sound investment management practices is suitable for 
the FCS. We encourage System institutions to refer to the FFIEC's 
Policy Statement when they devise, implement, and review policies that 
govern their investment management practices pursuant to Sec. 615.5133. 
Additionally, FCS institutions should refer to our policy statement on 
interest rate risk management (FCA-PS-74) for further guidance on 
managing market risks.\6\
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    \5\ See 63 FR 20191 (Apr. 23, 1998).
    \6\ See 63 FR 69285 (Dec. 10, 1998).
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2. What Are the Responsibilities of Boards of Directors?
    In general, the board of directors of any association or service 
corporation that holds eligible investments and every bank is 
responsible for establishing written investment policies that are 
appropriate for the size, types, and risk characteristics of its 
investments. Investment policies are a critical aspect of effective 
risk management and should set appropriate limits on exposure to 
credit, market, and liquidity risks. We emphasize that investment 
policies of each Farm Credit bank and any association or service 
corporation with significant investments should embody the following 
key elements.
    Investment Objectives. A general explanation of the board's 
investment objectives, expectations, and performance goals is necessary 
to guide investment managers.
    Risk Tolerance. Risk tolerance should be based on the strength of 
each institution's capital position and its ability to measure and 
manage risk. Additionally, risk limits should be consistent with 
broader business strategies and institutional objectives. Risk 
tolerance can be expressed through several parameters: duration, 
convexity, sector distribution, yield curve distribution, credit 
quality, risk-adjusted return, portfolio size, total return volatility, 
or value-at-risk.\7\ Each institution should use a combination of 
parameters to appropriately limit its exposure to credit and market 
risk.
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    \7\ Generically, duration is a measure of a bond or portfolio's 
price sensitivity to a change in interest rates. Convexity measures 
the rate of change in duration with respect to a change in interest 
rates. A sector refers to a broad class of investments with similar 
characteristics or industry classification. Yield curve distribution 
refers to the distribution of the portfolio's investments in short-
term, intermediate, or long-term investments. Value-at-risk is a 
methodology used to measure market risk in an investment portfolio.
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    Asset Allocation. The board's asset allocation policy should ensure 
appropriate diversification within the various asset classes, as well 
as across the entire investment portfolio.\8\ Final Sec. 615.5140 
eliminates the portfolio limits on many eligible investments, and 
therefore, we expect each bank, association, and service corporation to 
establish its own asset allocation guidelines. Investment parameters 
may include points where the investment portfolio should be reallocated 
or rebalanced to bring it back in line with the board's strategic asset 
allocation goals.
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    \8\ Asset allocation is generally defined as the allocation of 
your investment portfolio across major asset classes, such as United 
States Treasury, corporate, mortgage or asset-backed securities.
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    Asset Selection. The investment policy should identify the risk 
characteristics (e.g., credit quality, price sensitivity, maturity, 
marketability or liquidity, maximum premiums or discounts, etc.) of 
investments that are suitable for inclusion in the investment 
portfolio.
    Derivatives. Derivative instruments can be used to hedge risk, 
leverage a position or otherwise modify the risk profile of an 
investment portfolio. The board's investment policy should address the 
application of derivatives

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within the portfolio and set appropriate limits on the use of 
derivatives.
    Controls and Reporting Requirements. The investment policy should 
describe the duties and responsibilities of the investment manager(s), 
set the delegation of authorities, outline any prohibited investments 
or activities, and specify the content and frequency of reports to the 
board on investment activities.
3. What Analysis Must Management Perform on Individual Investments 
Prior to Purchase and on an Ongoing Basis?
    Not all investment instruments need an extensive pre-purchase or 
post-purchase analysis. Non-complex instruments that have minimal price 
sensitivity need little or no pre-purchase analysis. Final and 
redesignated Sec. 615.5133(f) (previously proposed Sec. 615.5133(d)(3)) 
generally requires System banks to perform an analysis of the credit 
and market risks on investments prior to purchase and on an ongoing 
basis. The primary objective of this provision is to ensure that 
management understands the risks and cashflow characteristics of any 
investment that it purchases. The board's investment policy should 
fully address the extent of the pre-purchase analysis that management 
needs to perform for various classes of instruments. For example, the 
policy should specifically indicate which stress tests in Sec. 615.5141 
should be performed on various types of mortgage securities.
    For investments that have unusual, leveraged, or highly variable 
cashflows, it is especially important for investment managers to 
exercise diligence and thoroughness in making investment decisions. 
Managers should have a reasonable and adequate basis, supported by 
appropriate analysis for their investment decisions, and maintain 
adequate documentation. The analysis should describe the basic risk 
characteristics of the investment and include a balanced discussion of 
risks involved in purchasing the investment. In preparing the analysis, 
investment managers should consider the current rate of return or 
yield, expected total return, annual income, the degree of uncertainty 
associated with the cashflows, the investment's marketability or 
liquidity, as well as its credit and market risks.
4. What Investment Management Approach Does the FCA Prefer?
    The PFC asked us to clarify when we expect System institutions to 
manage their investments on an individual, portfolio or institutional 
basis. The appropriate level of risk management depends on the 
complexity of instruments and the size of your investment portfolio. A 
System institution may need to analyze risk on an individual, 
portfolio, and institutional level. As appropriate, stress testing 
should be performed on individual investments, the investment portfolio 
or the entire institution. Additionally, other risk management 
techniques, such as total return analysis or value-at-risk, may be used 
to effectively manage risk exposures.
    When a new investment position is likely to significantly alter the 
risk profile of an institution, management should complete an analysis 
of the potential effects on the portfolio and the entire institution 
prior to purchasing the investment. Although investors have 
traditionally looked at investments one at a time, modern portfolio 
theory suggests that investors should look at the effect of individual 
investments on the entire portfolio. Often, investments that seem 
acceptable on an individual basis have a significant exposure to a 
single risk factor on a cumulative basis. Conversely, under the 
portfolio approach, financial institutions may hold individual 
investments that are fairly risky, if the risks are offset by other 
investments or derivative instruments. As a result, the portfolio 
approach allows investment managers to achieve higher returns while 
maintaining overall portfolio risk at a reasonable level.
    System institutions should tailor their investment management 
approach to meet their needs based on the type and level of their 
investment activities and unique risk profile. Regardless of the 
approach taken, each Farm Credit bank, association, and service 
corporation should ensure that it is able to effectively measure, 
monitor, and control the credit, market, liquidity, and operational 
risks stemming from its investment activities. This requires an 
understanding of the source and degree of the institution's risk 
exposures and how these risk exposures may change under differing 
economic scenarios.

III. Eligible Investments

A. Overview

    System banks may purchase and hold the eligible investments listed 
in Sec. 615.5140 to maintain liquidity reserves, manage interest rate 
risk, and invest surplus short-term funds. Similarly, redesignated 
Sec. 615.5142 (formerly Sec. 615.5141) authorizes FCS associations to 
hold eligible investments listed in Sec. 615.5140 to invest surplus 
funds and reduce interest rate risk. Only investments that can be 
promptly converted into cash without significant loss are suitable for 
achieving these objectives. For this reason, the eligible investments 
listed in Sec. 615.5140 generally have short terms to maturity and high 
credit ratings from nationally recognized statistical rating 
organizations (NRSROs). Furthermore, all eligible investments are 
either traded in active secondary markets or are valuable as 
collateral.
    We proposed to amend Sec. 615.5140 so System banks and associations 
could purchase and hold a broader array of high-quality and liquid 
investments. As a result, the proposed regulations expanded the list of 
eligible investments and relaxed or repealed certain restrictions in 
Sec. 615.5140. These revisions reflect changes in the financial markets 
and help fulfill our objective of developing a regulatory framework 
that can more readily accommodate innovations in financial products and 
analytical tools.
    Two commenters, the PFC and The Bond Market Association, generally 
supported our proposal to amend Sec. 615.5140. The commenters also 
asked us to approve other instruments that would offer higher yields 
and further diversify the investment portfolios of System institutions. 
As we explain in greater detail below, we incorporated many of the 
commenters' suggestions into final Sec. 615.5140. In addition, as part 
of our efforts to write regulations that are easier to understand and 
use, we converted most of Sec. 615.5140 into a chart.
    We received no comments on proposed Sec. 615.5140(a)(1), (a)(3), 
(a)(7), and (a)(8), which respectively authorize FCS banks and 
associations to invest in:
     Securities that are issued or guaranteed by the United 
States, its agencies, or instrumentalities;
     Obligations of international and multilateral development 
banks;
     Corporate debt obligations; and
     Shares of investment companies that register under the 
Investment Company Act of 1940 (e.g., money market mutual funds).
    Accordingly, we made no substantive changes to Sec. 615.5140(a)(1), 
(a)(3), (a)(7), and (a)(8).

State and Municipal Securities

    Existing Sec. 615.5140(a)(10) authorizes System banks and 
associations to invest in the general obligations of State and 
municipal governments. We proposed to redesignate this provision as 
Sec. 615.5140(a)(2) without significant change. However, we added a 
definition of ``general obligation of a State or political 
subdivision'' to Sec. 615.5131 to

[[Page 28889]]

codify our recent guidance on bonds guaranteed by the full faith and 
credit of a State or local government.\9\ We rewrote the definition to 
make it clear and we now adopt Secs. 615.5140(a)(2) and 615.5131(e) as 
final regulations.
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    \9\ See FCA BL-038, ``Guidance Relating to Investment 
Activities,'' Nov. 26, 1997).
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    Prior to this rulemaking, System banks requested authority to 
invest in revenue bonds. Revenue bonds are not supported by the 
taxation powers of the obligor, and are repayable from fee income and 
other sources of revenue. We requested input on how the final 
regulation could authorize investments in revenue bonds while limiting 
risks to System institutions. More specifically, we solicited comments 
on how the final regulation could establish:
     Criteria for determining which revenue bonds meet the 
investment purposes in Sec. 615.5132; and
     Appropriate limits on the amount of these investments.
    We received only one comment concerning municipal securities. The 
PFC suggested that all highly rated revenue bonds should be eligible 
investments. The PFC believes that highly rated revenue bonds are 
suitable for meeting liquidity and interest rate risk management 
objectives.
    Municipal revenue bonds may provide FCS banks and associations with 
another suitable investment to diversify their portfolios. The universe 
of municipal revenue bonds is diverse and some, but not all, of these 
instruments are actively traded in established secondary markets. 
Although the full faith and credit of a governmental entity with 
taxation powers does not back municipal revenue bonds, these 
instruments usually enjoy an implicit guarantee of the State 
government. For these reasons, we add municipal revenue bonds as 
eligible investments, subject to certain safety and soundness controls. 
Final Sec. 615.5140(a)(2) authorizes FCS banks and associations to 
invest in municipal revenue bonds that are rated in the highest 
investment rating category by an NRSRO and mature within 5 years or 
less. The final regulation requires the investing System bank or 
association to document, at the time of purchase, that the particular 
issue is actively traded in an established secondary market. 
Additionally, these investments are subject to a 15-percent portfolio 
limit. We also added a conforming definition of ``revenue bonds'' to 
final Sec. 615.5131.

C. Money Market Instruments

    We proposed several changes to the provisions in Sec. 615.5140 that 
authorize FCS banks and associations to invest in money market 
instruments. Under our proposal, all money market instruments were 
grouped together into a single regulatory provision, 
Sec. 615.5140(a)(4). We proposed to repeal existing limitations on the 
amounts of negotiable certificates of deposit, Federal funds (Fed 
Funds), bankers acceptances, and prime commercial paper that each FCS 
institution can hold in its investment portfolio. We also added 
Eurodollar time deposits and master notes to the list of eligible money 
market investments.
    Only the PFC commented on proposed Sec. 615.5140(a)(4). The 
commenter asked us to: (1) Repeal the ``callable'' requirement for Term 
Federal Funds; and (2) clarify the credit rating requirements for 
repurchase agreements and master notes.
1. Term Federal Funds
    From the commenter's perspective, our insistence that System 
institutions invest only in negotiable Term Fed Funds is inconsistent 
with our approach toward Eurodollar time deposits. The PFC pointed out 
that proposed Sec. 615.5140(a)(4) granted System institutions new 
authority to invest in non-negotiable Eurodollar time deposits, which 
are very similar to Term Fed Funds in terms of credit, liquidity, and 
market risks. The PFC asserts that Term Fed Funds do not need a 
``callable'' feature to make them liquid because our regulation already 
requires them to maintain a high credit rating and mature within 100 
days. Thus, the PFC urges us to delete the provision in 
Sec. 615.5140(a)(4)(i) that requires all Term Fed Funds to be 
``callable.''
    The PFC persuaded us that highly rated Term Fed Funds that mature 
within 100 days are suitable investments, even if they are not 
``callable.'' Thus, we amended this provision so final 
Sec. 615.5140(a)(4) no longer requires System banks and associations to 
invest only in ``callable'' Term Fed funds.\10\ This change will 
provide System institutions with additional flexibility to invest with 
counterparties that do not offer ``callable'' features on Term Fed 
Funds.
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    \10\ In the final regulations, Term Fed Funds are defined as 
having a maturity between 2 and 100 business days.
---------------------------------------------------------------------------

    In addition, the final regulations apply consistent treatment of 
investments in Term Fed Funds and Eurodollar time deposits. Final 
Sec. 615.5140 subjects non-callable Term Fed Funds to the same 20-
percent portfolio limit as Eurodollar time deposits. From a safety and 
soundness perspective, this portfolio limit is necessary to limit the 
amount of non-negotiable instruments that are held in bank and 
association investment portfolios. The final regulation continues to 
place no portfolio limit on the amount of ``continuously callable'' 
Term Fed Funds that FCS banks and associations can hold. Like 
Eurodollar time deposits, non-callable Term Fed Funds must also be 
invested at depository institutions with the highest short-term credit 
rating from an NRSRO.
2. Response to Comments on Credit Ratings
    a. When are short-term or long-term credit ratings appropriate for 
the collateral securing repurchase agreements? Final 
Sec. 615.5140(a)(4) allows System banks and associations to invest in 
repurchase agreements that are backed either by: (1) Eligible 
investments; or (2) other marketable securities that are rated in the 
highest credit rating category by an NRSRO. The type of collateral 
should determine whether a short-term or a long-term credit rating is 
appropriate. System banks and associations may use an equivalent long-
term rating if it is the only credit rating available for a short-term 
financial instrument held as collateral in a repurchase agreement.
    b. Are long-term credit ratings appropriate when no short-term 
ratings are available for counterparties to master note agreements? 
Yes. We recognize that certain institutions that are counterparties to 
master note agreements may only have long-term credit ratings from an 
NRSRO. When short-term credit ratings are unavailable, System 
institutions may use an equivalent long-term rating to determine if the 
money market instrument is eligible under our regulations. For example, 
we consider an ``A-1'' short-term rating from Standard and Poor's (S&P) 
to be the equivalent to a ``AA'' or higher long-term S&P rating.

D. Mortgage Securities

1. Overview
    We proposed significant changes to the authority of FCS 
institutions to invest in mortgage securities. The proposal expanded 
the list of eligible investments to include certain non-agency mortgage 
securities and stripped mortgage-backed securities (SMBS). We proposed 
these amendments to grant FCS banks and associations more options for 
managing risks and diversifying their portfolios.
    Both the PFC and The Bond Market Association suggested additional 
revisions to the regulation, and asked us

[[Page 28890]]

several questions about the proposed requirements. They recommend that 
we grant FCS banks and associations authority to invest in: (1) 
Mortgage securities that are rated within the two highest rating 
categories by an NRSRO, (2) multifamily mortgage securities, and (3) 
non-agency commercial mortgage-backed securities (CMBS). In response to 
these comments, we revised Sec. 615.5140(a)(5) so System banks and 
associations can invest in a broader array of mortgage securities.
2. Credit Ratings
    Both the PFC and The Bond Market Association asked us to authorize 
investments in mortgage securities that are rated in the ``two'' 
highest (rather than only the highest) credit rating categories of an 
NRSRO. The commenters assert that investment grade mortgage securities 
in general have exhibited a remarkable credit performance history. Over 
the past 20 years, few mortgage security issues have experienced 
credit-related problems. Furthermore, the two highest credit ratings 
would correspond with the criteria in the Secondary Mortgage Market 
Enhancement Act of 1984.\11\
---------------------------------------------------------------------------

    \11\ See Pub. L. 98-440, 98 Stat. 1689 (Oct. 3, 1984).
---------------------------------------------------------------------------

    After carefully considering the commenters' input and weighing the 
potential risks, we did not adopt the suggestion to lower the credit 
rating for mortgage securities. There is an ample assortment of 
mortgage securities in the highest investment credit rating category 
that System banks and associations can use for liquidity, cash and 
interest rate risk management. We believe the final regulation 
maintains the high credit quality of System investments without 
depriving System institutions of any significant opportunity to invest 
in mortgage securities.
3. Mortgage Securities that are Issued or Guaranteed by the United 
States
    We made a technical correction to the provision that allows FCS 
banks and associations to invest in mortgage securities that are issued 
or fully guaranteed by the United States. Our proposal omitted language 
in the former regulations that authorize investment in securities that 
are backed by mortgages that are guaranteed as to both principal and 
interest by the full faith and credit of the United States. Final 
Sec. 615.5140(a)(5) allows System banks and associations to invest in 
mortgage securities that are:
     Issued or guaranteed by the Government National Mortgage 
Association (GNMA); or
     Secured by mortgages that are guaranteed as to both 
principal and interest by the full faith and credit of the United 
States.
    This provision extends to mortgage securities issued by the Small 
Business Administration (SBA) or other Federal government agencies if 
the full faith and credit of the United States back the principal and 
interest payment of the underlying mortgages. All mortgage securities 
that System banks and associations purchase under Sec. 615.5140(a)(5) 
must comply with the stress-testing requirements in Sec. 615.5141.
4. Agency Mortgage Securities
    We made no changes to FCS institutions' authorities to invest in 
residential mortgage securities that are:
     Issued by Fannie Mae and the Freddie Mac; or
     Issued under a private label but are collateralized by 
Fannie Mae or Freddie Mac mortgage-backed securities.
    System banks, however, suggested that we add Fannie Mae Delegated 
Underwriting and Servicing (DUS) bonds to the list of eligible 
investments. Fannie Mae DUS bonds are mortgage securities backed by 
multifamily mortgage loans. They carry the Fannie Mae guarantee on the 
timely payment of principal and interest. They also have low prepayment 
risk due to yield maintenance agreements, prepayment lockouts, and 
prepayment fees. We agree that agency mortgage securities backed by 
multifamily loans are suitable investments for FCS institutions. 
Therefore, we amended the definition of ``mortgage securities'' in 
Sec. 615.5131(i) to clarify that FCS banks and associations have the 
authority to invest in Fannie Mae DUS bonds and other mortgage 
securities on multifamily residential properties that are issued or 
guaranteed by Federal agencies and instrumentalities. Agency mortgage 
securities that are secured by multifamily loans must meet the stress-
testing requirements of Sec. 615.5141.
5. Portfolio Limits on Fannie Mae and Freddie Mac Mortgage Securities
    Two commenters, the PFC and The Bond Market Association, asserted 
that the 50-percent portfolio limit on Fannie Mae and Freddie Mac 
mortgage securities is overly restrictive and unprecedented. According 
to these commenters, the credit risk on these securities is almost non-
existent and no other financial regulatory agency places any 
restrictions on the amount of these securities.
    After a thorough evaluation of these comments, we decided not to 
eliminate the portfolio limit on Fannie Mae and Freddie Mac mortgage 
securities. We believe that regulatory portfolio limits enhance safety 
and soundness by promoting diversification of System investment 
portfolios and curtailing investments in securities that may exhibit 
considerable interest rate risk. The final regulation greatly expands 
the types of mortgage securities that are eligible investments. Under 
the circumstances, we believe portfolio limits are an appropriate 
regulatory tool for controlling the System's market risk exposure from 
these instruments.
    We did, however, make one important modification to the proposed 
portfolio limits in response to the commenters' concerns. Under the 
final regulations, the 50-percent limit on agency mortgage securities 
is now separate from the 15-percent limit on non-agency residential and 
commercial mortgage securities. The new portfolio limits accommodate 
the System's desire for greater opportunities to invest in mortgage 
securities.
    We emphasize that the board and management of each System bank, 
association, or service corporation are responsible for establishing 
exposure limits on all types of mortgage securities. Regulatory 
portfolio limits on certain mortgage securities do not absolve an 
institution's board or management of its responsibility to set limits 
based on its unique risk-bearing capacity, management capabilities, and 
objectives. Moreover, the board of directors of each System bank or 
association has a fiduciary duty to maintain a well-diversified 
investment portfolio to reduce the risk of substantial loss. We also 
expect FCS banks and associations to diversify their investments within 
each major asset class.
6. Non-Agency Mortgage Securities
    Our proposal would authorize System institutions to invest in 
mortgage securities that are offered by private entities.\12\ Under the 
proposal, only the highest rated privately issued securities that are 
collateralized by qualifying residential mortgages meeting the 
collateral requirements of the Secondary Mortgage Market Enhancement 
Act of 1984 (SMMEA), would be eligible investments.\13\ SMMEA 
securities must generally be secured by a first lien on

[[Page 28891]]

a single parcel of real estate (residential or mixed residential 
commercial structure) and originated by a qualifying financial 
institution.\14\ Our proposal required System banks and associations to 
subject these mortgage securities to a stress test under Sec. 615.5141 
prior to purchase.
---------------------------------------------------------------------------

    \12\ See proposed Sec. 615.5140(a)(5)(ii).
    \13\ The proposed rule allows investments in mortgage securities 
that are offered and sold pursuant to section 4(5) of the Securities 
Act of 1933, 15 U.S.C. 77d(5) or are residential mortgage-related 
securities within the meaning of section 3(a)(41) of the Securities 
Exchange Act of 1934, 15 U.S.C. 78c(a)(41).
    \14\ See SMMEA amended section 3(a)(41) of the Securities 
Exchange Act of 1934.
---------------------------------------------------------------------------

    System banks requested additional authority to invest in mortgage 
securities that are collateralized by mortgages on commercial 
properties, such as apartment buildings, shopping centers, office 
buildings, and hotels. CMBS typically have yield maintenance provisions 
or other features that provide greater prepayment protection to 
investors than residential mortgage securities.\15\ However, CMBS are 
more difficult to analyze in terms of credit risk. The structure of 
CMBS securities can vary widely and the more unique structures may 
contain additional risks that need to be thoroughly evaluated. The CMBS 
market is relatively young and has recently experienced liquidity 
problems.
---------------------------------------------------------------------------

    \15\ ``CMBS'' refers only to non-mortgage securities on 
commercial real estate. This term does not cover Fannie Mae mortgage 
securities on mixed residential and commercial properties or 
mortgage securities on commercial real estate that the SBA issues or 
guarantees.
---------------------------------------------------------------------------

    On balance, we conclude CMBS with appropriate safety and soundness 
controls may help Farm Credit banks achieve greater portfolio 
diversification and risk-adjusted returns. We, therefore, authorized 
investments in CMBS that are rated in the highest credit rating 
category by an NRSRO and supported by no less than 100 mortgage loans 
that are geographically dispersed. Additionally, no single obligor can 
be the mortgagor on more than 5 percent of the loans in the entire 
mortgage pool. The final regulation subjects CMBS to the same portfolio 
cap as non-agency mortgage securities. As a result, the combined 
investment in CMBS and non-agency mortgage securities cannot exceed 15 
percent of the total investment portfolio.
    Prudent investment practices require investment managers to fully 
understand the cashflow characteristics and price sensitivity of CMBS 
investments. Thus, we require System institutions to subject CMBS 
investments to stress testing in accordance with Sec. 615.5141. 
Furthermore, System banks should rely on evaluation methodologies that 
take into account all the risk elements in CMBS investments. In this 
regard, we stress the importance of making an independent and critical 
evaluation of the security's credit and liquidity risks prior to 
purchase, and on an ongoing basis.
7. Other Mortgage-Derivative Products
    The FCA proposed to repeal existing Secs. 615.5131(r) and (s), 
615.5140(a)(2)(v), and certain provisions in Sec. 615.5174(c) that 
explicitly ban investments in SMBS and inverse floating-rate debt 
classes. We concluded that the explicit regulatory ban on certain 
mortgage-derivative products (MDP) is unnecessary because all mortgage 
securities are subject to stress-testing requirements. We received no 
comments regarding these proposed changes, and therefore adopt this 
provision as a final rule.
    However, certain MDP (such as SMBS) may pose substantial risks to 
the System institutions, and, therefore we take this opportunity to 
reiterate the importance of effective risk management and to provide 
additional guidance. Although we recognize that MDP can be useful tools 
for reducing interest rate risk, certain MDP are risky because their 
prices may be subject to substantial fluctuations. Successful risk 
management of these instruments requires a thorough understanding of 
the principles that govern the pricing of these instruments. The degree 
of price sensitivity that a mortgage security exhibits to changes in 
market interest rates is influenced by its unique characteristics. A 
System institution should determine whether a particular mortgage 
security meets its risk management objectives by using analytical 
techniques and methodologies that effectively evaluate how interest 
rate changes will affect prepayments and cashflows of the instrument.
    Investment managers must have a reasonable basis for making 
investments in MDP that exhibit significant price sensitivity and 
maintain appropriate records to support their investment decisions. In 
general, the FCA would view it as an unsafe and unsound practice for 
FCS banks and associations to hold highly price-sensitive MDPs, such as 
interest-only or principal-only SMBS, for any purpose other than to 
reduce specific interest rate risks. Managers must document, prior to 
purchase and each quarter thereafter, that the MDP is reducing the 
interest rate risk of a designated group of assets or liabilities and 
the interest rate risk of the institution.

E. Asset-Backed Securities

1. An Overview of Our Proposal and Summary of Comments
    Our proposal expanded the collateral for eligible asset-backed 
securities (ABS) to include student loans, manufactured housing loans, 
wholesale dealer automobile loans, equipment loans and home equity 
loans. Under these regulations, securities collateralized by home 
equity loans qualify as ABS, not mortgage securities. Proposed 
Sec. 615.5140(a)(6) specified that the weighted average life (WAL) for 
all eligible ABS could not exceed 5 years and the final maturity could 
not exceed 7 years. We further proposed that all eligible ABS achieve 
the highest credit rating from an NRSRO, and we suggested a 20-percent 
portfolio cap on these investments. We also solicited your comments on 
how we could develop a more flexible regulatory framework that could 
effectively respond to new innovations in the ABS market.
    The PFC and The Bond Market Association responded to our proposal 
on ABS. They asked us to revise the provisions in proposed 
Sec. 615.5140(a)(6) relating to ABS maturity, collateral, and credit 
rating requirements and the portfolio limit. In response, we made 
several modifications to these proposed provisions, which are explained 
below.
2. Final Maturity
    The PFC and The Bond Market Association advised us that the 
combination of a 5-year WAL and a final maturity of 7 years would 
effectively prevent System banks and associations from investing in 
some of the most liquid segments of the ABS markets. As a result, both 
commenters asked us to omit the provision that establishes a final 
maturity for ABS from final Sec. 615.5140(a)(6).
    We conclude that the commenters' suggestion has merit. Generally, 
the WAL is the average amount of time required for each dollar of 
invested principal to be repaid, based on the cashflow structure of an 
ABS and an assumed level of prepayments. In contrast, the final 
maturity of an ABS refers to the date that the final principal payment 
on the underlying collateral is due. Nearly all ABS are priced and 
traded on the basis of their WAL. We agree that the 7-year final 
maturity restriction in the proposed rule would have effectively 
foreclosed the System's ability to invest in ABS that are backed by 
certain types of collateral, especially manufactured housing and home 
equity loans. Therefore, the final rule does not

[[Page 28892]]

impose a maximum final maturity on ABS.
3. Adjustable Rate ABS
    The PFC also asked us to modify the maturity guidelines for 
adjustable rate ABS so that they are more consistent with the criteria 
for adjustable rate mortgage securities. The preamble to the proposed 
rule noted that repricing frequency, periodic life caps, and the 
underlying index are important determinants of how a floating rate ABS 
performs and its interest rate risk profile.\16\ Although the PFC 
generally agreed with this statement, it pointed out that the maturity 
(whether defined as WAL, expected final or legal final maturity) will 
not provide much insight into the interest rate risk profile of the 
instrument. The PFC also noted that these securities have minimal price 
sensitivity and interest rate risk because most adjustable rate ABS: 
(1) Frequently reprice off a recognized index; (2) are uncapped; or (3) 
have very high lifetime interest rate caps. We agree and we have 
modified the regulations to address these concerns. Under the final 
regulations, the expected WAL on eligible ABS must not exceed:
---------------------------------------------------------------------------

    \16\ See 63 FR 33281, 33289 (June 18, 1998).
---------------------------------------------------------------------------

     Five (5) years for a fixed rate security or floating rate 
security at its contractual interest rate cap;
     Seven (7) years for a floating rate security without a cap 
or floating rate security that remains below its contractual interest 
rate cap.
4. Collateral and Credit Ratings
    The PFC suggests that final Sec. 615.5140(a)(6) authorizes System 
banks to invest in any ABS that is rated in the two highest credit 
rating categories by an NRSRO once a liquid market is established. The 
PFC believes that its suggestion would expand the System's 
opportunities to invest in the ABS market while preventing System banks 
and associations from acquiring individual securities that are 
illiquid. The PFC asserts that a high credit rating is indicative of 
whether an ABS is liquid. The commenter supports its position by 
pointing out that the secondary market for ABS is now larger than the 
secondary market for Collateralized Mortgage Obligations (CMOs). If we 
adopted this approach, the final regulation would not restrict the 
types of collateral that back eligible ABS.
    We did not incorporate the PFC's suggestion into final 
Sec. 615.5140(a)(6). This regulation allows System banks and 
associations to invest in most ABS that are available in the financial 
markets. Although the ABS market now outpaces the CMO market, the 
secondary market for ABS issues secured by other types of collateral is 
more limited. The PFC acknowledges in its comment letter that its 
suggestion may not necessarily be a reliable gauge of liquidity in ABS 
markets. Final Sec. 615.5140(a)(6) provides System institutions ample 
opportunities to invest in highly rated, fixed-income ABS that offer 
stable cashflows. Furthermore, the FCA will consider approval of other 
types of ABS on a case-by-case basis under final Sec. 615.5140(e).
5. Portfolio Limit
    We did not incorporate The Bond Market Association's suggestion to 
increase the portfolio limit on ABS from 20 to 50 percent. The ABS 
market primarily developed during a period of prolonged economic 
growth, and, for the most part, the performance of the ABS market has 
not been tested under significant economic stress. For this reason, we 
are reluctant to increase the System's exposure to ABS investments at 
this time.
    Separately, System institutions asked us to explain how 
Sec. 615.5140 applies to senior ABS that are secured by student loans 
the United States Department of Education conditionally guarantees. 
These securities are backed by loans that are conditionally guaranteed 
by the United States Department of Education through a program that 
reinsures the guarantees of loans by State and nonprofit agencies. The 
portion of the security that the United States Department of Education 
does not conditionally guarantee must be counted toward the 20-percent 
ABS limit. The portfolio limit does not apply to the portion of the 
security that the United States guarantees. This treatment is 
consistent with our approach of placing no portfolio restrictions on 
investments in obligations that are insured or guaranteed by the United 
States or its agencies. Obligations that are insured or guaranteed by 
the United States or its agencies are authorized under 
Sec. 615.5140(a)(1).

F. Approval Process for Other Investments

    We solicited comments on how final Sec. 615.5140 could permit FCS 
banks and associations to invest in highly rated marketable securities 
that are not expressly authorized by Sec. 615.5140 without requiring 
FCA approval. System banks suggested that the FCA should pursue a more 
general and broader approach to risk management and establish a set of 
price volatility guidelines that could be applied to all types of 
investments. After considering this suggestion, we concluded, for the 
reasons explained below, that this suggestion is not an effective 
replacement for the prior approval requirement in Sec. 615.5140.
    We make no changes in our process for approving investments not 
listed in Sec. 615.5140 for several reasons. We designed final 
regulations that would grant FCS banks more flexibility to manage risk 
in accordance with their own unique risk tolerance and objectives. For 
example, FCS institutions now have the option under Sec. 615.5141 to 
establish their own internal price volatility guidelines for mortgage 
securities. Furthermore, the final regulations expand the list of 
eligible investments and remove or relax regulatory restrictions on 
other authorized investments. Together, these amendments provide each 
FCS bank with a broader selection of investments so it can establish a 
well diversified investment portfolio that will enable it to maintain a 
liquidity reserve, invest surplus funds, and manage interest rate 
risks. Similarly, Sec. 615.5133 places the primary responsibility for 
identifying, measuring, and managing risk with each System institution. 
This provision allows each FCS institution to set its own risk 
tolerance levels based on its unique circumstances.
    Furthermore, establishing a single set of price volatility 
guidelines that applies to all types of investments and all System 
banks and associations is inconsistent with our new regulatory 
approach. We believe we can achieve our safety and soundness objectives 
by placing greater emphasis on effective investment and risk management 
practices within the System. Therefore, the final regulations continue 
to require System institutions to seek our approval before they 
purchase investments not listed in Sec. 615.5140.

G. Equity Investments

    CoBank, ACB, responded to our initiative on regulatory burden by 
suggesting that we amend Sec. 615.5140 so FCS banks could hold equity 
investments in borrowers and other third parties who form strategic 
alliances to serve System customers. These types of investments further 
the System's mission to finance agriculture and rural communities, but 
usually they are not suitable for managing liquidity and market risks 
at System institutions. We plan to initiate a rulemaking in the future 
that will address the authority of FCS banks and associations to hold 
equity investments that are related to their agricultural credit 
mission.

[[Page 28893]]

Accordingly, we will address CoBank's request at that time.

IV. Stress Testing for Mortgage Securities

    We adopt the requirements for stress testing mortgage securities in 
Sec. 615.5141 as a final regulation without substantive amendment. 
However, we did receive several questions and comments regarding stress 
testing that require a response.
    Prior to this rulemaking, FCS banks requested technical 
modifications to our existing regulatory stress tests. System banks 
subsequently requested that we repeal the regulatory stress tests after 
the FFIEC rescinded a policy statement that required depository 
institutions to stress test mortgage-derivative products.\17\ System 
banks commented that the FCA should make its regulatory approach 
consistent with the FFIEC's new policy. In response, we proposed 
significant changes to existing requirements for evaluating the price 
sensitivity of mortgage securities and determining their suitability. 
We, however, did not propose to rescind the stress-testing requirement 
for mortgage securities.
---------------------------------------------------------------------------

    \17\ See 63 FR 20191 (Apr. 23, 1998).
---------------------------------------------------------------------------

    We concluded that stress testing is an essential risk management 
practice for several reasons. Although credit risk on highly rated 
mortgage securities is minimal, mortgage securities may expose 
investors to significant interest rate risk. Since borrowers may prepay 
their mortgages, investors may not receive the expected cashflows and 
returns on these securities. Additionally, numerous factors influence 
the cashflow pattern and price sensitivity of mortgage securities. 
Prepayments on these securities are affected by the spread between 
market rates and the actual interest rates of mortgages in the pool, 
the path of interest rates, and the unpaid balances and remaining terms 
to maturity on the mortgage collateral. The price behavior of a 
mortgage security also depends on whether the security was purchased at 
a premium or at a discount. As a result of these factors, we concluded 
that each System institution needs to employ appropriate analytical 
techniques and methodologies to measure and evaluate interest rate risk 
inherent in mortgage securities. More specifically, prudent risk 
management practices require every System institution to examine the 
performance of each mortgage security under a wide array of possible 
interest rate scenarios.
    Our proposal allowed each System institution to accomplish this 
performance analysis by choosing between two options for stress testing 
mortgage securities. Under the first option, an FCS institution could 
continue to use a modified version of the existing three-pronged stress 
test in Sec. 615.5141(a). The three tests include an average life test, 
an average life sensitivity test, and a price sensitivity test.
    The Bond Market Association suggested that we eliminate the 
standardized stress tests in Sec. 615.5141(a) because a risk management 
program that requires a financial institution to identify, measure, 
monitor, and control risk on an institutional or portfolio level is 
more effective than a pass/fail test for individual instruments.
    However, we elect to retain the three-pronged stress test in 
Sec. 615.5141(a) as a viable option for System institutions. Our 
reasoning for this decision stems from our concerns about additional 
resources, costs, and expertise associated with more comprehensive 
analytical techniques needed to effectively manage risk at the 
portfolio or institutional level. From a historical perspective, the 
tests in Sec. 615.5141(a) successfully protected Farm Credit banks from 
significant losses in certain mortgage products. By requiring the pre-
purchase and quarterly price sensitivity analysis, System banks were 
better able to understand the risks associated with their investments.
    Under the second stress-testing option, proposed Sec. 615.5141(b) 
allowed the use of alternative stress test criteria and methodologies 
to evaluate the price sensitivity of mortgage securities. We proposed 
this alternative because new risk management techniques better enable 
investors to measure interest rate risks in complex mortgage 
securities. We also emphasized that alternate stress tests must be able 
to measure the price sensitivity of mortgage instruments over different 
interest rate and yield curve scenarios. Furthermore, the methodology 
must be commensurate with the complexity of the instrument's structure 
and cashflows. For example, a pre-purchase analysis should show the 
effect of an immediate and parallel shift in the yield curve of plus 
and minus 100, 200, and 300 basis points. An instrument's complexity 
determines whether the risk analysis should encompass a wider range of 
scenarios, including non-parallel changes in the yield curve. A 
comprehensive analysis may also take into consideration other relevant 
factors. Most importantly, the methodology that each System bank or 
association uses to evaluate an instrument's suitability must be able 
to determine that a particular mortgage security:
     Meets the objectives and risk limits in its investment 
policies; and
     Does not expose the capital and earnings of the 
institution to excessive risk.
    We received one comment from the PFC on proposed Sec. 615.5141(b). 
The PFC requested clarification on whether the board or the management 
of each FCS bank and association is responsible for establishing the 
risk parameters of alternate stress tests. If the board elects to use 
alternative stress tests as permitted under Sec. 615.5141(b) to gauge 
market risk in mortgage securities, it must also assume responsibility 
for establishing the risk parameters for the stress test.
    In further response to the PFC, we reaffirm that Sec. 615.5141(b) 
is consistent with the guidance in the FFIEC's policy statement 
regarding stress testing mortgage securities. Our new approach, which 
we now adopt as a final regulation, enables System banks and 
associations to rely on more comprehensive analytical techniques that 
enhance their risk management. Our regulations no longer prevent System 
banks and associations from holding mortgage securities solely on the 
basis that they exhibit significant price sensitivity. The final 
regulation affords FCS banks and associations the latitude to consider 
a number of factors when evaluating a mortgage security's suitability. 
For example, System banks and associations may consider interest rate 
volatility, changes in credit spreads, an instrument's total return or 
whether the instrument reduces the overall risk in the investment 
portfolio or throughout the institution.
    The PFC inquired whether derivative hedge transactions could be 
considered when determining whether a mortgage security is an eligible 
investment. We confirm that FCS institutions may consider the effect of 
derivative hedge transactions on the price sensitivity of instruments 
as part of their evaluation of whether a particular mortgage security 
is a suitable investment under either Sec. 615.5141(a) or (b).

V. Farmer Mac Mortgage Securities

1. Our Proposal

    We proposed technical amendments to Sec. 615.5174, which authorizes 
FCS banks and associations to invest in mortgage securities that are 
issued or guaranteed by Farmer Mac. Basically, we intended to revise 
Sec. 615.5174 so it conforms to amendments in subpart E of part 615. 
More specifically, these technical amendments would:

[[Page 28894]]

     Delete cross-references to the former definitions of 
``mortgage-backed securities,'' ``collateralized mortgage 
obligations,'' ``Real Estate Mortgage Investment Conduits,'' and 
``adjustable rate mortgages'' in Sec. 615.5131; and
     Repeal existing Sec. 615.5174(c), which prohibits FCS 
banks and associations from investing in Farmer Mac stripped mortgage-
backed securities.

2. Summary of Comments

    Two commenters requested substantive revisions to Sec. 615.5174. 
Farmer Mac asked us to amend our regulations to equalize the regulatory 
treatment of mortgage securities of Farmer Mac, Fannie Mae, and Freddie 
Mac. Farmer Mac asserts that our original justification for according 
Farmer Mac mortgage securities a different regulatory treatment than 
Fannie Mae and Freddie Mac mortgage securities is no longer valid. 
Farmer Mac points out that 2 years after we adopted existing 
Sec. 615.5174, Congress enacted the Farm Credit System Reform Act of 
1996 \18\ (1996 Act), which repealed several statutory provisions that 
distinguished its mortgage securities from those of Fannie Mae and 
Freddie Mac. As a result of these statutory changes, Farmer Mac asserts 
that the spreads of Farmer Mac mortgage securities are now close to 
those on comparable Fannie Mae and Freddie Mac products. For these 
reasons, Farmer Mac believes that the mortgage securities of all three 
GSEs expose investors to approximately the same risk of loss and should 
be treated in a similar fashion.
---------------------------------------------------------------------------

    \18\ Pub. L. 104-105, 110 Stat. 162 (Feb. 10, 1996).
---------------------------------------------------------------------------

    The jointly managed Central Coast Production Credit Association/
Federal Land Credit Association (Central Coast) responded to our notice 
on regulatory burden by encouraging us to repeal the 20-percent 
portfolio limit on Farmer Mac mortgage securities in existing 
Sec. 615.5174(a). As the commenter notes, we enacted this portfolio 
limit in 1993, when the Act required System banks and associations to 
guarantee 10 percent of Farmer Mac mortgage securities through either a 
cash reserve or a subordinated participation interest in the underlying 
loans. The associations assert that the original safety and soundness 
rationale for the 20-percent portfolio limit no longer exists because 
Farmer Mac now has the authority both to issue mortgage securities and 
to fully guarantee principal and interest payments to investors.

3. Response to Comments

    We acknowledge that the 1996 Act granted Farmer Mac many of the 
same powers that Fannie Mae and Freddie Mac have to issue and guarantee 
mortgage securities. These statutory amendments profoundly changed 
Farmer Mac's business operations and the market for its securities. We 
agree that the 1996 Act has rendered many provisions of existing 
Sec. 615.5174 obsolete, and for this reason, this regulation requires 
more than technical and conforming amendments.

4. Final Regulation

    We have fashioned a final regulation that balances the interests of 
both Farmer Mac and other System institutions. We recognized Farmer 
Mac's new statutory powers and market realities by repealing all 
obsolete provisions in Sec. 615.5174. The final regulation responds to 
Farmer Mac's request for comparable treatment with Fannie Mae and 
Freddie Mac by applying the investment management provisions of final 
Sec. 615.5133(b) and (c) and the stress test requirements of final 
Sec. 615.5141 to Farmer Mac mortgage securities. In the same context, 
final Sec. 615.5174 focuses on issues that are unique to investments by 
FCS banks and associations in Farmer Mac mortgage securities. In 
addition, the final regulation allows System banks and associations 
more latitude to manage their credit risks through investments in 
Farmer Mac securities.
    Final Sec. 615.5174(a) continues to authorize System banks and 
associations to invest in mortgage securities that are issued or 
guaranteed as to principal and interest by Farmer Mac. This provision 
specifically allows System banks and associations to purchase and hold 
Farmer Mac securities for the purposes of: (1) Managing credit and 
interest rate risk; and (2) furthering their mission to finance 
agriculture. Certain Farmer Mac mortgage securities may help System 
banks and associations to manage interest rate risk exposures in their 
portfolios. Additionally, System banks and associations can use these 
mortgage securities for cashflow management because Farmer Mac 
guarantees that investors will receive timely payment of principal and 
interest.
    We added explicit references to associations to final Sec. 615.5174 
to clarify the scope of this regulation. Because redesignated 
Sec. 615.5142 contained a redundant authorization for FCS associations 
to purchase and hold Farmer Mac mortgage securities, we deleted the 
reference to Sec. 615.5174 in redesignated Sec. 615.5142.
    System banks and associations can still acquire subordinated 
participation interests in Farmer Mac pools, although title VII of the 
Act no longer requires them to do so. Investments by System banks and 
associations in subordinate Farmer Mac securities are also subject to 
regulations in part 614 of this chapter.
    In response to Central Coast's request, we modified the portfolio 
cap in this regulation. Farmer Mac mortgage securities can be used to 
diversify the credit risk exposure in FCS bank and association 
agricultural loans and further their important mission objectives. 
Therefore, final Sec. 615.5174 allows System banks and associations to 
hold Farmer Mac mortgage securities in an amount that is equal to their 
total outstanding loans.
    We note that System banks must not count Farmer Mac mortgage 
securities as part of their total outstanding loans when they calculate 
their 30-percent portfolio limit for liquid investments under 
Sec. 615.5132. Our reason for this treatment is that Farmer Mac 
mortgage securities are not considered loans of System banks and 
associations.
    Final Sec. 615.5174(b) covers the responsibilities of boards and 
senior management for overseeing investments in Farmer Mac securities. 
This provision requires each Farm Credit bank and association board of 
directors to adopt written policies that will govern their investments 
in Farmer Mac securities. Final Sec. 615.5174(b) closely parallels 
similar provisions in Sec. 615.5133 that guide investment management 
practices for non-agricultural investments.
    Final Sec. 615.5174(c) also closely follows similar provisions in 
Sec. 615.5133. This provision requires banks and associations to 
establish policies that identify the types and quantity of Farmer Mac 
securities they will hold to achieve their objectives and set credit, 
market, and liquidity risk limits. Under final Sec. 615.5174(c)(2), the 
board's policy must establish specific criteria for managing credit 
risk by establishing product and geographic diversification 
requirements for investments in Farmer Mac mortgage securities. Final 
Sec. 615.5174(c)(3) requires the board's policies to address how the 
market risk of Farmer Mac mortgage securities affects the institution's 
capital and earnings.
    Under final Sec. 615.5174(c)(4), board policies must indicate 
liquidity risk tolerance levels. Risk preferences may be based on the 
liquidity characteristics of the types of Farmer Mac securities you 
wish to select for your portfolio and your institutional objectives. We

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recognize that if your objective is to hold Farmer Mac securities until 
maturity, liquidity risk is less important. Additionally, the final 
regulations prohibit Farm Credit banks from holding Farmer Mac mortgage 
securities in the liquidity reserve they maintain under Sec. 615.5134. 
Our concern over concentration risk led us to develop this provision. 
For example, if the System had real or perceived credit problems due to 
a crisis in the agricultural economy and could not access the market at 
reasonable rates, those same economic factors may also adversely affect 
the price and liquidity of Farmer Mac securities.
    Lastly, final Sec. 615.5174(d) requires System banks and 
associations to perform stress tests in accordance with final 
Sec. 615.5141 to measure market risks in these securities.

VI. Liquidity Reserve

    We received no comment on our proposal to repeal a provision in 
existing Sec. 615.5134(b) which requires System banks to segregate 
investments in the liquidity reserve from investments that are held for 
other purposes under Sec. 615.5132. This amendment provides FCS banks 
with greater flexibility to decide how to best use their investments to 
manage risk exposure.
    In response to our initiative on regulatory burden, CoBank, ACB, 
stated that the ``burdensome liquidity reserve requirement calculations 
should be simplified.'' The commenter did not offer any suggestions for 
simplifying the liquidity reserve requirement in Sec. 615.5134.
    The liquidity reserve requirement for System banks is calculated 
using a basic formula. The liquidity reserve requirement ensures that 
FCS banks have a pool of liquid investments to fund their operations 
for approximately 15 days if their access to the capital markets 
becomes impeded. We believe the significance of maintaining an ample 
supply of liquid funds outweighs any burdens created by the liquidity 
reserve calculation process. Thus, we made no changes to the liquidity 
reserve calculation at this time.

List of Subjects in 12 CFR Part 615

    Accounting, Agriculture, Banks, banking, Government securities, 
Investments, Rural areas.

    For the reasons stated in the preamble, part 615 of chapter VI, 
title 12 of the Code of Federal Regulations is amended to read as 
follows:

PART 615--FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS, 
AND FUNDING OPERATIONS

    1. The authority citation for part 615 continues to read as 
follows:

    Authority: Secs. 1.5, 1.7, 1.10, 1.11, 1.12, 2.2, 2.3, 2.4, 2.5, 
2.12, 3.1, 3.7, 3.11, 3.25, 4.3, 4.3A, 4.9, 4.14B, 4.25, 5.9, 5.17, 
6.20, 6.26, 8.0, 8.3, 8.4, 8.6, 8.7, 8.8, 8.10, 8.12 of the Farm 
Credit Act (12 U.S.C. 2013, 2015, 2018, 2019, 2020, 2073, 2074, 
2075, 2076, 2093, 2122, 2128, 2132, 2146, 2154, 2154a, 2160, 2202b, 
2211, 2243, 2252, 2278b, 2278b-6, 2279aa, 2279aa-3, 2279aa-4, 
2279aa-6, 2279aa-7, 2279aa-8, 2279aa-10, 2279aa-12); sec. 301(a) of 
Pub. L. 100-233, 101 Stat. 1568, 1608.

Subpart E--Investment Management

    2. Section 615.5131 is revised to read as follows:


Sec. 615.5131  Definitions.

    For purposes of this subpart, the following definitions apply:
    (a) Asset-backed securities (ABS) mean investment securities that 
provide for ownership of a fractional undivided interest or collateral 
interests in specific assets of a trust that are sold and traded in the 
capital markets. For the purposes of this subpart, ABS exclude mortgage 
securities that are defined in Sec. 615.5131(i).
    (b) Bank means a Farm Credit Bank, agricultural credit bank, or 
bank for cooperatives.
    (c) Eurodollar time deposit means a non-negotiable deposit 
denominated in United States dollars and issued by an overseas branch 
of a United States bank or by a foreign bank outside the United States.
    (d) Final maturity means the last date on which the remaining 
principal amount of a security is due and payable (matures) to the 
registered owner. It does not mean the call date, the expected average 
life, the duration, or the weighted average maturity.
    (e) General obligations of a State or political subdivision means:
    (1) The full faith and credit obligations of a State, the District 
of Columbia, the Commonwealth of Puerto Rico, a territory or possession 
of the United States, or a political subdivision thereof that possesses 
general powers of taxation, including property taxation; or
    (2) An obligation that is unconditionally guaranteed by an obligor 
possessing general powers of taxation, including property taxation.
    (f) Liquid investments are assets that can be promptly converted 
into cash without significant loss to the investor. In the money 
market, a security is liquid if the spread between its bid and ask 
price is narrow and a reasonable amount can be sold at those prices.
    (g) Loans are defined by Sec. 621.2(f) of this chapter and they are 
calculated quarterly (as of the last day of March, June, September, and 
December) by using the average daily balance of loans during the 
quarter.
    (h) Market risk means the risk to the financial condition of your 
institution because the value of your holdings may decline if interest 
rates or market prices change. Exposure to market risk is measured by 
assessing the effect of changing rates and prices on either the 
earnings or economic value of an individual instrument, a portfolio, or 
the entire institution.
    (i) Mortgage securities means securities that are either:
    (1) Pass-through securities or participation certificates that 
represent ownership of a fractional undivided interest in a specified 
pool of residential (excluding home equity loans), multifamily or 
commercial mortgages, or
    (2) A multiclass security (including collateralized mortgage 
obligations and real estate mortgage investment conduits) that is 
backed by a pool of residential, multifamily or commercial real estate 
mortgages, pass-through mortgage securities, or other multiclass 
mortgage securities.
    (j) Nationally Recognized Statistical Rating Organization (NRSRO) 
means a rating organization that the Securities and Exchange Commission 
recognizes as an NRSRO.
    (k) Revenue bond means an obligation of a municipal government that 
finances a specific project or enterprise but it is not a full faith 
and credit obligation. The obligor pays a portion of the revenue 
generated by the project or enterprise to the bondholders.
    (l) Weighted average life (WAL) means the average time until the 
investor receives the principal on a security, weighted by the size of 
each principal payment and calculated under specified prepayment 
assumptions.
    (m) You means a Farm Credit bank, association, or service 
corporation.
    3. Section 615.5133 is revised to read as follows:


Sec. 615.5133  Investment management.

    (a) Responsibilities of Board of Directors. Your board must adopt 
written policies for managing your investment activities. Your board of 
directors must also ensure that management complies with these policies 
and that appropriate internal controls are in place to prevent loss. 
Annually, the board of directors must

[[Page 28896]]

review these investment policies and make any changes that are needed.
    (b) Investment policies. Your board's written investment policies 
must address the purposes and objectives of investments, risk 
tolerance, delegations of authority, and reporting requirements. 
Investment policies must be appropriate for the size, types, and risk 
characteristics of your investments.
    (c) Risk tolerance. Your investment policies must establish risk 
limits and diversification requirements for the various classes of 
eligible investments and for the entire investment portfolio. These 
policies must ensure that you maintain appropriate diversification of 
your investment portfolio. Risk limits must be based on your 
institutional objectives, capital position, and risk tolerance. Your 
policies must identify the types and quantity of investments that you 
will hold to achieve your objectives and control credit, market, 
liquidity, and operational risks. The policy of any association or 
service corporation that holds significant investments and each bank 
must establish risk limits for the following four types of risk.
    (1) Credit risk. Investment policies must establish:
    (i) Credit quality standards, limits on counterparty risk, and risk 
diversification standards that limit concentrations based on a single 
or related counterparty(ies), a geographical area, industries or 
obligations with similar characteristics.
    (ii) Criteria for selecting brokers, dealers, and investment 
bankers (collectively, securities firms). You must buy and sell 
eligible investments with more than one securities firm. As part of 
your annual review of your investment policies, your board of directors 
must review the criteria for selecting securities firms and determine 
whether to continue your existing relationships with them.
    (iii) Collateral margin requirements on repurchase agreements.
    (2) Market risk. Investment policies must set market risk limits 
for specific types of investments, the investment portfolio, or your 
institution. Your board of directors must establish market risk limits 
in accordance with these regulations and our other policies.
    (3) Liquidity risk. Investment policies must describe the liquidity 
characteristics of eligible investments that you will hold to meet your 
liquidity needs and institutional objectives.
    (4) Operational risk. Investment policies must address operational 
risks, including delegations of authority and internal controls in 
accordance with paragraphs (d) and (e) of this section.
    (d) Delegation of authority. All delegations of authority to 
specified personnel or committees must state the extent of management's 
authority and responsibilities for investments.
    (e) Internal controls. You must:
    (1) Establish appropriate internal controls to detect and prevent 
loss, fraud, embezzlement, conflicts of interest, and unauthorized 
investments.
    (2) Establish and maintain a separation of duties and supervision 
between personnel who execute investment transactions and personnel who 
approve, revaluate, and oversee investments.
    (3) Maintain management information systems that are appropriate 
for the level and complexity of your investment activities.
    (f) Securities valuation.
    (1) Before you purchase a security, you must evaluate its credit 
quality and its price sensitivity to changes in market interest rates. 
You must also verify the value of a security that you plan to purchase, 
other than a new issue, with a source that is independent of the 
broker, dealer, counterparty or other intermediary to the transaction.
    (2) You must determine the fair market value of each security in 
your portfolio and the fair market value of your whole investment 
portfolio at least monthly. You must also evaluate the credit quality 
and price sensitivity to change in market interest rates of all 
investments that you hold on an ongoing basis.
    (3) Before you sell a security, you must verify its value with a 
source that is independent of the broker, dealer, counterparty, or 
other intermediary to the transaction.
    (g) Reports to the board. Each quarter, management must report to 
the board of directors or a board committee on the performance and risk 
of each class of investments and the entire investment portfolio. These 
reports must identify all gains and losses that you incur during the 
quarter on individual securities that you sold before maturity. Reports 
must also identify potential risk exposure to changes in market 
interest rates and other factors that may affect the value of your 
bank's investment holdings. Management's report must discuss how 
investments affect your bank's overall financial condition and must 
evaluate whether the performance of the investment portfolio 
effectively achieves the board's objectives. Any deviations from the 
board's policies must be specifically identified in the report.
    4. Section 615.5134 is amended by revising paragraph (b) to read as 
follows:


Sec. 615.5134  Liquidity reserve requirement.

* * * * *
    (b) All investments that the bank holds for the purpose of meeting 
the liquidity reserve requirement of this section must be free of lien.
* * * * *
    5. Section 615.5140 is revised to read as follows:


Sec. 615.5140  Eligible investments.

    (a) You may hold only the following types of investments listed in 
the Investment Eligibility Criteria Table. These investments must be 
denominated in United States dollars.

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    (b) Rating of foreign countries. Whenever the obligor or issuer of 
an eligible investment is located outside the United States, the host 
country must maintain the highest sovereign rating for political and 
economic stability by an NRSRO.
    (c) Marketable securities. All eligible investments, except money 
market instruments, must be marketable. An eligible investment is 
marketable if you can sell it quickly at a price that closely reflects 
its fair value in an active and universally recognized secondary 
market.
    (d) Obligor limits.
    (1) You may not invest more than 20 percent of your total capital 
in eligible investments issued by any single institution, issuer, or 
obligor. This obligor limit does not apply to obligations, including 
mortgage securities, that are issued or guaranteed as to interest and 
principal by the United States, its agencies, instrumentalities, or 
corporations.
    (2) Obligor limits for your holdings in an investment company You 
must count securities that you hold through an investment company 
towards the obligor limit of this section unless the investment 
company's holdings of the security of any one issuer do not exceed five 
(5) percent of the investment company's total portfolio.
    (e) Other investments approved by the FCA. You may purchase and 
hold other investments that we approve. Your request for our approval 
must explain the risk characteristics of the investment and your 
purpose and objectives for making the investment.


Secs. 615.5141 through 615.5143  [Redesignated]

    6. Sections 615.5141, 615.5142, and 615.5143 are redesignated as 
Secs. 615.5142, 615.5143, and 615.5144, respectively, and a new 
Sec. 615.5141 is added to read as follows:


Sec. 615.5141  Stress tests for mortgage securities.

    Mortgage securities are not eligible investments unless they pass a 
stress test. You must perform stress tests to determine how interest 
rate changes will affect the cashflow and price of each mortgage 
security that you purchase and hold, except for adjustable rate 
securities that reprice at intervals of 12 months or less and are tied 
to an index. You must also use stress tests to gauge how interest rate 
fluctuations on mortgage securities affect your institution's capital 
and earnings. You may conduct the stress tests as described in either 
paragraph (a) or (b) of this section.
    (a) Mortgage securities must comply with the following three tests 
at the time of purchase and each following quarter:
    (1) Average Life Test. The expected WAL of the instrument does not 
exceed 5 years.
    (2) Average Life Sensitivity Test. The expected WAL does not extend 
for more than 2 years, assuming an immediate and sustained parallel 
shift in the yield curve of plus 300 basis points, nor shorten for more 
than 3 years, assuming an immediate and sustained parallel shift in the 
yield curve of minus 300 basis points.
    (3) Price Sensitivity Test. The estimated change in price is not 
more than thirteen (13) percent due to an immediate and sustained 
parallel shift in the yield curve of plus or minus 300 basis points.
    (4) Exemption. A floating rate mortgage security is subject only to 
the price sensitivity test in paragraph (a)(3) of this section if at 
the time of purchase and each quarter thereafter it bears a rate of 
interest that is below its contractual cap.
    (b) You may use an alternative stress test to evaluate the price 
sensitivity of your mortgage securities. An alternative stress test 
must be able to measure the price sensitivity of mortgage instruments 
over different interest rate/yield curve scenarios. The methodology 
that you use to analyze mortgage securities must be appropriate for the 
complexity of the instrument's structure and cashflows. Prior to 
purchase and each quarter thereafter, you must use the stress test to 
determine that the risk in the mortgage security is within the risk 
limits of your board's investment policies. The stress test must enable 
you to determine at the time of purchase and each subsequent quarter 
that the mortgage security does not expose your capital or earnings to 
excessive risks.
    (c) You must rely on verifiable information to support all your 
assumptions, including prepayment and interest rate volatility 
assumptions, when you apply the stress tests in either paragraph (a) or 
(b) of this section. You must document the basis for all assumptions 
that you use to evaluate the security and its underlying mortgages. You 
must also document all subsequent changes in your assumptions. If at 
any time after purchase, a mortgage security no longer complies with 
requirements in this section, you must divest it in accordance with 
Sec. 615.5143.
    7. Newly designated Sec. 615.5142 is revised to read as follows:


Sec. 615.5142  Association investments.

    An association may hold eligible investments listed in 
Sec. 615.5140, with the approval of its funding bank, for the purposes 
of reducing interest rate risk and managing surplus short-term funds. 
Each bank must review annually the investment portfolio of every 
association that it funds.
    8. Newly designated Sec. 615.5143 is revised to read as follows:


Sec. 615.5143  Disposal of ineligible investments.

    You must dispose of an ineligible investment within 6 months unless 
we approve, in writing, a plan that authorizes you to divest the 
instrument over a longer period of time. An acceptable divestiture plan 
must require you to dispose of the ineligible investment as quickly as 
possible without substantial financial loss. Until you actually dispose 
of the ineligible investment, the managers of your investment portfolio 
must report at least quarterly to your board of directors about the 
status and performance of the ineligible instrument, the reasons why it 
remains ineligible, and the managers' progress in disposing of the 
investment.

Subpart F--Property and Other Investments

    9. Section 615.5174 is revised to read as follows:


Sec. 615.5174  Farmer Mac securities.

    (a) General authority. You may purchase and hold mortgage 
securities that are issued or guaranteed as to both principal and 
interest by the Federal Agricultural Mortgage Corporation (Farmer Mac 
securities). You may purchase and hold Farmer Mac securities for the 
purposes of managing credit and interest rate risks, and furthering 
your mission to finance agriculture. The total value of your Farmer Mac 
securities cannot exceed your total outstanding loans, as defined by 
Sec. 615.5131(g).
    (b) Board and management responsibilities. Your board of directors 
must adopt written policies that will govern your investments in Farmer 
Mac securities. All delegations of authority to specified personnel or 
committees must state the extent of management's authority and 
responsibilities for managing your investments in Farmer Mac 
securities. The board of directors must also ensure that appropriate 
internal controls are in place to prevent loss, in accordance with 
Sec. 615.5133(e). Management must submit quarterly reports to the board 
of directors on the performance of all investments in Farmer Mac 
securities. Annually, your board of directors must review these 
policies and the performance of your

[[Page 28900]]

Farmer Mac securities and make any changes that are needed.
    (c) Policies. Your board of directors must establish investment 
policies for Farmer Mac securities that include your:
    (1) Objectives for holding Farmer Mac securities.
    (2) Credit risk parameters including:
    (i) The quantities and types of Farmer Mac mortgage securities that 
are collateralized by qualified agricultural mortgages, rural home 
loans, and loans guaranteed by the Farm Service Agency.
    (ii) Product and geographic diversification for the loans that 
underlie the security; and
    (iii) Minimum pool size, minimum number of loans in each pool, and 
maximum allowable premiums or discounts on these securities.
    (3) Liquidity risk tolerance and the liquidity characteristics of 
Farmer Mac securities that are suitable to meet your institutional 
objectives. A bank may not include Farmer Mac mortgage securities in 
the liquidity reserve maintained to comply with Sec. 615.5134.
    (4) Market risk limits based on the effects that the Farmer Mac 
securities have on your capital and earnings.
    (d) Stress Test. You must perform stress tests on mortgage 
securities that are issued or guaranteed by Farmer Mac in accordance 
with the requirements of Sec. 615.5141(b) and (c). If a Farmer Mac 
security fails a stress test, you must divest it as required by 
Sec. 615.5143.

    Dated: May 13, 1999.
Vivian Portis,
Secretary, Farm Credit Administration Board.
[FR Doc. 99-13622 Filed 5-27-99; 8:45 am]
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