[Federal Register Volume 67, Number 249 (Friday, December 27, 2002)]
[Proposed Rules]
[Pages 78996-79007]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-32496]


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 Proposed Rules
                                                 Federal Register
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 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
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  Federal Register / Vol. 67, No. 249 / Friday, December 27, 2002 / 
Proposed Rules  

[[Page 78996]]



NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 703 and 742


Investment and Deposit Activities and Regulatory Flexibility 
Program

AGENCY: National Credit Union Administration (NCUA).

ACTION: Proposed rule with request for comments.

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SUMMARY: NCUA proposes to amend its rule regarding the investment 
activities of federal credit unions (FCUs). The amendments clarify and 
reformat the rule to make it easier to read and locate information. The 
amendments expand FCU investment authority to include purchasing 
equity-linked options for certain purposes and exempts RegFlex eligible 
credit unions from several investment restrictions. NCUA also proposes 
to expand the Regulatory Flexibility Program to conform to the proposed 
revisions to the investment rule.

DATES: Comments must be received on or before February 25, 2003.

ADDRESSES: Direct comments to Becky Baker, Secretary of the Board. Mail 
or hand-deliver comments to: National Credit Union Administration, 1775 
Duke Street, Alexandria, Virginia 22314-3428. You are encouraged to fax 
comments to (703) 518-6319, or E-mail comments to [email protected] 
instead of mailing or hand-delivering them. Whatever method you choose, 
please send comments by one method only.

FOR FURTHER INFORMATION CONTACT: Scott Hunt, Senior Investment Officer, 
Office of Strategic Program Support and Planning (OSPSP) at the above 
address or telephone (703) 518-6620; Dan Gordon, Senior Investment 
Officer, OSPSP at the above address or telephone (703) 518-6620; Kim 
Iverson, Program Officer, Office of Examination and Insurance, at the 
above address or telephone (703) 518-6360; or Frank Kressman, Staff 
Attorney, Office of General Counsel, at the above address or telephone 
(703) 518-6540.

SUPPLEMENTARY INFORMATION: 

A. Background

    NCUA identified part 703 as in need of revision. To that end, NCUA 
issued an advanced notice of proposed rulemaking (ANPR) on October 18, 
2001. 66 FR 54168 (October 26, 2001). In the ANPR, NCUA solicited 
comments as to how it could revise part 703 to make it easier to 
understand. The ANPR also solicited comments as to how NCUA could 
provide FCUs with greater flexibility and enhanced investment 
authorities without sacrificing safety and soundness. NCUA received 
thirty-eight comment letters: fifteen from FCUs, two from state credit 
unions, eleven from financial services entities, nine from credit union 
trade organizations, and one from a banking trade organization. The 
comments were generally supportive of the ANPR, except for those 
offered by the banking trade organization. As discussed more fully 
below, the commenters offered numerous suggestions of ways part 703 
could be improved. NCUA has considered these comments, and other issues 
that have arisen since the ANPR was issued, and is issuing this 
proposal to amend part 703.

B. Discussion

1. Broker-Dealer Requirements

    Section 703.50(a) describes the minimum criteria a broker-dealer 
must meet for an FCU to conduct business with a broker-dealer. 12 CFR 
703.50(a). In general, it requires FCUs to use broker-dealers that are 
registered with the Securities and Exchange Commission or depository 
institutions whose broker-dealer activities are regulated by a federal 
regulatory agency. NCUA believes depository institutions whose broker-
dealer activities are regulated by a state regulatory agency are 
supervised to a similar degree as those regulated by a federal agency. 
Accordingly, in proposed Sec.  703.8, NCUA proposes to amend this 
provision to permit FCUs to also use the services of depository 
institutions whose broker-dealer activities are regulated by a state 
regulatory agency. This will provide FCUs with greater access to 
broker-dealers.
    NCUA has become increasingly aware of circumstances where broker-
dealers have engaged in deceptive practices in the sale of CDs to FCUs, 
such as misrepresenting yields, providing misleading information about 
the terms of the CD, and inducing purchases of unsuitable and 
impermissible CDs. Some FCUs have asked NCUA to intervene and pursue 
remedies on their behalf in these circumstances.
    In recent years, NCUA has issued three Letters to Credit Unions to 
warn credit unions about the risks associated with certain brokered 
CDs: 00-CU-05, Investment in Brokered Certificates of Deposit, 
September 2000; 01-FCU-04, Broker Registration/Short-Term Investments, 
April 2001; and 01-CU-23, Investments in Brokered Certificates of 
Deposit sold By Bentley Financial Services, Inc. and Entrust Group, 
December 2001. NCUA has also issued Interpretive Ruling and Policy 
Statement 98-2, Supervisory Policy Statement on Investment Securities 
and End-User Derivatives Activities, which describes best practices 
when making investment decisions. Despite these efforts, NCUA believes 
further regulatory action is necessary to address the problems 
associated with brokered CDs.
    The ANPR asked whether setting minimum standards for broker-dealers 
would help prevent deceptive practices by broker-dealers. The ANPR 
contemplated requiring broker-dealers to have at least one General 
Securities Representative registered with the National Association of 
Securities Dealers (NASD). Alternatively, if a depository institution 
wishes to transact purchases and sales of investments with an FCU, its 
broker-dealer activities would have to be regulated by a federal or 
state regulatory agency. The ANPR further suggested that an individual 
broker-dealer might also have to be registered with the NASD as a 
General Securities Representative, whether the individual broker-dealer 
works with a brokerage firm or a federal or state regulated depository 
institution. NCUA was not contemplating imposing these standards on a 
broker-dealer acting only as a CD finder. A CD finder provides 
information about CD offering rates and terms, but does not take 
custody of the funds or the investment at any time.
    Twenty-eight commenters responded to NCUA's statement that it was 
considering more clearly defining minimum criteria a broker-dealer must

[[Page 78997]]

meet for an FCU to buy or sell investments through that broker-dealer. 
Twenty-one commenters supported NCUA's efforts to clarify and set 
minimum standards for broker-dealers. In general, the commenters viewed 
the registration requirements as prudent and did not believe they would 
significantly impair an FCU's ability to conduct investment activities. 
Four commenters supported NCUA's intention to provide guidelines to 
help FCUs make their own evaluation of a broker-dealer's 
qualifications, but were not in favor of NCUA setting rigid standards. 
One commenter not only supported NCUA setting the standards, but called 
for a more restrictive approach than that suggested by the ANPR. One 
commenter stated the current rule does not need to be changed. The 
banking trade group commented that it would be unfair for the NCUA to 
require individual broker-dealers working for a depository institution 
to be registered with the NASD as a General Securities Representative. 
It explained that the nature of their employment with the depository 
institution and NASD rules preclude those individuals from complying 
with the contemplated registration requirement.
    In certain cases, broker-dealer's deceptive practices have caused 
losses in credit unions, but it is not clear that additional standards 
on broker-dealers such as those suggested in the ANPR, would have 
prevented those losses. NCUA has determined that the existing rules 
represent prudent minimum criteria that a broker-dealer must meet for a 
credit union to purchase and sell investments through the broker-
dealer.
    The Board believes that education is the key to mitigating risk by 
improving credit unions' due diligence regarding the selection and 
monitoring of brokers-dealers. For this reason, the broker-dealer rules 
have not been revised to require more stringent broker-dealer 
requirements. However, NCUA will continue to provide guidance to the 
industry.

2. Safekeeper Requirements

    An FCU may only use the services of a safekeeping firm that meets 
the minimum criteria provided for in Sec.  703.60. 12 CFR 703.60. A 
safekeeper secures the FCU's ownership interest in investments without 
an FCU having to register the securities in its name or take physical 
possession of investment documents. Safekeepers that do not operate 
scrupulously, independently from broker-dealers, or under sufficient 
supervisory oversight can pose a risk to FCUs. NCUA's primary concern 
about safekeeper activities is in the brokered CD context. NCUA is 
aware of instances where a safekeeper, working with an unscrupulous 
broker-dealer, aided the broker-dealer in misleading the FCU about the 
terms and characteristics of brokered CDs or otherwise failed to 
fulfill its fiduciary responsibilities. NCUA is not aware of any 
problems with the safekeeping of other securities such as securities 
issued by the U.S. Department of the Treasury and other authorized 
credit union investments. The ANPR suggested the possibility of 
expanding the current safekeeping requirements to address this problem.
    Twenty-six commenters responded to NCUA's statement that it was 
considering limiting permissible safekeepers to clearing broker-dealers 
regulated by the Securities and Exchange Commission or depository 
institutions regulated by a state or federal agency. Twenty-one 
commenters supported this position. Five commenters were in favor of 
minimizing risk associated with safekeepers, but did not support the 
approach contemplated by the ANPR. These commenters preferred allowing 
FCUs to make their own evaluations of the qualifications of their 
safekeepers, but supported NCUA guidelines to help FCUs make those 
determinations. Three commenters wanted to replace depository 
institutions regulated by a state or federal agency with financial 
institutions regulated by a state or federal agency to increase the 
universe of eligible safekeepers.
    NCUA has concluded that the more stringent safekeeper standards 
contemplated in the ANPR would not effectively address the problems 
associated with brokered CDs. NCUA believes federal credit unions are 
best served by conducting thorough evaluations of safekeeping firms 
prior to doing business with them. The current rule requires a federal 
credit union to investigate a safekeeper's background to determine the 
safekeeper's reputation and compliance with laws and regulations. The 
NCUA Board is proposing to add a due diligence requirement that a 
federal credit union review the safekeeper's financial condition as 
well. Ascertaining the safekeeper's financial capacity to fulfill its 
custodial responsibilities is a sound business practice. NCUA will also 
emphasize education and understanding in the industry. In this regard, 
NCUA will continue to issue guidance to credit unions and promote due 
diligence reviews of safekeepers.
    Several commenters suggested that NCUA expand permissible 
safekeepers to include state-regulated trust companies, which are 
entities created for the purpose of meeting the fiduciary needs of 
their clients and customers and are subject to regular examinations. 
NCUA agrees with this suggestion and, in proposed Sec.  703.9, NCUA 
proposes to permit state-regulated trust companies to be safekeepers 
for FCUs. In addition, in proposed Sec.  703.4, NCUA proposes to 
require FCUs to retain the documentation their boards of directors used 
to approve the use of a safekeeper in the same manner and to the same 
extent this must be done in the broker-dealer context.

3. Expanded Investment Authorities

    The Federal Credit Union Act (Act) enumerates FCU investment 
powers. 12 U.S.C. 1757. NCUA has adopted regulatory prohibitions 
against certain investments and investment activities permitted by the 
Act on the basis of safety and soundness concerns. 12 CFR 703.100 and 
703.110. Investments and investment activities prohibited by regulation 
include financial derivatives, stripped mortgage-backed securities, 
residual interests in collateralized mortgage obligations/real estate 
mortgage investment conduits (CMOs/REMICs), commercial mortgage or 
small business related securities, mortgage servicing rights, short 
sales, adjusted trading, and variable rate products with indexes tied 
to foreign interest rates.
    The ANPR solicited comments regarding granting FCUs expanded 
investment authority and possible methods of doing so. Fifteen 
commenters supported expanded investment authority for FCUs that 
demonstrate, through an application process, the expertise to manage a 
particular investment product. Ten commenters supported expanded 
authority, but objected to an FCU having to apply to NCUA each time it 
wished to add a new investment product to its portfolio. Five 
commenters suggested an FCU's CAMEL rating should determine its level 
of expanded authorities and its application requirements. Many of the 
commenters noted specific investment products they would like to have 
available, but there was no discernable consensus in that regard. Two 
commenters were opposed to granting any expanded investment authority 
to FCUs.
    Section 107(15)(B) of the Act, 12 U.S.C. 1757(15)(B), permits FCUs 
to purchase mortgage related securities as that term is defined in 
Section 3(a)(41) of the Securities Exchange Act of 1934. 15 U.S.C. 
78c(a)(41). That definition includes mortgage related securities backed 
solely by residential mortgages, solely by commercial mortgages

[[Page 78998]]

 (Commercial Mortgage Related Securities or CMRS), and mixed 
residential and commercial mortgages. Generally speaking, section 
107(7)(E) of the Act permits FCUs to purchase investments issued, 
guaranteed, or sold by government agencies, government corporations and 
other government enterprises. 12 U.S.C. 1757(7)(E). Although section 
107(15)(B) and section 107(7)(E) permit different kinds of investments 
for FCUs, there is some overlap between the two. Specifically, some 
CMRS described in section 107(15)(B) also fit the description of 
investments permitted by section 107(7)(E).
    Part 703 currently prohibits the purchase of section 107(15)(B) 
CMRS that are not otherwise permitted by section 107(7)(E). This is 
because when part 703 was last revised, the CMRS market was not well 
established, and NCUA had concerns about liquidity and performance of 
the market. This market has since grown and seasoned to a point where 
NCUA believes an expansion of FCU authority in this context is 
justified. Accordingly, NCUA proposes to permit Regulatory Flexibility 
Program (RegFlex) eligible FCUs to purchase CMRS, that are not 
otherwise permitted by section 107(7)(E), subject to certain safety and 
soundness related restrictions. Specifically, a RegFlex eligible FCU 
may purchase CMRS, that are not otherwise permitted by section 
107(7)(E), if the CMRS: (1) Are rated in one of the two highest rating 
categories by at least one nationally-recognized statistical rating 
organization; (2) otherwise meet the definitions of mortgage related 
security as defined in 15 U.S.C. 78c(a)(41) and commercial mortgage 
related security as defined in proposed section 703.2 and (3) have an 
underlying pool of loans containing more than 50 loans with no one loan 
representing more than 10 percent of the pool. A RegFlex eligible FCU 
is limited to purchasing CMRS that are not otherwise permitted by 
section 107(7)(E) up to 50 percent of its net worth in the aggregate. 
As with all investments, FCUs should develop written policies and an 
understanding of the risks associated with CMRS before purchasing them.
    NCUA believes the investment pilot program is the most appropriate 
system for evaluating and granting expanded investment authority to 
FCUs. The pilot program's application and approval process gives an FCU 
the opportunity to demonstrate it has the ability to implement and 
administer safely an investment activity prohibited by regulation. Not 
only does the investment pilot program provide flexibility to FCUs, but 
it is also a useful tool for NCUA to evaluate whether granting 
additional investment authorities is appropriate. This approach allows 
NCUA to analyze an FCU's management's abilities and knowledge, and 
understand how an FCU plans to incorporate an investment activity into 
its overall investment and risk management strategies. In this regard, 
NCUA encourages those credit unions that possess the necessary 
knowledge and expertise to administer investments or investment 
activities currently prohibited by the regulation, but permitted by the 
FCU Act (e.g., the purchase of MSRs from other credit unions, stripped 
mortgage-backed securities) to apply for expanded powers through the 
pilot program.
    Although the purchase of mortgage servicing rights remains an 
impermissible investment, the proposed rule recognizes that a credit 
union, as a financial service to a member that is engaged in making 
mortgage loans, may perform servicing for a member's mortgage loans. 
For this activity to be permissible as a financial service to a member, 
the member must continue to own the loan during the time that the 
credit union provides servicing. In this context, the NCUA Board 
concludes that providing mortgage servicing is an appropriate exercise 
of a credit union's incidental powers to provide financial service to a 
member.
    To expedite the investment pilot program application and approval 
process, NCUA will make available guidelines for participation in 
approved investment pilot programs. These guidelines will be available 
on the NCUA website or by contacting the appropriate NCUA regional 
office. NCUA expects these guidelines will help FCUs better understand 
NCUA's criteria and will enable FCUs to submit more complete 
applications. These guidelines may also help FCUs determine where they 
may need to improve their infrastructure, resources, or knowledge 
before beginning the application process. Additionally, investment 
pilot program applicants are encouraged to submit alternative 
guidelines for NCUA's consideration. NCUA will make minor revisions to 
the proposed Sec.  703.19 investment pilot program to clarify it and 
reflect this discussion.
    On October 25, 2002, NCUA issued a final rule revising part 704 of 
its rules regarding corporate credit unions. 67 FR 65640 (October 25, 
2002). As part of that final rule, NCUA also revised Sec.  703.100(c). 
12 CFR 703.100(c). Specifically, NCUA increased the limit on an FCU's 
purchase of paid-in capital and membership capital in one corporate to 
2 percent of the FCU's assets and 4 percent for purchases in all 
corporates. The below revisions in proposed Sec.  703.14 conform to the 
final revisions made in October 2002.
    On September 19, 2002, NCUA issued a proposed rule regarding 
federally-insured credit unions branching outside the United States. 67 
FR 60607 (September 26, 2002). In that proposal, NCUA recognized that 
part 703 may not permit sufficient investment tools for FCUs to manage 
currency rate risk and other risks associated with conducting business 
in foreign countries. NCUA has determined that FCUs with foreign 
branches may apply to NCUA for expanded investment authority to address 
those risks under the investment pilot program.

4. Discretionary Control of Investments

    Section 703.40(c)(6) authorizes an FCU to delegate to an outside 
third party discretionary control over the purchase and sale of 
investments up to 100 percent of an FCU's net capital at the time of 
delegation. 12 CFR 703.40(c)(6). RegFlex. exempts FCUs meeting specific 
eligibility requirements from the Sec.  703.40(c)(6) cap. 12 CFR 742.4. 
The ANPR solicited comments on whether this cap should be raised for 
all FCUs and under what circumstances. Eleven commenters supported 
raising the cap and did not object to NCUA requiring FCUs to meet 
certain minimum standards or seek prior approval to exceed the cap. Six 
commenters supported raising the cap but did not favor a process 
requiring prior agency approval. Rather, some of these commenters 
preferred NCUA setting guidelines that an FCU could follow and 
requiring only that an FCU notify the NCUA when it exceeds the cap. One 
of these commenters recommended setting minimum standards for 
investment managers to whom FCUs entrust discretionary control. Nine 
commenters opposed raising the cap.
    NCUA believes that it would not be prudent to raise the cap on 
discretionary control of investments for all FCUs. NCUA believes that 
the exemption from this cap for RegFlex eligible FCUs is sufficient 
relief at this time. NCUA wishes to clarify that the cap on delegating 
discretionary control over the purchase and sale of investments is not 
applicable to the purchase or sale of mutual funds.
    The Board also believes it is prudent that the cap be evaluated 
annually so that the amount of investments under discretionary control 
does not exceed the credit union's net worth subsequent

[[Page 78999]]

to the original delegation of investment authority. Therefore, the 
Board has added the requirement that, should the amount of investments 
under discretionary control exceed the net worth cap at the time of the 
annual evaluation, the federal credit union's board of directors must 
receive notice as soon as possible, but no later than the next 
regularly scheduled board meeting. The board of directors must notify 
the appropriate regional director within 5 days after the board 
meeting. The FCU must also develop a plan to bring the credit union 
into compliance with the cap. The plan does not need to require 
divestiture of the investments, but the credit union must be brought 
back into compliance within a reasonable period of time.

5. Investment Credit Ratings

    Currently, an FCU must conduct a credit analysis for any investment 
that is not issued by or fully guaranteed as to principal and interest 
by the U.S. government or its agencies, enterprises, or corporations, 
or fully insured by the NCUA or the Federal Deposit Insurance 
Corporation. 12 CFR 703.40(d). FCUs are not required to express credit 
exposure in terms of risk to capital and, except for municipal bonds 
and privately issued mortgage related securities, FCUs are not required 
to obtain or monitor credit ratings on the issue or issuer. The ANPR 
solicited comments as to whether standards should be set.
    Six commenters supported NCUA setting regulatory standards for 
evaluating investment credit risk. Fourteen commenters opposed 
regulatory standards, but supported NCUA guidelines to assist FCUs in 
assessing credit risk on their own without hampering their ability to 
manage their investments according to their individual risk management 
capabilities. Six commenters suggested that, unless an investment is 
fully insured or guaranteed by the U.S. government or its agencies, it 
should only be permissible for FCUs if it meets certain minimum credit 
ratings as established by a national rating organization such as 
Moody's or Standard and Poor's. NCUA has determined that the current 
rule sufficiently encourages FCUs to adopt prudent credit review 
practices and that no revisions are necessary at this time. Further, if 
NCUA established specific, minimum criteria such as credit ratings and 
capital-at-risk levels, it might encourage credit unions to forsake 
other prudent credit evaluation practices, for example, monitoring 
pertinent current events and news stories or reviewing financial 
statements.

6. Borrowing Repurchase Transaction

    Borrowing repurchase transactions, presently referred to as reverse 
repurchase transactions in Sec.  703.100(j), enable an FCU to sell 
securities under an agreement to repurchase in order to borrow funds. 
12 CFR 703.100(j). Section 703.100(j)(2) prohibits an FCU from 
purchasing an investment with the proceeds from a borrowing repurchase 
agreement if the purchased investment matures after the maturity of the 
borrowing repurchase agreement. 12 CFR 703.100(j)(2). Before this 
restriction, FCUs could incur significant interest rate risk by 
borrowing funds at short-term interest rates and investing in long-term 
fixed rate instruments. Problems can result when the spreads between 
short-term and long-term rates narrow, adversely affecting earnings and 
capital. NCUA has not imposed similar prohibitions for other borrowing 
arrangements. For example, if an FCU borrows funds without engaging in 
a borrowing repurchase agreement, it is not limited by the maturity 
limit of Sec.  703.100(j)(2) when it invests the proceeds.
    The ANPR solicited comments on whether removing this restriction 
would raise liquidity or safety and soundness concerns and whether an 
approval process is preferable to removing the restriction. Twenty 
commenters supported NCUA removing the maturity limit restriction on 
borrowing repurchase transactions without imposing on FCUs a prior 
approval requirement. Three commenters stated they did not want the 
restriction removed.
    One of the commenters that opposed removing the restriction stated 
there are risks associated with this kind of activity and there should 
be regulatory limitations to mitigate that risk. That commenter further 
stated that borrowing repurchase transactions are typically used for 
positive arbitrage opportunities. Interest rate risk is created if the 
proceeds of the transaction are invested significantly shorter or 
longer than the borrowing transaction.
    The NCUA agrees with this commenter and intends to leave in place 
the prohibition on purchasing an investment with the proceeds from a 
borrowing repurchase transaction if the purchased investment matures 
after the maturity of the borrowing repurchase transaction. To increase 
flexibility for qualified credit unions, however, the NCUA proposes to 
expand RegFlex in proposed Sec.  742.4 to include a limited exemption 
from this restriction. Specifically, RegFlex eligible FCUs will be able 
to purchase securities with maturities exceeding the maturity of the 
borrowing repurchase transaction in an amount not to exceed the credit 
union's net worth.

7. Investment Repurchase Transaction

    Section 703.100(i) defines repurchase transactions. 12 CFR 
703.100(i). The proposed rule renames them ``investment repurchase 
transactions'' and conforms the requirements for investment repurchase 
transactions to those of securities lending transactions. Other than 
these revisions, the proposal does not make any substantive amendments 
in this regard.

8. Securities Lending Transaction

    Section 703.100(k) addresses securities lending transactions and 
requires the FCU to take a perfected first priority security interest 
in all collateral the FCU receives. 12 CFR 703.100(k). Proposed Sec.  
703.13 removes the word ``perfected'', but still requires a first 
priority security interest through possession or control of the 
collateral. Often, under state law, possession or control of collateral 
constitutes a perfected security interest. In addition, the proposed 
rule clarifies that an FCU's agent may act in its place in these 
transactions.

9. Purchase of Equity-linked Options

    Although Sec.  703.110(a) prohibits FCUs from purchasing financial 
derivatives, including options, 12 CFR 703.110(a), NCUA has approved an 
investment pilot program permitting a vendor to act as agent for an FCU 
to purchase equity-linked options for limited purposes. Specifically, 
under the pilot program, an FCU may offer share certificates where the 
dividend rate is tied to the performance of the S&P 500 stock index and 
may purchase equity-linked options to fund the dividend. NCUA has 
placed limitations on the pilot program to minimize risk and continues 
to prohibit FCUs from investing in options for their own accounts.
    Because of the positive experience with the pilot program, the ANPR 
stated that NCUA was considering amending the investment regulation to 
make the purchase of equity-linked options a permissible investment 
activity for FCUs for the limited purpose of funding equity-linked 
dividends. The ANPR discussed potential regulatory limitations to this 
new authority and solicited comments. Fourteen commenters supported 
FCUs being permitted to purchase equity-linked options for the purpose 
of offering equity-linked dividends to their

[[Page 79000]]

members and also supported the limitations suggested by NCUA. Two 
commenters opposed FCUs being given permission to purchase equity-
linked options.
    Proposed Sec.  703.14 expands permissible investment activities for 
all FCUs to permit them to purchase equity-linked options for the sole 
purpose of offering equity-linked dividends to their members, subject 
to limitations including: (1) Maximum shares permitted in the program; 
(2) minimum counterparty rating; (3) collateral requirements; (4) 
option proceeds to fund dividend costs only; (5) final maturity of the 
options coincide with the maturity of the share account; and (6) 
minimum monthly reporting requirements. FCUs are still prohibited from 
investing in options for their own accounts.

10. Investment Advisers

    Section 703.40(c)(2) currently requires an FCU to analyze an 
investment adviser's background, including whether there are any 
enforcement actions against the adviser or the adviser's associated 
personnel before transacting business with the adviser. 12 CFR 
703.40(c)(2). NCUA proposes to amend this provision to clarify that, as 
part of this background check, an FCU should analyze the background of 
the firm for whom the investment adviser works, in addition to the 
investment adviser and associated personnel.

11. Recordkeeping and Generally Accepted Accounting Principles

    The Act provides that the accounting principles applicable to 
reports or statements required to be filed with the NCUA by insured 
credit unions, except those with total assets of less than $10 million, 
must be uniform and consistent with generally accepted accounting 
principles (GAAP). 12 U.S.C. 1782a(a)(6)(C). The accounting standard 
required in Sec.  703.40(a) only requires FCUs to classify their 
securities as hold-to-maturity, available-for-sale, or trading, in 
accordance with GAAP. 12 CFR 703.40(a). Accordingly, in proposed Sec.  
703.4, NCUA proposes to revise that rule to clarify that FCUs having 
total assets of $10 million or more must comply with all GAAP 
provisions related to the accounting principles applicable to reports 
or statements required to be filed with the NCUA, not just selected 
ones. While not mandatory for FCUs with total assets of less than $10 
million, NCUA encourages them also to comply with GAAP or to account 
for their investments consistent with the NCUA Accounting Manual For 
Federal Credit Unions (Accounting Manual). NCUA recognizes that at the 
present the Accounting Manual, which can be found on NCUA's web site, 
is only in draft form.

12. Net Worth

    Part 703 defines the term ``net capital'' and uses an FCU's net 
capital, or percentage of net capital, as the basis for measuring and 
specifying limits on some of an FCU's investment activities. Amendments 
to the Act related to prompt corrective action define ``net worth'' and 
use net worth as its unit of measure instead of net capital. To be 
consistent, NCUA proposes to replace in the investment rule all 
references to ``net capital'' with ``net worth.''

13. Format

    The ANPR solicited comments as to whether the format of part 703 
needs to be changed. Nine commenters stated that the current format of 
part 703 should be changed to make the rule easier to read and more 
conducive to finding information quickly. They suggested eliminating 
the question and answer format and dividing large, cumbersome sections 
of the rule into smaller, distinct sections with individual topic 
headings. Two commenters preferred the current format remain unchanged. 
NCUA agrees with the nine commenters who favor a more user-friendly 
investment rule and proposes to reformat the rule.
    As part of this effort to make the investment rule easier to read 
and locate information, NCUA proposes to revise the manner in which 
specific terms are defined. Specifically, the proposed rule adds a 
number of new definitions, deletes a number of existing definitions, 
and segregates all definitions into proposed Sec.  703.2 to make the 
rule easier to understand.

Regulatory Procedures

Regulatory Flexibility Act

    The Regulatory Flexibility Act requires NCUA to prepare an analysis 
to describe any significant economic impact a proposed rule may have on 
a substantial number of small credit unions (those under one million 
dollars in assets). The proposed rule clarifies the investment 
authority granted to FCUs and conforms the regulatory flexibility 
program to the investment rule. The proposed rule would not have a 
significant economic impact on a substantial number of small credit 
unions, and, therefore, a regulatory flexibility analysis is not 
required.

Paperwork Reduction Act

    The current Office of Management and Budget control number assigned 
to Part 703 is 3133-0133. NCUA has determined that the proposed rule 
would not increase paperwork requirements under the Paperwork Reduction 
Act of 1995 and regulations of the Office of Management and Budget.

Executive Order 13132

    Executive Order 13132 encourages independent regulatory agencies to 
consider the impact of their actions on state and local interests. In 
adherence to fundamental federalism principles, NCUA, an independent 
regulatory agency as defined in 44 U.S.C. 3502(5), voluntarily complies 
with the executive order. The proposed rule would not have substantial 
direct effects on the states, on the connection between the national 
government and the states, or on the distribution of power and 
responsibilities among the various levels of government. NCUA has 
determined that this proposed rule does not constitute a policy that 
has federalism implications for purposes of the executive order.

The Treasury and General Government Appropriations Act, 1999--
Assessment of Federal Regulations and Policies on Families

    The NCUA has determined that this proposed rule would not affect 
family well-being within the meaning of section 654 of the Treasury and 
General Government Appropriations Act, 1999, Public Law 105-277, 112 
Stat. 2681 (1998).

Agency Regulatory Goal

    NCUA's goal is to promulgate clear and understandable regulations 
that impose minimal regulatory burden. We request your comments on 
whether the proposed rule is understandable and minimally intrusive.

List of Subjects

12 CFR Part 703

    Credit unions, Investments.

12 CFR Part 742

    Credit unions, Reporting and recordkeeping requirements.

    By the National Credit Union Administration Board on December 
19, 2002.
Becky Baker,
Secretary of the Board.

    Accordingly, NCUA proposes to amend 12 CFR parts 703 and 742 as 
follows:

[[Page 79001]]

PART 703--ORGANIZATION AND OPERATIONS OF FEDERAL CREDIT UNIONS

    1. The authority citation for part 703 continues to read as 
follows:

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

    2. Revise part 703 to read as follows:

PART 703--INVESTMENT AND DEPOSIT ACTIVITIES

Sec.
703.1 Purpose and scope.
703.2 Definitions.
703.3 Investment policies.
703.4 Recordkeeping and documentation requirements.
703.5 Discretionary control over investments and investment 
advisers.
703.6 Credit analysis.
703.7 Notice of non-compliant investments.
703.8 Broker-dealers.
703.9 Safekeeping of investments.
703.10 Monitoring non-security investments.
703.11 Valuing securities.
703.12 Monitoring securities.
703.13 Permissible investment activities.
703.14 Permissible investments.
703.15 Prohibited investment activities.
703.16 Prohibited investments.
703.17 Conflicts of interest.
703.18 Grandfathered Investments.
703.19 Investment pilot program.


Sec.  703.1  Purpose and scope.

    (a) This part interprets several of the provisions of sections 
107(7), 107(8), and 107(15) of the Federal Credit Union Act (Act), 12 
U.S.C. 1757(7), 1757(8), 1757(15), which list those securities, 
deposits, and other obligations in which a federal credit union may 
invest. Part 703 identifies certain investments and deposit activities 
permissible under the Act and prescribes regulations governing those 
investments and deposit activities on the basis of safety and soundness 
concerns. Additionally, part 703 identifies and prohibits certain 
investments and deposit activities. Investments and deposit activities 
that are permissible under the Act and not prohibited or otherwise 
regulated by part 703 remain permissible for federal credit unions.
    (b) This part does not apply to:
    (1) Investment in loans to members and related activities, which is 
governed by Sec. Sec.  701.21, 701.22, 701.23, and part 723 of this 
chapter;
    (2) The purchase of real estate-secured loans pursuant to section 
107(15)(A) of the Act, which is governed by Sec.  701.23 of this 
chapter;
    (3) Investment in credit union service organizations, which is 
governed by part 712 of this chapter;
    (4) Investment in fixed assets, which is governed by Sec.  701.36 
of this chapter;
    (5) Investment by corporate credit unions, which is governed by 
part 704 of this chapter; or
    (6) Investment activity by state-chartered credit unions, except as 
provided in Sec.  741.3(a)(3) of this chapter.


Sec.  703.2  Definitions.

    The following definitions apply to this part:
    (a) Adjusted trading means selling an investment to a counterparty 
at a price above its current fair value and simultaneously purchasing 
or committing to purchase from the counterparty another investment at a 
price above its current fair value.
    (b) Associated personnel means a person engaged in the investment 
banking or securities business who is directly or indirectly controlled 
by a National Association of Securities Dealers (NASD) member, whether 
or not this person is registered or exempt from registration with NASD. 
Associated personnel includes every sole proprietor, partner, officer, 
director, or branch manager of any NASD member.
    (c) Bank note means a direct, unconditional, and unsecured general 
obligation of a bank that ranks equally with all other senior unsecured 
indebtedness of the bank, except deposit liabilities and other 
obligations that are subject to any priorities or preferences.
    (d) Banker's acceptance means a time draft that is drawn on and 
accepted by a bank and that represents an irrevocable obligation of the 
bank.
    (e) Borrowing repurchase transaction means a transaction in which 
the federal credit union agrees to sell a security to a counterparty 
and to repurchase the same or an identical security from that 
counterparty at a specified future date and at a specified price.
    (f) Call means an option that gives the holder the right to buy the 
underlying security at a specified price during a fixed time period.
    (g) Collective investment fund means a fund maintained by a 
national bank under part 9 of the Comptroller of the Currency's 
regulations.
    (h) Commercial mortgage related security means a mortgage related 
security, as defined below, except that it is collateralized entirely 
by commercial real estate, such as a warehouse or office building, or a 
multi-family dwelling consisting of more than four units.
    (i) Counterparty means the party on the other side of the 
transaction.
    (j) Custodial agreement means a contract in which one party agrees 
to exercise ordinary care in protecting the securities held in 
safekeeping for others.
    (k) Delivery versus payment means payment for an investment must 
occur simultaneously with its delivery.
    (l) Deposit note means an obligation of a bank that is similar to a 
certificate of deposit but is rated.
    (m) Derivatives means financial instruments or other contracts 
whose value is based on the performance of an underlying financial 
asset, index or other investment that have the three following 
characteristics:
    (1) It has one or more underlyings and one or more notional amounts 
or payment provisions or both that determine the amount of the 
settlement or settlements, and, in some cases, whether or not a 
settlement is required;
    (2) It requires no initial net investment or an initial net 
investment that is less than would be required for other types of 
contracts that would be expected to have a similar response to changes 
in market factors; and
    (3) Its terms require or permit net settlement, it can readily be 
settled net by means outside the contract, or it provides for delivery 
of an asset that puts the recipient in a position not substantially 
different from net settlement.
    (n) Embedded option means a characteristic of an investment that 
gives the issuer or holder the right to alter the level and timing of 
the cash flows of the investment. Embedded options include call and put 
provisions and interest rate caps and floors. Since a prepayment option 
in a mortgage is a type of call provision, a mortgage-backed security 
composed of mortgages that may be prepaid is an example of an 
investment with an embedded option.
    (o) Eurodollar deposit means a U.S. dollar-denominated deposit in a 
foreign branch of a United States depository institution.
    (p) European financial options contract means an option that can be 
exercised only on its expiration date.
    (q) Fair value means the amount at which an instrument could be 
exchanged in a current, arms-length transaction between willing 
parties, as opposed to a forced or liquidation sale.
    (r) Financial options contract means an agreement to make or take 
delivery of a standardized financial instrument upon demand by the 
holder of the contract as specified in the agreement.
    (s) Immediate family member means a spouse or other family member 
living in the same household.
    (t) Industry-recognized information provider means an organization 
that obtains compensation by providing information to investors and 
receives no compensation for the purchase or sale of investments.

[[Page 79002]]

    (u) Investment means any security, obligation, account, deposit, or 
other item authorized for purchase by a federal credit union under 
sections 107(7), 107(8), or 107(15) of the Act, or this part, other 
than loans to members.
    (v) Investment repurchase transaction means a transaction in which 
an investor agrees to purchase a security from a counterparty and to 
resell the same or an identical security to that counterparty at a 
specified future date and at a specified price.
    (w) Maturity means the date the last principal amount of a security 
is scheduled to come due and does not mean the call date or the 
weighted average life of a security.
    (x) Mortgage related security means a security as defined in 
section 3(a)(41) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(41)), e.g., a privately-issued security backed by first lien 
mortgages secured by real estate upon which is located a dwelling, 
mixed residential and commercial structure, residential manufactured 
home, or commercial structure, that is rated in one of the two highest 
rating categories by at least one nationally-recognized statistical 
rating organization.
    (y) Mortgage servicing rights means a contractual obligation to 
perform mortgage servicing and the right to receive compensation for 
performing those services. Mortgage servicing is the administration of 
a mortgage loan, including collecting monthly payments and fees, 
providing recordkeeping and escrow functions, and, if necessary curing 
defaults and foreclosing.
    (z) Negotiable instrument means an instrument that may be freely 
transferred from the purchaser to another person or entity by delivery, 
or endorsement and delivery, with full legal title becoming vested in 
the transferee.
    (aa) Net worth means the retained earnings balance of the credit 
union at quarter end as determined under generally accepted accounting 
principles and as further defined in Sec.  702.2(f) of this chapter.
    (bb) Official means any member of a federal credit union's board of 
directors, credit committee, supervisory committee, or investment-
related committee.
    (cc) Ordinary care means the degree of care, which an ordinarily 
prudent and competent person engaged in the same line of business or 
endeavor should exercise under similar circumstances.
    (dd) Pair-off transaction means an investment purchase transaction 
that is closed or sold on, or before the settlement date. In a pair-
off, an investor commits to purchase an investment, but then pairs-off 
the purchase with a sale of the same investment before or on the 
settlement date.
    (ee) Put means a financial options contract that entitles the 
holder to sell, entirely at the holder's option, a specified quantity 
of a security at a specified price at any time until the stated 
expiration date of the contract.
    (ff) Registered investment company means an investment company that 
is registered with the Securities and Exchange Commission under the 
Investment Company Act of 1940 (15 U.S.C. 80a). Examples of registered 
investment companies are mutual funds and unit investment trusts.
    (gg) Regular way settlement means delivery of a security from a 
seller to a buyer within the time frame that the securities industry 
has established for immediate delivery of that type of security. For 
example, regular way settlement of a Treasury security includes 
settlement on the trade date (cash), the business day following the 
trade date (regular way), and the second business day following the 
trade date (skip day).
    (hh) Residual interest means the remainder cash flows from 
collateralized mortgage obligations/real estate mortgage investment 
conduits (CMOs/REMICs), or other mortgage-backed security transaction, 
after payments due bondholders and trust administrative expenses have 
been satisfied.
    (ii) Securities lending means lending a security to a counterparty, 
either directly or through an agent, and accepting collateral in 
return.
    (jj) Security means a share, participation, or other interest in 
property or in an enterprise of the issuer or an obligation of the 
issuer that: (1) Either is represented by an instrument issued in 
bearer or registered form or, if not represented by an instrument, is 
registered in books maintained to record transfers by or on behalf of 
the issuer; (2) Is of a type commonly dealt in on securities exchanges 
or markets or, when represented by an instrument, is commonly 
recognized in any area in which it is issued or dealt in as a medium 
for investment; and (3) Either is one of a class or series or by its 
terms is divisible into a class or series of shares, participations, 
interests, or obligations.
    (kk) Senior management employee means a federal credit union's 
chief executive officer (typically this individual holds the title of 
President or Treasurer/Manager), an assistant chief executive officer, 
and the chief financial officer.
    (ll) Small business related security means a security as defined in 
section 3(a)(53) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(53)), e.g., a security that is rated in 1 of the 4 highest 
rating categories by at least one nationally recognized statistical 
rating organization, and represents an interest in 1 or more promissory 
notes or leases of personal property evidencing the obligation of a 
small business concern and originated by an insured depository 
institution, insured credit union, insurance company, or similar 
institution which is supervised and examined by a Federal or State 
authority, or a finance company or leasing company. This definition 
does not include Small Business Administration securities permissible 
under section 107(7) of the Act.
    (mm) Weighted average life means the weighted-average time to the 
return of a dollar of principal, calculated by multiplying each portion 
of principal received by the time at which it is expected to be 
received (based on a reasonable and supportable estimate of that time) 
and then summing and dividing by the total amount of principal.
    (nn) When-issued trading of securities means the buying and selling 
of securities in the period between the announcement of an offering and 
the issuance and payment date of the securities.
    (oo) Yankee dollar deposit means a deposit in a United States 
branch of a foreign bank licensed to do business in the state in which 
it is located, or a deposit in a state-chartered, foreign controlled 
bank.
    (pp) Zero coupon investment means an investment that makes no 
periodic interest payments but instead is sold at a discount from its 
face value. The holder of a zero coupon investment realizes the rate of 
return through the gradual appreciation of the investment, which is 
redeemed at face value on a specified maturity date.


Sec.  703.3  Investment policies.

    A federal credit union's board of directors must establish written 
investment policies consistent with the Act, this part, and other 
applicable laws and regulations and must review the policy at least 
annually. These policies may be part of a broader, asset-liability 
management policy. Written investment policies must address the 
following:
    (a) The purposes and objectives of the federal credit union's 
investment activities;
    (b) The characteristics of the investments the federal credit union 
may make including the issuer,

[[Page 79003]]

maturity, index, cap, floor, coupon rate, coupon formula, call 
provision, average life, and interest rate risk;
    (c) How the federal credit union will manage interest rate risk;
    (d) How the federal credit union will manage liquidity risk;
    (e) How the federal credit union will manage credit risk including 
specifically listing institutions, issuers, and counterparties that may 
be used, or criteria for their selection, and limits on the amounts 
that may be invested with each;
    (f) How the federal credit union will manage concentration risk, 
which can result from dealing with a single or related issuers, lack of 
geographic distribution, holding obligations with similar 
characteristics like maturities and indexes, holding bonds having the 
same trustee, and holding securitized loans having the same originator, 
packager, or guarantor;
    (g) Who has investment authority and the extent of that authority. 
Those with authority must be qualified by education or experience to 
assess the risk characteristics of investments and investment 
transactions. Only those individuals with investment authority may be 
voting members of an investment committee;
    (h) The broker-dealers the federal credit union may use;
    (i) The safekeepers the federal credit union may use;
    (j) How the federal credit union will handle an investment that, 
after purchase, is outside of board policy or fails a requirement of 
this part; and
    (k) How the federal credit union will conduct investment trading 
activities, if applicable, including addressing:
    (1) Who has purchase and sale authority;
    (2) Limits on trading account size;
    (3) Allocation of cash flow to trading accounts;
    (4) Stop loss or sale provisions;
    (5) Dollar size limitations of specific types, quantity and 
maturity to be purchased;
    (6) Limits on the length of time an investment may be inventoried 
in a trading account; and
    (7) Internal controls, including segregation of duties.


Sec.  703.4  Recordkeeping and documentation requirements.

    (a) Federal credit unions with assets of $10,000,000 or greater 
must comply with all generally accepted accounting principles 
applicable to reports or statements required to be filed with the NCUA. 
Federal credit unions with assets less than $10,000,000 are encouraged 
to do the same, but are not required to do so. Federal credit unions 
with assets less than $10,000,000 may choose to account for their 
investments consistent with the NCUA Accounting Manual For Federal 
Credit Unions.
    (b) A federal credit union must maintain documentation for each 
investment transaction for as long as it holds the investment and until 
the documentation has been audited in accordance with Sec.  701.12 of 
this chapter and examined by NCUA. The documentation should include, 
where applicable, bids and prices at purchase and sale and for periodic 
updates, relevant disclosure documents or a description of the security 
from an industry-recognized information provider, financial data, and 
tests and reports required by the federal credit union's investment 
policy and this part.
    (c) A federal credit union must maintain documentation its board of 
directors used to approve a broker-dealer or a safekeeper for as long 
as the broker-dealer or safekeeper is approved and until the 
documentation has been audited in accordance with Sec.  701.12 of this 
chapter and examined by NCUA.
    (d) A federal credit union must obtain an individual confirmation 
statement from each broker-dealer for each investment purchased or 
sold.


Sec.  703.5  Discretionary control over investments and investment 
advisers.

    (a) Except as provided in paragraph (b) of this section, a federal 
credit union must retain discretionary control over its purchase and 
sale of investments. A federal credit union has not delegated 
discretionary control to an investment adviser when the federal credit 
union reviews all recommendations from investment advisers and is 
required to authorize a recommended purchase or sale transaction before 
its execution.
    (b)(1) A federal credit union may delegate discretionary control 
over the purchase and sale of investments to a person other than a 
federal credit union official or employee:
    (i) Provided the person is an investment adviser registered with 
the Securities and Exchange Commission under the Investment Advisers 
Act of 1940 (15 U.S.C. 80b); and
    (ii) In an amount up to 100 percent of its net worth in the 
aggregate at the time of delegation.
    (2) At least annually, the federal credit union must adjust the 
amount of funds held under discretionary control to comply with the 100 
percent of net worth cap. The federal credit union's board of directors 
must receive notice as soon as possible, but no later than the next 
regularly scheduled board meeting, of the amount exceeding the net 
worth cap and notify in writing the appropriate regional director 
within 5 days after the board meeting. The credit union must develop a 
plan to comply with the cap within a reasonable period of time.
    (3) Before transacting business with an investment adviser, a 
federal credit union must analyze his or her background and information 
available from state or federal securities regulators, including any 
enforcement actions against the adviser, associated personnel, and the 
firm for which the adviser works.
    (c) A federal credit union may not compensate an investment adviser 
with discretionary control over the purchase and sale of investments on 
a per transaction basis or based on capital gains, capital 
appreciation, net income, performance relative to an index, or any 
other incentive basis.
    (d) A federal credit union must obtain a report from its investment 
adviser at least monthly that details the investments under the 
adviser's control and their performance.


Sec.  703.6  Credit analysis.

    A federal credit union must conduct and document a credit analysis 
on an investment and the issuing entity before purchasing it, except 
for investments issued or fully guaranteed as to principal and interest 
by the U.S. government or its agencies, enterprises, or corporations or 
fully insured (including accumulated interest) by the National Credit 
Union Administration or the Federal Deposit Insurance Corporation. A 
federal credit union must update this analysis at least annually for as 
long as it holds the investment.


Sec.  703.7  Notice of non-compliant investments.

    A federal credit union's board of directors must receive notice as 
soon as possible, but no later than the next regularly scheduled board 
meeting, of any investment that either is outside of board policy after 
purchase or has failed a requirement of this part. The board of 
directors must document its action regarding the investment in the 
minutes of the board meeting, including a detailed explanation of any 
decision not to sell it. The federal credit union must notify in 
writing the appropriate regional director of an investment that has 
failed a requirement of this part within 5 days after the board 
meeting.


Sec.  703.8  Broker-dealers.

    (a) A federal credit union may purchase and sell investments 
through a broker-dealer as long as the broker-

[[Page 79004]]

dealer is registered as a broker-dealer with the Securities and 
Exchange Commission under the Securities Exchange Act of 1934 (15 
U.S.C. 78a et seq.) or is a depository institution whose broker-dealer 
activities are regulated by a federal or state regulatory agency.
    (b) Before purchasing an investment through a broker-dealer, a 
federal credit union must analyze and annually update the following:
    (1) The background of any sales representative with whom the 
federal credit union is doing business;
    (2) Information available from state or federal securities 
regulators and securities industry self-regulatory organizations, such 
as the National Association of Securities Dealers and the North 
American Securities Administrators Association, about any enforcement 
actions against the broker-dealer, its affiliates, or associated 
personnel; and
    (3) If the broker-dealer is acting as the federal credit union's 
counterparty, the ability of the broker-dealer and its subsidiaries or 
affiliates to fulfill commitments, as evidenced by capital strength, 
liquidity, and operating results. The federal credit union should 
consider current financial data, annual reports, reports of nationally-
recognized statistical rating agencies, relevant disclosure documents, 
and other sources of financial information.


Sec.  703.9  Safekeeping of investments.

    (a) A federal credit union's purchased investments and repurchase 
collateral must be in the federal credit union's possession, recorded 
as owned by the federal credit union through the Federal Reserve Book-
Entry System, or held by a board-approved safekeeper under a written 
custodial agreement that requires the safekeeper to exercise, at least, 
ordinary care.
    (b) Any safekeeper used by a federal credit union must be regulated 
and supervised by either the Securities and Exchange Commission, a 
federal or state depository institution regulatory agency, or a state 
trust company regulatory agency.
    (c) A federal credit union must obtain and reconcile monthly a 
statement of purchased investments and repurchase collateral held in 
safekeeping.
    (d) Annually, the federal credit union must analyze the ability of 
the safekeeper to fulfill its custodial responsibilities, as evidenced 
by capital strength, liquidity, and operating results. The federal 
credit union should consider current financial data, annual reports, 
reports of nationally-recognized statistical rating agencies, relevant 
disclosure documents, and other sources of financial information.


Sec.  703.10  Monitoring non-security investments.

    (a) At least quarterly, a federal credit union must prepare a 
written report listing all of its shares and deposits in banks, credit 
unions, and other depository institutions, that have one or more of the 
following features:
    (1) Embedded options;
    (2) Remaining maturities greater than 3 years; or
    (3) Coupon formulas that are related to more than one index or are 
inversely related to, or multiples of, an index.
    (b) The requirement of paragraph (a) of this section does not apply 
to shares and deposits that are securities.
    (c) If a federal credit union does not have an investment-related 
committee, then each member of its board of directors must receive a 
copy of the report described in paragraph (a) of this section. If a 
federal credit union has an investment-related committee, then each 
member of the committee must receive a copy of the report, and each 
member of the board must receive a summary of the information in the 
report.


Sec.  703.11  Valuing securities.

    (a) Before purchasing or selling a security, a federal credit union 
must obtain either price quotations on the security from at least two 
broker-dealers or a price quotation on the security from an industry-
recognized information provider. This requirement to obtain price 
quotations does not apply to new issues purchased at par or at original 
issue discount.
    (b) At least monthly, a federal credit union must determine the 
fair value of each security it holds. It may determine fair value by 
obtaining a price quotation on the security from an industry-recognized 
information provider, a broker-dealer, or a safekeeper.
    (c) At least annually, the federal credit union's supervisory 
committee or its external auditor must independently assess the 
reliability of monthly price quotations received from a broker-dealer 
or safekeeper. The federal credit union's supervisory committee or 
external auditor must follow generally accepted auditing standards, 
which require either re-computation or reference to market quotations.
    (d) If a federal credit union is unable to obtain a price quotation 
required by this section for a particular security, then it may obtain 
a quotation for a security with substantially similar characteristics.


Sec.  703.12  Monitoring securities.

    (a) At least monthly, a federal credit union must prepare a written 
report setting forth, for each security held, the fair value and dollar 
change since the prior month-end, with summary information for the 
entire portfolio.
    (b) At least quarterly, a federal credit union must prepare a 
written report setting forth the sum of the fair values of all fixed 
and variable rate securities held that have one or more of the 
following features:
    (1) Embedded options;
    (2) Remaining maturities greater than 3 years; or
    (3) Coupon formulas that are related to more than one index or are 
inversely related to, or multiples of, an index.
    (c) Where the amount calculated in paragraph (b) of this section is 
greater than a federal credit union's net worth, the report described 
in that paragraph must provide a reasonable and supportable estimate of 
the potential impact, in percentage and dollar terms, of an immediate 
and sustained parallel shift in market interest rates of plus and minus 
300 basis points on:
    (1) The fair value of each security in the federal credit union's 
portfolio;
    (2) The fair value of the federal credit union's portfolio as a 
whole; and
    (3) The federal credit union's net worth.
    (d) If the federal credit union does not have an investment-related 
committee, then each member of its board of directors must receive a 
copy of the reports described in paragraphs (a) through (c) of this 
section. If the federal credit union has an investment-related 
committee, then each member of the committee must receive copies of the 
reports, and each member of the board of directors must receive a 
summary of the information in the reports.


Sec.  703.13  Permissible investment activities.

    (a) Regular way settlement and delivery versus payment basis. A 
federal credit union may only contract for the purchase or sale of a 
security as long as the delivery of the security is by regular way 
settlement and the transaction is accomplished on a delivery versus 
payment basis.
    (b) Federal funds. A federal credit union may sell federal funds to 
an institution described in Section 107(8) of the Act and credit 
unions, as long as the interest or other consideration received from 
the financial institution is at the market rate for federal funds 
transactions.
    (c) Investment repurchase transaction. A federal credit union may 
enter into an investment repurchase transaction so long as:

[[Page 79005]]

    (1) Any securities the federal credit union receives are 
permissible investments for federal credit unions, the federal credit 
union, or its agent, either takes physical possession or control of the 
repurchase securities or is recorded as owner of them through the 
Federal Reserve Book Entry Securities Transfer System, the federal 
credit union, or its agent, receives a daily assessment of their market 
value, including accrued interest, and the federal credit union 
maintains adequate margins that reflect a risk assessment of the 
securities and the term of the transaction; and
    (2) The federal credit union has entered into signed contracts with 
all approved counterparties.
    (d) Borrowing repurchase transaction. A federal credit union may 
enter into a borrowing repurchase transaction so long as:
    (1) The transaction meets the requirements of paragraph (c) of this 
section;
    (2) Any cash the federal credit union receives is subject to the 
borrowing limit specified in Section 107(9) of the Act, and any 
investments the federal credit union purchases with that cash are 
permissible for federal credit unions; and
    (3) The investments referenced in paragraph (d)(2) of this section 
mature no later than the maturity of the borrowing repurchase 
transaction.
    (e) Securities lending transaction. A federal credit union may 
enter into a securities lending transaction so long as:
    (1) The federal credit union receives written confirmation of the 
loan;
    (2) Any collateral the federal credit union receives is a legal 
investment for federal credit unions, the federal credit union, or its 
agent, obtains a first priority security interest in the collateral by 
taking physical possession or control of the collateral, or is recorded 
as owner of the collateral through the Federal Reserve Book Entry 
Securities Transfer System; and the federal credit union, or its agent, 
receives a daily assessment of the market value of the collateral, 
including accrued interest, and maintains adequate margin that reflects 
a risk assessment of the collateral and the term of the loan;
    (3) Any cash the federal credit union receives is subject to the 
borrowing limit specified in section 107(9) of the Act, and any 
investments the federal credit union purchases with that cash are 
permissible for federal credit unions and mature no later than the 
maturity of the transaction; and
    (4) The federal credit union has executed a written loan and 
security agreement with the borrower.
    (f)(1) Trading securities. A federal credit union may trade 
securities, including engaging in when-issued trading and pair-off 
transactions, so long as the federal credit union can show that it has 
sufficient resources, knowledge, systems, and procedures to handle the 
risks.
    (2) A federal credit union must record any security it purchases or 
sells for trading purposes at fair value on the trade date. The trade 
date is the date the federal credit union commits, orally or in 
writing, to purchase or sell a security.
    (3) At least monthly, the federal credit union must give its board 
of directors or investment-related committee a written report listing 
all purchase and sale transactions of trading securities and the 
resulting gain or loss on an individual basis.


Sec.  703.14  Permissible investments.

    (a) Variable rate investment. A federal credit union may invest in 
a variable rate investment, as long as the index is tied to domestic 
interest rates and not, for example, to foreign currencies, foreign 
interest rates, or domestic or foreign commodity prices, equity prices, 
or inflation rates. For purposes of this part, the U.S. dollar-
denominated London Interbank Offered Rate (LIBOR) is a domestic 
interest rate.
    (b) Corporate credit union shares or deposits. A federal credit 
union may purchase shares or deposits in a corporate credit union, 
except where the NCUA Board has notified it that the corporate credit 
union is not operating in compliance with part 704 of this chapter. A 
federal credit union's aggregate amount of paid-in capital and 
membership capital, as defined in part 704 of this chapter, in one 
corporate credit union is limited to two percent of its assets measured 
at the time of investment or adjustment. A federal credit union's 
aggregate amount of paid-in capital and membership capital in all 
corporate credit unions is limited to four percent of its assets 
measured at the time of investment or adjustment.
    (c) Registered investment company. A federal credit union may 
invest in a registered investment company or collective investment 
fund, as long as the prospectus of the company or fund restricts the 
investment portfolio to investments and investment transactions that 
are permissible for federal credit unions.
    (d) Collateralized mortgage obligation/real estate mortgage 
investment conduit. A federal credit union may invest in a fixed or 
variable rate collateralized mortgage obligation/real estate mortgage 
investment conduit.
    (e) Municipal security. A federal credit union may purchase and 
hold a municipal security, as defined in section 107(7)(K) of the Act, 
only if a nationally-recognized statistical rating organization has 
rated it in one of the four highest rating categories.
    (f) Instruments issued by institutions described in section 107(8) 
of the Act. A federal credit union may invest in the following 
instruments issued by an institution described in section 107(8) of the 
Act:
    (1) Yankee dollar deposits;
    (2) Eurodollar deposits;
    (3) Banker's acceptances;
    (4) Deposit notes; and
    (5) Bank notes with original weighted average maturities of less 
than five years.
    (g) European financial options contract. A federal credit union may 
purchase a European financial options contract or a series of European 
financial options contracts only to fund the payment of dividends on 
member share certificates where the dividend rate is tied to an equity 
index provided:
    (1) The option and dividend rate are based on a domestic equity 
index;
    (2) Proceeds from the options are used only to fund dividends on 
the equity-linked share certificates;
    (3) Dividends on the share certificates are derived solely from the 
change in the domestic equity index over a specified period;
    (4) The options' expiration dates coincide with the maturity date 
of the share certificate;
    (5) The certificate may be redeemed prior to the maturity date only 
upon the member's death or termination of the corresponding option;
    (6) The total costs associated with the purchase of the option is 
known by the federal credit union prior to effecting the transaction;
    (7) The options are purchased at the same time the certificate is 
issued to the member.
    (8) The counterparty to the transaction is a domestic counterparty 
and has been approved by the federal credit union's board of directors;
    (9) The counterparty to the transaction:
    (i) Has a long-term, senior, unsecured debt rating from a 
nationally-recognized statistical rating organization of AA- (or 
equivalent) or better at the time of the transaction, and the contract 
between the counterparty and the federal credit union specifies that if 
the long-term, senior, unsecured debt rating declines below AA- (or 
equivalent) then the counterparty agrees to post collateral with an 
independent party in an amount fully securing the value of the option; 
or

[[Page 79006]]

    (ii) Posts collateral with an independent party in an amount fully 
securing the value of the option if the counterparty does not have a 
long-term, senior unsecured debt rating from a nationally-recognized 
statistical rating organization.
    (10) Any collateral posted by the counterparty is a permissible 
investment for federal credit unions and is valued daily by an 
independent third party along with the value of the option;
    (11) The aggregate amount of equity-linked member share 
certificates does not exceed the credit union's net worth;
    (12) The terms of the share certificate include a guarantee that 
there can be no loss of principal to the member regardless of changes 
in the value of the option unless the certificate is redeemed prior to 
maturity; and
    (13) The federal credit union provides it board of directors with a 
monthly report detailing at a minimum:
    (i) The dollar amount of outstanding equity-linked share 
certificates;
    (ii) Their maturities; and
    (iii) The fair value of the options as determined by an independent 
third party.


Sec.  703.15  Prohibited investment activities; adjusted trading or 
short sales.

    A federal credit union may not engage in adjusted trading or short 
sales.


Sec.  703.16  Prohibited investments.

    (a) Derivatives. A federal credit union may not purchase or sell 
financial derivatives, such as futures, options, interest rate swaps, 
or forward rate agreements, except as permitted under Sec. Sec.  
701.21(i) and 703.14(h) of this chapter;
    (b) Zero coupon investments. A federal credit union may not 
purchase a zero coupon investment with a maturity date that is more 
than 10 years from the settlement date; and
    (c) Mortgage servicing rights. A federal credit union may not 
purchase mortgage servicing rights as an investment but may perform 
mortgage servicing functions as a financial service for a member as 
long as the mortgage loan is owned by a member;
    (d) A federal credit union may not purchase a commercial mortgage 
related security that is not otherwise permitted by section 107(7)(E) 
of the Act.
    (e) Other prohibited investments. A federal credit union may not 
purchase stripped mortgage-backed securities, residual interests in 
collateralized mortgage obligations/real estate mortgage investment 
conduits, or small business related securities.


Sec.  703.17  Conflicts of interest.

    (a) A federal credit union's officials and senior management 
employees, and their immediate family members, may not receive anything 
of value in connection with its investment transactions. This 
prohibition also applies to any other employee, such as an investment 
officer, if the employee is directly involved in investments, unless 
the federal credit union's board of directors determines that the 
employee's involvement does not present a conflict of interest. This 
prohibition does not include compensation for employees.
    (b) A federal credit union's officials and employees must conduct 
all transactions with business associates or family members that are 
not specifically prohibited by paragraph (a) of this section at arm's 
length and in the federal credit union's best interest.


Sec.  703.18  Grandfathered Investments.

    (a) Subject to safety and soundness considerations, a federal 
credit union may hold a CMO/REMIC residual, stripped mortgage-backed 
securities, or zero coupon security with a maturity greater than 10 
years, if it purchased the investment:
    (1) Before December 2, 1991; or
    (2) On or after December 2, 1991, but before January 1, 1998, if 
for the purpose of reducing interest rate risk and if the federal 
credit union meets the following:
    (i) The federal credit union has a monitoring and reporting system 
in place that provides the documentation necessary to evaluate the 
expected and actual performance of the investment under different 
interest rate scenarios;
    (ii) The federal credit union uses the monitoring and reporting 
system to conduct and document an analysis that shows, before purchase, 
that the proposed investment will reduce its interest rate risk;
    (iii) After purchase, the federal credit union evaluates the 
investment at least quarterly to determine whether or not it actually 
has reduced the interest rate risk; and
    (iv) The federal credit union accounts for the investment 
consistent with generally accepted accounting principles.
    (b) All grandfathered investments are subject to the valuation and 
monitoring requirements of Sec. Sec.  703.10, 703.11, and 703.12 of 
this part.


Sec.  703.19  Investment pilot program.

    (a) Under the investment pilot program, NCUA will permit a limited 
number of federal credit unions to engage in investment activities 
prohibited by this part but permitted by the Act.
    (b) Except as provided in paragraph (c) of this section, before a 
federal credit union may engage in additional activities, it must 
obtain written approval from NCUA. To obtain approval, a federal credit 
union must submit a request to its regional director that addresses the 
following items:
    (1) Certification that the federal credit union is ``well-
capitalized'' under part 702 of this chapter;
    (2) Board policies approving the activities and establishing limits 
on them;
    (3) A complete description of the activities, with specific 
examples of how they will benefit the federal credit union and how they 
will be conducted;
    (4) A demonstration of how the activities will affect the federal 
credit union's financial performance, risk profile, and asset-liability 
management strategies;
    (5) Examples of reports the federal credit union will generate to 
monitor the activities;
    (6) Projections of the associated costs of the activities, 
including personnel, computer, audit, and so forth;
    (7) Descriptions of the internal systems that will measure, 
monitor, and report the activities;
    (8) Qualifications of the staff and officials responsible for 
implementing and overseeing the activities; and
    (9) Internal control procedures that will be implemented, including 
audit requirements.
    (c) A third-party seeking approval of an investment pilot program 
must submit a request to the Director of the Office of Examination and 
Insurance that addresses the following items:
    (1) A complete description of the activities with specific examples 
of how a credit union will conduct and account for them, and how they 
will benefit a federal credit union;
    (2) A description of any risks to a federal credit union from 
participating in the program; and
    (3) Contracts that must be executed by the federal credit union.
    (d) A federal credit union need not obtain individual written 
approval to engage in investment activities prohibited by this part but 
permitted by statute where the activities are part of a third-party 
investment program that NCUA has approved under this section.

PART 742--REGULATORY FLEXIBILITY PROGRAM

    3. The authority citation for part 742 continues to read as 
follows:

    Authority: 12 U.S.C. 1756 and 1766.


[[Page 79007]]


    4. Revise Sec.  742.4 to read as follows:


Sec.  742.4  From what NCUA Regulations will I be exempt?

    (a) RegFlex credit unions are exempt from the provisions of the 
following NCUA regulations without restrictions or limitations: Sec.  
701.25, Sec.  701.32(b) and (c), Sec.  701.36(a), (b) and (c), Sec.  
703.5(b)(1)(ii) and (b)(2), Sec.  703.12(c); and Sec.  703.16(b) of 
this chapter.
    (b) RegFlex credit unions are exempt from the provisions of the 
following NCUA regulations with certain restrictions or limitations:
    (1) Sec.  703.13(d)(3) of this chapter, provided the value of the 
investments that mature later than the borrowing repurchase transaction 
does not exceed 100 percent of the federal credit union's net worth; 
and
    (2) Sec.  703.16(d) of this chapter provided,
    (i) The issuer of the security is domestic;
    (ii) The security is rated in one of the two highest rating 
categories by at least one nationally-recognized statistical rating 
organization;
    (iii) The security meets the definition of mortgage related 
security as defined in 15 U.S.C. 78c(a)(41) and the definition of 
commercial mortgage related security as defined in Sec.  703.2 of this 
chapter;
    (iv) The security's underlying pool of loans contains more than 50 
loans with no one loan representing more than 10 percent of the pool; 
and
    (v) The aggregate total of commercial mortgage related securities 
purchased by the federal credit union does not exceed 50 percent of its 
net worth.

[FR Doc. 02-32496 Filed 12-26-02; 8:45 am]
BILLING CODE 7535-01-P