[Federal Register Volume 69, Number 21 (Monday, February 2, 2004)]
[Proposed Rules]
[Pages 4886-4890]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-1765]


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NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 703 and 704


Investment in Exchangeable Collateralized Mortgage Obligations

AGENCY: National Credit Union Administration.

ACTION: Proposed rule with request for comments.

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SUMMARY: The National Credit Union Administration (NCUA) proposes to 
amend its regulations regarding investment in collateralized mortgage 
obligations (CMOs). Currently, NCUA regulations prohibit federal credit 
unions (FCUs) and certain corporate credit unions from investing in 
stripped mortgage backed securities (SMBS) and exchangeable CMOs that 
represent interests in one or more SMBS. NCUA has safety and soundness 
concerns with direct investment in SMBS, but recognizes that some 
exchangeable CMOs representing interests in one or more SMBS may be 
safe investments for credit unions. This proposed rule will

[[Page 4887]]

authorize all FCUs and corporate credit unions to invest in 
exchangeable CMOs representing interests in one or more SMBS subject to 
certain safety and soundness limitations. This proposed rule also 
contains miscellaneous technical corrections and clarifying amendments 
to NCUA's Investment and Deposit Activities rule and Corporate Credit 
Unions rule.

DATES: Comments must be received on or before April 2, 2004.

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: Steve Sherrod, Senior Investment 
Officer, Office of Strategic Program Support and Planning (OSPSP) at 
the above address or telephone (703) 518-6620; Kim Iverson, Senior 
Investment Officer, Office of Strategic Program Support and Planning, 
at the above address or telephone (703) 518-6620; George Curtis, 
Corporate Program Specialist, Office of Corporate Credit Unions at the 
above address or telephone (703) 518-6640; or Paul Peterson, Staff 
Attorney, Office of General Counsel, at the above address or telephone 
(703) 518-6555.

SUPPLEMENTARY INFORMATION:

A. Exchangeable Collateralized Mortgage Obligations

    The Federal Credit Union Act permits FCUs and corporate credit 
unions to purchase mortgage related securities (MRS) subject to such 
regulations as the NCUA Board may prescribe. 12 U.S.C. 1757(15)(B). 
NCUA regulations generally permit the purchase of CMOs, a multi-class 
MRS, but not if the CMO is a stripped mortgage backed security (SMBS). 
12 CFR 703.14(d) and 703.16(e); 704.5(c)(5) and (h)(4). SMBS, including 
interest-only CMOs (IOs) and principal-only CMOs (POs) are, when 
purchased individually, highly volatile and risky investments. For 
example, in a declining interest rate environment, such as that 
experienced over the last few years, the value of an IO can drop 
precipitously in a short time period. Accordingly, individual SMBS are 
generally not suitable investments for most credit unions.
    Currently, many CMO issues contain one or more classes of 
exchangeable CMOs. An exchangeable CMO represents a beneficial 
ownership interest in a combination of two or more underlying CMOs, and 
the owner may pay a fee and take delivery of the underlying CMOs. In 
many cases, these underlying CMOs include IOs and POs.
    Because NCUA regulations prohibit investment in SMBS, the 
regulations also prohibit investment in an exchangeable CMO that 
represents an interest in one or more IOs or POs. Certain exchangeable 
CMOs representing IOs or POs, however, do not carry the risk or raise 
the same safety and soundness concerns associated with direct 
investment in an SMBS. For example, an exchangeable CMO might represent 
ownership in two securities: (1) An interest-bearing CMO (i.e., a non-
SMBS CMO) with a coupon of 5.0 percent and (2) a SMBS in the form of an 
IO representing 0.5 percent interest on the interest-bearing CMO. See 
RCR class PA from Federal National Mortgage Association (Fannie Mae) 
Prospectus Supplement 2001-73. As indicated in the Prospectus 
Supplement for this particular combination, the notional principal of 
the underlying IO is not large relative to the principal of the 
underlying interest-bearing CMO and will decline at the same rate as 
the principal on the interest-bearing CMO. As a result, the risks 
associated with this combination more closely resemble the risks 
associated with the underlying interest-bearing CMO than the risks 
associated with the IO or any other SMBS.
    This proposed rule, if adopted, will authorize FCUs and corporate 
credit unions to invest in an exchangeable CMO representing interests 
in one or more IOs or POs if the exchangeable CMO meets certain 
conditions.
    One condition concerns the rate of amortization of the underlying 
IOs and POs. Specifically, for an exchangeable CMO representing one or 
more IOs, the notional principal of each IO must decline at the same 
rate as the principal on one or more non-IO CMOs included in the 
combination. For an exchangeable CMO representing one or more POs, the 
principal of each PO must decline at the same rate as the notional 
principal of one or more IOs included in the combination or at the same 
rate as the principal on one or more interest-bearing CMOs included in 
the combination. This requirement helps mitigate the risk associated 
with the IO and PO SMBS.
    Each exchangeable CMO has an offering circular, which includes the 
final prospectus and all supplements to that prospectus, that contains 
performance characteristics for the exchangeable CMO and its various 
underlying CMOs. One set of tables, labeled as ``decrement'' or 
``declining balance'' tables, displays the remaining principal (or, for 
IOs, the notional principal) balance on each CMO at periodic intervals 
following issuance, assuming certain principal repayment speeds for the 
mortgage pool as a whole. The Board believes that the principal, or 
notional principal, of two underlying CMOs will decline at the same 
rate only if the two CMOs share the same decrement or declining balance 
table. The rule text also requires this condition be satisfied 
throughout the life of the investment, so that a credit union may not 
exercise a call option, or other embedded option, that causes the 
exchangeable CMO to fail this condition after purchase.
    The amortization condition discussed above helps mitigate risk, but 
by itself will not ensure that an exchangeable CMO representing 
interests in underlying SMBS does not perform like a stand-alone SMBS. 
For example, an issuer might fashion an exchangeable CMO that 
represents ownership in two securities: (1) An interest-bearing CMO and 
(2) an IO, but with the notional principal of the IO much larger than 
the principal of the interest-bearing CMO. Even assuming the notional 
principal on the IO declines at the same rate as the principal on the 
interest-bearing CMO, the exchangeable CMO representing these two 
interests will still have the substantive risk characteristics of the 
underlying IO.
    Accordingly, the Board finds it necessary to add another condition: 
that, at the time of purchase, the ratio of the market price to the 
remaining principal balance is between .8 and 1.2, meaning that the 
discount or premium of the market price to par must be less than 20 
points. In the Board's view, if an exchangeable CMO is priced at a 
premium of 20% or more to the remaining principal balance due on the 
CMO at the time of purchase, or its ``par,'' the CMO has substantially 
the same risk characteristics as an IO. Similarly, if an exchangeable 
CMO is priced at a discount of 20% or more to par, it has substantially 
the same risk characteristics as a PO. ``Remaining principal balance'' 
refers to the actual principal remaining to be paid, not notional 
principal.
    The proposed rule also states that credit unions may not exercise 
the right to exchange an exchangeable CMO if it represents an interest 
in one or more impermissible SMBS. Corporate credit unions with part I 
or part II Expanded Authorities may exercise the exchange

[[Page 4888]]

function if the resulting SMBS are all permissible under those 
authorities.
    This proposed rule also adds a definition of collateralized 
mortgage obligation to part 703 of NCUA's rules and regulations. This 
definition parallels the definition found in NCUA's corporate rule. 12 
CFR 704.2.

B. Technical Corrections and Minor Changes

    The Board also proposes to make several technical corrections and 
other minor changes to parts 703 and 704.

1. Investment and Deposit Activities (Part 703)

    The Board proposes to modify the definitions of put and call in 
Sec. 703.2. Puts and calls are parallel devices, with a put giving the 
holder the option to sell, and a call giving the holder an option to 
buy, a security under certain conditions. The proposed definitions 
reflect this relationship more closely. The Board also proposes to 
modify the definition of put to clarify that the exercise of a put need 
only be during a fixed time period rather than, as currently stated, 
``at any time until the stated expiration date.''
    Section 703.2 defines ``custodial agreement'' and limits such 
agreements to those where one party agrees to exercise ordinary care in 
the safekeeping of securities. The term ``custodial agreement'' only 
appears in Sec. 703.9(a), and that section references a ``written 
custodial agreement that requires the safekeeper to exercise, at least, 
ordinary care.'' Accordingly, the use of ``ordinary care'' in the 
definition of custodial agreement is redundant and the Board proposes 
to eliminate it.
    The Board wishes to amend the current definition of derivative in 
part 703. The Board intends that the term derivative mean any 
derivative instrument that, under generally accepted accounting 
principles (GAAP), must be recognized as an asset or liability in the 
statement of financial condition and be valued at fair market value. 
Currently, FASB Statement No. 133 (FAS 133), as amended and 
interpreted, discusses the accounting treatment of derivative 
instruments, which include certain financial contracts and other 
contracts that meet conditions specified in FAS 133. Stand-alone 
interest rate swaps, options, swaptions, and futures, for example, are 
derivative instruments under FAS 133 that must be recognized as assets 
or liabilities and valued at fair market value and so are considered to 
be derivatives for purposes of parts 703 and 704. In contrast, embedded 
options that are not required under GAAP to be accounted for separately 
from the host contract are not derivatives for purposes of parts 703 
and 704.
    Sections 703.8(b)(3) and 703.9(d) employ the term ``nationally-
recognized statistical rating agencies.'' The Board proposes to replace 
this term with the more commonly used ``nationally-recognized 
statistical rating organizations.''
    Section 703.14(g) allows for the purchase, subject to certain 
conditions, of European financial options contracts to fund the payment 
of dividends on member share certificates. One condition in paragraph 
(g)(4) requires that ``[t]he options' expiration dates coincide with 
the maturity date of the share certificate.'' The Board proposes a 
change to allow these options to expire ``no later than the maturity 
date of the share certificate.'' This change will provide more 
flexibility in the use of options.
    In Sec. 703.14(g)(13), the Board proposes to replace the word 
``it'' with ``its.''

2. Corporate Credit Unions (Part 704)

    In Sec. 704.2, the Board proposes to amend the definitions of 
``small business related security'' and ``weighted average life'' to 
make them identical to the definitions of those terms in Sec. 703.2. 
Also, the Board proposes to revise Sec. 704.8(a)(4) by changing the 
phrase ``interest rate risk simulation tests'' to ``interest rate 
sensitivity analysis requirements.'' Section 704.8(a)(4) cross-
references Sec. 704.8(d) which uses the phrase ``interest rate 
sensitivity analysis requirements.'' The Board also proposes to add a 
definition of ``derivatives'' to part 704. The proposed part 704 
definition is identical to the amended definition proposed for part 703 
and discussed above.

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 $10 million in 
assets). This proposed rule expands the investment authority granted to 
FCUs and corporate credit unions. The proposed amendments will 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

    NCUA has determined that the final 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, Pub. L. 105-277, 112 Stat. 
2681 (1998).

Small Business Regulatory Enforcement Fairness Act

    The Small Business Regulatory Enforcement Act of 1996 (Pub. L. 104-
121) provides generally for congressional review of agency rules. A 
reporting requirement is triggered in instances where NCUA issues a 
final rule as defined by section 551 of the Administrative Procedure 
Act. 5 U.S.C. 551. The Office of Management and Budget has determined 
that this rule is not a major rule for purposes of the Small Business 
Regulatory Enforcement Fairness Act of 1996.

List of Subjects

12 CFR Part 703

    Credit unions, Investments.

12 CFR Part 704

    Corporate credit unions, Reporting and recordkeeping requirements.

    By the National Credit Union Administration Board on January 22, 
2004.
Becky Baker,
Secretary of the Board.

    For the reasons stated in the preamble, NCUA proposes to amend 12 
CFR part 703 and 12 CFR part 704 as follows:

[[Page 4889]]

PART 703--INVESTMENT AND DEPOSIT ACTIVITIES

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

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

    2. Amend Sec. 703.2 to revise the definitions of Call, Custodial 
Agreement, Derivatives, and Put, and add definitions of Collateralized 
Mortgage Obligation and Exchangeable Collateralized Mortgage 
Obligation, as follows:


Sec. 703.2  Definitions.

* * * * *
    Call means an option that gives the holder the right to buy a 
specified quantity of a security at a specified price during a fixed 
time period.
* * * * *
    Collateralized Mortgage Obligation (CMO) means a multi-class 
mortgage related security.
* * * * *
    Custodial Agreement means a contract in which one party agrees to 
hold securities in safekeeping for others.
* * * * *
    Derivatives means any derivative instrument, as defined under 
generally accepted accounting principles (GAAP), that GAAP requires be 
recognized as an asset or liability in the statement of financial 
condition and be valued at fair market value. Stand-alone interest rate 
swaps, options, swaptions, and futures, for example, are derivatives. 
Embedded options that are not required under GAAP to be accounted for 
separately from the host contract are not derivatives.
* * * * *
    Exchangeable Collateralized Mortgage Obligation means a 
collateralized mortgage obligation (CMO) that represents beneficial 
ownership interests in a combination of two or more underlying CMOs. 
The holder of an exchangeable CMO may pay a fee and take delivery of 
the underlying CMOs.
* * * * *
    Put means an option that gives the holder the right to sell a 
specified quantity of a security at a specified price during a fixed 
time period.
* * * * *
    3. Amend Sec. 703.8 by revising the second sentence of paragraph 
(b)(3) to read as follows:


Sec. 703.8  Broker-dealers.

* * * * *
    (b) * * *
    (3) * * * The federal credit union should consider current 
financial data, annual reports, reports of nationally-recognized 
statistical rating organizations, relevant disclosure documents, and 
other sources of financial information.
* * * * *
    4. Amend Sec. 703.9 by revising the second sentence of paragraph 
(d) to read as follows:


Sec. 703.9  Safekeeping of investments.

* * * * *
    (d) * * * The federal credit union should consider current 
financial data, annual reports, reports of nationally-recognized 
statistical rating organizations, relevant disclosure documents, and 
other sources of financial information.
    5. Amend Sec. 703.14 to revise paragraph (g)(4) and paragraph 
(g)(13) introductory text to read as follows:


Sec. 703.14  Permissible investments.

* * * * *
    (g) * * *
    (4) The options' expiration dates are no later than the maturity 
date of the share certificate.
* * * * *
    (13) The federal credit union provides its board of directors with 
a monthly report detailing at a minimum:
* * * * *
    6. Amend Sec. 703.16 to revise paragraph (e) and add paragraph (f) 
to read as follows:


Sec. 703.16  Prohibited investments.

* * * * *
    (e) Stripped mortgage backed securities (SMBS). A federal credit 
union may not invest in SMBS or securities that represent interests in 
SMBS except as described in paragraph (e)(1) of this section.
    (1) A federal credit union may invest in and hold exchangeable 
collateralized mortgage obligations (exchangeable CMOs) representing 
beneficial ownership interests in one or more interest-only CMOs (IO 
CMOs) or principal-only CMOs (PO CMOs), but only if:
    (i) At the time of purchase, the ratio of the market price to the 
remaining principal balance is between .8 and 1.2, meaning that the 
discount or premium of the market price to par must be less than 20 
points, and
    (ii) Throughout the life of the investment, the notional principal 
on each underlying IO CMO declines at the same rate as the principal on 
one or more of the underlying non-IO CMOs, and the principal on each 
underlying PO CMO declines at the same rate as the principal, or 
notional principal, on one or more of the underlying non-PO CMOs.
    (2) A federal credit union that invests in an exchangeable CMO may 
exercise the exchange option only if all of the underlying CMOs are 
permissible investments for that credit union.
    (f) Other prohibited investments. A federal credit union may not 
purchase residual interests in collateralized mortgage obligations/real 
estate mortgage investment conduits, or small business related 
securities.

PART 704--CORPORATE CREDIT UNIONS

    7. The authority citation for part 704 continues to read as 
follows:

    Authority: 12 U.S.C. 1762, 1766(a), 1781, and 1789.

    8. Amend Sec. 704.2 to add definitions of Derivatives and 
Exchangeable collateralized mortgage obligation, and to revise the 
definitions of Small business related security and Weighted average 
life, as follows:


Sec. 704.2  Definitions.

* * * * *
    Derivatives means any derivative instrument, as defined under 
generally accepted accounting principles (GAAP), that GAAP requires be 
recognized as an asset or liability in the statement of financial 
condition and be valued at fair market value. Stand-alone interest rate 
swaps, options, swaptions, and futures, for example, are derivatives. 
Embedded options that are not required under GAAP to be accounted for 
separately from the host contract are not derivatives.
* * * * *
    Exchangeable collateralized mortgage obligation means a 
collateralized mortgage obligation (CMO) that represents beneficial 
ownership interests in a combination of two or more underlying CMOs. 
The holder of an exchangeable CMO may pay a fee and take delivery of 
the underlying CMOs.
* * * * *
    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

[[Page 4890]]

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.
* * * * *
    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.
* * * * *
    9. Amend Sec. 704.5 by revising paragraphs (h)(1) and (h)(4) and 
adding paragraph (h)(5) to read as follows:


Sec. 704.5  Investments.

* * * * *
    (h) * * *
    (1) Purchasing or selling derivatives.
* * * * *
    (4) Purchasing mortgage servicing rights, small business related 
securities, or residual interests in collateralized mortgage 
obligations/real estate mortgage investment conduits or asset-backed 
securities; and
    (5) Purchasing stripped mortgage backed securities (SMBS), or 
securities that represent interests in SMBS, except as described as 
follows:
    (i) A corporate credit union may invest in exchangeable 
collateralized mortgage obligations (exchangeable CMOs) representing 
beneficial ownership interests in one or more interest-only CMOs (IO 
CMOs) or principal-only CMOs (PO CMOs), but only if:
    (A) At the time of purchase, the ratio of the market price to the 
remaining principal balance is between .8 and 1.2, meaning that the 
discount or premium of the market price to par must be less than 20 
points, and
    (B) Throughout the life of the investment, the notional principal 
on each underlying IO CMO declines at the same rate as the principal on 
one or more of the underlying non-IO CMOs, and the principal on each 
underlying PO CMO declines at the same rate as the principal, or 
notional principal, on one or more of the underlying non-PO CMOs.
    (ii) A corporate credit union that invests in an exchangeable CMO 
may exercise the exchange option only if all of the underlying CMOs are 
permissible investments for that credit union.
    10. Amend Sec. 704.8 by revising paragraph (a)(4) to read as 
follows:


Sec. 704.8  Asset and liability management.

    (a) * * *
    (4) Policy limits and specific test parameters for the interest 
rate sensitivity analysis requirements set forth in paragraph (d) of 
this section; and
* * * * *
[FR Doc. 04-1765 Filed 1-30-04; 8:45 am]
BILLING CODE 7535-01-P