[Federal Register Volume 69, Number 126 (Thursday, July 1, 2004)]
[Rules and Regulations]
[Pages 39827-39833]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-14762]


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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: Final rule.

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SUMMARY: The National Credit Union Administration (NCUA) is issuing 
final revisions to its regulations regarding investment in 
collateralized mortgage obligations (CMOs) to authorize all federal 
credit unions (FCUs) and corporate credit unions to invest in 
exchangeable CMOs representing interests in one or more SMBS subject to 
certain safety and soundness limitations. Currently, NCUA regulations 
prohibit 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 rule will also authorize FCUs 
and corporate credit unions to accept exchangeable CMOs as assets in a 
repurchase transaction or as collateral on a securities lending 
transaction regardless of whether the CMO contains SMBS. Finally, this 
rule contains miscellaneous technical corrections and minor changes to 
NCUA's Investment and Deposit Activities rule and Corporate Credit 
Unions rule.

DATES: This rule is effective August 2, 2004.

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. Background

    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 include 
interest-only CMOs (IOs) and principal-only CMOs (POs).
    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.
    On January 22, 2004, the NCUA Board issued a notice of proposed 
rulemaking to amend NCUA rules to 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. 69 
FR 4886 (February 2, 2004).
    The first condition concerned the rate of amortization of the 
underlying IOs and POs. For an exchangeable CMO representing one or 
more IOs, the Board proposed that 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 Board proposed that 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. The Board 
also proposed a second condition: that, at the time of purchase, the 
ratio of the market price of the CMO to its 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. The proposed rule also 
stated that credit unions may not exercise the right to exchange an 
exchangeable CMO if it represents an interest in one or more SMBS that 
would be impermissible for that credit union to hold as a separate 
investment.
    The Board's proposal also contained several definitional changes 
and other technical corrections to Parts 703 and 704 of NCUA's rules 
and regulations. In Part 703, the Board proposed to add a definition of 
``collateralized mortgage obligation;'' amend the definitions of 
``put,'' ``call,'' ``custodial agreement,'' ``derivative,'' and 
``european financial options;'' and change the phrase ``nationally 
recognized statistical rating

[[Page 39828]]

agency'' to ``nationally recognized statistical rating organization.'' 
In Part 704, the Board proposed to add a definition of ``derivative,'' 
amend the definitions of ``small business related security'' and 
``weighted average life,'' and change the phrase ``interest rate risk 
simulation tests'' to ``interest rate sensitivity analysis 
requirements.''

B. Summary of Changes From the Proposed Rule

    In this final rule, the Board generally adopts the rule as proposed 
with some variations. The Board will permit the purchase of 
exchangeable CMOs representing interests in SMBS only if the CMOs 
satisfy the conditions established in the proposed rule. The final rule 
differs from the proposed rule as follows: First, the Board believes 
that CMOs are not appropriate for all credit unions, and notes that 
those with investment authority at a credit union must be qualified by 
education or experience to assess the risk characteristics of every 
investment that they make, including CMOs. Since exchangeable CMOs are 
a more complex investment, the final rule specifically requires that a 
credit union seeking to invest in exchangeable CMOs must have the 
expertise to apply the unique price range and amortization conditions 
in this rule. Second, the final rule relaxes the proposed conditions on 
exchangeable CMOs containing SMBS, but only for CMOs that are accepted 
by the credit union as assets associated with repurchase transactions 
or as collateral associated with securities lending transactions. 
Third, the rule clarifies that derivatives in the form of interest rate 
lock commitments and forward sales commitments on loans originated by 
the credit union are not prohibited. Fourth, the rule changes the NCUA 
office to which applications for an Investment Pilot Program should be 
addressed from the Office of Examination and Insurance to the Office of 
Strategic Program Support and Planning.

C. Public Comments

    NCUA received 30 comment letters regarding the proposed rule. Many 
commenters supported the exchangeable CMO portion of the proposed rule 
without reservation, and all but a few of the remaining commenters 
expressed general support for the Board's intent to allow credit unions 
to invest in certain exchangeable CMOs containing strips. In addition, 
the commenters uniformly supported the miscellaneous technical 
corrections and clarifying amendments.

Comments Requesting Elimination of the Proposed Safety and Soundness 
Conditions

    Several commenters supported authorizing credit unions to purchase 
exchangeable CMOs representing SMBS without conditions, or with 
significantly lesser conditions, than those NCUA proposed.
    One commenter suggested that NCUA authorize credit unions to buy 
any exchangeable CMO containing strips, without restriction, so long as 
the credit union does not exercise the exchange option. This commenter 
believes a simple statement that the exchange option cannot be 
exercised is sufficient, and no other conditions are necessary.
    Several commenters thought that, for corporate credit unions, NCUA 
should focus on the interest rate risk associated with the corporate's 
aggregate portfolio and should not place conditions on particular 
individual investments such as exchangeable CMOs and strips. These 
commenters believe that the proposed conditions on the purchase of 
individual exchangeable CMOs are unnecessary and overly complex in 
light of the requirement that corporate credit unions conduct a 
periodic interest rate sensitivity analysis on their investment 
portfolios and limit their risk exposure as described in Sec.  704.8. 
12 CFR 704.8.
    Two commenters said NCUA should allow FCUs to invest directly in 
SMBS, and in exchangeable CMOs containing SMBS, without restriction 
when used for the purpose of reducing balance sheet risk and earnings 
volatility.
    One commenter suggested that credit unions qualifying under NCUA's 
Regulatory Flexibility Program, 12 CFR part 742, should be exempt from 
the Part 703 prohibition on investment in SMBS and any prohibition on 
exchangeable CMOs representing SMBS.
    A few commenters question the need for the proposed rule. One of 
these commenters stated, ``It appears that the proposed rule is 
basically seeking to prevent practices that simply do not exist today. 
Current rules clearly state that investing in IO and PO Strips is not 
allowed because of the highly volatile nature of theses investments. 
Exchangeable CMOs are clearly not MBS strips.'' The commenter requests 
a simple clarification that ``a credit union may not exercise the right 
to exchange an exchangeable CMO nor undertake any re-engineering of 
mortgage cash flows that results in the creation of securities that are 
impermissible under NCUA rules and regulations.''
    While the Board appreciates these comments, it is concerned about 
the volatile and risky nature of SMBS. The Board believes SMBS are 
generally inappropriate investments for credit unions and are not 
normally well suited to risk reduction practices such as hedging, even 
in a well-run credit union or a credit union conducting aggregate 
portfolio interest rate risk analysis. On the other hand, the Board 
agrees that very few, if any, of the existing exchangeable CMOs that 
represent SMBS are overly risky. In fact, the Board believes that all 
or almost all currently existing exchangeable CMOs satisfy the safety 
and soundness conditions imposed in the final rule. Nevertheless, the 
securities market is constantly evolving, and the Board anticipates 
that, in the future, the market may include exchangeable CMOs 
representing SMBS that do have the substantive risks of those SMBS. The 
Board wants to make clear in this rulemaking how federal credit unions 
and corporate credit unions can determine the permissibility of any 
exchangeable CMO representing SMBS.

Comments Expressing Concern About the Complexity of Exchangeable CMO 
Investments

    Two commenters remarked on the complexity of the exchangeable CMO 
investment and thought credit unions that invest in them should 
demonstrate a complete understanding of how these products work and the 
risks they entail. Another commenter noted that SMBS are volatile and 
should only play a limited role, if any, as a core investment. Still 
another commenter thought NCUA should not authorize credit unions to 
purchase exchangeable CMOs representing SMBS because of a perceived 
lack of expertise and sophistication at some credit unions.
    The Board appreciates that CMOs may offer a unique risk-reward 
tradeoff among the various investments permitted for FCUs by the FCU 
Act, and that CMOs may play an important role in a well-diversified 
investment portfolio. Still, the Board agrees with these commenters 
that CMOs are not appropriate investments for all credit unions and 
notes that NCUA's investment regulation specifically provides that 
``those with investment authority [at the FCU] must be qualified by 
education or experience to assess the risk characteristics of 
investments and investment transactions.'' 12 CFR 703.3(g). The Board 
expects FCUs and corporate credit unions to understand each and every 
investment that they make, including CMOs, and how those investments 
work. Since exchangeable CMOs are a more complex investment and subject 
to unique price range and amortization conditions, the final rule

[[Page 39829]]

specifically requires that a credit union seeking to invest in 
exchangeable CMOs must have the expertise to apply the price range and 
amortization conditions.

Comments on the Proposed Price Range Condition for Exchangeable CMOs 
Representing SMBS

    Most commenters thought the .8 to 1.2 range on the ratio of 
purchase price to par was a reasonable method to separate out those 
exchangeable CMOs with risk characteristics substantially similar to 
the underlying SMBS. Some commenters suggested variations on this 
condition.
    A few commenters suggest NCUA should treat exchangeable CMOs 
containing PO strips differently from those containing IO strips. These 
commenters believe NCUA should allow the purchase at less than 80% of 
par of exchangeable CMOs containing PO strips. One commenter states ``A 
PO that trades at a steep discount (less than 80% of par) is often less 
risky than one that trades at par, since it can result in significant 
gains if paid off early, and it does not have more downside risk than a 
PO CMO purchased at greater than 80% of par.''
    One commenter suggests that, to keep an exchangeable CMO from 
having the substantive risk characteristics of an IO, NCUA should limit 
the coupon rate of the exchangeable CMO so that it is no higher than 
the coupon on the underlying collateral. The same commenter suggests 
that, to keep the exchangeable CMO from having the substantive risk 
characteristics of a PO, NCUA should require eligible securities to 
have a coupon at the time of issuance that is above a readily available 
index. For example, if the security has an expected weighted average 
life of 3 years at the time of issuance, the coupon for such security 
can not be below the yield on a 3 year Treasury plus a set spread, such 
as 50 basis points.
    One commenter suggests that a credit union with adequate staff and 
resources to monitor an exchangeable CMO would be in the best position 
to determine acceptable risk tolerances and set premium or discount 
limits.
    As stated above, the Board believes some safety and soundness 
conditions on exchangeable CMOs representing SMBS are necessary. The 
conditions in the final rule are simple enough for a credit union to 
apply but specific enough to ensure that any exchangeable CMO that 
meets these conditions will not be too risky. Any FCU that wishes to 
invest in exchangeable CMOs subject to different conditions may always 
submit an application seeking NCUA approval for an investment pilot 
program. 12 CFR 703.19.

Comments on the Proposed Amortization Condition for Exchangeable CMOs 
Representing SMBS

    Another commenter asks that NCUA provide more flexibility to allow 
for underlying IOs to amortize slower than other non-IO portions of 
exchangeable CMO. The commenter believes this would allow the investing 
credit union to receive more income over the life of the investment.
    The Board notes that if the underlying IO amortized more slowly 
than the other non-IO portions of the exchangeable CMO, the credit 
union would eventually hold an exchangeable CMO that represented only 
an IO and had risk characteristics identical to the underlying IO. This 
is unacceptable to the Board and demonstrates the need for the 
amortization condition.
    One commenter agreed with the proposed price range restrictions but 
stated that the amortization limitations do not materially advance 
NCUA's safety and soundness objectives and may unnecessarily restrict 
the investment flexibility of FCUs.
    Another commenter also supported the ``pre-purchase'' condition, 
meaning the limit on premium or discount of purchase price to par, but 
objects to the ``post-purchase'' condition, meaning the amortization 
requirement. This commenter believes the latter issue is addressed for 
corporate credit unions by the interest rate modeling of Sec.  704.8, 
and that ``to require separate risk management requirements specific to 
exchangeable CMOs is both unnecessary and overly burdensome.''
    The Board does not intend that the amortization condition be a 
``post-purchase'' condition; that is, that the credit union monitor 
amortization speeds after purchase. The Board is changing the language 
of the final rule to clarify that the determination of whether a 
particular CMO complies with the amortization condition will be made at 
the time of purchase from estimates of amortization speeds contained in 
the offering circular or other official information.

Comments on the Proposed Requirement That Credit Unions Not Exercise 
the Exchange Option if One or More of the Underlying CMOs Is an 
Impermissible IO or PO

    One commenter suggests NCUA allow credit unions that hold otherwise 
permissible exchangeable CMOs representing IOs or POs to exchange the 
CMO for the underlying securities if the credit union immediately sells 
the impermissible IOs or POs resulting from the exchange. This 
commenter believes this approach will allow the credit union 
flexibility to make best use of the exchangeable CMO feature.
    As stated above, the Board is generally opposed to credit unions 
holding SMBS. A credit union that invests in exchangeable CMOs 
representing impermissible SMBS and that would like to exercise the 
exchange option may, however, submit an investment pilot program for 
NCUA review and possible approval. 12 CFR 703.19.

Miscellaneous Comments on the Proposed Exchangeable CMO Rule

    Several commenters state a final prospectus may not be available 
for CMOs purchased at time of issue. These commenters ask that, for 
investments in exchangeable CMOs made before issuance of the final 
prospectus, NCUA authorize the credit union to rely on a preliminary 
prospectus to determine if the CMO is exchangeable and, if so, 
permissible. If the preliminary prospectus does not indicate the CMO 
will be exchangeable or does not include decrement tables allowing the 
CU to determine if the underlying investments amortize at the same 
rate, these commenters want NCUA to allow the credit union to purchase 
and hold the investment even if the final prospectus indicates the 
investment is an exchangeable CMO that fails the amortization 
requirement.
    The Board appreciates that credit unions may have difficulty 
ascertaining if a CMO purchased at or before issuance satisfies the 
requirements of this final rule. Before committing to purchase, a 
credit union should use its best efforts to examine the available 
documentary information to determine if the CMO will satisfy the 
requirements. If necessary, a credit union may seek assurances of 
compliance from the issuer. If an FCU uses its best efforts, and then 
determines after purchase that the CMO fails the requirements of this 
rule, it should process the investment as specified in its investment 
policies for investments that fail a requirement of part 703. 12 CFR 
703.3(j). Corporate credit unions should process the failed investment 
under the Investment Action Plan provisions of the corporate rule. 12 
CFR 704.10.
    Several commenters ask that NCUA provide guidance to credit unions 
currently holding exchangeable CMOs that fail the requirements in the 
proposed rule, preferring that NCUA allow credit unions to continue 
holding

[[Page 39830]]

these CMOs. One of these commenters also noted that in 1993 NCUA 
indicated some CMOs created from SMBS might be permissible. See 58 FR 
34868 (June 30, 1993) (``The NCUA Board notes that recently some CMOs 
and REMICs have been created from stripped mortgage-backed securities. 
These instruments are permitted if they can pass the high-risk security 
tests.'') This 1993 statement has lead the commenter to believe that 
there is no regulatory prohibition on CMOs containing strips.
    As stated above, the Board believes that few, if any, existing 
exchangeable CMOs will fail the conditions established in this final 
rule. Any CMOs that do fail the conditions should be processed under 
the FCU's investment policies or, for corporate credit unions, under an 
Investment Action Plan. 12 CFR 703.3(j), 704.10. While the NCUA 
recognized in 1993 that some CMOs had been created from SMBS and that 
they might be permissible if they passed the high-risk securities test 
(HRST), any CMO that had substantially the same risk characteristics as 
the underlying SMBS would likely have failed the HRST. NCUA regulations 
no longer require HRS testing. To ensure that credit unions do not hold 
exchangeable CMOs with significant risks from the underlying SMBS, 
those CMOs must satisfy the conditions provided in this final rule.
    One corporate credit union commenter is particularly concerned 
about the effect of the rule on repurchase transactions. FCUs and 
corporate credit unions may only accept as repurchase assets those 
assets in which they can invest directly, and this commenter believes 
it will be difficult to identify and cull out impermissible 
exchangeable CMOs. 12 CFR 703.13(c)(1), 704.5(d)(2). The commenter 
states that, since credit unions are a small portion of the repurchase 
market, it is improbable that repurchase custodians will restrict 
repurchase assets to those CMOs qualifying under this proposal. Given 
the speed and volume of repurchase transactions, the commenter believes 
it would be onerous for a credit union to review each CMO that is part 
of the repurchase transaction to ensure it complies with this proposal.
    The Board appreciates the commenter's concerns about the 
difficulties in separating out impermissible assets and collateral in 
these transactions. The Board also notes that, in both repurchase 
transactions and securities lending transactions, a credit union relies 
primarily on the creditworthiness of the counterparty to get its money 
back and only secondarily on the repurchase asset or securities lending 
collateral. The potential for interest rate risk and price volatility 
associated with CMOs representing interests in SMBS is less significant 
in these transactions. Accordingly, the Board is amending parts 703 and 
704 to indicate that exchangeable CMOs representing interests in SMBS 
may be used as assets or collateral in investment repurchase 
transactions or securities lending transactions, and the price range 
and amortization conditions need not be applied to exchangeable CMOs 
used in this way.
    One commenter seeks clarification that the rule applies to both 
privately issued and federally issued CMOs. The Board intends that the 
rule apply to all exchangeable CMOs, regardless of issuer.

Miscellaneous Comments on the Exchangeable CMO Rule

    Two commenters suggested that NCUA modify the proposed exchangeable 
CMO definition, and references to CMOs in the rule text, to reflect 
that the purchase of a CMO is an investment in a particular class of a 
CMO structure, not in an instrument that is a multi-class CMO 
structure. The Board agrees with the commenter and amends the final 
rule text as suggested.
    One commenter states credit unions should set aggregate investment 
limits, not NCUA. Another commenter states NCUA should amend the call 
report to obtain additional detail on exchangeable CMOs. These issues 
are beyond the scope of the proposed rule and are not addressed in the 
final rule.

Comments on the Proposed Miscellaneous Technical Corrections and 
Clarifying Amendments

    One commenter states that, if NCUA does not intend with its 
proposed change to the definition of derivative to expand or contract 
permissible types of investments for credit unions, it should say so.
    The Board does not intend, through its changes to the derivative 
definition and other provisions of parts 703 and 704 that reference 
that definition, to either expand or contract the universe of 
investments currently permissible for FCUs and corporate credit unions.

D. Other Changes in the Final Rule

    The Board is making additional changes not triggered by specific 
public comment. The Board proposed to change the definition of 
derivative so it would track the definition of derivative instrument 
used under generally accepted accounting principles (GAAP) while 
excluding those derivatives that, under GAAP, do not have to be 
recognized as an asset or liability in the statement of financial 
condition and be valued at fair market value. The Board's intent was to 
ensure that: (1) The regulatory definition of derivative is consistent 
with the accounting definition; and (2) embedded options in an 
otherwise permissible investment that are not significant enough to 
require separate accounting under GAAP would not cause that investment 
to be considered a prohibited derivative. The final rule retains the 
Board's intent but achieves it through different rule text. Instead of 
excluding embedded options from the regulatory definition of 
derivative, the final rule recognizes them as derivatives but excludes 
them from the general prohibition on derivatives.
    Recently, the GAAP definition of derivative evolved to include loan 
commitments that relate to the origination of mortgage loans that will 
be held for sale. Financial Accounting Standards Board Statement of 
Financial Accounting Standards No. 149, Amendment of Statement 133 on 
Derivative Instruments and Hedging Activities, paragraph 6(c). FCUs 
routinely enter into loan commitments such as interest rate lock 
commitments and forward sales commitments on mortgage loans they 
originate for sale, and the Board supports such commitments when used 
in a prudent manner. Since NCUA will now tie the regulatory definition 
of derivative to the GAAP definition, the general prohibition on 
derivatives could be interpreted to prohibit these types of 
commitments. Accordingly, the final rule clarifies that derivatives in 
the form of interest rate lock commitments and forward sales 
commitments on loans FCUs originate are excluded from the general 
prohibition on derivatives. Similarly, for corporate credit unions, the 
general prohibition on derivatives excludes forward sales commitments 
on loans originated by another credit union where the corporate intends 
to purchase the loan.
    Currently, the responsibility for receipt and initial processing of 
applications under the Investment Pilot Program rests with NCUA's 
Office of Examination and Insurance. 12 CFR 703.19(c). The final rule 
transfers that responsibility to NCUA's Office of Strategic Program 
Support and Planning.

Regulatory Procedures

Regulatory Flexibility Act

    The Regulatory Flexibility Act requires NCUA to prepare an analysis 
to

[[Page 39831]]

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 rule expands the investment authority granted to FCUs and 
corporate credit unions. The rule 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. NCUA currently has 
OMB clearance of part 703 and part 704 collection requirements. See OMB 
No. 3133-0133 for 12 CFR part 703, and OMB No. 3133-0129 for 12 CFR 
part 704.

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 executive order states that: ``[n]ational 
action limiting the policymaking discretion of the states shall be 
taken only where there is constitutional and statutory authority for 
the action and the national activity is appropriate in light of the 
presence of a problem of national significance.'' Portions of the rule 
apply to all corporates that accept funds from federally insured credit 
unions, including state chartered corporates. The Board believes that 
the protection of such credit unions from unwarranted investment in 
risky investments, and ultimately the National Credit Union Share 
Insurance Fund (NCUSIF), warrants application of the proposed rule to 
all corporates, including both state chartered and nonfederally 
insured. The rule does not impose additional costs or burdens on the 
states or affect the states' ability to discharge traditional state 
government functions. NCUA has determined that this rule may have an 
occasional direct effect on the states, on the relationship between the 
national government and the states, or on the distribution of power and 
responsibilities among the various levels of government. However, the 
potential risk to the NCUSIF without the final changes justifies them.

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

    The NCUA has determined that this 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 is reviewing 
whether this rule is 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 June 24, 
2004.
Becky Baker,
Secretary of the Board.


0
For the reasons stated in the preamble, NCUA amends 12 CFR part 703 and 
12 CFR part 704 as follows:

PART 703--INVESTMENT AND DEPOSIT ACTIVITIES

0
1. The authority citation for part 703 continues to read as follows:

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

0
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).
* * * * *
    Exchangeable Collateralized Mortgage Obligation means a class of a 
collateralized mortgage obligation (CMO) that, at the time of purchase, 
represents beneficial ownership interests in a combination of two or 
more underlying classes of the same CMO structure. The holder of an 
exchangeable CMO may pay a fee and take delivery of the underlying 
classes of the CMO.
* * * * *
    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.
* * * * *
0
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.
* * * * *

0
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.
* * * * *

0
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.
* * * * *

[[Page 39832]]

    (13) The Federal credit union provides its board of directors with 
a monthly report detailing at a minimum:
* * * * *

0
6. Amend Sec.  703.16 to revise paragraphs (a) and (e) and add 
paragraph (f) to read as follows:


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 swaps. This prohibition does not apply to:
    (1) Any derivatives permitted under Sec. Sec.  701.21(i) and 
703.14(g) of this chapter;
    (2) Embedded options not required under GAAP to be accounted for 
separately from the host contract; and
    (3) Interest rate lock commitments or forward sales commitments 
made in connection with a loan originated by the Federal credit union.
* * * * *
    (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 paragraphs (1) and (3) below.
    (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 classes of 
a CMO (IO CMOs) or principal-only classes of a CMO (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;
    (ii) The offering circular or other official information available 
at the time of purchase indicates that the notional principal on each 
underlying IO CMO should decline at the same rate as the principal on 
one or more of the underlying non-IO CMOs, and that the principal on 
each underlying PO CMO should decline at the same rate as the 
principal, or notional principal, on one or more of the underlying non-
PO CMOs; and
    (iii) The credit union staff has the expertise dealing with 
exchangeable CMOs to apply the conditions in paragraphs (e)(1)(i) and 
(e)(1)(ii) of this section.
    (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.
    (3) A Federal credit union may accept an exchangeable CMO 
representing beneficial ownership interests in one or more IO CMOs or 
PO CMOs as an asset associated with an investment repurchase 
transaction or as collateral in a securities lending transaction. When 
the exchangeable CMO is associated with one of these two transactions, 
it need not conform to the conditions in paragraphs (e)(1)(i) and (ii) 
of this section.
    (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.
0
7. Amend Sec.  703.19 by revising the introductory language of 
paragraph (c) to read as follows:


Sec.  703.19  Investment Pilot Program.

* * * * *
    (c) A third-party seeking approval of an investment pilot program 
must submit a request to the Director of the Office of Strategic 
Program Support and Planning that addresses the following items:
* * * * *

PART 704--CORPORATE CREDIT UNIONS

0
8. The authority citation for part 704 continues to read as follows:

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

0
9. 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).
* * * * *
    Exchangeable collateralized mortgage obligation means a class of a 
collateralized mortgage obligation (CMO) that, at the time of purchase, 
represents beneficial ownership interests in a combination of two or 
more underlying classes of the same CMO structure. The holder of an 
exchangeable CMO may pay a fee and take delivery of the underlying 
classes of the CMO.
* * * * *
    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 Sec.  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.
* * * * *

0
10. 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, except for embedded options 
not required under GAAP to be accounted for separately from the host 
contract or forward sales commitments on loans to be purchased by the 
corporate credit union;
* * * * *
    (4) Purchasing mortgage servicing rights, small business related 
securities, residual interests in collateralized mortgage obligations, 
residual interests in real estate mortgage investment conduits, or 
residual interests in asset-backed securities; and
    (5) Purchasing stripped mortgage backed securities (SMBS), or 
securities that represent interests in SMBS, except as described in 
subparagraphs (i) and (iii) below.
    (i) A corporate credit union may invest in exchangeable 
collateralized mortgage obligations (exchangeable CMOs) representing 
beneficial ownership interests in one or more interest-only classes of 
a CMO (IO CMOs) or principal-only classes of a CMO (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

[[Page 39833]]

of the market price to par must be less than 20 points;
    (B) The offering circular or other official information available 
at the time of purchase indicates that the notional principal on each 
underlying IO CMO should decline at the same rate as the principal on 
one or more of the underlying non-IO CMOs, and that the principal on 
each underlying PO CMO should decline at the same rate as the 
principal, or notional principal, on one or more of the underlying non-
PO CMOs; and
    (C) The credit union investment staff has the expertise dealing 
with exchangeable CMOs to apply the conditions in paragraphs 
(h)(5)(i)(A) and (B) of this section.
    (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.
    (iii) A corporate credit union may accept an exchangeable CMO 
representing beneficial ownership interests in one or more IO CMOs or 
PO CMOs as an asset associated with an investment repurchase 
transaction or as collateral in a securities lending transaction. When 
the exchangeable CMO is associated with one of these two transactions, 
it need not conform to the conditions in paragraphs (h)(5)(i)(A) or (B) 
of this section.

0
11. 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. 04-14762 Filed 6-30-04; 8:45 am]
BILLING CODE 7535-01-P