BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551 DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 91-2 (FIS)
January 31, 1991
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Collateralized Mortgage Obligations/Real Estate Mortgage Investment Conduits
Collateralized mortgage obligations (CMOs) or real estate mortgage investment conduits (REMICS) (hereafter, collectively referred to as CMOs) have become increasingly prevalent assets in the portfolios of banks and bank holding companies. The structure of these instruments has evolved over time and the instruments have become more complex as the cash flows from the underlying pool of assets are reallocated in an increasingly complicated manner. (See attachment A for a brief discussion of CMO tranches.) As a consequence, certain CMO tranches involve a high degree of price volatility and can result in significantly increased levels of interest rate risk exposure for banking organizations.
The banking agencies are currently working under the auspices of the Federal Financial Institution Examination Council (FFIEC) to update the April 1988 policy statement entitled, "Supervisory Policy Concerning Selection of Securities Dealers and Unsuitable Investment Practices." That policy statement addresses the holding of stripped mortgage-backed securities (SMBS), e.g., interest-only strips (IOs) and principal-only strips (POs), as well as residual interests. On January 3, 1991, the FFIEC published for comment a proposed revision of the April 1988 policy statement. (See attachment B.) The proposed revision would modify the earlier statement to relate specifically to CMO tranches and address their associated risks.
Supervisory/Examination Treatment. Pending completion of the policy revision, Reserve Banks in reviewing CMO holdings should be guided by the 1988 policy statement. In particular, that policy states that certain investments, such as IOs and POs, are generally not suitable investments for banking organizations. As suggested by the proposed revision, that policy is equally applicable to residual interests and CMO tranches that display a high degree of price volatility due to interest rate or prepayment risk. As a matter of safe and sound banking practice, the only exception to this principle would appear to apply to institutions that have written policies, adequate systems and controls, and procedures in place to demonstrate clearly and convincingly at the time of purchase and on an ongoing basis that their holdings of these instruments are reducing their interest rate risk exposure. The price volatility and prepayment risk associated with many of these instruments suggest that in many cases it may be particularly difficult to demonstrate their effectiveness in reducing interest rate risk exposure. Consequently, banking organizations holding these instruments bear a heavy responsibility in documenting convincingly their ability to understand, monitor and control the risks associated with these instruments, as well as how any holdings of these instruments reduce the overall risk profile of the organization.
It should be noted that while some of these instruments have investment grade ratings, such ratings are generally based upon the possible credit risks associated with the securities. These ratings in no way suggest that the instruments bear little or no overall risk; nor should they cause institutions to ignore the potentially high level of price and interest rate risk associated with the securities.
In view of these considerations, any holdings of SMBS, residual interests, and CMO tranches should be closely and carefully scrutinized by examiners for their volatility and effect on the interest rate risk exposure of the institution. Procedures and documentaton regarding the risks of these instruments should also be carefully reviewed. Furthermore, examiners should determine that a banking organization does not rely solely upon the conclusions of external parties (such as dealers or investment advisors) when assessing the risks and deciding to purchase a mortgage-derivative product. In general, as noted above, many of these instruments are not suitable investments for banking organizations given their price volatility and prepayment risk.
Risk-Based Capital Treatment. For the purposes of risk-based capital, all stripped mortgage-backed securities, residual interests, and any CMO tranche that absorbs more than its pro rata share of loss are assigned to the 100 percent risk category. This treatment is specified in the risk-based capital guidelines under section III.B.3, "Mortgage-backed securities."
If there are any questions, call Rhoger Pugh (202-728-5883), Thomas Boemio (202-452-2982), or Charles Holm (202-452-3502).
Richard Spillenkothen
Deputy Associate Director
ATTACHMENT A ELECTRONICALLY TRANSMITTED BELOW
ATTACHMENT B CAN BE OBTAINED FROM FEDERAL RESERVE BANK AND FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL
Attachment A
CMOs were first issued in 1983. They are multi-class obligations that are generally backed by mortgage pass-through securities; however, they may also be backed by whole mortgage loans. In contrast to the typical mortgage pass-through security, which passes principal and interest cash flows through to investors on a pro rata basis, a CMO aggregates the cash flows from the underlying pool of mortgage assets and reallocates them to two or more classes of securities having different maturities, coupon rates, and cash flow characteristics. The cash flows to each of these classes are prioritized according to a set schedule intended to provide investors with a greater degree of certainty about the maturity of specific classes than they would otherwise have. This increased degree of certainty about the likely maturity of these classes is commonly referred to as "call protection," primarily because it gives the investor in certain classes a limited degree of protection against prepayment risk. This is achieved by directing all prepayments of principal from the underlying mortgage to the CMO classes with the shortest maturities, thus insulating classes with longer maturities against prepayment risk until the shorter-term classes have been fully paid off.
Initially, CMOs were structured to contain several classes of securities (or tranches) with differing maturities and coupons, and the scheduled principal payments and any prepayments of principal were paid to the various classes in sequential order. That is, the principal cash flows were first directed to the earliest maturing class or security until it was retired at which time the principal payments were redirected to the second class and so forth. Typically, such an issue would have 4 classes of bonds. Today, however, the number of classes may vary from as few as 6 to more than 40. In addition, some CMOs have become extremely complex with respect to both the characteristics of specific classes and the prioritization of cash flows to the various classes. Two types of classes that have evolved within the CMO structure are planned amortization classes (PACs) and targeted amortization classes (TACs) which provide an even greater degree of call protection than do classes in earlier structures.
A PAC bond is one of several possible classes of bonds within a CMO structure designed to increase the investor's protection from prepayment risk. PAC bonds are distinguished from other CMO classes by the fixed and stable cash flows that they receive over a range of prepayment scenarios (called the "protected range"). Over this range, PAC bonds have a set schedule of principal payments that must be met before principal can be paid to the other classes of securities in the CMO issue, so-called PAC support classes or companion bonds. Within this range of prepayment possiblities, investors are provided call protection against unexpected prepayments in addition to protection against an extended life expectancy due to slower than expected prepayments. This protection allows investors to more accurately predict the average life of the asset and may reduce the price volatility that would have been assumed if the underlying mortgage pass-through securities had been purchased.
Any deviations in the actual prepayments from the expected prepayment schedule are absorbed by the associated PAC support bonds. Thus, prepayment risk is shifted from the PAC bond to the associated PAC support bonds within a particular CMO issue. As a result, PAC support bonds generally will have more volatile cash flows than comparable, conventional CMO classes. The degree of protection provided by the PAC depends upon the size of the protected range which in turn is determined by the proportion of PAC classes relative to the entire CMO issue.
Many PACs have a "cumulative shortfall feature," which diverts principal payments from PAC support bonds to cover any previous shortfall in scheduled principal payments. As a result, the majority of PAC bonds have a senior claim to the PAC support or "companion" bonds not only with repect to the scheduled principal payments for each period but also to the coverage of any previous shortfalls.
A TAC bond is a derivative of the PAC bond and, like PACs, is designed to provide the investor with call protection and have a priority in receiving principal payments under certain circumstances. Instead of being protected against prepayments over a range of scenarios as are PACs, TACs are insulated from effects of prepayments only in one direction, i.e., they are protected against a rise in the prepayment rate or, conversely, against a fall in interest rates. Thus, any rise in prepayments will result in the additional cashflows being directed to the other classes in the CMO structure. As a result, the associated TAC support bonds are adversely affected by the protection granted the TAC bond from increases in prepayments.