TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
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).
Deputy Associate Director
ATTACHMENT A ELECTRONICALLY TRANSMITTED BELOW
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.
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