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| #     |   | ## Unsafe             | ## Des    | ## Supple       |   |
| # Sub |   | and Unsound Investmen | cription: | mental Guidance |   |
| ject: |   | t Portfolio Practices |           |                 |   |
+-------+---+-----------------------+-----------+-----------------+---+

**TO:** Chief Executive Officers of All National Banks, Federal Branches
and Agencies, and All Examining Personnel

**PURPOSE**

This bulletin alerts banks to the potential risk to future earnings and
capital from poor investment decisions made at the current low level of
interest rates. It emphasizes the importance of maintaining prudent
credit, interest rate, and liquidity risk management practices to
control risk in the investment portfolio. This guidance supplements OCC
Bulletin 98-20, "Investment Securities: Policy Statement," dated April
27, 1998.

CONTENTS PAGE

Background 1

Unsound Investment Practices 2

1\. Yield Chasing - Credit Risk 2

2\. Yield Chasing - Interest Rate Risk 4

3\. Yield Chasing - Combinations of Credit, Interest Rate and Liquidity
Risk 5

Risk Management Considerations 7

Supervisory Review of Investment Activities 8

**BACKGROUND**

The Federal Reserve has reduced overnight lending rates 11 times since
January 2001. These rate reductions, coupled with soft loan demand,
asset prepayments, and core deposit inflows, have put pressure on asset
yields and net interest margins for many banks. Unwilling to accept low
overnight yields, many banks have looked to their investment portfolios
to generate higher yields. While this is an understandable response to
the current economic climate, it is fraught with longer-term risks if
not controlled properly. The OCC has observed a number of recent cases
where banks have engaged in unsafe and unsound practices, particularly
regarding the assumption of credit risk, in an effort to increase
investment portfolio yields. The OCC wants to alert banks to these
unsound practices and underscore the importance of an appropriate risk
management system.

**UNSOUND INVESTMENT PRACTICES**

Some banks have seen such a large decline in their investment yields
that, faced with the alternative of selling a large amount of funds at
very low overnight rates, they are "chasing" investment yields. These
banks have allowed the fear of rapidly declining asset yields to
override prudent banking judgment and, in some cases, to assume
unwarranted levels of risk. In many cases, banks have not taken steps to
strengthen their risk management practices and policy controls
consistent with the increase in their tolerance for risk.

There is no "free lunch." To obtain higher yields, banks must take more
credit risk, interest rate risk, liquidity risk, or combinations
thereof.

**National banks must ensure that they have an appropriate risk
management framework in place for the level of risk taken in their
investment portfolios. Banks choosing to increase their risk tolerance
must reassess their risk management processes to ensure they are
appropriate for current and projected risk profiles.**

**1. Yield Chasing -- Credit Risk**

There are a variety of ways banks have chased yields, but potentially
the most dangerous involves purchasing investment assets at the lower
end of the permissible credit quality spectrum. Legal requirements
generally mandate that banks purchase securities that are rated
investment grade or, if not rated, are the credit equivalent of
investment grade. Many banks have purchased corporate, municipal and
asset-backed securities that are at the lower end of investment grade,
trying to take advantage of the higher yields available on such assets.

Yield is an important consideration when a bank evaluates a security for
purchase, and it is not inherently an unsafe and unsound practice to
purchase high-yielding securities that are at the low end of the
investment grade rating scale. However, when banks change their
investing practices to take on more credit risk without appropriate
credit due diligence, limits, and guidelines (including higher capital
when needed), such practices become unsafe and unsound.

The further down the credit quality spectrum a bank invests, the more
critical it becomes to supplement ratings from credit rating agencies
with internal credit analysis. External credit ratings often are lagging
indicators of credit quality. If a bank relies exclusively upon a credit
rating, and does no internal analysis, it may find it has not received
sufficient yield to compensate for the additional risk recognized in the
market but not yet reflected in credit ratings. When a bank purchases
securities rated at the bottom end of investment grade (e.g.,
Baa3/BBB-), a subsequent downgrade will result in a classified
asset.[^1] Default will generally result in an assessment that
depreciation is "other than temporary" and the bank will have to
recognize the security's depreciation as a current period expense. The
record volume of corporate defaults in 2001 underscores the risks
involved in chasing yield down the credit spectrum.[^2]

**Non-Rated Securities**. The OCC has observed that some banks have not
done the credit due diligence necessary to show that non-rated
securities are the credit equivalent of investment grade, as required by
12 CFR 1.2(e). It is not unsafe or unsound to purchase non-rated
securities. However, to show that a non-rated security is the credit
equivalent of investment grade, a bank must [document]{.underline},
through its own credit assessment and analysis, that the security is a
strong "pass" asset under its internal credit rating standards.[^3] This
rule also applies to securities that have principal, but not interest,
rated. Banks must show that the interest portion is the credit
equivalent of investment grade. Originating credit exposures without
adequate credit due diligence is an unsafe and unsound banking practice.
Moreover, as a prudent credit practice, banks should review the quality
of material holdings of non-rated securities on an ongoing basis after
purchase. Banks that fail to perform and document the necessary credit
analysis are not in compliance with 12 CFR 1 and the sound investment
practices outlined in OCC 98-20.

**National banks must have a documented analysis that supports the
determination of credit equivalence of investment grade for each
purchased non-rated security**.

**Securities Rated Below Investment Grade**. The OCC has also observed
problems when banks have used their legal lending authority to acquire
securities rated below investment grade but have failed to perform the
credit analysis necessary to satisfy safety and soundness standards.[^4]
It is not unsafe or unsound for banks to acquire investment assets using
the bank's legal lending authority; the OCC has issued several precedent
letters permitting such transactions. Banks typically use their lending
authority to acquire securities when the securities do not conform to
either the quality (i.e., investment grade rating) or marketability
requirements of 12 CFR 1. However, banks that use their lending
authority to acquire securities must apply the same standards of credit
analysis, underwriting, and approval as they would normally apply to
large corporate loans. In addition, banks must make the decision to use
their legal lending authority to acquire securities before purchase, not
after. It is unacceptable to buy securities that do not meet the quality
or marketability requirements of 12 CFR 1 and then call them "loans" in
an attempt to avoid a violation of the investment regulation. Examiners
will review all securities a bank acquires with its lending authority to
assess the bank's credit due diligence procedures. Examiners will review
the assets for classification purposes as loans and will require
appropriate corrective action when banks fail to acquire these credit
exposures in a prudent manner.

Securities that a bank acquires pursuant to its lending authority are
subject to the accounting requirements of Statement of Financial
Accounting Standards No. 115 (Accounting for Certain Investments in Debt
and Equity Securities). Therefore, banks must designate them as
held-to-maturity, available-for-sale, or trading. Examiners will
generally consider depreciation on defaulted securities to be "other
than temporary" and require banks to take losses against current period
earnings.

The use of the lending authority to acquire securities does not
eliminate the need to measure, manage and control the investment risks
of the securities. It is an unsafe and unsound practice to overlook the
risks of investment assets simply because a bank has acquired them under
its lending authority.

**National banks must understand and prudently limit the price
sensitivity and credit exposures of securities acquired via their legal
lending authority. As part of their ongoing limits and controls, banks
should also periodically obtain current prices for these securities and
consistently follow the required accounting standards, including
recognizing losses where appropriate.**

**Complex Security Structures**. An additional credit issue involves the
proliferation of new and complex asset-backed security structures. Two
securities with identical credit ratings (e.g., Baa3/BBB-) can trade at
significantly different yields depending upon the collateral backing the
security and the structure of the securities. Some banks seeking to
generate high yields have begun to purchase securities backed by
subprime consumer paper, trust preferred stocks and corporate bonds. As
the default rate for some of these asset classes has increased, the
securities have depreciated rapidly and many now have "other than
temporary" impairment. It is not an unsafe or unsound practice to
purchase securities that have high yields simply because of the type of
collateral or structural complexity. However, it is unsafe and unsound
to do so without an understanding of the security structure and a
scenario analysis that shows that the bank has evaluated how the
security will perform in different default environments.

**National banks should demonstrate an understanding of the specific
type of asset-backed security structures they plan to purchase.
Investment policies should specifically permit the holdings and
establish appropriate limits. National banks should conduct appropriate
due diligence before purchasing complex asset-backed security structures
and should consider the impact of such purchases on the bank's capital
and earnings under a variety of possible scenarios.**

**2. Yield Chasing -- Interest Rate Risk**

The significant reduction in short-term interest rates brought about by
Federal Reserve easing has resulted in a very steep and upward sloping
yield curve. For investors trying to enhance yield, a steeply sloping
yield curve provides an incentive to extend maturities. The current
yield curve environment is similar to the one that prevailed during
1993, when banks faced a similar dilemma concerning how to replace the
yields on called/prepaid assets. At that time, some banks made the
mistake of investing a disproportionate amount of funds within a short
time period and locked in a large volume of earning assets at a cyclical
low point in yields. Then, as now, many banks chased yields to avoid
investing excess liquidity at very low overnight rates.[^5]

In 1993, many banks acquired large volumes of structured notes, focusing
on the excellent credit quality of agency issuers and high yields, but
overlooking the complex structures, embedded options and resultant price
sensitivity. In response to concerns about risk management weaknesses
for these assets, the OCC issued guidance in 1994 alerting banks to the
risks of structured notes. When interest rates increased sharply in
1994, many of these investment portfolios suffered severe depreciation.
For some institutions, the deterioration in security values caused
supervisory concerns about their viability. More recently, the OCC has
observed that some banks have purchased callable securities with very
long stated maturities and short non-call periods. Securities with long
maturities and short non-call periods contain a combination of
non-credit risk factors that often produce very high yields, and very
high risk. Such structures often leave a bank vulnerable to interest
rate movements in either direction: a long maturity, depreciated asset
if rates increase or a prepaid asset requiring reinvestment if rates
decline. Additionally, the OCC has observed that range notes, an old
structured note product, have begun to reappear in bank portfolios. A
range note is a long maturity, callable security that pays a very high
coupon to investors as long as a market index, such as Libor, is below a
specified level or within a certain range. If Libor exceeds that level,
or is outside the range, the note pays no interest. Now, as earlier,
many banks appear to have purchased these more complex securities
without performing the necessary scenario analysis, i.e., analyzing how
the security performs in different interest rate environments, or
understanding the impact of the assets on the bank's overall interest
rate risk profile.

It is not an unsafe or unsound practice to purchase securities with long
maturities or complex options. However, it is an unsafe and unsound
practice to do so in material amounts, without a pre-purchase analysis,
and when the desire for yield causes management to overlook normal
prudential controls. Sound investment practices dictate that management
must understand the structure and price sensitivity of its security
purchases, as well as how they affect the bank's overall interest rate
risk profile.

The build-up of earning assets with options that allow early repayment
(i.e., embedded short options) over the past decade has caused much of
the current excess liquidity and declining investment yields as
borrowers and security issuers have prepaid or called their debt
obligations. The greater the percentage of earning assets that the
bank's debtors (borrowers or security issuers) can redeem at their
option, the greater the likelihood that a large decline in interest
rates will cause a significant erosion in earning asset yields. Banks
should resist the temptation to invest material amounts of funds in
securities with long stated maturities within a short period of time. A
portfolio that has diversification, both in maturities and in the timing
of security purchases, should reduce a bank's vulnerability to an
investment portfolio that performs poorly if interest rates rise. It
will help to avoid the possibility that the investment portfolio will
serve as a drag on earnings for years to come.

**National banks should review the volume of their earning assets with
embedded short options and establish appropriate limits to control the
severity of future problems associated with rapidly changing interest
rates.**

**3. Yield Chasing -- Combinations of Credit, Interest Rate, and
Liquidity Risks**

Banks have recently raised questions about purchasing investment
securities or other financial instruments that present some combination
of higher credit risk, interest rate risk or liquidity risk due to their
maturity, options or structure. Trust preferred securities,
equity-linked CDs and bank-owned life insurance (BOLI) are three types
of assets that warrant further attention in the current environment.

**Trust Preferred Securities**. A number of banks have acquired
significant amounts of trust preferred securities and failed to
recognize the associated interest rate, liquidity, and credit risks
arising from the terms of these securities. In fact, some banks
mistakenly believe that the credit exposure arising from purchasing
trust preferred securities issued by a bank holding company is similar
to the credit exposure arising from selling federal funds to a bank that
is a member of that holding company. It is not.

Unlike federal funds sold to a bank that is a member of a holding
company, a trust preferred security generally is [not]{.underline} an
obligation of a bank. Trust preferred securities are typically issued by
a subsidiary grantor trust of a bank holding company, which uses the
proceeds of the equity issuance to purchase deeply subordinated debt
issued by the bank holding company. The securities contain an option
that allows the issuer to defer payment of dividends for up to five
years, without representing an event of default. While the tenor of
federal funds transactions is usually overnight, trust preferred
securities, if not called, generally represent a 30-year (or more)
bullet maturity.

It is unsafe and unsound to buy long term securities from corporate
issuers without appropriate controls over credit, interest rate and
liquidity risks. Credit risks associated with trust preferred securities
are especially high, given their long maturities, but occasionally
receive inadequate attention from bank management. Some banks that would
not consider purchasing 30-year Treasury securities due to their high
interest rate risk have nevertheless purchased 30-year corporate debt
because of the rich yields. Moreover, banks that have not documented
that their unrated trust preferred holdings are the credit equivalent of
investment grade have a violation of 12 CFR 1. Some banks have also
failed to consider the price sensitivity of these securities or their
impact on the bank's overall interest rate risk profile. Some trust
preferred securities did not increase in value when interest rates
declined, an indication of their generally poor liquidity.

**National banks that purchase trust preferred securities must have
appropriate prudential controls, including minimum quality and
diversification requirements, and limits on the percentage of capital
allocated to this asset class**.

**Equity-Linked CDs**. Banks have begun to issue equity-linked CDs, a
deposit instrument that provides a return linked to a major market index
such as the S&P 500. Issuing banks typically hedge the risk of these
deposits, i.e., the risk of paying an equity-linked return, through a
swap transaction, often with a Federal Home Loan Bank.

Some banks have asked whether it is permissible to purchase, as
investments, equity-linked CDs issued by other banks. These CDs may well
provide diversification benefits to a bank investment portfolio, and
they are permissible assets. However, they generally have poor liquidity
and pose a number of complex accounting and tax issues. Investor banks
will have to value the embedded call option on the market index,
pursuant to Statement of Financial Accounting Standards No. 133
(Accounting for Derivative Instruments and Hedging Activities), and
record changes in that value as a current period income or expense item.
Moreover, the amount of income a bank can accrue on the instrument will
be determined by the value of the call option at inception, which itself
is a function of the volatility of equity prices. Additionally,
investing banks will pay taxes on interest they have not received, which
reduces the asset's effective yield.

**National banks interested in purchasing equity-linked CDs should
consider these instruments as new products and subject them to an
internal risk management review that carefully evaluates the associated
accounting, liquidity, credit, and operational risks. Because there is
the potential to earn a zero [economic]{.underline} return for the
instrument's entire life, national banks should adopt conservative
limits on the volume of such assets**.

**Bank-Owned Life Insurance (BOLI).** A number of banks have begun to
use BOLI as a means of protecting against the loss of key employees or
hedging employee compensation and benefit plans. As detailed more
thoroughly in OCC Bulletin 2000-23, "Bank Purchases of Life Insurance:
Guidelines for National Banks," dated July 20, 2000, banks purchasing
BOLI must demonstrate and document a thorough understanding of the risks
associated with this product.

Management must determine the need for insurance by identifying the
specific risk of loss or obligation to be insured against, quantifying
the amount of insurance needed, and performing a careful review of
vendors and carriers.

In addition to the credit risk associated with this typically long tenor
asset, BOLI presents potential volatility to earnings and capital due to
liquidity and tax considerations. Although banks can surrender their
BOLI policies for their cash surrender value, they typically would incur
substantial losses to do so. Moreover, a determination that the policies
do not satisfy insurable interest requirements may result in a forced
cancellation, and/or jeopardize the tax-free status of the accumulation
of cash surrender value, thereby negatively impacting the originally
anticipated return. Because of heightened liquidity, credit and tax
risks, purchasing or holding excessive BOLI represents an unsafe and
unsound banking practice.

**National banks should review their BOLI holdings to verify that the
contracts are associated with a legitimate insurance need and divest
those that are not.**

**RISK MANAGEMENT CONSIDERATIONS**

With nominal interest rates at low levels, reinvestment decisions have
significant implications for interest rate, liquidity, and credit risk
management. The vast majority of 30-year mortgage assets (both loans and
securities) held by banks have rates below 7.5 percent. Many banks that
have purchased a disproportionate volume of securities at the low point
in the yield cycle have significantly increased interest rate risk
profiles. Should interest rates rise, as they have begun to do, earning
asset portfolios may depreciate at accelerating rates, as the effective
maturity of securities with options becomes longer. Banks that have
taken on increased levels of interest rate risk without hedging
protection will suffer from lost flexibility, diminished accounting
earnings, and impaired economic value. Should economic conditions
deteriorate further, the rising level of credit risks in investment
portfolios may produce similar effects.

As banks contemplate investment strategies, they should carefully
consider their risk tolerance. Given the long-term risks to earnings and
capital from investment decisions made now, banks should not make
strategic and policy changes to permit more aggressive risk profiles
without careful consideration of their risk management capabilities. The
Board of Directors should review the bank's risk management framework
for investment risks and confirm that it provides appropriate controls
over the current level of risk. The Board should also formally approve
changes to policies and practices that permit increased risk tolerance.
It is understandably difficult to reinvest cash flows from called or
prepaid high yielding assets at today's low yields. However, for many
banks it may be more prudent to accept somewhat lower than expected
earnings for the near term in order to increase the likelihood of more
favorable earnings for the long term. Banks should focus on long-term
performance.

**The importance of strong risk management controls over investing
activities has rarely been more important than now. National banks
should review the risk management disciplines (policies, guidelines,
reporting procedures, etc.) governing their investment activities and
make enhancements as needed. Banks must resist the temptation to cut
costs by reducing risk management staff or postponing capital
expenditures for risk management systems unless they have reduced risk
tolerances to a commensurate level. An effective risk management program
provides a critical first line of defense against potential problems.**

**SUPERVISORY REVIEW OF INVESTMENT ACTIVITIES**

During examinations, OCC examiners will focus on the following issues
highlighted in this bulletin:

1\. Changes in the bank's risk tolerance and whether increases in
tolerance have received appropriate board approval and are adequately
supported by the existing risk management framework.

2\. The longer term consequences, especially on capital adequacy, of the
bank's current investment practices.

3\. The extent and quality of the bank's internal credit analysis when
purchasing securities that are non-rated, acquired under the bank's
lending authority, or rated at the lower end of the permissible credit
quality spectrum.

4\. The volume of earning assets that have short embedded call options
and the adequacy of the bank's controls and limits over economic risk
exposures.

5\. Whether the bank has considered the probable performance of
securities in different interest rate and/or default scenarios.

6\. The bank's documentation of legitimate insurance need where the bank
reports bank-owned life insurance.

**RESPONSIBLE OFFICE**

Questions or concerns regarding this guidance should be directed to Kurt
Wilhelm or Michael Drennan in the Treasury and Market Risk Division at
(202) 874-5670.

Kathryn E. Dick

Director, Treasury and Market Risk Division

[^1]: See OCC Banking Circular 127, "Uniform Agreement on the
    Classification of Assets and Appraisal of Securities Held by Banks"
    for a discussion of classification standards.

[^2]: Standard & Poor's Corporation reported on January 14, 2002 that
    211 issuers, or 3.99% of all issuers, defaulted on \$115.4 billion
    of debt in 2001. The previous record, 132 issuers defaulting on
    \$42.3 billion of debt, occurred in 2000. Moreover, defaults by
    issuers rated investment grade at the beginning of the year nearly
    matched the record set in 1982. On January 31, 2002, Standard &
    Poor's reported that defaults for January, 2002 set multiple
    records. Forty-one issuers worldwide defaulted on \$31.3 billion in
    rated bonds.

[^3]: Because most internal bank rating systems "pass" some credit
    exposures that are not, or would not be, rated investment grade, a
    security will generally have to be rated higher than the bottom tier
    of internal credit rating "pass" standards in order to be the credit
    equivalent of investment grade.

[^4]: National banks may also acquire a limited amount of securities
    rated below investment grade with their investment authority. The
    "reliable estimates" provision in 12 CFR 1.3(i) permits banks to
    purchase securities that do not qualify as "investment securities"
    up to an aggregate amount of 5% of capital and surplus. The bank
    must show, through a credit analysis, that the obligor will be able
    to satisfy its obligations. The security must also be liquid (i.e.,
    it can be sold with reasonable promptness at a price that
    corresponds reasonably to its fair value).

[^5]: The federal funds rate was 3 percent in 1993; it is 1.75 percent
    now.