Office of Thrift Supervision Page 1

Office of Thrift Supervision April 12, 2001

Department of the Treasury

Regulatory Bulletin

RB 32-18

Handbook: Thrift Activities

Subjects: Liquidity and Sensitivity to Market Risk Sections: 510, 540, 660

Thrift Activities Regulatory Handbook Update 

Summary: This bulletin provides updates to the following Thrift Activities Regulatory Handbook Sections:

• 510, Funds Management. Remove existing section 510, Asset/Liability Management, and 

insert new handbook section 510. 

• 540, Investment Securities. Remove existing sections 220, Investment Securities, and 542, 

Mortgage-Backed Securities and Mortgage-Derivative Products. Insert new handbook section 540. 

· 660, Derivative Instruments and Hedging. Remove existing sections 541, Hedging, and 543, 

Derivative Instruments. Insert new handbook section 660. 

For Further Information Contact: Your Office of Thrift Supervision (OTS) Regional Office or 

the Supervision Policy Division of the OTS, Washington, DC. You may access this bulletin at our 

web site: www.ots.treas.gov. If you wish to purchase a handbook and a subscription to the updates, please contact the OTS Order Department at (301) 645-6264.

Regulatory Bulletin 32-18

SUMMARY OF CHANGES

OTS is issuing updates to the following Thrift Activities Handbook Sections. We restructured 

sections 510, 540, and 660 so we did not include change bars in these sections. We provide a 

summary of all substantive changes below. These handbook sections are in plain language.

510 Funds Management

We changed the name of this section from Asset/Liability Management to Funds Management and made the following revisions: 

• Moved several topics relating to interest rate risk to Section 650, Interest Rate Risk.

• Moved several topics relating to profitability and management decisions to Section 

310, Oversight by the Board of Directors.

• Removed the detailed Asset/Liability Committee requirements and made it clear that 

OTS does not require Asset/Liability Committees.

• Eliminated obsolete regulatory references.
Regulatory Bulletin 32-18

Page 2 Office of Thrift Supervision

540 Investment Securities

This section combines sections 220, Investment Securities, and 542, Mortgage-Backed 

Securities and Mortgage-Derivative Products. We added the following information:

• New types of investments and changes in regulatory and accounting policy.

• Applicable guidance from TB 13a, Management of Interest Rate Risk, Investment Securities, and Derivative Activities.

• Applicable guidance from CEO Memo No. 130, Underwriting the Purchase of Investment Securities.

• Reporting of investment securities from the rescinded FFIEC Supervisory Policy 

Statement on Investment Securities and End-User Derivatives Activities. The banking 

agencies included this information in the glossary to the call report instructions.

• Appendix A, Total Return; Appendix B, Money Market, Fixed-Income Market, and 

Equity Market Securities; and Appendix C, Mortgage-Related Securities. We omitted 

appendices A and B to previous section 220; they are no longer necessary due to a 

regulatory change.

660 Derivative Instruments and Hedging

We combined the Derivative Instruments and Hedging Handbook Sections and moved 

them from the Liquidity Chapter to the Sensitivity to Market Risk Chapter. We omitted 

the Hedging General Questionnaire. We added the following information:

• An expanded discussion of Risks of Using Derivatives.

• A discussion of OTS Policy on Derivatives that incorporates Sensitivity Analysis or 

Stress Testing from TB 13a.

• A discussion of FASB’s SFAS No. 133, Accounting for Derivative Instruments and 

Hedging Activities.

—Scott M. Albinson

 Managing Director, Supervision
CHAPTER: Liquidity

SECTION: Funds Management Section 510

INTRODUCTION

Office of Thrift Supervision April 2001 Regulatory Handbook 510.1

Funds management encompasses both the treasury 

management and asset/liability management functions. The goal of funds management is to achieve 

an association’s targeted risk and return objectives 

through the effective management of the association’s resources. Funds management is the 

management of an association’s balance sheet mix 

and pricing of assets and liabilities. 

Funds management encompasses the coordination 

and integration of a broad range of functions, policies, and decisions that influence the association’s 

net interest earnings, net interest margin, and net 

portfolio value, including the following:

• Asset and liability composition 

• Loan and deposit pricing

• Funds transfer pricing policies

• Capital structure and capital financing

• Asset securitizations

• Hedging activities.

An effective funds management process should 

increase the likelihood that an association will 

achieve its financial objectives. Successful funds 

management programs typically have four elements:

• Management that understands how to structure 

the balance sheet and price deposits, loans, and 

other products to achieve risk and return objectives.

• A clearly defined funds management process 

that includes sound policies, procedures, and 

controls.

• Effective information systems that provide the 

information needed to make sound funds management decisions.

• An effective performance measurement system.

The sophistication of an association’s funds management process and systems should be 

appropriate to the size and complexity of the association. 

In assessing an association’s funds management, 

you should:

• Review the policies, procedure, and controls 

governing the funds management process.

• Determine whether the policies, procedures, and 

controls are sufficient given the size and complexity of the association.

• Determine whether the association’s information/analytical systems are adequate given the 

size and complexity of the association.

• Review the reports to the board that summarize 

major decisions and transactions.

• Determine compliance with policies, procedures, and controls governing funds 

management.

SETTING FINANCIAL GOALS: THE 

RISK/RETURN PROFILE

The Risk/Return Tradeoff

The board of directors and senior management 

should define the association’s overall financial 

objectives with clearly defined risk and return 

measures.

An association usually states its overall financial 

objectives regarding return with accounting-based 

earnings and profitability measures or with economic or market value-based performance 

measures. In specifying these goals, a number of 

specific measurement gauges may be appropriate, 

either individually or in combination. 

The most common accounting-based measures are:

• Return on assets
SECTION: Funds Management Section 510

510.2 Regulatory Handbook April 2001 Office of Thrift Supervision

• Return on equity

• Net Interest Margin.

The economic/market value-based measures that 

associations commonly use are:

• Net portfolio value

• Market value capitalization

• Total return. 

Associations sometimes seek to achieve short- term 

earnings and profitability targets by accepting 

greater risk and in the process compromise longterm earnings and market value objectives.

THE FUNDS MANAGEMENT DECISIONMAKING PROCESS

You should review the funds management policies 

and procedures. 

• Are the policy limits reasonable given the association’s financial condition?

• Is management complying with the boardapproved policies?

• Are periodic reports to the board adequate?

An integrated, funds management process is 

important. A piecemeal approach to funds 

management, or a structure in which one or more 

of the financial functions are autonomous, will 

complicate the attainment of a common overall 

risk/return profile. The funds management process 

in small associations may be informal, while in 

larger associations the process may be very formal. 

FUNDS MANAGEMENT FUNCTIONS

Presented below are the functions of the typical 

funds management process: 

• Determine financial objectives and set policy 

for each of the financial functions. 

• Provide periodic reports to the board concerning funds management.

• Periodically review the funds management policies with the board.

• Oversee funding activities. 

• Coordinate asset and liability product pricing. 

• Evaluate proposed strategies and transactions 

through sound methodology, including simulation and scenario analysis. 

• Oversee investment portfolio management activities.

• Monitor the economic and interest-rate environment, including local economic conditions, 

prepayment trends, and volatility.

• Identify instruments that the board of directors 

authorized for use to manage the association’s 

risk exposures.

• Oversee funding and capital financing activities, including debt and equity issuance, and 

dividend policies. 

PROCEDURES AND CONTROLS

If the funds management process is not functioning 

properly, then you should focus on the related operating procedures and internal controls. Typically 

in a large association, extensive documented procedures are necessary to accommodate a large 

volume of data flow from numerous functional 

areas to the manager responsible for funds management. In smaller associations such complex 

procedures are not necessary.

Internal Procedures

Associations should document and follow procedures that allow for the smooth and timely flow of 

data to the funds management function. Flow 

charts documenting the physical flow of data to 

and from all departments are usually very informative. Other procedures may be necessary to 

accommodate the funds management function at 

certain associations. 

Internal Control

In small associations, the lack of adequate internal 

controls may be more of a concern because one 

individual will often perform multiple functions. 

For example, the CFO may direct funds management, but may also execute transactions, oversee 

the disbursement of cash, and authorize the related 
SECTION: Funds Management Section 510

Office of Thrift Supervision April 2001 Regulatory Handbook 510.3

accounting entries. Associations should segregate 

these duties to the extent possible to ensure adequate internal control. 

You should verify that internal controls are adequate in the following areas:

• Transaction authorizations – both internal (officers authorized to transact business) and 

external (approved dealers).

• Position and transaction limits, regulatory requirements or limits, and other guidelines. 

REFERENCES

Code of Federal Regulations (12 CFR)

§ 563.172 Financial Derivatives

§ 563.176 Interest Rate Risk Management Procedures

Office of Thrift Supervision Bulletins

RB 3a-1 Policy Statement on Growth for 

Savings Associations 

TB 13a Management of Interest Rate Risk, 

Investment Securities, and Derivatives Activities

TB 13a-2 Structured Advances 

FFIEC Policy Statements

Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities

Financial Accounting Standards Board (FASB)

No. 107 Disclosures About Fair Value of Financial Instruments

No. 115 Accounting for Certain Investments 

in Debt and Equity Securities

No. 133 Accounting for Derivative Instruments and Hedging Activities

Other References

Standard & Poor’s, Inc. Credit Review
Funds Management

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 510P.1

Examination Objectives

Ascertain whether the institution has sufficient funds management policies, procedures, and controls. 

Verify that management uses appropriate instruments to manage the institution’s risk/return profile. 

Examination Procedures

Level I Wkp.Ref.

1. Review scoping materials applicable to funds management. Due to the nature of the 

funds management review, consult and coordinate with the examiner(s) assigned to review interest rate risk, cash flow and liquidity management, investment management, 

and related areas. Discuss the scope of the proposed review with the examiner in charge 

if needed.

2. Identify the institution’s return objectives and risk constraints. 

3. Review and evaluate trends in the institution’s return on equity, return on assets, and 

net interest margin. Review the interest rate risk exposure report to evaluate trends in 

net portfolio value. 

4. Review the institution’s policies, procedures, and controls regarding funds management. Determine whether objectives are reasonable, and whether risk constraints are 

prudent given the association’s capital and earnings characteristics. Determine whether 

written policies, procedures, and controls are adequate. 

5. Review applicable board or committee minutes and reports.

6. Determine whether the board of directors and management have a comprehensive funds 

management process and adequately performs the funds management functions. 
Funds Management

Program

Exam Date

Prepare By:

Reviewed By:

Docket #:

510P.2 Regulatory Handbook April 2001 Office of Thrift Supervision

Wkp.Ref.

7. Evaluate senior management’s depth of understanding of the funds management process.

8. Study the flow of data from the functional areas. Review any assumptions the association uses.

9. Review output reports from any analytical models used in funds management. Determine whether they are adequate to fulfill the needs of the funds management function. 

10. Determine whether the institution relies excessively on outside vendors or consultants 

for financial modeling. 

11. Review the execution and related documentation of the association’s strategies. If there 

are procedural or control concerns, expand scope to include Level II procedures.

12. Determine compliance with board-approved funds management policies.

13. Review Level II procedures and perform those necessary to test, support, and present 

conclusions derived from performance of Level I procedures.

Level II

14. Review related internal procedures and controls in detail. Verify the institution follows 

all procedures and controls.
Funds Management

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 510P.3

Wkp.Ref.

15. Determine whether any inaccuracies in or misuse of data or assumptions are contributing to inappropriate or poorly executed funds management decisions. 

16. Review the assumptions used in any financial modeling systems. Determine whether the 

models are appropriate given the association’s size and complexity. Perform on-site review of vendor or consultant models, if necessary.

17. Recommend changes in structure, functions, and other aspects of the funds management 

process, if necessary. 

18. Ensure that your review meets the Objectives of this Handbook Section. State your 

findings and recommendations on the appropriate work papers and report pages.
CHAPTER: Liquidity

SECTION: Investment Securities Section 540

INTRODUCTION

Office of Thrift Supervision April 2001 Regulatory Handbook 540.1

Savings associations must conduct their investment activities prudently and within the bounds of 

a clear and well-reasoned investment policy. Associations should have diversified portfolios that 

achieve an appropriate balance between risk and 

return. In addition, associations should establish 

appropriate risk management systems and controls 

to monitor and control investment portfolio activity and performance.

This section outlines the following areas:

• Role of the investment portfolio

• Permissible investments

• The investment process

• Investment risks

• TB 13a requirements and guidance

• Use of investment consultants

• Reporting and accounting for securities

• Collateralized Mortgage Obligation

(CMO) issuances

In addition, this section has three appendices that 

cover the following areas:

Appendix A — Total Return Analysis

Appendix B — Money Market, Fixed-Income 

Market, and Equity Market Securities

Appendix C — Mortgage-Related Securities

ROLE OF THE INVESTMENT 

PORTFOLIO

A savings association’s investment portfolio 

serves as a source of income and liquidity, as well 

as a tool for asset/liability management. At many 

associations, the primary influences of loan demand and liquidity needs determine the percentage 

of assets allocated to the investment portfolio. 

When loan demand is weak, the association deploys excess cash inflows in the investment 

account, and when loan demand is strong, the association draws down the investment account. 

Since savings associations can change the composition of an investment portfolio with relative ease, 

many savings associations also use the investment 

portfolio to adjust their overall interest rate risk 

exposure. Similarly, some associations use the 

investment portfolio to manage diversification, 

asset quality, and risk-based capital levels. 

PERMISSIBLE INVESTMENTS

Section 5 of the Home Owners’ Loan Act 

(HOLA) outlines permissible investments for federal savings associations. Applicable OTS 

regulations include those in Part 560, Lending and 

Investment.

Subject to certain restrictions and limitations, the 

following types of investments are permissible 

investments for savings associations:

• Bankers’ bank stock

• Business development credit corporations

• Commercial paper

• Corporate debt securities

• Community development equity investments

• Deposits in insured depository institutions

• U.S. Treasury securities

• Securities and instruments issued by U.S. 

Government-sponsored enterprises

• Foreign assistance investments

• HUD-insured or guaranteed investments
SECTION: Investment Securities Section 540

540.2 Regulatory Handbook April 2001 Office of Thrift Supervision

• Liquidity investments

• Mortgage-backed securities

• National Housing Partnerships Corporation 

and related partnerships and joint ventures

• Open-end management investment companies 

registered with the SEC

• Small business investment companies

• Small business-related securities

• State and local government obligations

• State and local housing

• State housing corporations.

See Appendices B, Money Market, Fixed-Income 

Market, and Equity Market Securities; and C, 

Mortgage-Related Securities, for information on 

specific types of investments.

THE INVESTMENT PROCESS

A sound investment program results from clear 

policies and objectives, and a sound investment 

process. The savings association should begin the 

investment process by determining its objectives 

for return requirements and risk tolerance. Management should have a clear understanding of how 

much return they expect the investment portfolio 

to generate and how much risk they can tolerate. 

Management should determine risk and return objectives in the context of the various investment 

constraints faced by the savings association, including those that restrict the list of permissible 

investments. The association’s investment objectives and constraints provide the foundation for 

developing sound investment policies. 

Investment Objectives

The savings association should clearly state portfolio objectives. The objectives should focus on 

the trade-off between risk and return. In formulating risk and return objectives, a savings 

association should consider the following constraints: 

• Liquidity

• Interest rate risk

• Investment horizon

• Taxes

• Laws and regulations 

• Other needs.

The investment objectives should be internally 

consistent and supportive of other efforts such as 

the interest rate risk policy, funds management, 

capital plan, and profit plan. The investment policy should fit into the association’s overall 

direction as described in the business plan.

INVESTMENT RISKS

Investment Risk Versus Portfolio Risk

While management should understand the risks 

associated with individual securities, the decision 

of whether to buy a security should not rest on the 

risk of a security alone. Management should 

evaluate how the addition of the security to the 

portfolio affects the overall risk and return of the 

portfolio. The addition of a risky security to a 

portfolio can either raise or lower portfolio risk 

depending on the characteristics of the security 

and the portfolio.

Management should have a clear understanding of 

how changes in the composition of the investment 

portfolio affect the risk of the investment portfolio 

and the overall risk of the savings association. In a 

sense, the investment portfolio is a portfolio within 

a larger portfolio that includes all the assets, liabilities, and off-balance sheet contracts of the 

savings association. The overall risk of the savings association should be the primary 

consideration of management.

All investments, even U.S. Treasury securities, 

carry some elements of risk. The primary risks 

associated with investments are:

• Market risk (including interest rate risk)

• Credit risk

• Prepayment risk

• Liquidity risk 
SECTION: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540.3

• Operational risk.

Market Risk

We define market risk as the potential that the 

market price of a security will fall due to changes 

in interest rates, exchange rates, commodity 

prices, or other market or political conditions. 

A primary market risk faced by investors in fixed 

income securities is interest rate risk. Simply put, 

interest rate risk is the risk that the price of a security will change when interest rates rise or fall. 

Almost all fixed income securities decline in price 

when interest rates rise. 

A savings association can control the degree of 

interest rate risk in its investment portfolio by 

managing the weighted average maturity of the 

securities in its portfolio. In general, the longer the 

weighted average maturity of a portfolio, the 

greater the interest rate risk. Similarly, a savings 

association can also control interest rate risk exposure by managing the duration of the portfolio. 

Duration is a more precise measure of the interest 

rate sensitivity of a security or a portfolio of securities than weighted average maturity. Duration is 

a measure of the average time required to receive 

all the cash flows (interest and principal) from a 

security or a portfolio of securities. The higher a 

portfolio’s duration, the greater the losses when 

interest rates rise. In general, bonds with longer 

maturities and higher durations carry more risk. 

For more information on interest rate risk, see 

Section 650.

Credit Risk

Credit risk is the risk that an issuer may default 

(fail to pay) on principal or interest payments. 

Savings associations can manage the credit risk of 

an investment portfolio by using the following 

techniques:

• Portfolio diversification — investing in a variety of securities with differing credit risks.

• Investment selection — managing the quality 

of securities in the portfolio. 

Savings associations can assess the overall quality 

of individual bonds by analyzing the financial 

condition of the issuer and other related factors. 

Such factors include the quality of management, 

competitive conditions in the industry, economic 

conditions, and so forth.

Many investors rely on credit rating agencies to 

measure the quality of corporate and municipal 

bonds. The most widely used bond rating agencies 

are Standard & Poor’s Ratings Services and 

Moody’s Investors Service.

Savings associations may only invest in investment grade bonds. Investment grade bonds are 

those in one of the four highest rating categories 

by a nationally recognized investment rating service such as Standard & Poor’s and Moody’s. 

Savings associations, by statute, may not invest in 

non-investment grade bonds. The table below 

shows investment-grade and non-investment-grade 

ratings of these agencies.

Bond-Quality Ratings

Moody’s Standard & Poor’s

Investment Grade: Investment Grade:

Aaa – Highest Quality

Aa

A

Baa

AAA – Highest Quality

AA

A

BBB

Non-Investment Grade 

(“Junk Bonds”) 

Ba and below 

Non-Investment Grade 

(“Junk Bonds”) 

BB and below

Savings associations that invest in corporate 

bonds should obtain current bond ratings before 

purchase and should review the ratings of their 

holdings on a regular basis. For more detailed information on bond ratings, see Appendix B, 

Money Market, Fixed-Income Market, and Equity 

Market Securities.

For both rated and non-rated issues, associations 

should develop a system of periodic credit review. 

Refer to Thrift Activities Regulatory Handbook 

Section 260, Classification of Assets, for classification of non-investment-grade corporate debt 

securities.
SECTION: Investment Securities Section 540

540.4 Regulatory Handbook April 2001 Office of Thrift Supervision

Prepayment Risk

Prepayment risk is the risk that an issuer may repay all or part of the principal on a bond prior to 

maturity. Prepayment risk is a particular concern 

with mortgage-backed securities (MBS). Issuers 

back MBS by mortgages that borrowers can prepay or refinance. When this occurs, the principal 

of the MBS is reduced and the issuer returns the 

cash flows from prepayments to the holders of the 

MBS. The risk is that the bonds will repay at an 

inopportune time, such as when interest rates are 

falling. Periods of falling interest rates usually 

generate widespread prepayments. If the investor 

wants to reinvest the proceeds from the prepayments, the prevailing yields on newly issued bonds 

are generally lower than the investor previously 

earned on the bond that prepaid. 

Liquidity Risk

Liquidity risk is the risk that a security will be 

difficult to sell at a reasonable price within a reasonable time. On occasion, the liquidity of entire 

securities markets can seize up due to financial 

crisis or panic. Certain types of securities, however, such as those of small firms and securities 

with unusual features, are inherently illiquid. 

By law, savings associations may not invest in 

corporate securities that they cannot sell with reasonable promptness at a price that corresponds 

reasonably to the fair value of the security. See 12 

CFR §541.7.

Operational Risk

Operational risk is the risk that deficiencies or 

failures in personnel, technology, or systems will 

result in unexpected losses.

Settlement Risk 

Settlement is an arrangement between parties for 

payment or receipt of cash or securities. Settlement risk is the possibility that a counterparty will 

fail to honor its obligation to deliver cash or securities at settlement, and is a key operational risk in 

managing investment portfolios. 

The careful selection of brokers and dealers can 

mitigate settlement risk. The selection process 

should include a review of each firm’s financial 

statements and an evaluation of its ability to honor 

its commitments. 

An inquiry into the general reputation of the dealer 

is also appropriate. This includes review of information from state or federal securities regulators 

and industry self-regulatory organizations. For 

example, the National Association of Securities 

Dealers provides public information concerning 

any formal enforcement actions against the dealers, their affiliates, and associated personnel.

TB 13a REQUIREMENTS 

You should ensure that the savings association 

conducts its investment activities in accordance 

with Thrift Bulletin 13a. Part III of TB 13a identifies, in broad terms, the types of analysis a 

savings association should undertake before making securities investments. A savings association 

should exercise diligence in assessing the risks and 

returns associated with investment securities, including expected total return. For a discussion of 

total return, see Appendix A, Total Return Analysis. As a matter of sound practice, before taking 

an investment position, an institution should:

• Ensure that the investment is legally permissible. Review the terms and conditions of the 

investment. Ensure that the investment is allowable under the institution’s investment 

policies and is consistent with the institution’s 

objectives and liquidity needs. Exercise diligence in assessing the market value, liquidity, 

and credit risk of the investment.

• Conduct a pre-purchase portfolio sensitivity 

analysis for any significant investment (see TB 

13a for details).

• Conduct a pre-purchase price sensitivity analysis of any complex security before taking a 

position (see TB 13a for details).

TB 13a states that, “Investments in complex securities and the use of financial derivatives by 

associations that do not have adequate risk measurement, monitoring, and control systems may be 

viewed as an unsafe and unsound practice.”
SECTION: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540.5

Risk Reduction 

In general, savings associations should limit investments in complex securities with high price 

sensitivity (see TB 13a) to transactions and 

strategies that lower interest rate risk. Any savings 

association that invests in such securities for a 

purpose other than that of reducing portfolio risk 

should do so in accordance with safe and sound 

practices.

Sound Practices for Market Risk Management

You should assess the overall quality and effectiveness of the savings association’s risk 

management process as it relates to investment 

activities. In making this assessment, you should 

review TB 13a, Appendix B, Sound Practices for 

Market Risk Management. This section summarizes the key elements of that Appendix. 

Board and Senior Management Oversight

The board and senior management should understand their oversight responsibilities regarding the 

management of investment activities. Board oversight need not involve the entire board, but may be 

carried out by an appropriate subcommittee of the 

board. In particular, the board, or an appropriate 

subcommittee of board members, should take the 

following steps:

• Approve broad objectives and strategies and 

major policies governing investment activities.

• Provide clear guidance to management regarding the board’s tolerance for risk.

• Ensure that senior management takes steps to 

measure, monitor, and control risk.

• Review periodically information that is sufficient in timeliness and detail to allow the board 

to understand and assess the institution’s investment activities. 

• Assess periodically compliance with boardapproved policies, procedures, and risk limits. 

• Review policies, procedures, and risk limits at 

least annually.

Senior management should ensure the effective 

management of the institution’s operations, establish and maintain appropriate risk management 

policies and procedures, and ensure that resources 

are available to conduct the institution’s activities 

in a safe and sound manner. In particular, senior 

management should take the following steps:

• Ensure that effective risk management systems 

are in place and properly maintained. 

• Establish and maintain clear lines of authority 

and responsibility for managing investment activities. 

• Ensure that competent staff with technical 

knowledge and experience consistent with the 

nature and scope of their activities conducts 

the institution’s operations and activities.

• Provide the board of directors with periodic 

reports and briefings on the institution’s investment activities and risk exposures. 

• Review periodically the institution’s investment risk management systems, including 

related policies, procedures, and risk limits. 

Adequate Policies and Procedures 

Savings associations should have written policies 

and procedures governing investment activities. 

Such policies and procedures should be consistent 

with the institution’s strategies, financial condition, risk-management systems, and tolerance for 

risk. An institution’s policies and procedures (or 

documentation issued pursuant to such policies) 

should do the following:

• Identify the staff authorized to conduct investment and derivatives activities, their lines of 

authority, and their responsibilities.

• Identify the types of authorized investments 

and investment instruments.

• Specify the required type and scope of prepurchase analysis for various types or classes 

of investment securities.

• Define, where appropriate, position limits and 

other constraints on each type of authorized 

investment, including constraints on the pur-
SECTION: Investment Securities Section 540

540.6 Regulatory Handbook April 2001 Office of Thrift Supervision

pose(s) for which such instruments may be 

used.

• Identify dealers, brokers, and counterparties 

that the board or a board-designated committee 

authorizes the institution to conduct business 

with and identify credit exposure limits for 

each authorized entity.

• Ensure that contracts are legally enforceable 

and documented correctly.

• Establish a code of ethics and standards of 

professional conduct applicable to personnel 

involved in investment and derivatives activities.

• Define procedures and approvals necessary for 

exceptions to policies, limits, and authorizations. 

Monitoring and Reporting 

Savings associations should have accurate, informative, and timely management information 

systems, both to inform management and to support compliance with investment policy. The 

board of directors and senior management should 

receive reports for monitoring investment risk on a 

timely basis.

The board of directors and senior management 

should monitor investment activities on a regular 

basis. The types of reports prepared for the board 

and various levels of management will vary depending on the size and complexity of the saving’s 

associations operations.

Record Keeping

Savings associations must maintain accurate and 

complete records of all securities transactions according to 12 CFR § 562.1. In particular, savings 

associations should retain any analyses (including 

pre- and post-purchase analyses) relating to investment transactions. A savings association 

should make these records available to you upon 

request.

Internal Controls

Savings associations should have adequate internal controls over investment activities. A 

fundamental component of the internal control 

system involves regular independent reviews and 

evaluations of the effectiveness of the system.

Internal controls should promote effective and 

efficient operations, reliable financial and regulatory reporting, and compliance with relevant laws, 

regulations, and institutional policies. An effective 

system of internal control should include the following elements:

• Effective policies, procedures, and risk limits.

• An adequate process for measuring and evaluating risk.

• Adequate risk monitoring and reporting systems.

• A strong control environment.

• Continual review of adherence to established 

policies and procedures.

Savings associations should review their system of 

internal controls at least annually. Individuals independent of the function being reviewed should 

conduct the review. Reviewers should report results directly to the board. You should consider 

the following factors when reviewing an institution’s internal controls: 

• Does the association maintain risk exposures 

at prudent levels?

• Does the association employ the risk measures 

that are appropriate to the nature of the portfolio?

• Does the association have board and senior 

management actively involved in the risk management process?

• Does the association document policies, controls, and procedures adequately?

• Do association personnel follow the established 

policies and procedures? 

• Does the association adequately document the 

assumptions of the risk measurement system? 

• Does the association accurately process data? 

• Is the risk management staff adequate?
SECTION: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540.7

• Has the association changed risk limits since 

the last review?

• Have there been any significant changes to the 

institution’s system of internal controls since 

the last review?

• Are internal controls adequate?

Analysis and Stress Testing

Management should thoroughly analyze the various risks associated with investment securities 

before making an investment. (See TB 13a, Part 

III.) In addition, management should periodically 

review the portfolio.

Before taking a position in any complex securities, 

management should analyze how the future direction of interest rates and other changes in market 

conditions could affect the instrument’s cash flows 

and market value. In particular, management 

should understand the following elements of the 

complex security:

• The structure of the instrument.

• The best case and worst-case interest rate scenarios for the instrument.

• How the existence of any embedded options or 

adjustment formulas might affect the instrument’s performance under different interest 

rate scenarios.

• The conditions, if any, under which the instrument’s cash flows might be zero or negative.

• The extent to which price quotes for the instrument are available.

• The instrument’s universe of potential buyers.

• The potential loss on the instrument (that is, 

the potential discount from its fair value) if 

sold prior to maturity. 

• That the issuer, together with any guarantors, 

has the financial capacity, and willingness to 

meet the repayment terms of the investment.

• That analysis of the legal structure of the investment affirms the institution’s authority to 

make such investment.

• How the investment is expected to perform 

under various loss and interest rate scenarios, 

the impact on the overall risk profile of the institution and how all covenants of any trust 

agreement apply to the senior tranches.

• The effect of the payment priority should the 

security be divided into separate tranches with 

unequal payments.

• That a review and analysis of the collateral 

managers includes historical performance to 

document investment prudence.

Evaluation of New Products, Activities, and Financial Instruments

New investment products and activities can entail 

significant risk. Senior management should evaluate the risks inherent in new products and 

activities to ensure that they are subject to adequate review procedures and controls. The board, 

or an appropriate committee, should approve major new initiatives involving new products and 

activities. 

Before authorizing a new initiative, the review 

committee should review the following items:

• A description of the relevant product, activity, 

or instrument.

• An analysis of the appropriateness of the proposed initiative in relation to the institution’s 

overall financial condition and capital levels.

• Descriptions of the procedures to measure, 

monitor, and control the risks of the proposed 

product, activity, or instrument.

Management should ensure that adequate risk 

management procedures are in place before undertaking any significant new initiatives.

USE OF INVESTMENT CONSULTANTS

Some savings associations use consultants in the 

investment process. The association should limit 

the role of consultants and brokers to advising 

management and executing transactions approved 

by management. The savings association should 

not delegate investment decision-making authority 
SECTION: Investment Securities Section 540

540.8 Regulatory Handbook April 2001 Office of Thrift Supervision

to third parties, including brokers or consultants. 

Ceding decision-making power to a consultant or 

broker represents an unsafe and unsound practice.

Any savings association that engages a consultant 

must have a formal written contract that covers 

the following elements:

• The types of assets that the consultant or broker can buy and sell on a pre-approved basis.

• The requirement for authorization from the 

board or senior management for any transactions not pre-approved in the contract.

• The documentation and rationale for each trade 

made for the savings association.

• The requirement of the consultant or broker to 

maintain records and submit evidence that they 

obtain prices from several brokers for all 

transactions, particularly if the consultant is a 

broker.

• Compensation programs that do not encourage 

churning (excessive trading activity) of portfolios or short-term strategies that are not in the 

savings association’s best interest.

• The right of the savings association or its agent 

to audit the records of transactions executed 

for the savings association.

• The authority of OTS to examine the records 

of the consultant or broker that pertain to the 

transactions for the savings association.

If a savings association uses consultants, it should 

establish internal policies, controls, and procedures that include the following criteria:

• Establish limitations on the assets managed by 

consultants with consideration to the types and 

level of risk of the assets authorized for purchase.

• Monitor compliance with the limitations established by the board.

• Require senior management personnel or an 

independent agent to periodically audit the 

consultant or broker to ensure that the firm is 

buying and selling securities at the most favorable price for the savings association.

• Guarantee that the savings association always 

has a perfected security interest on securities 

bought for its account.

The savings association should measure the performance of the consultant against a relevant 

benchmark (for example, a standard bond index). 

In measuring the performance (total return) of the 

consultant against a benchmark, the association 

should factor in fees and expenses charged by the 

consultant. Savings associations should note that 

consultants and contractors may be subject to 

OTS enforcement actions as provided for by Section 8 of the FDIA, as amended by FIRREA.

Senior management personnel should supervise 

the activities of the consultant to ensure conformity to the savings association’s investment, 

liquidity, and interest rate risk management plan. 

Management must keep the board of directors informed of the performance of the consultant, 

through periodic reports.

REPORTING AND ACCOUNTING FOR 

SECURITIES

Part 562 of the OTS regulations, require savings 

associations to record and report their financial 

condition according to GAAP. This responsibility 

includes the obligation to properly account for the 

savings association’s securities under GAAP.

Savings associations must categorize each security as trading, available-for-sale (AFS), or heldto-maturity consistent with FASB Statement No. 

115, Accounting for Certain Investments in Debt 

and Equity Securities, as amended. A savings association should determine whether securities are 

for its trading accounts, AFS, or held-to-maturity 

at the time it purchases or originates the securities. 

The savings association should not record securities in a suspense account until it determines the 

appropriate category. Management should periodically reassess its security categorization 

decisions to ensure they remain appropriate.

Trading Assets

Savings associations should classify as trading 

assets securities that the association intends to 

hold principally for the purpose of selling them in 
SECTION: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540.9

the near term. Trading activity includes active and 

frequent buying and selling of securities for the 

purpose of generating profits on short-term fluctuations in price. Savings associations must report 

securities held for trading purposes at fair value; 

and recognize unrealized gains and losses in current earnings and regulatory capital.

Held-to-Maturity

Held-to-maturity securities are debt securities that 

the savings association has the positive intent and 

ability to hold to maturity. Savings associations 

generally report held-to-maturity securities at amortized cost.

Available-for-Sale

Savings associations must report securities not 

categorized as trading or held-to-maturity as 

available-for-sale. Savings associations must report AFS securities at fair value on the balance 

sheet. Savings associations must exclude unrealized gains and losses from earnings and report 

them in a separate component of equity capital.

Section 260, Classification of Assets, states that 

savings associations holding noninvestment grade 

securities with maturities of July 1, 1994, or later 

must classify these securities as held for sale since 

they do not have the ability to hold them to maturity.

Changes in Categorization

If a savings association judges a decline in fair 

value of a held-to-maturity or AFS security to be 

other than temporary, the cost basis of the individual security shall be written down to fair value 

as a new cost basis and include the amount of the 

write-down in earnings. For example, if it is probable that a savings association will be unable to 

collect all amounts due according to the contractual terms of a debt security not impaired at 

acquisition, an other-than-temporary impairment 

has occurred.

Sales from the held-to-maturity portfolio could 

call the intent to hold to maturity into question and 

result in tainting the remaining portfolio. The savings association may need to redesignate the 

portfolio as AFS and be subject to mark-to-market 

adjustments. As a result, savings associations 

normally limit portfolio restructuring activities to 

AFS portfolios.

Proper Categorization of Securities

The proper categorization of securities ensures 

that savings associations promptly recognize trading gains and losses in earnings and regulatory 

capital.

Trading Activity

While designating certain assets for trading can be 

consistent with prudent investment securities management, you may consider certain practices 

speculative or otherwise abusive. OTS and the 

other banking agencies consider the following 

practices to be trading activities.

Gains Trading

Gains trading is the purchase of a security and the 

subsequent sale of the same security at a profit 

after a short holding period. Savings associations 

typically retain securities acquired for this purpose that the association cannot sell at a profit in 

the AFS or held-to-maturity portfolio. Savings 

associations may use gains trading to defer recognition of losses because unrealized losses on AFS 

and held-to-maturity debt securities do not directly 

affect regulatory capital. Generally, savings associations do not report unrealized losses in income 

until the security is sold. A pattern of selling 

above-market securities at a gain while retaining 

below-market securities overstates the institution’s 

financial health.

When-Issued Securities Trading

When-issued securities trading is the buying and 

selling of securities in the period between the announcement of an offering and the issuance and 

payment date of the securities. A purchaser of a 

when-issued security acquires the risks and rewards of owning a security and may sell the whenissued security at a profit before having to take 

delivery and pay for it. Because savings associations intend such transactions to generate profits 

from short-term price movements, savings asso-
SECTION: Investment Securities Section 540

540.10 Regulatory Handbook April 2001 Office of Thrift Supervision

ciations should categorize such transactions as 

trading.

Pair-offs

Pair-offs are security purchase transactions that 

are closed-out or sold at, or prior to, settlement 

date. In a pair-off, a savings association commits 

to purchase a security. Then, prior to the predetermined settlement date, the savings association 

will pair-off the purchase with a sale of the same 

security. Pair-offs are settled net when one party 

to the transaction remits the difference between 

the purchase and sale price to the counter party. 

Pair-offs may also involve the same sequence of 

events using swaps, options on swaps, forward 

commitments, options on forward commitments, 

or other off-balance sheet derivative contracts.

Extended Settlements

In the U.S., regular-way settlement for federal 

government and federal agency securities (except 

mortgage-backed securities and derivative contracts) is one business day after the trade date. 

Regular-way settlement for corporate and municipal securities is three business days after the trade 

date. For mortgage-backed securities, it can be up 

to 60 days or more after the trade date. Securities 

dealers may offer the use of extended settlements 

to facilitate speculation on the part of the purchaser, often in connection with pair-off 

transactions. Savings associations should report 

as trading assets securities acquired through the 

use of a settlement period in excess of the regularway settlement periods to facilitate speculation. 

Repositioning Repurchase Agreements

A repositioning repurchase agreement is a funding 

technique offered by a dealer in an attempt to enable a savings association to avoid recognition of 

a loss. 

A repositioning repurchase agreement occurs 

when a savings association enters into a whenissued trade or a pair-off (which may include an 

extended settlement) that the savings association 

cannot close out at a profit on the payment or settlement date. The dealer provides financing in an 

effort to fund its speculative position until the security can be sold at a gain. The savings 

association purchasing the security typically pays 

the dealer a small margin that approximates the 

actual loss in the security. The dealer then agrees 

to fund the purchase of the security, typically by 

buying it back from the purchaser under a resale 

agreement. The savings association should report 

as trading assets any securities acquired through a 

dealer financing technique such as a repositioning 

repurchase agreement that the association uses to 

fund the speculative purchase of securities.

Short Sales

A short sale is the sale of a security that the savings association does not own. The purpose of a 

short sale generally is to speculate on a fall in the 

price of a security.

Adjusted Trading

Adjusted trading is not acceptable under any circumstances. Adjusted trading involves the sale of 

a security to a broker dealer at a price above the 

prevailing market value. Simultaneously, the savings association purchases and books a different 

security, frequently a lower-rated or lower quality 

issue or one with a longer maturity, at a price 

above its market value. Thus, the savings association reimburses the dealer for losses on the 

purchase from the savings association and ensures 

the dealer a profit. Such transactions inappropriately defer the recognition of losses on the security 

sold and establish an excessive cost basis for the 

newly acquired security. Consequently, the banking agencies prohibit such transactions. In 

addition, these transactions may be in violation of 

18 USC §§ 1001, False Statements or Entries, and 

1005, False Entries.

Limits on MBS Trading Activity

Savings associations may buy and sell securities 

to manage risk or to improve profitability. Active 

management of an MBS portfolio may presume an 

ability to anticipate changes in market interest 

rates. In practice, interest rates are notoriously 

difficult to predict. Active portfolio management 

requires outguessing the market consensus sufficiently to cover transaction costs. Historical data 

suggests that very few investment professionals 

can outperform a passive fixed income indexing 

strategy with active portfolio management. 
SECTION: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540.11

OTS allows savings associations to use an MBS 

portfolio for trading purposes only in limited cases 

and subject to certain safeguards. The institution 

should have the core earnings and capital to absorb potential trading losses. The savings 

association should also possess the financial expertise and management information systems to 

monitor and evaluate trading activity effectively.

You should determine the amount of MBS trading 

activity by reviewing the volume of trades transacted since the previous examination. You should 

quantify the volume and compare it with the 

change in portfolio balances since the previous 

examination. Calculate portfolio turnover ratio by 

comparing the dollar amount of securities sold, by 

type, with the balance of the portfolio at the beginning of a period. For example, if the savings 

association sold $10 million of MBSs all with the 

same coupon rate during the quarter, compared 

with the balance of $10 million of this coupon rate 

at the beginning of the quarter, the turnover ratio 

would be 100 percent. You can make these comparisons on a monthly or annual basis.

There is no threshold of turnover that automatically indicates that the MBS portfolio is part of a 

trading portfolio. You should review the composition of the trades and determine the rationale for 

the transactions. 

While designating certain assets for trading can be 

consistent with prudent portfolio management, 

you may consider certain practices speculative or 

otherwise abusive. 

COLLATERALIZED MORTGAGE 

OBLIGATION (CMO) ISSUANCES

Some savings associations issue CMOs. The issuer may retain a subordinate interest in the CMO 

as a credit enhancement to outside investors. The 

gain recognized on the sale depends on the relative 

fair values assigned to the sold and retained 

tranches. The higher the value assigned to the retained pieces, the lower the cost basis for the 

securitized assets, and the larger the recognized 

gain on sale. There is often no liquid market for 

the retained securities, so their fair values may be 

difficult to verify. You must analyze the savings 

association’s valuation assumptions to ensure that 

the savings association bases its gain on sale upon 

the economics of the transaction rather than 

merely an inflated value assigned to retained 

tranches. Particularly important variables include 

the assumed prepayment rate, loss rate on the underlying mortgages, and required rate of return 

(discount rate).

Consult Appendix C of this section and Section 

560, Deposits/Borrowed Funds, for a more detailed discussion of CMO issuances.

REFERENCES

United States Code (12 USC)

§ 1464(c)(1) Loans for Investments Without 

Percentage of Asset Limitation

§ 1464(c)(2) Loans or Investments Limited to 

Stated Percentage of Assets or 

Capital 

§ 1464(c)(4) Other Loans and Investments 

Code of Federal Regulations (12 CFR)

§ 560.40 Commercial Paper and Corporate 

Debt Securities 

§ 560.42 Government Obligations

§ 560.93 Lending Limitations 

§ 562.2 Regulatory Reports

§ 563.172 Financial Derivatives

Part 566 Liquidity

Office of Thrift Supervision Bulletins and 

Memoranda

RB 3b Policy Statement on Growth for

Savings Associations

TB 13a Management of Interest Rate 

Risk, Investment Securities, and 

Derivative Activities

TB 13a-2 Structured Advances

FFIEC Policy Statement

Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities (April 

23, 1998)
SECTION: Investment Securities Section 540

540.12 Regulatory Handbook April 2001 Office of Thrift Supervision

Financial Accounting Standards Board, Statement of Financial Accounting Standards 

(SFAS)

No. 91 Accounting for Nonrefundable 

Fees and Costs Associated with 

Originating or Acquiring Mortgages with Initial Direct Cost of 

Leases

No. 107 Disclosures about Fair Value of 

Financial Instruments

No. 115 Accounting for Certain Investments 

in Debt and Equity Securities

No. 125 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities

Emerging Issues Task Force (EITF) 

No. 86-38 Implications of Mortgage Prepayments on Amortization of Servicing 

Rights

Other References

Committee on Sponsoring Organizations of the 

Treadway Commission (COSO), Internal Control 

Issues in Derivatives Usage: An Information Tool 

for Considering the COSO Internal Control – Integrated Framework for Derivatives Applications.
Investment Securtities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 540P.1

Examination Objectives

To determine the adequacy of the savings association’s policies, procedures, and internal controls regarding its 

investments.

To determine if the savings association’s investment policy, interest rate risk policy, funds management policy, 

and business plan adequately describe the type and level of authorized investments.

To determine if the savings association documents and describes the rationale for all investments.

To determine if the savings association adequately analyzes its investments prior to purchase.

To determine if these investments are appropriate based on the savings association’s current portfolio, interest 

rate risk structure, and regulatory capital position.

To determine the prudence of risk management strategies through evaluation of practices and procedures.

To determine if the savings association’s officers and employees are operating in conformance with the established policies and whether these individuals have the necessary expertise to execute the authorized strategies.

To determine the overall quality of the savings association’s investments and assess the effect of the portfolio 

quality on the overall soundness of the savings association.

To determine if the savings association is in compliance with the regulations and whether the savings association records transactions according to generally accepted accounting principles (GAAP).

To determine the scope and adequacy of the internal and external audit functions considering the type and 

complexity of the savings association’s investments. 

To determine if the savings association incurred any significant prepayment risk from its investment in mortgage-backed securities (MBSs) or mortgage-derivative products (MDPs).

To determine if the savings association actively monitors its investments.

To determine if the savings association, at least quarterly, obtains or performs analysis of each complex security purchased with board of director approved techniques demonstrating that the security reduces overall 

interest rate risk.

To determine if the savings association engages in speculative trading.

To evaluate investment and trading activities to determine if the volume and number of transactions have any 

broad and potentially adverse effect on the savings association’s financial health. 

To summarize findings and initiate corrective actions when there are deficiencies.
Investment Securtities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

540P.2 Regulatory Handbook April 2001 Office of Thrift Supervision

Examination Procedures

Level I Wkp.Ref.

1. Review scoping materials applicable to this program. If another examiner performed the 

review of scoping materials, obtain a written or oral summary of the review(s) of items 

concerning this program.

2. Determine if the savings association corrected any transactions or policies and procedures subject to any of the following:

• Previous examination report comments and previous examination exceptions.

• Independent audit exceptions.

3. Review the current written investment policy and business plan.

4. Review all procedures related to investment activities.

5. Ascertain whether the board adopted any policy revisions since the previous examination.

6. Judge the adequacy of the guidance in the written investment policy.

7. Evaluate the objectives of the savings association’s investment activities as stated in the 

investment policy and business plan. Discuss any apparent conflicting objectives with 

management.

8. Evaluate whether management has the expertise necessary to carry out the objectives of 

the policy. Identify any backup expertise available to management.
Investment Securities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 540P.3

Wkp.Ref.

9. Review management’s reports to the board for accuracy and completeness.

10. Review board meeting minutes to determine the following:

• Did the board approve the broad objectives, strategies, and major policies for investment activities?

• Do the investment strategies contain an adequate amount of detail?

• Did the board establish appropriate dollar and percentage limits on investment securities?

• Do the reports to the board accurately and adequately detail the returns from the 

investment activity?

11. Review the securities transactions in the context of the savings association’s funds management structure and current interest rate risk profile, profitability, capital, and 

liquidity positions. Discuss findings with examiners working on liquidity funds management, earnings, operations, interest rate risk, and capital.

12. Evaluate whether the savings association classifies transactions appropriately in the 

portfolio as held-to-maturity, available-for-sale (AFS), or trading.

13. Assess policies and procedures for reviewing investment securities for asset classification purposes or coordinate with the examiner reviewing classifications.

14. Identify methods used to estimate prepayments for investment securities.

• Determine if prepayment assumptions differ markedly from those of securities with 

similar underlying collateral.

• Determine the yield and estimated maturity of the investment portfolio.
Investment Securtities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

540P.4 Regulatory Handbook April 2001 Office of Thrift Supervision

Wkp.Ref.

15. Examine the documentation of the analysis of investment securities.

16. Considering a review of the information gathered through procedures, observations, and 

discussions with management and other personnel, determine the following:

• The adequacy of internal controls.

• Proper authorization of all trades.

• Compliance with regulations and conformance with GAAP.

• Management’s level of expertise and conformance by management with the savings 

association’s policies and procedures.

• The adequacy of the management report and information system used to provide 

management and the directors with accurate decision-making information and the 

ability to monitor compliance with established guidelines.

17. Summarize findings, obtain management responses, and update programs and the continuing examination file (CEF), if applicable, with any information that will facilitate 

future examinations. File exception sheets in the general file.

18. Determine that investment securities meet applicable regulatory and policy requirements, including:

• 12 CFR 560.40, Commercial Paper and Corporate Debt Securities.

• 12 CFR 560.32, Pass-Through Investments.

• TB 13a, Management of Interest Rate Risk, Investment Securities, and Derivatives 

Securities.

19. Determine that investment securities are suitable to the institution’s operational and strategic goals and that the securities are safe and sound.
Investment Securities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 540P.5

Wkp.Ref.

20. Determine that the institution performed thorough underwriting analyses prior to purchase.

21. Review Level II procedures and perform those necessary to test, support, and present 

conclusions derived from performance of Level I procedures.

Level II

22. Obtain a listing of all investment securities held. The list should contain, at a minimum, 

the following information:

• Description of the security.

• Classification as held-to-maturity, AFS, or trading.

• Committee on Uniform Securities Identification Procedures (CUSIP) number.

• Purchase price or cost.

• Date of purchase.

• Par value and principal amount purchased.

• Current book value including any unaccreted discounts or unamortized premiums.

• Maturity date and call provisions, if any.

• Current market value.

23. Ascertain whether management shifted its risk posture. Also determine if the savings 

association is taking on riskier investments.

• Obtain a list of securities purchased, sold, and matured between examinations.

• Categorize the securities by type; for example, U.S. Government, agency, state and 

municipal obligations, corporate debt.
Investment Securtities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

540P.6 Regulatory Handbook April 2001 Office of Thrift Supervision

Wkp.Ref.

• Review the analysis of municipal and corporate issues by rating classification. For 

non-U.S. Government securities, obtain most recent bond ratings by an independent 

bond rating service.

• Determine the total in each rating class and total of unrated issues.

• Determine the total of unrated investment securities issued by obligors located outside the savings association’s trade area.

24. Identify any changes in the portfolio composition from the previous examination by type 

and rating.

25. Ascertain whether any concentration of credit exists by type, area, or in any one entity.

26. Ascertain whether market value depreciation is significant in comparison with capital 

and total investment portfolio.

27. Evaluate the overall effectiveness of investment activities and the portfolio’s contribution to the income stream.

• Analyze yields and spreads of the investment portfolio. Ascertain whether investment strategies are effective in maintaining targeted yields and spreads.

• Review net trading gains/losses, taking into consideration broker/dealer commissions.

28. Compare the coupon rates and yields of recently acquired investments with similar instruments. Discuss with management the appearance of any differences where coupon 

rates or yields may be significantly higher or lower.
Investment Securities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 540P.7

Wkp.Ref.

29. Evaluate the savings association’s transactions to determine if securities are held to maturity, AFS, or for trading. Ascertain if the savings association records trading and AFS 

portfolios at fair value.

30. Determine if the association’s trading activity is speculative or abusive. Also determine 

if the association makes adjusted trades.

31. Review any transfers or swaps of securities from the trading or AFS portfolios to the 

held-to-maturity portfolio. 

32. Evaluate the adequacy of credit analysis procedures. Review the savings association’s 

credit analysis of the following:

• The obligor on securities purchased under agreement to resell, when the readily 

marketable value of the security is not sufficient to satisfy the obligation or when 

collateral custody procedures are inadequate to ensure the association’s unassailable right to the collateral.

• All money market instruments acquired since the previous examination.

33. Determine if management identifies credit and default risks; and all defaulted issues.

34. Ascertain any changes in the credit rating after the savings association purchased the 

security.

35. Review the savings association’s classification of securities in accordance with asset 

classification regulations. Indicators of the extent of credit deterioration include credit 

rating downgrades or market value depreciation (excluding that caused by interest-rate 

shifts). The savings association should classify the market value depreciation of defaulted issues as Loss.
Investment Securtities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

540P.8 Regulatory Handbook April 2001 Office of Thrift Supervision

Wkp.Ref.

36. Review the use of outside investment consultants:

• Determine the extent of the capacity in which the consultant serves.

• Review the consultant’s contract.

• Determine the consultant’s background and expertise.

• Determine the consultant’s investment powers and authority.

• Evaluate the supervision, level of control over, and degree of dependence upon outside consultants.

37. Review safekeeping of records to determine location of securities held by third parties. 

Determine if management has procedures to verify that securities are being held in safekeeping. 

38. If the savings association’s stock trades publicly, review the applicable reports filed 

with the Securities and Exchange Commission, including the 10K (Annual) and 10Q 

(Quarterly) for any mention of investments. Determine the accuracy of these references 

and report any discrepancies to OTS Washington pursuant to procedures in Section 

110, Capital Stock and Ownership.

39. Determine if the savings association’s investment in MBSs or MDPs exacerbated or 

caused any deficiencies noted in areas such as:

• The purchase of excessive quantities of low-coupon rate or discount securities that 

would increase interest rate risk.

• Reliance on nonrecurring gains from the sale of MBSs or MDPs to sustain profitability.

• Inadequate capital to sustain adverse fluctuations in the returns from stripped 

mortgage-backed securities (SMBSs) or the residual interest in multiple-class securities.
Investment Securities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 540P.9

Wkp.Ref.

40. Obtain a detailed listing of the mortgage securities as of the examination date. Determine the following:

• The type, coupon rate, and maturity of the securities in the portfolio.

• The dollar amount of these investments as a percentage of total assets.

• If there was a significant increase in the portfolio, identify the funding source and 

the cause of the increase.

41. For MDPs, also ascertain the following:

• The particular class of the security purchased and the terms of that class.

• The characteristics of the collateral underlying the MDP, for example, the type of 

security, weighted average coupon (WAC), and maturity.

• If the savings association performed an analysis of the MDPs.

42. Obtain the contract registers, general and subsidiary ledgers, and trade confirmations 

from brokers to determine:

• The extent of trading activity by reviewing the amount and composition of the portfolio turnover and existence of margin accounts.

• If the savings association obtained and documented comparative price quotes from 

brokers/dealers other than the broker/dealer that executed the transaction.

• If the savings association’s contract register and general and subsidiary records 

correspond to the information detailed on confirmations from brokers.

• The location of all investment securities in safekeeping with other parties or 

pledged as collateral for any transaction.
Investment Securtities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

540P.10 Regulatory Handbook April 2001 Office of Thrift Supervision

Wkp.Ref.

43. Assess the effect of these transactions on the viability of the savings association. Identify the cause of the problems that could involve inadequate management expertise or 

lack of adequate research prior to execution of the strategy. Obtain management’s intended corrective action.

44. Review the adjustable-rate MBSs purchased since the previous examination. Determine 

the following:

• The index, margin, interest rate caps, and any other adjustment features of the adjustable-rate MBS portfolio.

• The dollar amount of the adjustable-rate MBSs retained in portfolio with a large 

portion of the underlying collateral having teaser rates.

• The interest rate risk of this portfolio by comparing the current interest rate with 

the lifetime cap and the frequency of interest-rate adjustments.

45. Determine if the savings association purchased the residual interest in an MDP. If so, 

determine the following:

• If the board of directors approved the transaction and if management updates the 

board regularly on the actual yield.

• If, prior to purchase, the savings association analyzed the effect on yield and potential value changes under varying prepayment assumptions.

• The expected return and prepayment assumptions the savings association based 

this yield upon.

• The underlying structure of the MDP.

• The characteristics of the collateral that underlies the MDP, such as the type of securities (GNMA, Freddie Mac, or Fannie Mae) or whole mortgages, the weighted 

average remaining maturity (WARM), the coupon rate, and the actual prepayment 

experience.

• If the issuer based the security upon real estate mortgage investment conduit 

(REMIC) authority.
Investment Securities

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 540P.11

Wkp.Ref.

• If the savings association intended the investment to be a hedging vehicle, and if so, 

the identity of the matched item and the estimated amount of interest-rate protection 

provided by the residual.

• If the savings association classifies a residual interest in securitized assets properly 

and accounts for them as AFS or trading securities in accordance with SFAS 125 

and SFAS 115.

46. Determine if the savings association purchased a SMBS or any security with similar 

characteristics. If so, determine the following:

• If the board of directors approved the investment and if management updates the 

board regularly on the investment’s actual yield and market value.

• If, prior to purchase, the savings association analyzed the expected yield based on 

various changes in interest and prepayments.

• If the interest only (IO) or principal only (PO) comprises most of the interest.

• The expected yield from the investment and the prepayment assumptions used to 

determine this yield.

• If the savings association intended to use the SMBS as a hedging vehicle, and if so, 

the matched item and the estimated amount of interest-rate protection provided by 

the SMBS.

47. Determine if the savings association purchased MBSs backed by commercial real estate. 

If so, determine the following:

• The type of property.

• The rating of the security, if any.

• If management reviewed the prospectus and supplement with particular attention to 

the risks of the underlying loans and the nature and quality of credit supports.
Investment Securtities

Program

Exam Date:

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Reviewed By:

Docket #:

540P.12 Regulatory Handbook April 2001 Office of Thrift Supervision

Wkp.Ref.

48. Determine if the savings association purchased an interest in a senior/subordinated security. If so, determine the following:

• If the savings association acquired the senior or subordinated interest.

• The types of mortgages underlying the security.

• The investment rating.

• The potential risk of default if the savings association purchased the subordinated 

interest.

• If the savings association is properly reporting its interest in the senior/subordinated securities in accordance with the recourse provisions in OTS 

regulatory capital guidelines.

49. Determine whether the savings association securitized assets and retained a residual interest in those securitized assets or subordinated interests. If so, determine the following:

• If the savings association calculates the gain or loss on the sale in accordance with 

GAAP.

• If the savings association bases the fair value assigned to the retained tranche(s) 

upon reasonable assumptions concerning prepayments and defaults on the underlying loans.

• Whether the savings association uses a reasonable discount rate that reflects the 

risk of the securities.

• The sensitivity of value of the retained tranches to changes in interest rates, prepayments, defaults, or discount rates. 

50. Ensure that your review meets the Objectives of this Handbook Section. State your findings and conclusions, and appropriate recommendations for any necessary corrective 

measures, on the appropriate work papers and report pages.
Investment Securities

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Office of Thrift Supervision April 2001 Regulatory Handbook 540P.13

Level III Wkp. Ref.

51. Reconcile the trial balances to general ledger accounts. Cross check investment trial balances with other schedules or records to determine if securities exist.

52. Verify the accuracy of registers by comparing broker advices with trade tickets. Send 

confirmations to brokers, if necessary.

53. Review pledged securities reports. Identify securities that may be overpledged or crosscollateralized with other securities.

54. Review the maturity distribution schedule and determine if the association is extending 

or shortening the portfolio’s maturity in line with policy objectives.

55. Test for proper accounting for premiums and discounts.

56. Determine proper accounting for gains and losses.
Investment Securities

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TA 540 (04/01) 540Q/Page 1 of 4

Yes No

General Questionnaire

1. Did the board of directors approve a written 

investment policy?.......................................

2. Does the savings association update its 

investment policy annually and whenever 

unanticipated conditions dictate? ................

3. Does the investment policy address the 

assignment of responsibilities and duties?..

4. Do the investment policy and business plan 

confirm the following requirements:

• Safety and soundness?..........................

• Regulatory limitations? ...........................

• The board of director’s requirements?....

5. Does the savings association monitor adherence to the policy? .................................

• How often?______________________

6. Is the investment strategy appropriate 

based upon the savings association’s investment portfolio, interest rate risk, 

profitability, and regulatory capital position?

7. Does the policy define the acceptable level 

of risk?.........................................................

8. Does the association take the following 

considerations into account when looking at 

the composition of the portfolio:

• Investment objectives?...........................

• Investment strategy ...............................

• Types and level of allowable investments?....................................................

• The decision-making process?...............

• Monitoring of investments?.....................

Yes No

• Record keeping and documentation 

requirements?.........................................

9. Does the savings association engage in 

speculative trading strategies? ....................

10. Does the savings association engage in any 

unsuitable investment practices?.................

11. Is the savings association’s trading activity 

appropriate based on the type and amount 

of activity?....................................................

12. Does the composition of the investment 

securities portfolio take into consideration 

the following items:

• Quality levels? ........................................

• Diversification? .......................................

• Maturity structure?..................................

• Liquidity? ................................................

13. Does the savings association have procedures in place to prevent overcollateralization?..........................................

14. Does the savings association maintain an 

adequate control register for its investment 

securities clearly showing the following 

information:

• Types of securities?................................

• Outstanding position?.............................

• Volume of purchases and sales? ...........

• Realized and unrealized gains or losses 

on these positions?.................................

15. Do subsidiary records of investment securities show all pertinent information, including 

the following items:

• A description of the security? .................
Investment Securities

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TA 540 (04/01) 540Q/Page 2 of 4

Yes No

• The safekeeping location of the security?

• Pledged or unpledged status of the security?.....................................................

• Premium amortization?...........................

• Discount accretion?................................

• Interest earned, collected, or accrued? ..

16. Does the savings association perform a 

price sensitivity analysis of complex securities prior to purchase? ................................

17. Does the savings association perform an 

internal analysis of its investment securities 

at least quarterly? .......................................

18. Does the savings association obtain periodic market valuations for the following 

investment securities:

• Thinly traded investments? ....................

• Issues not quoted daily on major markets? ......................................................

19. Does the savings association perform credit 

analyses independently of the investment 

department? ................................................

20. Does the association obtain bond ratings 

from any of the well-known bond rating 

services? .....................................................

• Which services? ....................................

21. Does the savings association appropriately 

classify investment securities? ...................

22. Did the savings association purchase any 

SMBSs or the residual interest in an MDP? 

If so:

Yes No

• Did the board of directors approve the 

investment? ...........................................

• Does the savings association analyze 

the investment prior to purchase, including the estimated yields under various 

interest-rate and prepayment scenarios? 

• Does the savings association document 

the expected yield and the prepayment 

assumptions used? ................................

• Are the initial prepayment assumptions 

reasonable considering the interest rate 

on the underlying collateral when compared with prevailing mortgage interest 

rates? .....................................................

23. Does the savings association periodically 

adjust the yield or book value of an MBS or 

MDP based upon changes in the prepayment experience of the underlying 

collateral? ...................................................

24. Does the savings association purchase 

commercial MBSs? If so, review the following question:

• Do any of these securities have teaser 

rates? .....................................................

• If so, how close was the current interest 

rate to the lifetime cap:

25. Does the savings association issue CMOs 

or MDPs through a subsidiary? ..................

26. Did the savings association purchase the 

senior interest of a senior/subordainted 

security structure? If so, answer the following questions:

• What was the investment rating? ..........
Investment Securities

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Yes No

• What was the underlying collateral? ......

27. Did the savings association purchase the 

subordinated interest in the security? .........

28. Is there adequate segregation between the 

individuals responsible for executing the 

transactions, accounting for the transactions 

and transferring funds? ...............................

29. Do trade tickets contain the following information:

• Trade date? ...........................................

• Settlement date? ...................................

• Purchase or sale transaction? ...............

• Contract description? .............................

• Quantity? ...............................................

• Price? ....................................................

• Reason for trade? ..................................

• Identity of person conducting transaction? .......................................................

30. Does someone other than the person who 

authorizes, executes, or controls the securities record the transaction? .........................

31. Does someone other than the person with 

custody or control of securities post transaction records?................................................

Yes No

32. Does the savings association reconcile 

subsidiary records at least monthly? ...........

• How often? _______________________

• Does the savings association test them 

for accuracy?..........................................

33. Does an independent party, not connected 

with the transaction, review commitments 

and advices?................................................

34. Does the savings association verify delivery 

or safekeeping records?..............................

35. Who has custody or control of securities?

36. Does the savings association obtain comparative price quotes from at least two 

broker/dealers other than the broker/dealer 

that executed the transaction? ....................

37. Does the savings association use reputable 

dealers?.......................................................

38. Is there a concentration of activity with one 

broker/dealer? .............................................

39. Does the association properly safeguard the 

physical securities? .....................................

40. Does the savings association have procedures in place to ensure proper access and 

control?........................................................

41. Does the savings association review safe 

keeping records for accuracy?.....................
Investment Securities

Questionnaire

Exam Date:

Prepared By:

Reviewed By:

Docket #:

TA 540 (04/01) 540Q/Page 4 of 4

Comments
Appendix A: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540A.1

TOTAL RETURN ANALYSIS

This appendix discusses total return analysis and shows how to measure the expected return of fixed-income 

securities. In evaluating the expected return of an individual fixed-income security or portfolio of fixed-income 

securities, investors typically use internal rates of return, such as yield to maturity (YTM) or yield to call 

(YTC), as selection criteria. These two yield measures, however, are unlikely to reflect the correct expected 

investment return. Instead, total return provides a better measure of prospective investment return.

Investment decisions made using YTM or YTC can lead to investments with lower total returns depending on 

the following variables:

• Changes in reinvestment rates.

• End-of-period required yields.

• Length of the investment horizon.

However, there is an important caveat. In computing total returns based on scenario analysis, investors should 

be aware that total return estimates will only reflect investment returns if expectations regarding reinvestment 

rates and end-of-period yields turn out to be correct.

Background

Both the Federal Financial Institutions Examination Council (FFIEC) and the Office of Thrift Supervision 

(OTS) issued policy guidance that recommends institutions conduct a total return analysis in assessing the effects of interest rate changes on the returns associated with investment securities and financial derivatives prior 

to taking a position in these financial instruments. The 1998 FFIEC policy statement states: “The agencies 

agree that the concept of total return can be a useful way to analyze the risk and return tradeoffs for an investment. This is because the analysis does not focus exclusively on the stated yield to maturity. Total return 

analysis, which includes income and price changes over a specified investment horizon, is similar to stress testing securities under various interest rate scenarios. The agencies’ supervisory emphasis on stress testing has, 

in fact, implicitly considered total return. Therefore the agencies endorse the use of total return analysis as a 

useful supplement to price sensitivity analysis for evaluating the returns for an individual security, the investment portfolio, or the entire institution.” In Thrift Bulletin 13a, issued December 1998, OTS states: “Management should exercise diligence in assessing the risks and returns (including expected total return) associated 

with investment securities and financial derivatives.”

Conventional Measures of Investment Return

The price of a bond is equal to the present value of the bond’s expected cash flows. By definition, the yield, or 

internal rate of return, is that interest rate that equates the present value of a bond’s cash flows to its current 

market price. As stated earlier, YTM and YTC are two frequently used measures of return (or yield) on fixedincome securities. YTM is used to price and trade non-callable bonds, while YTC is used to price and trade 

callable bonds.

YTM is the internal rate of return on a non-callable bond that is held until maturity. In using this yield measure, one assumes that the security is held until maturity and that all cash flows can be reinvested at the same 

constant YTM. YTC is the internal rate of return on a callable bond that is held until either the first call or 

first par call date. In using this yield measure, one assumes that the security is held until being called by the 

issuer and that all cash flows can be reinvested at the same constant YTC. 
Appendix A: Investment Securities Section 540

540A.2 Regulatory Handbook April 2001 Office of Thrift Supervision

Both of these return measures have several important drawbacks: 

• Investors typically do not hold fixed-income investments until these investments mature or are called.

• Interim cash flows cannot be reinvested at the assumed constant yields.

• It is not possible to compare the likely returns on investments with different maturities or more complex

return/risk profiles.

Total Return Analysis in Theory

Total return analysis avoids the shortcomings associated with using the two conventional yield measures, 

YTM and YTC, and provides an investor with a better measure of the expected return on fixed-income investments. The total return (also known as the horizon or total holding-period return) accounts for the three 

sources of potential dollar return on a bond:

• Coupon interest payments,

• Capital gain or loss when bond matures, is sold, or called, and

• Income from reinvestment of coupon interest payments (interest-on-interest income).

Therefore, to calculate the total return for a non-callable bond, an investor chooses an investment horizon or 

holding period, a reinvestment rate, and a selling price for the bond at the end of the investment horizon (that 

is, end-of-period required return). Based on the values chosen for these parameters, the total return calculation 

is straightforward. First, calculate total coupon payments plus interest-on-interest income for the assumed reinvestment rate over the given investment horizon using the following expression:

where

h = length of investment horizon, and

r = assumed reinvestment rate.

Second, calculate the predicted sales price of the bond at the end of the investment horizon. Third, calculate 

total future dollars derived from the bond over the holding period by summing total coupon payments, reinvestment income, and the predicted sales price. Finally, substitute this value into the following expression to 

obtain the total return:

where r and h are defined as above, and

Total future dollars = Coupon payments + Interest-on-interest income + Sales price.

1

Purchase price of bond

Total future dollars

y

1/h

h

− 











=











 + −

=

r

[(1 r) 1

Coupon plus interest - on - interest Coupon

h
Appendix A: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540A.3

For example, to obtain the total return on a bond-equivalent basis for a bond with semiannual coupon payments, the semiannual total return calculated using the above expression would be multiplied by a factor of 

two.1

Total Return Analysis in Practice

There are three different approaches an investor or portfolio manager can use to calculate total return:

• Subjective forecasts of the reinvestment rate and required yield at the end of the investment horizon.

• Implied forward rates from the yield curve (for instance, U. S. Treasury or LIBOR yield curves) to determine the reinvestment rates and the yield on a bond at the end of the investment horizon. This approach to 

total return analysis produces an arbitrage-free total return because the calculation is based on the market’s expectations of the reinvestment rate and end-of-period required yield. 

• Scenario analysis. Scenario analysis involves specifying different possible values for the reinvestment rate 

and the required yield at the end of a given investment horizon, and then calculating the total return associated with each scenario. 

Of the three approaches, total return analysis based on scenario analysis is the best approach because it allows 

an investor, or portfolio manager, to measure how sensitive a bond’s expected performance is to differing reinvestment rates and end-of-period required yields. One can also use total return analysis to compare the expected returns of a bond for investment horizons of varying lengths. In the two examples that follow, scenario 

analysis is used to compare:

• The total returns for a bond using two different investment horizons.

• The total returns for two bonds of different maturities.

Assess the effect on a bond’s total return by varying the length of the investment horizon using scenario analysis. Assume Bond A is a 9 percent coupon, 20-year non-callable bond with a current market price of $109.90 

and a yield to maturity of 8 percent. Tables 1 and 1A show scenarios for the reinvestment rate and end of period required yields for Bond A for a three-year and ten-year investment horizon, respectively. 

Table 1

Scenario Analysis for Bond A’s Total Return

Required Yield at End of 3-Year Investment Horizon (%)

6.0 8.0 10.0 

Reinvestment Rate (%)

4.0 13.36 7.78 3.06

5.0 13.44 7.87 3.16

6.0 13.53 7.97 3.26

 

1

 This discussion draws on material from Frank J. Fabozzi, editor, The Handbook of Fixed Income Securities, 5th

Edition, 1997, Chapter 4. See this chapter for further discussion of the total return concept.
Appendix A: Investment Securities Section 540

540A.4 Regulatory Handbook April 2001 Office of Thrift Supervision

Table 1A

Sensitivity of Bond A’s Total Return to Investment Horizon

Required Yield at End of 10-Year Investment Horizon (%)

6.0 8.0 10.0 

Reinvestment Rate (%)

4.0 7.59 6.88 6.24

5.0 7.85 7.16 6.53

6.0 8.11 7.43 6.82

As shown in the tables, there are three different reinvestment rates, 4, 5, and 6 percent, and three different endof-period required yields, 6, 8, and 10 percent. In both tables, for each combination of reinvestment rate and 

end-of-period yield, there is a total return estimate for Bond A. As shown in the two tables, the total return 

estimates vary substantially across the two investment horizons. The differences in the total return estimates 

illustrate the effect that the choice of investment horizon has on a bond’s expected return since the relative importance of the reinvestment rate and end-of-period required return change is related to investment horizon. 

For short investment horizons, reinvestment income is small, but it increases in size as the investment horizon 

lengthens.

The second example compares the total returns for two bonds of different maturities. The first bond, Bond A, 

is the same bond used in the previous example. The second bond, Bond B, is a 7.25 percent coupon, 14-year 

non-callable bond with a current market price of $94.55 and a yield to maturity of 7.9 percent.2 In comparing 

the total returns for the two bonds below, the investment horizon is set to three years. Based on yield to maturity, Bond A appears to be a better investment than Bond B because of Bond A’s higher yield to maturity. 

However, as the example shows convincingly, yield to maturity is not a reliable measure of expected investment return.

Table 1 and Table 2 show various scenarios for the reinvestment rate and end of period required yields for 

Bond A and Bond B, respectively. There are three different reinvestment rates, 4, 5, and 6 percent, and three 

different end of period required yields, 6, 8, and 10 percent. These are the same values used in the previous 

example.

Table 2

Scenario Analysis for Bond B’s Total Return 

Required Yield at End of 3-Year Investment Horizon (%)

6.0 8.0 10.0 

Reinvestment Rate (%)

4.0 12.00 7.50 3.48

5.0 12.08 7.58 3.57

6.0 12.16 7.67 3.67

The total return estimates for both bonds vary substantially across the different rate scenarios. For Bond A, 

these estimates range from a maximum value of 13.53 percent to a minimum value of 3.06 percent. For Bond 

B, these estimates range from a maximum value of 12.16 percent to a minimum value of 3.48 percent. This 

example shows the high degree of sensitivity of a bond’s expected return to different values for reinvestment 

rates and end-of-period required yields. 

 

2

 This example is adapted from Fabozzi, The Handbook of Fixed Income Securities, 5th Edition, pages 72-75.
Appendix A: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540A.5

If a portfolio manager currently owned Bond B, the higher yield to maturity on Bond A might induce the manager to swap Bond A for Bond B in a pure yield pickup swap transaction. However, Tables 1 and 2 show that 

the likely returns on both bonds are sensitive to what happens to interest rates, despite the higher promised 

yield to maturity for Bond A. To see this more clearly, Table 3 shows the total return for Bond A minus the 

total return for Bond B in basis points.

Table 3

Bond A’s Total Return Minus Bond B’s Total Return (in Basis Points) 

Required Yield at End of 3-Year Investment Horizon (%)

6.0 8.0 10.0 

Reinvestment Rate (%)

4.0 136 28 -42

5.0 137 29 -41

6.0 137 30 -41

Table 3 shows that for required yields of 6 and 8 percent, Bond A’s total return exceeds that of Bond B’s for 

all three reinvestment rates. However, for a required yield of ten percent, the situation reverses dramatically, 

with Bond B’s total return exceeding that of Bond A. These results suggest that investment decisions based 

only on stated yield to maturity will not produce the best total returns as interest rates change. The results of 

this simple example demonstrate the importance of conducting a stress test over various interest rate scenarios 

when evaluating the expected return on investment securities before taking positions in these financial instruments.
Appendix B: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540B.1

MONEY MARKET, FIXED-INCOME MARKET, AND EQUITY MARKET SECURITIES

There are investment opportunities in each of the three major areas that make up the money and capital markets:

• Money market

• Fixed-income market

• Equity market.

Money Market

The money market is the arena where financial institutions and other businesses adjust their liquidity positions. 

This primarily consists of debt instruments with a remaining maturity of one year or less. Money market securities generally have a high degree of liquidity and low risk to principal. The money market operates through 

dealers, money center banks, and the Open Market Trading Desk of the New York Federal Reserve Bank.

Federal Funds

Federal funds are balances at the Federal Reserve that financial institutions lend to one another and are not 

subject to reserve requirements. The purchasing institution uses these funds to meet reserve requirements or for 

a special arbitrage funding arrangement. Federal funds sold are subject to default risk, as with any unsecured 

loan. The shorter the term of the transaction, the less default risk is a primary concern. The majority of federal 

funds transactions are for overnight or over weekends. Term federal funds, however, are not uncommon. They 

transact at a fixed rate for a period longer than one day, typically 30, 60, or 90 days. Term federal funds are 

subject to loans-to-one-borrower and other lending limitations.

Negotiable Certificates of Deposit

These certificates are usually issued by money center or large regional banks in denominations of $1M or more 

and the issuing institution may issue them at face value with a stated rate of interest, or at a discount similar to 

U.S. Treasury bills. These certificates are widely traded and offer substantial liquidity.

Eurodollar Time Deposits

Eurodollar time deposits are certificates of deposit issued by banks in Europe, with interest and principal paid 

in dollars. Such certificates of deposit usually have minimum denominations of $100,000 and short-term maturities of less than two years. Usually they have interest rates pegged to LIBOR.

Certificates of Deposit

Certificates of deposit are time deposits in banks or savings associations with maturities longer than 30 days. 

Most certificates of deposit have an original maturity of one to three months. Variable-rate certificates of deposit are also available, typically either six-month with a 30-day roll or one year with a three-month roll. In 

general, certificates of deposit have a slightly higher return, are slightly riskier, and are slightly less liquid than 

Treasury bills. A prudent investment manager should limit holdings in any depository institution to amounts 

covered by federal deposit insurance.
Appendix B: Investment Securities Section 540

540B.2 Regulatory Handbook April 2001 Office of Thrift Supervision

Repurchase Agreements

In a repurchase transaction, an institution loans funds and, in effect, buys securities from a counterparty. They 

also commit to resell the same securities back to the counterparty, at a later date at a specified price. In a reverse repurchase transaction an institution receives funds from and sells securities to a counterparty. They also 

promise to repurchase the same securities at a specified price and date. Repurchase agreements are short-term 

in nature; therefore, the transaction takes place in the money market.

Treasury Bills

U.S. Treasury bills are U.S. Government securities with three-month, six-month, and one-year maturities. The 

government issues them in minimum denominations of $10,000 and multiples of $5,000 thereafter. The government issues treasury bills at a discount from face value. They are exempt from state and local taxation, and 

are backed by the full faith and credit of the U.S. Government.

Municipal Notes

Short-term municipal bond with a maturity of one year or less. 

Municipal Bonds

Municipal bonds based on the general taxing authority of the issuer or general obligation bonds have certain 

factors that may adversely affect the creditworthiness of these types of bonds. These factors include the 

following:

• Declining property values and an increasing number of delinquent taxpayers.

• Increasing tax burden relative to other regions.

• Increasing property tax rate in conjunction with declining population.

• Actual general fund revenues consistently falling below budgeted amounts.

• Budget expenditures increasing annually in excess of inflation rate.

• General obligation debt increasing while property values remain static.

• Declining economy as measured by increased unemployment and declining population.

• Investment activities that involve excessive leveraging to achieve enhanced yields.

Floating-rate notes usually have a maturity of five to seven years, and interest payments periodically adjust, 

often every six months. A money market index, usually Treasury bills or Eurodollar rates determine the interest rate. State, municipal, and other political subdivisions, including independent school districts, issue 

municipal bonds that are usually dependent upon the general taxing authority of the locality or on specific 

revenue generating projects for repayment. Interest income generated by state and municipal obligations is not 

subject to federal income taxes and is usually exempt from taxation by the issuing state and local authorities. 

Other state and municipal obligations include Bond Anticipation Notes (BANs), Tax Anticipation Notes 

(TANs), and Revenue Anticipation Notes (RANs). These notes are short-term obligations to finance current 

expenditures pending receipt of proceeds from expected bond offerings or revenues. 

Section 560.42 permits savings associations to invest in obligations of state or political subdivisions. The obligations must meet the following requirements:
Appendix B: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540B.3

• Rated in one of the four highest grades.

• Issued by a public housing agency.

• Backed by the full faith and credit of the United States.

The regulation limits investments in state or political subdivisions ten percent of capital for any one issuer, 

excluding general obligations of any one issuer. A savings association may invest, in the aggregate, up to one 

percent of its assets outside of the rating requirements and guarantee provisions within the state or political 

subdivision where the savings association’s home or branch office is located.

Revenue Bonds

Revenue bonds are dependent upon the income generated by specific projects established by government authority. A type of revenue bond often held by savings associations are public housing authority revenue bonds. 

Although they have corporate debt characteristics, the FDIC does not consider such public entity issues to be 

corporate debt securities and are not subject to the FDIC divestiture requirements. The credit quality of these 

issues varies greatly and is dependent upon the revenue source, any guarantees, sinking funds, and market 

value of collateral, if any. 

Because the taxing authority does not support revenue bonds, unless rated, you should classify them the same

as other commercial credits. Other factors that negatively affect their creditworthiness include:

• Decreasing coverage of debt service by net revenues.

• Regular use of debt reserves and other reserves by the issuer.

• Growing financial dependence of the issuer on unpredictable federal and state aid appropriations for meeting operating budget expenses.

• Unanticipated cost overruns and schedule delays on capital construction projects.

• Frequent or significant user rates increases.

• Deferred capital plant maintenance and improvement.

• Shrinking customer base.

• New and unanticipated competition.

Commercial Paper

Top-rated corporations issue commercial paper with 2- to 270-day maturities. Commercial paper is unsecured, 

usually discounted and possibly backed by bank lines of credit. Standard and Poor’s rates commercial paper 

ranging from A, the highest quality, to D, the lowest quality. Moody’s uses designations of Prime-1 to Prime3, and Not Prime (issuers that do not fall within any of the Prime rating categories). 

Banker’s Acceptances

Banker’s acceptances arise mostly out of foreign trade transactions and are similar to commercial paper in 

form. They are noninterest-bearing notes sold at a discount and redeemed by the accepting bank at maturity for 

full face value. Banker’s acceptances are short-term instruments with maturities of nine months or less. Most 

banker’s acceptances are for very large amounts, although some are available for as low as $5,000. Liquidity 

risk varies considerably based on the size of the security. There is no secondary market for the very low de-
Appendix B: Investment Securities Section 540

540B.4 Regulatory Handbook April 2001 Office of Thrift Supervision

nomination instruments. Banker’s acceptances have very low credit risk since the accepting bank and the ultimate borrower both guarantee payment.

Federal Agency Discount Notes and Coupon Securities

Although they are only a small portion of the money market, federal agency securities are second highest in 

credit quality. The purposes, maturities, and types of agency securities issued vary widely. Typically the government backs these issues with collateral such as cash, U.S. Government securities, and debt obligations the 

issuing agency acquires through its lending activities. The more common types of federal agency securities 

include obligations of the following agencies:

• Federal Home Loan Banks (FHLBs)

• Farm Credit System (FCS)

• Federal National Mortgage Association (Fannie Mae)

• Federal Home Loan Mortgage Corporation (Freddie Mac)

• Government National Mortgage Association (GNMA)

• Student Loan Marketing Association (SLMA).

Obligations of the U.S. Government and federal agencies are safe and liquid. Federal agency securities (except 

for GNMAs) generally do not bear the full faith and credit of the U.S. Government. They do bear the full faith 

and credit of the U.S. Government agency or government sponsored enterprise that sponsors them.

Structured Notes

Federal agency notes include structured notes that are securities with derivative-like characteristics. Structured 

notes are fixed-income securities with embedded options where the bond’s coupon, average life, or redemption 

value are dependent on a reference rate, an index, or formula. Fannie Mae, Freddie Mac, and the FHLBs are 

the primary issuers of structured notes. OTS considers structured notes a complex security and they require a 

price sensitivity analysis. See TB 13a-2 for more information.

Structured notes take various forms. The term structured notes includes the following securities:

• Dual-indexed floaters

• De-leveraged floaters

• Inverse floaters

• Leveraged inverse floaters

• Ratchet floaters

• Range floaters

• Leveraged cap floaters

• Stepped cap/floor floaters

• Capped callable floaters
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Office of Thrift Supervision April 2001 Regulatory Handbook 540B.5

• Stepped spread floaters

• Multi-step bonds

• Indexed amortization notes.

The major type of structured note owned by financial institutions are step-up bonds. These bonds have successively higher coupons over their life and the issuer may call them. Institutions should carefully evaluate the 

purchase of a step-up bond. See the explanation of the call feature of step up bonds immediately below in the 

description of corporate bonds.

OTS does not consider standard, non-leveraged, floating rate securities (where the interest rate is not based on 

a multiple of the index) to be structured notes.

Shares in Money Market Funds

The combined money of many entities that is jointly invested in high yield financial instruments including U.S. 

government securities, certificates of deposits, and commercial paper. A money market fund is a mutual fund 

that makes its profit by buying and selling various forms of money rather than buying and selling shares of 

ownership in corporations.

Fixed-Income Investments

The bond (or debt) market represents debt instruments with maturities of longer than one year and includes 

longer-term U.S. Government and federal agency bonds and notes, corporate debt securities, and municipal 

bonds.

Bond Ratings

Bond ratings are good threshold indicators of the probability of default, but savings associations should conduct a thorough credit analysis of the security issuer before buying a security. Savings associations should also 

monitor the security after the purchase. The issuer should have the capacity to meet principal and interest 

payments as they become due. Failure to do so results in a default. Credit analysis should, at a minimum, encompass a review of the issuing entity’s financial statement, level of capitalization, management, earnings, 

business reputation, and other relevant factors. Other relevant factors may include: adequacy of sinking funds, 

collateralization, refinancing needs, and callability.

Besides performing the very basic credit analysis, each type of bond or industry has a unique set of factors. 

The institution should also review these factors when performing a credit review. 

Rated Securities

We identify Moody’s ratings first, and Standard & Poor’s ratings in parentheses.

Investment Grade

• Aaa (AAA): Bonds judged to be of the best quality that carry the smallest degree of risk. The capacity to 

pay interest and repay principal is extremely strong. 

• Aa (AA): Bonds judged to be of high quality by all standards. These securities have a very strong capacity 

to pay interest and repay principal. They differ from the higher-rated issues only in a small degree.
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540B.6 Regulatory Handbook April 2001 Office of Thrift Supervision

• A (A): Bonds of upper-medium-grade obligation with many favorable investment attributes. These securities have a strong capacity to pay interest and principal. However, they are somewhat more susceptible to 

the adverse effects of changes in circumstance and economic conditions than debt in higher-rated categories.

• Baa (BBB): Bonds considered to be of medium-grade obligation. They are not highly protected nor poorly 

secured. These securities have an adequate capacity to pay interest and repay principal. Normally, debt in 

this category exhibits adequate protection limits. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal than in 

higher-rated categories.

Below Investment Grade

• Ba (BB): Bonds judged to have speculative elements. Often the protection of interest and principal payments may be moderate and thereby not well safeguarded.

• B (B): These bonds generally lack the characteristics of a desirable investment. Assurance of principal and 

interest payments or maintenance of other contract terms over a long period may be suspect.

• Caa, Ca, C (D): These bonds are of poor standing. Such issues may be in default or have other shortcomings.

The rating agencies (Moody’s or Standard & Poor’s) may append a designation of Provisional (Moody’s) or 

Conditional (Standard & Poor’s) to a rating. For example, the provisional or conditional description is when 

the issuer does not specify an offering date.

Subquality debt is, on balance, predominantly speculative regarding capacity to pay interest and repay principal according to the terms of the obligation. Large uncertainties on major risk exposures to adverse conditions 

outweigh any quality and protective characteristics. Debt rated D is in payment default. Rating companies use 

the D rating category when issuers do not make interest or principal payments on the date due. They assign the 

D rating even if the applicable grace period has not expired, unless the rating agency believes that the issuer 

will make such payments during the grace period.

Institutions should obtain current bond ratings or credit analysis before any purchase. Associations invested in 

corporate bonds should regularly review the current ratings of their holdings for any adverse changes, and 

management should report the result of these credit reviews to the board of directors.

Non-Rated Securities

For non-rated securities, institutions should establish guidelines to ensure that the securities meet legal requirements and that the institution fully understands the risk involved. Institutions should establish limits on 

individual counterparty exposures. Policies should also provide credit risk and concentration limits. Such limits may define concentrations relating to a single or related issuer or counterparty, a geographical area, or 

obligations with similar characteristics. 

U.S. Treasury Securities

Treasury Notes

A U.S. government long-term security, sold to the public and having a maturity of one to ten years.
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Office of Thrift Supervision April 2001 Regulatory Handbook 540B.7

Treasury Bonds

A U.S. government long-term security, sold to the public and having a maturity longer than ten years.

Zero-Coupon Treasuries or STRIPS

Zero-coupon bonds, although they can be U.S. Government or agency securities, are most frequently corporate 

bonds. The market sells zero-coupon bonds at a deep discount from par value. They accumulate and compound interest and pay full face value at maturity. Zero-coupon bonds are highly sensitive to interest rates and 

tend to exacerbate interest rate risk in the majority of savings associations. As a result, it may be an unsafe 

and unsound practice for savings associations with excessive exposure to interest rate risk to invest in zerocoupon bonds. Moreover, taxable zero-coupon securities receive unfavorable tax treatment. Even though the 

savings association receives no cash, thrifts must pay taxes annually on accrued interest.

Corporate Bonds

Corporate bonds can consist of subordinated debentures, collateralized or mortgage bonds, and floating-rate 

notes. Corporate debt securities face the same risks as loans to a business entity. Section 560.40 restricts investments in corporate obligations that sets forth requirements for minimum credit quality and loan-to-oneborrower limitations. Federal institutions may only invest in investment grade corporate bonds. Investment 

grade corporate debt securities are those that, at the time of their purchase, were in one of the four highest rating categories by at least one nationally recognized statistical rating organization.

Collateralized Bonds

Corporate bonds come in many varieties with differing features and characteristics such as being secured or 

unsecured. The real estate mortgage or capital equipment that the bond money purchases usually collateralizes 

the bond. The bondholder can sell the collateral to satisfy a claim if the bond issuer fails to pay principal and 

interest when due. The full faith and credit of the issuer, but not any specific collateral backs an unsecured 

bond or debenture.

Debenture Bonds

A bond that has no specific security set aside or allocated for repayment of the principal. A debenture bond is 

secured only by the general credit of the issuer.

Callable Bonds

Institutions should carefully evaluate provisions that permit the issuer to modify the maturity of a bond. Many 

corporate bonds contain call privileges that permit the issuer to redeem the bond, either fully or partially, before the scheduled maturity. Call provisions are generally detrimental to investors since they run the risk of 

losing a high-coupon bond when rates begin to fall. Call provisions also tend to limit the price appreciation of 

the bond that might otherwise occur when interest rates decline. The presence of call protection, however, limits the right of the issuer to call the bond to a specified number of years early in the life of the bond.

Sinking Fund Bonds

Sinking fund provisions are a form of maturity modification most often found in industrial bonds but increasingly found in other types of bonds as well. A sinking fund provision can take either of two forms. In one form, 

the issuer makes periodic payments to a segregated fund that is sufficient to retire the bonds upon maturity.
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540B.8 Regulatory Handbook April 2001 Office of Thrift Supervision

The other form mandates the issuer to retire some portion of the debt in a prearranged schedule during its life 

and before the stated maturity. Sinking funds are beneficial because they assure an orderly retirement of debt 

and enhance liquidity. Sinking funds can also be disadvantageous to investors. In particular those investors 

holding one of the early bonds to be called for a sinking fund are disadvantageous to the investor.

Equity Instruments 

The equity markets are the primary exchanges for the trading of stocks. The shares of common stock and preferred stock bought and sold in these markets represent actual ownership interest in a corporate entity. The 

major markets are the New York Stock Exchange, the American Stock Exchange, and the over-the-counter 

market. Savings associations may not generally invest in or retain equity securities. The Home Owners’ Loan 

Act permits the following investments:

Federal Agency Securities

Savings association may invest in certain equity securities of FHLBs, Freddie Mac, Fannie Mae, SLMA and 

GNMA.

Banker’s Banks

A federal savings association may purchase for its own account shares of stock of a bankers’ bank, provided 

the following conditions are met:

• The institution is insured by the Federal Deposit Insurance Corporation or a holding company that owns or 

controls such an insured institution, if the stock of such institution or company is owned exclusively by depository institutions or depository institution holding companies.

• Such bank or company and all subsidiaries are engaged exclusively in providing services to or for other 

depository institutions, their holding companies, and the officers, directors, and employees of such institutions and companies, and in providing correspondent banking services at the request of other depository 

institutions or their holding companies.

• The total amount of such stock held by the association in any bank or holding company must not exceed at 

any time ten percent of the association’s capital stock and paid in and unimpaired surplus.

• The purchase of such stock must not result in an association’s acquiring more than five percent of any class 

of voting securities of such bank or company.

Trust-Preferred Securities

Savings associations may invest in trust-preferred securities in accordance with the limitations established in 

12 CFR § 560.40. Trust preferred securities are non-perpetual cumulative preferred stock issued by a wholly 

owned trust subsidiary of a corporation. Revenue from the sale of the trust-preferred securities is exchanged 

for junior subordinated debentures issued by the parent corporation. These debentures feature coupon payment 

and term to maturity identical to those of the trust preferred securities. See Thrift Bulletin 73 for a complete 

discussion of trust secured preferred securities.
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Office of Thrift Supervision April 2001 Regulatory Handbook 540C.1

MORTGAGE-RELATED SECURITIES

Mortgage-Backed Securities 

High default rates on mortgage bonds during the Great Depression inhibited demand for these instruments until 

the introduction of the Government National Mortgage Association (GNMA) pass-through security in 1970. 

Even with the federal government guarantee there was considerable skepticism about the acceptance of mortgage securities in the investment community when GNMA first issued its securities.

The mortgage-backed securities (MBSs) introduced by GNMA in 1970, consisted only of Federal Housing 

Administration (FHA) and Veteran’s Administration (VA) mortgages. Conventional lenders had indirect access to the capital markets only through the Federal Home Loan Mortgage Corporation (Freddie Mac) 

beginning in 1971. Originators could sell mortgages to Freddie Mac, which pooled and sold the resulting securities as Participation Certificates (PCs). 

In 1981, Freddie Mac began a swap program, Guarantor I, that allowed lenders to exchange conventional 

mortgages for pass-through securities. In the first Freddie Mac swap of mortgages for securities, no cash exchanged hands. The seller received payment as PCs representing ownership in the mortgages sold. In this 

exchange or swap of assets, the savings association believed it could sell its low-rate mortgages more easily 

and at a higher price in security form rather than mortgage form. Soon after, the Federal National Mortgage 

Association introduced its Mortgage-Backed Security program. This restructuring of savings association 

mortgage portfolios was the major factor in the rapid growth of conventional mortgage securities. 

As the mortgage securities market grew, lenders began to recognize that the swap programs provided an 

attractive alternative method for mortgage sales. In addition, many lenders began to securitize their portfolio 

mortgages to add both value and liquidity. Most issuers now issue the securities through the swap programs. 

Fannie Mae, Freddie Mac, and GNMA all collect a small guarantee fee throughout the life of the mortgages 

for the service.

The term mortgage security describes a variety of mortgage-related financial instruments. Although characteristics can vary widely, there are only two basic types of mortgage securities:

• A certificate representing ownership of an undivided interest in a proportionate share of each mortgage in a 

pool, referred to as a mortgage pass-through security or a mortgage-backed security (MBS).

• A debt obligation secured by a specified pool of mortgages, referred to as a mortgage derivative product 

(MDP).

Within each type, the market designed variations to appeal to certain investor classes or to reduce the cost of 

security financing.

Some mortgage derivative products (MDPs) exhibit considerably more price volatility than mortgages or ordinary mortgage pass-through securities and can expose investors to significant risk of loss if not managed in a 

safe and sound manner. Uncertain cash flows that result from changes in the prepayment rates of the underlying mortgages cause this price volatility. 

Because these products are complex, savings associations need a high degree of technical expertise to understand how their prices and cash flows may behave in various interest-rate and prepayment environments. An 

institution’s management should understand the risks and cash flow characteristics of its investments. This is 

particularly important for products that have unusual, leveraged, or highly variable cash flows. Moreover, because the secondary market for some of these products is relatively thin, they may be difficult to liquidate 

should the need arise. Finally, there is additional uncertainty because the market continues to introduce new 
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540C.2 Regulatory Handbook April 2001 Office of Thrift Supervision

variants of these instruments. Savings associations are not able to test their price performance under varying 

market and economic conditions because the products are too new.

Savings associations should ensure that levels of activity involving MDPs are reasonable and appropriately 

relate to a savings association’s capital, capacity to absorb losses, and level of in-house management sophistication and expertise. OTS considers investments in complex securities and the use of financial derivatives by 

institutions that do not have adequate risk measurement, monitoring, and control systems to be an unsafe and 

unsound practice. Appropriate managerial and financial controls must be in place and the savings association 

must analyze, monitor, and prudently adjust its holdings of MDPs in an environment of changing price and 

maturity expectations.

Secondary Mortgage Market 

Through this market, original lenders are able to sell loans in their portfolios to build liquidity to support additional lending. Mortgage agencies, such as Freddie Mac, Fannie Mae, and investment bankers buy mortgage 

loans. In turn, these agencies and investment bankers create pools of mortgages that they repackage as mortgage-backed securities, which they sell to investors. Mortgage-backed securities or mortgage pass-through 

certificates provide investors with payments of interest and principal on the underlying mortgages. Since the 

underlying issuer guarantees the mortgage pass-through certificate, the default risk is low for this type of security.

The buying, selling, and trading of existing mortgage loans and mortgage-backed securities constitutes the secondary mortgage market. This has become a significant activity for many savings associations.

The payments for MBSs resemble mortgage payments but without delinquencies. Principal and interest payments, less guarantee and servicing fees, pass through to the investor whether or not the issuer collects them. 

The servicer advances the delinquencies to the investor until the mortgage either becomes current or foreclosure is complete. Prepayments pass through to the investor as received. 

The servicer collects mortgage payments on a monthly basis from the mortgagor and remits those funds less its 

servicing fee to a central collection point, or directly to the investors for GNMA I. Fannie Mae, Freddie Mac, 

and GNMA II collect their guarantee fee either directly from the payments that they pass through or from the 

servicer. 

Fannie Mae and GNMA have always guaranteed the timely payment of both principal and interest to investors 

for their MBSs, requiring the servicer to advance its own funds to the investor to make up for delinquencies. 

Freddie Mac only guaranteed the timely payment of principal until they developed their Gold PC and now it, 

too, guarantees the timely payment of both principal and interest. The following characteristics determine the 

structure of an MBS:

• Types of mortgages in the pool.

• Weighted-average coupon on the pool of underlying mortgages.

• Pass-through rate on the MBS. 

• Weighted-average remaining maturities of the mortgages.

• Number and size of the mortgages.

• Geographic distribution of mortgages.
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Office of Thrift Supervision April 2001 Regulatory Handbook 540C.3

Weighted-Average Coupon and Pass-Through Rate

The weighted-average coupon (WAC) of the mortgage pool is an important factor in determining prepayment 

speeds. In general, higher WACs relative to current mortgage rates result in faster prepayments because 

homeowners have an incentive to refinance at lower market rates. Lower WACs relative to current mortgage 

rates lead to slower prepayments because lower refinancing rates are not readily available.

The average interest rate on the underlying mortgages of an MBS usually exceeds the pass-through rate. The 

spread between the WAC and the pass-through rate represents guarantee fees and servicing fees. A savings 

association that originates and packages loans for securitization can set limits on the permissible range of interest rates in a pool. These limits must be within the guidelines established by the guarantor of the MBS for 

each specific program.

Original Term and Weighted-Average Remaining Maturity

The original term and the weighted-average remaining maturity (WARM) also affect the rate of repayment. 

Longer terms to maturity mean that amortization of principal will spread out over a longer period. This means 

the security passes through less principal during the early years of the security. In addition, prepayment patterns vary by original terms such as 30 years or 15 years. Loan age, which represents the difference between 

original and remaining maturity, also affects the rate of repayment. Payments on older mortgages allocate 

more to principal than to interest. Prepayments on a mortgage pool also tend to increase as the mortgages age, 

or become more seasoned. Eventually, prepayments slow down, or burn out. This occurs when most of the 

mortgagors remaining in the pool are either unwilling or unable to prepay. The maturity date of an MBS is 

generally the date on which the last mortgage in the pool repays in full. Each guarantor of an MBS sets limits 

on the permissible range of interest rates and maturities for each specific program.

Geographic Distribution

The location of the mortgages comprising the pool affects the likelihood and predictability of prepayments. 

Different areas of the country prepay at much different rates. Geographical diversity permits greater predictability of cash flows as the mortgage pool is less subject to regional economic conditions and other local 

influences. More mortgages in a given pool tend to diversify risks and make cash flows more regular and predictable.

Types of Mortgage-Backed Securities

Agency-Issued MBS

Agency-issued MBSs are attractive to certain investors because of their minimal credit risk, ease of trading, 

and liquidity. The low credit risk of MBSs results from the guarantees that Fannie Mae, Freddie Mac, or 

GNMA places on its mortgage securities.

Non-Agency MBSs

Other issuers, including mortgage bankers, insurance companies, investment banks, and other financial institutions that issue MBSs, also create and issue securities from a pool of loans. Non-agency MBSs include both 

pass-through and pay-through structures.

These securities typically have more credit risk and less liquidity than agency MBSs but still often carry AA or 

AAA ratings due to various credit enhancements. These credit enhancements include primary mortgage insurance and reserve funds. Some issuers split the security into a senior/subordinated structure. The 

senior/subordinated structure splits the security into low-credit risk (senior) and high-credit risk (subordinated) 
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540C.4 Regulatory Handbook April 2001 Office of Thrift Supervision

pieces or tranches. The subordinated tranche(s) absorb the first wave of losses. Only after exhausting the subordinate class(es) does the senior tranche(s) incur losses. The credit risk of the subordinated tranches depends 

on the credit risk of the underlying mortgages and the deal structure. Therefore, the credit risk depends on the 

amount of loss exposure assigned to the tranche. Investors should monitor the credit ratings on MBSs and 

CMOs issued by private conduits.

Non-agency MBSs often include nonconforming mortgages that are too large or otherwise ineligible for securitization by the agencies. Non-agency MBSs also tend to be more geographically concentrated than Fannie 

Maes, Freddie Macs, and GNMAs.

Fixed-Rate MBSs

Fannie Mae, Freddie Mac, and GNMA issue fixed-rate MBSs with terms of 30 years, 20 years, and 15 years. 

They also issue pools of balloon mortgages that follow a 30-year amortization schedule but mature after five 

or seven years. Graduated Payment Mortgages (GPMs) and Tiered Payment Mortgages (TPMs) pay a preestablished but increasing rate over time.

Adjustable-Rate MBSs

The issuance of MBSs backed by adjustable-rate mortgages (ARMs) provides an additional type of passthrough security in the secondary market. An adjustable-rate MBS offers protection against rising rates by 

linking its interest rate to a market-based index, like the one-year Constant Maturity Treasury (CMT) rate or 

the Eleventh District Cost of Funds. Periodic and lifetime caps along with teaser rates limit that protection by 

constraining the extent of rate adjustment. A teaser ARM features a low introductory interest rate designed to 

induce borrowers to select ARMs over fixed-rate mortgages.

ARMs often have periodic caps, lifetime caps, or both. A typical periodic cap on a one-year ARM limits the 

increase or decrease in the coupon to two percent per year. While an annual cap limits the amount of rate adjustment during any given year, the lifetime cap establishes a maximum coupon on the ARM throughout the 

life of the mortgage. Some ARMs without periodic caps still have payment caps that limit the increase in 

monthly payments rather than the interest rate. Negative amortization can occur, that is, the principal balance 

increases, if the mortgage reaches its payment cap.

You should determine the effect of teaser rates, periodic caps, and lifetime caps on the savings association’s 

ARM MBS portfolio. The interaction between teaser rates and periodic caps is particularly important. Consider an ARM with a teaser rate of five percent, a fully indexed rate of eight percent, and an annual cap of two 

percent. This ARM offers the investor no protection against rising rates for at least two years. The rate at the 

start of the second year will be the same (seven percent) if rates fall one percent or rise four percent. The ARM 

only reaches its fully indexed rate in the third year if the index rate increases by 100 basis points or more. A 

teaser rate affects the lifetime cap as well. With a five percent teaser rate, the lifetime cap will typically be 11 

percent, or only 300 basis points above the current, fully indexed rate.

Mortgage-Backed Security Considerations

MBS Yields and Prices

Present value analysis discounts the future cash flows of mortgages by their required rate of return, which 

equals the rate available in the market for investments of similar risk. This process calculates an MBS’s present value or estimated market value. Alternately, given a market price, it is possible to determine the rate of 

return or yield that would make the sum of the discounted cash flows equal to the market price. Two common 

measures of yield are the cash flow yield and the option-adjusted yield. 
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Office of Thrift Supervision April 2001 Regulatory Handbook 540C.5

Cash Flow Yield

To determine the cash flow, or static yield of an MBS, discount the sum of all future cash flows back to the 

current market price. The cash flow yield calculation requires two major inputs: the current price of the security and a projection of future cash flows. Issuers usually base prepayment estimates upon Wall Street 

forecasts for similar MBSs and incorporate those prepayment estimates into the analysis.

The cash flow yield assumes cash flows will follow projections. Actual prepayments may exceed or fall short 

of projections, depending largely on the future course of interest rates. Falling market interest rates encourage 

homeowners to prepay their mortgages and refinance them at the new, lower rate. Rising interest rates encourage homeowners to retain mortgages, which would then have below-market rates. The cash flow yield does not 

take the variability of future interest rates and, therefore, prepayments into account. While cash flow yield may 

be an adequate measure (particularly for MBSs at or near par), it is less accurate than the option-adjusted 

yield measure described below.

Option-Adjusted Yield

The option-adjusted yield method can provide a more accurate comparison of the yield on investments with 

embedded options, like the prepayment option on a mortgage, to investments without embedded options such 

as noncallable corporate bonds. The option-adjusted yield does not rely on a single projected cash flow using a 

single prepayment estimate. The option-adjusted yield derives from many projected cash flows and prepayment 

estimates. The option-adjusted yield equals the discount rate (internal rate of return) that makes the average 

present value of the cash flows equal to the market price of the security. As shown in the example below, option-adjusted yields are typically lower than nominal yields. The difference between nominal and optionadjusted yields is greatest when prepayments are most interest-rate sensitive.

Example: Nominal Yield Vs. Option-Adjusted Yield

Compare an MBS with a seven percent coupon and a five-year base case weighted average life to a five-year 

noncallable corporate bond also with a seven percent coupon and of similar credit risk and liquidity. Both are 

priced at par. Consider three possible interest-rate scenarios: rates rise 100 basis points (25 percent probability), rates fall 100 basis points (25 percent probability), and rates stay the same. The weighted average life of 

the MBS increases to seven years if rates go up 100 basis points and decreases to three years if rates fall 100 

basis points. The discount rate (internal rate of return) needs to equal 6.84 percent for the average present 

value of the cash flows to equal the current market price.

Rate Scenario Probability Present Value Discount Rate

Flat .50 100.668 6.84%

Up 100 basis points .25 95.54 7.84%

Down 100 basis points .25 103.15 5.84%

Weighted Average 1.00 100.00 6.84%

Although the bond and MBS provide the same nominal yield (seven percent), the bond outperforms the MBS 

by an average of 16 basis points once the investor considers interest rate and cash flow volatility. The optionadjusted yield is usually superior to cash flow yield as a measure of the yield of financial instruments with embedded prepayment options. This is because the option-adjusted yield considers the estimated probability 

distribution of potential prepayment rates instead of using a single estimate.
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540C.6 Regulatory Handbook April 2001 Office of Thrift Supervision

MBS Accounting

The interest method is the required accounting measurement for recording the yield for MBSs. Savings associations should amortize or accrete into income premiums and discounts using the interest method over the 

expected life of the mortgage security. This should result in a constant rate of interest (level-yield) when applied to the amount outstanding at the beginning of any given period. 

Account for differences between anticipated and actual prepayments by recalculating the effective yield to reflect actual payments to date and anticipated future payments. This adjusts the net investment in the MBS to 

the amount that would have existed had the new effective yield been applied since acquisition.

For adjustable-rate MBSs, savings associations may base the effective yield on either the rate in effect at acquisition or recalculate the effective yield each time the rate on the MBSs change. Solicit comparable market 

quotes from at least two brokers other than the broker that executes the transactions. Even if a savings association does not have significant volume, they should obtain comparable price quotes.

Mortgage-Backed Bonds

A mortgage-backed bond is unlike a mortgage-backed pass-through security because they do not convey ownership of any portion of the underlying pool mortgages. However, mortgage-backed bonds do offer a more 

predictable maturity and thus offer a form of call protection. The bond issuer retains nearly all the risk associated with the security, including the interest rate risk and the credit risk. A pay-through bond has less risk 

exposure for the issuer than a straight bond, but greater risk than a pass-through security.

Mortgage Derivative Products

OTS defines a financial derivative in § 563.172. A financial derivative is a financial contract whose value depends on the value of one or more underlying assets, indices, or reference rates. The most common types of 

financial derivatives are futures, forward commitments, options, and swaps. OTS does not consider certain 

mortgage derivative securities such as collateralized mortgage obligations (CMOs) or real estate mortgage investment conduits (REMICs) as financial derivatives. 

Collateralized Mortgage Obligations

Freddie Mac first issued collateralized mortgage obligations (CMOs) in 1983. Freddie Mac designed CMOs in 

the early 1980s to broaden investor demand. They do this by splitting an underlying pool of mortgages and 

MBSs into different classes, or tranches, that appeal to different types of investors. For example, Freddie Mac 

splits a pool of 30-year, fixed-rate MBSs into short-term, intermediate-term, and long-term tranches. Listed 

below are various types of CMO tranches found in savings association portfolios.

A major initial drawback to widespread use of the CMO was the substantial size of the mortgage pool; $100 

million or more was necessary to support the cost of issuance. The appearance of CMO conduits, however, 

made CMO issues feasible for smaller lenders. The conduit achieves the economies of scale needed to make 

the issue cost-effective for the lender by pooling collateral supplied by a number of lenders. Only a few of the 

conduits survived and, as a result, Fannie Mae, Freddie Mac, GNMA, and investment bankers that have access to large volumes of collateral dominate the list of issuers.

CMOs demand higher yields than other investments of similar quality and maturity because the actual life of 

the bond is uncertain. Some CMOs, like PACs, offer more predictability of prepayments than mortgages or 

other types of mortgage-backed bonds because of the large collateral pools backing each type of issue and the 

prioritization of cash flows.
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Office of Thrift Supervision April 2001 Regulatory Handbook 540C.7

The market’s assumptions regarding the average life and average life volatility of each investor class determine 

CMO yields and yield spreads over comparable treasuries. Short-term agency PACs, which have little average 

life volatility, often trade at spreads of less than 50 basis points over Treasury. More volatile tranches earn 

significantly wider spreads. As with mortgage investments, the actual prepayment of the mortgages will determine the actual yield to maturity.

Prepayments on a CMO tranche are a function of prepayments on the underlying mortgages and the tranche 

structure. Faster or slower prepayments on the underlying mortgages can affect the weighted average life of an 

individual CMO tranche, but not necessarily proportionately. As noted above, PACs usually have much more 

stable cash flows than the underlying mortgages, but support tranches have much more volatile cash flows.

Geographic concentrations, loan size, and market interest rates affect prepayments on non-agency MBSs. If 

the MBS consists of mortgages concentrated in a particular state, prepayments on the MBS may differ substantially from national prepayment patterns. Prepayments on the large loans that characterize many nonagency MBSs tend to accelerate more quickly when market interest rates fall.

CMO Risks

The tranche structure of CMOs allocates rather than eliminates the risk of the underlying mortgages. The creation of tranches with shorter average lives than the underlying mortgages requires the creation of tranches with 

longer average lives. Stable PAC tranches require volatile support tranches. Investment-grade senior classes 

create speculative-grade subordinated tranches. The yield and market value of subordinate interests in CMOs 

are extremely sensitive to prepayment fluctuations. These kinds of riskier tranches can still attract investors in 

one of two ways. They may appeal to investors with different risk profiles; for example, long-term CMOs can 

match the long-term liability structure of insurance companies. Issuers may also attract investors by offering 

higher yields.

CMO structures can also present risks that are less obvious. These risks include PAC drift, cap risk, basis 

risk, and illiquidity.

• PAC Drift

The industry designed PACs to provide a predictable stream of cash flows across a range of prepayments, 

known as a PAC band. Many investors incorrectly assume that PAC bands remain fixed. In fact, faster-thanpredicted prepayments can cause the band to narrow or drift. The support tranches will shrink or prepay entirely. The planned amortization rate guarantee disappears without a support tranche available to cushion 

future prepayment volatility. Investors often refer to these securities as busted PACs.

The amount of protection afforded by the PAC depends on the following factors:

* Width of the PAC band – wider bands provide more protection.

* Relative sizes of the PACs and supports in the deal – more supports provide greater insulation 

against prepayment volatility.

* Prepayment volatility of the underlying mortgages.

The consequences of a PAC’s drifting or “busting” depend on the security type. For a traditional PAC, the 

CMO merely assumes the prepayment characteristics of the underlying mortgages. Narrowing or eliminating 

the PAC band causes Type II PACs to assume the prepayment characteristics of a support tranche and can be 

much more volatile than the underlying mortgages.
Appendix C: Investment Securities Section 540

540C.8 Regulatory Handbook April 2001 Office of Thrift Supervision

• Cap Risk

Lifetime caps limit the extent to which floating-rate CMOs can adjust to rising market interest rates. One can 

consider a lifetime cap an embedded option and, as the value of the option increases, the price of the security 

falls. As with any option, the effect of a lifetime cap on price and price volatility depends on the following factors:

* The option’s intrinsic value, that is, the distance between the cap and the current rate on the CMO.

* The volatility of the index.

* The time to expiration (the average life of the CMO).

Many issuers use floaters as support tranches. With floaters, an increase in market interest rates causes a reduction in the distance to the lifetime cap and an extension (sometimes dramatic) of the average life of the 

CMO. Savings associations must fully incorporate the effect of lifetime caps on price sensitivity when selfreporting the price sensitivity of floating-rate CMOs on Schedule CMR. 

• Basis Risk

Mismatched floaters can expose institutions to considerable basis risk if the index rate on the floater diverges 

significantly from short-term market interest rates, such as LIBOR. Such a divergence can arise from a nonparallel shift in the yield curve (if the index is the Ten-Year CMT) or from a lag between current market rates 

and the index rate (if the index is COFI). Basis risk is most significant for mismatched floaters with long or 

volatile average lives. Savings associations should evaluate the potential effect of nonparallel yield curve shifts 

on mismatched floaters.

• Liquidity Risk

Volatile or exotic CMO tranches tend to be the least liquid. Illiquidity places both purchasers and sellers at a 

disadvantage. The lack of an available market makes the asset difficult to sell without considerable price concessions. Illiquidity also makes it difficult to determine the true market value for a security and increases the 

possibility that the savings association will overpay. Illiquidity imposes transaction costs on buyers and sellers 

of securities. The broker receives the difference between the amount paid by the buyer and received by the 

seller, known as the bid-ask spread. A wide bid-ask spread means the buyer pays more and the seller receives 

less.

Types of CMOS

• Sequential Pay

Issuers often structure CMO deals as a series of Sequential Pay bonds. Each investor class generally receives 

monthly interest payments on the outstanding principal balance of its class. The bond allocates principal payments to each investor class in the order of maturity. The shortest outstanding maturity receives all principal 

payments until that class is fully retired, then holders of the second class begin to receive principal payments, 

and so forth. Most CMO issues have a compound interest or accrual class (called the Z Bond) that receives no 

interest or principal payments until the retirement of all other investor classes. The accrual bond’s coupon rate 

compounds during the accrual phase and converts to an interest-paying instrument following retirement of all 

shorter maturity classes.
Appendix C: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540C.9

• Planned Amortization Class

A CMO innovation that was very popular in the late 1980s is the Planned Amortization Class (PAC). The 

PAC structure reduces cash flow uncertainty by guaranteeing a specific cash flow stream, provided that prepayments on the underlying mortgages remain within an established range or band. The increased certainty of 

PAC tranches causes other tranches in the issue (known as companion or support tranches) to have more uncertain cash flows. A Type II PAC represents a hybrid between a PAC and a support tranche. Type II PACs 

offer predictable cash flows, but within a narrower range of prepayments. If prepayments fall outside that 

range, Type II PACs assume the cash flow volatility of a support tranche.

• Floating-Rate CMOs

The market developed floating-rate tranches to attract investors more concerned with interest rate risk. Floaters typically adjust monthly or quarterly based on some index, such as LIBOR. Rate adjustments are usually 

subject to a lifetime cap, but periodic caps are unusual.

• Mismatched Floaters

A further innovation involves mismatched floating-rate CMOs that may adjust monthly or quarterly. Their rate 

adjustment ties either to a longer-term index, such as the Ten-Year Constant Maturity Treasury (CMT), or to 

a lagging index, such as COFI. These CMOs offer higher yields than traditional floaters but present basis risk 

from lack of perfect correlation between the index rate and short-term market interest rates.

• Kitchen Sink Bonds

Typically, a homogeneous pool of MBSs creates a diverse group of CMO tranches. A kitchen sink bond (also 

called a re-REMIC or a Matched Principal Bond) reverses the process by creating a single CMO from a dissimilar group of mortgage securities. Risky individual securities make up kitchen sink bonds. The resulting 

bond may not necessarily be volatile due to offsetting risks (that is, combining IOs and POs) but is usually 

difficult to analyze due to its complex composition. 

Real Estate Mortgage Investment Conduits 

Congress passed Real Estate Mortgage Investment Conduit (REMIC) legislation in 1987. This legislation provided a new vehicle for issuing MBSs. Issuers structure REMICs much like CMOs and other securitized 

receivables but REMICs offer certain tax advantages. The government does not generally tax the special purpose entity formed to issue the pass-through or pay-through certificate at the entity level. Also, the savings 

association does not typically consolidate the special purpose entities. This allows for increased securitizations 

in REMIC form and leveraging of savings association capital because the assets are off-balance sheet. Nearly 

all CMOs are REMICs, as are most non-agency MBSs, including those with a pass-through structure.

Futures, Forwards, and Options

In the futures market, investors buy and sell contracts for the future delivery of a commodity or security. The 

forward market is a market in which participants trade some commodity, security, or instrument at a fixed 

price at a future date. The proper use of derivatives such as futures, forwards, swaps, and options can reduce 

an institution’s exposure to interest rate risk and can provide a framework for hedging strategies. Improper use 

of these securities can generate extreme losses. See the discussion of swaps in this section under Mortgage Derivative Products. See also Sections 650, Interest Rate Risk Management; and 660, Derivative Instruments and 

Hedging.
Appendix C: Investment Securities Section 540

540C.10 Regulatory Handbook April 2001 Office of Thrift Supervision

Stripped Mortgage-Backed Securities

In 1986, Fannie Mae issued the first stripped mortgage-backed securities (SMBSs). This instrument created 

two new classes of investors or security holders. Each class received a percentage of the principal and interest 

payments from either the MBS or from the whole mortgages that served as the underlying collateral. For example, one class of the SMBS may receive 99 percent of the interest payments and one percent of the principal 

payments from the underlying MBS. Investors in different classes of SMBSs buy a derivative mortgage instrument that has significantly different characteristics from the underlying mortgages or the MBSs. The 

industry also refers to these classes as tranches.

In 1987, Fannie Mae introduced an SMBS composed of an interest only (IO) class and a principal only (PO) 

class. The holder of the IO receives all the interest payments from the underlying MBS while the holder of the 

PO receives all the principal payments. 

Investment bankers also create their own version of SMBSs both through private placements and public offerings. Investment bankers normally create the private placement through a participation agreement that entitles 

the holder to a certain predefined percentage of the principal and interest payments from the underlying mortgages or the MBS. These private placements are similar to the original Fannie Mae SMBSs in that holders 

receive varying percentages of the principal and interest payments rather than a percentage of all the interest or 

principal. In addition, Freddie Mac issues its own version of IOs and POs using participation certificates 

rather than MBSs.

Fallen Angels

Examiners refer to securities not performing as expected due to changes in either tranche structure or market 

conditions as fallen angels. Savings associations may continue to account for fallen angels as held-to-maturity. 

You should consider unrealized losses on these securities in your evaluation of the institution’s capital adequacy.

Mortgage Swaps

Mortgage swaps are off-balance sheet transactions designed to replicate the purchase of MBSs with reverse 

repurchase agreements or some other short-term or floating-rate source of funding. In essence, the transaction 

combines a forward commitment to purchase MBSs with an amortizing interest-rate swap. Unlike the traditional purchase of mortgage securities, however, the issue makes no cash payment at the outset of the 

agreement. 

Mortgage swaps are an alternative to a straight purchase of MBSs. They involve a great deal of leverage because the initial collateral on the transaction is a small fraction (typically four points) of the par value of the 

mortgage securities and the transaction is off-balance sheet. They also may enable the investor to effectively 

finance mortgage securities at a rate tied to a floating-rate index below LIBOR on a guaranteed multiyear basis.

Collateralized Loan Obligations

Collateralized loan obligations (CLOs) are securities primarily collateralized by commercial loans of varying 

quality. Some issues may also be collateralized in part by high-yield corporate debt securities. 

CLOs are generally sold in several progressively risky tranches. The first tranche often has a high investment 

rating, such as AAA, due to its payment priority and the initial overcollateralization of the security. The collateral also sequentially supports the next tranche(s). CLOs typically have a revolving period and an 

amortization period. During the revolving period, principal payments are reinvested in other assets in accor-
Appendix C: Investment Securities Section 540

Office of Thrift Supervision April 2001 Regulatory Handbook 540C.11

dance with the terms of the agreement. During the amortization period, any principal payments are used to first 

repay the Class A note holders in full, then any remaining principal is used to pay junior tranche investors in 

order of their priority.

The middle tranches are often rated at the lower investment grade ratings, such as BBB. The lowest priority 

tranche, or the residual interest tranche, is generally not rated. It is typically subordinated not only to senior 

tranches, but also to expenses of the issuing trust. These residual tranches are typically difficult to value and 

are illiquid investments by themselves. To make the residual tranche more marketable, the CLO issuer or trustee may swap the residual interest tranche for certificates guaranteed by a AAA-rated counterparty as to the 

principal amount at maturity (generally up to 12 years).

While the swap creates a guarantee of the full principal at maturity, the amount guaranteed must be discounted 

to its present value if terminated early. In that respect, the guaranteed portion of the security is similar to a 

zero-coupon Treasury bond. Therefore, the credit support provided by the guarantor may cover less than 50 

percent of the face value of the certificate at purchase. Unlike zero-coupon bonds, however, these certificates 

are generally sold at par. Investors must rely on the performance of the reference asset (the residual tranche in 

this case) to return the remaining portion of their investment and provide any yield. The performance of the 

reference asset is not, however, guaranteed. Therefore, these investments are not, and should not be considered, fully rated.

Apparently, the motivation to purchase such certificates is the high yield projected if the CLO collateral pool 

(and thereby the reference asset) performs well. However, there is no guarantee of residual cash flows, and the 

certificates will not default if no cash flows are paid to the investors. These investments are speculative, and 

are clearly not intended to hedge interest rate risk or credit risk. Based on discussions with rating agencies, and 

the lack of supporting cash flow analysis, it is difficult to assess the likelihood that a particular return could be 

achieved on these investments. In essence, an institution should not be misled by split ratings where only a part 

of the security is either guaranteed or rated investment grade.

It is imperative that institutions properly underwrite investment securities for quality, applicable regulatory 

and policy compliance, and suitability to operational and strategic plans.
CHAPTER: Sensitivity to Market Risk

SECTION: Derivative Instruments and Hedging Section 660

INTRODUCTION

Office of Thrift Supervision April 2001 Regulatory Handbook 660.1

The market for derivatives has grown rapidly during the past decade. For the most part, this rapid 

growth reflects the broad range of applications for 

these derivative products and their wide acceptance by financial institutions, institutional 

investors, and corporate treasurers. Savings associations typically use derivatives for hedging 

purposes. In this Handbook Section, we discuss 

specific objectives and considerations associated 

with hedging activity. Also in this Section, we 

describe the characteristics and risks of derivatives, and several regulatory considerations 

surrounding their use in hedging interest rate risk.

DERIVATIVE INSTRUMENTS

Financial derivatives are contracts that derive their 

value from that of an underlying asset, index, or 

reference rate. The most commonly used financial 

derivatives are swaps, futures, forwards, and options.

Some also use the term derivative security to describe securities with option-like characteristics 

and securities created by tranching, or stripping, 

other financial instruments. Derivative securities 

include structured notes and collateralized mortgage obligations (CMOs). A discussion of CMOs 

appears in Handbook Section 540, Investment 

Securities, Appendix C; and Handbook Section 

560, Deposits and Borrowed Funds. 

There are two distinct groups of derivative instruments: forward-based products and optionbased products. Forward-based products include 

futures, forward contracts, and swaps. Optionbased products include puts, calls, caps, floors, 

and collars. Some derivatives, such as options on 

futures, optional-purchase mortgage commitments, swaptions, and forward caps, combine the 

features of both forward and option contracts. 

Some derivatives trade on organized exchanges, 

while others trade on over-the-counter (OTC) 

markets.

Standardized contracts traded on the futures and 

options exchanges are exchange-traded derivatives. Each exchange operates a corporation, 

known as a clearinghouse, where it reconciles, 

guarantees, and settles all contracts. The clearinghouse places itself between the buyer and seller of 

each contract, and serves as the counterparty to 

each contract.

OTC contracts, on the other hand, are agreements 

entered into through private negotiations. Parties 

seek each other out to negotiate a trade. Many 

large securities firms and commercial banks, 

known as derivatives dealers, deal or make markets in derivatives. Swaps, forward agreements, 

options, caps, and floors actively trade in the OTC 

market. We discuss the different types of derivative instruments later in this Handbook Section.

Risks of Using Derivatives

Derivative instruments provide benefits but, as 

with other types of financial products, their use 

entails certain risks. The specific risks of a particular derivative transaction depend on the terms 

of the transaction and the financial condition and 

circumstances of the parties involved in the transaction. The primary risks include market risk, 

credit risk, legal risk, and operational risk.

Market Risk

Market risk involves the potential loss in value of 

a derivative due to changes in market conditions. 

These changes can include movements in interest 

rates (interest rate risk), changes in supply and 

demand factors (liquidity risk), and changes in 

other factors that can affect price. Sources of market risk differ for various types of derivatives. 

Savings associations should understand the forces 
SECTION: Derivative Instruments and Hedging Section 660

660.2 Regulatory Handbook April 2001 Office of Thrift Supervision

that cause the market prices of derivatives to 

change.

Higher asset values or lower funding costs offset 

market losses on derivatives that savings associations use as hedges. In practice, however, 

offsetting gains may not occur due to nonparallel 

movements in the yield curve, mortgage prepayments, deposit attrition, timing differences, or lack 

of liquidity. We discuss various types of market 

risk below.

Correlation Risk

The balance sheet item and the corresponding derivative may have different interest rate indices. 

There may not be perfect correlation between the 

movements of the interest indices or their correlation may change over time. For example, if a 

savings association uses a LIBOR-based swap to 

hedge short-term certificates of deposit (CDs),

the effectiveness of the hedge will depend on the 

extent the CD rate moves with LIBOR. If other 

factors, such as local market conditions, play a 

major role in setting rates, the hedge may be ineffective or, conversely, lower funding costs may 

not offset losses on the derivative. A similar 

correlation problem emerges when the balance 

sheet item and the corresponding derivatives use 

indices of different maturities. In that case, an 

inversion, or other nonparallel shift, in the yield 

curve could make the hedge ineffective.

Prepayment Risk

Because mortgages contain prepayment options, 

we do not know their actual effective maturity in 

advance. Moreover, prepayment rates tend to 

change as interest rates change. A derivative may 

be an effective hedge for small changes in interest 

rates but become invalid if interest rates move 

sharply up or down. Gains on a mortgage portfolio may, therefore, not fully offset losses on 

derivatives, and vice versa.

Deposit Attrition

Determining the effective term and rate sensitivity 

of non-maturity deposits, such as MMDAs and 

passbook accounts, is difficult because these deposits do not have explicit maturities. Withdrawal 

rates and the extent their interest rates track market rates vary over time and across institutions. As 

a result, hedging these liabilities is imprecise and 

requires a thorough analysis of depositor behavior.

Timing Differences

Another source of risk arises from timing differences between the hedging instrument and the 

hedged item. Consider the case of using swaps to 

hedge retail CDs. Swaps reprice on a specific date 

(for example, the end of a quarter) but CDs mature or reprice throughout a quarter. If interest 

rates change considerably within a quarter, the 

swap could be an ineffective hedge. A savings 

association can diversify this timing risk by entering into a number of separate swaps with different 

reset dates.

Inaccurate Initial Pricing

Certain complex derivative instruments may be 

difficult to price accurately. As a result, the savings association could initiate a swap with a 

negative market value or overpay for an option. 

Savings associations should be able to ascertain 

that the price and rate on a derivative instrument 

is consistent with current market conditions.

Illiquidity

Derivative use involves two types of liquidity 

risks. The derivative instrument may be illiquid, 

making the position difficult or expensive to unwind. Potential illiquidity is greatest with exotic 

derivatives.

Credit Risk

Credit risk is the potential for loss due to counterparty default. The evaluation of credit risk is 

particularly important in the case of OTC derivatives because the creditworthiness of 

counterparties can vary significantly. By comparison, the market views counterparty risk on 

exchange-traded contracts as minimal because the 

exchanges guarantee the performance of each contract. In addition, credit exposures on exchange-
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.3

traded options are small because of the margin

requirements and daily settlement practices imposed by the exchanges.

The credit risk of derivatives consists of two distinct elements: current exposure and potential 

exposure. Current exposure is the market value of 

the derivative at any point in time. The market 

value of a derivative equals the net present value 

of the derivative’s future cash flows and represents the cost of replacing the contract with a new 

one if the counterparty defaults.

The current exposure can be either positive or 

negative. When the current exposure is positive, 

the contract represents an asset and the holder of 

the contract will suffer a loss if the counterparty 

defaults. When the market value of the contract is 

negative, the contract represents a liability. Therefore, no credit loss occurs if there is a default 

since the contract has no value. The current exposure on exchange-traded contracts is negligible 

since exchanges require daily settlement of gains 

and losses on contracts.

The calculation of potential exposure incorporates 

possible changes in the market value of the contract as market conditions change. Market 

participants use various techniques, such as Monte 

Carlo simulation and option pricing models, to 

estimate potential exposures. For a credit loss to 

occur on a swap, two conditions must exist: the 

market value of the contract must be positive and 

the counterparty must default on the contract.

Only one side of an option contract confronts 

credit exposure. The writer (seller) of the option 

receives its fees up front, so only the buyer of the 

option faces a loss in the case of default. If the 

seller of the option defaults, the option buyer 

stands to lose the economic benefits associated 

with the option as well as an accounting loss equal 

to the unamortized option premium.

Savings associations must restrict their choice of 

counterparties to banks and well-capitalized nonbank entities. The market often uses collateral 

arrangements in derivative transactions to reduce 

exposure to counterparty risk. In swap transactions, collateral arrangements are subject to 

negotiation and can be either unilateral or bilateral. Under a unilateral arrangement, only the less 

creditworthy counterparty must post collateral. 

Under a bilateral arrangement, neither side posts 

collateral initially, but either side may need to 

post collateral later if a triggering event occurs. 

Triggering events include credit down gradings or 

sharp movements in interest rates.

When a party has two or more swap transactions 

involving the same counterparty, it uses a netting 

arrangement to reduce risk. Typical netting arrangements call for counterparties to net all 

transactions in the event of default. This means 

that all contracts between the two parties are 

marked-to-market, and those with negative values 

provide an offset against those with positive values.

Without netting arrangements, no offset occurs in 

the event of default. As a result, a practice known 

as cherry picking may occur. For example, a firm 

may have two swaps with the same counterparty— one with a positive replacement value and 

one with a negative replacement value. If the firm 

confronts bankruptcy, it may attempt to seek relief 

from the swap that has a negative replacement 

value (a liability) and attempt to force the counterparty to continue to pay on the swap with a 

positive value.

Legal Risk

Legal risk with OTC derivatives results from the 

fact that provisions may be unenforceable for the 

following reasons:

• Inadequate documentation.

• Illegality of the contract.

• Ineligibility of a counterparty to enter the 

transaction.

• Bankruptcy or insolvency of the counterparty.

Operational Risk

Operational risk is the potential for loss from a 

failure of internal systems and controls, human 

error, or fraud. Operational risk can arise from 
SECTION: Derivative Instruments and Hedging Section 660

660.4 Regulatory Handbook April 2001 Office of Thrift Supervision

lack of management expertise and depth, excessive reliance on third parties, lack of involvement 

by senior management and the board of directors, 

and lack of checks and balances in derivative 

transactions.

HEDGING

Savings associations can reduce financial risk by 

hedging. Hedging can involve forward commitments, futures, options, and swaps.

Before engaging in any hedging strategy, management must review the savings association’s 

overall interest rate risk position under various 

interest rate scenarios as required by Thrift Bulletin 13a. This evaluation would also include the 

effect of any hedge strategies.

Macro-hedging and Micro-hedging

The objective of a macro-hedge is to reduce the 

interest rate risk of a savings association based on 

a complete analysis of the balance sheet and offbalance sheet items. The objective of a microhedge is to reduce or eliminate the risk of a specific balance sheet or off-balance sheet item. 

Section 563.172 generally requires that the hedge 

positions reduce the interest rate risk of the 

institution. 

You should not evaluate the appropriateness of a 

micro-hedge in isolation, but rather in the context 

of its effect on the overall interest rate risk of the 

savings association. Sometimes a micro-hedge can 

increase rather than reduce a savings association’s 

overall interest rate risk. For example, a savings 

association that is liability sensitive can establish 

a micro-hedge to offset the interest rate risk of a 

fixed-rate mortgage-servicing portfolio. This portfolio may provide protection against an increase 

in interest rates, as the value of the portfolio 

would increase as interest rates increase and 

mortgage prepayments slow.

A well-constructed hedge (one developed with the 

benefit of an analysis of the overall interest rate 

risk) should meet the requirements of Statement 

of Financial Accounting Standard (SFAS) 133, 

Accounting for Derivative Instruments and Hedging Activities. 

In June 1998, the Financial Accounting Standards 

Board (FASB) issued SFAS 133 as amended by 

SFAS 137, Accounting for Derivative Instruments 

and Hedging Activities — Deferral of the Effective Date of FASB Statement No. 133 (issued 

June 1999); and SFAS 138, Accounting for Certain Derivative Instruments and Certain Hedging 

Activities (issued June 2000). SFAS 137 became 

effective with fiscal years ending after June 15, 

2000.

Management, in coordination with an independent 

audit firm, should establish a policy containing 

standards, parameters, and conditions to assess the 

required level of correlation and hedge effectiveness. SFAS 133 requires that a gain or loss from 

the item hedged be highly correlated to the gain or 

loss from the hedging instrument. SFAS 133 does 

not define high correlation. However, in practice, 

the gain or loss from the future contracts should 

equal no less than 80 percent to 120 percent of the 

change in value from the hedged instrument. 

SFAS 133 limits hedge accounting to those relationships in which derivative instruments and 

certain foreign currency-denominated nonderivative instruments are designated as hedging 

instruments and the necessary qualifying criteria 

are met.

Derivatives subject to SFAS 133 include, but are 

not limited to, interest rate swaps, options, futures, 

and forwards. In developing this complex proposal, the FASB concluded that the following five 

fundamental decisions should serve as cornerstones:

• Derivatives are assets or liabilities, and should 

be reported in the financial statements. (Prior 

to SFAS 133, most derivatives, except those 

held for trading, were “off-balance sheet” and, 

savings associations did not report them in the 

financial statements.)

• Fair value is the most relevant measure for 

financial instruments, and the only relevant 

measure for derivatives.
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.5

• Savings associations should measure derivatives at fair value, and adjustments to the 

carrying amount of hedged items should reflect changes in their fair value (that is, gains 

and losses) that are attributable to the risk being hedged and that arise while the hedge is in 

effect.

• Savings associations should report only items 

that are assets or liabilities in the financial 

statements. (Savings associations should not 

defer and treat realized gains and losses on 

certain derivatives used for hedging as an asset or liability.)

• Savings associations should use special accounting for items designated as being hedged 

only for qualifying transactions; one aspect of 

qualification should be an assessment of offsetting changes in fair values or cash flows.

Accounting Treatment

Savings associations must account for and disclose hedging transactions and derivative 

instruments according to generally accepted accounting principles (GAAP). SFAS 133 is a 

significant accounting change that requires an institution to record all derivatives on the balance 

sheet as assets or liabilities at their fair value. Under SFAS 133, savings associations should report 

changes in the fair value of most derivatives in net 

income. However, savings associations should 

record the accumulated gains (losses) for derivatives that qualify as effective cash flow hedges, in 

other comprehensive income, a component of 

GAAP equity capital. SFAS No. 133 also requires 

certain disclosures.

Management should consult with its independent 

auditor to ensure compliance with GAAP. Where 

GAAP does not specifically address the accounting treatment for a particular derivative 

instrument, the savings association should document the accounting treatment they use and record 

the basis for the adopted treatment.

Evolving accounting and regulatory requirements 

makes it necessary to keep abreast of legislative, 

regulatory, and accounting initiatives that could 

affect the treatment of certain derivatives and influence their market values. On December 29, 

1998, the FFIEC issued interim regulatory reporting and capital guidance that departs from GAAP.

That guidance requires an institution that has 

adopted SFAS 133 to report derivative instruments as follows:

• Do not include accumulated gain (losses) for 

effective cash flow hedges in regulatory capital. 

• Report accumulated gain (losses) for ineffective cash flow hedges and for all fair value 

hedges in net income. This affects the numerator for both the Tier 1 and risk-based 

capital calculations.

• Separately record and independently riskweight embedded derivatives and the associated financial instrument.

Management should regularly perform worst-case 

scenario analysis that measures the potential effect 

on the savings association of changes in regulatory or accounting rules.

OTS POLICY ON DERIVATIVES

The Office of Thrift Supervision’s rule on financial derivatives in § 563.172 permits savings 

associations to engage in transactions involving 

financial derivatives. The rule also describes the 

responsibilities of a savings association’s board of 

directors and management regarding financial derivatives. In addition, Thrift Bulletin 13a (TB 13a) 

provides guidance on the use of financial derivatives.

Sensitivity Analysis or Stress Testing

Management should exercise diligence in assessing the risks and returns (including expected total 

return) associated with investment securities and 

financial derivatives. As a matter of sound practice, before taking an investment position or 

initiating a derivatives transaction, a savings association should:
SECTION: Derivative Instruments and Hedging Section 660

660.6 Regulatory Handbook April 2001 Office of Thrift Supervision

• Ensure that the proposed transaction is legally 

permissible for a savings association.

• Review the terms of and condition of the financial derivatives.

• Ensure that the proposed transaction is allowable under the savings association’s 

derivatives policies.

• Ensure that the proposed transaction is consistent with the savings association’s portfolio 

objectives and liquidity needs.

• Exercise diligence in assessing the market 

value, liquidity, and credit risk of the financial 

derivatives.

• Conduct a pre-purchase portfolio sensitivity 

analysis for any significant transaction involving financial derivatives (as described below 

in Significant Transactions).

• Conduct a pre-purchase price sensitivity 

analysis of any financial derivative before taking a position.1

Significant Transactions

A significant transaction is any transaction (including one involving financial instruments other 

than complex securities) that is expected to increase a savings association’s Sensitivity Measure 

by more than 25 basis points. Before undertaking 

any significant transaction, management should 

conduct an analysis of the incremental effect of 

the proposed transaction on the interest rate risk 

profile of the institution. The analysis should 

show the expected change in the savings association’s net portfolio value (with and without the 

proposed transaction) that would result from an 

immediate parallel shift in the yield curve of plus 

and minus 100, 200, and 300 basis points. In general, a savings association should conduct its own 

 

1

 The following financial derivatives are exempt from 

pre-purchase analysis: commitments to originate, purchase, or sell mortgages. To perform the pre-purchase 

analysis for derivatives whose initial value is zero (for 

instance, futures, swaps), the savings association 

should calculate the change in value as a percentage of 

the notional principal amount.

analysis. It may, however, rely on analysis conducted by an independent third-party (that is, 

someone other than the seller or counterparty) 

provided management understands the analysis 

and its key assumptions.

Savings associations with less than $1 billion in 

assets that do not have an internal modeling capability to conduct such an incremental analysis may 

use the most recent quarterly NPV estimates for 

their institution provided by OTS. The association 

can use these NPV estimates to estimate the incremental effect of a proposed transaction on the 

sensitivity of its net portfolio value.

2

Complex Securities and Financial Derivatives

Before taking a position in a complex security or 

financial derivative, a savings association should 

conduct a price sensitivity analysis (that is, a prepurchase analysis) of the instrument. At a minimum, the analysis should show the expected 

change in the value of the instrument that would 

result from an immediate parallel shift in the yield 

curve of plus and minus 100, 200, and 300 basis 

points. Where appropriate, the analysis should 

encompass a wider range of scenarios (for example, nonparallel changes in the yield curve, 

changes in interest rate volatility, changes in 

credit spreads, and in the case of mortgage-related 

securities, changes in prepayment speeds). In general, a savings association should conduct its own 

in-house pre-acquisition analysis. A savings association may, however, rely on an analysis 

conducted by an independent third-party provided 

management understands the analysis and its key 

assumptions.

 

2

 Savings associations that are exempt from filing 

Schedule CMR and that choose not to file voluntarily 

should ensure that no transaction – whether involving 

complex securities, financial derivatives, or any other 

financial instruments – causes the institution to fall out 

of compliance with its board of directors’ interest rate 

risk limits.
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.7

Risk Reduction

In general, the use of financial derivatives with 

high-price sensitivity3 is limited to transactions 

and strategies that lower a savings association’s 

interest rate risk as measured by the sensitivity of 

net portfolio value to changes in interest rates. A 

savings association that uses financial derivatives 

for a purpose other than reducing portfolio risk 

should do so according to safe and sound practices 

and should:

• Obtain written authorization from its board of 

directors to use such instruments for a purpose 

other than to reduce risk.

• Ensure that, after the proposed transaction(s), 

the savings association’s post-shock NPV Ratio would not be less than four percent.

The use of financial derivatives or complex securities with high price sensitivity for purposes other 

than to reduce risk by savings associations that do 

not meet the conditions above, constitutes an unsafe and unsound practice.

Recordkeeping

Savings associations must maintain accurate and 

complete records of all derivatives transactions 

according to 12 CFR § 562.1. Savings associations should retain any analyses (including preand post-purchase analyses) relating to investments and derivatives transactions and make such 

analyses available to examiners upon request.

In addition, for each type of financial derivative

instrument the board of directors authorizes, the 

savings association should maintain records containing the following information:

• The names, duties, responsibilities, and limits 

of authority (including position limits) of em-

 

3

 For purposes of TB 13a, complex securities with high 

price sensitivity include those whose price would be 

expected to decline by more than 10 percent under an 

adverse parallel change in interest rates of 200 basis 

points.

ployees authorized to engage in transactions 

involving the instrument.

• A list of approved counterparties with which 

transactions may be conducted.

• A list showing the credit risk limit for each 

approved counterparty.

• A contract register containing key information 

on all outstanding contracts and positions.

The contract registers should specify the following information:

• Type of contract

• Price of each open contract

• Dollar amount

• Trade and maturity dates

• Date and manner in which contracts were offset

• Total outstanding positions.

Where deferred gains or losses on derivatives 

from hedging activities are consistent with generally accepted accounting principles (GAAP), the 

savings association should maintain appropriate 

supporting documentation.

GUIDELINES FOR THE BOARD OF 

DIRECTORS AND MANAGEMENT

A savings association’s board of directors must 

manage interest rate risk prudently (12 CFR § 

563.176). Under Part 570 Appendix A II, Operational and Management Standards, savings 

associations must have prudent policies, practices, 

and systems. These requirements include management of interest rate risk, assessment of asset 

quality, maintenance of internal controls and information systems and appropriate internal audit 

systems. Savings associations also must maintain 

and make available to you an accurate and complete record of transactions involving derivative 

products (12 CFR Part 562).
SECTION: Derivative Instruments and Hedging Section 660

660.8 Regulatory Handbook April 2001 Office of Thrift Supervision

Derivatives Guidelines

Savings associations that use derivatives should 

adhere to the following guidelines.

Board of Directors’ Approval

The board of directors should adopt and enforce a 

written policy authorizing and governing the use 

of derivative products. The policy should (1) identify authorized derivative products and (2) 

mandate record-keeping systems detailed enough 

to permit internal auditors to determine whether 

personnel have operated according to the board’s 

authorization.

Management should report periodically to the 

board regarding compliance with the board’s policies on the use of derivative products.

Interest Rate Risk Policy

Savings associations must have a comprehensive 

policy detailing their overall interest rate risk 

management and investment strategy, pursuant to 

12 CFR § 563.176. That plan should include a 

description of the savings association’s derivative 

strategy and objectives.

Internal Controls

A savings association should establish the following internal controls and procedures:

• Periodic reports to management.

• Segregation of duties.

• Adherence to internal policies and procedures.

• Prevention of unauthorized transactions and 

other abuses.

Segregation of Duties

Internal systems and procedures should segregate 

duties between those responsible for execution, 

record keeping, and verification. Management 

should designate those authorized to transact derivatives.

Position Limits

Management should establish specific position 

limits (expressed as dollar amounts, or as a percentage of assets or capital) for each major type of 

derivative product and for each counterparty. Savings associations can measure position limits in 

terms of either notional balances or value at risk 

(VAR). The VAR approach provides a more comprehensive indicator of credit and market risk 

because it considers the current market value and 

volatility of a derivative contract as well as its 

size. A ten-year swap has more credit risk and 

market risk than a two-year swap of the same notional balance because a given change in market 

interest rates has a greater effect on market value.

The limits should be consistent with the following 

characteristics:

• The savings association’s intent.

• Level of management expertise.

• Sophistication of internal control and monitoring systems.

• Asset/liability structure.

• Capacity to maintain liquidity and absorb 

losses out of capital.

The board of directors, an authorized committee 

thereof, or the savings association’s internal auditors should monitor conformance with such limits. 

Internal auditors should report their reviews to the 

board of directors or a committee of the board on 

a regular basis.

Aggregating Credit Exposures

Savings associations should aggregate credit exposures to a counterparty considering enforceable 

netting arrangements. The savings association 

should regularly calculate credit exposures and 

compare them to credit limits.

Marking-to-Market

Savings associations should mark their derivatives 

positions to market on a regular basis for risk 

management purposes.
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.9

Professional Expertise

Savings associations must ensure that they have 

adequate staff to undertake their derivatives 

activities. The staff must have the appropriate 

experience, skill levels, and degrees of specialization.

Savings associations should not place undue reliance on, or delegate decision-making authority to 

third-party investment advisors. Savings associations must document decisions they make on the 

recommendations of third parties. (The use of investment advisors should be according to the 

guidance provided in Handbook Section 540, Investment Securities.)

Counterparty Credit Analysis

Savings associations should control counterparty 

credit risk by limiting transactions to financially 

strong counterparties. Savings associations should 

conduct a credit analysis of the counterparty before entering into a transaction. In addition, 

associations should investigate the dealer’s general reputation for fair and honest dealings with 

customers. Savings associations should also conduct an inquiry of appropriate state or federal 

securities regulators and securities industry selfregulatory organizations concerning any formal 

enforcement actions against the dealer, its affiliates, or associated personnel.

Savings associations that use derivatives should 

assess both the benefits and costs of credit enhancement and related risk-reduction 

arrangements. If credit downgrades would trigger 

early termination or collateral requirements, an 

association should carefully consider its own capacity and that of its counterparties to meet the 

substantial funding needs that might result.

Legal Review

Management should ascertain the rights and obligations of all parties to derivative transactions by 

carefully reviewing all related contractual and 

account documents, including margin and collateral requirements, and recourse arrangements. 

Management should thoroughly understand those 

rights and obligations to avoid possible misunderstandings.

Master Agreements

Savings associations that use derivatives should 

use one master agreement with each counterparty

to document existing and future derivatives transactions, including options. Master agreements 

should provide for payments netting and closeout 

netting, using a full two-way payments approach.

Evaluation of Hedging Transactions

For hedging transactions, internal reports should 

show the market value of the derivative instruments and reconcile the gains and losses to the 

changes in the value of hedged balance sheet 

items. For example, if a savings association 

bought futures contracts to hedge the market value 

of a group of assets, the savings association 

should compare the performance of the futures 

contracts with the performance of the hedged assets to evaluate the overall performance of a 

hedging program. The savings association should 

perform an assessment of hedging effectiveness at 

least quarterly. Monthly assessment may be necessary for larger hedging transactions.

TFR Reporting

Savings associations report derivatives positions 

on Schedule CMR (Consolidated Maturity and 

Rate) of the Thrift Financial Report. In addition, 

savings associations indicate whether they have 

any outstanding futures and options positions on 

Schedule SQ (Consolidated Supplemental Questions).

Hedging Guidelines

There are numerous ways to hedge. Management 

must select the optimal method for hedging based 

on the institution’s level of risk and the level of 

in-house expertise. Management must assess the 

potential costs and benefits of a hedge strategy 

before its implementation. The savings association 

must analyze the yield and price characteristics of 

the hedging instrument(s) and compare these 

characteristics to those of the hedged assets, li-
SECTION: Derivative Instruments and Hedging Section 660

660.10 Regulatory Handbook April 2001 Office of Thrift Supervision

abilities, or off-balance sheet positions. Management should evaluate and document the prehedging analysis with various examples of the 

intended strategies and how these strategies would 

perform under varying interest rate scenarios.

The board of directors and management must consider the level of expertise needed to implement a 

hedge strategy. If using outside consultants, the 

savings association must have in-house personnel 

who thoroughly understand the consultants’ recommendations. Management must maintain the 

final decision-making authority, but they can use 

the information provided by consultants and brokers. Following the advice of an outside 

consultant without a thorough understanding of 

the strategy is not an acceptable practice. Management should not rely solely on the advice of a 

broker to determine hedge ratios or when to establish or offset hedge positions. Since the broker’s 

commissions depend on transaction volume, there 

may be an inherent conflict.

One of the keys to a successful hedging program 

is the expertise of management. Management 

must have adequate knowledge of various hedging 

instruments, a thorough understanding of asset/liability management techniques, and the 

savings association’s current interest rate risk position under different interest rate scenarios. 

Management must also be able to explain the 

strategies and the methods used to evaluate the 

effectiveness of the hedging program without 

relying on assistance from outside consultants or 

brokers.

Policies, Procedures, and Recordkeeping 

Requirements

Savings associations that engage in hedging transactions must have specific written policies and 

internal control procedures regarding these activities. Policy objectives must be specific enough to 

outline permissible strategies and take into account:

• The price and yield correlations between assets or liabilities and the hedging instruments 

with which they are matched (that is, the 

hedge ratio).

• The relationship of the strategies to the institution’s operations.

• How the strategies reduce interest rate risk.

If the hedging program involves complex strategies, documentation should include examples of 

the intended strategies. The hedging policy should 

reflect changes in hedging strategies.

The written policy should establish position limits 

and the parameters by which the board of directors and management will monitor the 

effectiveness of the hedging program. The board 

should authorize the individual(s) responsible for 

executing hedging transactions and establish limits of authority for the individual(s). The board 

should also approve the selection of consultants 

and brokers and set specific limitations on the 

level of authority granted. Policies and procedures 

should include the segregation of duties between 

the execution of hedge positions and the transfer

of funds. Monthly monitoring reports should detail the volume of transactions, all outstanding 

positions, the unrealized gains or losses on these 

positions, and the realized gains or losses from 

closed positions.

Savings associations must document and monitor 

all facets of hedging programs, and maintain contract registers for all financial derivatives. The 

contract registers should specify the type of contract, the price of each open contract, the dollar 

amount, the trade and maturity dates, the date and 

manner in which contracts offset each other, the 

offset gain or loss, and the total outstanding positions. Savings associations must maintain a 

schedule of the hedged assets and/or liabilities and 

document the method used to determine the dollar 

amount of the hedging instrument. The savings 

association must also maintain documentation on 

the following:

• Deferred gains or losses from hedge positions. 

• Correlation between the gain or loss from the 

hedging instrument. 

• Change in value of the item hedged during the 

hedge period. 
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.11

• Method used to amortize any deferred gains 

or losses from hedge positions.

TYPES OF DERIVATIVE INSTRUMENTS

Swaps

Interest Rate Swaps

Interest rate swaps are the most common type of 

financial derivative used by savings associations. 

An interest rate swap is an agreement between 

two parties to exchange a series of cash flows 

(based on notional principal amounts) at specified 

intervals known as payment or settlement dates. 

The parties do not exchange actual principal 

amounts. Instead, the parties usually net interim 

payments, with the net amount being paid to one 

party or the other.

Savings associations use interest rate swaps primarily to manage interest rate exposure and to 

reduce debt-financing costs. Swaps transform an 

existing cash flow stream into a more desirable 

one from the point of view of a financial institution. For example, a savings association can use a 

swap to transform floating-rate liabilities into 

fixed-rate liabilities. Because the parties negotiate 

swap contracts, they can swap virtually any kind 

of payment stream. The most common type of 

swap is the fixed-for-floating interest rate swap.

With a fixed-for-floating interest rate swap, one 

party exchanges a fixed-rate interest payment 

stream for a floating-rate payment stream. The 

party that agrees to make fixed-rate payments is 

the fixed-rate payer, and the party that makes the 

floating-rate payments is the floating-rate payer. 

In this instance, a fixed-for-floating swap enables 

the fixed-rate payer to transform floating-rate liabilities into fixed-rate liabilities. A party could 

also transform fixed-rate assets into floating-rate 

assets.

Figure 1 shows an example of a fixed-for-floating 

interest rate swap. In this example, Counterparty 

A has $10 million of fixed-rate borrowings that it 

wants to convert into floating-rate borrowings. 

Counterparty B has $10 million of floating-rate 

borrowings that it wants to convert into fixed-rate 

borrowings. Both parties agree to enter into an 

interest rate swap with a notional amount of $10 

million. The agreement requires Counterparty B 

to make semiannual payments to Counterparty A 

at a fixed rate of five percent for three years. In 

exchange, Counterparty A agrees to make floating-rate payments based on the six-month London 

Interbank Offered Rate (LIBOR) with an initial 

rate of four percent.

In the example, B (the fixed-rate payer) will make 

a net payment of $50,000 to A (the floating-rate 

payer) on the first semiannual payment date. On 

that date, the floating rate for the next six months 

resets based on the prevailing six-month LIBOR. 

If six-month LIBOR increases after the swap is 

initiated, A’s cost of funds will rise because it is 

obligated to make floating-rate payments to B. On 

the other hand, B, will benefit if rates rise, since it 

will receive higher floating-rate payments, while 

its payments remain fixed at five percent of the 

notional amount. Savings associations exposed to 

rising rates (for example, the typical savings association holding interest-bearing deposits) can 

reduce their exposure by entering into fixed-forfloating swaps as the fixed-rate payer.

Figure 1

Fixed-for-Floating Interest Rate Swap

 fixed-rate payment

 5% semiannual

 ($250,000)

 floating-rate

 payment

 4% semiannual

 ($200,000)

 Fixed interest Floating interest

*Floating-rate payment is reset semiannually based on six-month LIBOR.

Counterparty A Counterparty B

 Fixed-rate

 debt

 Floating-rate

 debt
SECTION: Derivative Instruments and Hedging Section 660

660.12 Regulatory Handbook April 2001 Office of Thrift Supervision

Basis Swaps

Basis swaps involve the exchange of payments 

based on two different floating-rate indices, such 

as one-month LIBOR against the Eleventh District 

Cost of Funds Index (COFI). For example, a payCOFI, receive-LIBOR swap effectively converts a 

COFI ARM into a LIBOR ARM, allowing the 

savings association to match LIBOR-indexed borrowings more closely. The market also calls basis 

swaps floating-for-floating swaps.

Swap Termination

A savings association may wish to reverse or terminate (unwind) a swap before maturity. There 

are two ways to unwind a swap position. One way 

is to negotiate a termination settlement with the 

original counterparty. The other is to enter into a 

new swap that is a mirror image of the existing 

swap to offset the existing position.

Swap Variations

Most swaps have a specified maturity date and a 

fixed notional amount. Some swaps, however, 

have notional amounts that amortize over time. 

Swaps can also be callable, where one of the 

counterparties has an option to terminate the swap 

if interest rates increase or decrease beyond the 

strike rate. A forward swap is a firm commitment 

to enter into a swap at a specified future date.

Uses and Evaluation of Swaps

Swaps can synthetically extend the term of a 

matched liability over the term of the swap in 

much the same way as futures contracts are used 

to fix financing costs. However, swaps do not require the same active management that futures or 

options positions require. Swaps are not as liquid 

as futures contracts. A savings association can 

offset a swap position and, in effect, cancel it if 

they negotiate an offset with the counterparty or 

enter into a reverse swap with terms that are similar to the original swap agreement.

To evaluate the appropriateness of a swap agreement, management should monitor the correlation 

of the effective spread from the assets and liabilities being hedged by using a swap with a fixedrate payable and a variable-rate receivable. For 

example, if a savings association enters into a 

five-year swap where the fixed interest rate is nine 

percent and the variable rate on the first payment 

date is seven percent, the savings associations 

must pay 200 basis points. However, if the savings association matches the swap, you should 

compare the variable rate with the rate paid on the 

matched short-term liability to determine how 

closely the variable rate received from the swap 

correlates. If these rates correlate well and the assets funded by the matched liability have a 

duration of approximately five years, the association may achieve a “locked-in” spread.

Forward Contracts

A forward contract obligates one counterparty to 

buy, and the other to sell, a specific underlying 

financial instrument at a specific price, amount, 

and date in the future. Contracts specifying settlement in excess of 30 days after the trade date 

are forward contracts. Forward contracts exist for 

a multitude of underlying assets, including currencies, commodities, and mortgages. Forward 

contracts trade over-the-counter and counterparties customize these contracts to fit their particular 

objectives.

Figure 2

Profit of Forward Contract - Long Position

 Gain

 Value of forward con-

 tract for a buyer of the 

 contract

 

 0 Price of 

 underlying asset

 or index

 Contract

 price

 Loss
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.13

Figure 2 shows the payoff profile of a forward 

contract. As shown, the change in the value of a 

forward contract is roughly proportional to the 

change in the value of the underlying asset or index. The value of the contract conveys at maturity 

through cash settlement or delivery. If, at maturity, the price of the underlying is higher than the 

contract price, then the buyer makes a profit. The 

gain to the buyer equals the loss to the seller.

Forward contracts create two-way credit risk. The 

counterparty on the side of the contract that has a 

positive replacement value confronts the credit 

risk of the other party. However, the market value 

of a contract can change from a positive value to a 

negative value, and vice versa. Therefore, each 

party must assess the creditworthiness of its counterparty because each side may experience a 

potential gain or loss. The value of the forward 

contract conveys on the maturity date of the contract. Neither party makes payments at origination

or during the life of the contract. The contract 

owner will either receive or make a payment at 

maturity, depending on the price movement of the 

underlying asset or index.

Mortgage bankers often use forward contracts to 

hedge the price risk of holding loans temporarily. 

The forward sale of mortgage loans transfers the 

price risk of holding mortgages in the pipeline to 

the counterparty. Figure 3 shows the payoff profile of a forward sale. The seller of the forward 

contract is short the underlying asset, and therefore gains if the value of the underlying asset 

declines. In a short position, the writer (seller) of a 

forward contract must fulfill the obligation of the 

contract.

Forward contracts to sell mortgage production can 

be either firm or optional commitments. Firm 

commitments require both parties to perform on 

the contract (delivery of mortgages or cash settlement), regardless of market conditions. In 

contrast, optional commitments, such as standbys, 

require performance only at the option of the party 

that purchased the option.

Savings associations typically attempt to match 

the terms of the forward agreement to the terms of 

the underlying asset that causes the risk exposure. 

For example, assume a savings association originates 30-year fixed-rate mortgages and expects to 

close most of these loans within a 45-day period. 

As loan production accumulates, the savings association enters into a firm forward commitment to 

sell 30-year loans with a settlement date 45-days 

in the future. For the portion of the pipeline that is 

uncertain as to closure, the savings association 

may use a standby agreement to hedge the interest 

rate risk.

Figure 3

Profit of Forward Contract - Short Position

 Gain

 Value of forward con-

 tract for a seller of the

 contract

 Price of

 0 underlying asset

 or index

 

 Contract

 price

 Loss

In general, forward contracts to buy mortgages or 

mortgage-backed securities will increase the overall interest rate risk exposure of a typical savings 

association. You should examine long forward 

positions to determine if they are being used for 

speculative purposes. In a long position, the purchaser (holder) of an option contract has the right 

to exercise the option against the option writer.

Hedging with Forward Commitments

Savings associations can use firm or standby forward commitments to sell loans or securities as an 

economic hedging vehicle to reduce the interest 

rate risk of holding long-term, fixed-rate mortgages or securities in portfolio or in the loan 

pipeline. (Refer to the Mortgage Banking sections 

of the Thrift Activities Handbook.) Commitments 

to sell at the current market price can provide protection against the risk of declining market value 

associated with rising interest rates. Some savings 

associations enter into firm commitments to sell 
SECTION: Derivative Instruments and Hedging Section 660

660.14 Regulatory Handbook April 2001 Office of Thrift Supervision

securities (short positions) with a dealer, but 

rather than deliver the securities at settlement, pair 

off (offset/buy back) the short positions. If interest 

rates rise during the commitment period, the commitments can usually be paired off at a gain.

Standby commitments to sell provide flexibility 

since the savings association can select the amount 

and cost of coverage. The maximum loss for a 

standby commitment to sell is the amount of the 

fee. The amount of the fee depends on the length of 

the commitment, the relationship between the market value of the underlying security and the 

commitment price, and the volatility of the underlying security. To determine the appropriateness of 

using standby commitments to sell, you should assess the cost of the option versus the amount of 

protection obtained.

You should review forward commitment and pairoff activity for safety and soundness. Significant 

losses can result from improper use of commitment contracts. 

You should check for pair-off positions, where the 

savings association closes out forward positions 

before settlement with offsetting forward contracts, usually at a profit. You should review pairoffs in a held-to-maturity portfolio to determine if 

they constitute trading activity. While pair-offs 

can represent an acceptable element of a mortgage 

pipeline-hedging program, excessive pair-off activity may indicate an inefficient hedging process 

and should receive additional scrutiny. Regulators 

should determine whether the activity represents 

an economic hedging strategy or simply a speculative trading activity. To be considered a prudent 

economic hedging activity, the hedged items (existing or anticipated) the association must meet 

the following criteria:

• Identify the hedged item.

• Document the purpose of the hedge. 

• Justify the hedge ratio based on historic correlation. 

• Monitor and maintain the correlation throughout the hedge period.

• Evaluate and justify the effectiveness of the 

strategy for risk exposure.

Savings associations that use commitments (firm 

or standby) to hedge the loan pipeline must also 

document the estimate of fallout since this variable will materially affect the outcome of the 

hedge. Conversely, you can identify speculative 

trading activity by the following indicators:

• High volume of purchase and sale and/or pairoff activity. 

• Positions held for only short periods.

• The lack of requisite documentation. 

• Correlation analysis appropriate to a prudent 

economic hedging strategy.

Futures Contracts

A futures contract is a legally binding agreement 

to make or take delivery of a standardized quantity and quality of a commodity or financial 

instrument on a specified date in the future. The 

value of a futures contract reacts to changes in the 

price of the underlying commodity or financial 

instrument in much the same manner as the value 

of forward contracts. Futures contracts trade on 

recognized exchanges, and an exchange clearinghouse is the counterparty to each trade.

Futures contracts based on a financial instrument 

or a financial index are financial futures. Financial 

futures include interest rate futures, stock futures, 

and currency futures. Financial futures can be an 

effective means of controlling interest rate risk for 

savings associations. The most commonly used 

interest rate futures are those with Treasury bills, 

notes, and bonds, and Eurodollar CDs as the underlying asset.

The buyer of a futures contract takes a long position in the market and is long on the futures 

contract. The buyer can sell the contract at any 

time before settlement. In the case of an interest 

rate futures contract, such as a Treasury bond contract, a long position will make a profit if interest 

rates decline. Lower interest rates mean higher 

contract prices because there is an inverse rela-
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.15

tionship between interest rates and bond prices. 

Conversely, an increase in interest rates will produce a loss on a long position. The payoff profile 

of a long futures position is the same as that of a 

long forward contract position (see Figure 4). 

Note that futures contracts obligate their owners 

to purchase a specified asset at a specified exercise price on a specified maturity date.

Figure 4

Profit of Futures Contract - Long Position

 Gain

 Value of long position

 0 Price of

underlying 

asset or 

index

 Contract

 price

 Loss

Figure 5

Profit of Treasury Bond Futures Contract -

Short Position

 Gain

 Value of short position

 0 Price of

 bonds

 Contract

 price

 Loss

The seller of a futures contract takes a short position in the market. In essence, the seller promises 

to deliver a commodity or financial asset even 

though he/she may not own the asset. A short position in a Treasury bond contract will produce a 

profit if Treasury bond prices decline (that is, if 

Treasury bond yields increase). Selling a futures 

contract (a short position) is an example of a 

hedging strategy that savings associations can use 

to reduce their interest rate risk exposure if the 

savings association will lose value when interest 

rates rise. Figure 5 shows the payoff profile of a 

short futures position in Treasury bonds.

Compared with swaps and forwards, the credit 

risk of futures contracts is minimal for three reasons:

• Values of futures contracts reflect daily 

marked-to-market changes. Any change in the 

value of the futures contract conveys, (that is, 

settled in cash) at the end of each trading day.

In contrast, the value of a forward contract 

conveys in a single payment at maturity. With 

a swap contract, changes in value convey periodically throughout the life of the swap on 

each settlement date.

• Buyers and sellers of futures contracts must 

post a performance bond, known as initial 

margin, with their brokers. The customer must 

establish an initial margin account when 

opening the contract. The broker adds or subtracts gains and losses on the futures contract 

from the margin account at the end of each 

day. If losses cause the margin account to fall 

below a specified level, the customer must 

post additional margin, or the broker will 

close out the account.

• An exchange clearinghouse is the counterparty to each futures transaction. 

Hedging with Future Contracts

There are numerous hedging strategies using futures contracts. You must evaluate each strategy 

on a case-by-case basis. A description of some of 

the commonly used strategies and some of the 

risks of these strategies follows:

• Savings associations that attempt to hedge 

fixed-rate mortgages or mortgage-backed securities (MBS) with futures contracts based 

on either Treasury bond or Treasury note futures contracts have significant cross-hedging 
SECTION: Derivative Instruments and Hedging Section 660

660.16 Regulatory Handbook April 2001 Office of Thrift Supervision

risk. Treasury bond futures contracts provide 

greater liquidity. When interest rates decline, 

Treasury bond futures contracts will increase 

in value because these contracts track cash 

market Treasury bonds. These bonds have set 

maturity dates. Therefore, when interest rates 

decline, these securities will increase in value 

much more than a MBS with the same stated 

maturity (positive convexity). However, the 

potential for value changes in the MBS will 

depend on the duration of the MBS, which 

will vary based upon the prepayment experience of the underlying mortgages (increased 

prepayments yield a shorter duration).

Because the price of the MBS exceeds the par 

value, price appreciation is limited (due to 

negative convexity). This occurs because a 

premium MBS results when the coupon rate 

exceeds the comparable interest rate for current mortgages. If the interest rate on the 

mortgages underlying the MBS significantly 

exceeds the prevailing mortgage interest rate, 

the probability of refinance increases. This 

causes the duration of the MBS to decrease 

faster than the duration of the Treasury bond 

that underlies the futures contract. If interest 

rates decrease, the losses from the futures positions could significantly exceed the 

appreciation on the MBS.

You should closely review any hedging strategy that uses Treasury futures matched 

against MBSs. You should also scrutinize the 

methods used to determine the number of futures contracts and the monitoring techniques 

used by management.

• Savings associations engaged in fixed-rate 

mortgage lending activity may attempt to 

protect the value of the loan pipeline by 

hedging. The savings association must estimate the amount of loans expected to 

close and quantify the risk. They may use 

futures contracts.

• Some savings associations attempt to synthetically extend the terms of their shortterm liabilities by matching futures contracts based on short-term instruments 

against them. They normally use Eurodollar and Treasury bill futures contracts (par 

value of $1 million) based on 90-day instruments. In this strategy, one determines 

the number of contracts by comparing the 

maturity of the hedged liability with the 

maturity of the instrument underlying the 

futures contract used. If the maturity of 

the liabilities and the instruments underlying the futures contract are equal (for 

example, both 90 days), the savings association uses a one-to-one hedge ratio. 

That is, for each $1 million of liabilities 

hedged, there is one futures contract. If 

the association hedges liabilities with a 

maturity of six months, there are two 90-

day futures contracts for each $1 million 

of hedged liabilities. There is a high correlation between the savings association’s 

method for setting the interest rates on its 

liabilities compared with the money market interest rate that determines the yield 

on the instruments that drive the futures 

contracts used.

Contract Placement of Futures

Once the savings association determines the number of contracts, the savings association must 

select the maturity date of the futures contract. If 

the savings association decides to place the hedge 

position in futures contracts that mature at approximately the same time that the liabilities 

reprice/roll over, this produces a stripped hedge. If 

the savings association decides to concentrate all 

or most of the contracts in the futures contract 

with the most recent contract maturity, this produces a stacked hedge.

To illustrate the structure of a stripped versus a 

stacked hedge, assume that on June 15, 2001, a 

savings association decides to hedge for one year 

$10 million of 90-day certificates of deposit 

(CDs) that will next reprice/roll over on September 1, 2001. To establish a stripped hedge, the 

savings association sells ten September 2001, ten 

December 2001, ten March 2002, and ten June 

2002 futures contracts. At each contract maturity 

date, ten contracts will close. To establish a 

stacked hedge, the savings association does not 
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.17

place the contracts evenly by contract month over 

the hedge period. Instead, the savings association 

places all forty contracts in the nearby September 

2001 contracts. When the CDs roll over in September, the association closes out ten of the 

futures contracts, but rolls forward thirty into December 2001 contracts. Similarly, in December 

2001, an additional ten contracts close and the 

remaining twenty roll into March 2002 contracts. 

The last ten contracts close in June 2002.

Stacking contracts, as opposed to selling a strip of 

contracts covering the hedge period, involve decisions pertaining to the yield curve and contract 

liquidity. A hedge manager may establish a hedge 

position in a nearby contract because these contracts are normally more liquid than the more 

distant contracts. The hedge manager may stack 

the hedge position if he anticipates that the yield

curve will steepen, as these contracts should provide a greater future gain relative to the nearby 

contracts. The manager may stack the hedge position in the nearby contracts, if he anticipates that 

the yield curve will flatten or invert. When reviewing stack hedges, it is important to determine 

that the motivation for the hedge transactions is to 

reduce the risk of the hedged item and to achieve 

a high level of correlation, and not to speculate on 

yield curve fluctuation.

Margin Requirements on Futures Contracts

The savings association must post the initial margin when they establish a futures position. This 

can be cash, pledged government securities, or 

irrevocable standby letters of credit. Initial margin 

requirements for Treasury bonds, Treasury bills, 

Eurodollars, and futures contracts are normally 

less than two percent of the contract par value. 

This margin serves as a good faith deposit, guaranteeing performance.

The value of the futures contract is marked-to 

market-daily, and all changes in value settle daily 

in cash. The daily dollar value that changes hands 

is the variation margin. If the futures positions 

have losses, the savings association must post additional margin. The savings association may also 

withdraw funds equal to the unrealized gains from 

the margin account.

A savings association must have sufficient funds 

to cover any calls for variation margin. If the savings association has a large open short futures 

position, there is the potential for large unrealized 

losses if interest rates decline. You should consider the opportunity cost of variation margin 

deposits when evaluating the effectiveness of the 

hedging program.

Options

The writer (or seller) of an option sells this contract to a buyer in exchange for a sum of money 

called the option premium, or the option price. 

The holder can exercise an American option at 

any time during the life of the contract. A holder 

can only exercise a European option on the expiration date. Option contracts trade on exchanges 

and in the OTC (over-the-counter) markets.

For exchange-traded options, the exchange establishes standardized terms. Conversely, the terms 

for OTC options (for example, standby commitments) will vary significantly depending on the 

participants of the agreement. Usually, exchangetraded options will have more liquidity than OTC 

options once market participants have accepted 

the contract. However, exchange-traded options 

track only a limited number of cash market instruments.

Characteristics of Options

A savings association can purchase (long position) 

or sell (short position) an option. Options differ 

from futures in that the holder of a option has the 

right to purchase or sell versus the obligation to 

purchase or sell with futures. In return for the 

right to buy or sell securities, put and call option 

buyers pay a negotiated premium to put and call 

option sellers. The seller of the option must perform if the holder exercises the option. Options 

can provide more flexibility than futures because 

the savings association can establish a wide variety of positions.

Mathematical models that represent the fair value 

of options use variables such as the relationship 

between the market and strike price, the term remaining until option expiration, marketplace 
SECTION: Derivative Instruments and Hedging Section 660

660.18 Regulatory Handbook April 2001 Office of Thrift Supervision

volatility, and short-term interest rates. These 

models are based on the concept that the option 

premium has two components: an intrinsic or inthe-money value and time value. Intrinsic value is 

the amount by which the current market price of 

the underlying security is above the strike price 

for calls and below the strike price for puts. Time 

value is the amount by which the premium exceeds the intrinsic value.

Because option buyers have no obligation to perform after paying the premium, there is no 

additional margin required. Option writers undertake a firm commitment to assume a long or short 

position in the market at the strike price if they 

exercise the option. Because the seller/writer must 

perform, a margin deposit is required when a position is opened.

Sellers can structure OTC option transactions to 

meet the specific requirements of the purchaser, 

thereby providing more flexibility than exchangetraded options. The trade-off is that OTC options 

are not standardized and usually must be offset by 

the original counterparty, thereby limiting their 

liquidity. OTC transactions most commonly involve options on MBSs.

The buyer of an option holds a long position, 

while the seller (writer) holds a short position. 

When the writer of the option owns the underlying 

asset, the option position is covered. When the 

writer does not own the underlying asset, the 

writer’s position is naked. An option is in the 

money, if exercising the option produces a gain, 

while an option is out of the money if exercising 

the option does not produce a gain.

The following five factors influence the value of 

an option:

• Strike price.

• Current price of the underlying instrument.

• Time to expiration of the contract.

• Expected volatility of yields (or prices) over 

the remaining life of the option.

• Short-term risk-free interest rate over the remaining life of the option.

Hedge Ratios for Options

As with other hedging instruments, some savings 

associations use the par value approach, thereby 

matching the contract par value of the options 

with the hedged item. This method of determining 

a hedge ratio can be flawed. However, regardless 

of the approach, if the savings association uses 

long puts or calls, the maximum losses are the 

amount of the option premium. Therefore, the 

savings association knows the potential losses 

from basis risk.

Some savings associations use the delta of an option to determine the necessary number of 

contracts to use in hedging. Option valuation 

models generate the delta of an option. It represents the expected change in the option premium 

for a given change in the price of the underlying 

instrument. For example, a delta of 0.5 indicates 

that if the price of the underlying instrument 

changed by one dollar, the option premium would 

change by only 50 cents. A savings association 

using the delta would use the reciprocal of the 

delta to determine the number of options contracts. In this example, 1.0 divided by 0.5 would 

equal two options contracts. 

Savings associations should be careful when relying on this measure to determine the number of 

option contracts. The delta changes frequently, 

resulting in a continually changing hedge ratio. If 

the option is out-of-the-money [exercise price is 

lower (higher) than market price for puts (calls)], 

this could result in a significant number of option 

contracts. For example, if the delta were 0.1, the 

option premium would change 10 cents for each 

dollar change in the price of the underlying instrument. If a savings association used this 

strategy to offset the price sensitivity of the instrument underlying the option, they would use a 

ratio of 10 option contracts for each dollar of 

matched items. However, the savings association 

may not hold in portfolio the security that underlies the option. If the savings association matched 

the option position against an asset or liability that 
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.19

differs from the instrument underlying the option, 

the delta will not be as accurate.

Basic Strategies using Options

Numerous strategies use options, including complex combinations of option positions and 

combinations of options and futures positions. 

The following subsections describe these strategies.

Caps, Floors, and Collars

Customized interest rate options that savings associations use to manage interest rate risk include 

interest rate caps, floors, and collars. A cap is a 

contract that provides a buyer with protection 

against a rise in interest rates above some specified rate. The contract specifies an underlying 

interest rate index. The most common index is 

LIBOR. The buyer pays a premium for the option. 

The contract will specify the notional amount of 

the contract, the maturity, the settlement frequency, the interest rate index, and the level of 

protection (for example, the strike rate of the cap). 

A strike price is the price one can buy, sell, or settle the underlying instrument upon exercise of the 

option contract.

A savings association can use a cap to set synthetically a maximum rate, or cap, on floating-rate 

borrowings. If rates rise above the cap rate, the 

savings association will receive a payment that 

will offset the increase in interest expense on the 

floating-rate borrowings above the cap rate. Thus, 

a savings association can use a cap to fix the 

maximum rate that it would pay out on a floatingrate obligation, while allowing the savings association to benefit from a decline in rates. (A 

savings association can also sell a cap to generate 

income through receipt of a premium. You can 

consider the sale of caps inappropriate if it exposes the savings association to an excessive 

amount of interest rate risk.)

A floor is an option contract that provides the 

buyer with protection against declining interest 

rates.

A commercial bank with a relatively large portfolio of floating-rate loans might, for example, buy a 

floor to protect its net interest earnings against a 

decline in rates. For a premium, the buyer of a 

floor receives the difference between the strike 

rate (floor) and the actual rate on the index if the 

index falls below the floor. No payments exchange hands if the strike rate on a floor is greater 

than the current index rate. The seller of a floor 

receives a premium. You can view a floor as a 

series of call options.

A collar is a combination of the purchase of a cap 

at one rate and the sale of a floor at another rate. 

The cap and floor rates usually ensure that the 

cost of the cap equals the premium on the floor, 

resulting in a zero cost collar. For a savings association exposed to rising rates, a collar provides 

protection if interest rates increase above the 

strike rate on the cap. But, in exchange for that 

protection, the savings association gives up the 

benefits of lower funding costs if rates fall below 

the strike rate on the floor.

Swaptions

A swaption (or swap option) is an option on a 

swap. It gives the buyer the right, but not the obligation, to enter into a specified swap at a future 

date.

Standby Agreements

A standby agreement is an OTC put option on 

mortgages or mortgage-backed securities. Usually 

mortgage bankers use these agreements to offset 

the risk of loans that they expect to close if interest rates increase, but are otherwise uncertain as to 

the closure date. A savings association pays a fee 

to purchase this protection.

Short standby positions (short puts) involve the 

receipt of a fee up front for assuming the risk of 

having to purchase loans at a price above market 

price. Short puts are usually speculative. You 

should view them as speculative, unless a savings 

association can demonstrate otherwise.

Calls 

A call option gives the holder (the buyer or long 

position) the right to buy the underlying asset at a
SECTION: Derivative Instruments and Hedging Section 660

660.20 Regulatory Handbook April 2001 Office of Thrift Supervision

predetermined strike price at a specified time. The 

buyer of a call option benefits if the price of the 

underlying asset rises above the strike price by an 

amount sufficient to cover the option premium. If 

the holder does not exercise the option before expiration, the option will expire worthless. The 

profit potential of the long call position is substantial, while the option premium is the maximum 

loss possible on the option. Figure 6 shows the 

payoff profile of a long call position.

Figure 6

Profit on Call Option - Long Position

 Gain 

 Profit on 

 call option

 Strike price

 Terminal price of

 0 underlying asset

 Premium { or index

 paid

 Breakeven

 price

 Loss

Figure 7

Profit on Call Option - Short Position

 Gain

 Premium

 received { Terminal price of

 0 underlying asset

 or index

 Strike price

 Loss on

 call option

 Loss

Figure 7 shows the payoff profile of the seller of a 

call option (the short position). Note that the payoff profile of a short call option position is the 

opposite of a long call position. Also, the profit 

potential of a short call position is only the 

amount of the option premium, while the loss potential is unlimited.

• Writing Calls

This strategy enhances the yield of securities in a 

portfolio. In return for a specified option premium, the savings association commits to deliver 

securities at a specified price within a specified 

time at the option of the purchaser. The savings 

association also receives the interest income from 

the securities and records any discount or premium for the securities during the term of the 

option. If interest rates remain stable, the time 

value component of the option premium will decline in value, thus benefiting the call writer. This 

decrease in the value of the option premium enhances the call writer’s yield.

Call writing does not provide a hedge. If interest 

rates increase, the only protection the strategy provides is the amount of the option premium. To 

reduce risk in call writing, the savings association 

should hold in portfolio the security that underlies 

the call option contract. The exercise price of the 

call agreement should equal or exceed the book 

value of the securities in portfolio. If interest rates 

decrease and the market value of the underlying 

instrument exceeds the commitment price, the 

option is exercised. If the savings association has 

the underlying security in portfolio and the exercise price of the call agreement exceeds the book 

value, the savings association will have only an 

opportunity loss. If the book value is greater than 

the exercise price and the securities are called 

away, the savings association must recognize the 

losses. Pursuant to SFAS 115, the savings association must classify the securities matched with 

short calls as either available for sale or trading.

An uncovered, or naked, short call option position 

can entail significant risk. This strategy involves 

selling call options matched against a security in 

portfolio that is not deliverable into the call option. One high-risk strategy is to short calls on 

Treasury bond futures and match this position 

against fixed-rate mortgages. If interest rates decline, the losses from the call positions driven by 

Treasury bond futures contracts can greatly exceed any benefit from the matched asset. The risks 

of matching Treasury bond futures against MBSs 

are discussed in the futures section.
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.21

• Purchasing Calls

For most savings associations with long-term assets and short-term liabilities, OTS does not 

consider the purchase of call options to be a 

hedge. The call provides the right to purchase the 

underlying securities at a specified price within a 

set time. When interest rates increase, call values 

decline, thereby providing no protection against 

rising interest rates.

Although not considered a hedge, some savings 

associations buy call options as a proxy for an 

investment in long-term assets. Instead of buying 

long-term securities, the savings association purchases call options with a portion of the funds and 

invests the remainder in short-term assets. If interest rates increase, the return from this strategy will 

be the interest income from the short-term investment reduced by the cost of the calls. This 

eliminates the unrealized losses that would have 

occurred on long-term securities. If interest rates 

decrease, the return will equal the interest income 

from the short-term investment plus the gain from 

the call options. For strategies of this type, the 

savings association should establish reasonable 

limits on the amount of the premium invested.

Other strategies involving long calls include buying call options to offset the losses that can result 

from mortgage loan pipeline fallout, prepayment 

risk from a mortgage portfolio, or prepayment risk 

from a servicing portfolio. Some savings associations that have structured their balance sheets with 

longer-term liabilities and shorter-term assets may 

also use long calls to reduce the risk of decreasing 

interest rates.

You should consider any strategy involving long 

calls in conjunction with the regulatory capital 

position and the overall asset liability structure of 

the savings association. The savings association 

should have sufficient capital after providing for 

the write-off of the entire dollar amount of the 

option premium.

Puts

A put option gives the holder (the buyer, or long 

position) the right to sell a designated asset (or 

instrument) to the option writer at a specified 

price at a specified time. The buyer of a put option 

benefits if the price of the underlying asset or investment declines by an amount sufficient to 

cover the option premium. Figure 8 shows the 

payoff profile of a long put position.

Figure 8

Profit on Put Option - Long Position

 Gain

 Profit on put option

 Strike price

 0 

 Premium { 

 paid Breakeven Terminal price of 

 price underlying

 asset or index

 Loss

Figure 9

Profit on Put Option - Short Position

 Gain

 Terminal price of

 underlying

 Premium asset or index

 received {

 0

 Strike price

Loss on put option

 Loss

Figure 9 shows the payoff profile of a short put 

option. Like a short call, the profit potential on a 

short put is only the premium received for writing 

the option. However, while the downside potential 

is substantial, unlike a short call, it is limited.

• Short Puts

For most savings associations, OTS considers 

short put positions to be speculative transactions. 

In this strategy, the savings association receives a 
SECTION: Derivative Instruments and Hedging Section 660

660.22 Regulatory Handbook April 2001 Office of Thrift Supervision

fee. In return, the savings association must buy the 

underlying security within the specified time at 

the strike price should the holder exercise the put 

option. The savings association expects interest 

rates to decline or remain stable. The maximum 

gain is the option premium received. The risk is 

equivalent to the amount by which the underlying 

instrument could potentially decrease in value 

during the term of the option if interest rates increase.

The regulations also require that the savings association record these positions at their immediate 

exercise value. If interest rates increase and the 

value of the instrument underlying the option decreases below the exercise price of the option, the 

savings association must record the difference as a 

loss through operations. The savings association 

must periodically adjust losses while the short put 

positions remain outstanding.

Combination Strategies using Options

Certain strategies involve the simultaneous purchase and sale of various options positions with 

different exercise prices and/or different settlement dates. For example, a savings association 

could purchase both a put and a call. This strategy 

attempts to profit from interest rate volatility. 

Other examples could involve the savings association simultaneously buying put or call options 

with different exercise prices. You must closely 

review any activity of this type to assess the rationale for the transactions, the risk and gains or 

losses.

Mortgage-Derivative Products

Some savings associations attempt to establish an 

economic hedge using the following instruments 

as hedging vehicles:

• Mortgage derivative securities such as interest 

only (IO) and principal only (PO) stripped 

mortgage-backed securities.

• Residuals and principals of real estate mortgage investment conduits (REMICs).

• Collateralized mortgage obligations (CMOs).

As hedging transactions, management should 

maintain reports tracking the market value of the 

derivative instruments and reconcile the gains and 

losses to the changes in the value of the hedged 

balance sheet items. For example, if a savings association bought $100 million in premium IOs to 

hedge the market value of $300 million of MBSs 

the savings association should compare the gains 

(losses) on the IOs with the losses (gains) on the 

MBSs to determine the net gain or loss from the 

transaction.

You should evaluate the appropriateness of using 

mortgage derivative products in the context of a 

savings association’s total portfolio. In general, 

savings associations should limit the use of derivatives to transactions that lower or do not 

increase their overall exposure to interest rate risk.

Savings associations may use mortgage derivatives as an economic hedge; however, OTS 

considers them to be cash market instruments that 

do not qualify as a hedge for accounting purposes. 

The hedging instrument (for example, IO) may 

require adjustment from time to time to reflect 

changes in prepayments and differences in convexity. Management should consult with its 

independent auditor to assure compliance with 

GAAP.

In addition to SFAS 133, Emerging Issues Task 

Force (EITF) Bulletin 89-4 provides guidance on 

the GAAP treatment for CMO residuals and IOs. 

REFERENCES

Code of Federal Regulations (12 CFR)

Part 562 Regulatory Reporting Standards

§ 563.170 Examinations and audits

§ 563.172 Financial Derivatives

§ 563.176 Interest Rate Risk Management

Procedures

Financial Accounting Standards Board, Statement of Financial Accounting Standards 

(SFAS)

SFAS No. 52 Foreign Currency Translation 

(amended and certain paragraphs 
SECTION: Derivative Instruments and Hedging Section 660

Office of Thrift Supervision April 2001 Regulatory Handbook 660.23

superseded by No. 133 as 

amended) 

SFAS No. 80 Accounting for Futures Contracts 

(superseded)

SFAS No. 105 Disclosure of Information about 

Financial Instruments with OffBalance Sheet Risk and Financial 

Instruments with Concentrations 

of Credit Risk (superseded)

SFAS No. 107 Disclosures about Fair Value of 

Financial Instruments (as 

amended by No. 133)

SFAS No. 115 Accounting for Certain Investments in Debt and Equity 

Securities (as amended by No. 

133)

SFAS No. 119 Disclosure about Financial Instruments and Fair Value of 

Financial Instruments (superseded)

SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities 

(supersedes SFAS Nos. 52, 80, 

105, and 119)

SFAS No. l37 Accounting for Derivative Instruments and Hedging Activities 

– Deferral of the Effective Date 

of FASB Statement No. 133 

(amends SFAS No. 133 with regard to effective date)

SFAS No. 138 Accounting for Certain Derivative Instruments and Certain 

Hedging Activities (amends certain paragraphs of No. 133)

Emerging Issues Task Force (EITF)

No. 89-4 Accounting for a Purchased

Investment in a Collateralized

Mortgage Obligation Instrument 

or in a Mortgage-Backed Interest 

Only Certificate

FFIEC

Supervisory Policy Statement on Investment Securities and End-User Derivative Activities – 63 

FR 20191 (April 23, 1998)

Joint Release: Interim Regulatory Reporting and 

Capital Guidance on SFAS 133, Accounting for 

Derivative Instruments and Hedging Activities 

(December 29, 1998)

Office of Thrift Supervision Bulletins

TB 13a Management of Interest Rate 

Risk, Investment Securities, and 

Derivative Activities

TB 13a-2 Structured Advances
Derivative Instruments and Hedging 

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 660P.1

Examination Objectives

Determine if the board of directors has adopted a comprehensive hedging policy.

Determine if the association’s policies adequately detail the various strategies involving derivatives and hedging.

Determine if the board of directors designates individuals responsible for transactions and specifies appropriate 

limits of authority.

Determine if management has the expertise to execute the program in conformance with the association’s policies.

Determine if the use of derivatives and hedging activity is reasonable based on the association’s operations, 

liquidity position, asset/liability structure, and capital position.

Determine if management and the board of directors adequately monitor the use of derivatives and hedging activity.

Determine if the association complies with regulations, maintains adequate documentation, and accounts for 

transactions properly.

Determine if there is risk from excessive hedging positions or low correlation between the hedged items and the 

hedging positions.

Determine if any of the hedging activity is speculative.

Examination Procedures Wkp.Ref.

Level I

1. Review scoping materials applicable to derivative instruments and hedging. Some 

scoping materials include: the regulatory profile, previous examination report(s), 

correspondence, agreements, audit report, management letter, applicable work papers from previous examinations, management discussions from previous 

examinations, notes on interim monitoring, and agreements with investment consultants or brokers.
Derivative Instruments and Hedging 

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

660P.2 Regulatory Handbook April 2001 Office of Thrift Supervision

 Wkp.Ref.

2. Obtain the association’s policies and procedures relating to derivatives use and 

hedging. Determine if the policies and procedures contain the following information:

• A description of the intended strategies.

• A list of individuals responsible for executing the transactions for each 

derivative instrument and established limits of their authority.

• Maximum amount of outstanding position by type (position limits).

• Adequate detail of the rationale for determining the hedge ratios.

• Description of the methods used to monitor the activity.

3. Review the board minutes to determine that the board of directors receives monthly 

reports on the association’s use of derivatives and hedging activity. Determine if the 

reports are adequate for decision-making and allow the board of directors to monitor 

compliance with established guidelines. Board reports should contain the following 

information:

• Positions established and offset (volume) by type during the month and realized 

gains or losses on these positions.

• Open positions at the reporting date and the unrealized gains or losses.

4. Determine if management has the expertise to use derivatives and execute a hedge 

program in accordance with the objectives in the policies and procedures. 

5. Review the association’s IRR Exposure Report to determine if it is using derivatives 

and hedging activity to lower its interest rate risk.

 
Derivative Instruments and Hedging 

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 660P.3

Wkp.Ref.

6. Summarize findings. Identify areas of concern and management’s responses. Update 

the CEF, if applicable, with any information that will facilitate future examinations. 

File any exception sheets in the general file.

7. Review Level II procedures and perform those necessary to test, support, and present conclusions.

Level II

8. Obtain a listing of each of the general and subsidiary ledger accounts for each derivative instrument. Perform the following procedures:

• Review a history of the significant transactions for each account to determine 

the purpose of the transaction and whether it was effective.

• Compare the actual activity reported on brokers’ statements, contract registers, 

and reports to the board of directors, with the general and subsidiary ledgers.

• Determine if the association concealed any losses in an account recorded as an 

asset.

• Determine the method of accounting used. For instance, deferral, lower of cost 

or market, marked to market, and determine if it is appropriate.

9. Review interest rate swaps and determine the following:

• Whether the spread between the fixed rate and variable rate is reasonable and 

the matched asset has a positive spread taking into account the net cost of the 

swap.

• The amount of the collateral requirements for the interest rate swaps and the 

location of the collateral.

.
Derivative Instruments and Hedging 

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

660P.4 Regulatory Handbook April 2001 Office of Thrift Supervision

Wkp.Ref.

10. Assess the overall effectiveness of the program by identifying, analyzing, and determining the following:

• The assets or liabilities hedged, including dollar amount, maturity, and interest 

rate.

• The specific intent of each transaction. For example, was the intent to shorten 

the term of the asset or extend the term of the liability? Ascertain if each transaction reduced the association’s interest rate risk.

• The method used to derive the hedge ratios and if these ratios are reasonable.

• The change in value of the hedged asset or liability during the hedge period by 

comparing the change in the interest rates of the liabilities or market values of 

the assets during the hedged period.

• The change in value of the hedged item compared with the gain or loss from the 

hedging contracts.

• The effectiveness between the hedging instrument and the matched asset or liability, by comparing the gains or losses from the hedging instrument with the 

increase or decrease in value of the asset or liability hedged.

• The effect of the hedge on the overall operation of the thrift.

• The opportunity cost (gain) of variation margin deposits if significant.

11. Prepare report comments. Identify transactions or matters that raise safety and 

soundness concerns. Provide the following information:

• A summary of overall finding.

• A description of deficiencies.

• Management’s proposed corrective actions.
Derivative Instruments and Hedging 

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

Office of Thrift Supervision April 2001 Regulatory Handbook 660P.5

 

Wkp.Ref.

12. Ensure that your review meets the Objectives of this Handbook Section. State your 

findings and conclusions, and appropriate recommendations for any necessary corrective measures, on the appropriate work papers and report pages.

Level III

13. Contact the regional capital markets specialist or other designated individual(s) for 

consultation on reviewing any of the hedging strategies. Assistance could involve the 

following items:

• Expanding the scope of review based on the amount of activity.

• Determining the reasonableness of hedging strategies.

• Selecting specific transactions for financial modeling.

• Participation in management discussions that could involve the thrift’s consultants or broker/dealers.

• Structuring comments for the report of examination.

14. Contact the regional accountant or the accounting policy division at OTS Washington to discuss the association’s accounting for any of the hedging transactions.

15. Determine if the association has stock that is publicly traded. If so, review the reports filed with the Securities and Exchange Commission, including the 10K 

(annual) and the 10Q (quarterly) for any mention of derivatives use or hedging activity. Descriptions of activity should be consistent with actual transactions.

16. Determine the creditworthiness of the counterparties if there is reason for concern 

about the counterparties’ financial strength.
Derivative Instruments and Hedging 

Program

Exam Date:

Prepared By:

Reviewed By:

Docket #:

660P.6 Regulatory Handbook April 2001 Office of Thrift Supervision

 Wkp.Ref.

17. If the association conducts a high level of futures and options trading, review auditors’ work papers to determine that they performed an appropriate level of 

verification of outstanding contracts with various brokers. 

18. If the association conducts active trading, determine the following through observations and discussions with management and other personnel:

• Is there a significant amount of activity with positions open for very short periods?

• Does the association ensure that the trading and accounting functions are segregated?