[Federal Register Volume 63, Number 117 (Thursday, June 18, 1998)]
[Proposed Rules]
[Pages 33281-33293]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-16208]


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Proposed Rules
                                                Federal Register
________________________________________________________________________

This section of the FEDERAL REGISTER contains notices to the public of 
the proposed issuance of rules and regulations. The purpose of these 
notices is to give interested persons an opportunity to participate in 
the rule making prior to the adoption of the final rules.

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Federal Register / Vol. 63, No. 117 / Thursday, June 18, 1998 / 
Proposed Rules

[[Page 33281]]


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FARM CREDIT ADMINISTRATION

12 CFR Part 615

RIN 3052-AB76


Funding and Fiscal Affairs, Loan Policies and Operations, and 
Funding Operations; Investment Management

AGENCY: Farm Credit Administration.

ACTION: Proposed rule.

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SUMMARY: The Farm Credit Administration (FCA), by the FCA Board 
(Board), proposes to amend the investment regulations to provide Farm 
Credit System (Farm Credit, FCS, or System) banks with a broader array 
of eligible investments. Under the proposed regulations, Farm Credit 
banks are expected to hold only high-quality and liquid investments to 
maintain a liquidity reserve, invest surplus funds, and manage interest 
rate risk. The proposal provides System banks with guidance on sound 
practices for managing risks associated with investment activities and 
grants System banks greater flexibility to manage risk on an 
institutional, portfolio, or individual instrument level. These 
amendments are also designed to better enable FCS banks to adjust to 
the rapid and continual changes in the financial markets.

DATES: Written comments should be received on or before August 17, 
1998.

ADDRESSES: Comments may be submitted by email to FCA at ``<a href="/cdn-cgi/l/email-protection#2a584f4d0720494547476a4c494b044d455c">reg-
<span class="__cf_email__" data-cfemail="1f7c7072725f797c7e31787069">[email protected]</span></a>.'' Comments may also be mailed or delivered to Patricia W. 
DiMuzio, Director, Regulation and Policy Division, Office of Policy and 
Analysis, Farm Credit Administration, 1501 Farm Credit Drive, McLean, 
Virginia 22102-5090 or sent by facsimile transmission to (703) 734-
5784. Copies of all communications received will be available for 
review by interested parties in the Office of Policy and Analysis, Farm 
Credit Administration.

FOR FURTHER INFORMATION CONTACT:

Laurie A. Rea, Senior Policy Analyst, Office of Policy Analysis, Farm 
Credit Administration, McLean, VA 22102-5090, (703) 883-4498;
    or
Richard Katz, Senior Attorney, Office of General Counsel, Farm Credit 
Administration, McLean, VA 22102-5090, (703) 883-4020, TDD (703) 883-
4444.

SUPPLEMENTARY INFORMATION:

I. Background

    Petitions by System banks, various developments and innovations in 
the securities markets, and improvements in risk management 
technologies have all led the FCA to reexamine its investment 
management regulations in subpart E of part 615. The FCA aims to 
develop a regulatory framework that establishes certain fundamental 
practices each Farm Credit bank should follow to fully understand and 
effectively manage the risks inherent in its investment portfolio. 
Although non-agricultural investments are a relatively small percentage 
of the assets of Farm Credit banks, proper investment management 
enables System banks to control risks stemming from their operations as 
monoline providers of agricultural credit. The FCA's proposal is 
specifically designed to enhance investment management practices at 
Farm Credit banks, and many aspects of this proposal are consistent 
with the policies that the Federal Financial Institutions Examination 
Council (FFIEC) recently adopted in a document entitled ``Supervisory 
Policy Statement on Investment Securities and End-User Derivatives 
Activities.'' \1\
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    \1\ See 63 FR 20191 (April 23, 1998).
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    The proposed amendments enable FCA to relax or repeal many of the 
detailed criteria that the existing regulations prescribe for specific 
types of investments. As a result, Sec. 615.5140 will provide broader 
parameters for various classes of investments while retaining essential 
safety and soundness controls, such as credit ratings and 
diversification standards.

II. Investment Portfolio Management

    Board and senior management should develop and implement 
comprehensive risk management processes to effectively identify, 
measure, monitor, and control risks associated with investment 
activities. Although risk management programs will differ among System 
banks, certain elements are fundamental to all sound risk management 
programs. Safe and sound banking practices require System banks to have 
programs to manage the market, credit, liquidity, operational, legal, 
and other risks associated with investment activities. Effective risk 
management also addresses risks in individual instruments, the 
investment portfolio, and the entire institution.
    Proposed Sec. 615.5133 sets forth the fundamental criteria for 
developing sound investment management practices at Farm Credit banks. 
Senior management, under the oversight of the board of directors, 
should adhere to investment practices that are appropriate for the 
bank's individual circumstances and consistent with these regulations. 
The failure to understand and manage the risks associated with 
investment activities will generally be considered an unsafe and 
unsound banking practice.

A. Investment Policy Requirements

    Many aspects of the current investment management regulations are 
retained in this proposal. However, the complexity of many financial 
products, both on- and off-balance sheet, compels the FCA and other 
Federal financial institution regulators to advocate a more 
comprehensive and institution-wide approach to risk management. Thus, 
the FCA is proposing to strengthen, redesign, and reorganize this 
section.
1. Board and Senior Management Oversight
    The introductory paragraph to proposed Sec. 615.5133 outlines the 
basic responsibilities of the board of directors regarding the 
investment activities of its bank. The proposed rule requires the board 
to adopt written policies that specifically identify the purposes and 
objectives, risk parameters, delegations of authority, and reporting 
requirements for managing the bank's investment portfolio. The 
investment policy should also address how investment activities affect 
the institution's capital and earnings. For this reason, a Farm Credit 
bank board may include its investment policy in a broader asset-
liability management (ALM) or risk management policy.
    Oversight by both the board of directors and senior management of 
each Farm Credit bank is an integral

[[Page 33282]]

part of an effective risk management program. The board of directors is 
responsible for ensuring that management and operational personnel have 
the requisite skills and resources to manage the risks associated with 
investment activities in accordance with the board's policies. 
Annually, the board of directors of each Farm Credit bank must review 
its investment policies to determine whether objectives and risk 
exposure limits continue to be appropriate for the bank. Senior 
management discharges its responsibility by adhering to the board's 
policies, providing advice to the board, and safely and soundly 
conducting investment activities on both a strategic and operational 
basis.
2. Risk Limits
    Proposed Sec. 615.5133(a) requires the board's policies to define 
the risk parameters for the bank's investment activities. Foremost, 
risk parameters are to be based on the strength of each Farm Credit 
bank's capital position and its ability to measure and manage risk. The 
risk parameters should be consistent with the bank's broader business 
strategies and institutional objectives. The bank's investment policies 
should identify the risk characteristics of permissible investments and 
establish risk limits and diversification requirements for the various 
classes of eligible investments and the investment portfolio. The 
policies of each Farm Credit bank should control credit, market, 
liquidity, and operational risks associated with investment activities.

B. Credit Risk

    A System bank should not acquire investments without assessing the 
creditworthiness of issuers, obligors, or other counterparties. Credit 
risk generally refers to the risk that an issuer, obligor, or other 
counterparty will default on its obligation to pay the investor under 
the terms of the security or instrument.
    Proposed Sec. 615.5133(a)(1) requires each System bank to establish 
comprehensive policies to control credit risk in its investment 
portfolio. Each Farm Credit institution must maintain a well-
diversified investment portfolio. As a result, every Farm Credit bank 
should limit concentrations relating to single or related 
counterparties, geographical areas, industries, or obligations with 
similar characteristics.
    The FCA proposes to delete current Sec. 615.5133(i) relating to 
specific credit risk controls on investments in collateralized mortgage 
obligations (CMOs), real estate investment conduits (REMICs), and 
asset-backed securities (ABS), in favor of the broader language 
proposed in Sec. 615.5133(a)(1)(i). Nevertheless, the FCA continues to 
expect banks to address concentration risks associated with CMOs, 
REMICs, mortgage-backed securities (MBS), and ABS by establishing 
appropriate portfolio limits on each of these investments. More 
specifically, the policy of each Farm Credit bank should address 
minimum pool size, the minimum number of loans in a pool, geographic 
diversification of a pool, and maximum allowable premiums.
    As part of its efforts to control credit risks, Farm Credit banks 
should consider the ability of counterparties to honor their 
obligations and commitments. The selection of dealers, brokers, and 
investment bankers (collectively, securities firms) is an important 
aspect of effective management of counterparty credit risk. Proposed 
Sec. 615.5133(a)(1)(ii) requires bank boards of directors to identify 
the criteria for selecting securities firms. A satisfactory approval 
process includes a review of each firm's financial statements and an 
evaluation of its ability to honor its commitments, including an 
inquiry into the general reputation of the securities firm. In some 
situations, it is also prudent for System banks to review information 
from Federal or State securities regulators and industry self-
regulatory organizations such as the National Association of Securities 
Dealers concerning any formal enforcement actions against the dealer, 
its affiliates, or associated personnel. Proposed 
Sec. 615.5133(a)(1)(ii) also requires the board of directors to set 
limits on the amounts and types of transactions that the bank can 
execute with authorized securities firms. The board of directors must 
annually review management's selection of securities firms and 
limitations on transactions with such firms.
    Proposed Sec. 615.5133(a)(1)(ii) responds to requests by System 
banks for modifications in the FCA's policy concerning the board's role 
in selecting securities firms, financial institutions, and other 
counterparties. The proposed rule would no longer require the board of 
directors to approve specific depository institutions where the bank 
holds certificates of deposits and Federal funds. The FCA originally 
imposed this requirement on System banks at a time when small, 
isolated, and financially weak commercial banks were offering brokered 
deposits with high rates of return.\2\ Reforms in the commercial 
banking industry and a widespread awareness of the risks inherent in 
such instruments have lessened FCA's regulatory concern. Furthermore, 
proposed Sec. 615.5140(a)(4)(i) sets minimum credit and maturity limits 
for investments in certificates of deposits, Federal funds, and bankers 
acceptances.
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    \2\ See 58 FR 63034, 63040 (November 30, 1993).
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    Proposed Sec. 615.5133(a)(1)(iii) requires Farm Credit banks to 
establish appropriate collateral margin requirements for repurchase 
agreements.\3\ The FCA is proposing this amendment, in part, because 
proposed Sec. 615.5140(a)(4)(iv) would expand the types of securities 
that Farm Credit banks may accept as collateral in repurchase 
transactions. As a means of managing potential counterparty credit 
risk, it is prudent for System banks to establish appropriate 
collateral margin requirements based on the quality of the collateral 
and the terms of the agreement. Farm Credit banks should also manage 
their exposure to loss on repurchase agreements by regularly marking 
the collateral to market and maintaining control of the collateral.\4\
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    \3\ In general, whether a given agreement is termed a 
``repurchase agreement'' or a ``reverse repurchase agreement'' 
depends largely on which party initiated the transaction. Market 
participants typically view the transaction from the dealer's 
perspective. In this preamble and the proposed regulation, the FCA 
uses the term ``repurchase agreement'' regardless of the perspective 
from which the transaction is viewed.
    \4\ For a more detailed discussion on managing risks associated 
with repurchase agreements, Farm Credit banks should review the 
FFIEC's modified policy statement on repurchase agreements with 
securities dealers and others. See 63 FR 6935 (February, 11, 1998).
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C. Market Risk

    From a safety and soundness perspective, it is crucial for the 
management of a Farm Credit bank to fully understand the market risks 
associated with investment securities prior to acquisition and on an 
ongoing basis. Market risk is the risk to a bank's financial condition 
resulting from adverse changes in value of its holdings arising from 
movements in interest rates or prices. The most significant market risk 
of investment activities is interest rate risk. Proposed 
Sec. 615.5133(a)(2) would require bank boards to establish limits on 
market risk exposure at the institutional, portfolio, or individual 
instrument level. This change corresponds with pending changes in other 
parts of the FCA regulations that address interest rate risk 
management.\5\
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    \5\ The FCA's proposed capital regulations provide more detailed 
discussions of FCS institution responsibilities as they relate to 
interest rate risk management. See 62 FR 49623 (September, 23, 
1997).
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    To manage market risk exposure, System banks should evaluate how

[[Page 33283]]

individual instruments and the investment portfolio as a whole affect 
the bank's overall interest rate risk profile. Bank's should monitor 
the price sensitivity of its investment portfolio and specify 
institution-wide interest rate risk limits. In addition, banks may find 
it useful to establish interest rate risk limits on the investment 
portfolio or on certain types of securities. Risk parameters should be 
commensurate with the bank's ability to measure, manage, and absorb 
risk. Boards should consider the bank's level of capital and earnings 
and its tolerance for market risk exposure when setting risk 
parameters. Market risk limits should be established in a manner that 
is consistent with all relevant regulations, policies, and guidance 
issued by the FCA.

D. Liquidity Risk

    The FCA expects Farm Credit banks to manage liquidity risk at both 
the investment and the institutional levels. System banks may encounter 
liquidity risk stemming from market conditions surrounding individual 
investment activities. In this context, liquidity risk is the risk that 
a bank would not be able to easily sell or liquidate an investment 
quickly at a fair price. This inability may be due to inadequate market 
depth or market disruption. At the institutional level, liquidity risk 
is the risk that System banks could encounter a liquidity crisis if 
they are unable to fund operations at reasonable rates because access 
to the capital markets is impeded. This impediment may result from a 
market disruption or real or perceived credit problems.
    The FCA proposes to repeal a provision in existing Sec. 615.5134(b) 
which requires System banks to segregate investments held in the 
liquidity reserve from investments that are maintained for the other 
purposes permitted by existing Sec. 615.5132. As a result of this 
amendment, System banks will have greater flexibility to decide how 
best to use their investments to manage exposure to risk.\6\ Since the 
liquidity characteristics of an investment influence whether it is 
suitable for meeting particular institutional objectives, the FCA also 
proposes a conforming change to Sec. 615.5133(a)(3). Pursuant to this 
amendment, the bank's policies must specify the desired liquidity 
characteristics of investments that it will use for maintaining a 
liquidity reserve and accomplishing other institutional objectives.
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    \6\ The minimum liquidity reserve that System banks maintain 
under Sec. 615.5134 must be sufficient to fund their operations for 
approximately 15 days in the event that System access to the capital 
markets becomes impeded.
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    The bank's investment policies must also require the bank to 
maintain sufficient quantities of liquid investments to comply with the 
liquidity reserve requirements of Sec. 615.5134. Pursuant to 
Sec. 615.5132, each Farm Credit bank's total investments, including its 
liquidity reserve, cannot exceed 30 percent of its total outstanding 
loans. The FCA expects the policies of each Farm Credit bank to strike 
an appropriate balance between the need for a liquidity reserve, the 
management of interest rate risk, and the investment of surplus funds 
as it strives to accomplish its institutional objectives.

E. Operational Risk

    Operational risk occurs when deficiencies in internal controls or 
information systems result in unexpected loss to a financial 
institution. Operational risk may arise from inadequate procedures, 
human error, information system failure, or fraud. Internal controls 
that effectively detect and prevent operating risks are an integral 
part of prudent investment management. The ability of management to 
accurately assess and control operating risks is often one of the 
greatest challenges that financial institutions face from investment 
activities. Therefore, proposed Sec. 615.5133(a)(4) would require the 
board of directors of each Farm Credit bank to address operating risks 
by establishing policies that foster effective internal controls.
    Organizational structure and reporting lines should clearly 
delineate responsibility and accountability for all investment 
management functions, including risk measurement, risk management, and 
oversight. Organizational structure should periodically be reviewed to 
reveal conflicts of interest or inadequate checks and balances. 
Proposed Sec. 615.5133(b) specifically requires System banks to 
identify who has delegated authority to conduct investment transactions 
and the extent of that authority. In addition, the proposed rule 
requires a separation of duties and supervision between personnel 
executing investment transactions and those responsible for approving, 
revaluating, and overseeing the bank's investments. Separation of 
duties promotes integrity, accuracy, and reasonable business practices 
that reduce the risk of loss. Senior management must ensure that bank 
investment practices and risk exposure are regularly reviewed and 
evaluated by personnel who are independent from those responsible for 
executing investment transactions.
    Existing Sec. 615.5133(h), which the FCA proposes to modify and 
redesignate as Sec. 615.5133(c), requires Farm Credit banks to 
establish appropriate internal controls to monitor their investment 
activities and prevent loss, fraud, embezzlement, conflicts of 
interest, and unauthorized investment practices. Redesignated 
Sec. 615.5133(c)(1) adds conflicts of interest as an issue that every 
System bank must specifically address in its investment policies. The 
policies of each Farm Credit bank should provide guidelines to prevent 
or resolve conflicts of interest that may arise from employees who are 
directly involved in purchasing and selling securities. Furthermore, 
the bank's policies should ensure that all directors, officers, and 
employees act in the best interest of the institution.
    Due to the increasingly complex nature of investment instruments, 
Farm Credit banks must maintain information systems that are capable of 
monitoring, measuring, and evaluating the risks inherent in their 
investment activities. Proposed Sec. 615.5133(c)(3) would require banks 
to maintain management information systems that are commensurate with 
the nature, scope, and complexity of the bank's investment activities. 
Internal quantitative models and management expertise must be adequate 
to analyze individual investment instruments, the investment portfolio, 
and the effect investments have on the bank's cashflows, earnings, and 
capital.
    Farm Credit banks may also be exposed to other sources of operating 
risks, such as legal risk that may result from contracts that are not 
legally enforceable. The FCA expects each bank to adequately assess and 
control other operational risks relating to investment activities. 
Accordingly, Farm Credit banks should clearly define documentation 
requirements for securities transactions, retention and safekeeping of 
documents, as well as possession and control of purchased instruments.

F. Securities Valuation

    Accurate and frequent securities valuation is essential to 
measuring risk and monitoring compliance with the bank's objectives and 
risk parameters. Proposed Sec. 615.5133(d) establishes the basic 
requirements for securities valuations by Farm Credit banks.\7\

[[Page 33284]]

System banks must understand the value and price sensitivity of their 
investments prior to purchase and on an ongoing basis. System banks 
should rely on valuation methodologies that take into account all the 
risk elements in a security to determine its price. Appropriate 
securities valuation practices enable managers to fully understand the 
risks and cashflow characteristics of the investments.
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    \7\ Two provisions of this regulation, Sec. 615.5133(d)(1) and 
(d)(2) are new, while existing Sec. 615.5140(d) has been modified 
and redesignated as proposed Sec. 615.5133(d)(3).
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    A critical step in sound investment management is the independent 
verification of securities prices. Accordingly, proposed 
Sec. 615.5133(d)(1) requires each Farm Credit bank, at the time of 
purchase or sale, to verify the value of the security (except new 
issues) with a source that is independent of the broker, dealer, 
counterparty, or other intermediary in the specific transaction. Under 
the proposed rule, independent verification of price can be as simple 
as obtaining a price from an industry-recognized information provider. 
Although price quotes from information providers are not actual market 
prices, they confirm whether the broker's price is reasonable. In the 
event that a bank is unable to obtain a second price quote on a 
particular security, a price quote may be obtained on a security with 
substantially similar characteristics.
    Proposed Sec. 615.5133(d)(2) requires Farm Credit banks to 
determine, at least monthly, the fair value of each security in their 
portfolio and the fair value of the investment portfolio as a whole. 
This provision is added to the regulations to ensure that management 
has the necessary information to assess the performance of the bank's 
investment portfolio. Additionally, this requirement enables management 
to provide accurate and timely reports to the board of directors in 
accordance with proposed Sec. 615.5133(e).
    Existing Sec. 615.5140(c) has been modified and redesignated as 
proposed Sec. 615.5133(d)(3). Currently, Sec. 615.5140(c) requires each 
Farm Credit bank to perform ongoing evaluations of all eligible 
investments in its portfolio and to support its evaluation with the 
most recent credit rating by at least one nationally recognized 
statistical rating organization (NRSRO). As amended, proposed 
Sec. 615.5133(d)(3) specifically requires Farm Credit banks to perform 
evaluations of the credit quality and price sensitivity to changes in 
market interest rates of all investments held in its portfolio prior to 
purchase and on an ongoing basis. This change emphasizes that effective 
credit and interest rate risk management is vital to successful FCS 
bank operations.
    The substance and form of the evaluations are likely to vary 
depending on the type of instrument. Relatively simple or standardized 
instruments with readily identifiable risks require significantly less 
analysis than more volatile or complex instruments. Proposed 
Sec. 615.5141 contains specific stress testing guidance for evaluating 
the price sensitivity of mortgage securities. Other eligible 
investments that have uncertain cashflows as a result of embedded 
options (such as call options, caps or floors) may require similar 
analytical techniques to appropriately evaluate the instruments. For 
example, prior to investing in ABS, the FCA expects a bank to conduct 
or obtain an evaluation of the collateral (including type, aging of the 
assets, and the credit quality of the underlying loans) and an analysis 
of the securities' structure and cashflows.
    System banks must continue to support their credit evaluations by 
the most recent credit rating with a NRSRO. However, Farm Credit banks 
should not rely exclusively on NRSRO ratings prior to purchasing 
investments because there may be a lag before an adverse event is 
reflected in the credit rating.

G. Reports to the Bank's Board

    Adequate reporting enables bank boards to properly discharge their 
fiduciary responsibilities. The investment policy should define routine 
reporting requirements and the means for reporting exceptions to 
policy. Management reports need to communicate effectively to the board 
of directors the nature of the risks inherent in the bank's investment 
activities. Reporting should occur frequently so that the board has 
timely, accurate, and sufficient information to understand how changes 
in the investment portfolio affect the balance sheet and the bank's 
risk profile. The FCA proposes to modify the second sentence of 
existing Sec. 615.5133(h) to emphasize these points and to redesignate 
it as Sec. 615.5133(e).
    Proposed Sec. 615.5133(e) requires quarterly reports on the 
performance (i.e., gains or losses) and risk of individual investments 
and the investment portfolio. Key risks should be specifically 
identified and discussed in the report. More specifically, reports 
should relate potential risk exposure to changes in market interest 
rates and any other factors (such as credit deterioration) that may 
affect the value of the bank's investment holdings. In addition, 
proposed Sec. 615.5133(e) requires management reports to discuss how 
investments affect the bank's overall financial condition and to 
evaluate whether the performance of the investment portfolio 
effectively achieves the objectives established by the board of 
directors. Reports should specifically identify any deviations from the 
board's policies.

III. Eligible Investments

A. Overview

    Section 615.5140 lists the eligible investments that System banks 
may purchase and hold to maintain a liquidity reserve, manage interest 
rate risk, and invest surplus short-term funds. Associations are also 
authorized to hold eligible investments listed in Sec. 615.5140 to 
invest surplus funds and reduce interest rate risk pursuant to existing 
Sec. 615.5141 (redesignated as Sec. 615.5142). Only investments that 
can be promptly converted into cash without significant loss are 
suitable for achieving these objectives. For this reason, the eligible 
investments listed in both existing and proposed Sec. 615.5140 
generally have short maturities and maintain a high investment grade 
credit rating by an NRSRO. Furthermore, all eligible investments are 
either traded in active secondary markets or are valuable as 
collateral.
    The proposed rule provides System institutions with a broad array 
of high-quality and liquid investments. The FCA proposes to expand the 
list of eligible investments and to relax or repeal certain 
restrictions in existing Sec. 615.5140. These revisions reflect changes 
in the financial markets as well as the FCA's desire to develop a 
regulatory framework that can more readily accommodate innovations in 
financial products and analytical tools.
    The FCA Board proposes to restructure the format of Sec. 615.5140 
to accommodate eligible investments that are newly authorized by the 
FCA and to provide an organizational structure that is easy to 
understand. Similar classes of investments, such as full faith and 
credit obligations of Federal and State governments and short-term 
money market instruments are now grouped together in proposed 
Sec. 615.5140(a). The FCA proposes to reduce the number of portfolio 
caps and repeal existing regulatory restrictions on the amount that 
each FCS institution can invest in negotiable certificates of deposit, 
Federal funds, bankers acceptances, and prime commercial paper.
    Requirements that apply to several categories of eligible 
investments have been relocated to Sec. 615.5140(b). For example, the 
requirement that an investment must be marketable will now be covered 
by a single provision in

[[Page 33285]]

proposed Sec. 615.5140(b)(1). Additionally, the sovereign rating for 
political and economic stability of foreign countries, which is 
currently repeated several times in the existing regulation, is 
relocated to proposed Sec. 615.5140(b)(2).
    The FCA is proposing to revise its regulatory terminology for 
credit ratings. References to the credit ratings of specific NRSROs are 
omitted from the proposed rule so it more accurately encompasses the 
broad universe of market ratings. Instead, the proposed regulation 
requires each eligible investment listed in Sec. 615.5140(a) to 
maintain a specified long-term or short-term credit rating by an NRSRO 
that is recognized by the Securities and Exchange Commission (SEC). 
Whereas the existing regulation refers, for example, to a Standards and 
Poor's (S&P) Corporation rating of ``AA'' or its equivalent, the 
proposed regulation refers to ``the highest two credit ratings by an 
NRSRO.'' The following table provides a comparative illustration of 
S&P's investment grades for both long-term and short-term issue credit 
ratings.

------------------------------------------------------------------------
                                                 S&P ratings            
          Investment grade          ------------------------------------
                                          Long-term         Short-term  
------------------------------------------------------------------------
First..............................  AAA                  A-1           
Second.............................  AA                   A-2           
Third..............................  A                    A-3           
Fourth.............................  BBB                                
------------------------------------------------------------------------

    The ratings in the table are often modified by either plus or minus 
signs to show relative standing within a major rating category. 
Specific investment credit ratings in the proposed rule refer to the 
generic rating categories, not modifiers within the generic group. 
Thus, for example, a long-term rating of ``AA-'' by S&P would be, for 
the purposes of FCA's regulations, within the ``two highest credit 
ratings by an NRSRO.''
    The following section provides a category-by-category discussion of 
the FCA's proposed regulatory framework for eligible investments.

B. U.S. Treasury and Agency Securities

    The FCA retains Sec. 615.5140(a)(1) without revision. This 
provision authorizes each FCS institution to invest in obligations that 
are backed by the full faith and credit of the United States, its 
agencies, instrumentalities, and corporations. In response to frequent 
questions about the scope of this provision, the FCA confirms that 
Sec. 615.5140(a)(1) permits the purchase of debt obligations of other 
Government-sponsored enterprises (GSEs). Private obligations that are 
fully insured or guaranteed as to both principal and interest by the 
United States, its agencies, instrumentalities, or corporations are 
also covered by this regulation. Thus, for example, a System 
institution may hold federally insured deposits, loans that are 
guaranteed by either the Export-Import Bank of the United States or the 
Overseas Private Investment Corporation, and certain obligations of the 
Small Business Administration.

C. Municipal Securities

    The FCA proposes to redesignate Sec. 615.5140(a)(10), which 
authorizes the investment in the general obligations of State and 
municipal governments, as Sec. 615.5140(a)(2), without significant 
change. The FCA proposes to add a definition of ``general obligation of 
a State or political subdivision'' to Sec. 615.5131 to codify its 
recent guidance on which bonds are deemed to be backed by the full 
faith and credit of a State or local government.\8\ Under this 
definition, general obligation bonds are those that are: (1) Full faith 
and credit obligations of a State or local government that possesses 
powers of general taxation; or (2) obligations of a governmental unit 
that lacks powers of general taxation if an obligor possessing general 
powers of taxation unconditionally guarantees to make all payments on 
these obligations.
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    \8\ See FCA BL-038, ``Guidance Relating to Investment 
Activities,'' (November 26, 1997).
---------------------------------------------------------------------------

    System banks have requested authority to invest in municipal 
revenue bonds. These bonds are not supported by the taxation powers of 
the obligor and are repayable from fee income and other sources of 
revenue. Although many municipal revenue bonds are highly rated by 
NRSROs and are actively traded in secondary markets, others are not. 
The universe of municipal revenue bonds is also diverse, and effective 
regulation of System investment in these securities could be difficult. 
For these reasons, the FCA requests comments on how it could permit 
these investments while limiting risks to System institutions. 
Specifically, the FCA solicits comments on how the regulation could 
establish: (1) Criteria for determining which revenue bonds are 
suitable for meeting the investment purposes in Sec. 615.5132; and (2) 
an appropriate limit on the amount of these investments.

D. International and Multilateral Development Banks

    Obligations of the International Bank for Reconstruction and 
Development (World Bank) are eligible investments under existing 
Sec. 615.5140(a)(3). The FCA's proposal expands the scope of this 
provision to include the obligations of other international and 
multilateral development banks (such as the Inter-American Development 
Bank and the North American Development Bank) in which the United 
States is a voting shareholder. This amendment recognizes other highly 
rated banks that work in concert with the World Bank to promote 
development in various countries.

E. Money Market Instruments

    Several provisions of existing Sec. 615.5140(a) authorize 
investments in negotiable certificates of deposit, Federal funds, 
bankers acceptances, prime commercial paper, and repurchase agreements. 
These money market instruments have high credit quality and short 
maturities. Additionally, they can be sold on active secondary markets 
prior to maturity. These qualities make them highly liquid and valuable 
as collateral. Accordingly, the FCA proposes to group all money market 
instruments together into a single regulatory provision, 
Sec. 615.5140(a)(4). Since these money market instruments pose limited 
risks to investors, the FCA believes that this regulation should no 
longer impose specific limitations on the amounts of negotiable 
certificates of deposit, Federal funds, bankers acceptances, and prime 
commercial paper that each FCS institution could hold in its investment 
portfolio. However, Sec. 615.5140(b)(3) continues to restrict the 
amount that an FCS institution could invest with a single obligor or 
institution to 20 percent of its total capital. The FCA is also 
proposing to omit the definitions of negotiable certificates of 
deposit, Federal funds, and Term Federal funds from existing 
Sec. 615.5131 because the meanings of these instruments are commonly 
understood by participants in the money markets. Additionally, the FCA 
has relocated the definitions of prime commercial paper and repurchase 
agreements from existing Sec. 615.5131 to proposed Sec. 615.5140(a)(4) 
so these regulations are easier to read.
    The FCA proposes to omit specific references to Eurodollar and 
Yankee certificates of deposits from Sec. 615.5131 and Sec. 615.5140 
because proposed Sec. 615.5140 (a)(4)(i) is sufficiently broad to 
permit investment in both of these instruments. The provision in 
existing Sec. 615.5140(a)(5) regarding deposit insurance for domestic 
and Yankee certificates of deposit became redundant in 1996 when the 
FCA amended Sec. 615.5140(a)(1) to specifically cover Federal insurance 
of private debt

[[Page 33286]]

obligations.\9\ Deposit insurance usually is not a consideration when 
an FCS institution purchases negotiable Eurodollar certificates of 
deposit because only a small portion of its investment is typically 
insured.
---------------------------------------------------------------------------

    \9\ See 61 FR 67187 (December 20, 1996).
---------------------------------------------------------------------------

    System banks requested authority to invest in Eurodollar time 
deposits. A Eurodollar time deposit is a non-negotiable deposit 
denominated in United States dollars that is issued by an overseas 
branch of a United States bank or by a foreign bank outside the United 
States. The riskiness of Eurodollar time deposits depends on both the 
creditworthiness of the issuing bank and the foreign country where the 
deposit is located. Financial institutions generally use Eurodollar 
time deposits as an alternative to Federal funds. Most Eurodollar time 
deposits mature within 180 days.
    The FCA agrees that Eurodollar time deposits are suitable for 
investing short-term surplus funds and interest rate risk management. 
However, the FCA proposes several safety and soundness constraints for 
Eurodollar time deposits because these instruments are not negotiable 
and they are held at depository institutions outside of the United 
States. Specifically, proposed Sec. 615.5140(a)(4)(ii) allows each FCS 
institution to invest in Eurodollar time deposits that mature within 90 
days and that are issued by depository institutions that maintain the 
highest short-term issuer credit rating by an NRSRO. In addition, 
proposed Sec. 615.5140(b)(2) further requires Eurodollar time deposits 
to be held at depository institutions located in foreign countries that 
maintain the highest sovereign rating for political and economic 
stability. The FCA also proposes to limit investments in Eurodollar 
time deposits to 20 percent of an FCS institution's total investment 
portfolio to control concentration risk in these non-negotiable 
instruments.
    System banks also requested authority to invest in certificates of 
deposits that mature within 3 years but contain a put option that 
enables the investor to require the depository institution to 
repurchase the instrument. The FCA's research reveals that the market 
for certificates of deposits with embedded put options is almost 
nonexistent, and no commercial banks have issued these instruments in 
several years. These instruments are neither liquid nor traded in 
active secondary markets. Commercial banks have engineered the few 
existing certificates of deposits with put options for specific 
customers. Therefore, the FCA has not added these instruments to the 
list of eligible investments in the proposed rule.
    Prime commercial paper remains an eligible investment under the 
proposed regulations. The FCA has redesignated Sec. 615.5140(a)(7) as 
Sec. 615.5140(a)(4)(iii).
    The FCA proposes to expand the types of collateral that support 
eligible repurchase agreements. System banks have asserted that the 
FCA's investment eligibility criteria limit their ability to 
participate in the repurchase agreement market because market 
participants are often unwilling to post collateral that specifically 
complies with the investment criteria in existing Sec. 615.5140. The 
FCA acknowledges that repurchase transactions can be a valuable tool 
for investing short-term surplus funds, and they are relatively safe 
due to short maturities, high quality of collateral, and collateral 
margin requirements. For this reason, the FCA proposes to amend this 
regulation. The proposed regulatory approach will allow more latitude 
to participate in this market, while maintaining essential safety and 
soundness controls.
    Redesignated Sec. 615.5140(a)(4)(iv) permits each FCS institution 
to invest in repurchase agreements where the FCS institution agrees to 
purchase marketable securities subject to a legal agreement that 
requires the counterparty to repurchase the same or identical 
securities at a specific price within 100 days or less. Any securities 
held as collateral in connection with repurchase agreements must be 
either eligible investments authorized by this section or other 
marketable securities that are rated in the highest credit rating 
category by an NRSRO. In the event that the counterparty defaults on 
the agreement and the FCS institution takes possession of the 
collateral, the divestiture requirements in existing Sec. 615.5142 
(redesignated as proposed Sec. 615.5143) apply to any collateral that 
fails to qualify as an eligible investment under Sec. 615.5140(a).
    In 1995, the FCA approved a System request to invest in Master 
Notes pursuant to existing Sec. 615.5140(a)(11), which permits the FCA 
to authorize additional investments on a case-by-case basis. As 
requested, the FCA proposes Sec. 615.5140(a)(4)(v) to codify System 
institutions' authority to invest in Master Notes.\10\ The proposed 
regulation authorizes investments in Master Notes that: (1) Are 
executed with a domestic counterparty that maintains the highest issuer 
short-term credit rating by an NRSRO; and (2) mature overnight or 
within 270 days under a callable contract. The FCA also proposes to 
increase the portfolio limit on Master Notes from 15 to 20 percent of 
the FCS institution's investment portfolio.
---------------------------------------------------------------------------

    \10\ Master Notes are interest-bearing unsecured promissory 
notes that are issued by institutions to investors under a master 
note agreement. The most common type of master note agreement is a 
variable-amount note which is a type of open-ended commercial paper 
that allows the investment and withdrawal of funds on a daily basis 
and pays a daily interest rate tied to the commercial paper rate.
---------------------------------------------------------------------------

F. Mortgage Securities

1. Overview
    Currently, Sec. 615.5140(a)(2) authorizes investment in mortgage 
securities that are issued or guaranteed by the Government National 
Mortgage Association (Ginnie Mae or GNMA), the Federal National 
Mortgage Association (Fannie Mae or FNMA), and the Federal Home Loan 
Mortgage Corporation (Freddie Mac or FHLMC). CMOs that are 
collateralized by mortgage securities of GNMA, FNMA and FHLMC are also 
expressly authorized under the current regulations, even though they 
are packaged, issued, and sold under a private label.\11\ Under the 
existing regulation, eligible mortgage securities must either reprice 
within 1 year or comply with the stress tests specified in 
Sec. 615.5140(a)(2)(iii).\12\ System banks may hold mortgage securities 
that are issued or fully guaranteed by Ginnie Mae without restriction 
as to amount. However, the existing regulation restricts mortgage 
securities that are issued or fully guaranteed by Fannie Mae and 
Freddie Mac to 50 percent of each bank's total investments.
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    \11\ See 58 FR 63035, (November 30, 1993). Private label 
mortgage securities are issued by commercial banks, thrifts, and 
private conduits. Unlike agency securities, private label mortgage 
securities must be registered with the SEC.
    \12\ Section 615.5174 permits Farm Credit banks and associations 
to invest in mortgage-related securities that are guaranteed by the 
Federal Agricultural Mortgage Corporation (Farmer Mac).
---------------------------------------------------------------------------

    System banks seek further opportunities to invest in the mortgage 
securities market because of the high credit quality and liquidity of 
these securities. In particular, Farm Credit banks have requested 
authority to invest in mortgage securities that are collateralized by 
loans that do not comply with the FNMA and FHLMC underwriting standards 
and certain stripped mortgage-backed securities (SMBS). Recently, 
System banks petitioned the FCA to repeal the portfolio limit on Fannie 
Mae and Freddie Mac mortgage securities. This request also suggested 
that the revised regulation authorize FCS institutions to invest in 
mortgage securities that are rated within the two highest investment 
credit grades by an NRSRO. The

[[Page 33287]]

proposed rule permits investment in a greater variety of mortgage 
securities, subject to essential safety and soundness constraints.
2. Limits on FNMA and FHLMC Mortgage Securities
    As previously noted, System banks requested that the FCA repeal the 
50-percent investment portfolio limit on mortgage securities that are 
issued or guaranteed as to principle and interest by FNMA and FHLMC. 
System banks commented that no other financial institution regulatory 
agency places restrictions on the credit exposure to GSEs and that 
exposure limits on these securities should be left to the discretion of 
each bank.
    At this time, the FCA does not propose to repeal the existing 
portfolio limits for FNMA and FHLMC mortgage securities. As explained 
in greater detail below, the proposed regulation significantly expands 
the authority of System institutions to purchase and hold mortgage 
securities. The FCA's proposal will permit System institutions to 
invest, for the first time, in non-agency mortgage securities. Under 
certain circumstances, System banks would also be able to hold mortgage 
derivative products, such as SMBS, for interest rate risk management. 
Additionally, the new regulations will enable System institutions to 
rely on alternate stress tests for measuring the price sensitivity of 
mortgage securities.
    The FCA agrees with System commenters that the board and management 
of each FCS institution should establish risk exposure limits for all 
mortgage securities. A regulatory portfolio limit on FNMA and FHLMC 
mortgage securities does not absolve an institution's board or 
management of its responsibility to establish risk parameters that are 
based on the institution's unique risk-bearing capacity. The FCA also 
expects each FCS institution to maintain a well-diversified investment 
portfolio, regardless of whether these regulations impose a portfolio 
cap on particular classes of investments.
    Regulatory portfolio limits enhance safety and soundness by 
limiting credit exposure, promoting diversification of System 
investment portfolios, and curtailing investments in securities that 
may exhibit considerable interest rate or liquidity risks. The FCA 
invites further comment about this issue.
3. Non-agency Mortgage Securities
    The size and liquidity of the non-agency mortgage securities market 
has increased markedly since the implementation of the current 
regulations in 1993. The largest sector of the non-agency market is 
comprised of securities that are collateralized by ``jumbo'' mortgages 
with principal amounts that exceed the maximum limits for FNMA and 
FHLMC programs.\13\
---------------------------------------------------------------------------

    \13\ Several other asset classes in the non-agency MBS market 
exist, including: (1) Housing and Urban Development paper; (2) high 
loan-to-value loans; (3) Community Reinvestment Act loans; and (4) 
loans to borrowers with conforming loan balances with other features 
that prevent agency securitization, such as low documentation, self-
employment, and unique property features.
---------------------------------------------------------------------------

    The credit quality and liquidity of any particular non-agency 
mortgage security are dependent upon a myriad of factors, including the 
type of collateral and the structure, term, and originator of the 
issue. Non-agency mortgage securities are not explicitly or implicitly 
guaranteed by the United States, so these instruments typically require 
credit enhancements to receive a high rating. Credit enhancement is 
usually provided by some combination of issuer or third-party 
guarantee, letter of credit, over-collateralization, pool insurance, or 
subordination. As a result of these credit enhancements, highly rated 
non-agency mortgage securities enjoy low default rates.
    The FCA determines that non-agency mortgage securities that 
maintain the highest credit rating by an NRSRO have sufficient 
protections against default risk. Proposed Sec. 615.5140(a)(5)(ii) 
permits each System institution to invest in mortgage securities that 
are offered by private sector entities. Under this proposal, privately 
issued mortgage securities are eligible investments for System 
institutions if they are rated in the highest rating category by an 
NRSRO and they are collateralized by qualifying residential mortgages, 
meeting the requirements of the Secondary Mortgage Market Enhancement 
Act of 1984 (SMMEA).\14\ Prior to investing in such securities, every 
System bank must subject each non-agency mortgage security to stress 
testing in accordance with Sec. 615.5141. Non-agency mortgage 
securities cannot exceed 15 percent of each institution's total 
investments. Furthermore, mortgage securities that are issued by any 
party other than Ginnie Mae cannot exceed 50 percent of each 
institutions' total investments. This amendment balances the System's 
request for a broader selection of mortgage securities with appropriate 
safety and soundness restraints.
---------------------------------------------------------------------------

    \14\ The proposed rule allows investments in mortgage securities 
that are offered and sold pursuant to section 4 (5) of the 
Securities Act of 1933, 15 U.S.C. 77d(5), or are residential 
mortgage related securities within the meaning of section 3 (a) (41) 
of the Securities Exchange Act of 1934, 15 U.S.C. 78c(a) (41). SMMEA 
amended several statutes to encourage private sector investment in 
certain mortgage-related securities. See Pub. L. 98-440, 98 Stat. 
1689, October 3, 1984.
---------------------------------------------------------------------------

4. Fixed-rate Mortgage Pass-through Securities
    Currently, fixed-rate mortgage securities are eligible investments 
for System institutions if they satisfy the three-pronged stress test 
in existing Sec. 615.5140(a)(2)(ii).\15\ This stress test provides a 
basic method for measuring the price sensitivity of a mortgage security 
to changes in interest rates.\16\ System banks requested that the FCA 
repeal the requirement in existing Sec. 615.5140(a)(2) that subjects 
mortgage pass-through securities to the stress test. The Farm Credit 
banks asserted that interest rate risk in mortgage pass-through 
securities is easier to model and analyze and other federally regulated 
financial institutions are not subject to similar requirements.
---------------------------------------------------------------------------

    \15\ A recent FCA bookletter explains the authority of System 
banks to invest in fixed-rate mortgage securities that convert to 
adjustable rate securities. See BL-038, ``Guidance Relating to 
Investment Activities,'' (November 26, 1997).
    \16\ Under existing Sec. 615.5140(a)(2)(ii), each fixed-rate 
mortgage security must have a weighted average life (WAL) of 5 years 
or less, and changes in its WAL and price cannot exceed specified 
percentages, assuming parallel and sustained shift in interest rates 
of 300 basis points.
---------------------------------------------------------------------------

    The FCA believes that stress testing of all mortgage securities is 
a necessary discipline that enables each System institution to better 
understand and manage the risks inherent in these instruments. 
Therefore, the FCA does not incorporate the System's suggestion in this 
proposal. However, as discussed below, the FCA proposes significant 
changes to the stress-testing requirements for mortgage securities.
5. Other Mortgage-derivative Products
    The FCA also plans to repeal existing Secs. 615.5131(r) and (s), 
615.5140(a)(2)(v), and certain provisions in Sec. 615.5174(c) that 
explicitly ban investments in SMBS and inverse floating-rate debt 
classes.\17\ System banks claim that the explicit ban on SMBS is overly 
broad and, as a

[[Page 33288]]

result, it excludes securities with limited interest rate risk. The FCA 
concludes that the explicit regulatory ban on certain mortgage-
derivative products is unnecessary because all mortgage securities are 
subject to stress-testing requirements under both the current and 
proposed rules. The degree of price sensitivity that a mortgage 
security exhibits to changes in market interest rates is influenced by 
its unique characteristics. A System institution should determine 
whether a particular mortgage security meets its risk management 
objectives by using analytical techniques and methodologies that 
effectively evaluate how interest rate changes will affect prepayments 
and cashflows of the instrument.
---------------------------------------------------------------------------

    \17\ Existing Sec. 615.5131(r) defines SMBS as ``securities 
created by segregating the cashflows from the underlying mortgages 
or mortgage securities to create two or more new securities, each 
with a specified percentage of the underlying security's principal 
payments, interest payments, or combination of the two.'' 
Furthermore, existing Sec. 615.5140(a)(2)(v)(A) and 615.5174(c) 
specifically prohibit System banks from acquiring SMBS that are 
issued by GNMA, FNMA, FHLMC, and the Farmer Mac. When the existing 
regulations were adopted, the FCA reasoned that SMBS exhibit extreme 
price volatility to shifting interest rates, and therefore, these 
instruments were not suitable for maintaining a liquidity reserve or 
managing interest rate risk. See 56 FR 65091, 65096 (December 18, 
1991); 58 FR 63034, 63046 (November 30, 1993).
---------------------------------------------------------------------------

    Repeal of these regulatory restrictions will afford each System 
institution greater latitude to manage interest rate risks in the 
investment portfolio and its balance sheet. Although certain mortgage 
derivative products are risky because their prices may be subject to 
substantial fluctuations, the FCA recognizes that they can also be 
useful tools for reducing interest rate risk. Successful risk 
management of these instruments requires a thorough understanding of 
the principles that govern the pricing of these instruments. In 
general, FCA would view it as an unsafe and unsound practice to hold 
SMBS and inverse floaters for any purpose other than to reduce specific 
interest rate risks. Management must document, prior to purchase and 
each quarter thereafter, that the mortgage derivative product is 
reducing the interest rate risk of a designated group of assets or 
liabilities and the interest rate risk of the institution. However, if 
such an instrument exhibits only minimal price sensitivity under the 
stress test in proposed Sec. 615.5141, a System institution would be 
allowed to purchase and hold the instrument for other purposes 
permitted by existing Sec. 615.5132.
6. Stress-testing Requirements
    Although credit risk on highly rated mortgage securities is 
minimal, these securities may expose investors to significant interest 
rate risk. Since borrowers may prepay their mortgages, investors may 
not receive the expected cashflows and returns on these securities. 
Numerous factors influence the cashflow pattern and price sensitivity 
of mortgage securities. Prepayments on these securities are affected by 
the spread between market rates and the actual interest rates of 
mortgages in the pool, the path of interest rates, and the unpaid 
balances and remaining terms to maturity on the mortgage collateral. 
The price behavior of a mortgage security also depends on whether the 
security was purchased at a premium or at a discount. Therefore, each 
System institution needs to employ appropriate analytical techniques 
and methodologies to measure and evaluate interest rate risk inherent 
in mortgage securities. More specifically, prudent risk management 
practices require every System institution to examine the performance 
of each mortgage security under a wide array of possible interest rate 
scenarios. For these reasons, the FCA continues to believe that 
appropriate stress testing of all mortgage securities is necessary to 
gain a full understanding of the risks inherent in the instruments.
    Originally, FCS banks requested technical modifications to FCA's 
existing regulatory stress test. System banks subsequently requested 
that the FCA repeal the regulatory stress test after the FFIEC 
rescinded a policy statement that required depository institutions to 
stress test mortgage derivative products.\18\ The System banks 
commented that the FCA should make its regulatory approach consistent 
with the FFIEC's new policy.
---------------------------------------------------------------------------

    \18\ See 63 FR 20191 (April 23, 1998).
---------------------------------------------------------------------------

    In response, the FCA proposes significant changes to existing 
requirements for evaluating the price sensitivity of mortgage 
securities and determining their suitability. The FCA's revised 
regulatory approach reflects improvements in prepayment models and 
methodologies for evaluating and measuring the price sensitivity of a 
security. Specifically, this proposal would enable each FCS institution 
to choose between two alternative approaches for measuring and 
evaluating the price sensitivity of mortgage securities to interest 
rate fluctuations.
    Under the first option, an FCS institution may continue to use a 
modified version of the existing three-pronged stress test. The FCA 
proposes to modify the third prong of the stress test, which 
establishes a price sensitivity limit for mortgage securities. Under 
proposed Sec. 615.5141(a)(3), the estimated change in the price of the 
security cannot exceed 13 percent due to an immediate and sustained 
parallel shift in the yield curve of plus or minus 300 basis points. 
This revision, which was originally requested by System banks, corrects 
an inconsistency in the test that may arise under certain interest rate 
scenarios. This change affords more latitude for investment in mortgage 
securities.
    Proposed Sec. 615.5141(b) allows the use of alternative stress 
tests to evaluate the price sensitivity of investments in mortgage 
securities. The FCA is permitting alternative stress tests because new 
risk management technologies better enable investors to measure 
interest rate risks in complex mortgage securities. Alternative stress 
tests must be able to measure the price sensitivity of mortgage 
instruments over different interest rate/yield curve scenarios prior to 
purchase and each quarter thereafter. The methodology that an FCS 
institution uses to analyze mortgage securities must be commensurate 
with the complexity of the instrument's structure and cashflows. For 
example, a pre-purchase analysis may show the effect of an immediate 
and parallel shift in the yield curve of plus and minus 100, 200, and 
300 basis points. Depending on the instrument's complexity, such 
analysis may encompass a wider range of scenarios, including non-
parallel changes in the yield curve. A comprehensive analysis may also 
take into consideration other relevant factors, such as interest rate 
volatility and changes in credit spreads. The methodology used to 
evaluate an instrument's price sensitivity should enable management to 
determine that the particular mortgage security: (1) Is compatible with 
the objectives and risk limits in the institution's investment 
policies; and (2) does not expose capital and earnings to excessive 
risk.
    An FCS institution employing internal models for valuation and risk 
measurement of mortgage securities should have adequate procedures to 
validate the models and periodically review all elements of the 
modeling process, including assumptions and risk measurement 
methodologies and techniques. Any FCS institution that relies on third 
parties for valuation and risk measurement must understand the 
assumptions and techniques used. All analysis must be available for 
review by the Office of Examination of the FCA.
7. Other Technical Changes
    The FCA proposes to replace the definitions of ``CMOs,'' 
``mortgage-backed securities,'' and ``REMICs'' in existing 
Sec. 615.5131(e), (l), and (p) with a single definition of ``mortgage 
securities'' in proposed Sec. 615.5131(i), which encompasses mortgage 
pass-through securities and all mortgage derivative products. Although 
proposed Sec. 615.5131(i) continues to refer to CMOs and REMICS, the 
FCA has omitted specific regulatory definitions for these securities 
from the regulation because

[[Page 33289]]

their meanings are commonly understood in the financial markets.
    The FCA proposes to relocate the applicable regulatory provision 
governing ARM securities from Sec. 615.5140(a)(2)(ii) to Sec. 615.5141 
and to delete the definition of ``adjustable-rate mortgage'' in 
existing Sec. 615.5131(b) because it is redundant.

G. Corporate Debt Obligations and ABS

    Currently, corporate debt obligations and ABS are subject to a 
single regulatory provision, existing Sec. 615.5140(a)(8). Under the 
existing regulation, corporate bonds and ABS, combined, cannot exceed 
15 percent of the total investments of each FCS institution. Under this 
proposal, corporate bonds and ABS would be governed by separate 
regulatory provisions, and the portfolio cap for each category would be 
20 percent of total outstanding investments. The FCA's proposal to 
expand the portfolio limits for these two investments provides every 
FCS institution with greater flexibility to invest in these securities 
within reasonable risk diversification parameters.
    Existing Sec. 615.5140(a)(8)(ii) authorizes each FCS institution to 
invest in ABS that mature in 5 years, are collateralized by loans on 
new automobiles (CARs) or credit card receivables (CARDs), and maintain 
the highest investment grade credit rating by an NRSRO. The FCA adopted 
Sec. 615.5140(a)(8)(ii) in 1993 when CARs and CARDs comprised 
approximately 80 percent of the ABS market and other types of ABS were 
not actively traded in the secondary markets.\19\
---------------------------------------------------------------------------

    \19\ See 58 FR 63034, 63050 (November 30, 1993).
---------------------------------------------------------------------------

    The scope and depth of the ABS market has expanded rapidly since 
1993. As a result, System banks have requested authority to invest in 
ABS that are collateralized by other types of assets. Originally, 
System banks petitioned the FCA for authority to purchase and hold ABS 
that are secured by home equity loans, manufactured housing loans, 
agricultural equipment loans, student loans, and wholesale dealer 
automobile loans. Subsequently, System banks requested that the FCA 
amend the regulation so it places no restrictions on the types of 
collateral that securitize ABS. System banks assert that a high credit 
rating is more indicative of an ABS's liquidity than its underlying 
collateral. Farm Credit banks also suggested that the FCA revise the 
maturity limits on ABS to permit fixed-rate ABS that have both a final 
maturity of 7 years or less and a WAL of 5 years or less, and floating-
rate ABS that have both a final maturity of 10 years or less and a WAL 
of 7 years or less.
    This proposal adopts a modified version of the System's original 
recommendation.\20\ Proposed Sec. 615.5140(a)(6) would authorize 
investment in ABS that are collateralized by CARs, CARDs, home equity 
loans, manufactured housing loans, equipment loans, student loans, and 
wholesale dealer automobile loans. The FCA emphasizes that securities 
collateralized by home equity loans are ABS, not mortgage securities, 
under this proposal. The FCA finds that the market for these types of 
ABS is sufficiently developed and that these securities are suitable 
for meeting the objectives of Sec. 615.5132. This broad array of ABS 
should provide FCS institutions with an ample selection of highly 
rated, fixed-income investments that have relatively stable cashflows.
---------------------------------------------------------------------------

    \20\ Although the System's recommendation did not address the 
credit rating for ABS, the FCA proposes to retain the requirement in 
the existing regulation that all eligible ABS maintain the highest 
credit rating by an NRSRO.
---------------------------------------------------------------------------

    Under proposed Sec. 615.5140(a)(6), FCA specifies that the WAL for 
all eligible ABS cannot exceed 5 years and the final maturity cannot 
exceed 7 years. The FCA proposes to extend the final maturity from 5 to 
7 years in recognition that ABS with final maturities of 7 years 
typically have much shorter WALs. This approach has the added advantage 
of facilitating comparisons between amortizing ABS and other fixed-
income securities. The FCA does not adopt the System's suggestion 
regarding the maturity of adjustable-rate ABS for two reasons. Most ABS 
have final maturities that are shorter than the timeframe recommended 
by Farm Credit banks. Other factors, such as the frequency of 
repricing, periodic and life-time interest rate caps and the index to 
which the instrument is tied are important determinants of how the 
instrument will perform. Therefore, the FCA requests comments on how 
the regulations could address maturity limits for adjustable ABS.
    The FCA anticipates that there will be further growth in the ABS 
market and active secondary markets will ultimately develop for ABS 
that are backed by other types of collateral. Thus, the FCA also 
requests comments on how it could develop a more flexible final 
regulation that would enable the regulator to establish criteria for 
determining the suitability of new types of ABS that financial markets 
may create.
    The FCA proposes no substantive changes to the regulatory 
provisions that govern investments in corporate debt obligations. Under 
this proposal, existing Sec. 615.5140(a)(8)(i) will be redesignated as 
Sec. 615.5140(a)(7).

H. Shares in Investment Companies

    The FCA believes that investment companies provide System 
institutions with another convenient method to diversify and manage 
risks. Therefore, the FCA proposes to authorize investment in shares of 
any investment company that is registered under section 8 of the 
Investment Company Act of 1940, 15 U.S.C. 80a-8, as long as the 
investment company's portfolio consists exclusively of securities that 
are authorized by Sec. 615.5140. Prior to investing in a particular 
investment company, an FCS institution would be required by proposed 
Sec. 615.5140(a)(8) to evaluate the investment company's risk and 
return objectives. As part of this evaluation, the FCS institution 
should determine whether the investment company's use of financial 
derivatives is consistent with its investment policies. For instance, 
the FCA would generally view it an unsafe and unsound practice for an 
FCS institution to invest in an investment company that uses financial 
derivatives for speculative purposes rather than as a risk management 
tool. Every System institution should maintain appropriate 
documentation on each investment, including a prospectus and analysis, 
so its investment and selection process can be audited and examined.
    Proposed Sec. 615.5140(b)(5) addresses how the obligor and 
portfolio limitations in Sec. 615.5140(b)(3) and (b)(4) apply to an FCS 
institution's interest in an investment company. Generally, proposed 
Sec. 615.5140(b)(5)(i) requires combining the institution's direct 
holdings of an eligible investment with its pro rata interest in the 
same type of instrument in the portfolio of an investment company for 
the purpose of complying with Sec. 615.5140(b)(3), (b)(4)(i), and 
(b)(4)(ii). The FCA notes that aggregation is required only if this 
regulation subjects a particular investment to an obligor or portfolio 
limit. For example, prime commercial paper is subject to an obligor 
limit, but not a portfolio limit. As a result, the regulation requires 
aggregation to ensure that no more than 20 percent of an FCS 
institution's total capital is invested in the prime commercial paper 
of any single obligor. However, no regulatory restriction applies to 
the amount of prime commercial paper that an FCS institution may hold 
in its investment portfolio, either directly or through an investment 
company.
    Proposed Sec. 615.5140(b)(5)(ii) carves out two exceptions to this 
aggregation rule. The first exception applies to the

[[Page 33290]]

obligor limit, while the second exemption covers portfolio 
restrictions. Under Sec. 615.5140(b)(5)(ii)(A), an FCS institution may 
elect not to combine its pro rata interest in a particular security in 
an investment company with its direct holdings of securities that are 
issued by the same obligor if the investment company's holdings of the 
securities of any one issuer do not exceed 5 percent of its total 
portfolio. Pursuant to Sec. 615.5140(b)(5)(ii)(B), an FCS institution 
may elect not to combine its pro rata interest in a type of security in 
an investment company with its direct holding of a class of securities 
that are subject to the portfolio limits if its shares in a particular 
investment company do not exceed 10 percent of its total investments.

I. Other Eligible Investments

    The FCA proposes to redesignate existing Sec. 615.5140(a)(11) as 
Sec. 615.5140(a)(9). This proposal contains no substantive amendments 
to this provision, which allows the purchase of other short-term 
investments, as authorized by the FCA that are marketable and highly 
rated by an NRSRO. Whenever possible, the FCA seeks to repeal 
regulatory prior-approval requirements that are not mandated by the 
Act. The FCA requests comments on how the final regulation could permit 
FCS institutions, under certain circumstances, to invest in short-term, 
highly rated, marketable securities that are not expressly authorized 
by Sec. 615.5140 without requiring Agency approval.

IV. Technical Amendments

    The FCA proposes several conforming amendments to Sec. 615.5174 
relating to investments in securities issued by Farmer Mac. The 
terminology for mortgage securities has been revised so that it is 
consistent with proposed amendments to Sec. 615.5131.
    The FCA proposes to repeal the definitions of ``asset-liability 
management,'' ``Federal funds,'' ``interest rate risk,'' ``market value 
of equity,'' ``net interest income,'' ``total capital,'' and ``weighted 
average maturity'' in Sec. 615.5131 because the meanings of these terms 
are commonly understood in financial markets. Separately, the FCA has 
redefined ``absolute final maturity'' in Sec. 615.5131(a) as ``final 
maturity'' in proposed Sec. 615.5131(c).
    The FCA also proposes to repeal Sec. 615.5142(a) and remove the 
designation from paragraph (b) because this provision is obsolete. 
Existing Sec. 615.5142(a) pertains to the divestiture of investments 
that were rendered ineligible when the FCA originally adopted these 
regulations in 1993.

List of Subjects in 12 CFR Part 615

    Accounting, Agriculture, Banks, banking, Government securities, 
Investments, Rural areas.
    For the reasons stated in the preamble, part 615 of chapter VI, 
title 12 of the Code of Federal Regulations is proposed to be amended 
to read as follows:

PART 615--FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS, 
AND FUNDING OPERATIONS

    1. The authority citation for part 615 continues to read as 
follows:

    Authority: Secs. 1.5, 1.7, 1.10, 1.11, 1.12, 2.2, 2.3, 2.4, 2.5, 
2.12, 3.1, 3.7, 3.11, 3.25, 4.3, 4.3A, 4.9, 4.14B, 4.25, 5.9, 5.17, 
6.20, 6.26, 8.0, 8.3, 8.4, 8.6, 8.7, 8.8, 8.10, 8.12 of the Farm 
Credit Act (12 U.S.C. 2013, 2015, 2018, 2019, 2020, 2073, 2074, 
2075, 2076, 2093, 2122, 2128, 2132, 2146, 2154, 2154a, 2160, 2202b, 
2211, 2243, 2252, 2278b, 2278b-6, 2279aa, 2279aa-3, 2279aa-4, 
2279aa-6, 2279aa-7, 2279aa-8, 2279aa-10, 2279aa-12); sec. 301(a) of 
Pub. L. 100-233, 101 Stat. 1568, 1608.

    2. Subpart E is amended by revising the heading to read as follows:

Subpart E--Investment Portfolio Management

    3. Section 615.5131 is revised to read as follows:


Sec. 615.5131  Definitions.

    For purposes of this subpart, the following definitions shall 
apply:
    (a) Asset-backed securities (ABS) mean investment securities that 
provide for ownership of a fractional undivided interest or collateral 
interests in specific assets of a trust that are sold and traded in the 
capital markets. For the purposes of this subpart, ABS exclude mortgage 
securities that are defined in Sec. 615.5131(i).
    (b) Eurodollar time deposit means a non-negotiable deposit 
denominated in United States dollars and issued by an overseas branch 
of a United States bank or by a foreign bank outside the United States.
    (c) Final maturity means the last date on which the remaining 
principal amount of a security is due and payable (matures) to the 
registered owner. It shall not mean the call date, the expected average 
life, the duration, or the weighted average maturity.
    (d) General obligations of a State or political subdivision means:
    (1) The full faith and credit obligations of a State, the District 
of Columbia, the Commonwealth of Puerto Rico, a territory or possession 
of the United States, or a political subdivision thereof that possesses 
general powers of taxation, including property taxation; or
    (2) An obligation payable from a special fund or by an obligor not 
possessing general powers of taxation when an obligor possessing 
general powers of taxation, including property taxation, has 
unconditionally promised to make payments into the fund or otherwise 
provide funds to cover all required payments on the obligation.
    (e) Liquid investments are assets that can be promptly converted 
into cash without significant loss to the investor. In the money 
market, a security is liquid if the spread between bid and ask prices 
is narrow and a reasonable amount can be sold at those prices.
    (f) Loans are defined by Sec. 621.2(f) of this chapter and are 
calculated quarterly (as of the last day of March, June, September, and 
December) by using the average daily balance of loans for the quarter 
then ended.
    (g) Market risk means the risk to the bank's financial condition 
resulting from a decline in value of its holdings arising from changes 
in interest rates or market prices. A bank's exposure to market risk 
can be measured by assessing the effect of changing rates and prices on 
either earnings or economic value of an individual instrument, a 
portfolio, or the entire institution.
    (h) Marketable investment means an asset that can be sold with 
reasonable promptness at a price that reasonably reflects its fair 
value in an active and universally recognized secondary market.
    (i) Mortgage securities means securities that are either:
    (1) Collateralized with residential mortgage loans (excluding home 
equity loans) that represent ownership of a fractional undivided 
interest in a specific pool of mortgages (commonly known as pass-
through securities or participation certificates), or
    (2) A multi-class, pay-through bond backed by a pool of residential 
mortgage pass-through securities or residential mortgage loans 
(including securities commonly known as collateralized mortgage 
obligations and real estate mortgage investment conduits).
    (j) Nationally Recognized Statistical Rating Organization (NRSRO) 
means a rating organization that the Securities and Exchange Commission 
has recognized as an NRSRO.
    (k) Weighted average life (WAL) means the average time to receipt 
of principal, weighted by the size of each principal payment. Weighted 
average

[[Page 33291]]

life for mortgage and asset-backed securities is calculated under 
specific prepayment assumptions.
    4. Section 615.5133 is revised to read as follows:


Sec. 615.5133  Investment portfolio management.

    The board of directors of each Farm Credit bank is responsible for 
adopting written policies for managing the bank's investment 
activities. The board of directors shall also ensure that the bank's 
investments are safely and soundly managed in accordance with the 
written policies and that appropriate internal controls are in place to 
preclude investment actions that undermine the solvency and liquidity 
of the bank. Written investment policies must address the purposes and 
objectives of investments, risk parameters, delegations of authority, 
and reporting requirements. Annually, the board of directors of each 
Farm Credit bank shall review its investment policies to determine 
whether objectives and risk exposure limits continue to be appropriate 
for the bank.
    (a) Risk parameters. The investment policies shall establish risk 
limits and diversification requirements for the various classes of 
eligible investments and the entire investment portfolio. Risk 
parameters shall be based on the Farm Credit bank's institutional 
objectives, capital position, and its tolerance for risk. The policies 
must identify the types and quantity of investments that the bank will 
hold to achieve its objectives and control credit, market liquidity, 
and operational risks.
    (1) Credit risk. The bank's investment policies shall establish:
    (i) Credit quality standards, limits on counterparty risk, and risk 
diversification requirements that limit concentrations based on a 
single or related counterparties, a geographical area, industries or 
obligations with similar characteristics.
    (ii) Criteria for selecting brokers, dealers, and investment 
bankers (collectively, securities firms). The policy shall also set 
limits on the amounts and types of transactions that the bank shall 
execute with authorized securities firms. The board of directors shall 
annually review management's selection of securities firms and 
limitations on transactions with such securities firms.
    (iii) Collateral margin requirements on repurchase agreements.
    (2) Market risk. The bank's investment policies shall set market 
risk limits for the institution, the investment portfolio or specific 
types of investments pursuant to the regulations in this chapter and 
guidance by the Farm Credit Administration.
    (3) Liquidity risk. The bank's policies shall describe the 
liquidity characteristics of investments used to accomplish 
institutional objectives and its liquidity needs sufficient to comply 
with the requirements of Sec. 615.5134.
    (4) Operational risk. The bank's policy shall address operational 
risks, including delegations of authority and internal controls in 
accordance with paragraphs (b) and (c) of this section.
    (b) Delegations of authorities. All delegations of the management 
of the bank's investments to specific personnel or committees shall 
state the extent of management's authority and responsibilities.
    (c) Internal controls. Each Farm Credit bank shall:
    (1) Establish appropriate internal controls to detect and prevent 
loss, fraud, embezzlement, conflicts of interest, and unauthorized 
investments and ensure compliance with policies established by the 
board.
    (2) Ensure that a separation of duties and supervision exists 
between personnel executing investment transactions and those 
responsible for approving, revaluating, and overseeing the bank's 
investments.
    (3) Maintain management information systems that are commensurate 
with the level and complexity of the bank's investment activities.
    (d) Securities valuation. Each Farm Credit bank shall:
    (1) Verify the value of any security (except new issues) that it 
purchases or sells from a source that is independent of the broker, 
dealer, counterparty, or other intermediary in the specific 
transaction.
    (2) Determine, at least monthly, the fair value of each security in 
its portfolio and the fair value of the portfolio as a whole.
    (3) Perform evaluations of the credit quality and price sensitivity 
to changes in market interest rates of all investments held in its 
portfolio prior to purchase and on an ongoing basis.
    (e) Reports to the board. Reports on the performance and risk of 
each investment and the investment portfolio shall be made to the board 
of directors or a committee thereof each quarter. Reports shall 
identify potential risk exposure to changes in market interest rates 
and other factors that may affect the value of the bank's investment 
holdings. Each report shall discuss how investments affect the bank's 
overall financial condition and evaluate whether the performance of the 
investment portfolio effectively achieves the objectives established by 
the board of directors. Any deviations from the board's policies shall 
be specifically identified in the report.
    5. Section 615.5134 is amended by revising paragraph (b) to read as 
follows:


Sec. 615.5134  Liquidity reserve requirement.

* * * * *
    (b) All investments held for the purpose of meeting the liquidity 
reserve requirement under this section shall be free of lien.
* * * * *
    6. Section 615.5140 is revised to read as follows:


Sec. 615.5140  Eligible investments.

    (a) Farm Credit banks are authorized to hold the following types of 
eligible investments, denominated in United States dollars, to comply 
with the requirements of Secs. 615.5132, 615.5134, and 615.5135 of this 
subpart:
    (1) Treasury and agency securities. Obligations of the United 
States; full-recourse obligations, other than mortgage securities, of 
agencies, instrumentalities or corporations of the United States, or 
debt obligations of other obligors that are fully insured or guaranteed 
as to both principal and interest by the United States, its agencies, 
instrumentalities, or corporations.
    (2) General obligations of a State or political subdivision that 
mature within 10 years and are rated in one of the three highest credit 
rating categories by an NRSRO.
    (3) Obligations of international and multilateral development banks 
in which the United States is a voting shareholder.
    (4) Money market instruments: (i) Negotiable certificates of 
deposit that mature within 1 year or less, Federal funds, term Federal 
funds that have a callable contract with a term to maturity of 100 days 
or less, and bankers acceptances that are issued by depository 
institutions. All issuers of money market instruments listed in 
paragraph (a)(4)(i) of this section shall maintain a rating in one of 
the two highest short-term credit rating categories by an NRSRO.
    (ii) Eurodollar time deposits that mature within 90 days and are 
held at depository institutions that maintain a rating in the highest 
short-term credit rating category by an NRSRO.
    (iii) Prime commercial paper that has a maturity of 270 days or 
less and is rated in the highest short-term credit rating category by 
an NRSRO.
    (iv) Repurchase agreements where a Farm Credit bank agrees to 
purchase marketable securities subject to an agreement that requires a 
counterparty

[[Page 33292]]

to repurchase the same or identical securities at a specific time 
within 100 days or less. The collateral for repurchase agreements shall 
be either eligible investments authorized by this section or other 
marketable securities that are rated in the highest credit rating 
category by an NRSRO.
    (v) Master notes that mature overnight, or have a callable feature 
and mature within 270 days, and are executed with domestic 
counterparties that maintain a rating in the highest short-term credit 
rating category by an NRSRO.
    (5) Mortgage securities that are rated in the highest credit rating 
category by an NRSRO and are either:
    (i) Agency mortgage securities that are issued or guaranteed as to 
principal and interest by the Government National Mortgage Association, 
the Federal National Mortgage Association, Federal Home Loan Mortgage 
Corporation, or
    (ii) Non-agency mortgage securities that are offered and sold 
pursuant to section 4(5) of the Securities Act of 1933, 15 U.S.C. 
77d(5) or are residential mortgage-related securities within the 
meaning of section 3(a)(41) of the Securities Exchange Act of 1934, 15 
U.S.C. 78c(a)(41).
    (iii) Mortgage securities shall not be consider eligible 
investments, unless they comply with the requirements of Sec. 615.5141 
of this subpart.
    (6) Asset-backed securities that are collateralized by credit card 
receivables, automobile loans, home equity loans, manufactured housing 
loans, equipment loans, student loans, or wholesale dealer automobile 
loans that are rated in the highest credit rating category by an NRSRO. 
The expected WAL on eligible ABS shall not exceed 5 years and the final 
maturity shall not exceed 7 years.
    (7) Corporate debt securities that are rated within the two highest 
credit rating categories by an NRSRO, mature within 5 years and are not 
convertible into equity securities.
    (8) Investment companies. Shares of an investment company 
registered under section 8 of the Investment Company Act of 1940, 15 
U.S.C. 80a-8 (including mutual funds, unit investment trusts, and 
collective investment funds maintained by a national bank under 12 CFR 
part 9), provided that the portfolio of the investment company consists 
exclusively of eligible investments that are authorized by this section 
or Sec. 615.5174 of this part. In addition, Farm Credit banks must 
evaluate the investment company's risk and return objectives and use of 
derivatives to ensure that the investment company's objectives and 
strategies for achieving its objectives are consistent with the bank's 
investment policies and the requirements of this subpart.
    (9) Other investments, as authorized by the Farm Credit 
Administration, that have a short maturity and are rated investment 
grade by an NRSRO. A Farm Credit bank seeking approval of an investment 
under this paragraph should provide the Farm Credit Administration with 
documentation that describes the risk characteristics of the investment 
and explains the bank's purpose and objectives for making the 
investment.
    (b) The authority of Farm Credit banks to hold the investments 
listed in paragraph (a) of this section is subject to the following 
requirements:
    (1) Marketable securities. Except for the money market instruments 
listed in paragraph (a)(4) of this section, all other eligible 
investments shall be marketable within the meaning of Sec. 615.5131(h).
    (2) Rating of foreign countries. Whenever the obligor or issuer of 
an eligible investment is located outside of the United States, the 
host country shall maintain the highest sovereign rating for political 
and economic stability by an NRSRO.
    (3) Obligor limits. Except for eligible investments covered by 
paragraph (a)(1) of this section and mortgage securities that are 
issued by or guaranteed as to principal and interest by the Government 
National Mortgage Association, Federal National Mortgage Association, 
or the Federal Home Loan Mortgage Corporation under paragraph (a)(5)(i) 
of this section, each Farm Credit bank shall not invest more than 
twenty (20) percent of its total capital in eligible investments issued 
by any single institution, issuer, or obligor.
    (4) Portfolio limits. Subject to Sec. 615.5132, each Farm Credit 
System bank is authorized to hold eligible investments listed in 
paragraph (a) of this section without limitation as to amount except:
    (i) Mortgage securities shall not exceed fifty (50) percent of the 
bank's total investments authorized under this section provided that 
mortgage securities that are issued under paragraph (a)(5)(ii) of this 
section shall not exceed fifteen (15) percent of the bank's total 
investments. Mortgage securities that are issued by the Government 
National Mortgage Association shall not be subject to any restriction 
on amount.
    (ii) Each of the following types of investments shall not exceed 
twenty (20) percent of the bank's total investments authorized under 
this section:
    (A) Eurodollar time deposits;
    (B) Master notes;
    (C) Asset-backed securities; and
    (D) Corporate bonds.
    (5) Limit on investment company holdings. (i) General. A Farm 
Credit bank shall combine its direct holdings of eligible investments 
with its pro rata interest in the same type of instrument or obligor in 
the portfolio of an investment company for the purpose of complying 
with the obligor and portfolio limitations of paragraphs (b)(3), 
(b)(4)(i), and (b)(4)(ii) of this section.
    (ii) Alternate diversification requirements for investment 
companies. (A) Exemption from the obligor limit. A Farm Credit bank may 
elect not to combine its pro rata interest in a particular security in 
an investment company with the bank's direct holdings of securities 
that are subject to the obligor limit in paragraph (b)(3) of this 
section if the investment company's holdings of the securities of any 
one issuer do not exceed five (5) percent of its total portfolio.
    (B) Exemption from the portfolio limits. A Farm Credit bank may 
elect not to combine its pro rata interest in a type of security in an 
investment company with the bank's direct holding of a class of 
securities that are subject to the portfolio limits in paragraphs 
(b)(4)(i) and (b)(4)(ii) of this section if the bank's shares in an 
investment company do not exceed ten (10) percent of its total 
investments.


Sec. 615.5141 through 615.5143  [Redesignated]

    7. Sections 615.5141, 615.5142, and 615.5143 are redesignated as 
Secs. 615.5142, 615.5143, and 615.5144, respectively, and a new 
Sec. 615.5141 is added to read as follows:


Sec. 615.5141  Stress tests for mortgage securities.

    Each Farm Credit bank shall perform stress tests to determine how 
interest rate fluctuations will affect the cashflows and price of all 
mortgage securities that it purchases and holds under 
Sec. 615.5140(a)(5), as well as their overall affect on the earnings 
and capital of the bank. Adjustable mortgage securities that have a 
repricing mechanism of 12 months or less and tied to an index are not 
subject to stress testing. Farm Credit banks may conduct the stress 
tests in accordance with either paragraph (a) or (b) of this section.
    (a) Mortgage securities shall comply with the following three tests 
at the time of purchase and each quarter thereafter:
    (1) Average Life Test. The expected WAL of the instrument does not 
exceed 5 years.
    (2) Average Life Sensitivity Test. The expected WAL does not extend 
for more

[[Page 33293]]

than 2 years, assuming an immediate and sustained parallel shift in the 
yield curve of plus 300 basis points, nor shorten for more than 3 
years, assuming an immediate and sustained parallel shift in the yield 
curve of minus 300 basis points.
    (3) Price Sensitivity Test. The estimated change in price is not 
more than thirteen (13) percent due to an immediate and sustained 
parallel shift in the yield curve of plus or minus 300 basis points.
    (4) Exemption. A floating-rate mortgage security shall not be 
subject to paragraphs (a)(1) and (2) of this section if at the time of 
purchase, and each subsequent quarter, it bears a rate of interest that 
is below the contractual cap on the instrument.
    (b) A Farm Credit bank may use alternative stress tests to evaluate 
the price sensitivity of its investments in mortgage securities. 
Alternative stress tests must be able to measure the price sensitivity 
of mortgage instruments over different interest rate/yield curve 
scenarios prior to purchase and each quarter thereafter. The 
methodology used to analyze mortgage securities shall be commensurate 
with the complexity of the instrument's structure and cashflows. Prior 
to purchase and quarterly thereafter, the stress test should determine 
that the mortgage security's risk is compatible with the bank's 
investment policies and the investment does not expose the bank's 
capital and earnings to excessive risks.
    (c) In applying the stress tests in either paragraphs (a) or (b) of 
this section, each Farm Credit bank shall rely on verifiable 
information to support all of its assumptions, including prepayment and 
interest-rate volatility assumptions. All assumptions that form the 
basis of the bank's evaluation of the security and its underlying 
collateral shall be available for review by the Office of Examination 
of the Farm Credit Administration. Subsequent changes in the bank's 
assumptions shall be documented. If at any time after purchase, a 
mortgage security no longer complies with requirements in this section, 
the bank shall divest the security in accordance with Sec. 615.5143 of 
this part.


Sec. 615.5143  [Amended]

    8. Newly designated Sec. 615.5143 is amended by removing paragraph 
(a) and the paragraph designation from paragraph (b).

Subpart F--Property and Other Investments


Sec. 615.5174  [Amended]

    9. Section 615.5174 is amended by removing the words ``mortgage-
backed securities (MBSs), as defined by Sec. 615.5131(l), 
collateralized mortgage obligations (CMOs), as defined by 
Sec. 615.5131(e), and Real Estate Mortgage Investment Conduits 
(REMICs), as defined by Sec. 615.5131(p)'' in paragraph (a), and adding 
in their place, the words ``mortgage securities as defined by 
Sec. 615.5131(l);'' by removing the words, ``as defined by 
Sec. 615.5131(b),'' from paragraph (b)(1); by removing paragraph (c); 
and redesignating paragraphs (d) and (e) as paragraphs (c) and (d), 
respectively.

    Dated: June 15, 1998.
Floyd Fithian,
Secretary, Farm Credit Administration Board.
[FR Doc. 98-16208 Filed 6-17-98; 8:45 am]
BILLING CODE 6705-01-P


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