# Secondary market.

SECONDARY MARKET

CMOs and REMICs have produced positive effects for the primary and secondary markets. CMOs have allowed depository institution investors to select investments with maturities and cash flows meeting their investment objectives, thus reducing interest rate risk for the depository institution as a whole. In addition, CMOs and REMICs have boosted the market prices for the underlying pass-through securities, which in turn has translated into more competitive mortgage rates for consumers. Unless steps are taken to amend a recent proposal by the Federal Financial Institutions Examinations Council (FFIEC) these benefits will be sharply diminished. The result will be measurably higher interest rates for American homebuyers.

The FFIEC proposes a quantitative measure for determining which derivative securities are high risk and unsuitable as investments by depository institutions. A high-risk mortgage security is defined as any mortgage derivative product that has (1) an expected weighted-average life greater than eight years (i.e., "average life" test); (2) an expected weighted-average life that extends by more than four years or shortens by more than five years assuming immediate and sustained parallel shifts in the yield curve of plus or minus 300 basis points, respectively (i.e., "average life sensitivity" test); or (3) an estimated change in the price of more than 16 percent due to an immediate and sustained parallel shift in the yield curve of plus or minus 300 basis points (i.e., "price sensitivity" test).

According to estimates provided by Wall Street firms, 44.6 percent of outstanding derivatives will be classified as high risk. This broad impact causes us to be extremely concerned that such an overly stringent policy concerning the investment and reporting of derivative securities will adversely affect the market for CMOs and REMICs and, in turn, the secondary market for pass-through securities.

Of particular concern is the fact that the FFIEC's tests for average life, average life sensitivity and price volatility of derivative products run contrary to FFIEC's stated principle of using the "standard" 30-year fixed-rate mortgage-backed security as a benchmark for determining "high risk" for derivative products. The FFIEC's proposed test for "high risk" appears to have been developed without sufficient consideration of the average life and price sensitivity of non-derivative pass-through securities currently treated as suitable investments for banks and thrifts. In fact, if the "high risk" tests were applied to these pass-throughs, current GNMA 8.5 percent coupons would fail the suitability test because of their weighted-average life of approximately 11 years. Furthermore, an immediate and sustained increase in the yield curve of 300 basis points would extend the life of a current coupon GNMA security just over five years (one year beyond the four-year standard). A 300 basis point decrease would shorten the life by six years (one year beyond the five-year standard).

Because the quantitative criteria do not sufficiently distinguish between high-risk derivatives and "plain vanilla" pass-throughs, MBA believes the average life and average life sensitivity criteria for defining high risk should be amended using GNMA and conventional pass-throughs as benchmarks as follows: (1) a derivative product with an average life of more than 12 years; and (2) a weighted-average life that extends or shortens by more than six years assuming a gradual but parallel shift in the yield curve of plus or minus 300 basis points. MBA believes that a gradual shift in the yield curve is more representational of market-place conditions than an "immediate and sustained" 300 basis point shift in the yield curve as proposed.

In regards to the price sensitivity measure, under the proposal a current coupon GNMA pass-through security would fail to meet the suitability test, because its price sensitivity measure is 18 percent to 19 percent. This supports the belief that the price sensitivity test is too strict a measure of risk and should be eliminated. While CMO prices are mostly governed by life sensitivity, other factors contribute to the price, such as supply and demand, investor psychology and spreads between bid and ask prices. The influence of these other factors on price are hard to ascertain. As a result we do not believe that price sensitivity alone is a reliable enough measure to gauge whether or not an investment is "high risk."

Furthermore, we believe the FFIEC's policy should focus on the entire portfolio of assets and liabilities, rather than focusing on each security in isolation. In many cases, a combination of assets will result in lower overall risk. FFIEC's approach is arbitrary because it would make ineligible certain derivative investments (e.g., longer tranche CMOs) while classifying as "eligible" investments in the securities backing the CMO even though they represent the same set of risks.

FFIEC's characterization of derivative investment as "unsuitable" should only establish a presumption of ineligibility. FFIEC should allow the institution to rebut this presumption if it can demonstrate that, when compared to total portfolio investments, the derivative security reduces total portfolio interest rate risk. Finally, MBA suggests that future changes to the quantitative criteria be applied prospectively and that examiner discretion be limited in order to create some level of certainty for banks and thrifts.

MBA believes that a more effective regulation can be developed that does not hinder institutions' investment in derivative securities with limited risk. We understand that FFIEC is in the process of revising its policy based on comments received from MBA and other industry groups, principally the Public Securities Association.

CMOs and REMICs have produced positive effects for the primary and secondary markets. CMOs have allowed depository institution investors to select investments with maturities and cash flows meeting their investment objectives, thus reducing interest rate risk for the depository institution as a whole. In addition, CMOs and REMICs have boosted the market prices for the underlying pass-through securities, which in turn has translated into more competitive mortgage rates for consumers. Unless steps are taken to amend a recent proposal by the Federal Financial Institutions Examinations Council (FFIEC) these benefits will be sharply diminished. The result will be measurably higher interest rates for American homebuyers.

The FFIEC proposes a quantitative measure for determining which derivative securities are high risk and unsuitable as investments by depository institutions. A high-risk mortgage security is defined as any mortgage derivative product that has (1) an expected weighted-average life greater than eight years (i.e., "average life" test); (2) an expected weighted-average life that extends by more than four years or shortens by more than five years assuming immediate and sustained parallel shifts in the yield curve of plus or minus 300 basis points, respectively (i.e., "average life sensitivity" test); or (3) an estimated change in the price of more than 16 percent due to an immediate and sustained parallel shift in the yield curve of plus or minus 300 basis points (i.e., "price sensitivity" test).

According to estimates provided by Wall Street firms, 44.6 percent of outstanding derivatives will be classified as high risk. This broad impact causes us to be extremely concerned that such an overly stringent policy concerning the investment and reporting of derivative securities will adversely affect the market for CMOs and REMICs and, in turn, the secondary market for pass-through securities.

Of particular concern is the fact that the FFIEC's tests for average life, average life sensitivity and price volatility of derivative products run contrary to FFIEC's stated principle of using the "standard" 30-year fixed-rate mortgage-backed security as a benchmark for determining "high risk" for derivative products. The FFIEC's proposed test for "high risk" appears to have been developed without sufficient consideration of the average life and price sensitivity of non-derivative pass-through securities currently treated as suitable investments for banks and thrifts. In fact, if the "high risk" tests were applied to these pass-throughs, current GNMA 8.5 percent coupons would fail the suitability test because of their weighted-average life of approximately 11 years. Furthermore, an immediate and sustained increase in the yield curve of 300 basis points would extend the life of a current coupon GNMA security just over five years (one year beyond the four-year standard). A 300 basis point decrease would shorten the life by six years (one year beyond the five-year standard).

Because the quantitative criteria do not sufficiently distinguish between high-risk derivatives and "plain vanilla" pass-throughs, MBA believes the average life and average life sensitivity criteria for defining high risk should be amended using GNMA and conventional pass-throughs as benchmarks as follows: (1) a derivative product with an average life of more than 12 years; and (2) a weighted-average life that extends or shortens by more than six years assuming a gradual but parallel shift in the yield curve of plus or minus 300 basis points. MBA believes that a gradual shift in the yield curve is more representational of market-place conditions than an "immediate and sustained" 300 basis point shift in the yield curve as proposed.

In regards to the price sensitivity measure, under the proposal a current coupon GNMA pass-through security would fail to meet the suitability test, because its price sensitivity measure is 18 percent to 19 percent. This supports the belief that the price sensitivity test is too strict a measure of risk and should be eliminated. While CMO prices are mostly governed by life sensitivity, other factors contribute to the price, such as supply and demand, investor psychology and spreads between bid and ask prices. The influence of these other factors on price are hard to ascertain. As a result we do not believe that price sensitivity alone is a reliable enough measure to gauge whether or not an investment is "high risk."

Furthermore, we believe the FFIEC's policy should focus on the entire portfolio of assets and liabilities, rather than focusing on each security in isolation. In many cases, a combination of assets will result in lower overall risk. FFIEC's approach is arbitrary because it would make ineligible certain derivative investments (e.g., longer tranche CMOs) while classifying as "eligible" investments in the securities backing the CMO even though they represent the same set of risks.

FFIEC's characterization of derivative investment as "unsuitable" should only establish a presumption of ineligibility. FFIEC should allow the institution to rebut this presumption if it can demonstrate that, when compared to total portfolio investments, the derivative security reduces total portfolio interest rate risk. Finally, MBA suggests that future changes to the quantitative criteria be applied prospectively and that examiner discretion be limited in order to create some level of certainty for banks and thrifts.

MBA believes that a more effective regulation can be developed that does not hinder institutions' investment in derivative securities with limited risk. We understand that FFIEC is in the process of revising its policy based on comments received from MBA and other industry groups, principally the Public Securities Association.

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Title Annotation: | Mortgage Bankers Association of America's views on the Federal Financial Institutions Examinations Council's quantitative measure for determining which derivative securities are high risk and unsuitable as investments by depository institutions |
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Author: | Taliefero, Michael |

Publication: | Mortgage Banking |

Article Type: | Column |

Date: | Oct 1, 1991 |

Words: | 894 |

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