Title: PROPOSED RULE--Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; Management of Investments; Liquidity; Interest Rate Risk; Eligible Investments--12 CFR Part 615
Issue Date: 12/18/1991
Agency: FCA
Federal Register Cite: 56 FR 65691
___________________________________________________________________________
FARM CREDIT ADMINISTRATION

12 CFR Part 615

RIN 3052-AB25

Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; Management of Investments; Liquidity; Interest Rate Risk; Eligible Investments


ACTION: Proposed rule.

SUMMARY: The Farm Credit Administration (FCA), by the Farm Credit Administration Board (Board) proposes to amend regulations at 12 CFR part 615 to allow Farm Credit Banks (FCBs), banks for cooperatives (BCs), and Agricultural Credit Banks (ACBs) (collectively, System banks) to hold specified eligible investments, in an amount not to exceed 20 percent of the total outstanding loans of such banks, for: (1) Maintaining a liquidity reserve; (2) investing short-term surplus funds; and (3) reducing interest rate risk (IRR). The FCA also proposes to establish by regulation a liquidity reserve requirement for all Farm Credit System (System) banks. The proposed regulations would require FCBs, BCs, and ACBs to follow certain procedures for measuring and managing interest rate risk in their portfolios. The FCA also proposes to strengthen existing requirements that compel the board of directors of each bank to adopt investment policies and procedures that ensure that the bank's investment activities are conducted in a safe and sound manner. The proposed regulations would enable System banks to achieve greater diversification in their investment portfolios by expanding the list of eligible investments, but would place limits on the amount, maturity, and credit rating of eligible investments.

DATES: Comments should be received on or before February 18, 1992.

ADDRESSES: Comments may be mailed or delivered (in triplicate) to Jean Noonan, General Counsel, Farm Credit Administration, McLean, Virginia 22102-5090. Copies of all communications received will be available for examination by interested parties in the Office of General Counsel, Farm Credit Administration.

FOR FURTHER INFORMATION CONTACT:

Michael J. LaVerghetta, Senior Financial Analyst, Technical Support Division, Office of Examination, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4231
or
Richard Katz, Attorney, Regulatory and Legislative Law Branch, Office of General Counsel, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4020, TDD (703) 883-4444

SUPPLEMENTARY INFORMATION:

I. General

The FCA proposes to amend its regulations that govern the investment activities of System banks. The existing regulations authorize Farm Credit banks to hold specified investments for the purposes of maintaining sufficient liquidity, investing surplus short-term funds, and managing short-term debt. The current regulation expressly prohibits System banks from maintaining investment portfolios primarily as a means of generating additional income. The proposed regulations would restrict the amount that each FCB, BC, or ACB could invest in certain eligible investments to 20 percent of its total outstanding loans. These eligible investments could only be used to maintain a liquidity reserve, manage short-term surplus funds, and reduce interest rate risk. For the first time, the FCA is proposing regulations that establish a liquidity reserve and requirements for reducing IRR at all System banks. The FCA also proposes to strengthen requirements in the existing regulation that compel the board of directors of each FCB, BC, or ACB to adopt investment policies and procedures that conform with applicable law, and ensure that competent personnel conduct the bank's investment activities in a safe and sound manner. The proposed regulation would expand the list of eligible investments that Farm Credit banks may use to achieve permissible investment objectives. Eligible investments, however, would be subject to percentage of asset limitations, as well as maturity and credit rating requirements.

Several provisions of the Farm Credit Act of 1971 (Act), 12 U.S.C. 2001 et seq., authorize the FCA to regulate the investment activities of System banks. Section 1.2(a) of the Act, 12 U.S.C. 2002, states that all System institutions are subject to FCA regulations. Sections 1.5(10) n1 and 2.1(13)(A) n2 of the Act authorize FCBs and BCs respectively to "buy or sell obligations of, or insured by the United States or any agency thereof, or securities backed by the full faith and credit of any such agency, and make such other investments as may be authorized under regulations issued by the Farm Credit Administration." Section 5.17(a)(4) of the Act, 12 U.S.C. 2252(a)(4), authorizes the FCA to approve the issuance of System debt obligations to fund the authorized operations of Farm Credit banks and associations. Section 5.17(a)(9) of the Act, 12 U.S.C. 2252(a)(9), authorizes the FCA to prescribe rules and regulations necessary or appropriate for carrying out the Act. Furthermore, section 5.17(a)(10), 12 U.S.C. 2252(a)(10), authorizes the FCA to exercise its enforcement powers to ensure the safety and soundness of System institutions.

n 1 12 U.S.C. 2013(15).

n 2 12 U.S.C. 2122(13)(A).

The FCA now proposes to exercise the powers conferred on it by the above-referenced sections of the Act to amend existing regulations, and to promulgate new regulations, governing the investment activities of Farm Credit banks. The current investment regulations, 615.5135 and 615.5140, have not been substantially revised since they were promulgated by the former Federal Farm Credit Board in 1982. See 47 FR 12136, 12147 (March 22, 1982). The FCA proposed in 1985, and again in 1986 to amend these regulations, however, no final regulations were adopted. See 50 FR 50798 (December 12, 1985); 51 FR 44310 (December 9, 1986). The FCA now withdraws its proposals of December 12, 1985 and December 9, 1986 and offers this proposed regulation.

In the past decade, the investment strategies of all financial institutions, including Farm Credit banks, have been significantly transformed by the development of new financial instruments, the global integration of financial markets, and technological innovations that enhance the ability to manage investment portfolios. The FCA is concerned that these financial and technological developments are rendering the current regulations obsolete. Accordingly, the FCA is proposing to revise these regulations so that FCBs, BCs, and ACBs can diversify their investment portfolios and conduct their investment activities prudently in a rapidly changing financial environment.

II. Definitions

Proposed 615.5131 defines many of the terms that would appear throughout subpart E of part 615. For the most part, proposed 615.5131 contains definitions of financial instruments that the FCA proposes either the authorize or prohibit as eligible investments under 615.5140. These definitions are consistent with terms used by Federal regulators of depository institutions and the securities industry.

Proposed 615.5131 also defines concepts that are crucial for managing liquidity and interest rate risk exposure. "Liquid investments" means assets that can be promptly converted into cash without substantial loss to the investor. The term "interest rate risk" refers to the impact that interest rate fluctuations have upon the bank's net interest income and market value of equity. The term "net interest income" (NII) refers to the difference between interest income and interest expense, while "market value of equity " (MVE) measures the impact that interest rate changes have on the market value of a bank's assets, liabilities, and off-balance sheet items.

III. Investment Purposes

Currently, 615.5135(a) restricts the purposes for which Farm Credit banks may hold investment portfolios to maintaining sufficient liquidity, investing short-term surplus funds, and managing short-term debt. The existing regulation also states that "[t]he banks are not authorized to maintain investment portfolios primarily as a means of generating additional income."

The FCA now proposes to amend and redesignate 615.5135(a) as 615.5132. As amended, proposed 615.5132 would limit the size of a bank's investment portfolio to 20 percent of its outstanding loans. The banks would be allowed to hold these investments solely for the purposes of: (1) Complying with the new liquidity reserve requirement in proposed 615.5134; (2) managing short-term cashflow needs; and (3) reducing interest rate risk pursuant to proposed 615.5135.

The FCA proposes to allow FCBs, BCs, and ACBs to hold eligible investments in an amount not to exceed 20 percent of their outstanding loans so they will have greater flexibility in managing their assets and liabilities. This approach should enable Farm Credit banks to maintain a liquid pool of investments as a protection against market disruptions. Farm Credit banks are sensitive to fluctuations in interest rates. Carefully planned investment strategies should enable financial institutions to combat maturity mismatches and interest rate fluctuations that could threaten their solvency. The proposed 20-percent formula represents the FCA's best judgment on what is a sufficient amount for System banks to maintain liquidity, reduce IRR, and invest short-term surplus funds.

The proposed limitation on total investment holdings is also designed to prevent FCBs, BCs, and ACBs from engaging in arbitrage activities that are incompatible with their status as a government-sponsored enterprise (GSE), which finances agriculture. Farm Credit banks, as instrumentalities of the United States government, generally have access to the money and capital markets at lower interest rates than their private sector competitors. The FCA does not believe it appropriate for the banks to use their GSE status to borrow funds for the purpose of accumulating large investment portfolios for arbitrage activities. As a result, the proposed regulation would continue to prohibit Farm Credit banks from misusing their GSE status to engage in arbitrage activities.

After careful consideration, the FCA proposes the 20-percent limit on investments to balance these two competing objectives. The proposed regulation would provide management with greater flexibility to reduce risks to bank solvency and liquidity, while simultaneously ensuring that Farm Credit banks do not abuse their GSE status by engaging in arbitrage activities primarily for the purpose of generating additional income.

The investment of short-term surplus funds is one of three authorized activities under the proposed regulation. A Farm Credit bank would be authorized to invest excess funds created during the normal course of operations until such time as maturing debt and expenses become due. The management of surplus funds and short-term debts concern the cashflow needs of the bank. These cashflow needs are used for operational matters that should not result in large investment positions over extended periods of time. The banks have daily access to funds through the sale of short-term debt instruments and, therefore, they have limited needs for holding large amounts of operating funds. Funds held for cashflow purposes should be kept to a minimum and be justified by historical analysis of cashflow needs.

The maintenance of a liquidity reserve and interest rate risk management are the only other investment purposes which are authorized by the proposed regulation. Since the FCA is proposing separate sections of the regulations governing liquidity and interest rate risk management, these issues will be discussed elsewhere in this preamble.

IV. Investment Management

Currently, 615.5135(b) requires the board of directors of each bank to adopt a policy regarding the management of its investments. The current regulation requires the policy to address the following items: (1) The purpose of the bank's investments; (2) portfolio objectives; (3) liquidity; (4) the size and quality of the investment portfolio; (5) maturity of investments; (6) internal authority to manage investments; (7) reporting and monitoring controls; and (8) other issues as deemed appropriate by the bank.

The FCA now proposes to redesignate 615.5135(b) as 615.5133, and to strengthen its requirements. As amended, the proposed regulation would continue to require that the board of directors of each bank adopt policies regarding the management of its investment portfolio. The proposed regulation would also expressly prohibit the board of directors from delegating its responsibility for supervising and reviewing the investment practices of the bank.

Under the proposed regulation, the board of directors would be responsible for adopting written investment policies and procedures that comply with the Act, FCA regulations, and other applicable provisions of law. Additionally, these written policies and procedures should ensure that investment management practices do not expose the bank to excessive levels of risks. More specifically, the proposed rule would require System banks to implement sufficient internal controls to preclude investment activities that would undermine the solvency and liquidity of the bank. The board of directors would also be responsible for ensuring that the portfolio managers conduct the bank's investment activities in accordance with board policies. Section 615.5133 of the proposed regulation would also require the board of directors of each Farm Credit bank to review its investment policies annually, and determine whether current investment strategies are achieving the portfolio objectives. The board should also annually review the quality of all investments in the portfolio.

The proposed regulation would require the board of each bank to address, at a minimum, eight broad areas in an acceptable investment policy. The board of directors of any Farm Credit bank could, in its discretion, adopt additional items which are appropriate for achieving the investment objectives of that bank. These policies should establish boundaries for decision-making and represent the investment objectives of the bank's board of directors.

The proposed regulation would combine existing 613.5135(b) (1) and (2) into a single provision. Proposed 615.5133(a) would require that the board's policies address the purpose of investments and portfolio objectives. This revision would not substantively change the current requirements. The FCA emphasizes that the board's portfolio objectives should address a long-term view of investment objectives, and provide direction for the portfolio managers.

The existing regulation requires the board to address the bank's liquidity needs in its investment policy. The FCA is proposing a new regulation, 615.5134, which would establish, for the first time, a liquidity reserve requirement. Accordingly, the FCA proposes to amend current 615.5135(b)(3) (redesignated as 615.5133(b)) to require the board's liquidity policy to comply with the requirements of proposed 615.5134. As amended, proposed 615.5133(b) would require board policy to identify which investments should be held for liquidity management. The relation between proposed 615.5133(b) and 615.5134 is discussed in greater detail in the section of this preamble concerning liquidity.

Proposed 615.5133(c) would require the board of directors of each bank to establish policies pertaining to the management of interest rate risk pursuant to 615.5135 of these proposed regulations. The factors that the board should address in its policy on interest rate risk management are discussed in the preamble to 615.5135.

The FCA proposes to add to the regulation a requirement that the board of directors for each bank develop appropriate guidelines so that portfolio managers place bank funds only through financially sound brokers, dealers, and financial institutions. The proposed regulation would also require the board to establish the maximum amount of funds that portfolio managers are authorized to invest or place with individual brokers, dealers, or financial institutions. In the aftermath of the recent collapse of major investment firms the financial institutions, the FCA emphasizes that Farm Credit banks must take adequate precautions to ensure that their investment portfolios are diversified and that their funds are only placed through solvent parties.

Accordingly, proposed 615.5133(d) would require the board of directors to establish criteria to guide portfolio managers in selecting brokers, dealers, and financial institutions where bank funds will be invested. The credit rating and capital position of the broker, dealer, or financial institution are among the factors that board policy should require portfolio managers to consider when investing bank funds. The proposed regulation would require the portfolio managers, at least semiannually, to update and submit for board approval, a list of institutions where bank funds may be invested. Additionally, proposed 615.5133(e) would require the board of directors to adopt procedures to that portfolio managers routinely monitor and evaluate the financial condition of institutions where bank funds are invested, pursuant to proposed 615.5140.

Proposed 615.5133(e) would retain the requirement in current 615.5135(b)(4) that the board adopt policies concerning the size and quality of investments in the portfolio. The board should structure the investment portfolio in the context of the requirements in proposed 615.5132 pertaining to liquidity, management of surplus short-term funds, and reduction of interest rate risk. While the maximum size of the investment portfolio would be limited by proposed 615.5132 to 20 percent of all outstanding loads, the board of directors, as a matter of policy, may choose to maintain a smaller investment portfolio. The size of the liquidity portfolio should be determined by the maturity structure of the bank's liabilities, as computed under the liquidity reserve requirement of proposed 615.5134. Similarly, the exposure to interest rate risk in the balance sheet should determine the amount of investments maintained for reducing interest rate risk. Furthermore, the board may adopt more stringent requirements concerning the quality of eligible investments than those set forth in proposed regulation 615.5140.

Section 615.5133(f) of the proposed regulation would require the board to establish risk diversification policies. The objective of this proposed provision is to ensure that the board of directors establish boundaries that would prevent an undue concentration of risk in the bank's investment portfolio. An acceptable risk diversification policy should, at a minimum preclude a bank from concentrating its investments in: (1) Particular types of financial instruments (i.e. mortgage-backed securities or prime commercial paper); (2) individual institutions or securities issued by a particular issuer or obligor; (3) particular industries; or (4) certain geographic regions. The risk diversification policies adopted by the board under proposed 615.5133(f) should be consistent with the requirements of proposed 615.5140(a) and (b).

Section 615.5133(g) of the proposed regulation would require the investment policies of the board to assign responsibility and accountability for managing the bank's investment portfolio to specific management positions or committees. The objective of this provision is to formalize the investment management process and establish clear lines of responsibility. Section 615.5133(g) of the proposed regulation is similar to current 615.5135(b)(6).

Section 615.5133(h) of the proposed regulation would continue the requirement in existing 615.5135(b)(7) that the board of directors of each bank establish formal monitoring controls and reporting requirements. The proposed regulation would add a requirement that the portfolio managers present to the board, on a quarterly basis, a detailed report of investment practices and activities. These quarterly reports should summarize past investment actions, detail the performance of current investments, and project planned investment strategies for the next 12 months. The proposed regulation envisions that the board of directors establish controls to prevent theft, fraud, and unauthorized investment practices. Controls should include dual authorizations for security transactions, audit requirements, approval processes, authorization limits, and separation of duties. Policies established by the board pursuant to proposed 615.5133(h) should require senior management to monitor market conditions, portfolio values, investment strategies, and investment activities on a continual basis to ensure that risk exposures are prudently managed.

V. Liquidity Reserve Requirement

Liquidity is based upon the ability to fund assets and liabilities. Since the Farm Credit System is funded through the sale of debt obligations, the liquidity of Farm Credit banks depends largely upon daily access to money and capital markets. In the event that access to these money and capital markets is totally or partially denied, Farm Credit banks draw upon their liquidity reserve, which is an emergency source of funds, to meet short-term funding needs, such as retiring maturing debt obligations, making current interest payments, and paying normal operating expenses.

Historically, the size of the liquidity reserve has been influenced by the Federal Reserve Board, the United States Treasury, and external economic events. The Farm Credit banks are considerably exposed to the vagaries of the marketplace. When Systemwide debt obligations are in demand by investors, and the basis point spreads to comparable maturity United States Treasury issues are near their historical levels, the Farm Credit banks retain a liquidity reserve to fund their exposure to short-term needs for approximately 15 days. However, during a financial crisis, such as the agricultural credit crisis of 1985-1987, loan defaults accelerate and credit quality deteriorates, while bank earnings decline. As a result, interest rate spreads widen dramatically as investor confidence in Systemwide obligations erodes and the Farm Credit banks experience difficulty raising funds in the money and capital markets. When this situation occurs, the Farm Credit banks increase their liquidity reserve so that they are able to fund their operations for approximately 30 days.

In recent years, the banks, acting in concert through the Board of Directors of the Federal Farm Credit Banks Funding Corporation, established a minimum Systemwide liquidity requirement. Under the current System formula, the Farm Credit banks are required, at a minimum, to maintain a liquidity reserve to fund 50 percent of the principal amount of bonds and interest due within 90 days divided by 3, plus 50 percent of the principal amount of discount notes due within 30 days. In effect, this formula requires all Farm Credit banks to maintain a liquidity reserve sufficient to fund their operations for approximately 15 days.

In practice, most Farm Credit banks maintain considerably more liquidity than this minimum requirement. On the average, System banks exceeded this requirement as of June 30, 1991, by about 1.4 times, while the liquidity at some banks was double or triple this requirement. In recent times, some banks have held liquidity up to 4 to 5 times the minimum liquidity requirement. Some Farm Credit banks claim that this excess liquidity is necessary to: (1) Protect market access; (2) hedge against potential increases in the cost of funding Systemwide debt obligations by using liquidity to bypass a Systemwide debt maturity; or (3) build short-term investment portfolios for the purpose of financing potential increases in loan demand. Some banks issue short-term (under 30 days) discount notes to fund and maintain their liquidity requirements.

From the perspective of FCA, these practices go beyond those needed to provide System liquidity. The practice of using excess liquidity to build and maintain an investment portfolio for generating additional income constitutes an abuse of GSE status. Additionally, the practice of issuing short-term obligations to fund current operations actually increases the bank's short-term debt load, and thus increases the amount of liquidity that a bank must maintain in order to meet the minimum Systemwide liquidity requirement. This practice of using the liquidity reserve to generate additional income can no longer be justified since proposed 615.5132 would enable each Farm Credit bank to invest an amount, not to exceed 20 percent of its total outstanding loans, in eligible investments pursuant to proposed 615.5140, for managing liquidity, investing surplus short-term funds and reducing interest rate risk.

Although the FCA endorses the current Systemwide formula which requires all FCBs, BCs, and ACBs to maintain sufficient liquidity to fund a portion of their maturing obligations, interest payments, and discount notes for the next 15 days, the agency, however, believes that this liquidity reserve requirement should not operate as a fixed liquidity level. The proposed regulation would prohibit Farm Credit banks for exceeding the liquidity reserve requirement unless the Farm Credit Administration Board modified or waived the requirement during an emergency.

Accordingly, the FCA proposes 615.5134, which would require each FCB, BC, and ACB to maintain a liquidity reserve to fund: (1) 50 percent of its bonds and interest due within the next 90 days divided by 3; and (2) 50 percent of discount notes due within the next 30 days. The proposed regulation would also require each Farm Credit bank to calculate its liquidity reserve requirement as of the last calendar day of March, June, September, and December, based upon the average daily balance of outstanding loans during the same quarter. The liquidity reserve requirement would remain in effect until it is recalculated for the next reporting period.

As noted above, Farm Credit banks will not be able to comply with this liquidity reserve requirement if their access to the capital and money markets is impeded during a crisis. Proposed 615.5134(b) would enable the FCA Board to modify or waive this liquidity reserve requirement by resolution, whenever the FCA determines in its sole discretion, after consultations with the Federal Farm Credit Banks Funding Corporation, that an agricultural, economic, financial, or national defense emergency impedes normal access to the money or capital markets.

VI. Reduction of Interest Rate Risk

The growing complexity and competitiveness of the financial intermediary market, the volatility of interest rates, and the greater diversity of financial instruments complicate the task of bank management. Interest rate fluctuations have a significant impact upon the net interest income (NII) and market value of equity (MVE) of Farm Credit banks. In this context, it becomes clear that changes in interest rates can undermine the solvency of Farm Credit banks. The effective management of IRR, therefore, is among the most difficult challenges facing boards of directors and bank managers.

Today, some Farm Credit banks utilize investments to help manage a part of their IRR. However, current 615.5135, does not explicitly authorize Farm Credit banks to hold eligible investments for the purpose of managing IRR. The FCA now proposes a new 615.5135, which identifies IRR management as a permissible investment activity by FCBs, BCs, and ACBs.

Bank management must ascertain the impact that interest rate changes could have on the bank's balance sheet, before it can devise an effective investment strategy that will help insulate the bank from IRR. More specifically, the bank management must determine how sudden changes in interest rates would effect the NII and MVE of the bank. Traditionally, bank management has conducted a series of stress tests to measure the bank's exposure to IRR. One of the most significant stress tests requires the bank to simulate the impact that an instantaneous and sustained 200-basis-points (interest rates shock or shocking) increase and decrease in interest rates would have on a bank's current NII and MVE. The FCA recognizes that in conducting IRR shocking, the assumptions used are of paramount importance and FCA would expect the board of directors to be aware of those assumptions.

Interest rate shock tests provide bank management with a method of measuring the impact of changing interest rates on the bank's balance sheet from one reporting period to the next. Interest rate shocks are primarily used for comparative purposes and are not intended to provide realistic expectations concerning future risk exposures. Shocking enables bank management to gauge the bank's exposure to IRR on a continual basis, and understand its impact on NII and MVE over extended periods of time.

Current FCA policy guidance suggests that each Farm Credit bank should conduct an interest rate shock test as part of its strategy to control IRR. n3 The FCA now proposes to require this test by regulation. Accordingly, proposed 615.5135(a) would require the board of directors of each bank to adopt IRR management sections under asset/liability management policies which establish interest rate risk (IRR) exposure limits. Additionally, proposed 615.5135(b) would require all FCBs, BCs, and ACBs to simulate, on a quarterly basis, the impact of an instantaneous and sustained 200-basis-points increase and decrease in interest rates over the next 12 months on the bank's current NII and MVE. Proposed 615.5135(c) would require each Farm Credit bank to develop, at least every quarter, the following three projections of the impact of interest rate changes on the bank's NII and MVE: (1) A best case scenario; (2) a worst case scenario; and (3) a most likely case scenario. Section 615.5135(d) of the proposed regulation would authorize Farm Credit banks to purchase and hold the eligible investments listed in 615.5140 of this subpart in order to reduce IRR resulting from the bank's normal lending operations. Under the proposed regulation, each bank would be required to document, prior to purchase, the reasons why a particular investment is needed to meet IRR objectives. Furthermore, the proposed regulation would require subsequent quarterly reports to indicate whether such investments are satisfying the IRR objectives of the bank.

n 3 See bookletter 281-OE (January 15, 1991) Re: Asset/Liability Management Practices.

The regulatory limits that would be placed on specific investment categories by proposed 615.5140 and overall limits based on loan volume pursuant to 615.5132, should not materially affect IRR practices of the banks because there may be other means for meeting IRR objectives, such as off-balance sheet alternatives, or other asset/liability management techniques.

VII. Eligible Investments

The FCA proposes to expand the list of eligible investments in existing 615.5140 that Farm Credit banks are authorized to hold in order to meet the requirements of proposed 615.5132. The FCA also proposes to promote portfolio diversification by establishing percentage limits on most eligible investments that FCBs, BCs, and ACBs could hold at any particular time. The FCA is concerned that investments by Farm Credit banks are, at the present time, unduly concentrated in the commercial banking industry. The FCA is proposing to amend 615.5140 in order to encourage Farm Credit banks to diversify their investment portfolios.

The expanded list of eligible investments proposed by the FCA are designed to help Farm Credit banks meet the requirements of proposed 615.5132 pertaining to liquidity, IRR, and the investment of surplus short-term funds. Only investments that can be promptly converted into cash, without significant loss, on an established secondary market are suitable for liquidity, IRR management, and the investment of surplus short-term funds. For these reasons, all eligible investments listed in proposed 615.5140 share the following characteristics: (1) Short-term maturities or short-term repricing mechanism; (2) a high investment grade credit rating by a nationally recognized credit rating service; and (3) an active and universally recognized secondary market exists for trading of these investments; and (4) these investments are valuable as collateral.

The proposed regulation would continue to require that all eligible investments be denominated in United States dollars. The FCA believes that currency exchange transactions would unduly complicate the already complex tasks of maintaining liquidity, reducing IRR, and investing surplus short-term funds. The FCA is concerned that Farm Credit banks could suffer significant losses if they engage in currency exchange transactions as part of their investment activities. The FCA emphasizes that nothing in proposed 615.5140(a) would prohibit BCs from exercising their powers to engage in currency exchange transactions for the purpose of financing exports or imports of agricultural products pursuant to section 3.7 of the Act, 12 U.S.C. 2128, and subpart Q of part 614 of these regulations.

A. Obligations of the United States, its Agencies and Instrumentalities

As noted above, sections 1.5(15) and 3.1(13)(A) of the Act authorize FCBs and BCs to invest in obligations issued or insured by the United States or its agencies, as well as securities backed by the full faith and credit of Federal agencies. Existing 615.5140(a) (1)-(8), currently authorize Farm Credit banks to hold obligations issued or fully guaranteed by the United States government, as well as securities issued by the System, the Federal Home Loan Banks, the Federal Home Loan Mortgage Corporation (FHLMC), the Federal National Mortgage Association (FNMA) and the Tennessee Valley Authority. The FCA notes that obligations of the United States, its agencies, and instrumentalities are suitable for managing liquidity, reducing IRR, and investing short-term surplus funds, because they pose virtually no risk of default, and are marketable investments within the meaning of proposed 615.5131(i).

The FCA proposes to allow FCBs, BCs and ACBs to hold obligations (other than mortgage-backed securities) issued or fully guaranteed as to both principal and interest by the United States or any of its agencies or instrumentalities. Although explicit references to the obligations of specific Federal agencies or instrumentalities would be deleted from 615.5140, Farm Credit banks would still be authorized to hold these securities in their investment portfolios. The FCA believes that this proposed amendment will grant Farm Credit banks greater flexibility to invest in obligations issued or guaranteed by the United States, its agencies and instrumentalities.

Proposed 615.5140(a)(1) would not impose any restrictions on the percentage of Federal obligations that Farm Credit banks could hold in their investment portfolios because these obligations are, from a regulatory perspective, inherently safe and sound.

Mortgage-backed securities (MBS) that are issued by an instrumentality of the United States, would be expressly excluded from coverage under proposed 615.5140(a)(1). Instead, proposed 615.5140(a)(2) would authorize Farm Credit banks to hold such MBSs that meet certain requirements. The FCA emphasizes that Farm Credit banks could not rely on proposed 615.5140(a)(1) for authority to hold MBSs that do not meet the requirements of proposed 615.5140(a)(2).

B. Mortgage-Backed Securities

Proposed 615.5140(a)(2) would authorize FCBs, BCs and ACBs to hold MBSs issued by, or fully guaranteed as to principal and interest by the Government National Mortgage Association (GNMA), FNMA, FHLMC, and the Federal Agricultural Mortgage Corporation (Farmer Mac) so long as: (1) All adjustable rate MBSs reprice within 12 months; or (2) All fixed-rate MBSs have an absolute final maturity of 5 years from the time of purchase. The proposed regulation would limit investments in qualified MBSs to 30 percent of the total investment portfolio of the bank.

A MBS represents a fractional undivided interest in a specific pool of mortgages. The mortgages in the pool collateralize the MBS. Basically, as the mortgages in a pool are repaid, both principal and interest payments are passed through to the investor in proportion (pro rata) to the investor's ownership interest in that pool. In contrast to other securities, the investor lacks certainty about the timing and cashflows from these MBSs because most mortgagors (whose loans underlie the security) have the option to prepay the mortgage at any time.

Each MBS has a stated maturity date, a weighted average maturity (WAM), and a coupon rate. The stated maturity date is the date on which the principal amount of the security, based on the longest contractual maturity of any mortgage in the pool, is due and payable to the registered owner of the MBS. The WAM, which is also referred to as the expected average life, represents an estimate of the weighted average length of time that each dollar of principal will be outstanding. The coupon rate is the stated annual percentage rate of interest paid on a fixed-rate MBS for the remaining amount of principal in the pool.

The term "mortgage-backed securities" is a generic term that refers to securities backed by mortgages including pass-through securities, mortgage-backed bonds, mortgage pay-through securities and collateralized mortgage obligations. As noted earlier, the FCA intends to authorize Farm Credit banks to hold only those MBSs which have little or no risk, and therefore, are suitable for maintaining a liquidity reserve, reducing IRR, and investing surplus short-term funds.

Under proposed 615.5140(a)(2), Farm Credit banks would only be authorized to hold certain MBSs issued, or guaranteed as to both principal and interest by FNMA, FHLMC, GNMA, or Farmer Mac. The MBSs issued by GNMA are explicitly backed by the full faith and credit of the United States, while MBSs issued by FNMA and FHLMC are implicitly backed by the United States, and accordingly, are rated AAA by nationally recognized credit rating services. The FCA assumes that once Farmer Mac issues MBSs, they will also enjoy a AAA rating. These MBSs possess little or no risk of default to investors. An active and universally recognized secondary market exists for MBSs issued by these Federal instrumentalities. The virtual absence of credit risk and the size of the secondary market establish a significant level of liquidity for MBSs issued or guaranteed by FHLMC, FNMA, and GNMA.

The FCA also proposes to impose short fixed maturities or short-term repricing characteristics on eligible MBSs in order to reduce the bank's exposure to IRR and prepayment risk. Short maturities also encourage Farm Credit banks to maintain liquid and marketable investments. Proposed 615.5140(a)(2) would allow Farm Credit banks to hold only MBSs backed by: (1) Adjustable rate mortgages (ARMs) which reprice within 12 months; or (2) fixed-rate mortgages (FRMs) with an absolute final maturity of 5 years. Under proposed 615.5131 and 615.5140(a)(2), the "absolute final maturity" of a FRM means that at the time of purchase, the longest contractual maturity of any mortgage remaining in the pool for a fixed-rate MBS shall not exceed 5 years. MBSs, which provide investors with the option to convert the underlying ARMs into FRMs, would not be eligible investments under proposed 615.5140(a)(2).

The current coupon on fixed-rate MBSs and the 12-month repricing mechanism on adjustable rate MBSs provide the liquidity for this type of investment. Farm Credit banks face greater IRR exposure from fixed-rate MBSs than from adjustable rate MBSs. The FCA recognizes that FRMs with an absolute final maturity of 5 years are in short supply in financial markets. While IRR exposure is higher for a FRM with an absolute maturity of 5 years, than an ARM, such FRMs could, in certain situations, be suitable for a bank's investment strategy to manage IRR.

The FCA proposes to exclude derivative products of MBSs from coverage under proposed 615.5140(a)(2). The prime derivatives of MBSs are: (1) Stripped Mortgage-Backed Securities (SMBS); and (2) Collateralized Mortgage Obligations (CMO) or Real Estate Mortgage Investment Conduits (REMIC).

SMBSs are created by segregating the monthly principal and interest cashflows from the underlying mortgages or mortgage securities. As a result, two classes of securities are derived from SMBSs. Investors in interest only (IO) SMBSs receive all of the interest cashflows and none of the principal payments from the underlying mortgages. Conversely, principal only (PO) SMBSs pass through to investors all of the principal cashflows, but none of the interest payments from the underlying mortgages.

The price characteristics of all IOs and POs are extremely volatile because interest rate changes impact the prepayment pattern of the underlying mortgages, which in turn, affects the realized maturity of the stripped securities. From the perspective of the FCA, investors in IOs and POs are speculating on future interest rate movements, and how these movements will affect the prepayment pattern of the underlying mortgages, which in turn, impacts the market value of the SMBS. The FCA notes that the SMBS is a relatively new financial instrument, and accordingly, the secondary market for this investment is not well developed. As a result, a SMBS is not a marketable investment for the purposes of proposed 615.5131(i). For these reasons, the FCA proposes to exclude SMBSs as an eligible investment under proposed 615.5140(a)(2).

CMOs, or REMICs (hereafter CMOs), are also derivatives of MBSs. CMOs were developed in response to investor concerns about the uncertainty of cashflows resulting from mortgage prepayments. Generally, a CMO is collateralized by MBSs issued or guaranteed by GNMA, FNMA, or FHLMC, and held in trust for CMO investors. In contrast to holders of MBSs, who receive a pro rata share of the cashflow, CMO investors hold different classes (tranches) of the bonds, and are paid in accordance with a predetermined schedule. Tranches are created by segmenting the different cashflows from the pool of mortgages that underlie the CMO. Some tranches consist of the earliest cashflows from the mortgages in the pool, while other tranches contain cashflows from the final years of the underlying mortgages. Since the cashflows from the mortgages in the pool are prioritized among separate tranches, different classes of bonds are created with their own maturity, estimated average life, coupon rate, and prepayment risk characteristics.

Many CMOs have one or more Planned Amortization Class (PAC) tranches, which usually have a fixed monthly principal amortization over a set period of time. PAC tranches, which are designed to meet specific investor requirements, are often illiquid and volatile, and therefore, they are not suitable for managing liquidity or investing surplus short-term funds. While these PCA tranches may be effective in reducing IRR, the universe of PAC tranches available in the marketplace is too diverse for effective regulation.

The PAC tranche transfers the prepayment risk to certain higher risk support or subordinated tranches. As a result of the increased prepayment risk, these support or subordinated tranches display highly volatile average life, yield and market price. for these reasons, the FCA is concerned that these support tranches will expose Farm Credit banks to an unacceptable level of interest rate risk, and therefore, proposes to prohibit Farm Credit banks from investing in CMOs.

C. Negotiable Certificates of Deposit

The FCA proposes several modifications to current 615.5140(a)(10), which authorizes Farm Credit banks to hold negotiable certificates of deposit (CDs). As discussed earlier, the FCA is concerned that investments by Farm Credit banks are heavily concentrated in commercial banks. The FCA, therefore, believes that remedial measures are needed to ensure that Farm Credit banks diversify their investment portfolios. The existing regulation, 615.5140(a)(10), imposes no limits on the amount of negotiable CDs that a Farm Credit bank can hold in its investment portfolio. Under proposed (and redesignated) 615.5140(a)(5), negotiable CDs would be limited to 30 percent of the bank's total investment portfolio.

The FCA proposes other revisions to this regulation so that Farm Credit banks hold only negotiable CDs that are suitable for the purposes of proposed 615.5132. For the first time, the FCA proposes that all CDs held by Farm Credit banks mature within 1 year or less. The proposed regulation retains the current requirement that Farm Credit bands only hold negotiable CDs. A CD is negotiable if the instrument contains no restrictions on its transferability.

The FCA is aware that FCBs and BCs currently hold negotiable CDs at depository institutions located in the United States and abroad. Essentially, the three classes of CDs are domestic, Yankee and Eurodollar accounts. Domestic CDs are issued inside the United States by commercial banks, savings associations, and credit unions that are chartered by the United States, or any State or territory thereof. Yankee CDs are issued by the United States branch of a foreign bank. Eurodollar CDs are denominated in United States dollars, and are issued in foreign countries by either local banks or the overseas branches of American banks.

The FCA is concerned that the current difficulties in the commercial banking and thrift industry potentially expose Farm Credit banks to undue financial risks on CDs. Accordingly, proposed 615.5140(b) would prohibit Farm Credit banks from concentrating their CD investments in a limited number of depository institutions. To the extent that a domestic, Yankee, or Eurodollar CD is not insured by an agency of a Federal or national Government, the proposed regulation would require that the depository institution maintain at least a B, or equivalent credit rating by a nationally recognized credit rating service (such as Thompson Bankwatch). The proposed regulation would additionally require the foreign country where Eurodollar CDs are held to maintain an AAA, or equivalent rating for political and economic stability from a nationally recognized credit rating service.

D. Federal Funds

As noted by proposed 615.5131(f), Federal funds are loans, for 1 business day or under a continuing contract, to a Federally insured depository institution. Federal funds increase the depository institution's reserve account with the Federal Reserve Bank. The proposed regulation would authorize Farm Credit banks to hold Federal funds which mature within 1 business day, or are subject to a callable contract. The short maturity on Federal funds are suitable for managing liquidity and investing surplus short-term funds. The FCA proposes to limit Federal funds investment to 30 percent of the bank's investment portfolio in order to encourage risk diversification.

E. Prime Commercial Paper

Currently, 615.5140(a)(11) and (12) authorize Farm Credit banks to hold highly rated prime commercial and finance paper, and limit the investment in each category to 15 percent of the bank's investment portfolio. The FCA proposes to combine existing 615.5140(a)(7).

As amended, the term "commercial paper" will henceforth include finance paper. Both commercial and finance paper are unsecured promissory notes which mature within a timeframe that is usually 270 days or less. The issuer of the debt obligation distinguishes commercial paper from finance paper. Finance paper is issued by financial intermediaries, such as bank holding companies, financial companies, insurance companies, and leasing and factoring companies. Commercial paper is issued by commercial corporations such as public utilities, manufacturers, retailers, wholesalers, and transportation companies. Since this distinction is irrelevant to the objectives of these proposed regulations, the FCA proposes to eliminate the dual terminology.

Proposed 615.5140(a)(6) would continue to authorize Farm Credit banks to only hold prime commercial paper. From a regulatory perspective, commercial paper is compatible with the objectives of proposed 615.5132 regarding the maintenance of a liquidity reserve, the reduction of IRR, and the investment of surplus short-term funds. Proposed 615.5140(a)(6) combines the two existing portfolio limits of 15 percent on commercial paper, to create a single limit of 30 percent. The FCA emphasizes that the amount of commercial paper issued by a single issuer would still be subject to the restrictions of proposed 615.5140(b).

Proposed 615.5140(a)(6) would not change the requirement in the existing regulation that Farm Credit banks only hold commercial paper that is rated P-1 or A-1 by a nationally recognized credit rating service. In situations where the commercial paper is issued by a foreign corporation, or the overseas subsidiary of a United States corporation, the country where the issuer is incorporated would be required by proposed 615.5140(a)(6) to receive the highest possible rating (AAA) for political and economic stability from a nationally recognized credit rating service.

F. Corporate Debt Obligations

For the first time, the FCA is proposing to authorize Farm Credit banks to hold corporate debt obligations that: (1) Mature within 3 years or less; (2) are rated in the two highest investment grades (AA or AAA) by a nationally recognized credit rating service; and (3) are not convertible into equity securities. Additionally, the proposed regulation would limit corporate debt obligations to 15 percent of the bank's total investment portfolio.

The FCA believes that this proposed new authority to invest in high quality, short-term corporate debt obligations will encourage Farm Credit banks to diversity their investment portfolios. Also, the FCA is proposing a short-term maturity deadline and a superior credit rating in order to ensure that Farm Credit banks only purchase highly liquid corporate debt obligations with limited IRR. While an obligation rated AA is of lesser credit quality than a AAA-rated instrument, it is still a superior credit risk, and it is cushioned against any potential downgrading to A or BBB rating, which are also regarded as investment grade.

The FCA proposes to prohibit Farm Credit banks from holding corporate debt obligations that are convertible into equity securities, because the agency believes that it is inappropriate for the banks to have an ownership interest in commercial enterprises. The FCA emphasizes that proposed 615.5140(a)(8) would not prevent the BCs from exercising their powers under section 3.7(b) of the Act, 12 U.S.C. 2128(b), and 615.5143 to directly purchase an ownership interest in a foreign business entity that facilitates the export or import of agricultural products. Similarly, nothing in proposed 615.5140(a)(8) would prohibit System institutions from purchasing and holding Class B common stock in Farmer Mac pursuant to section 8.4 of the Act, 12 U.S.C. 2279aa-4 and proposed 614.5173.

G. Repurchase Agreements

Current 615.5410(a)(13) authorizes Farm Credit banks to hold repurchase agreements on eligible investments enumerated in this section, This provision would be redesignated as 615.5140(a)(9). As defined by proposed 615.5131(p), a repurchase agreement is a transaction where a Farm Credit bank agrees to purchase an eligible security from a vendor, and to sell the same or identical security back to the same party at a later date for a specified price. In effect, these transactions are secured loans. Repurchase transactions usually have a term of 1 day, or are by a continuing contract. Since proposed 615.5140(a)(9) only authorizes repurchase agreements of eligible investments during short periods of time, the FCA determines that these investments are suitable for the purposes of proposed 615.5132.

H. State Obligations

The FCA proposes to redesignate current 615.5140(a)(11), which authorizes Farm Credit banks to hold the full faith and credit obligations of a State, municipality, political subdivision, or agency or instrumentality thereof as 615.5140(a)(10). The FCA proposes no substantive changes to this provision. The FCA notes that Farm Credit banks enjoy tax-exempt status, and therefore, they rarely invest in tax-exempt State obligations. Instead, Farm Credit associations, which are subject to Federal income tax, occasionally purchase the obligations of the States where they are chartered in order to invest in their communities. The investment authority of associations will be addressed in further detail, later in this preamble.

I. Other Investments

New financial instruments are constantly being developed in financial markets. Many of these new instruments may be suitable for managing liquidity, reducing interest rate risk, and investing surplus short-term funds. The FCA seeks to design proposed 615.5140(a)(11) so that Farm Credit banks have flexibility to invest in new financial instruments that fulfill the requirements of proposed 615.5132.

Accordingly, proposed 615.5140(a)(11) would authorize FCBs, BCs, and ACBs to hold, subject to FCA approval, other financial instruments which: (1) have short maturities; (2) are marketable investments pursuant to proposed 615.5131; and (3) maintain a high rating from a nationally recognized credit rating service. In the event that proposed 615.5140(a)(11) is adopted as a final regulation, the FCA would determine on a case-by-case basis whether a new financial instrument meets the requirements of this section.

VIII. Risk Management and Diversification

Proposed 615.5140(b) would impose a percent of capital limit on investments held by Farm Credit banks with a single obligor, issuer or financial institution. The FCA believes that this restriction is necessary for safety and soundness purposes because it compels Farm Credit banks to diversify their risk. Proposed 615.5140(b) would limit investments with individual domestic issuers, obligors or financial institutions to 20 percent of the bank's total capital, while investments with each foreign issuer, obligor or financial institution could not exceed 10 percent of a bank's total capital. The political and/or economic risks in many foreign countries justify the more stringent limit on overseas investments. Obligations of, or fully guaranteed as to both principal and interest by, the United States, its agencies and instrumentalities would be exempt from these restrictions.

As discussed earlier, proposed 615.5133 would require the board of directors of each FCB, BX, or ACB to adopt policies that ensure that portfolio managers invest bank funds only with creditworthy brokers, dealers and financial institutions. Proposed 615.5140(c) would require each bank to continually perform internal evaluations of the creditworthiness of institutions where bank funds are invested. The proposed regulation would require the banks to subscribe to at least one nationally recognized credit rating service in order to assure that the credit quality of all investments are properly monitored. Acceptable nationally recognized credit rating services would include such organizations as Standard and Poor's, Moody Investor's Services, Fitch, Thompson Bankwatch, Duff and Phelps, and International Bank Credit Association.

While rating services provide an important source of information, Farm Credit banks cannot substitute these ratings for their own credit analysis. The FCA recognizes that the credit rating of the same investment differs from one rating service to another. There may also be a lag time between credit rating services as downgrades or upgrades in ratings occur. Accordingly, proposed 615.5140(c) would still require management of each bank to exercise their independent credit judgment when evaluating credit rating information.

IX. Investments by Associations

The associations of the System derive their investment authority from the Act. Production credit associations (PCAs) and Federal land bank associations (FLBAs) are respectively authorized by sections 2.2(11) and 2.12(17) of the Act, 12 U.S.C. 2073(11) and 2093(17) to "buy and sell obligations of or insured by the United States or of any agency thereof or of any banks of the [System]." PCAs are authorized by section 2.2(10) of the Act, 12 U.S.C. 2073(10) to "invest funds of the association as may be approved by the [FCB] under the regulations of the [FCA] and deposit the current funds and securities of such with the [FCB], a member bank of the Federal Reserve System, or any bank insured under the Federal Deposit Insurance Corporation." FLBAs are authorized by section 2.12(18), 12 U.S.C. 2093(18), to "invest association funds in such obligations as may be authorized in regulations of the [FCA] and approved by the bank and deposit securities and current funds of the association with any member bank of the Federal Reserve System, with the [FCB], or with any bank insured by the Federal Deposit Insurance Corporation."

Existing regulations implement these statutory provisions. Current 615.5141 permits PCAs to hold eligible investment under 615.5140, as authorized by the supervising bank. Similarly, existing 615.5142 allows FLBAs to invest its excess cash in the unsecured obligations of its supervising banks and eligible investments under 615.5140, as authorized by its supervising bank.

Current 615.5180 requires the FCBs to semiannually review the investment strategies and investment portfolio of every association in the district. This regulation also requires associations to hold investments listed in 615.5140, as the FCB instructs. Section 615.5180 requires the FCBs to assist the associations in the management of their investment portfolios.

These three regulations were promulgated before the Agricultural Credit Act of 1987 n4 (1987 Act) restructured the System by merging and consolidating both banks and associations. As a result of the 1986 Act, two new types of associations, the agricultural credit association (ACA) and the Federal land credit association (FLCA) have been created. The FCA proposes to revise its regulations pertaining to the investment activities of System associations to reflect these structural changes.

n 4 Pub. L. No. 100-233, 101 Stat. 1635 (1988).

Current 615.5180 is the most comprehensive regulation governing the investment activities of the associations. As noted earlier, this regulation requires FCBs to monitor and supervise the investment activities of associations, while associations are permitted to hold investments listed in 615.5140, subject to FCB approval. This regulation reflects the current relationship between the FCBs and the associations.

The associations receive most of their funding from the FCB in their district. Associations normally use their excess funds to repay direct loan balances with the district bank. Therefore, associations do not maintain large or permanent investment portfolios. Associations do not need to maintain a separate liquidity reserve because they rely upon their district bank for funding.

The FCA proposes to redesignate 615.5180 as new 615.5141, and relocate it to subpart E of part 615. Newly redesignated 615.5141 would be amended to expressly cover PCAs, ACAs, FLCAs, and FLBAs. The FCA also proposes to delete existing 615.5141 and 615.5142 because they are redundant.

X. Divestment of Impermissible Investments

The FCA realizes that some FCBs and BCs may currently hold investments that would no longer be permissible in the event that proposed 615.5140 is promulgated as a final regulation. Certain investments would become ineligible because they would not comply with the investment criteria (such as credit ratings or maturity deadlines) of proposed 615.5140(a). Other investments would qualify as eligible investments under proposed 615.5140, but the bank currently exceeds the percentage limitations that the proposed regulation would impose on a certain category of investments.

Proposed 615.5142 would require FCBs and BCs either to dispose of all prohibited investments within 6 calendar months from the effective date of the final regulation, or in the alternative, to obtain approval from the director of the Office of Examination for a comprehensive plan to bring the bank's portfolio into compliance with 615.5140. While the FCA intends that all Farm Credit banks dispose of ineligible investments as quickly as possible, the agency seeks to avoid situations where the banks are exposed to heavy losses. The FCA is aware that many of these investments will either mature or reprice in the near future. As a result, Farm Credit banks should be able to divest of such investments without significant loss. The FCA proposes to delegate to the director of the Office of Examination authority to approve comprehensive compliance plans, submitted by the banks, to divest ineligible investments over a longer period of time. The proposed regulation would require all applications, and all subsequent approvals or denials to be in writing. The director would be required to consider all relevant factors, such as earnings and capital, when deciding whether to approve a compliance plan. An acceptable compliance program would enable a bank to divest of impermissible investments as soon as possible, without substantial loss.

XI. Miscellaneous

The FCA proposes to rename subpart F as "Property and Other Investments" and to redesignate 615.5150 as 615.5170, 615.5151 as 615.5171, and 615.5160 as 615.5172. The FCA proposes to add a new 615.5173, which would explicitly permit System institutions to purchase and hold Class B common stock in Farmer Mac pursuant to section 8.4 of the Act. These four regulations would become provisions in subpart F.

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, 1.11, 1.12, 2.2, 2.3, 2.4, 2.5, 2.12, 3.1, 3.7, 3.11, 3.25, 4.3, 4.9, 4.14B, 4.25, 5.9, 5.17, 6.20, 6.26; 12 U.S.C. 2013, 2019, 2020, 2073, 2074, 2075, 2076, 2093, 2122, 2128, 2132, 2146, 2154, 2160, 2202b, 2211, 2243, 2252, 2278b, 2278b-6; sec. 301(a) of Pub. L. 100-233.

2. The heading of subpart E is revised to read as follows:

Subpart E -- Investment Management

615.5141 and 615.5142 [Removed]

3. Subpart E is amended by removing 615.5141 and 615.5142.

4. A new 615.5131 is added to read as follows:

615.5131 Definitions.

(a) Absolute final maturity means the date on which the remaining principal amount of a mortgage-backed security is due and payable (matures) to the registered owner. It shall not mean the average life, the expected average life, the duration, or the weighted average maturity.

(b) Adjustable rate mortgage (ARM) means a mortgage-backed security that features a predetermined adjustment of the interest rate at regular intervals tied to an index.

(c) Asset/liability management means the process used to plan, acquire, and direct the flow of funds through a Farm Credit bank in order to generate adequate and stable earnings and to steadily build equity, while taking reasonable and measured business risks.

(d) Collateralized mortgage obligation (CMO) means a multi-class pay-through bond representing a general obligation of issuer backed by mortgage collateral. Each CMO consists of a set of, at least, four tranches of bonds with different maturities and cashflow patterns. An accrual bond is last tranche.

(e) Interest rate risk means the risk of loss resulting from the impact of interest rate fluctuations upon the net interest income and market value of equity of a bank.

(f) Federal funds means funds sold to or bought from a Federally insured depository institution for 1 business day or under a continuing callable contract which increases or decreases that institution's reserve account of immediately available funds with a Federal Reserve Bank.

(g) 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.

(h) Loans is defined as in 621.2(a)(13) of this chapter, and is calculated quarterly (as of the last day of March, June, September, and December) by using the average daily balance of loans outstanding for the previous 90 days.

(i) Marketable investment is 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.

(j) Market value of equity measures the impact that interest rate changes have upon the market value of the bank's assets, liabilities and off-balance sheet items.

(k) Mortgage-backed securities (MBSs) means investment securities collateralized with mortgage loans. MBSs provide for ownership of a fractional undivided interest in a specified pool of mortgages. Each MBS has a stated maturity, expected average life, and coupon rate.

(l) Negotiable certificates of deposit means a negotiable large-denomination time deposit with a specific maturity, as evidenced by a certificate. Yankee certificate of deposit means a certificate of deposit issued in the United States by the American branch of a foreign bank. Eurodollar certificate of deposit means a certificate of 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.

(m) Net interest income means the difference between interest income and interest expense.

(n) Prime commercial paper means an unsecured promissory note of a corporation with a fixed maturity of no more than 270 days that is rated A-1 or P-1 or an equivalent rating by a nationally recognized credit rating service.

(o) Real estate mortgage investment conduit (REMIC) means a nontaxable entity (created under the Tax Reform Act of 1986) formed for the sole purpose of holding a fixed pool of mortgages (both residential and commercial) secured by an interest in real property and issuing multiple classes of interests in the underlying mortgages.

(p) Repurchase agreement means a transaction where any Farm Credit Bank, bank for cooperatives, or Agricultural Credit Bank agrees to purchase a security from a counterparty and to subsequently sell the same or identical security back to that counterparty for a specified price at a later date.

(q) Stripped mortgage-backed securities means 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. In their purest form, stripped mortgage-backed securities represent mortgage-backed securities that have been converted into interest-only securities, where the investor received 100 percent of the interest flows, and principal-only securities, where the investor receives 100 percent of the principal cashflows.

(r) Total capital is defined as in Subpart H -- Capital Adequacy, 615.5201(1) of this chapter.

4a. The FCA proposes to redesignate the following sections in part 615 as set forth in the table below:
Redesignation Table
Existing section
New
section
Subpart
615.5135(a).................................................
615.5135(b).................................................
615.5150......................................................
615.5151......................................................
615.5160......................................................
615.5180......................................................
615.5132
615.5133
615.5170
615.5171
615.5172
615.5141
E
E
F
F
F
E


5. Newly redesignated 615.5132 and 615.5133 are revised to read as follows:

615.5132 Investment purposes.

Farm Credit Banks, banks for cooperatives and Agricultural Credit Banks are authorized to hold eligible investments, listed under 615.5140, in an amount not to exceed 20 percent of the total outstanding loans of such banks, for the purposes of complying with the liquidity reserve requirement of 615.5134, managing surplus short-term funds, and for reducing interest rate risk under 615.5135.

615.5133 Investment management.

The board of directors of each Farm Credit Bank, bank for cooperatives, or Agricultural Credit Bank shall adopt written policies regarding the management of the bank's investments that are consistent with the Farm Credit Act of 1971, Farm Credit Administration regulations, and all other applicable statutes and regulations. The board of directors shall also ensure that the bank's investments are safely and soundly managed in accordance with these written policies, and that appropriate internal controls are in place to preclude investment actions that undermine the solvency and liquidity of the bank. The board of directors shall not delegate its responsibility to supervise and review the investment practices of the bank. The board of directors of each Farm Credit Bank, bank for cooperatives, or Agricultural Credit Bank shall, on an annual basis, review these policies, as well as the objectives and performance of the investment portfolio. At a minimum, the written policy should address:

(a) The purpose and objectives of the bank's investment portfolio;

(b) The liquidity needs of the bank pursuant to the requirements of 615.5134;

(c) Interest rate risk management pursuant to 615.5135;

(d) Permissible brokers, dealers, and institutions for investing bank funds and limitations consistent with 615.5140 of this subpart, and the amount of funds that shall be invested or placed with any broker, dealer or institution;

(e) The size and quality of the investment portfolio;

(f) Risk diversification of the investment portfolio;

(g) Delegation of authority to manage bank investments to specific personnel or committees and a statement about the extent of their authority and responsibilities;

(h) Controls to monitor the performance of the bank's investments and to prevent loss, fraud, embezzlement, and unauthorized investments. Quarterly reports about the performance of all investments in the portfolio shall be made to the board of directors.

6. Sections 615.5134 and 615.5135 are added to read as follows:

615.5134 Liquidity reserve requirement.

(a) Each Farm Credit Bank, bank for cooperatives, and Agricultural Credit Bank shall use the eligible investments under 615.5140 to maintain liquidity sufficient to fund 50 percent of the bank's bonds, notes, and interest due within the next 90 days divided by 3, plus 50 percent of the bank's discount notes due within the next 30 days.

(b) The liquidity reserve requirement shall be calculated quarterly, as of the last day of the months of March, June, September, and December.

(c) The Farm Credit Administration shall modify or waive the liquidity reserve requirement by a resolution of the Farm Credit Administration Board whenever the Farm Credit Administration, determines in its sole discretion, after consultations with the Federal Farm Credit Banks Funding Corporation that an emergency exits. An emergency shall be deemed to exist whenever a financial, economic, agricultural, or national defense crisis impedes the normal access of the Federal Farm Credit Banks Funding Corporation to the capital markets.

615.5135 Reduction of interest rate risk.

(a) The board of directors of each Farm Credit Bank, bank for cooperatives, and Agricultural Credit Bank shall adopt an interest rate risk management section of an asset/liability management policy which establishes interest rate risk exposure limits.

(b) Each Farm Credit Bank, bank for cooperatives and Agricultural Credit Bank shall simulate, on quarterly basis, the impact that a parallel instantaneous and sustained 200-basis-point increase and decrease shift in interest rates would have on net interest income and market value of equity during the next 12 months.

(c) Each Farm Credit Bank, bank for cooperatives and Agricultural Credit Bank shall also quarterly simulate the impact that a best case, worst case, and most likely projection of interest rate changes would have on net interest income and market value of equity during the next 12 months.

(d) Farm Credit Banks, banks for cooperatives and Agricultural Credit Banks are authorized to purchase and hold the eligible investments listed in 615.5140 of this subpart in order to reduce interest rate risk resulting from the bank's normal lending operations. Prior to purchase, each bank shall evaluate in writing how a proposed eligible investment will reduce its interest rate risk. Subsequent to purchase, the bank shall evaluate and document, at least on a quarterly basis, whether the investment has actually met the objective or reducing interest rate risk.

7. Section 615.5140 is amended by revising the section heading and paragraph (a); redesignating paragraph (b) as paragraph (d); and adding new paragraph (b) and (c) to read as follows:

615.5140 Eligible investments and risk diversification.

(a) In order to comply with 615.5132, 615.5134, and 615.5135 of this subpart, each Farm Credit Bank, bank for cooperatives, and Agricultural Credit Bank is authorized to hold the following eligible investments, denominated in United States dollars:

(1) Obligations of the United States and obligations, other than mortgage-backed securities, issued and guaranteed as to both principal and interest by an agency or instrumentality of the United States;

(2) Mortgage-backed securities issued by or guaranteed as to both principal and interest by the Government National Mortgage Association, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Federal Agricultural Mortgage Corporation not to exceed 30 percent of the bank's investment portfolio, and subject to the following requirements:

(i) The mortgage-backed securities shall either be backed by the full faith and credit of the United States, or be rated not lower than AAA (or equivalent) by a nationally recognized credit rating service;

(ii) The securities shall be backed by either adjustable rate mortgages, that are not convertible into fixed-rate mortgages, with a 12-month repricing mechanism tied to an index, or fixed mortgages with an absolute final maturity of 5 years at time of purchase; and

(iii) Stripped mortgage-backed securities including Interest Only (IO) and Principal Only (PO) classes, and Collateralized Mortgage Obligations (CMO) including Real Estate Mortgage Investment Conduits (REMIC) are not eligible investments for the purpose of this section.

(3) Obligations of the International Bank for Reconstruction and Development (The World Bank);

(4) Bankers Acceptances, not to exceed 30 percent of the bank's total investment portfolio;

(5) Negotiable certificates of deposit in an amount not to exceed 30 percent of the bank's total investment portfolio. Any portion of a domestic or Yankee certificate of deposit that is not insured by either the Federal Deposit Insurance Corporation or the National Credit Union Administration, shall be held in a bank that maintains at least a rating of B, or its equivalent by a nationally recognized credit rating services. Eurodollar certificates of deposit that are not insured by the Federal or national government of the host country shall be held at banks maintaining a rating of B or better, and the country where the account is located shall receive an AAA rating (or equivalent) for political and economic stability from a nationally recognized credit rating service;

(6) Federal funds, as defined in 615.5131(f), which shall not exceed 30 percent of the bank's total investment portfolio;

(7) Prime commercial paper, as defined by 615.5131(n) of this subpart, shall not exceed 30 percent of the bank's total investment portfolio. In the event that the prime commercial paper is issued by a corporation located outside the United States, the country where the corporation is incorporated shall maintain a rating for political and economic stability of AAA or its equivalent by a nationally recognized credit rating service.

(8) Corporate debt obligations, not to exceed 15 percent of the bank's investment portfolio, that shall:

(i) Maintain at least a rating of AA, or its equivalent by a nationally recognized credit rating service, and when applicable, the foreign country where the corporate debtor is incorporated shall maintain an AAA rating or its equivalent for political and economic stability.

(ii) Qualify as a marketable investment pursuant to 615.5131(i);

(iii) Mature within 3 years or less from the time of purchase;

(iv) Not be convertible into equity securities.

(9) Repurchase agreements of eligible investments authorized by this section, which have a term of 1 business day or are by a continuing contract.

(10) Full faith and credit obligations of any State, territory, or possession of the United States, or political subdivision thereof, including any agency, corporation, or instrumentality of any State, territory, possession, or political subdivision thereof, provided that the obligations:

(i) Maintain at least a rating of A, or the equivalent, by a nationally recognized credit rating service;

(ii) Mature within 10 years from the date of purchase; and

(iii) Qualify as marketable investments within the meaning of 615.5131(i) of this subpart.

(11) Other investments; as authorized by the Farm Credit Administration, that manifest the following characteristics:

(i) A short maturity;

(ii) Qualify as a marketable investment pursuant to 615.5131(i) of this subpart;

(iii) Maintain a high investment rating by a nationally recognized credit rating service.

(b) Except for eligible investments covered by paragraphs (a) (1) and (2) of this section, each Farm Credit Bank, bank for cooperatives, or Agricultural Credit Bank shall not invest more than:

(1) Twenty (20) percent of its total capital in eligible investments issued by any single institution, issuer, or obligor which is incorporated in, or chartered by, the United States, or any State or territory thereof; or

(2) Ten (10) percent of its total capital for eligible investments issued by any single institution, issuer, or obligor which is incorporated or chartered outside of the United States.

(c) Each Farm Credit Bank, bank for cooperatives, and Agricultural Credit Bank shall perform ongoing evaluations of all eligible investments held in its portfolio. Each bank shall support its evaluation with the most recent credit rating of each investment by at least one nationally recognized credit rating service.

8. Newly redesignated 615.5141 is revised to read as follows:

615.5141 Association investment portfolios.

Each Farm Credit Bank shall review annually as of June 30 of December 31 the investment portfolios of every Federal land bank association, production credit association, agricultural credit association, and Federal land credit association in the district. Associations are authorized to hold eligible investments pursuant to 615.5140 as authorized by the Farm Credit Bank. Each Farm Credit Bank shall assist the associations in managing their investment portfolios to reduce interest rate risk and to invest surplus short-term funds.

9. A new 615.5142 is added to read as follows:

615.5142 Disposal of ineligible investments.

Any Farm Credit Bank, bank for cooperatives, or Agricultural Credit Bank that holds investments that are not in compliance with 615.5140 shall dispose of such investments within 6 months of the effective date of the final regulation unless the director of the Office of Examination approves in writing a comprehensive written plan to comply with 615.5140. The Office of Examination shall consider whether the proposed plan will enable the bank to dispose of impermissible investments within a reasonable period of time, without a substantial loss to the earnings or capital of the bank.

11. The heading for subpart F is revised to read as follows:

Subpart F -- Property and Other Investments

12. A new 615.5173 is added to read as follows:

615.5173 Stock of the Federal Agricultural Mortgage Corporation.

Banks and associations of the Farm Credit System are authorized to purchase and hold Class B common stock of the Federal Agricultural Mortgage Corporation pursuant to section 8.4 of the Farm Credit Act.

Dated: December 11, 1991.

Curtis M. Anderson,

Secretary, Farm Credit Administration Board.

[FR Doc. 91-30015 Filed 12-17-91; 8:45 am]

BILLING CODE 6705-01-M