Investment and Deposit Activities

NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Part 703

RIN 3133-AB73

Investment and Deposit Activities

AGENCY: National Credit Union Administration (NCUA).

ACTION: Final rule.

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SUMMARY: The final regulation clarifies a number of areas, adds

restrictions on some securities which have been determined to be

inappropriate for credit unions, broadens authority in certain areas,

and requires that a credit union's staff and board of directors meet

certain safety and soundness standards with respect to the potential

risks of the credit union's investment options.

DATES: This rule is effective January 1, 1998. However, early

participation in the pilot program in Sec. 703.140 may begin on or

after July 18, 1997.

ADDRESSES: National Credit Union Administration, 1775 Duke Street,

Alexandria, Virginia 22314-3428.

FOR FURTHER INFORMATION CONTACT: David M. Marquis, Director, Office of

Examination and Insurance, (703) 518-6360, or Daniel Gordon, Senior

Investment Officer, Office of Investment Services, (703) 518-6620, or

at the above address.

SUPPLEMENTARY INFORMATION:

A. Background

In recent years there have been significant advances in modeling

and measuring the risk factors of debt instruments. During this same

period, financial market innovations severed any necessary link between

the cash flows of an instrument and its underlying collateral. Based on

these developments, which deal directly with safety and soundness

issues, NCUA has shifted the focus of Part 703 from emphasis on

specific instruments to the characteristics that affect risk management

of investment activities.

Proposed Rule

On November 16, 1995, the NCUA Board issued a proposed rule to

significantly revise Part 703. 60 FR 61219 (November 29, 1995). The

proposal (i) emphasized credit union board and staff understanding of

the potential risks associated with a credit union's investment

activities and (ii) established new procedures to value and monitor

instruments in the investment portfolio. The comment period was to have

expired on March 28, 1996, but was extended three times. 61 FR 8499

(March 5, 1996); 61 FR 29697 (June 12, 1996); 61 FR 41750 (August 12,

1996). The comment period expired on November 18, 1996.

Comments

Federal credit unions, state-chartered credit unions, corporate

credit unions, trade organizations, securities broker-dealers,

investment advisors, state credit union regulators, law firms, banks,

and individuals delivered a total of 596 comments to NCUA on the

proposed rule. A majority of the commenters supported the general

approach of the proposed rule but suggested specific changes. A sizable

minority of the commenters disagreed with substantial portions of the

proposed rule. NCUA thoroughly evaluated the comments and incorporated

many of the suggested changes into this final rule.

CMO Study

The preamble to the proposed rule noted an NCUA study of

approximately 300 credit unions with investments in collateralized

mortgage obligations (CMOs) and Real Estate Mortgage Investment

Conduits (REMICs) in excess of capital (CMO Study). The CMO Study

revealed that in 39 percent of the credit unions, credit union managers

did not fully understand and appreciate the interest rate risk of CMOs/

REMICs, 24 percent of credit unions were taking unacceptable risks, and

47 percent did not have acceptable asset-liability management policies.

A number of commenters stated that the CMO Study, by itself, did not

justify all of the proposed changes to Part 703.

NCUA notes that while the CMO Study provided important information

regarding the management and understanding of some individual

investments, it was not the primary impetus for the proposed changes.

The safety and soundness concerns raised by the prospect of continuous

innovation in the financial marketplace and increasing interest rate

risk to credit union balance sheets, together with technical

innovations that aid the analysis of risk, motivated NCUA to amend the

rule to place greater emphasis on risk management.

Final Rule

This final rule establishes parameters for risk assessment and

permits credit unions to operate flexibly within those parameters. At

the same time, it minimizes the regulatory burden on those credit

unions that choose to maintain a simple portfolio of investments.

A credit union's balance sheet risk only partially arises from its

investment activities. In fact, on average, investments constitute

approximately one-third of all credit union assets. Comprehensive risk

management should include an ongoing risk evaluation of the entire

balance sheet and appropriate asset-liability management (ALM) policies

and procedures. NCUA has decided not to develop an ALM rule at this

time because of the diversity of approaches that could be appropriate

for credit unions. Instead NCUA will evaluate a credit union's ALM

through the examination process.

An underlying premise of the regulation is that a credit union must

establish its own risk limits and measure, monitor, and control the

risks it decides to undertake. Credit unions that have the capacity for

minimal risk management will necessarily set conservative risk

parameters in order to meet the requirements of the rule. On the other

hand, credit unions that have the capacity to measure, monitor, and

control greater risks may set broader parameters.

Many credit unions will, as part of their standard business

practice, establish policies and procedures which properly go beyond

the minimum requirements of this rule. In fact, one of the primary

conclusions of the six focus groups conducted in the early stages of

development of the rule was that the rule reflected sound business

principles and would impose little additional burden on most credit

unions.

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Format

Although the proposed rule was written in the traditional

regulatory format, this final rule uses plain language drafting

techniques that have been promoted by the Vice President's Regulatory

Reinvention Initiative. The goal of plain language drafting is to

decrease confusion, inadvertent errors, the need to seek clarification

in correspondence and phone calls, and the amount of staff time credit

unions must devote to understanding the regulations. Plain language

drafting emphasizes the use of informative headings (often written as a

question), lists and charts where appropriate, sections and paragraphs,

non-technical language (including the use of ``you''), and sentences in

the active voice. This final rule is written as a series of questions

and answers, asked by a federal credit union and answered by NCUA. The

words ``I'' in a question and ``you'' in an answer refer to a federal

credit union. Occasionally, the regulation refers to ``you'' performing

some action in relation to ``your'' board of directors. This should be

read as a credit union's staff and/or management performing the action

in relation to the credit union's board.

One plain language drafting technique is to move definitions away

from the beginning of a regulation, to avoid bombarding the reader with

terms for which there is no context. In this final rule, a number of

definitions have been moved to the end of the part, and others to where

the term is used.

Although commenters did not have the opportunity to express

opinions on the plain language format prior to its use in this final

rule, NCUA believes that the benefits of using the format justify this

omission. NCUA welcomes comments on the format, however, and

suggestions on how to improve it. NCUA is committed to converting more

of its regulations to the plain language format in order to reduce

regulatory burden and notes that the recently issued proposed rules

governing credit union service organizations, 62 FR 11779 (March 13,

1997), and production of nonpublic records and testimony of NCUA

employees in legal proceedings, 62 FR 19941 (April 24, 1997), and an

upcoming proposed rule governing member business loans use plain

language drafting.

B. Section-by-Section Analysis

Section 703.10 What Does Part 703 Cover?

The proposed rule deleted some sentences in the scope section as

unnecessary, and added the provision that Part 703 does not apply to

corporate credit unions. Investment activities of corporate credit

unions are governed by Part 704. The proposed rule, however, did not

change the format of the section. To improve readability, this final

rule divides the section in two, with Section 703.10 addressing what

Part 703 does cover and Section 703.20 addressing what it does not

cover. The language in Section 703.10 is a slight rewording of the

first two sentences in the scope section of the proposed rule to

provide further clarification, with no change in meaning intended.

Section 703.20 What Does Part 703 Not Cover?

In the scope section of the proposed rule, the clauses addressing

the activities and entities not covered by Part 703 follow one another

as part of one dense paragraph. To improve readability, Section 703.20

of this final rule sets out each activity or entity separately.

As noted above, the proposed rule added the provision that Part 703

does not apply to corporate credit unions. The preamble explained that

the investment activities of corporate credit unions are governed by

Part 704 of NCUA's regulations. There was no objection to this

proposal, and it has been retained in the final rule.

One commenter suggested that the rule should expressly state that

Part 703 does not apply to state-chartered credit unions. NCUA agrees

and has added paragraph (f) to Section 703.20. That paragraph states

that Part 703 does not apply to state-chartered credit unions, except

as provided in Section 741.3(a)(3) of NCUA's regulations. Under Section

741.3(a)(3), a state-chartered credit union must establish a separate

reserve if it invests in instruments not permitted for federal credit

unions by Part 703 or the Federal Credit Union (FCU) Act. In a limited

sense, therefore, Section 703.110, which sets forth activities that are

prohibited for federal credit unions, ``applies'' to state-chartered

credit unions. Paragraph (f) clarifies, however, that the other

requirements of Part 703 do not apply to state-chartered credit unions.

Section 703.30 What Are the Responsibilities of My (a Federal Credit

Union's) Board of Directors?

Section 703.3(a) of the proposed rule expanded on the current

rule's requirements regarding investment policies. Section 703.3(b) of

the proposed rule established a new list of required investment

practices. This final rule divides policies and practices into two

sections; Section 703.30 addresses policies and Section 703.40

addresses practices. In addition, the final rule modifies many of the

specific policies and practices that were proposed. Of the commenters

who addressed this section generally, most agreed with the need to have

investment policies.

Purposes and Objectives of Investment Activities

Proposed Section 703.3(a)(1) required that the board of directors

state in the credit union's policies the purposes and objectives of the

credit union's investment activities. The intent was that the policy

provide a clear statement of the credit union's investment goals. For

example, a credit union's primary goals may be to minimize risk,

provide liquidity, and generate a reasonable rate of return. The

emphasis placed on each goal will vary based on individual credit union

constraints or needs. NCUA received no comments on this provision and

has retained it in Section 703.30(a) of the final rule.

Characteristics of Authorized Investments

Proposed Section 703.3(a)(2) required that a credit union's

investment policy set out the investments that the credit union may

make, by issuer and characteristics. The definitions section of the

proposed rule defined an investment characteristic as a feature of an

investment such as its maturity, index, cap, floor, coupon rate, coupon

formula, call provision, or average life. The preamble stated that a

policy could, for example, authorize investments issued or guaranteed

by the U.S. Treasury, the Federal Home Loan Mortgage Corporation, and

the Federal National Mortgage Association, or could limit investments

to instruments with a maximum maturity of 5 years, or those with a

fixed coupon, or those tied to a particular index. A few commenters

expressed concern that the requirement was too restrictive and would

not allow management sufficient flexibility in making investment

decisions.

NCUA did not intend for boards to specify the parameters of each

approved investment. The intent was for boards to establish guidelines

for investment characteristics. NCUA believes that it is imperative for

a board, which sets the overall ALM strategy for the credit union, to

set investment guidelines and risk parameters that are consistent with

that strategy. Further, for the guidelines to be meaningful, they must

be fairly specific. Therefore, the requirement has been retained in the

final rule, at Section 703.30(b). The language has been modified,

however, to clarify that

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the issuer is another type of characteristic.

The following additional examples may prove helpful in illustrating

the types of policy statements that NCUA might see boards establish: 3-

year bullets (securities that make one principal payment at maturity)

with a fixed coupon; variable rate securities linked to the 3-month

Treasury bill yield or U.S. dollar-denominated LIBOR that, at the time

of purchase, are at least 300 basis points below their cap; and fixed

rate federally insured deposits of one year or less. With respect to

the last, NCUA would not view as necessary that the policy go on to

list specific authorized depository institutions.

As an alternative to the type of limits discussed above, or in

addition to such limits, a board could specify acceptable interest rate

risk for individual investments. For example, a policy could restrict

the credit union to purchasing instruments that are predicted to

experience a price change of less than a certain percentage for an

immediate and sustained parallel shift in the yield curve of a certain

amount. A credit union choosing this approach must be confident it has

the methodology to assess this potential risk.

Interest Rate Risk

Section 703.3(a)(3) of the proposed rule required credit unions to

develop policies on interest rate risk management. One commenter noted

that the rule did not define ``interest rate risk.'' Stated in the

broad context of ALM, interest rate risk is the exposure of a credit

union's current and future earnings and capital arising from adverse

movements in interest rates. Changes in interest rates affect a credit

union's earnings by changing its net interest income and the level of

other interest-sensitive income and operating expenses. Changes in

interest rates also affect the underlying economic value of the credit

union's assets, liabilities, and off-balance sheet items. These changes

occur because the present value of future cash flows, and in many cases

the cash flows themselves, change when interest rates change. The

combined effects of the changes in these present values reflect the

change in the credit union's underlying economic value as well as

provide an indicator of the expected change in the credit union's

future earnings arising from the change in interest rates. While

interest rate risk is inherent in the role of credit unions as

financial intermediaries, a credit union that has a high level of risk

can face diminished earnings, impaired liquidity and capital positions,

and, ultimately, greater risk of insolvency.\1\

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\1\ This discussion of interest rate risk comes from a joint

agency policy statement on interest rate risk issued by the Office

of the Comptroller of the Currency, the Board of Governors of the

Federal Reserve System, and the Federal Deposit Insurance

Corporation in May 1996. See 61 FR 33166, 33167 (June 26, 1996).

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Since this rule is limited to investment activity, it only

addresses interest rate risk in the investment portfolio. Several

commenters observed that a credit union should manage interest rate

risk through its ALM policies and procedures, which additionally take

into account its loan portfolio and liabilities. NCUA recognizes that

interest rate risk can be more fully evaluated this way but, for

reasons discussed in the background section of this preamble, has

decided to limit the rule to investments. A credit union with an ALM

policy that addresses interest rate risk across the balance sheet,

however, need not establish a separate policy addressing interest rate

risk in the investment portfolio.

No commenters objected to the requirement that a credit union

develop a policy on how it will manage interest rate risk in its

investment portfolio, and the requirement has been retained in Section

703.30(c) of the final rule. Based on the comments and further NCUA

discussion, a sentence has been added requiring that a credit union's

interest rate risk management policy establish the amount of risk that

the credit union can take with its investments in relation to its net

capital and earnings.

A credit union's interest rate risk policy must be commensurate

with the scope, size, and complexity of the risks the credit union

assumes. The policy of a credit union with a simple portfolio and

conservative risk parameters might specify that net capital, earnings,

or investment income, may not vary by more than a certain percentage

for a parallel shift in interest rates. The policy of a credit union

with a complex portfolio, however, might also set limits that reflect

changes in the shape of the yield curve, credit spreads, prepayment

patterns, and volatility.

Liquidity Risk

Section 703.3(a)(6) of the proposed rule required credit unions to

develop policies on liquidity risk management. Liquidity risk is the

risk that a credit union will have insufficient liquid assets to meet

immediate cash demands. A liquid asset is one that can be converted

quickly into cash with minimal loss. The intent was that the board

assess the potential for cash demands, document how it arrived at this

assessment, and establish a liquidity policy that will enable it to

meet the demands. Only one commenter opposed the requirement, and it

has been retained in the final rule, in Section 703.30(d).

In assessing the potential for immediate cash demands, credit

unions may use a simple estimate, based upon the history of prior cash

flows. Credit unions also may use a more elaborate approach. Two

commenters suggested that the occasional, temporary use of alternative

balance sheet funding sources (short-term borrowing) is a reasonable

part of liquidity management. NCUA does not disagree but emphasizes

that borrowing should be part of a well thought-out liquidity plan.

Credit Risk

Section 703.3(a)(7) of the proposed rule required credit unions to

develop policies on the management of credit risk, including approved

issuers, or criteria for issuers, and limits on the amounts that may be

invested with each issuer. As noted in the preamble to the proposed

rule, a credit union may rely on credit ratings to manage credit risk.

However, boards should be aware that ratings may fail to timely reflect

a creditor's deteriorating ability to repay its obligations and is only

one source of credit information. A credit union without the ability to

evaluate credit risk may choose to limit its investments to those that

are fully guaranteed or insured. The provision is located at Section

703.30(e) of the final rule.

Concentration Risk

Section 703.3(a)(4) of the proposed rule required credit unions to

set concentration limits in their investment policies. The preamble

stated that the board must develop concentration limits for, among

other things, shares and deposits in corporate credit unions. The

commenters generally supported the requirement to establish

concentration limits, but a number asked whether NCUA would continue

its policy of not taking exception to credit unions placing 100 percent

of their investments in corporate credit unions. Examiners will not

automatically object to 100 percent concentration in a corporate credit

union, but will require all but the smallest credit unions investing

more than the insured amount in a corporate to perform an appropriate

credit analysis. The scope of credit analysis for investments in

corporates and other institutions and issuers is addressed in the

discussion of credit analysis under Section 703.40(e).

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Concentrations can increase a credit union's vulnerability to

unforeseen market, credit, and liquidity risks. Each credit union must

evaluate concentration risk in relation to its financial condition and

its ability to analyze the risks of all investments. The provision is

located at Section 703.30(f) of the final rule.

CMO/REMIC Prepayment Models

Section 703.3(a)(5) of the proposed rule directed credit unions to

identify in their investment policies the specific CMO/REMIC prepayment

models they would use when performing the tests required to purchase or

hold CMOs/REMICs. This was to control the practice of selecting the

prepayment model that would allow a particular CMO/REMIC to pass the

tests. The preamble noted that each credit union had the flexibility to

choose the prepayment models it believed were the best measures of

potential risk, as long as they were reasonable and supportable.

One commenter stated that NCUA should specify which models are

permissible and accept the fact that models are imperfect and will

sometimes give different results.

Since the forecasting of prepayments is an evolving science, NCUA

prefers to leave to each credit union the decision as to which models

it will use. For consistency, it is essential that a credit union use

the same models for testing all CMOs/REMICs.

This final rule moves some material that was in the CMO/REMIC

testing section to the policy section. It clarifies that a credit union

board's first policy decision will be whether the credit union will use

a median prepayment estimate or individual, proprietary estimates. Once

that determination is made, the credit union may use only that method.

If the choice is to use a median estimate, the board then must

determine the source of that estimate, whether it be Bloomberg or

another similar source. If the choice is to use individual estimates,

the board then must determine the sources of those estimates. In

response to a comment, the final rule uses the less confusing term

``prepayment estimate'' rather than ``prepayment model.'' Finally, in

response to a comment, the final rule clarifies that a board must set

policies for prepayment sources for CMO/REMIC testing only where it has

authorized the purchase of CMOs/REMICs. The provision is located at

Section 703.30(g) of the final rule.

Investment Authority

Section 703.3(a)(8) of the proposed rule required a credit union to

state in its investment policy the persons in the credit union to whom

investment authority was delegated, the knowledge and experience

required of such persons, and the extent of their authority. The

provision also stated that this requirement could be met by the board's

approval of position descriptions that address the same criteria. In

addition to this policy requirement, Section 703.3(b)(2)(i) of the

proposed rule required that a credit union follow certain practices

regarding investment authority. It stated that any official or employee

of a credit union who had discretionary investment authority had to

``demonstrate'' an understanding of the risk characteristics of

investments and investment transactions under that authority. It

provided that only a credit union's officials, employees, and members

could be voting members of its investment and/or asset-liability

management committees. Finally, it explicitly affirmed that the

ultimate responsibility for supervising a credit union's investment

activities rested with the board of directors.

There was some confusion regarding the burden that would be imposed

on directors with respect to understanding the risk of authorized

investments. It was never NCUA's intention to require volunteers to

understand all of the factors that affect the risks of each instrument.

This appropriately remains the responsibility of the individuals to

whom investment authority has been delegated. It is the responsibility

of the board, however, to set policy limits, approve procedures,

understand the overall risks associated with the investments, and

receive reports assessing whether the portfolio has remained within

established limits.

The final rule combines proposed Sections 703.3(a)(8) and

703.3(b)(2)(i) into a policy requirement at Section 703.30(h). That

provision requires the investment policy to specify who, of the credit

union's officials and employees, has investment authority and the

extent of that authority. The final rule does not explicitly provide

that the requirement may be met by approving appropriate position

descriptions. NCUA omitted the provision because it was unnecessarily

detailed and might suggest that there was no other way to meet the

requirement. It remains a permissible way to meet the requirement.

Section 703.30(h) also states that individuals given investment

authority must be professionally qualified, by education and/or

experience, to exercise that authority in a prudent manner and to fully

comprehend and assess the risk characteristics of investments and

investment transactions under that authority. Rather than requiring

that persons with investment authority ``demonstrate'' an understanding

of the risk characteristics of the investments under that authority,

the final rule simply requires that they be qualified to exercise that

authority. It is the responsibility of the board to ensure such

qualification.

Section 703.30(h) states that only a credit union's officials and

employees may be voting members of a credit union's ``investment-

related committee.'' Credit unions use a variety of terms for the

committee that is primarily concerned with investments. The proposed

rule used ``investment committee,'' ``asset-liability management

committee,'' or a combination of the two. To avoid inadvertently

excluding a committee with a different name, the final rule uses the

term ``investment-related committee'' throughout.

The final rule also does not include ``member'' in the list of

individuals who can be voting members of that committee. The proposed

rule intended to allow credit union members who serve on such

committees to be able to vote. To lessen confusion, however, the final

rule redefines ``official'' to include a member of a credit union's

investment-related committee.

Finally, Section 703.30(h) does not contain the statement that the

ultimate responsibility for supervising a credit union's investment

activities rests with the board. It is not necessary to make the

statement in the regulation, as Section 113(6) of the FCU Act, 12

U.S.C. 1761b(6), provides that a federal credit union's board of

directors shall have charge of investments.

Broker-Dealers

Section 703.3(a)(9) of the proposed rule required that a credit

union's investment policy list approved broker-dealers and limits on

the amounts and types of transactions for each. The preamble noted that

although the proposal did not require approval of more than one broker-

dealer, reliance on a single individual or firm could be

disadvantageous to the credit union. A credit union might choose to

approve one broker-dealer for the full range of its investment

activities and another for only certain of the investments authorized

by policy. For example, the credit union may permit one broker, with

more limited knowledge, to sell to

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the credit union only Treasury securities with less than 1 year

maturity, while permitting another, with more knowledge and ability, to

sell longer term securities or securities with embedded options issued

by U.S. government agencies, as well as Treasury securities. The

preamble stated that details for these authorizations should be

established by policy.

In response to comments, NCUA has deleted the language regarding

establishing limits on the amounts and types of transactions. In

addition, Section 703.30(i) of the final rule clarifies that the

requirement to list approved broker-dealers applies only if the credit

union uses third parties to purchase or sell investments. A credit

union could purchase an investment without using a third party by, for

example, obtaining a certificate of deposit (CD) directly from a bank

or a Treasury security through the Treasury Direct program. The final

rule defines any such third party as a ``broker-dealer,'' even if that

third party only buys and sells investments that do not meet the formal

definition of ``security,'' such as CDs. Section 703.30(i) also

requires that the credit union maintain the documentation the board

used to approve a broker-dealer as long as the broker-dealer is

approved and until the documentation has been both audited and

examined. That requirement was located at Section 703.3(b)(10) of the

proposed rule.

Safekeeping

Section 703.3(a)(10) of the proposed rule required that a credit

union's investment policy list approved safekeeping entities and limits

on the amounts and types of investments that could be safekept with

each entity. In response to comments, NCUA has deleted the language

regarding amounts and types of investments and the requirement to

maintain documentation used to approve a safekeeper. Section 703.30(j)

of the final rule clarifies that the requirement to list approved

safekeepers applies only if a credit union uses such entities. Also in

response to comments, NCUA wishes to make clear that corporate credit

unions may serve as safekeepers.

``Failed'' Investments

Section 703.4(b)(3) of the proposed rule required that management

notify the board by the next board meeting of any investment that,

because of changing market conditions, falls outside of board policy

after purchase. The proposed rule also created an entire section,

Section 703.7, which established divestiture requirements for a credit

union holding an investment that, because of a credit downgrade or

failure to meet an interest rate shock test, no longer meets regulatory

mandates. Many commenters stated that the proposed requirements,

particularly those regarding ``failed'' investments, preempted the

board's right to establish its own policies in those areas.

NCUA has determined to retain only a few simple requirements for

investments that fail board policy or part 703. They are contained in

Section 703.40(f) of the final rule. Other than these, Section

703.30(k) requires that the board establish its own policies for such

investments.

Trading

Section 703.3(a)(11) of the proposed rule required that a credit

union establish trading policies, if it engages in trading. The

provision listed a number of items that the policies should address. In

1987 NCUA issued Letter to Credit Unions No. 89, which discussed

trading activities. This Letter is still effective. No significant

comments having been received on this provision, it is retained in the

final rule, at Section 703.30(l).

Section 703.40 What General Practices and Procedures Must I Follow in

Conducting Investment Transactions?

As noted earlier, Section 703.3(b) of the proposed rule established

a list of required investment practices. Those practices, many of which

have been modified, are found in Section 703.40 of this final rule.

Classification of Securities

Section 703.3(b)(1) of the proposed rule required that a credit

union classify securities in accordance with generally accepted

accounting principles (GAAP). The applicable principle is Statement of

Financial Accounting Standard (SFAS) 115. The preamble stated that

deposits and shares in depository institutions are not securities and

are not subject to SFAS 115. In response to comments, NCUA notes that

the Financial Accounting Standards Board has stated that jumbo CDs may

meet the definition of security and may be subject to SFAS 115. A

credit union should review the relevant disclosure documents to

determine whether a CD meets the definition of security. The

classification provision has been retained in the final rule, at

Section 703.40(a).

Delegation of Discretionary Investment Authority

Section 703.3(b)(2)(ii) of the proposed rule established a general

prohibition against delegating discretionary control of investment

authority to a person other than an official or employee of the credit

union. However, proposed Section 703.3(b)(2)(iii) permitted a credit

union to delegate such control to an investment adviser who is

registered with the Securities and Exchange Commission (SEC) under the

Investment Advisers Act of 1940. Proposed Section 703.3(b)(2)(iii)

limited the total of a credit union's delegation of discretionary

investment control and investment in mutual funds to 100 percent of

capital.

The commenters strongly opposed the limitation on delegation of

discretionary investment control, particularly the inclusion of

investments in mutual funds in that limitation. Some of the concern

stemmed from confusion over the concept of ``delegation of control.''

Although Section 703.3(b)(2)(ii) stated that control was not considered

delegated if the credit union authorized each purchase and sale,

several commenters thought that a traditional relationship with a

broker-dealer was included in the concept. A credit union has not

delegated discretionary investment control where its broker-dealer

recommends purchases and sales but does not act until it has received

the credit union's approval for the specific transaction. Likewise, if

a credit union is receiving investment advice from an investment

adviser but is still approving each purchase and sale, it has not

delegated discretionary investment control.

For example, if a broker proposed that a credit union purchase a

specific security, and the credit union authorized the purchase, the

credit union has not delegated discretionary control. On the other

hand, if a broker informed a credit union that CMOs/REMICs with 2-year

weighted average lives looked like good investments, and the credit

union responded that the broker should purchase one that ``looks

good,'' the credit union has delegated discretionary control.

NCUA has determined to retain the general prohibition against

delegation of discretionary investment control, except under certain

conditions. Section 703.40(b) establishes the prohibition, and Section

703.40(c) establishes the conditions under which delegation is

permitted. No commenters objected to the proposed requirement that

delegations of discretionary control be limited to investment advisers

registered with the SEC, and it has been retained in paragraph (c)(1).

Paragraph (c)(2) makes explicit what is a part of normal business

practices; that is, analyzing a potential investment adviser's

background.

[[Page 32994]]

Section 703.3(b)(2)(iii) of the proposed rule restricted how an

investment adviser could be compensated, to keep his or her interest

allied with that of the credit union. Several commenters suggested that

the provision be modified to make it clear that there are no

restrictions on compensating a registered investment adviser who does

not have discretionary investment control. NCUA agrees and has made the

change. The provision is located at paragraph (c)(3) of Section 703.40.

Proposed Section 703.3(b)(2)(v) required that investments under the

discretionary control of an investment adviser be classified as either

available-for-sale or trading. One commenter was opposed to this

provision, but NCUA continues to believe it is necessary and has

retained it, at paragraph (c)(4) of Section 703.40. Paragraph (c)(5)

codifies what should be a part of normal business practices, that is

receiving a monthly statement from an adviser.

Finally, as noted above, proposed Section 703.3(b)(2)(iii) limited

the total of a credit union's delegation of discretionary investment

control and investment in mutual funds to 100 percent of capital. In

response to the commenters' concerns, NCUA has determined not to

include investments in mutual funds in the limitation. Also in response

to the comments, NCUA has clarified that the limitation is the

aggregate of a credit union's delegation of discretionary control, that

is, regardless of the number of investment advisers a credit union

uses, it may delegate discretionary control over the portion of its

investment portfolio that represents 100 percent of its capital. This

provision is located at paragraph (c)(6) of Section 703.40. NCUA notes

that whenever a credit union uses any third party, such as investment

adviser, broker-dealer, or safekeeper, to carry out investment

transactions on its behalf, it must ensure that the third party

complies with the restrictions of Part 703 and the FCU Act. This could

be accomplished through written agreement with the third party.

Credit Analysis

Section 703.3(b)(6) of the proposed rule required credit unions to

perform credit analyses of issuing entities unless the investment is

issued or guaranteed by the U.S. government or is covered by share or

deposit insurance. Recognizing that it often is difficult for credit

unions to perform detailed credit analyses, the proposed rule

established a minimum rating of B/C for financial institutions that are

rated. The preamble noted that credit unions should perform credit

analyses for uninsured investments in nonrated financial institutions,

including corporate credit unions.

A number of commenters expressed concern regarding the proposed

requirements, particularly credit analyses of corporate credit unions.

They argued that credit analyses were too burdensome and that credit

unions should be permitted to rely entirely on ratings. Many wondered

how credit analyses of corporate credit unions could be conducted,

while others believed it was not necessary, since corporate credit

unions are examined by NCUA.

NCUA recognizes that a small credit union may be unable to perform

a detailed credit analysis. For a small credit union, investing funds

in corporate credit unions is an appropriate risk management

alternative to investing in securities. NCUA will not take exception to

a small credit union investing all of its surplus funds in a corporate

credit union.

NCUA expects a larger credit union, however, to perform a credit

analysis whenever there is credit risk. The uninsured portion of an

investment in a corporate credit union presents such risk. NCUA

supervises corporate credit unions and is primarily concerned with

their safe and sound operations and adherence to applicable laws,

rules, and regulations. This supervision does not serve as a guarantee

of the investment products a corporate credit union may offer, nor as

assurance against potential loss.

A credit union's membership relationship with its corporate should

assist it in evaluating the corporate's operations and financial

condition. A credit union should review the corporate credit union's

earnings performance, capital level, and investment portfolio. A credit

union also should be aware of the corporate's operating level under

Part 704 and its exposure to a 300 basis point shift in interest rates.

In addition to uninsured investments in corporate credit unions,

investments with credit risk include uninsured CDs, federal funds, bank

notes, municipal securities, and repurchase transactions. As with

investments in corporate credit unions, a credit union must conduct a

credit analysis of these other investments that is commensurate with

the risk of the exposure. The analysis should include a review of

capital, ratings, financial trends, earnings, and loan losses. While

the proposed rule required that this analysis be updated semiannually,

the final rule requires only an annual update. The final rule, located

at Section 703.40(d), also does not establish a minimum financial

institution rating. The commenters noted that the ratings from the

various rating agencies are not consistent and that too many

institutions are unrated.

``Failed'' Investments

As noted above in the discussion of Section 703.30(k), the proposed

rule required board notification of investments that fall outside of

board policy after purchase and also established divestiture

requirements for investments that fail the regulation. In response to

comments, NCUA determined to retain the board notification requirement

for investments failing board policy and to eliminate all of the

requirements for investments failing the regulation except board and

NCUA notification. These requirements are located at Section 703.40(e)

of the final rule. To the extent that Section 703.40(e) conflicts with

Letter to Credit Unions No. 169, governing CMOs/REMICs that fail the

stress test, the Letter is superseded. Credit unions should not

interpret the removal of specific divestiture requirements from the

final rule as NCUA's tacit approval to hold a failed investment

indefinitely. On the contrary, NCUA will continue to review the safety

and soundness of failed investments to determine whether divestiture is

necessary. As always, instruments that were impermissible when

purchased may be subject to immediate divestiture.

Documentation

Proposed Section 703.3(b)(10) required that documentation be

maintained through the examination and audit cycles. The preamble noted

that there had been instances where credit unions failed to maintain

enough documentation for the examiner and auditor to properly analyze

the security or determine the relationship of the investment decisions

to the credit union's policies. There were few comments on this

section, and it has been retained in the final rule, at Section

703.30(f). A credit union must maintain sufficient information to

demonstrate that it has exercised prudent judgment in making investment

decisions.

Section 703.50 What Rules Govern My Dealings With Entities I Use To

Purchase and Sell Investments (``Broker-Dealers'')?

Section 703.3(b)(7) of the proposed rule required that any broker-

dealer used by a credit union be either a federally regulated

depository institution or registered with the Securities and Exchange

Commission

[[Page 32995]]

(SEC). The proposed rule also required that credit unions conduct an

analysis of the financial condition and reputation of the broker-dealer

and sales representative. The comments on this section were mixed, with

some in favor of the proposed requirements and others objecting that

they were too burdensome. NCUA continues to believe that credit unions

should do business only with broker-dealers that meet a certain minimum

standard of conduct and has retained the requirement. This means that

even when purchasing a CD through a broker who only sells CDs, the

broker must be either registered with the SEC or a federally regulated

depository institution.

NCUA also believes that credit unions should exercise due diligence

in determining whether to transact business with a broker-dealer and/or

sales representative. As an additional control, a credit union should

consider prohibiting any official or employee with discretionary

investment authority from maintaining a personal account with the same

sales representative that the credit union uses. If the broker-dealer

acts as a credit union's counterparty in transactions, introducing

credit risk, the credit union must increase its level of due diligence.

Section 703.60 What Rules Govern My Safekeeping of Investments?

Section 703.3(b)(8) of the proposed rule established new

safekeeping requirements for credit unions. It required that a credit

union maintain its securities independently of its broker-dealer and

that it receive a safekeeping receipt for each investment held in

safekeeping. It permitted an investment to be held in street name as

long as the credit union and/or safekeeper maintain documentation

establishing that the credit union is the beneficial owner of the

investment. It required a credit union to review the financial

condition of approved safekeepers at least annually and that purchases

and sales be ``delivery versus payment,'' where payment for an

investment occurs simultaneously with its delivery.

In response to comments, NCUA has eliminated the requirement to

obtain safekeeping receipts, the requirement to review the financial

condition of approved safekeepers, and the language regarding street

name. A credit union may permit investments to be held in the name of a

broker or nominee and should maintain documentation showing that it is

the true owner of the investments. The credit union should be listed as

owner on the individual confirmation statements and monthly safekeeping

statements required by the final rule.

The proposed requirement for investments to be held by a safekeeper

under a written custodial agreement has been retained in the final

rule. In response to comments, however, NCUA wishes to clarify that the

provision does not require that the agreement be between the credit

union and the custodian. The agreement may be between the broker and

the custodian, although in that case, the credit union should obtain a

copy.

Section 703.70 What Must I Do to Monitor My Non-Security Investments

in Banks, Credit Unions, and Other Depository Institutions?

One of the challenges of this rule was establishing criteria to

ensure that credit unions with portfolios of securities know the risks

of those instruments, while permitting credit unions that restrict

their investments to CDs and corporate credit union deposits to do so

without undue burden, even though those instruments can present some

credit and interest rate risk. Sections 703.3 (b)(4) and (b)(5) of the

proposed rule required credit unions to perform certain actions to

value and monitor their securities. The GAAP definition of ``security''

includes marketable instruments such as Treasuries, agencies, mortgage

backed instruments, and as previously discussed, certain jumbo CDs. The

only monitoring provision that addressed investments that were not

securities, such as ordinary CDs and corporate deposits, was at

proposed Section 703.3(b)(4)(ii)(A), which required credit unions to

prepare monthly reports listing the characteristics of each investment

held.

Some commenters expressed concern that the requirements for

securities also applied to ordinary CDs and corporate deposits. This

final rule maintains the proposed rule's distinction between

``securities'' and ``investments,'' but to make it clearer that a

credit union that chooses to invest only in ordinary shares and

deposits need not worry about the requirements for securities, this

final rule establishes a separate section for investments in depository

institutions that do not constitute securities. Further, the regulatory

burden itself has been reduced. Section 703.70 requires a credit union

to list, quarterly rather than monthly, the dollar value of only those

non-security shares or deposits that have embedded options, remaining

maturities greater than 3 years, or coupon formulas related to more

than one index or inversely related to, or multiples of, an index. A

credit union's board should be aware of the potential risk of shares or

deposits with these characteristics.

Section 703.80 What Must I Do to Value My Securities?

Proposed Section 703.3(b)(5)(i) required that before purchasing or

selling a security, a credit union obtain a price quotation from a

second broker or from an industry-recognized information provider. The

preamble noted that credit unions have been known to pay or receive

prices that were significantly different from market prices because

their brokers knew they were not verifying prices with other sources.

A number of commenters objected to the requirement to obtain a

second price, arguing that it was burdensome and unrealistic. NCUA

continues to believe that it is imperative for credit unions to ensure

that they know the market prices of the securities they buy and sell,

and has retained the requirement, at Section 703.80(a). Again, to

minimize burden, the rule allows a credit union to obtain a second

price from an industry-recognized information provider. This may be an

electronic service that provides market information (Bloomberg,

Reuters, etc.) or a newspaper of general and regular circulation (Wall

Street Journal, New York Times, etc.). NCUA recognizes that prices from

information providers are indicative only, but they should show whether

a broker's price is reasonable. To further reduce burden, and in

response to comments, an exception has been added for new issues

purchased at par.

The rule does not require that the credit union use the broker with

the best price. NCUA understands that a credit union can receive

ancillary services from a broker that are not reflected in fees, and a

credit union may choose to compensate the broker by occasionally

accepting a poorer price than that available from another broker.

However, credit unions should be aware of the implicit cost of these

services. Therefore, as discussed earlier, Section 703.40(g) requires

that a credit union document the prices it pays or receives for

securities. NCUA understands that prices received from broker-dealers

generally will not be in writing; however, the credit union should

document who was called, the date and time of the call, and the quoted

price or spread to the relevant security. A phone note with the

identified information would meet this requirement.

Proposed Section 703.3(b)(5)(ii) required a monthly review of the

fair value of each security in a credit union's

[[Page 32996]]

portfolio. The preamble noted that this information generally is

provided by broker-dealers or safekeepers. There was virtually no

opposition to this requirement, and it has been retained in the final

rule, at Section 703.90(b).

To ensure some independent verification of a broker's or

safekeeper's prices, proposed Section 703.3(b)(5)(iii) required credit

unions to obtain semi-annual prices on their securities from another

broker or an industry-recognized information provider. In response to

comments, Section 703.80(c) of the final rule simply requires a credit

union's supervisory committee to comply with existing auditing

standards and annually assess the reliability of prices received from a

broker or safekeeper. Credit unions or their auditors should refer to

the practices and procedures discussed in the investments chapter of

the American Institute of Certified Public Accountants guide Audits of

Credit Unions.

Proposed Section 703.3(b)(5) provided, throughout, that where a

credit union could not obtain the price of a particular security, it

could obtain the price of one with substantially similar

characteristics. Rather than repeating this each time a price is

required, Section 703.80(d) of the final rule states it generally.

Section 703.90 What Must I Do to Monitor the Risk of My Securities?

Monthly Report

Proposed Section 703.3(b)(4)(ii) (A) and (B) required a federal

credit union to prepare a monthly report showing the characteristics of

each investment in the portfolio and the change in the fair value or

total return of each security since the date of purchase and for the

last month. In response to comments, NCUA has eliminated the

requirement to list the characteristics of each investment each month.

In addition, since several commenters were confused about the total

return concept, NCUA has deleted all references to total return from

the rule, although credit unions may choose to calculate it in addition

to fair value.

A number of commenters questioned the need to calculate the fair

value of securities classified as hold-to-maturity. NCUA has determined

to retain the requirement for a credit union to report the fair value

and dollar change since the prior month-end of all its securities,

since those changes can affect future earnings. For example, in a

rising interest rate environment, with rate-sensitive members, a credit

union may be compelled to increase its share rates. A credit union with

fixed coupon investments experiences no equivalent increase in interest

income. The resulting decline in earnings occurs regardless of whether

the securities are classified as hold-to-maturity or available-for-

sale. Therefore, it is important for the investment-related committee

and board to know what has happened to the value of all those

securities. The requirement is located at Section 703.90(a) of the

final rule. A credit union that chooses to keep all of its investments

in CDs and corporate credit union shares and deposits is not required

to price its investments and therefore is not subject to the

requirement.

Quarterly Report

Proposed Section 703.3(b)(4)(ii)(C) required a credit union to

calculate, quarterly, the value of securities that NCUA determined

represented greater potential interest rate risk. They were: (1)

Securities that amortize; (2) securities with embedded options; (3)

securities with maturities greater than 3 years; and (4) securities

where contract rates are related to more than one index or are

inversely related to, or multiples of, an index.

In response to comments, NCUA has removed amortizing securities

from the list, located at Section 703.90(b) of the final rule. Most

amortizing securities that represent greater potential interest rate

risk will be included because they contain embedded options. NCUA

includes all securities with embedded options because even put

provisions and interest rate floors can affect the price of a security

independent of actual changes in interest rates. To be consistent with

market terminology, NCUA also has changed the term ``contract rate'' to

``coupon formula.''

A number of commenters urged that the maturity threshold be

extended to 5 years, to be consistent with the definition of risk asset

in Section 700.1(i) of the NCUA Rules and Regulations. NCUA notes that

the proposed requirement and the risk asset regulation have different

purposes and effects. The classification of a security as a risk asset

under Section 700.1(i), results in a credit union having to transfer

additional income to reserves under Section 116 of the FCU Act. In

contrast, the only result of classifying a security as representing

greater potential risk under Part 703 is that a credit union might have

to test its securities to gain important information about the interest

rate risk on its balance sheet. NCUA believes that significant risk

would be missed by failing to include securities with maturities from 3

to 5 years in the category that could trigger testing requirements and

has determined to leave the threshold at 3 years. NCUA has clarified,

however, that maturity means remaining maturity.

Several commenters suggested excluding U.S. Treasury and agency

securities from the group that represents greater potential risk. This

comment reflects a misunderstanding of the risk being evaluated. The

securities at issue are those that represent greater potential interest

rate risk, not credit risk. Although Treasury and agency securities do

not present credit risk, they can have considerable interest rate risk

depending on their characteristics. To some extent, this risk can be

estimated by subjecting these securities to interest rate shock tests.

Shock Test

Under Section 703.3(b)(4)(iii) of the proposed rule, if the total

value of securities determined to represent greater potential risk was

greater than a credit union's capital, the credit union was required to

calculate the potential impact, on the fair value and/or total return

of each security in the portfolio and the portfolio as a whole, of

parallel shifts of plus and minus 300 basis points. The purpose of the

analysis was to determine the impact of potential shifts in interest

rates on the credit union's future capital position.

NCUA recognized this was a naive test and that substantial risks

could be missed by credit unions holding potentially more risky

securities in a total amount less than capital. NCUA believed, however,

that the requirement represented a reasonable compromise between

imperfect risk assessment and the burden that would result if every

credit union had to test every security.

As limited as the testing was, a number of commenters argued that

it would be too burdensome, suggesting that the threshold of 100% of

capital be raised to 150% or 200%. To determine the impact of the

requirement on federal credit unions, NCUA analyzed data from December

1995 call reports. NCUA used assumptions about the characteristics of

Treasury and agency securities that probably caused more of such

securities to be included than would actually be the case. The results

of the analysis are described in the following table:

------------------------------------------------------------------------

Asset size (in millions) A B C

------------------------------------------------------------------------

$50...................................... 462 795 58.1%

-----------------------------

[[Page 32997]]

Total............................... 921 7,244 12.7%

------------------------------------------------------------------------

A--Number of federal credit unions that would be required to complete

the 300 basis point stress test.

B--Total number of federal credit unions in the respective asset

ranges.

C--Percentage of A to B (AB=C).

The analysis shows that, at most, only 921, or 12.7 percent, of all

federal credit unions would be required to subject their portfolios to

the test. The vast majority of these have assets greater than $10

million. NCUA believes that the test would not be a significant burden

to these credit unions and that it is imperative for these credit

unions to monitor their potential interest rate risk. Therefore, it has

retained the test, at Section 703.90(c). Credit unions that are either

unwilling or unable to monitor their risk through the test should

rethink their investment strategy. In response to comments, however,

NCUA has reduced their frequency of the test from monthly to quarterly.

Further, as discussed earlier, to avoid confusion, there is no longer

any reference to total return.

NCUA understands that credit unions with deteriorating securities

in the hold-to-maturity portfolio may have less and less likelihood of

meeting the shock test ``hurdle'' due to the use of fair value versus

amortized cost in the calculation. Since securities classified as hold-

to-maturity are not adjusted to fair value, when their value goes down,

there is no corresponding decrease in net capital. As a result, the

ratio of potentially more risky securities to net capital declines.

This may lead to the anomalous situation of a decreasing requirement to

test, because the threshold is less likely to be triggered when hold-

to-maturity values are declining substantially. However, the purpose of

the test is to show potential problems with the portfolio, and

securities rapidly losing value will already be reported under Section

703.90(a).

Some commenters suggested that a test that applies to securities

but not deposits could induce some credit unions to purchase deposit

instruments that have the same risk characteristics as the securities

that trigger the test. If the test is not triggered, the credit unions

will be ignorant of the interest rate risk of their investments. NCUA

was aware of this trade-off, and chose not to impose the test on credit

unions with minimal investments in securities. However, Section 703.70

requires credit unions to list shares and deposits with the relevant

risk characteristics. This information should make credit union boards

aware of the possibility of interest rate risk. In addition, NCUA

intends to collect the information through the call report.

Section 703.100 What Investments and Investment Activities Are

Permissible for Me?

Contracting for Securities

Current Section 703.4(a) permits a credit union to contract for the

purchase or sale of a security provided that the delivery of the

security is to be made within 30 days from the trade date. This

accommodates the settlement of U.S. government and agency securities.

Section 703.4(b) permits a credit union to enter into a cash forward

agreement to purchase or sell a security provided that the period from

the trade date to the settlement date does not exceed 120 days. This

was designed to accommodate the settlement of mortgage-backed

securities. Section 703.4(a) of the proposed rule deleted these

specific time frames, and the authority to enter into cash forward

agreements, and simply provided for a credit union to contract for the

purchase or sale of a security provided that delivery of the security

was by ``regular-way'' settlement.

The current regulation had created some problems distinguishing

between regular delivery and forward commitments. The proposed

regulation was intended to permit a credit union to contract for the

purchase of a security no matter when it settles, as long as the

settlement date is within the normal time frame that the securities

industry has established for that type of security. Regular-way

settlement varies, depending on the type of security and whether it is

being purchased or sold on the secondary market or is a new issuance.

Securities industry practices for regular-way settlement have

become well-defined for most types of investments that are permissible

for credit unions. The time frames arise from customary practice in the

securities industry among brokers and dealers, guidelines established

by the Public Securities Association, and requirements of the

Securities and Exchange Commission and the Municipal Securities

Rulemaking Board.

Regular-way settlement for the most common types of secondary

market securities purchased or sold by credit unions is either one or

three business days after the trade date. For securities that are just

being issued, the time frame from trade date to settlement date can be

considerably longer, depending on the period between the announcement

of the offering and the issuance of the security. Although several

commenters expressed concern about being bound by regular-way time

frames, NCUA is not convinced that it is necessary to go beyond regular

way. Therefore, it has retained the requirement, at Section 703.100(a).

Indexes

The current rule is silent as to the types of indexes to which

variable rate instruments can be tied. Section 703.4(h) of the proposed

rule limited permissible indexes to those tied to domestic interest

rates only. These include, for example, constant maturity Treasury and

U.S. dollar-denominated LIBOR rates, Prime, and the 11th District Cost

of Funds. The preamble noted that this would prohibit a credit union

from purchasing an investment linked to an equity index, either as a

speculative investment or to match against a product offered to a

member. NCUA continues to believe that it is not appropriate for a

credit union to invest in an instrument that does not correlate to its

cost of funds, and has retained the prohibition, at Section 703.100(b).

The provision also prohibits a credit union from purchasing the new

inflation-indexed Treasury bonds.

Corporate Credit Unions

Proposed Section 703.4(f) addressed credit union investments in

corporate credit union capital shares and deposits. The proposed rule

limited credit union investment in the capital shares of a corporate

credit union to a total of one percent of the investing credit union's

assets, due to the potential risk associated with such investments.

A number of commenters seemed confused by the provision, believing

that NCUA was proposing a limit on all investments in corporate credit

unions. That is not the case. The proposed limit does not apply to

regular shares or deposits in corporate credit unions; it applies only

to capital shares, which can come in two forms:

Membership capital and member paid-in capital. To clarify the scope

of the limitation, the final rule expressly uses those terms. NCUA

intends that a credit union be limited to investing a total of 1

percent of its assets, all in membership capital, all in member paid-in

capital, or divided between them, in each corporate credit union in

which it invests. A few commenters expressed concern that some credit

unions might now have more than 1 percent of assets in capital shares

in one corporate credit union. Any such investment will be

grandfathered.

[[Page 32998]]

A credit union must fully understand the risks associated with

paid-in and membership capital before making such investments. An

investing credit union must be aware that its funds are at risk and

that it may not have access to them for 20 years, in the case of paid-

in capital, and 3 years, in the case of membership capital. Corporate

credit unions are required to fully disclose the conditions of their

capital instruments, and a credit union should review the disclosures

carefully before deciding to invest.

Common Trust Funds, Mutual Funds, and Other Investment Companies

Section 703.4(j) of the current regulation provides that a federal

credit union may invest in a mutual fund, provided that the investments

and investment transactions of the fund are legally permissible for

federal credit unions under the FCU Act and NCUA regulations. Proposed

Section 703.4(d) broadened this authority by permitting investment in

an investment company that was registered with the Securities and

Exchange Commission under the Investment Company Act of 1940.

The proposal retained the requirement that the investments and

investment transactions of the investment company be permissible for

federal credit unions and clarified that this limitation be established

by the company's prospectus and/or statement of additional information,

changeable only by shareholder vote. One method of establishing that a

fund was a permissible investment was for the prospectus to state that

it was ``a legal investment for federal credit unions'' or ``legal

under the FCU Act and NCUA Rules and Regulations.'' The proposed rule

also limited the aggregate of a credit union's investment in investment

companies and delegation of discretionary investment control to an

investment adviser to 100 percent of capital.

In response to comments, NCUA has eliminated the shareholder

approval requirement in Section 703.100(d) of the final rule. NCUA also

has determined that Section 703.100(d) need not explicitly mention the

statement of additional information, since it is generally incorporated

by reference into the prospectus. In addition, NCUA has removed the

limitation on how much a credit union may invest in an investment

company.

NCUA also has deleted the sentence that described how a mutual fund

can establish that it is a permissible investment for federal credit

unions. Some commenters mistakenly concluded that it meant that for a

mutual fund to be legal for federal credit unions, the prospectus was

required to say that the fund complies with the FCU Act and NCUA Rules

and Regulations. The sentence was intended to make it clear that NCUA

was departing from the position taken in Letter to Credit Unions No.

155, which required that a prospectus detail every investment and

transaction authorized for a fund, so that a credit union could

determine whether the fund was a permissible investment. As noted in

the preamble to the proposed rule, NCUA found it difficult to establish

how much detail was necessary to determine that a fund engaged only in

activities that were permissible for credit unions. The proposed

sentence intended to convey that one way of meeting that requirement

was for a prospectus to state that the fund was permissible. Federal

securities laws require that a prospectus accurately represent the

activities of the fund.

To avoid confusion, NCUA has deleted the sentence. The position

remains the same, however. A credit union should review the prospectus

of any mutual fund in which it is considering investing. If the

prospectus lists the authorized investments and investment activities

of the fund in sufficient detail for the credit union to determine that

all of them are permissible, it may invest in the fund. If the

prospectus lists the activities of the fund generally, and none of them

are impermissible for federal credit unions, but also states that the

fund is ``legal under the FCU Act and NCUA Rules and Regulations,'' or

something to that effect, a credit union may invest in the fund.

Regardless of whether a prospectus states that a fund is legal for

federal credit unions, if it is clear that some of the activities are

impermissible, a credit union may not invest in the fund.

A final change to this section was the addition of bank-managed

collective investment funds, also known as common trust funds, as

permissible investments. Such funds are subject to the same rules as

are mutual funds regarding the underlying investments and content of

the prospectus.

CMOs/REMICs

Section 704.4(e) of the proposed rule addressed the high risk

securities test (HRST) for CMOs/REMICs. The most significant change was

the application of the entire test to variable as well as fixed rate

CMOs/REMICs. NCUA had determined that the price sensitivity portion of

the HRST failed to reflect adequately the impact of basis and cap risk.

Although a number of commenters objected to applying the average life

and average life sensitivity tests to variable rate CMOs/REMICs, NCUA

has concluded that the requirement should substantially reduce the risk

exposure for these securities and has retained it at Section

703.100(e).

Municipal Securities

Section 703.4(g) of the proposed rule established minimum credit

ratings for municipal bonds. Credit unions were limited to purchasing

bonds rated in one of the two highest rating categories by at least one

nationally recognized statistical rating organization (NRSRO). In

response to comments, NCUA has expanded the category of permissible

municipal bonds to those rated in one of the four highest rating

categories, that is, those that are investment grade. NCUA also has

added language to explain NRSROs. The provision is located at Section

703.100(f).

Depository Institutions

Section 703.4(c) of the proposed rule permitted a credit union to

sell federal funds to a Section 107(8) institution, and Section

703.4(h) provided that a credit union could purchase yankee dollar

deposits, eurodollar deposits, and banker's acceptances. NCUA received

no comments on these sections and has retained them in Sections 703.100

(g) and (h), respectively, of the final rule. To clarify and

standardize positions it has taken in opinion letters, NCUA also has

added the authority to purchase deposit notes and certain bank notes.

Repurchase Transactions

Section 703.4(b) of the proposed rule simplified the language

authorizing credit union investment in repurchase transactions. NCUA

received no negative comments on the provision and has retained it at

Section 703.100(i) of the final rule. The provision has been clarified

to require daily assessment of the market value of the repurchase

securities and explicitly includes the standard practice of entering

into signed contracts with approved counterparties. Credit unions

should review NCUA Interpretive Ruling and Policy Statement (IRPS) No.

85-2 for a detailed discussion of appropriate controls for repurchase

transactions.

Reverse Repurchase Transactions and Securities Lending

Proposed Section 703.6 established a new section addressing the

pledging of securities through reverse repurchase transactions,

securities lending, and collateralized borrowing. In response to a

comment, the final rule establishes separate sections for reverse

repurchase

[[Page 32999]]

transactions and securities lending, Sections 703.100 (j) and (k),

respectively. The final rule does not explicitly address collateralized

borrowing. The new sections have been clarified to require daily

pricing of any securities received in the transaction. The sections

also include the standard practice of entering into signed contracts

with approved counterparties and borrowers. IRPS 85-2, discussed above,

provides guidance for reverse repurchase transactions and may also be

consulted when lending securities.

Trading

The current regulation does not specifically address trading

practices. Section 703.3(b)(9) of the proposed rule incorporated

trading practices from Letter to Credit Unions No. 89. NCUA received no

comments regarding the proposed trading practices but did receive

several comments urging that when-issued trading and pair-off

transactions be permitted in the trading account. NCUA agrees, and in

addition to describing required trading practices, Section 703.100(l)

of the final rule authorizes when-issued trading and pair-offs. NCUA

notes that IRPS 92-1 states that federal credit unions engaging in

when-issued trading must follow NCUA's regulation on cash forward

agreements. When this rule becomes effective, that statement will no

longer be accurate. Cash forward agreements will be impermissible, and

when-issued trading will be permissible without restriction, except for

being accounted for in accordance with GAAP. In general, when IRPS 92-1

conflicts with this rule, the IRPS is superseded.

Section 703.110 What Investments and Investment Activities Are

Prohibited for Me?

Section 703.5 of the proposed rule added prohibitions against

engaging in when-issued trading and pair-off transactions and

purchasing or selling options, interest rate swaps, stripped mortgage-

backed securities, CMO/REMIC residuals, commercial mortgage related

securities, and small business related securities. It also prohibited

credit unions from purchasing mortgage servicing rights directly. As

noted above, NCUA has determined to permit credit unions to engage in

when-issued trading and pair-offs, when conducted in the trading

account. These activities have been deleted from the prohibitions

section, located at Section 703.110 of the final rule.

Several commenters urged that credit unions be permitted to engage

in financial derivatives. NCUA recognizes that in a dynamic financial

environment it will be desirable for credit unions to consider a

broader range of financial alternatives. The most likely extension will

be into swaps, futures and options, which can be used to reduce

interest rate exposure. NCUA has decided to consider allowing a limited

number of individual credit unions to expand into these areas through

the investment pilot program, described in Section 703.140.

Other than comments regarding financial derivatives, only a few

commenters opposed the proposed prohibitions. NCUA continues to believe

that the listed investments are inappropriate for federal credit

unions, and has prohibited them in the final rule. NCUA notes, however,

that a CMO/REMIC with the characteristics of a stripped mortgage-backed

security is permissible if it meets the CMO/REMIC stress tests in this

regulation. NCUA also notes that the prohibition against small business

related securities does not prohibit credit unions from purchasing

investments in securities issued or guaranteed by the Small Business

Administration. Finally, NCUA notes that the prohibition against

purchasing mortgage servicing rights directly does not affect a credit

union's authority to retain servicing rights of loans that it sells,

whether the loans have been made by the credit union or purchased to

complete a pool for sale or pledge on the secondary market.

Section 703.120 May My Officials or Employees Accept Anything of Value

in Connection With an Investment Transaction?

No commenters objected to Section 703.8 of the proposed rule, which

addressed prohibited fees, and it has been retained at Section 703.120

of the final rule.

Section 703.130 May I Continue To Hold Investments Purchased Before

January 1, 1998, That Will Be Impermissible After That Date?

To assist credit unions in determining what regulations govern

investments purchased prior to January 1, 1998, the effective date of

this final rule, Section 703.9 of the proposed rule set out various

provisions that have governed certain investments since 1991. Minor

corrections have been made to these provisions, and they have been

retained at Section 703.130 of the final rule.

Section 703.140 What Is the Investment Pilot Program and How Can I

Participate in It?

A number of commenters asked for authority to engage in certain

investment activities that NCUA does not believe are appropriate for

all federal credit unions at this time. However, certain activities

that are permissible under the FCU Act but prohibited under this rule,

such as financial derivatives, may be appropriate for some credit

unions. As credit unions and NCUA gain experience with the activities,

NCUA may determine that they are appropriate for all credit unions, are

suitable only for some, or remain inappropriate for all credit unions.

To assist credit unions and NCUA in gaining experience with these

activities, NCUA has developed the investment pilot program.

Under the program, a credit union that wishes to engage in an

otherwise prohibited activity must apply to NCUA for permission to

engage in the activity. Section 703.140 sets out the requirements and

procedures for the application. NCUA will assess the credit union to

determine its ability to safely and soundly engage in the activity.

NCUA will determine the scope of the activity to assess its impact on

the credit union industry as a whole. If NCUA determines that a

particular activity is appropriate for all credit unions, it will

consider amending Part 703.

The pilot program also provides for NCUA to approve a third party's

investment program. In such a case, a credit union would not be

required to obtain individual approval to participate in the program,

although NCUA might limit the number of credit unions to which the

third party may market the program.

NCUA notes that the pilot program is not equivalent to a waiver

process. That is, once there are enough credit unions engaging in an

activity for NCUA to assess it, no more credit unions will be approved

to engage in the activity. An important factor in the number of credit

unions and activities that will be approved for the program is the

availability of NCUA staff resources.

Although commenters did not have the opportunity to express

opinions on the investment pilot program, NCUA notes that without

adding it to the final rule, credit unions would have no ability to

engage in these activities, which may benefit the credit union industry

and NCUA. NCUA believes that the benefits of the program justify adding

it at this late date. NCUA welcomes comments on the program, however,

and suggestions on how to improve it.

Section 703.150 What Additional Definitions Apply to This Part?

NCUA proposed to add a number of new definitions, to clarify

certain already-defined terms by re-definition,

[[Page 33000]]

and to delete several unnecessary definitions. In the final rule, some

of the proposed terms are not used, some new terms have been added,

and, based on comments, some definitions have been modified. In

addition, NCUA has deleted definitions for some terms, believing them

to be of such common usage as to no longer require definitions.

C. Derivation Table

------------------------------------------------------------------------

Original provision New provision Comment

------------------------------------------------------------------------

703.1........................... 703.10 & 703.20... Modified.

703.2........................... 703.150........... Significantly

Changed.

703.3(a)........................ 703.30(a)......... Modified.

703.3(b)........................ 703.30(h)......... Modified.

703.3(c)........................ 703.30(f)......... Modified.

703.3(d)........................ 703.30(b)......... Significantly

Changed.

703.3(e)........................ 703.30(c)......... Modified.

703.3(f)........................ 703.30(e)......... Modified.

703.3(g)........................ 703.30(i)......... Modified.

703.3(h)........................ 703.30(j)......... Modified.

N/A............................. 703.30 (d), (g), Added.

(k), & (l).

N/A............................. 703.40 (a), (b), Added.

(c), (e), & (f).

N/A............................. 703.70, 703.80, & Added.

703.90.

703.4 (a) & (b)................. 703.100(a)........ Significantly

Changed.

703.4(c)........................ 703.40(d) & Significantly

703.100(c). Changed.

703.4(d)........................ 703.100(i)........ Significantly

Changed.

703.4(e)........................ 703.100(j)........ Modified.

703.4(f)........................ 703.100(g)........ Modified.

703.4 (g), (h), & (i)........... 703.100(h) (1), No Change.

(2), & (3).

703.4(j)........................ 703.100(d)........ Modified.

N/A............................. 703.100 (b), (f), Added.

(h) (4) & (5),

(k), & (l).

703.5(a)........................ N/A............... Removed.

703.5(b)........................ 703.110(a)........ No Change.

703.5 (c) & (d)................. 703.110(b)........ No Change.

703.5(e)........................ 703.100(c)........ Modified.

703.5 (f) & (h)................. 703.110(c)........ Modified.

703.5 (g) & (j)................. 703.100(e)........ Modified.

703.5(i)........................ N/A............... Removed.

703.5(k)........................ 703.110(d)........ No Change.

703.5 (l) & (m)................. 703.120........... Modified.

N/A............................. 703.130 & 703.140. Added.

------------------------------------------------------------------------

D. Regulatory Procedures

Regulatory Flexibility Act

The Regulatory Flexibility Act requires NCUA to prepare an analysis

to describe any significant economic impact any final regulation may

have on a substantial number of small credit unions, defined as those

having less than $1 million in assets. The NCUA Board has determined

and certifies that the final rule will not have a significant economic

impact on a substantial number of small credit unions. Approximately

1,300 federal credit unions, out of 7,200, have assets of $1 million or

less. Of these 1,300, only 95 have investments in treasury or agency

securities, which are the investments that are subject to the majority

of the policy, reporting, and monitoring requirements of the final

rule. Accordingly, the NCUA Board has determined that a regulatory

flexibility analysis is not required.

Paperwork Reduction Act

The information collection requirements of the proposed rule were

submitted to the Office of Management and Budget. Fifteen commenters

addressed NCUA's estimates of the burden of those requirements, with

all but one stating that the estimates were too low. Credit unions

range in asset size from less than $100,000 to over $9 billion,

however, and the estimates were based on averaging the time it would

take both small and large credit unions to comply with the

requirements. Although the estimates may be understated for larger

credit unions, the reverse is true for smaller institutions.

The final rule has been modified from the proposed rule in ways

that reduce the burden estimates. The requirement to prepare a monthly

written report of investments was reduced by eliminating the obligation

to list all characteristics. The frequency of the interest rate shock

test was changed from monthly to quarterly. The requirement to

semiannually verify the pricing of all securities held was changed to

annually and only the amount necessary to satisfy generally accepted

auditing standards. The credit analysis requirement was changed from

semiannually to annually. Finally, the requirement to prepare and

provide to the Regional Director a written divestiture plan was

eliminated.

A revised Paperwork Reduction Act estimate will be sent to the

Office of Management and Budget (OMB). The NCUA Board invites comment

on: (1) Whether the collection of the information is necessary for the

proper performance of the functions of NCUA, including whether the

information will have practical utility; (2) the accuracy of NCUA's

estimate of the burden of collecting the information; (3) ways to

enhance the quality, utility, and clarity of the information to be

collected; and (4) ways to minimize the burden of collecting the

information. Send comments to Attn: Alexander Hunt, OMB Reports

Management Branch, New Executive Office Building, Rm. 10202,

Washington, DC 20530, with copies to Betty May, Acting Paperwork

Reduction Act Coordinator, NCUA, 1775 Duke St., Alexandria, VA 22314-

3428.

Under the Paperwork Reduction Act of 1995, no persons are required

to respond to a collection of information unless it displays a valid

OMB control number. The control number will be displayed in the table

at 12 CFR Part 795.

Executive Order 12612

Executive Order 12612 requires NCUA to consider the effect of its

actions on state interests. The final rule applies directly only to

federal credit unions, with Sec. 704.110 of the final rule applying

indirectly to state-chartered credit unions, through the insurance

provisions at 12 CFR Part 741. NCUA has determined that the final rule

does not constitute a ``significant regulatory action'' for purposes of

the Executive Order.

Small Business Regulatory Enforcement Fairness Act

The Small Business Regulatory Enforcement Fairness Act of 1996

(Public Law 104-121) provides generally for Congressional review of

agency rules. The reporting requirement is triggered in instances where

NCUA issues a final rule as defined by Section 551 of the

Administrative Procedure Act, 5 U.S.C. 551.

OMB has determined that this final revision to Part 703 does not

constitute a ``major'' rule as defined by the statute. A ``major'' rule

is defined as being any final rule that the Administrator of the Office

of Information and Regulatory Affairs of OMB finds has resulted in or

is likely to result in: (1) An annual effect on the economy of $100

million or more; (2) A major increase in costs or prices for consumers,

individual industries, Federal, State, or local government agencies, or

geographic regions; or (3) Significant adverse effects on competition,

employment, investment, productivity, innovation, or on the ability of

United States based

[[Page 33001]]

enterprises to compete with foreign-based enterprises in domestic and

export markets.

List of Subjects in 12 CFR Part 703

Credit unions, Investments, Reporting and recordkeeping

requirements.

By the National Credit Union Administration Board on June 12,

1997.

Becky Baker,

Secretary of the Board.

For the reasons set forth in the preamble, NCUA revises 12 CFR part

703 to read as follows:

PART 703--INVESTMENT AND DEPOSIT ACTIVITIES

Sec.

703.10 What does this part 703 cover?

703.20 What does this part 703 not cover?

703.30 What are the responsibilities of my (a federal credit

union's) board of directors?

703.40 What general practices and procedures must I follow in

conducting investment transactions?

703.50 What rules govern my dealings with entities I use to

purchase and sell investments (``broker-dealers'')?

703.60 What rules govern my safekeeping of investments?

703.70 What must I do to monitor my non-security investments in

banks, credit unions, and other depository institutions?

703.80 What must I do to value my securities?

703.90 What must I do to monitor the risk of my securities?

703.100 What investments and investment activities are permissible

for me?

703.110 What investments and investment activities are prohibited

for me?

703.120 May my officials or employees accept anything of value in

connection with an investment transaction?

703.130 May I continue to hold investments purchased before January

1, 1998, that will be impermissible after that date?

703.140 What is the investment pilot program and how can I

participate in it?

703.150 What additional definitions apply to this part?

Authority: 12 U.S.C. 1757(7), 1757(8), 1757(15).

Sec. 703.10 What does this part 703 cover?

This part 703 interprets several of the provisions of Sections

107(7), 107(8), and 107(15) (B) and (C) of the Federal Credit Union Act

(``Act''), 12 U.S.C. 1757(7), 1757(8), 1757(15) (B) and (C), which list

those securities, deposits, and other obligations in which a federal

credit union (``you'') may invest.

Sec. 703.20 What does this part 703 not cover?

This part 703 does not apply to:

(a) Investment in loans to members and related activities, which is

governed by Secs. 701.21, 701.22, and 701.23 of this chapter;

(b) The purchase of real estate-secured loans pursuant to Section

107(15)(A) of the Act, which is governed by Sec. 701.23 of this

chapter;

(c) Investment in credit union service organizations, which is

governed by Sec. 701.27 of this chapter;

(d) Investment in fixed assets, which is governed by Sec. 701.36 of

this chapter;

(e) Investment by corporate credit unions, which is governed by

part 704 of this chapter; or

(f) Investment activity by state-chartered credit unions, except as

provided in Sec. 741.3(a)(3) of this chapter.

Sec. 703.30 What are the responsibilities of my (a federal credit

union's) board of directors?

Your (a federal credit union's) board of directors must establish a

written investment policy that is consistent with the Act, this part,

and other applicable laws and regulations. The investment policy may be

part of a broader, asset-liability management policy. Your board must

review the policy at least annually. The policy must address the

following items:

(a) The purposes and objectives of your investment activities.

(b) The characteristics of the investments you may make. The

characteristics of an investment are such things as its issuer,

maturity, index, cap, floor, coupon rate, coupon formula, call

provision, average life, and interest rate risk.

(c) How you will manage your interest rate risk, including the

amount of risk you can take with your investments in relation to your

net capital and earnings.

(d) How you will manage your liquidity risk.

(e) How you will manage your credit risk. The policy must list

specific institutions, issuers, and counterparties you may use, or

criteria for their selection, and limits on the amounts you may invest

with each. Counterparty means the party on the other side of a

transaction.

(f) How you will manage your concentration risk, which can result

from single or related issuers, lack of geographic distribution,

holdings of obligations with similar characteristics, such as

maturities and indexes, holdings of bonds having the same trustee, and

holdings of securitized loans having the same originator, packager, or

guarantor.

(g) If you purchase CMOs/REMICs, whether you will use a median

prepayment estimate or individual prepayment estimates for the CMO/

REMIC testing required in Sec. 703.100(e). Once the board makes that

determination, you may use only that method.

(1) If the policy states that you will use a median estimate, it

must identify the industry-recognized information provider that will

supply the estimate.

(2) If the policy states that you will use individual estimates, it

must identify at least two specific sources for those estimates. One

source may be the median estimate from an industry-recognized

information provider.

(h) Who of your officials or employees has investment authority and

the extent of that authority. The individuals given investment

authority must be professionally qualified by education and/or

experience to exercise that authority in a prudent manner and to fully

comprehend and assess the risk characteristics of investments and

investment transactions under that authority. Only your officials and

employees may be voting members of any investment-related committee.

(i) If you use third-party entities to purchase or sell investments

(``broker-dealers''), the specific broker-dealers you may use. You must

maintain the documentation the board used to approve a broker-dealer as

long as the broker-dealer is approved and until the documentation has

been audited in accordance with Sec. 701.12 of this chapter and

examined by NCUA.

(j) If you use a third-party entity to safekeep your investments,

the specific entities you may use.

(k) How you will handle an investment that either is outside board

policy after purchase or fails a requirement of this part.

(l) If you engage in trading activities, how you will conduct those

activities. The policy should address the following:

(1) The persons who have purchase and sale authority;

(2) Trading account size limitations;

(3) Allocation of cash flow to trading accounts;

(4) Stop loss or sale provisions;

(5) Dollar size limitations of specific types, quantity and

maturity to be purchased;

(6) Limits on the length of time an investment may be inventoried

in the trading account; and

(7) Internal controls, including appropriate segregation of duties.

Sec. 703.40 What general practices and procedures must I follow in

conducting investment transactions?

(a) You (a federal credit union) must classify a security as hold-

to-maturity, available-for-sale, or trading, in accordance with

generally accepted

[[Page 33002]]

accounting principles and consistent with your documented intent and

ability regarding the security.

(b) Except as provided in paragraph (c) of this section, you must

retain discretionary control over the purchase and sale of investments.

NCUA does not consider you to have delegated discretionary control when

you are required to authorize a recommended purchase or sale

transaction prior to its execution and you, in practice, review such

recommendations and authorize such transactions.

(c)(1) You may delegate discretionary control over the purchase and

sale of investments, within established parameters, to a person other

than your official or employee, provided that the person is an

investment adviser registered with the Securities and Exchange

Commission under the Investment Advisers Act of 1940 (15 U.S.C. 80b).

(2) In determining whether to transact business with an investment

adviser, you must analyze his or her background and information

available from state or federal securities regulators, including any

enforcement actions against the adviser or associated personnel.

(3) You may not compensate an investment adviser with discretionary

control over the purchase and sale of investments on a per transaction

basis or based on capital gains, capital appreciation, net income,

performance relative to an index, or any other incentive basis.

(4) When you have delegated discretionary control over the purchase

and sale of investments to a person other than your official or

employee, you do not direct the holdings under that person's control.

Therefore, you must classify those holdings as either available-for-

sale or trading.

(5) You must obtain a report from your investment adviser, at least

monthly, that details your investments under his or her control and how

they are performing.

(6) Your aggregate delegation of discretionary control over the

purchase and sale of investments under this paragraph (c) is limited to

100 percent of net capital at the time of delegation.

(d) Except for investments that are issued or fully guaranteed as

to principal and interest by the U.S. government or its agencies,

enterprises, or corporations or fully insured (including accumulated

interest) by the National Credit Union Administration or the Federal

Deposit Insurance Corporation, you must conduct and document a credit

analysis of the issuing entity and/or investment before you purchase

the investment. You must update the analysis at least annually as long

as you hold the investment.

(e) You must notify your board of directors as soon as possible,

but no later than the next regularly scheduled board meeting, of any

investment that either is outside board policy after purchase or has

failed a requirement of this part. You must document the board's action

regarding the investment in the minutes of the board meeting, including

a detailed explanation of any decision not to sell an investment that

has failed a requirement of this part. Within 5 days after the board

meeting, you must notify the appropriate regional director in writing

of an investment that has failed a requirement of this part.

(f) You must maintain documentation regarding an investment

transaction as long as you hold the investment and until the

documentation has been both audited and examined. The documentation

should include, where applicable, bids and prices at purchase and sale

and for periodic updates, relevant disclosure documents or a

description of the security from an industry-recognized information

provider, financial data, and tests and reports required by your

investment policy and this part.

Sec. 703.50 What rules govern my dealings with entities I use to

purchase and sell investments (``broker-dealers'')?

(a) You (a federal credit union) may use a third-party entity to

purchase and sell investments (a ``broker-dealer'') as long as the

broker-dealer either is registered with the Securities and Exchange

Commission under the Securities Exchange Act of 1934 (15 U.S.C. 78a et

seq.) or is a depository institution whose broker-dealer activities are

regulated by a federal regulatory agency.

(b) In determining whether to buy or sell investments through a

broker-dealer, you must analyze and annually update the following

factors:

(1) The background of any sales representative with whom you are

doing business.

(2) Information available from state or federal securities

regulators and securities industry self-regulatory organizations, such

as the National Association of Securities Dealers and the North

American State Administrators Association, about any enforcement

actions against the broker-dealer, its affiliates, or associated

personnel.

(3) If the broker-dealer is acting as your counterparty, the

ability of the broker-dealer and its subsidiaries or affiliates to

fulfill commitments, as evidenced by capital strength, liquidity, and

operating results. You should consider current financial data, annual

reports, reports of nationally recognized statistical rating agencies,

relevant disclosure documents, and other sources of financial

information.

Sec. 703.60 What rules govern my safekeeping of investments?

(a) Your (a federal credit union's) purchased investments and

repurchase collateral must be in your possession, recorded as owned by

you through the Federal Reserve Book-Entry System, or held by a board-

approved safekeeper under a written custodial agreement. A custodial

agreement is a contract in which a third party agrees to exercise

ordinary care in protecting the securities held in safekeeping for its

customers.

(b) You must obtain an individual confirmation statement for each

investment purchased or sold.

(c) You may not allow the selling broker-dealer to safekeep

purchased investments or repurchase collateral, except that where the

broker-dealer is a bank or corporate credit union, you may allow a

separately identifiable department or division of the bank or corporate

credit union to safekeep investments or collateral.

(d) You must obtain and reconcile monthly a statement of purchased

investments and repurchase collateral held in safekeeping.

(e) All purchases and sales of investments must be delivery versus

payment (i.e., payment for an investment must occur simultaneously with

its delivery).

Sec. 703.70 What must I do to monitor my non-security investments in

banks, credit unions, and other depository institutions?

(a) At least quarterly you (a federal credit union) must prepare a

written report listing all of your shares and deposits in banks, credit

unions, and other depository institutions, that have one or more of the

following features:

(1) Embedded options;

(2) Remaining maturities greater than 3 years; or

(3) Coupon formulas that are related to more than one index or are

inversely related to, or multiples of, an index.

(b) The requirement described in paragraph (a) of this section does

not apply to your shares and deposits that are securities.

(c) Where you do not have an investment-related committee, each

member of your board of directors must receive a copy of the report

described in paragraph (a) of this section. Where you have an

investment-related committee, each member of the committee must

[[Page 33003]]

receive a copy of the report, and each member of the board must receive

a summary of the information in the report.

Sec. 703.80 What must I do to value my securities?

(a) Prior to purchasing or selling a security, except for new

issues purchased at par, you (a federal credit union) must obtain,

either:

(1) Price quotations on the security from at least two broker-

dealers; or

(2) A price quotation on the security from an industry-recognized

information provider.

(b) At least monthly, you must determine the fair value of each

security you hold. You may determine fair value by obtaining a price

quotation on the security from an industry-recognized information

provider, a broker-dealer, or a safekeeper.

(c) At least annually, your supervisory committee (itself or

through its external auditor) must independently assess the reliability

of monthly price quotations you receive from a broker-dealer or

safekeeper. Your supervisory committee (or external auditor) must

follow Generally Accepted Auditing Standards, which require either

recomputation or reference to market quotations.

(d) Where you are unable to obtain a price quotation required by

this section for the precise security in question, you may obtain a

quotation for a security with substantially similar characteristics.

Sec. 703.90 What must I do to monitor the risk of my securities?

(a) At least monthly, you (a federal credit union) must prepare a

written report setting forth, for each security you hold, the fair

value and dollar change since the prior month-end, with summary

information for the entire portfolio.

(b) At least quarterly, you must prepare a written report setting

forth the sum of the fair values of all fixed and variable rate

securities you hold that have one or more of the following features:

(1) Embedded options;

(2) Remaining maturities greater than 3 years; or

(3) Coupon formulas that are related to more than one index or are

inversely related to, or multiples of, an index.

(c) Where the amount calculated in paragraph (b) of this section is

greater than your net capital, the report described in that paragraph

must provide a reasonable and supportable estimate of the potential

impact, in percentage and dollar terms, of an immediate and sustained

parallel shift in market interest rates of plus and minus 300 basis

points on:

(1) The fair value of each security in your portfolio;

(2) The fair value of your portfolio as a whole; and

(3) Your net capital.

(d) Where you do not have an investment-related committee, each

member of your board of directors must receive a copy of the reports

described in paragraphs (a) through (c) of this section. Where you have

an investment-related committee, each member of the committee must

receive copies of the reports, and each member of the board must

receive a summary of the information in the reports.

Sec. 703.100 What investments and investment activities are

permissible for me?

(a) You (a federal credit union) may contract for the purchase or

sale of a security as long as the delivery of the security is by

regular-way settlement. Regular-way settlement means delivery of a

security from a seller to a buyer within the time frame that the

securities industry has established for that type of security.

(b) You may invest in a variable rate investment, as long as the

index is tied to domestic interest rates and not, for example, to

foreign currencies, foreign interest rates, or domestic or foreign

commodity prices, equity prices, or inflation rates. For purposes of

this part, the U.S. dollar-denominated London Interbank Offered Rate

(LIBOR) is a domestic interest rate.

(c) You may purchase shares or deposits in a corporate credit

union, except where the NCUA Board has notified you that the corporate

credit union is not operating in compliance with part 704 of this

chapter. Your aggregate purchase of member paid-in capital and

membership capital in one corporate credit union is limited to one

percent of your assets. Member paid-in capital and membership capital

are defined in part 704 of this chapter.

(d) You may invest in a registered investment company or collective

investment fund, as long as the prospectus of the company or fund

restricts the investment portfolio to investments and investment

transactions that are permissible for federal credit unions. For the

purposes of this part, the following definitions apply:

(1) A registered investment company is an investment company that

is registered with the Securities and Exchange Commission under the

Investment Company Act of 1940 (15 U.S.C. 80a). Examples of registered

investment companies are mutual funds and unit investment trusts.

(2) A collective investment fund is a fund maintained by a national

bank under 12 CFR part 9.

(e)(1) You may invest in a fixed or variable rate CMO/REMIC only if

it meets all of the following tests:

(i) Average Life Test. The CMO/REMIC's estimated average life is 10

years or less.

(ii) Average Life Sensitivity Test. The CMO/REMIC's estimated

average life extends by 4 years or less, assuming an immediate and

sustained parallel shift in interest rates of up to and including plus

300 basis points, and shortens by 6 years or less, assuming an

immediate and sustained parallel shift in interest rates of up to and

including minus 300 basis points.

(iii) Price Sensitivity Test. The CMO/REMIC's estimated price

change is 17 percent or less, as a result of an immediate and sustained

parallel shift in interest rates of up to and including plus and minus

300 basis points.

(2) You must retest CMOs/REMICs at least quarterly, more frequently

if market or business conditions dictate.

(3) If you use individual prepayment estimates for testing, you

must obtain estimates from all of the prepayment sources listed in your

investment policy. When you purchase a CMO/REMIC, it must pass the

tests for each estimate. When you retest the CMO/REMIC, it must pass

the tests for a majority of the estimates.

(4) If you use a median prepayment estimate, the median estimate

when you purchase a CMO/REMIC must be based on at least five prepayment

sources. When you retest the CMO/REMIC, the median estimate must be

based on at least two prepayment sources.

(f) You may purchase and hold a municipal security only if a

nationally recognized statistical rating organization (NRSRO) has rated

it in one of the four highest rating categories. A municipal security

is a security as defined in Section 107(7)(K) of the Act. An NRSRO is a

rating organization that the Securities and Exchange Commission has

recognized as an NRSRO.

(g) You may sell federal funds to Section 107(8) institutions and

credit unions, as long as the interest or other consideration received

from the financial institution is at the market rate for federal funds

transactions.

(h) You may invest in the following instruments issued by a Section

107(8) institution or branch:

(1) Yankee dollar deposits;

(2) Eurodollar deposits;

(3) Banker's acceptances;

(4) Deposit notes; and

[[Page 33004]]

(5) Bank notes with original weighted average maturities of less

than five years.

(i) A repurchase transaction is a transaction in which you agree to

purchase a security from a counterparty and to resell the same or an

identical security to that counterparty at a specified future date and

at a specified price. You may enter into a repurchase transaction as

long as:

(1) The repurchase securities are legal investments for federal

credit unions;

(2) You receive a daily assessment of the market value of the

repurchase securities, including accrued interest, and maintain

adequate margin that reflects a risk assessment of the repurchase

securities and the term of the transaction; and

(3) You have entered into signed contracts with all approved

counterparties.

(j) A reverse repurchase transaction is a transaction in which you

agree to sell a security to a counterparty and to repurchase the same

or an identical security from that counterparty at a specified future

date and at a specified price. You may enter into reverse repurchase

and collateralized borrowing transactions as long as:

(1) Any securities you receive are permissible investments for

federal credit unions, you receive a daily assessment of their market

value, including accrued interest, and you maintain adequate margin

that reflects a risk assessment of the securities and the term of the

transaction;

(2) Any cash you receive is subject to the borrowing limit

specified in Section 107(9) of the Act, and any investments you

purchase with that cash are permissible for federal credit unions and

mature no later than the maturity of the transaction; and

(3) You have entered into signed contracts with all approved

counterparties.

(k) You may enter into a securities lending transaction as long as:

(1) You receive written confirmation of the loan;

(2) Any collateral you receive is a legal investment for federal

credit unions, you obtain a perfected first priority interest in the

collateral, you either take physical possession or control of the

collateral or are recorded as owner of the collateral through the

Federal Reserve Book-Entry Securities Transfer System; and you receive

a daily assessment of the market value of the collateral, including

accrued interest, and maintain adequate margin that reflects a risk

assessment of the collateral and the term of the loan;

(3) Any cash you receive is subject to the borrowing limit

specified in Section 107(9) of the Act, and any investments you

purchase with that cash are permissible for federal credit unions and

mature no later than the maturity of the transaction; and

(4) You have executed a written loan and security agreement with

the borrower.

(l)(1) You may trade securities, including engaging in when-issued

trading and pair-off transactions, as long as you can show that you

have sufficient resources, knowledge, systems, and procedures to handle

the risks.

(2) You must record any security you purchase or sell for trading

purposes at fair value on the trade date. The trade date is the date

you commit, orally or in writing, to purchase or sell a security.

(3) At least monthly, you must give your board of directors or

investment-related committee a written report listing all purchase and

sale transactions of trading securities and the resulting gain or loss

on an individual basis.

Sec. 703.110 What investments and investment activities are prohibited

for me?

(a) You (a federal credit union) may not purchase or sell financial

derivatives, such as futures, options, interest rate swaps, or forward

rate agreements, except as permitted under Sec. 701.21(i) of this

chapter.

(b) You may not engage in adjusted trading or short sales.

(c) You may not purchase stripped mortgage backed securities,

residual interests in CMOs/REMICs, mortgage servicing rights,

commercial mortgage related securities, or small business related

securities.

(d) You may not purchase a zero coupon investment with a maturity

date that is more than 10 years from the settlement date.

Sec. 703.120 May my officials or employees accept anything of value in

connection with an investment transaction?

(a) Your (a federal credit union's) officials and senior management

employees, and their immediate family members, may not receive anything

of value in connection with your investment transactions. This

prohibition also applies to any other employee, such as an investment

officer, if the employee is directly involved in investments, unless

your board of directors determines that the employee's involvement does

not present a conflict of interest. This prohibition does not include

compensation for employees.

(b) Your officials and employees must conduct all transactions with

business associates or family members that are not specifically

prohibited by paragraph (a) of this section at arm's length and in your

best interest.

(c) Senior management employee means your chief executive officer

(typically this individual holds the title of President or Treasurer/

Manager), any assistant chief executive officers (e.g., Assistant

President, Vice President, or Assistant Treasurer/Manager) and the

chief financial officer (Comptroller).

(d) Immediate family member means a spouse or other family member

living in the same household.

Sec. 703.130 May I continue to hold investments purchased before

January 1, 1998, that will be impermissible after that date?

(a) Subject to safety and soundness considerations, your (a federal

credit union's) authority to hold an investment is governed by the

regulations in effect when you purchased the investment. Paragraphs (b)

through (d) of this section describe past regulations governing certain

investments.

(b) Subject to safety and soundness considerations, you may hold a

CMO/REMIC purchased:

(1) Before December 2, 1991;

(2) On or after December 2, 1991, but before July 30, 1993, if its

average life does not extend or shorten by more than 6 years if

interest rates rise or fall 300 basis points;

(3) On or after December 2, 1991, but before January 1, 1998, if

for the sole purpose of reducing interest rate risk and:

(i) You have a monitoring and reporting system in place that

provides the documentation necessary to evaluate the expected and

actual performance of the investment under different interest rate

scenarios;

(ii) You use the monitoring and reporting system to conduct and

document an analysis that shows, before purchase, that the proposed

investment will reduce your interest rate risk;

(iii) After purchase, you evaluate the investment at least

quarterly to determine whether or not it actually has reduced your

interest rate risk; and

(iv) You classify the investment as either trading or available-

for-sale.

(c) Subject to safety and soundness considerations, and

notwithstanding paragraph (b) of this section, you may hold a variable-

rate CMO/REMIC purchased:

(1) On or after December 2, 1991, but before July 30, 1993, if:

(i) The interest rate is reset at least annually;

(ii) The maximum allowable interest rate on the instrument is at

least 300

[[Page 33005]]

basis points above the interest rate of the instrument at the time of

purchase; and

(iii) The interest rate of the instrument varies directly (not

inversely) with the index upon which it is based and is not reset as a

multiple of the change in the related index; or

(2) On or after July 30, 1993, but before January 1, 1998, if:

(i) The interest rate of the instrument is reset at least annually;

(ii) The interest rate of the instrument, at the time of purchase

or at a subsequent testing date, is below the contractual cap of the

instrument;

(iii) The index upon which the interest rate is based is a

conventional widely-used market interest rate such as the London

Interbank Offered Rate (LIBOR);

(iv) The interest rate of the instrument varies directly (not

inversely) with the index upon which it is based and is not reset as a

multiple of the change in the related index; and

(v) The estimated change in the instrument's price is 17 percent or

less, due to an immediate and sustained parallel shift in the yield

curve of plus or minus 300 basis points.

(d) Subject to safety and soundness considerations, you may hold a

CMO/REMIC residual, SMBS, or zero coupon security with a maturity

greater than 10 years, if you purchased the investment:

(1) Before December 2, 1991; or

(2) On or after December 2, 1991, but before January 1, 1998, if

for the purpose of reducing interest rate risk and you meet the

requirements of paragraph (b)(3) of this section.

(e) All grandfathered investments are subject to the valuation and

monitoring requirements of Secs. 703.70, 703.80, and 703.90.

Sec. 703.140 What is the investment pilot program and how can I

participate in it?

(a) Under the investment pilot program, NCUA will permit a limited

number of federal credit unions to engage in investment activities

prohibited by this part but permitted by statute.

(b) Except as provided in paragraph (c) of this section, before you

(a federal credit union) may engage in additional activities, you must

obtain written approval from

NCUA. To begin the approval process, you must submit a request to

your regional director that addresses the following items:

(1) Board policies approving the activities and establishing limits

on them.

(2) A complete description of the activities, with specific

examples of how you will conduct them and how they will benefit you.

(3) A demonstration of how the activities will affect your

financial performance, risk profile, and asset-liability management

strategies.

(4) Examples of reports you will generate to monitor the

activities.

(5) A projection of the associated costs of the activities,

including personnel, computer, audit, etc.

(6) A description of the internal systems to measure, monitor, and

report the activities, and the qualifications of the staff and/or

official(s) responsible for implementing and overseeing the activities.

(7) The internal control procedures you will implement, including

audit requirements.

(c) You need not obtain individual written approval to engage in

investment activities prohibited by this part but permitted by statute

where the activities are part of a third-party investment program that

NCUA has approved under this paragraph (c). A third party seeking

approval of such a program must submit a request to the Director of the

Office of Examination and Insurance that addresses the following items:

(1) A complete description of the activities, with specific

examples of how a credit union will conduct them and how they will

benefit a credit union.

(2) A description of any risks to a credit union from participating

in the program.

Sec. 703.150 What additional definitions apply to this part?

The following definitions apply to this part:

Adjusted trading means selling a security to a counterparty at a

price above its current fair value and simultaneously purchasing or

committing to purchase from the counterparty another security at a

price above its current fair value.

Average life means the weighted average time to principal repayment

with the amount of the principal paydowns (both scheduled and

unscheduled) as the weights.

Bank note means a direct, unconditional, and unsecured general

obligation of a bank that ranks equally with all other senior unsecured

indebtedness of the bank, except deposit liabilities and other

obligations that are subject to any priorities or preferences.

Banker's acceptance means a time draft that is drawn on and

accepted by a bank and that represents an irrevocable obligation of the

bank.

Commercial mortgage related security means a mortgage related

security where the mortgages are secured by real estate upon which is

located a commercial structure.

Deposit note means an obligation of a bank that is similar to a

certificate of deposit but is rated.

Embedded option means a characteristic of an investment that gives

the issuer or holder the right to alter the level and timing of the

cash flows of the investment. Embedded options include call and put

provisions and interest rate caps and floors. Since a prepayment option

in a mortgage is a type of call provision, a mortgage-backed security

composed of mortgages that may be prepaid is an example of an

investment with an embedded option.

Eurodollar deposit means a U.S. dollar-denominated deposit in a

foreign branch of a United States depository institution.

Fair value means the price at which a security can be bought or

sold in a current, arms length transaction between willing parties,

other than in a forced or liquidation sale.

Industry-recognized information provider means an organization that

obtains compensation by providing information to investors and receives

no compensation for the purchase or sale of investments.

Investment means any security, obligation, account, deposit, or

other item authorized for purchase by a federal credit union under

Sections 107(7), 107(8), or 107(15) (B) or (C) of the Federal Credit

Union Act, or this part, other than loans to members.

Maturity means the date the last principal amount of a security is

scheduled to come due and does not mean the call date or the average

life of the security.

Mortgage related security means a security as defined in Section

3(a)(41) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(41)),

i.e., a privately-issued security backed by mortgages secured by real

estate upon which is located a dwelling, mixed residential and

commercial structure, residential manufactured home, or commercial

structure.

Mortgage servicing means performing tasks to protect a mortgage

investment, including collecting the installment payments, managing the

escrow accounts, monitoring and dealing with delinquencies, and

overseeing foreclosures and payoffs.

Net capital means the total of all undivided earnings, regular

reserves, other reserves (excluding the allowance for loan losses), net

income, accumulated unrealized gains (losses)

[[Page 33006]]

on available-for-sale securities, and secondary capital as defined in

Sec. 701.34 of this chapter.

Official means any member of a federal credit union's board of

directors, credit committee, supervisory committee, or investment-

related committee.

Pair-off transaction means a security purchase transaction that is

closed or sold at, or prior to, the settlement date. In a pair-off, an

investor commits to purchase a security, but then pairs-off the

purchase with a sale of the same security prior to or on the settlement

date.

Prepayment estimate means a reasonable and supportable forecast of

mortgage prepayments in alternative interest rate scenarios. Broker-

dealers and industry-recognized information providers are sources for

these estimates. Estimates are used in tests to forecast the weighted

average life, change in weighted average life, and price sensitivity of

CMOs/REMICs and mortgage-backed securities.

Residual interest means the remainder cash flows from a CMO/REMIC,

or other mortgage-backed security transaction, after payments due

bondholders and trust administrative expenses have been satisfied.

Section 107(8) institution means an institution in which Section

107(8) of the Act authorizes you to make deposits, i.e., an institution

that is insured by the Federal Deposit Insurance Corporation or is a

state bank, trust company or mutual savings bank operating in

accordance with the laws of a state in which you maintain a facility. A

facility is your home office or any suboffice, including, but not

necessarily limited to, a credit union service center, wire service,

telephonic station, or mechanical teller station.

Security means a share, participation, or other interest in

property or in an enterprise of the issuer or an obligation of the

issuer that: (1) Either is represented by an instrument issued in

bearer or registered form or, if not represented by an instrument, is

registered in books maintained to record transfers by or on behalf of

the issuer;

(2) Is of a type commonly dealt in on securities exchanges or

markets or, when represented by an instrument, is commonly recognized

in any area in which it is issued or dealt in as a medium for

investment; and

(3) Either is one of a class or series or by its terms is divisible

into a class or series of shares, participations, interests, or

obligations.

Settlement date means the date to which a purchaser and seller

originally agree for settlement of the purchase or sale of a security.

Short sale means the sale of a security not owned by the seller.

Small business related security means a security as defined in

Section 3(a)(53) of the Securities Exchange Act of 1934 (15 U.S.C.

78c(a)(53)), i.e., a security that represents ownership of one or more

promissory notes or leases of personal property which evidence the

obligation of a small business concern. It does not mean a security

issued or guaranteed by the Small Business Administration.

Stripped mortgage-backed security (SMBS) means a security that

represents either the principal-only or the interest-only portion of

the cash flows of an underlying pool of mortgages or mortgage-backed

securities. Some mortgage-backed securities represent essentially

principal-only cash flows with nominal interest cash flows or

essentially interest-only cash flows with nominal principal cash flows.

These securities are considered SMBSs for the purposes of this part.

When-issued trading of securities means the buying and selling of

securities in the period between the announcement of an offering and

the issuance and payment date of the securities.

Yankee dollar deposit means a deposit in a United States branch of

a foreign bank licensed to do business in the state in which it is

located, or a deposit in a state-chartered, foreign controlled bank.

You means a federal credit union.

Zero coupon investment means an investment that makes no periodic

interest payments but instead is sold at a discount from its face

value. The holder of a zero coupon investment realizes the rate of

return through the gradual appreciation of the investment, which is

redeemed at face value on a specified maturity date.

[FR Doc. 97-15915 Filed 6-17-97; 8:45 am]

BILLNG CODE 7535-01-P