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

FARM CREDIT ADMINISTRATION

12 CFR Part 615

RIN 3052-AB76

Funding and Fiscal Affairs, Loan Policies and Operations, and

Funding Operations; Investment Management

AGENCY: Farm Credit Administration.

ACTION: Final rule.

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SUMMARY: The Farm Credit Administration (FCA) adopts final investment

management regulations that help Farm Credit System (System or FCS)

banks and associations respond to rapid and continual changes in

financial markets and instruments. The final regulations:

Expand the list of high-quality investments that System

banks and associations can purchase;

Provide more flexibility to use comprehensive analytical

techniques to manage risks at the portfolio or institutional level;

Strengthen our requirements for sound investment

management practices; and

Streamline the requirements for investments in mortgage

securities issued or guaranteed by the Federal Agricultural Mortgage

Corporation (Farmer Mac).

EFFECTIVE DATE: These regulations will become effective 30 days after

they are published in the Federal Register during which either one or

both houses of Congress are in session. We will publish a notice of the

effective date in the Federal Register.

FOR FURTHER INFORMATION CONTACT: Laurie A. Rea, Senior Policy Analyst,

Office of Policy Analysis, Farm Credit Administration, McLean, VA

22102-5090, (703) 883-4498; or Richard Katz, Senior Attorney, Office of

General Counsel, Farm Credit Administration, McLean, VA 22102-5090,

(703) 883-4020, TDD (703) 883-4444.

SUPPLEMENTARY INFORMATION:

I. Background

System banks may purchase eligible investments for the purpose of

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maintaining a liquidity reserve, managing interest rate risk, and

investing surplus funds. Farm Credit associations have authority to

hold eligible investments to manage short-term surplus funds and reduce

interest rate risk, subject to the approval of their funding banks.

Eligible investments help FCS banks and associations to control

risks that result from their operations as single-industry agricultural

lenders. On June 18, 1998, we proposed revisions to our investment

management regulations.

The proposal balanced our desire to institute a disciplined

investment management framework with the System's desire for more

flexibility to respond to changing market conditions and advances in

risk management and securities valuation.\1\

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\1\ See 63 FR 33281.

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We proposed two fundamental changes to the existing investment

regulations. First, we established guidelines for implementing an

effective oversight and risk management process for investment

activities. Second, our proposal expanded the list of eligible

investments, and it relaxed or repealed many of the restrictions on

investments that we previously authorized. For instance, we proposed to

expand System bank and association investment authority to include a

broader array of money market instruments, mortgage securities, and

asset-backed securities.

Our proposal also balanced the System's need for greater

flexibility regarding investments with essential safety and soundness

controls, such as credit rating and diversification standards.

Furthermore, our proposal continued to limit non-agricultural

investments to 30 percent of each bank's total outstanding loans.

Overview of the Comments

The Presidents Finance Committee (PFC) for Farm Credit System

banks, The Bond Market Association, and Farmer Mac commented on the

proposed rule. All eight FCS banks fully supported the PFC's comments.

The PFC's letter identified over 20 separate issues concerning

investment management and eligible investments that the PFC asked us to

address in the final rule. The Bond Market Association, which

represents securities firms and investment banks that underwrite and

trade debt securities, supported many of the System's positions on

eligible investments. Farmer Mac's comments focused primarily on the

different regulatory treatment of its mortgage securities and the

Federal National Mortgage Association (Fannie Mae) and the Federal Home

Loan Mortgage Corporation (Freddie Mac).

Separately, we published a notice in the Federal Register that

asked the public to identify existing FCA regulations and policies that

impose unnecessary regulatory burdens on FCS institutions.\2\ CoBank

ACB and four Farm Credit associations asked us to reduce regulatory

burden on the System by repealing or revising provisions in the

existing investment regulations that pertain to the liquidity reserve

requirement, association investments and the portfolio limit on Farmer

Mac mortgage securities. We address these regulatory burden comments in

the final investment rule.

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\2\ See 63 FR 44176 (Aug. 18, 1998); 63 FR 64013 (Nov. 18,

1998).

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We respond to these comments by making several substantive changes

to the proposed investment management regulations and by rewriting the

regulations so they are easier to understand. In addition, we also

address commenters' questions and requests for clarification in the

preamble.

II. Investment Activities of Associations and Service Corporations

We received several comments and questions about the investment

authorities of associations, both in response to the proposed

investment rule and our regulatory burden initiative. The PFC asked us

to confirm that funding banks still retain the responsibility to review

and approve the investments of their affiliated associations. In

response to our regulatory burden initiative, three associations stated

that the Farm Credit Act of 1971, as amended (Act) does not require the

degree of bank oversight that redesignated Sec. 615.5142 imposes on

association investment activities. These associations suggested that

funding banks should rely on the General Financing Agreements (GFA) to

oversee the investment activities of their affiliated associations.

We modified final Secs. 615.5131, 615.5133, 615.5140, 615.5141,

615.5142, and 615.5143 to confirm the existing investment authorities

of associations and clarify that associations that elect to hold

investments are expressly subject to regulations governing investment

management, eligible investments, stress tests, and divestiture.

Redesignated Sec. 615.5142 continues to authorize associations to

acquire eligible investments that are listed in Sec. 615.5140, with the

approval of their funding banks, for the purposes of reducing interest

rate risk and investing surplus funds. The final rule also retains the

existing requirement that each System bank annually review the

investment portfolio of every association that it funds.

Final Sec. 615.5142 implements sections 2.2(10) and 2.12(18) of the

Act, which require each funding bank to supervise and approve the

investment activities of its affiliated associations. In response to

comments that focused on the scope of bank supervision of association

investments, we note that a number of satisfactory methods exist for

System banks to oversee association investment activities under our

regulatory framework. A bank may take an active role in advising and

approving an association's investment decisions and strategies. For

example, banks may provide research, analytical or advisory services

that help associations to manage their investment portfolios.

Alternatively, as suggested by three association commenters, the GFA

can be an appropriate tool for funding banks to oversee the investment

activities of their affiliated associations.

Bank oversight does not absolve an association's board and managers

of their fiduciary duties to manage investments in a safe and sound

manner. The fiduciary responsibilities of association boards of

directors obligate them to develop appropriate investment management

policies and practices to manage the credit, market, liquidity, and

operational risks associated with investment activities. Additionally,

it is incumbent upon each association's investment managers to fully

understand the risks of its investments and make independent and

objective evaluations of investments prior to purchase.

We incorporated explicit references to associations into final

Sec. 615.5133 to acknowledge the existing responsibility of

associations to effectively manage their investments. We recognize,

however, that associations have historically maintained few or no

investments in non-agricultural financial instruments. The few

associations that maintain investment portfolios hold primarily money

market instruments and municipal securities. Therefore, the final

regulation requires an association's board of directors to develop

investment policies that are commensurate with its institution's

investment activities.

An association's investment policies should be appropriate for the

size, risk characteristics, and complexity of the association's

investment portfolio and should be based on an association's unique

circumstances, risk tolerances, and objectives. Associations must

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comply with all the requirements in Sec. 615.5133 if the level or type

of their investments could expose their capital to material loss.

However, an association's board does not need to develop an investment

policy if it elects not to hold non-agricultural investments authorized

under Sec. 615.5140.

Final Sec. 615.5140, which lists eligible investments, is modified

to clarify that it applies to associations. As noted earlier,

associations already have the authority under redesignated

Sec. 615.5142 to hold eligible investments that are listed in

Sec. 615.5140. This revision more accurately reflects the scope of this

regulation.

We take this opportunity to reiterate our long-standing position

that service corporations, organized under section 4.25 of the Act, are

subject to the investment regulations in subpart E of part 615.

Although we have noted on past occasions that Sec. 611.1136 of this

chapter applies these investment regulations to both incorporated and

unincorporated service organizations, questions about this issue have

remained. Final Sec. 615.5131(m) resolves this matter by expressly

subjecting FCS service corporations that hold investments to these

regulations. Service corporations that hold no investments are not

required to develop investment policies or comply with Sec. 615.5133.

III. Investment Management

We proposed significant changes to Sec. 615.5133, which governs

investment management practices and internal controls in the FCS. Our

objective was to strengthen this regulation so each System institution

would follow certain fundamental practices that enable its board and

management to fully understand and effectively manage risks in its

investment portfolio. An effective risk management process for

investments requires financial institutions to establish: (1) Policies;

(2) risk limits; (3) a mechanism for identifying, measuring, and

reporting risk exposures; and, (4) a system of internal controls. As a

result, the proposed rule required each Farm Credit board of directors

to adopt policies that establish risk parameters and guide the

decisions of investment managers. More specifically, we required board

policies to establish objective criteria so investment managers can

prudently manage credit, market, liquidity, and operational risks.

Additionally, proposed Sec. 615.5133 established other controls that

help prevent loss, such as:

Clear delegation of responsibilities and authorities to

investment managers;

Separation of duties;

Timely and effective security valuation practices; and,

Routine reports on investment performance.

A. Requests for Change

Only the PFC commented on proposed Sec. 615.5133. Although the PFC

supported the FCA's approach, it requested changes to three provisions

of proposed Sec. 615.5133. In response, we revised two of these

regulations so they advance our safety and soundness objectives without

placing unnecessary burden on the FCS. We resolved the PFC's third

concern with a preamble explanation rather than a regulatory change. In

addition to the two substantive amendments described above, we

reorganized and rewrote this regulation so it is easier to understand

and use.

1. Limits on Transactions With Each Securities Firm

The PFC asked us to eliminate the provision in proposed

Sec. 615.5133(a)(1)(ii) that requires investment policies to ``set

limits on the amounts and types of transactions that the bank shall

execute with authorized securities firms.'' \3\ The PFC believes that

this requirement is overly burdensome because the risk of loss from

purchase and sale transactions with securities firms is negligible. The

commenter also opined that this provision reduces the System's

flexibility to trade with the securities firm that provides the best

terms and execution for investment transactions.

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\3\ The term ``securities firms'' in the final rule and this

preamble collectively refers to brokers, dealers, and investment

banks.

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The PFC persuaded us that some of the requirements in proposed

Sec. 615.5133(a)(1)(ii) might have inadvertently reduced the System's

flexibility in executing transactions with various securities firms.

However, we continue to believe that each System institution must

carefully select and properly manage its relationships with securities

firms as part of its efforts to manage credit risk associated with

settlements on securities transactions. Thus, we respond to the PFC's

concerns by revising the regulation so that the necessary safety and

soundness constraints do not unreasonably hinder business

relationships. In addition, this revision offers System institutions

greater flexibility to trade with the securities firms of their choice.

Specifically, final and redesignated Sec. 615.5133(c)(1)(ii) no

longer obligates the board of directors to set specific limits on the

amount and types of transactions that its institution executes with

authorized securities firms. Instead, the final regulation requires

System institutions to buy and sell eligible investments with more than

one securities firm. As a result, the final rule still requires System

institutions to diversify their exposure to credit risk from brokers,

dealers, and investment bankers.

Nevertheless, final and redesignated Sec. 615.5133(c)(1)(ii) still

requires board policies to establish the criteria that investment

managers will use to select securities firms. We have also retained the

regulatory provisions that require each board of directors to:

Annually review its criteria for selecting securities

firms; and

Determine whether its existing relationships with various

securities firms should continue.

2. Reporting Investment Performance to the Board

The PFC expressed concern about a provision in proposed

Sec. 615.5133(e) that requires investment managers to report quarterly

to the board on the performance and risk of ``each'' investment in the

portfolio. According to the PFC, many FCS banks hold several hundred

individual securities in sizeable investment portfolios. Under these

circumstances, reporting to the board on every single investment is

cumbersome and meaningful board review is difficult. The PFC suggests

the reports to the board should summarize the risks associated with

investment activities and address compliance with investment policies,

objectives, risk limits, and regulatory requirements. The commenter

further suggests that managers should report on individual investments

only in exceptional circumstances.

We revise this provision to address the PFC's concern. Final and

redesignated Sec. 615.5133(g) requires management to report each

quarter to its board of directors or a committee thereof on the

performance and risk of each class of investments and the entire

investment portfolio. Additionally, the final rule continues to require

the report to identify all gains and losses that the institution incurs

during the quarter on individual securities sold before maturity. We

retained a reporting requirement on individual securities because it

provides the board important and accurate information relating to the

performance of investments and investment activity in general.

This new approach requires investment portfolio managers to provide

System boards of directors

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accurate, concise, meaningful, and timely information on the

performance and risk of their institution's investments. This

information helps the board to understand the risks inherent in the

investment portfolio and oversee the investment activities of

investment managers. We believe this revision removes burdensome

reporting requirements from the final regulation while simultaneously

promoting safe and sound investment management practices in the FCS. We

have made no other modification to redesignated Sec. 615.5133(g).

3. Securities Valuations

The only comment on securities valuation was from the PFC. The PFC

asked us to delete proposed Sec. 615.5133(d)(1), which requires System

institutions to verify with an independent source the value of any

security (other than a new issue) that they purchase or sell. The PFC

interprets proposed Sec. 615.5133(d)(1) as requiring FCS institutions

to solicit a second bid for all securities from a competing broker,

dealer, or other intermediary. The PFC warns that this requirement

would undermine the good reputation of the System and cause its

business relationships with securities firms to quickly deteriorate. As

a result, the FCS would ultimately pay higher prices for securities and

obtain lower yields.

We observe that nothing in the proposed regulation or preamble

would require bids on investments from parties who compete with the

seller, purchaser, counterparty, or other intermediary to a specific

transaction. Instead, our regulation requires System banks,

associations, and service corporations to verify the value of a

security with an independent source. As the preamble to the proposed

regulation notes, ``independent verification of a price can be as

simple as obtaining a price from an industry recognized information

provider.'' The same preamble passage also states that ``although price

quotes from information providers are not actual market prices, they

confirm whether the broker's price is reasonable.'' \4\ This regulatory

provision allows System institutions to independently verify the price

of a security with an on-line market reporting service, such as

Bloomberg, Telerate, or Reuters. Additionally, the regulation provides

sufficient flexibility for System institutions to use internal

valuation models to verify the reasonableness of prices that they pay

or receive for securities. Moreover, independent verification of

securities prices is a fundamental component of safe and sound

investment management, and ensures that FCS institutions understand the

value of their investments at purchase and sale.

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\4\ See 63 FR 33284 (June 18, 1998).

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In view of these considerations, we conclude that the requirement

for independent verification of securities prices is appropriate and

should be retained in the final regulation. We also made several

stylistic changes to the securities valuation requirements, which we

redesignated as final Sec. 615.5133(f)(1).

B. Other Comments and Questions on Investment Management

We offer the following responses to requests for clarification on

proposed Sec. 615.5133 and additional guidance regarding investment

management.

1. Are the FCA Regulations Consistent With the Federal Financial

Institutions Examination Council's Policy on Investment Activities?

Yes. We confirm that Sec. 615.5133 is consistent with the Federal

Financial Institutions Examination Council's (FFIEC) ``Supervisory

Policy Statement on Investment Securities and End-User Derivatives

Activities'' (Policy Statement).\5\ We used the FFIEC's Policy

Statement as a benchmark for developing this regulation. In our

opinion, the FFIEC's guidance to other federally regulated financial

institutions on sound investment management practices is suitable for

the FCS. We encourage System institutions to refer to the FFIEC's

Policy Statement when they devise, implement, and review policies that

govern their investment management practices pursuant to Sec. 615.5133.

Additionally, FCS institutions should refer to our policy statement on

interest rate risk management (FCA-PS-74) for further guidance on

managing market risks.\6\

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\5\ See 63 FR 20191 (Apr. 23, 1998).

\6\ See 63 FR 69285 (Dec. 10, 1998).

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2. What Are the Responsibilities of Boards of Directors?

In general, the board of directors of any association or service

corporation that holds eligible investments and every bank is

responsible for establishing written investment policies that are

appropriate for the size, types, and risk characteristics of its

investments. Investment policies are a critical aspect of effective

risk management and should set appropriate limits on exposure to

credit, market, and liquidity risks. We emphasize that investment

policies of each Farm Credit bank and any association or service

corporation with significant investments should embody the following

key elements.

Investment Objectives. A general explanation of the board's

investment objectives, expectations, and performance goals is necessary

to guide investment managers.

Risk Tolerance. Risk tolerance should be based on the strength of

each institution's capital position and its ability to measure and

manage risk. Additionally, risk limits should be consistent with

broader business strategies and institutional objectives. Risk

tolerance can be expressed through several parameters: duration,

convexity, sector distribution, yield curve distribution, credit

quality, risk-adjusted return, portfolio size, total return volatility,

or value-at-risk.\7\ Each institution should use a combination of

parameters to appropriately limit its exposure to credit and market

risk.

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\7\ Generically, duration is a measure of a bond or portfolio's

price sensitivity to a change in interest rates. Convexity measures

the rate of change in duration with respect to a change in interest

rates. A sector refers to a broad class of investments with similar

characteristics or industry classification. Yield curve distribution

refers to the distribution of the portfolio's investments in short-

term, intermediate, or long-term investments. Value-at-risk is a

methodology used to measure market risk in an investment portfolio.

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Asset Allocation. The board's asset allocation policy should ensure

appropriate diversification within the various asset classes, as well

as across the entire investment portfolio.\8\ Final Sec. 615.5140

eliminates the portfolio limits on many eligible investments, and

therefore, we expect each bank, association, and service corporation to

establish its own asset allocation guidelines. Investment parameters

may include points where the investment portfolio should be reallocated

or rebalanced to bring it back in line with the board's strategic asset

allocation goals.

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\8\ Asset allocation is generally defined as the allocation of

your investment portfolio across major asset classes, such as United

States Treasury, corporate, mortgage or asset-backed securities.

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Asset Selection. The investment policy should identify the risk

characteristics (e.g., credit quality, price sensitivity, maturity,

marketability or liquidity, maximum premiums or discounts, etc.) of

investments that are suitable for inclusion in the investment

portfolio.

Derivatives. Derivative instruments can be used to hedge risk,

leverage a position or otherwise modify the risk profile of an

investment portfolio. The board's investment policy should address the

application of derivatives

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within the portfolio and set appropriate limits on the use of

derivatives.

Controls and Reporting Requirements. The investment policy should

describe the duties and responsibilities of the investment manager(s),

set the delegation of authorities, outline any prohibited investments

or activities, and specify the content and frequency of reports to the

board on investment activities.

3. What Analysis Must Management Perform on Individual Investments

Prior to Purchase and on an Ongoing Basis?

Not all investment instruments need an extensive pre-purchase or

post-purchase analysis. Non-complex instruments that have minimal price

sensitivity need little or no pre-purchase analysis. Final and

redesignated Sec. 615.5133(f) (previously proposed Sec. 615.5133(d)(3))

generally requires System banks to perform an analysis of the credit

and market risks on investments prior to purchase and on an ongoing

basis. The primary objective of this provision is to ensure that

management understands the risks and cashflow characteristics of any

investment that it purchases. The board's investment policy should

fully address the extent of the pre-purchase analysis that management

needs to perform for various classes of instruments. For example, the

policy should specifically indicate which stress tests in Sec. 615.5141

should be performed on various types of mortgage securities.

For investments that have unusual, leveraged, or highly variable

cashflows, it is especially important for investment managers to

exercise diligence and thoroughness in making investment decisions.

Managers should have a reasonable and adequate basis, supported by

appropriate analysis for their investment decisions, and maintain

adequate documentation. The analysis should describe the basic risk

characteristics of the investment and include a balanced discussion of

risks involved in purchasing the investment. In preparing the analysis,

investment managers should consider the current rate of return or

yield, expected total return, annual income, the degree of uncertainty

associated with the cashflows, the investment's marketability or

liquidity, as well as its credit and market risks.

4. What Investment Management Approach Does the FCA Prefer?

The PFC asked us to clarify when we expect System institutions to

manage their investments on an individual, portfolio or institutional

basis. The appropriate level of risk management depends on the

complexity of instruments and the size of your investment portfolio. A

System institution may need to analyze risk on an individual,

portfolio, and institutional level. As appropriate, stress testing

should be performed on individual investments, the investment portfolio

or the entire institution. Additionally, other risk management

techniques, such as total return analysis or value-at-risk, may be used

to effectively manage risk exposures.

When a new investment position is likely to significantly alter the

risk profile of an institution, management should complete an analysis

of the potential effects on the portfolio and the entire institution

prior to purchasing the investment. Although investors have

traditionally looked at investments one at a time, modern portfolio

theory suggests that investors should look at the effect of individual

investments on the entire portfolio. Often, investments that seem

acceptable on an individual basis have a significant exposure to a

single risk factor on a cumulative basis. Conversely, under the

portfolio approach, financial institutions may hold individual

investments that are fairly risky, if the risks are offset by other

investments or derivative instruments. As a result, the portfolio

approach allows investment managers to achieve higher returns while

maintaining overall portfolio risk at a reasonable level.

System institutions should tailor their investment management

approach to meet their needs based on the type and level of their

investment activities and unique risk profile. Regardless of the

approach taken, each Farm Credit bank, association, and service

corporation should ensure that it is able to effectively measure,

monitor, and control the credit, market, liquidity, and operational

risks stemming from its investment activities. This requires an

understanding of the source and degree of the institution's risk

exposures and how these risk exposures may change under differing

economic scenarios.

III. Eligible Investments

A. Overview

System banks may purchase and hold the eligible investments listed

in Sec. 615.5140 to maintain liquidity reserves, manage interest rate

risk, and invest surplus short-term funds. Similarly, redesignated

Sec. 615.5142 (formerly Sec. 615.5141) authorizes FCS associations to

hold eligible investments listed in Sec. 615.5140 to invest surplus

funds and reduce interest rate risk. Only investments that can be

promptly converted into cash without significant loss are suitable for

achieving these objectives. For this reason, the eligible investments

listed in Sec. 615.5140 generally have short terms to maturity and high

credit ratings from nationally recognized statistical rating

organizations (NRSROs). Furthermore, all eligible investments are

either traded in active secondary markets or are valuable as

collateral.

We proposed to amend Sec. 615.5140 so System banks and associations

could purchase and hold a broader array of high-quality and liquid

investments. As a result, the proposed regulations expanded the list of

eligible investments and relaxed or repealed certain restrictions in

Sec. 615.5140. These revisions reflect changes in the financial markets

and help fulfill our objective of developing a regulatory framework

that can more readily accommodate innovations in financial products and

analytical tools.

Two commenters, the PFC and The Bond Market Association, generally

supported our proposal to amend Sec. 615.5140. The commenters also

asked us to approve other instruments that would offer higher yields

and further diversify the investment portfolios of System institutions.

As we explain in greater detail below, we incorporated many of the

commenters' suggestions into final Sec. 615.5140. In addition, as part

of our efforts to write regulations that are easier to understand and

use, we converted most of Sec. 615.5140 into a chart.

We received no comments on proposed Sec. 615.5140(a)(1), (a)(3),

(a)(7), and (a)(8), which respectively authorize FCS banks and

associations to invest in:

Securities that are issued or guaranteed by the United

States, its agencies, or instrumentalities;

Obligations of international and multilateral development

banks;

Corporate debt obligations; and

Shares of investment companies that register under the

Investment Company Act of 1940 (e.g., money market mutual funds).

Accordingly, we made no substantive changes to Sec. 615.5140(a)(1),

(a)(3), (a)(7), and (a)(8).

State and Municipal Securities

Existing Sec. 615.5140(a)(10) authorizes System banks and

associations to invest in the general obligations of State and

municipal governments. We proposed to redesignate this provision as

Sec. 615.5140(a)(2) without significant change. However, we added a

definition of ``general obligation of a State or political

subdivision'' to Sec. 615.5131 to

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codify our recent guidance on bonds guaranteed by the full faith and

credit of a State or local government.\9\ We rewrote the definition to

make it clear and we now adopt Secs. 615.5140(a)(2) and 615.5131(e) as

final regulations.

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\9\ See FCA BL-038, ``Guidance Relating to Investment

Activities,'' Nov. 26, 1997).

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Prior to this rulemaking, System banks requested authority to

invest in revenue bonds. Revenue bonds are not supported by the

taxation powers of the obligor, and are repayable from fee income and

other sources of revenue. We requested input on how the final

regulation could authorize investments in revenue bonds while limiting

risks to System institutions. More specifically, we solicited comments

on how the final regulation could establish:

Criteria for determining which revenue bonds meet the

investment purposes in Sec. 615.5132; and

Appropriate limits on the amount of these investments.

We received only one comment concerning municipal securities. The

PFC suggested that all highly rated revenue bonds should be eligible

investments. The PFC believes that highly rated revenue bonds are

suitable for meeting liquidity and interest rate risk management

objectives.

Municipal revenue bonds may provide FCS banks and associations with

another suitable investment to diversify their portfolios. The universe

of municipal revenue bonds is diverse and some, but not all, of these

instruments are actively traded in established secondary markets.

Although the full faith and credit of a governmental entity with

taxation powers does not back municipal revenue bonds, these

instruments usually enjoy an implicit guarantee of the State

government. For these reasons, we add municipal revenue bonds as

eligible investments, subject to certain safety and soundness controls.

Final Sec. 615.5140(a)(2) authorizes FCS banks and associations to

invest in municipal revenue bonds that are rated in the highest

investment rating category by an NRSRO and mature within 5 years or

less. The final regulation requires the investing System bank or

association to document, at the time of purchase, that the particular

issue is actively traded in an established secondary market.

Additionally, these investments are subject to a 15-percent portfolio

limit. We also added a conforming definition of ``revenue bonds'' to

final Sec. 615.5131.

C. Money Market Instruments

We proposed several changes to the provisions in Sec. 615.5140 that

authorize FCS banks and associations to invest in money market

instruments. Under our proposal, all money market instruments were

grouped together into a single regulatory provision,

Sec. 615.5140(a)(4). We proposed to repeal existing limitations on the

amounts of negotiable certificates of deposit, Federal funds (Fed

Funds), bankers acceptances, and prime commercial paper that each FCS

institution can hold in its investment portfolio. We also added

Eurodollar time deposits and master notes to the list of eligible money

market investments.

Only the PFC commented on proposed Sec. 615.5140(a)(4). The

commenter asked us to: (1) Repeal the ``callable'' requirement for Term

Federal Funds; and (2) clarify the credit rating requirements for

repurchase agreements and master notes.

1. Term Federal Funds

From the commenter's perspective, our insistence that System

institutions invest only in negotiable Term Fed Funds is inconsistent

with our approach toward Eurodollar time deposits. The PFC pointed out

that proposed Sec. 615.5140(a)(4) granted System institutions new

authority to invest in non-negotiable Eurodollar time deposits, which

are very similar to Term Fed Funds in terms of credit, liquidity, and

market risks. The PFC asserts that Term Fed Funds do not need a

``callable'' feature to make them liquid because our regulation already

requires them to maintain a high credit rating and mature within 100

days. Thus, the PFC urges us to delete the provision in

Sec. 615.5140(a)(4)(i) that requires all Term Fed Funds to be

``callable.''

The PFC persuaded us that highly rated Term Fed Funds that mature

within 100 days are suitable investments, even if they are not

``callable.'' Thus, we amended this provision so final

Sec. 615.5140(a)(4) no longer requires System banks and associations to

invest only in ``callable'' Term Fed funds.\10\ This change will

provide System institutions with additional flexibility to invest with

counterparties that do not offer ``callable'' features on Term Fed

Funds.

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\10\ In the final regulations, Term Fed Funds are defined as

having a maturity between 2 and 100 business days.

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In addition, the final regulations apply consistent treatment of

investments in Term Fed Funds and Eurodollar time deposits. Final

Sec. 615.5140 subjects non-callable Term Fed Funds to the same 20-

percent portfolio limit as Eurodollar time deposits. From a safety and

soundness perspective, this portfolio limit is necessary to limit the

amount of non-negotiable instruments that are held in bank and

association investment portfolios. The final regulation continues to

place no portfolio limit on the amount of ``continuously callable''

Term Fed Funds that FCS banks and associations can hold. Like

Eurodollar time deposits, non-callable Term Fed Funds must also be

invested at depository institutions with the highest short-term credit

rating from an NRSRO.

2. Response to Comments on Credit Ratings

a. When are short-term or long-term credit ratings appropriate for

the collateral securing repurchase agreements? Final

Sec. 615.5140(a)(4) allows System banks and associations to invest in

repurchase agreements that are backed either by: (1) Eligible

investments; or (2) other marketable securities that are rated in the

highest credit rating category by an NRSRO. The type of collateral

should determine whether a short-term or a long-term credit rating is

appropriate. System banks and associations may use an equivalent long-

term rating if it is the only credit rating available for a short-term

financial instrument held as collateral in a repurchase agreement.

b. Are long-term credit ratings appropriate when no short-term

ratings are available for counterparties to master note agreements?

Yes. We recognize that certain institutions that are counterparties to

master note agreements may only have long-term credit ratings from an

NRSRO. When short-term credit ratings are unavailable, System

institutions may use an equivalent long-term rating to determine if the

money market instrument is eligible under our regulations. For example,

we consider an ``A-1'' short-term rating from Standard and Poor's (S&P)

to be the equivalent to a ``AA'' or higher long-term S&P rating.

D. Mortgage Securities

1. Overview

We proposed significant changes to the authority of FCS

institutions to invest in mortgage securities. The proposal expanded

the list of eligible investments to include certain non-agency mortgage

securities and stripped mortgage-backed securities (SMBS). We proposed

these amendments to grant FCS banks and associations more options for

managing risks and diversifying their portfolios.

Both the PFC and The Bond Market Association suggested additional

revisions to the regulation, and asked us

[[Page 28890]]

several questions about the proposed requirements. They recommend that

we grant FCS banks and associations authority to invest in: (1)

Mortgage securities that are rated within the two highest rating

categories by an NRSRO, (2) multifamily mortgage securities, and (3)

non-agency commercial mortgage-backed securities (CMBS). In response to

these comments, we revised Sec. 615.5140(a)(5) so System banks and

associations can invest in a broader array of mortgage securities.

2. Credit Ratings

Both the PFC and The Bond Market Association asked us to authorize

investments in mortgage securities that are rated in the ``two''

highest (rather than only the highest) credit rating categories of an

NRSRO. The commenters assert that investment grade mortgage securities

in general have exhibited a remarkable credit performance history. Over

the past 20 years, few mortgage security issues have experienced

credit-related problems. Furthermore, the two highest credit ratings

would correspond with the criteria in the Secondary Mortgage Market

Enhancement Act of 1984.\11\

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\11\ See Pub. L. 98-440, 98 Stat. 1689 (Oct. 3, 1984).

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After carefully considering the commenters' input and weighing the

potential risks, we did not adopt the suggestion to lower the credit

rating for mortgage securities. There is an ample assortment of

mortgage securities in the highest investment credit rating category

that System banks and associations can use for liquidity, cash and

interest rate risk management. We believe the final regulation

maintains the high credit quality of System investments without

depriving System institutions of any significant opportunity to invest

in mortgage securities.

3. Mortgage Securities that are Issued or Guaranteed by the United

States

We made a technical correction to the provision that allows FCS

banks and associations to invest in mortgage securities that are issued

or fully guaranteed by the United States. Our proposal omitted language

in the former regulations that authorize investment in securities that

are backed by mortgages that are guaranteed as to both principal and

interest by the full faith and credit of the United States. Final

Sec. 615.5140(a)(5) allows System banks and associations to invest in

mortgage securities that are:

Issued or guaranteed by the Government National Mortgage

Association (GNMA); or

Secured by mortgages that are guaranteed as to both

principal and interest by the full faith and credit of the United

States.

This provision extends to mortgage securities issued by the Small

Business Administration (SBA) or other Federal government agencies if

the full faith and credit of the United States back the principal and

interest payment of the underlying mortgages. All mortgage securities

that System banks and associations purchase under Sec. 615.5140(a)(5)

must comply with the stress-testing requirements in Sec. 615.5141.

4. Agency Mortgage Securities

We made no changes to FCS institutions' authorities to invest in

residential mortgage securities that are:

Issued by Fannie Mae and the Freddie Mac; or

Issued under a private label but are collateralized by

Fannie Mae or Freddie Mac mortgage-backed securities.

System banks, however, suggested that we add Fannie Mae Delegated

Underwriting and Servicing (DUS) bonds to the list of eligible

investments. Fannie Mae DUS bonds are mortgage securities backed by

multifamily mortgage loans. They carry the Fannie Mae guarantee on the

timely payment of principal and interest. They also have low prepayment

risk due to yield maintenance agreements, prepayment lockouts, and

prepayment fees. We agree that agency mortgage securities backed by

multifamily loans are suitable investments for FCS institutions.

Therefore, we amended the definition of ``mortgage securities'' in

Sec. 615.5131(i) to clarify that FCS banks and associations have the

authority to invest in Fannie Mae DUS bonds and other mortgage

securities on multifamily residential properties that are issued or

guaranteed by Federal agencies and instrumentalities. Agency mortgage

securities that are secured by multifamily loans must meet the stress-

testing requirements of Sec. 615.5141.

5. Portfolio Limits on Fannie Mae and Freddie Mac Mortgage Securities

Two commenters, the PFC and The Bond Market Association, asserted

that the 50-percent portfolio limit on Fannie Mae and Freddie Mac

mortgage securities is overly restrictive and unprecedented. According

to these commenters, the credit risk on these securities is almost non-

existent and no other financial regulatory agency places any

restrictions on the amount of these securities.

After a thorough evaluation of these comments, we decided not to

eliminate the portfolio limit on Fannie Mae and Freddie Mac mortgage

securities. We believe that regulatory portfolio limits enhance safety

and soundness by promoting diversification of System investment

portfolios and curtailing investments in securities that may exhibit

considerable interest rate risk. The final regulation greatly expands

the types of mortgage securities that are eligible investments. Under

the circumstances, we believe portfolio limits are an appropriate

regulatory tool for controlling the System's market risk exposure from

these instruments.

We did, however, make one important modification to the proposed

portfolio limits in response to the commenters' concerns. Under the

final regulations, the 50-percent limit on agency mortgage securities

is now separate from the 15-percent limit on non-agency residential and

commercial mortgage securities. The new portfolio limits accommodate

the System's desire for greater opportunities to invest in mortgage

securities.

We emphasize that the board and management of each System bank,

association, or service corporation are responsible for establishing

exposure limits on all types of mortgage securities. Regulatory

portfolio limits on certain mortgage securities do not absolve an

institution's board or management of its responsibility to set limits

based on its unique risk-bearing capacity, management capabilities, and

objectives. Moreover, the board of directors of each System bank or

association has a fiduciary duty to maintain a well-diversified

investment portfolio to reduce the risk of substantial loss. We also

expect FCS banks and associations to diversify their investments within

each major asset class.

6. Non-Agency Mortgage Securities

Our proposal would authorize System institutions to invest in

mortgage securities that are offered by private entities.\12\ Under the

proposal, only the highest rated privately issued securities that are

collateralized by qualifying residential mortgages meeting the

collateral requirements of the Secondary Mortgage Market Enhancement

Act of 1984 (SMMEA), would be eligible investments.\13\ SMMEA

securities must generally be secured by a first lien on

[[Page 28891]]

a single parcel of real estate (residential or mixed residential

commercial structure) and originated by a qualifying financial

institution.\14\ Our proposal required System banks and associations to

subject these mortgage securities to a stress test under Sec. 615.5141

prior to purchase.

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\12\ See proposed Sec. 615.5140(a)(5)(ii).

\13\ The proposed rule allows investments in mortgage securities

that are offered and sold pursuant to section 4(5) of the Securities

Act of 1933, 15 U.S.C. 77d(5) or are residential mortgage-related

securities within the meaning of section 3(a)(41) of the Securities

Exchange Act of 1934, 15 U.S.C. 78c(a)(41).

\14\ See SMMEA amended section 3(a)(41) of the Securities

Exchange Act of 1934.

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System banks requested additional authority to invest in mortgage

securities that are collateralized by mortgages on commercial

properties, such as apartment buildings, shopping centers, office

buildings, and hotels. CMBS typically have yield maintenance provisions

or other features that provide greater prepayment protection to

investors than residential mortgage securities.\15\ However, CMBS are

more difficult to analyze in terms of credit risk. The structure of

CMBS securities can vary widely and the more unique structures may

contain additional risks that need to be thoroughly evaluated. The CMBS

market is relatively young and has recently experienced liquidity

problems.

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\15\ ``CMBS'' refers only to non-mortgage securities on

commercial real estate. This term does not cover Fannie Mae mortgage

securities on mixed residential and commercial properties or

mortgage securities on commercial real estate that the SBA issues or

guarantees.

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On balance, we conclude CMBS with appropriate safety and soundness

controls may help Farm Credit banks achieve greater portfolio

diversification and risk-adjusted returns. We, therefore, authorized

investments in CMBS that are rated in the highest credit rating

category by an NRSRO and supported by no less than 100 mortgage loans

that are geographically dispersed. Additionally, no single obligor can

be the mortgagor on more than 5 percent of the loans in the entire

mortgage pool. The final regulation subjects CMBS to the same portfolio

cap as non-agency mortgage securities. As a result, the combined

investment in CMBS and non-agency mortgage securities cannot exceed 15

percent of the total investment portfolio.

Prudent investment practices require investment managers to fully

understand the cashflow characteristics and price sensitivity of CMBS

investments. Thus, we require System institutions to subject CMBS

investments to stress testing in accordance with Sec. 615.5141.

Furthermore, System banks should rely on evaluation methodologies that

take into account all the risk elements in CMBS investments. In this

regard, we stress the importance of making an independent and critical

evaluation of the security's credit and liquidity risks prior to

purchase, and on an ongoing basis.

7. Other Mortgage-Derivative Products

The FCA proposed to repeal existing Secs. 615.5131(r) and (s),

615.5140(a)(2)(v), and certain provisions in Sec. 615.5174(c) that

explicitly ban investments in SMBS and inverse floating-rate debt

classes. We concluded that the explicit regulatory ban on certain

mortgage-derivative products (MDP) is unnecessary because all mortgage

securities are subject to stress-testing requirements. We received no

comments regarding these proposed changes, and therefore adopt this

provision as a final rule.

However, certain MDP (such as SMBS) may pose substantial risks to

the System institutions, and, therefore we take this opportunity to

reiterate the importance of effective risk management and to provide

additional guidance. Although we recognize that MDP can be useful tools

for reducing interest rate risk, certain MDP are risky because their

prices may be subject to substantial fluctuations. Successful risk

management of these instruments requires a thorough understanding of

the principles that govern the pricing of these instruments. The degree

of price sensitivity that a mortgage security exhibits to changes in

market interest rates is influenced by its unique characteristics. A

System institution should determine whether a particular mortgage

security meets its risk management objectives by using analytical

techniques and methodologies that effectively evaluate how interest

rate changes will affect prepayments and cashflows of the instrument.

Investment managers must have a reasonable basis for making

investments in MDP that exhibit significant price sensitivity and

maintain appropriate records to support their investment decisions. In

general, the FCA would view it as an unsafe and unsound practice for

FCS banks and associations to hold highly price-sensitive MDPs, such as

interest-only or principal-only SMBS, for any purpose other than to

reduce specific interest rate risks. Managers must document, prior to

purchase and each quarter thereafter, that the MDP is reducing the

interest rate risk of a designated group of assets or liabilities and

the interest rate risk of the institution.

E. Asset-Backed Securities

1. An Overview of Our Proposal and Summary of Comments

Our proposal expanded the collateral for eligible asset-backed

securities (ABS) to include student loans, manufactured housing loans,

wholesale dealer automobile loans, equipment loans and home equity

loans. Under these regulations, securities collateralized by home

equity loans qualify as ABS, not mortgage securities. Proposed

Sec. 615.5140(a)(6) specified that the weighted average life (WAL) for

all eligible ABS could not exceed 5 years and the final maturity could

not exceed 7 years. We further proposed that all eligible ABS achieve

the highest credit rating from an NRSRO, and we suggested a 20-percent

portfolio cap on these investments. We also solicited your comments on

how we could develop a more flexible regulatory framework that could

effectively respond to new innovations in the ABS market.

The PFC and The Bond Market Association responded to our proposal

on ABS. They asked us to revise the provisions in proposed

Sec. 615.5140(a)(6) relating to ABS maturity, collateral, and credit

rating requirements and the portfolio limit. In response, we made

several modifications to these proposed provisions, which are explained

below.

2. Final Maturity

The PFC and The Bond Market Association advised us that the

combination of a 5-year WAL and a final maturity of 7 years would

effectively prevent System banks and associations from investing in

some of the most liquid segments of the ABS markets. As a result, both

commenters asked us to omit the provision that establishes a final

maturity for ABS from final Sec. 615.5140(a)(6).

We conclude that the commenters' suggestion has merit. Generally,

the WAL is the average amount of time required for each dollar of

invested principal to be repaid, based on the cashflow structure of an

ABS and an assumed level of prepayments. In contrast, the final

maturity of an ABS refers to the date that the final principal payment

on the underlying collateral is due. Nearly all ABS are priced and

traded on the basis of their WAL. We agree that the 7-year final

maturity restriction in the proposed rule would have effectively

foreclosed the System's ability to invest in ABS that are backed by

certain types of collateral, especially manufactured housing and home

equity loans. Therefore, the final rule does not

[[Page 28892]]

impose a maximum final maturity on ABS.

3. Adjustable Rate ABS

The PFC also asked us to modify the maturity guidelines for

adjustable rate ABS so that they are more consistent with the criteria

for adjustable rate mortgage securities. The preamble to the proposed

rule noted that repricing frequency, periodic life caps, and the

underlying index are important determinants of how a floating rate ABS

performs and its interest rate risk profile.\16\ Although the PFC

generally agreed with this statement, it pointed out that the maturity

(whether defined as WAL, expected final or legal final maturity) will

not provide much insight into the interest rate risk profile of the

instrument. The PFC also noted that these securities have minimal price

sensitivity and interest rate risk because most adjustable rate ABS:

(1) Frequently reprice off a recognized index; (2) are uncapped; or (3)

have very high lifetime interest rate caps. We agree and we have

modified the regulations to address these concerns. Under the final

regulations, the expected WAL on eligible ABS must not exceed:

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\16\ See 63 FR 33281, 33289 (June 18, 1998).

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Five (5) years for a fixed rate security or floating rate

security at its contractual interest rate cap;

Seven (7) years for a floating rate security without a cap

or floating rate security that remains below its contractual interest

rate cap.

4. Collateral and Credit Ratings

The PFC suggests that final Sec. 615.5140(a)(6) authorizes System

banks to invest in any ABS that is rated in the two highest credit

rating categories by an NRSRO once a liquid market is established. The

PFC believes that its suggestion would expand the System's

opportunities to invest in the ABS market while preventing System banks

and associations from acquiring individual securities that are

illiquid. The PFC asserts that a high credit rating is indicative of

whether an ABS is liquid. The commenter supports its position by

pointing out that the secondary market for ABS is now larger than the

secondary market for Collateralized Mortgage Obligations (CMOs). If we

adopted this approach, the final regulation would not restrict the

types of collateral that back eligible ABS.

We did not incorporate the PFC's suggestion into final

Sec. 615.5140(a)(6). This regulation allows System banks and

associations to invest in most ABS that are available in the financial

markets. Although the ABS market now outpaces the CMO market, the

secondary market for ABS issues secured by other types of collateral is

more limited. The PFC acknowledges in its comment letter that its

suggestion may not necessarily be a reliable gauge of liquidity in ABS

markets. Final Sec. 615.5140(a)(6) provides System institutions ample

opportunities to invest in highly rated, fixed-income ABS that offer

stable cashflows. Furthermore, the FCA will consider approval of other

types of ABS on a case-by-case basis under final Sec. 615.5140(e).

5. Portfolio Limit

We did not incorporate The Bond Market Association's suggestion to

increase the portfolio limit on ABS from 20 to 50 percent. The ABS

market primarily developed during a period of prolonged economic

growth, and, for the most part, the performance of the ABS market has

not been tested under significant economic stress. For this reason, we

are reluctant to increase the System's exposure to ABS investments at

this time.

Separately, System institutions asked us to explain how

Sec. 615.5140 applies to senior ABS that are secured by student loans

the United States Department of Education conditionally guarantees.

These securities are backed by loans that are conditionally guaranteed

by the United States Department of Education through a program that

reinsures the guarantees of loans by State and nonprofit agencies. The

portion of the security that the United States Department of Education

does not conditionally guarantee must be counted toward the 20-percent

ABS limit. The portfolio limit does not apply to the portion of the

security that the United States guarantees. This treatment is

consistent with our approach of placing no portfolio restrictions on

investments in obligations that are insured or guaranteed by the United

States or its agencies. Obligations that are insured or guaranteed by

the United States or its agencies are authorized under

Sec. 615.5140(a)(1).

F. Approval Process for Other Investments

We solicited comments on how final Sec. 615.5140 could permit FCS

banks and associations to invest in highly rated marketable securities

that are not expressly authorized by Sec. 615.5140 without requiring

FCA approval. System banks suggested that the FCA should pursue a more

general and broader approach to risk management and establish a set of

price volatility guidelines that could be applied to all types of

investments. After considering this suggestion, we concluded, for the

reasons explained below, that this suggestion is not an effective

replacement for the prior approval requirement in Sec. 615.5140.

We make no changes in our process for approving investments not

listed in Sec. 615.5140 for several reasons. We designed final

regulations that would grant FCS banks more flexibility to manage risk

in accordance with their own unique risk tolerance and objectives. For

example, FCS institutions now have the option under Sec. 615.5141 to

establish their own internal price volatility guidelines for mortgage

securities. Furthermore, the final regulations expand the list of

eligible investments and remove or relax regulatory restrictions on

other authorized investments. Together, these amendments provide each

FCS bank with a broader selection of investments so it can establish a

well diversified investment portfolio that will enable it to maintain a

liquidity reserve, invest surplus funds, and manage interest rate

risks. Similarly, Sec. 615.5133 places the primary responsibility for

identifying, measuring, and managing risk with each System institution.

This provision allows each FCS institution to set its own risk

tolerance levels based on its unique circumstances.

Furthermore, establishing a single set of price volatility

guidelines that applies to all types of investments and all System

banks and associations is inconsistent with our new regulatory

approach. We believe we can achieve our safety and soundness objectives

by placing greater emphasis on effective investment and risk management

practices within the System. Therefore, the final regulations continue

to require System institutions to seek our approval before they

purchase investments not listed in Sec. 615.5140.

G. Equity Investments

CoBank, ACB, responded to our initiative on regulatory burden by

suggesting that we amend Sec. 615.5140 so FCS banks could hold equity

investments in borrowers and other third parties who form strategic

alliances to serve System customers. These types of investments further

the System's mission to finance agriculture and rural communities, but

usually they are not suitable for managing liquidity and market risks

at System institutions. We plan to initiate a rulemaking in the future

that will address the authority of FCS banks and associations to hold

equity investments that are related to their agricultural credit

mission.

[[Page 28893]]

Accordingly, we will address CoBank's request at that time.

IV. Stress Testing for Mortgage Securities

We adopt the requirements for stress testing mortgage securities in

Sec. 615.5141 as a final regulation without substantive amendment.

However, we did receive several questions and comments regarding stress

testing that require a response.

Prior to this rulemaking, FCS banks requested technical

modifications to our existing regulatory stress tests. System banks

subsequently requested that we repeal the regulatory stress tests after

the FFIEC rescinded a policy statement that required depository

institutions to stress test mortgage-derivative products.\17\ System

banks commented that the FCA should make its regulatory approach

consistent with the FFIEC's new policy. In response, we proposed

significant changes to existing requirements for evaluating the price

sensitivity of mortgage securities and determining their suitability.

We, however, did not propose to rescind the stress-testing requirement

for mortgage securities.

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\17\ See 63 FR 20191 (Apr. 23, 1998).

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We concluded that stress testing is an essential risk management

practice for several reasons. Although credit risk on highly rated

mortgage securities is minimal, mortgage securities may expose

investors to significant interest rate risk. Since borrowers may prepay

their mortgages, investors may not receive the expected cashflows and

returns on these securities. Additionally, numerous factors influence

the cashflow pattern and price sensitivity of mortgage securities.

Prepayments on these securities are affected by the spread between

market rates and the actual interest rates of mortgages in the pool,

the path of interest rates, and the unpaid balances and remaining terms

to maturity on the mortgage collateral. The price behavior of a

mortgage security also depends on whether the security was purchased at

a premium or at a discount. As a result of these factors, we concluded

that each System institution needs to employ appropriate analytical

techniques and methodologies to measure and evaluate interest rate risk

inherent in mortgage securities. More specifically, prudent risk

management practices require every System institution to examine the

performance of each mortgage security under a wide array of possible

interest rate scenarios.

Our proposal allowed each System institution to accomplish this

performance analysis by choosing between two options for stress testing

mortgage securities. Under the first option, an FCS institution could

continue to use a modified version of the existing three-pronged stress

test in Sec. 615.5141(a). The three tests include an average life test,

an average life sensitivity test, and a price sensitivity test.

The Bond Market Association suggested that we eliminate the

standardized stress tests in Sec. 615.5141(a) because a risk management

program that requires a financial institution to identify, measure,

monitor, and control risk on an institutional or portfolio level is

more effective than a pass/fail test for individual instruments.

However, we elect to retain the three-pronged stress test in

Sec. 615.5141(a) as a viable option for System institutions. Our

reasoning for this decision stems from our concerns about additional

resources, costs, and expertise associated with more comprehensive

analytical techniques needed to effectively manage risk at the

portfolio or institutional level. From a historical perspective, the

tests in Sec. 615.5141(a) successfully protected Farm Credit banks from

significant losses in certain mortgage products. By requiring the pre-

purchase and quarterly price sensitivity analysis, System banks were

better able to understand the risks associated with their investments.

Under the second stress-testing option, proposed Sec. 615.5141(b)

allowed the use of alternative stress test criteria and methodologies

to evaluate the price sensitivity of mortgage securities. We proposed

this alternative because new risk management techniques better enable

investors to measure interest rate risks in complex mortgage

securities. We also emphasized that alternate stress tests must be able

to measure the price sensitivity of mortgage instruments over different

interest rate and yield curve scenarios. Furthermore, the methodology

must be commensurate with the complexity of the instrument's structure

and cashflows. For example, a pre-purchase analysis should show the

effect of an immediate and parallel shift in the yield curve of plus

and minus 100, 200, and 300 basis points. An instrument's complexity

determines whether the risk analysis should encompass a wider range of

scenarios, including non-parallel changes in the yield curve. A

comprehensive analysis may also take into consideration other relevant

factors. Most importantly, the methodology that each System bank or

association uses to evaluate an instrument's suitability must be able

to determine that a particular mortgage security:

Meets the objectives and risk limits in its investment

policies; and

Does not expose the capital and earnings of the

institution to excessive risk.

We received one comment from the PFC on proposed Sec. 615.5141(b).

The PFC requested clarification on whether the board or the management

of each FCS bank and association is responsible for establishing the

risk parameters of alternate stress tests. If the board elects to use

alternative stress tests as permitted under Sec. 615.5141(b) to gauge

market risk in mortgage securities, it must also assume responsibility

for establishing the risk parameters for the stress test.

In further response to the PFC, we reaffirm that Sec. 615.5141(b)

is consistent with the guidance in the FFIEC's policy statement

regarding stress testing mortgage securities. Our new approach, which

we now adopt as a final regulation, enables System banks and

associations to rely on more comprehensive analytical techniques that

enhance their risk management. Our regulations no longer prevent System

banks and associations from holding mortgage securities solely on the

basis that they exhibit significant price sensitivity. The final

regulation affords FCS banks and associations the latitude to consider

a number of factors when evaluating a mortgage security's suitability.

For example, System banks and associations may consider interest rate

volatility, changes in credit spreads, an instrument's total return or

whether the instrument reduces the overall risk in the investment

portfolio or throughout the institution.

The PFC inquired whether derivative hedge transactions could be

considered when determining whether a mortgage security is an eligible

investment. We confirm that FCS institutions may consider the effect of

derivative hedge transactions on the price sensitivity of instruments

as part of their evaluation of whether a particular mortgage security

is a suitable investment under either Sec. 615.5141(a) or (b).

V. Farmer Mac Mortgage Securities

1. Our Proposal

We proposed technical amendments to Sec. 615.5174, which authorizes

FCS banks and associations to invest in mortgage securities that are

issued or guaranteed by Farmer Mac. Basically, we intended to revise

Sec. 615.5174 so it conforms to amendments in subpart E of part 615.

More specifically, these technical amendments would:

[[Page 28894]]

Delete cross-references to the former definitions of

``mortgage-backed securities,'' ``collateralized mortgage

obligations,'' ``Real Estate Mortgage Investment Conduits,'' and

``adjustable rate mortgages'' in Sec. 615.5131; and

Repeal existing Sec. 615.5174(c), which prohibits FCS

banks and associations from investing in Farmer Mac stripped mortgage-

backed securities.

2. Summary of Comments

Two commenters requested substantive revisions to Sec. 615.5174.

Farmer Mac asked us to amend our regulations to equalize the regulatory

treatment of mortgage securities of Farmer Mac, Fannie Mae, and Freddie

Mac. Farmer Mac asserts that our original justification for according

Farmer Mac mortgage securities a different regulatory treatment than

Fannie Mae and Freddie Mac mortgage securities is no longer valid.

Farmer Mac points out that 2 years after we adopted existing

Sec. 615.5174, Congress enacted the Farm Credit System Reform Act of

1996 \18\ (1996 Act), which repealed several statutory provisions that

distinguished its mortgage securities from those of Fannie Mae and

Freddie Mac. As a result of these statutory changes, Farmer Mac asserts

that the spreads of Farmer Mac mortgage securities are now close to

those on comparable Fannie Mae and Freddie Mac products. For these

reasons, Farmer Mac believes that the mortgage securities of all three

GSEs expose investors to approximately the same risk of loss and should

be treated in a similar fashion.

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\18\ Pub. L. 104-105, 110 Stat. 162 (Feb. 10, 1996).

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The jointly managed Central Coast Production Credit Association/

Federal Land Credit Association (Central Coast) responded to our notice

on regulatory burden by encouraging us to repeal the 20-percent

portfolio limit on Farmer Mac mortgage securities in existing

Sec. 615.5174(a). As the commenter notes, we enacted this portfolio

limit in 1993, when the Act required System banks and associations to

guarantee 10 percent of Farmer Mac mortgage securities through either a

cash reserve or a subordinated participation interest in the underlying

loans. The associations assert that the original safety and soundness

rationale for the 20-percent portfolio limit no longer exists because

Farmer Mac now has the authority both to issue mortgage securities and

to fully guarantee principal and interest payments to investors.

3. Response to Comments

We acknowledge that the 1996 Act granted Farmer Mac many of the

same powers that Fannie Mae and Freddie Mac have to issue and guarantee

mortgage securities. These statutory amendments profoundly changed

Farmer Mac's business operations and the market for its securities. We

agree that the 1996 Act has rendered many provisions of existing

Sec. 615.5174 obsolete, and for this reason, this regulation requires

more than technical and conforming amendments.

4. Final Regulation

We have fashioned a final regulation that balances the interests of

both Farmer Mac and other System institutions. We recognized Farmer

Mac's new statutory powers and market realities by repealing all

obsolete provisions in Sec. 615.5174. The final regulation responds to

Farmer Mac's request for comparable treatment with Fannie Mae and

Freddie Mac by applying the investment management provisions of final

Sec. 615.5133(b) and (c) and the stress test requirements of final

Sec. 615.5141 to Farmer Mac mortgage securities. In the same context,

final Sec. 615.5174 focuses on issues that are unique to investments by

FCS banks and associations in Farmer Mac mortgage securities. In

addition, the final regulation allows System banks and associations

more latitude to manage their credit risks through investments in

Farmer Mac securities.

Final Sec. 615.5174(a) continues to authorize System banks and

associations to invest in mortgage securities that are issued or

guaranteed as to principal and interest by Farmer Mac. This provision

specifically allows System banks and associations to purchase and hold

Farmer Mac securities for the purposes of: (1) Managing credit and

interest rate risk; and (2) furthering their mission to finance

agriculture. Certain Farmer Mac mortgage securities may help System

banks and associations to manage interest rate risk exposures in their

portfolios. Additionally, System banks and associations can use these

mortgage securities for cashflow management because Farmer Mac

guarantees that investors will receive timely payment of principal and

interest.

We added explicit references to associations to final Sec. 615.5174

to clarify the scope of this regulation. Because redesignated

Sec. 615.5142 contained a redundant authorization for FCS associations

to purchase and hold Farmer Mac mortgage securities, we deleted the

reference to Sec. 615.5174 in redesignated Sec. 615.5142.

System banks and associations can still acquire subordinated

participation interests in Farmer Mac pools, although title VII of the

Act no longer requires them to do so. Investments by System banks and

associations in subordinate Farmer Mac securities are also subject to

regulations in part 614 of this chapter.

In response to Central Coast's request, we modified the portfolio

cap in this regulation. Farmer Mac mortgage securities can be used to

diversify the credit risk exposure in FCS bank and association

agricultural loans and further their important mission objectives.

Therefore, final Sec. 615.5174 allows System banks and associations to

hold Farmer Mac mortgage securities in an amount that is equal to their

total outstanding loans.

We note that System banks must not count Farmer Mac mortgage

securities as part of their total outstanding loans when they calculate

their 30-percent portfolio limit for liquid investments under

Sec. 615.5132. Our reason for this treatment is that Farmer Mac

mortgage securities are not considered loans of System banks and

associations.

Final Sec. 615.5174(b) covers the responsibilities of boards and

senior management for overseeing investments in Farmer Mac securities.

This provision requires each Farm Credit bank and association board of

directors to adopt written policies that will govern their investments

in Farmer Mac securities. Final Sec. 615.5174(b) closely parallels

similar provisions in Sec. 615.5133 that guide investment management

practices for non-agricultural investments.

Final Sec. 615.5174(c) also closely follows similar provisions in

Sec. 615.5133. This provision requires banks and associations to

establish policies that identify the types and quantity of Farmer Mac

securities they will hold to achieve their objectives and set credit,

market, and liquidity risk limits. Under final Sec. 615.5174(c)(2), the

board's policy must establish specific criteria for managing credit

risk by establishing product and geographic diversification

requirements for investments in Farmer Mac mortgage securities. Final

Sec. 615.5174(c)(3) requires the board's policies to address how the

market risk of Farmer Mac mortgage securities affects the institution's

capital and earnings.

Under final Sec. 615.5174(c)(4), board policies must indicate

liquidity risk tolerance levels. Risk preferences may be based on the

liquidity characteristics of the types of Farmer Mac securities you

wish to select for your portfolio and your institutional objectives. We

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recognize that if your objective is to hold Farmer Mac securities until

maturity, liquidity risk is less important. Additionally, the final

regulations prohibit Farm Credit banks from holding Farmer Mac mortgage

securities in the liquidity reserve they maintain under Sec. 615.5134.

Our concern over concentration risk led us to develop this provision.

For example, if the System had real or perceived credit problems due to

a crisis in the agricultural economy and could not access the market at

reasonable rates, those same economic factors may also adversely affect

the price and liquidity of Farmer Mac securities.

Lastly, final Sec. 615.5174(d) requires System banks and

associations to perform stress tests in accordance with final

Sec. 615.5141 to measure market risks in these securities.

VI. Liquidity Reserve

We received no comment on our proposal to repeal a provision in

existing Sec. 615.5134(b) which requires System banks to segregate

investments in the liquidity reserve from investments that are held for

other purposes under Sec. 615.5132. This amendment provides FCS banks

with greater flexibility to decide how to best use their investments to

manage risk exposure.

In response to our initiative on regulatory burden, CoBank, ACB,

stated that the ``burdensome liquidity reserve requirement calculations

should be simplified.'' The commenter did not offer any suggestions for

simplifying the liquidity reserve requirement in Sec. 615.5134.

The liquidity reserve requirement for System banks is calculated

using a basic formula. The liquidity reserve requirement ensures that

FCS banks have a pool of liquid investments to fund their operations

for approximately 15 days if their access to the capital markets

becomes impeded. We believe the significance of maintaining an ample

supply of liquid funds outweighs any burdens created by the liquidity

reserve calculation process. Thus, we made no changes to the liquidity

reserve calculation at this time.

List of Subjects in 12 CFR Part 615

Accounting, Agriculture, Banks, banking, Government securities,

Investments, Rural areas.

For the reasons stated in the preamble, part 615 of chapter VI,

title 12 of the Code of Federal Regulations is amended to read as

follows:

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

AND FUNDING OPERATIONS

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

follows:

Authority: Secs. 1.5, 1.7, 1.10, 1.11, 1.12, 2.2, 2.3, 2.4, 2.5,

2.12, 3.1, 3.7, 3.11, 3.25, 4.3, 4.3A, 4.9, 4.14B, 4.25, 5.9, 5.17,

6.20, 6.26, 8.0, 8.3, 8.4, 8.6, 8.7, 8.8, 8.10, 8.12 of the Farm

Credit Act (12 U.S.C. 2013, 2015, 2018, 2019, 2020, 2073, 2074,

2075, 2076, 2093, 2122, 2128, 2132, 2146, 2154, 2154a, 2160, 2202b,

2211, 2243, 2252, 2278b, 2278b-6, 2279aa, 2279aa-3, 2279aa-4,

2279aa-6, 2279aa-7, 2279aa-8, 2279aa-10, 2279aa-12); sec. 301(a) of

Pub. L. 100-233, 101 Stat. 1568, 1608.

Subpart E--Investment Management

2. Section 615.5131 is revised to read as follows:

Sec. 615.5131 Definitions.

For purposes of this subpart, the following definitions apply:

(a) Asset-backed securities (ABS) mean investment securities that

provide for ownership of a fractional undivided interest or collateral

interests in specific assets of a trust that are sold and traded in the

capital markets. For the purposes of this subpart, ABS exclude mortgage

securities that are defined in Sec. 615.5131(i).

(b) Bank means a Farm Credit Bank, agricultural credit bank, or

bank for cooperatives.

(c) Eurodollar time deposit means a non-negotiable deposit

denominated in United States dollars and issued by an overseas branch

of a United States bank or by a foreign bank outside the United States.

(d) Final maturity means the last date on which the remaining

principal amount of a security is due and payable (matures) to the

registered owner. It does not mean the call date, the expected average

life, the duration, or the weighted average maturity.

(e) General obligations of a State or political subdivision means:

(1) The full faith and credit obligations of a State, the District

of Columbia, the Commonwealth of Puerto Rico, a territory or possession

of the United States, or a political subdivision thereof that possesses

general powers of taxation, including property taxation; or

(2) An obligation that is unconditionally guaranteed by an obligor

possessing general powers of taxation, including property taxation.

(f) Liquid investments are assets that can be promptly converted

into cash without significant loss to the investor. In the money

market, a security is liquid if the spread between its bid and ask

price is narrow and a reasonable amount can be sold at those prices.

(g) Loans are defined by Sec. 621.2(f) of this chapter and they are

calculated quarterly (as of the last day of March, June, September, and

December) by using the average daily balance of loans during the

quarter.

(h) Market risk means the risk to the financial condition of your

institution because the value of your holdings may decline if interest

rates or market prices change. Exposure to market risk is measured by

assessing the effect of changing rates and prices on either the

earnings or economic value of an individual instrument, a portfolio, or

the entire institution.

(i) Mortgage securities means securities that are either:

(1) Pass-through securities or participation certificates that

represent ownership of a fractional undivided interest in a specified

pool of residential (excluding home equity loans), multifamily or

commercial mortgages, or

(2) A multiclass security (including collateralized mortgage

obligations and real estate mortgage investment conduits) that is

backed by a pool of residential, multifamily or commercial real estate

mortgages, pass-through mortgage securities, or other multiclass

mortgage securities.

(j) Nationally Recognized Statistical Rating Organization (NRSRO)

means a rating organization that the Securities and Exchange Commission

recognizes as an NRSRO.

(k) Revenue bond means an obligation of a municipal government that

finances a specific project or enterprise but it is not a full faith

and credit obligation. The obligor pays a portion of the revenue

generated by the project or enterprise to the bondholders.

(l) Weighted average life (WAL) means the average time until the

investor receives the principal on a security, weighted by the size of

each principal payment and calculated under specified prepayment

assumptions.

(m) You means a Farm Credit bank, association, or service

corporation.

3. Section 615.5133 is revised to read as follows:

Sec. 615.5133 Investment management.

(a) Responsibilities of Board of Directors. Your board must adopt

written policies for managing your investment activities. Your board of

directors must also ensure that management complies with these policies

and that appropriate internal controls are in place to prevent loss.

Annually, the board of directors must

[[Page 28896]]

review these investment policies and make any changes that are needed.

(b) Investment policies. Your board's written investment policies

must address the purposes and objectives of investments, risk

tolerance, delegations of authority, and reporting requirements.

Investment policies must be appropriate for the size, types, and risk

characteristics of your investments.

(c) Risk tolerance. Your investment policies must establish risk

limits and diversification requirements for the various classes of

eligible investments and for the entire investment portfolio. These

policies must ensure that you maintain appropriate diversification of

your investment portfolio. Risk limits must be based on your

institutional objectives, capital position, and risk tolerance. Your

policies must identify the types and quantity of investments that you

will hold to achieve your objectives and control credit, market,

liquidity, and operational risks. The policy of any association or

service corporation that holds significant investments and each bank

must establish risk limits for the following four types of risk.

(1) Credit risk. Investment policies must establish:

(i) Credit quality standards, limits on counterparty risk, and risk

diversification standards that limit concentrations based on a single

or related counterparty(ies), a geographical area, industries or

obligations with similar characteristics.

(ii) Criteria for selecting brokers, dealers, and investment

bankers (collectively, securities firms). You must buy and sell

eligible investments with more than one securities firm. As part of

your annual review of your investment policies, your board of directors

must review the criteria for selecting securities firms and determine

whether to continue your existing relationships with them.

(iii) Collateral margin requirements on repurchase agreements.

(2) Market risk. Investment policies must set market risk limits

for specific types of investments, the investment portfolio, or your

institution. Your board of directors must establish market risk limits

in accordance with these regulations and our other policies.

(3) Liquidity risk. Investment policies must describe the liquidity

characteristics of eligible investments that you will hold to meet your

liquidity needs and institutional objectives.

(4) Operational risk. Investment policies must address operational

risks, including delegations of authority and internal controls in

accordance with paragraphs (d) and (e) of this section.

(d) Delegation of authority. All delegations of authority to

specified personnel or committees must state the extent of management's

authority and responsibilities for investments.

(e) Internal controls. You must:

(1) Establish appropriate internal controls to detect and prevent

loss, fraud, embezzlement, conflicts of interest, and unauthorized

investments.

(2) Establish and maintain a separation of duties and supervision

between personnel who execute investment transactions and personnel who

approve, revaluate, and oversee investments.

(3) Maintain management information systems that are appropriate

for the level and complexity of your investment activities.

(f) Securities valuation.

(1) Before you purchase a security, you must evaluate its credit

quality and its price sensitivity to changes in market interest rates.

You must also verify the value of a security that you plan to purchase,

other than a new issue, with a source that is independent of the

broker, dealer, counterparty or other intermediary to the transaction.

(2) You must determine the fair market value of each security in

your portfolio and the fair market value of your whole investment

portfolio at least monthly. You must also evaluate the credit quality

and price sensitivity to change in market interest rates of all

investments that you hold on an ongoing basis.

(3) Before you sell a security, you must verify its value with a

source that is independent of the broker, dealer, counterparty, or

other intermediary to the transaction.

(g) Reports to the board. Each quarter, management must report to

the board of directors or a board committee on the performance and risk

of each class of investments and the entire investment portfolio. These

reports must identify all gains and losses that you incur during the

quarter on individual securities that you sold before maturity. Reports

must also identify potential risk exposure to changes in market

interest rates and other factors that may affect the value of your

bank's investment holdings. Management's report must discuss how

investments affect your bank's overall financial condition and must

evaluate whether the performance of the investment portfolio

effectively achieves the board's objectives. Any deviations from the

board's policies must be specifically identified in the report.

4. Section 615.5134 is amended by revising paragraph (b) to read as

follows:

Sec. 615.5134 Liquidity reserve requirement.

* * * * *

(b) All investments that the bank holds for the purpose of meeting

the liquidity reserve requirement of this section must be free of lien.

* * * * *

5. Section 615.5140 is revised to read as follows:

Sec. 615.5140 Eligible investments.

(a) You may hold only the following types of investments listed in

the Investment Eligibility Criteria Table. These investments must be

denominated in United States dollars.

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(b) Rating of foreign countries. Whenever the obligor or issuer of

an eligible investment is located outside the United States, the host

country must maintain the highest sovereign rating for political and

economic stability by an NRSRO.

(c) Marketable securities. All eligible investments, except money

market instruments, must be marketable. An eligible investment is

marketable if you can sell it quickly at a price that closely reflects

its fair value in an active and universally recognized secondary

market.

(d) Obligor limits.

(1) You may not invest more than 20 percent of your total capital

in eligible investments issued by any single institution, issuer, or

obligor. This obligor limit does not apply to obligations, including

mortgage securities, that are issued or guaranteed as to interest and

principal by the United States, its agencies, instrumentalities, or

corporations.

(2) Obligor limits for your holdings in an investment company You

must count securities that you hold through an investment company

towards the obligor limit of this section unless the investment

company's holdings of the security of any one issuer do not exceed five

(5) percent of the investment company's total portfolio.

(e) Other investments approved by the FCA. You may purchase and

hold other investments that we approve. Your request for our approval

must explain the risk characteristics of the investment and your

purpose and objectives for making the investment.

Secs. 615.5141 through 615.5143 [Redesignated]

6. Sections 615.5141, 615.5142, and 615.5143 are redesignated as

Secs. 615.5142, 615.5143, and 615.5144, respectively, and a new

Sec. 615.5141 is added to read as follows:

Sec. 615.5141 Stress tests for mortgage securities.

Mortgage securities are not eligible investments unless they pass a

stress test. You must perform stress tests to determine how interest

rate changes will affect the cashflow and price of each mortgage

security that you purchase and hold, except for adjustable rate

securities that reprice at intervals of 12 months or less and are tied

to an index. You must also use stress tests to gauge how interest rate

fluctuations on mortgage securities affect your institution's capital

and earnings. You may conduct the stress tests as described in either

paragraph (a) or (b) of this section.

(a) Mortgage securities must comply with the following three tests

at the time of purchase and each following quarter:

(1) Average Life Test. The expected WAL of the instrument does not

exceed 5 years.

(2) Average Life Sensitivity Test. The expected WAL does not extend

for more than 2 years, assuming an immediate and sustained parallel

shift in the yield curve of plus 300 basis points, nor shorten for more

than 3 years, assuming an immediate and sustained parallel shift in the

yield curve of minus 300 basis points.

(3) Price Sensitivity Test. The estimated change in price is not

more than thirteen (13) percent due to an immediate and sustained

parallel shift in the yield curve of plus or minus 300 basis points.

(4) Exemption. A floating rate mortgage security is subject only to

the price sensitivity test in paragraph (a)(3) of this section if at

the time of purchase and each quarter thereafter it bears a rate of

interest that is below its contractual cap.

(b) You may use an alternative stress test to evaluate the price

sensitivity of your mortgage securities. An alternative stress test

must be able to measure the price sensitivity of mortgage instruments

over different interest rate/yield curve scenarios. The methodology

that you use to analyze mortgage securities must be appropriate for the

complexity of the instrument's structure and cashflows. Prior to

purchase and each quarter thereafter, you must use the stress test to

determine that the risk in the mortgage security is within the risk

limits of your board's investment policies. The stress test must enable

you to determine at the time of purchase and each subsequent quarter

that the mortgage security does not expose your capital or earnings to

excessive risks.

(c) You must rely on verifiable information to support all your

assumptions, including prepayment and interest rate volatility

assumptions, when you apply the stress tests in either paragraph (a) or

(b) of this section. You must document the basis for all assumptions

that you use to evaluate the security and its underlying mortgages. You

must also document all subsequent changes in your assumptions. If at

any time after purchase, a mortgage security no longer complies with

requirements in this section, you must divest it in accordance with

Sec. 615.5143.

7. Newly designated Sec. 615.5142 is revised to read as follows:

Sec. 615.5142 Association investments.

An association may hold eligible investments listed in

Sec. 615.5140, with the approval of its funding bank, for the purposes

of reducing interest rate risk and managing surplus short-term funds.

Each bank must review annually the investment portfolio of every

association that it funds.

8. Newly designated Sec. 615.5143 is revised to read as follows:

Sec. 615.5143 Disposal of ineligible investments.

You must dispose of an ineligible investment within 6 months unless

we approve, in writing, a plan that authorizes you to divest the

instrument over a longer period of time. An acceptable divestiture plan

must require you to dispose of the ineligible investment as quickly as

possible without substantial financial loss. Until you actually dispose

of the ineligible investment, the managers of your investment portfolio

must report at least quarterly to your board of directors about the

status and performance of the ineligible instrument, the reasons why it

remains ineligible, and the managers' progress in disposing of the

investment.

Subpart F--Property and Other Investments

9. Section 615.5174 is revised to read as follows:

Sec. 615.5174 Farmer Mac securities.

(a) General authority. You may purchase and hold mortgage

securities that are issued or guaranteed as to both principal and

interest by the Federal Agricultural Mortgage Corporation (Farmer Mac

securities). You may purchase and hold Farmer Mac securities for the

purposes of managing credit and interest rate risks, and furthering

your mission to finance agriculture. The total value of your Farmer Mac

securities cannot exceed your total outstanding loans, as defined by

Sec. 615.5131(g).

(b) Board and management responsibilities. Your board of directors

must adopt written policies that will govern your investments in Farmer

Mac securities. All delegations of authority to specified personnel or

committees must state the extent of management's authority and

responsibilities for managing your investments in Farmer Mac

securities. The board of directors must also ensure that appropriate

internal controls are in place to prevent loss, in accordance with

Sec. 615.5133(e). Management must submit quarterly reports to the board

of directors on the performance of all investments in Farmer Mac

securities. Annually, your board of directors must review these

policies and the performance of your

[[Page 28900]]

Farmer Mac securities and make any changes that are needed.

(c) Policies. Your board of directors must establish investment

policies for Farmer Mac securities that include your:

(1) Objectives for holding Farmer Mac securities.

(2) Credit risk parameters including:

(i) The quantities and types of Farmer Mac mortgage securities that

are collateralized by qualified agricultural mortgages, rural home

loans, and loans guaranteed by the Farm Service Agency.

(ii) Product and geographic diversification for the loans that

underlie the security; and

(iii) Minimum pool size, minimum number of loans in each pool, and

maximum allowable premiums or discounts on these securities.

(3) Liquidity risk tolerance and the liquidity characteristics of

Farmer Mac securities that are suitable to meet your institutional

objectives. A bank may not include Farmer Mac mortgage securities in

the liquidity reserve maintained to comply with Sec. 615.5134.

(4) Market risk limits based on the effects that the Farmer Mac

securities have on your capital and earnings.

(d) Stress Test. You must perform stress tests on mortgage

securities that are issued or guaranteed by Farmer Mac in accordance

with the requirements of Sec. 615.5141(b) and (c). If a Farmer Mac

security fails a stress test, you must divest it as required by

Sec. 615.5143.

Dated: May 13, 1999.

Vivian Portis,

Secretary, Farm Credit Administration Board.

[FR Doc. 99-13622 Filed 5-27-99; 8:45 am]

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