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• W137690835 abstract "How's that old saying go? Be careful what you wish for. It may come Many bank portfolio managers have been wishing for the repeal of the regulatory test for high-risk collateralized mortgage obligations since its inception in February 1992. Their wish may finally be coming true. On Oct. 3, the Federal Financial Institutions Examination Council (FFIEC) released a notice and request for public comment concerning a new Supervisory Policy Statement on Investment Securities and End-User Derivative Activities (Federal Register, Oct. 3, p. 51862). As part of this proposed new statement, the regulators envision eliminating the three-part high-risk test for CMOs. Yes, that's right, eliminate it. We have long criticized the logic and consistency of the high-risk tests. They were implemented, in the words of the FFIEC's announcement, because the agencies, at that time, believed that many institutions had demonstrated an insufficient understanding of the risks associated with investments in [mortgage derivative products]. This occurred, in part, because most MDPs were issued or backed by collateral guaranteed by government-sponsored enterprises. We have been especially critical of the fact that existence of the tests can create an un-level playing field between CMOs and other investment securities. We have noted, however, that this un-level playing field can lead to inefficiencies and therefore opportunities. Why Washington changed colors What has led the regulators to eliminate these tests after over five years of implementation? In general, they cited changes in generally accepted accounting principles (GAAP), various developments in both securities and derivatives markets, and revisions to their approach to management -- there is more emphasis on banks' own risk-preparedness, versus regulators' direct thou shalt nots. Specifically, they cited several unintended consequences of the tests. To quote liberally from their proposal: ... the high-risk tests may have created unintended distortions of the investment decision-making process. Many institutions eliminated all MDPs [mortgage derivative products] from their investment choices, regardless of the versus return merits of such instruments. These reactions were due, in part, to concerns about regulatory burden, such as higher-than-normal examiner review of MDPs. By focusing only on MDPs, the test, and its accompanying burden indirectly provided incentives for institutions to acquire other types of securities with complex cash flows, often with price sensitivities similar to high-risk MDPs. The emergence of the structured note market is just one example. The test may have also created the impression that supervisors were more concerned with the type of instrument involved (i.e., residential mortgage products), rather than the characteristics of the instrument, since only MDPs were subject to the high-risk test. The specification of tests applied to individual securities may have also inhibited some institutions from applying more analytical techniques at the portfolio and institutional level. Notice their words: risk versus reward merits, risk characteristics, and comprehensive analytical techniques. The regulators are admitting that the existence of this test created some unintended consequences. It took investors' eyes off what was really important -- the bond's risk/reward profile -- and focused them instead on whether or not a bond was subject to a test. What follows in the document is, for regulators, a strongly worded conclusion: ... the agencies no longer believe that the pass/fall criteria of the high tests as applied to specific instruments are useful for the supervision of well-managed institutions. They go on to say that they still believe in management and the remainder of the proposal describes elements of an effective management system. …" @default.
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• W137690835 date "1997-12-01" @default.
• W137690835 modified "2023-09-23" @default.
• W137690835 title "Why the CMO Test Had to Die" @default.
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