June 22, 1987
TO THE CHIEF EXECUTIVE OFFICER OF THE STATE CHARTERED BANK ADDRESSED:
Recently we have been made aware that several state chartered banks have invested funds in the newest creation of the mortgage-backed securities market -- interest-only (IO) and principal-only (PO) strips. The IO component represents a claim against the future payment of interest by the underlying mortgagee, which is passed through to the investor. The investor of the IO component not only faces the usual market risks associated with fixed rate securities, but also faces the risk of early prepayment of the principal on the underlying collateral upon which the IO cash flows are based. If all underlying mortgages were to prepay, the investor would not only experience loss of anticipated income, but would experience the likelihood of not recovering the initial investment. We believe investments in which a state bank may not recover its initial investment are speculative in nature and not a prudent investment. Iowa Administrative Rule 187-9.1 provides as follows:
187-9.1(524) Bonds or securities investment characteristics.
Bonds or other investment securities purchased for investment by a state bank for its own account as provided in section 524.901(2) of the Code shall consist of obligations, which have been publicly offered or which are of such sound value or are so well secured as to be readily salable at a fair value, with investment characteristics not distinctly or predominantly speculative (emphasis added). They shall fall within the four highest grades according to a reputable rating service or they shall represent unrated issues of equivalent value.
It is our position that investment in IO stripped mortgage-backed securities violates this provision. Accordingly, any state chartered bank with IO stripped mortgage-backed securities currently in its investment portfolio or trading account should dispose of the issues immediately.
The principal only component of a mortgage-backed security represents a claim against the monthly repayment of principal by the underlying mortgagee. While early prepayment of underlying mortgages negatively impacts the investor in IO strips, such prepayments provide an enhancement to the yield of the PO strips since the investor receives the principal cash flow at an accelerated rate. Obviously, should prepayments not materialize as quickly as assumed, the yields on the PO strips will be less favorable. Although PO stripped mortgage backed securities would be considered permissible investments for state chartered banks, such investments may not be appropriate for all banks. We believe state chartered banks should be fully aware of the additional market risks associated with this type of investment and have in place policies which appropriately administer the additional risks undertaken.
The financial markets have become extremely volatile recently with various types of investment products being sold by both in-state and out-of-state investment firms. We recommend that before any commitment is made to purchase a PO stripped mortgage-backed security or any other security issue in which you are unfamiliar with the risk characteristics, that a complete analysis of the risks associated with the issue, as well as the investment firm and representative, be performed by the bank on an independent basis. You need to be aware of the fact that assumptions are sometimes used to determine price yields and liquidity in the marketplace of certain issues, and those assumptions are not always close to reality. If we may be of assistance to you as you perform your analysis of these types of securities, do not hesitate to contact this office.
Steven C. Moser