Transcription
Chapter 12INVESTMENT ANALYSISTABLE OF CONTENTSINVESTMENT ANALYSIS .12-3Examination Objectives .12-3Associated Risks .12-3Overview .12-3Examiner Resources.12-4Policies .12-4Examination Guidance .12-10Classification of Securities SFAS 115 .12-10Broker-Dealer Analysis .12-11Audit .12-14Safekeeping .12-14Records .12-17Investment Valuation .12-18Bond Basics .12-18Principal .12-19Coupon Rate.12-19Day Count Basis.12-20Accrued Interest .12-20Price Quotations .12-20Yield Quotations .12-21Investment Products .12-22US Treasury Securities.12-22Treasury Bills .12-22Treasury Notes and Bonds .12-23Treasury Zeros or STRIPS .12-23Other US Guaranteed Securities .12-24Federal Agency Securities.12-24Government Corporations .12-24Government Sponsored Enterprises .12-25Obligations .12-26Participations.12-26Secondary Participations .12-27GNMAs .12-28SBA Guaranteed Loans .12-31Zero Coupon Bonds .12-31SMBS .12-32IOs and POs .12-32CMOs .12-35
INVESTMENT ANALYSISREMIC .12-37IRPS 98-02 .12-37Divestiture of Securities .12-40Residual Interests .12-41Fair Values .12-41Investment in Mortgage Notes .12-42Mutual Funds, Common Trusts, Unit Trusts .12-42Legality of Fund .12-43Characteristics and Risks .12-43Fees .12-44Unit Investment Trusts .12-44CUSOs .12-45Federal Funds .12-45Credit Risk .12-46Corporate Credit Unions .12-46Other Credit Unions .12-47Other Shares, Deposits, and Certificates .12-47Thrift Shares and Bank Deposits .12-47Time Certificates of Deposit .12-48Deposit Notes .12-52Bank Notes .12-52Eurodollar Deposits .12-53Yankee Deposits .12-53Bankers’ Acceptances .12-53Mutual Savings Banks, State Banks, Trust Companies .12-53Loans to Other Credit Unions .12-54State and Municipal Obligations .12-54Repurchase Transactions.12-54Commitments to Purchase or Sell Securities .12-55Standby Commitment .12-55Cash Forward Agreement .12-56Short Sale .12-56Pair-Off Transactions .12-56Reverse Repurchase Transactions .12-56Adjusted Trading .12-58Impermissible or Unsuitable Investments .12-59Investment Trading .12-60Workpapers and References.12-61GLOSSARY OF INVESTMENT TERMS - APPENDIX 12A .12-63REVIEWING THE AUDIT OF DERIVATIVE INSTRUMENTS, HEDGINGACTIVITIES, AND INVESTMENTS IN SECURITIES – APPENDIX 12B.12-99Definitions.12-99Overview .12-99References .12-104
ExaminationObjectivesINVESTMENT ANALYSISChapter 12INVESTMENT ANALYSIS Determine adequacy of the credit union’s investment policy, procedures, and internalcontrolsAssess legality of investments and compliance with related regulations, accountingprocedures, and other guidelinesEvaluate suitability of the investment portfolio in relation to the credit union’sbusiness plan, asset-liability management (ALM) strategies, liquidity, and net worthpositionDetermine fair value of the investment portfolio and the effect of realized or potentiallosses from investment transactions on the credit union’s earnings and capital positionReview correction of investment-related problems by managementAssociatedRisksThe investment area affects all seven risks found in credit union operations – credit,interest rate, liquidity, transaction, compliance, strategic, and reputation. (The RiskFocused Program chapter contains a description of the seven risks faced by credit unions.)This chapter specifically addresses credit, interest rate, liquidity, transaction, compliance,and other operational risks; however, if credit unions suffer significant losses due toinvestment decisions, the credit union could also face reputation risk. Examiner’sjudgment plays an important role in identifying both the type and extent of risks as wellas deciding on appropriate examination procedures.OverviewThe investment portfolio serves as an important source of liquidity and can represent asubstantial portion of a credit union’s assets. Likewise, investment income can serve asan important source for meeting a credit union’s operating expenses, dividend payments,and reserve requirements (if applicable.) Thus, the examiner’s assessment ofmanagement’s ability to invest prudently is an important part of the examination.The extent of the examiners’ investment reviews will depend on the following: The results of reviews of investment policies, procedures, practices, and internalcontrols;The adequacy of management’s risk monitoring system for investments;The condition of investment records;The volume and materiality of investment transactions; and12-3
ExaminerResourcesPoliciesINVESTMENT ANALYSIS The degree of problems disclosed by previous audits or examinations.Examiners record the extent of the investment analysis (if they perform such an analysis)in the Scope Workbook. They should also complete applicable investment questionnairesor reports.The key investment references for this chapter are NCUA Rules and Regulations §703,IRPS 98-02, and related Guidance Papers. Other resources that may assist examiners intheir analysis of complex investment portfolios include: Regional capital market specialists (RCMS) in each regional office provide technicalassistance;Bloomberg terminal, an information vendor system available through each RCMS,provides investment characteristics and analysis;Office of Strategic Program Support and Planning (OSPSP) in the Central Officeprovides additional assistance (examiners should follow regional procedures);The NCUA Investment Hotline (1-800-755-5999) provides examiners and creditunions a resource to call and discuss investment questions.The board of directors must (1) adopt a written investment policy consistent with theFederal Credit Union Act, NCUA Rules and Regulations, and other applicable laws; and(2) review and update the investment policy at least annually. A monitoring and reportingprogram helps ensure the credit union’s investment process adheres to the written policy.If the investment review discloses exceptions to sound investment policies or procedures,the examiner will recommend appropriate changes to resolve the concerns.The credit union's size and asset mix determine the scope of the investment policy. At aminimum, the policy must address the following: Purpose and objectives. The credit union must document its intentions (purpose) atthe time it purchases investment securities, and must classify each security as one ofthe following: held-to-maturity, available-for-sale, or trading. SFAS 115 containsadditional guidance.Investment objectives should reflect the relative importance of investments to thecredit union's overall goals and objectives. Generally, credit unions attempt to balancethe need for safety and liquidity against the need for yield, while maintaining enoughflexibility to respond to rapid changes in market interest rates. Thus, investment12-4
INVESTMENT ANALYSISobjectives should closely coincide with internal asset-liability goals and the short- andlong-term business plan. Characteristics of investments. Investment characteristics describe the permissibleinvestments and explain their pros and cons. The board of directors must specify inthe investment policy the types and characteristics of investments permitted for thecredit union. Characteristics may include the issuer, maturity, coupon rate, index, cap,floor, coupon formula, call provisions, average life, and interest rate risk (e.g.,duration.) For example, a board policy specifying permissible interest rate risk (IRR)of an investment communicates to management the board’s tolerance for risk at theinstrument level. The policy should ensure management considers the effect ofinvestment characteristics on the marketability and resale value of the investment andthe credit union’s ability to achieve established liquidity objectives. IRR. IRR is the potential for change in the value of a security as market interest rateschange (also referred to as market risk.) Changes in interest rates can reduce theinvestment’s value. Managing IRR on a total balance sheet basis, which includesmonitoring the price sensitivity of the investment portfolio and long-term loans, is asound business practice. A credit union may consider whether it should specifyinstitution-wide IRR limits (generally for net economic value or earnings exposures)in light of its long-term investment and lending activities and its level of capital.Credit unions, especially those that do not establish institution-wide IRR limits, maychoose to establish price sensitivity limits on their investment portfolio or individualinvestments. The officials must understand that, while many investments have goodmarketability, the selling price of an investment may be sensitive to changes ininterest rates. For example, although Treasury securities usually have readymarketability, longer-term fixed-rate Treasury securities generally will experiencegreater price volatility than shorter-term fixed-rate Treasury securities.Management must prepare a risk report at least quarterly if the fair value of allsecurities with (1) embedded options, (2) maturities greater than three years, or (3)complex coupon formulas exceeding net capital. The risk report must documentpotential effects of interest rate shifts of plus and minus three percent (300 basispoints) on each security’s fair value and the cumulative effect of those shifts oncapital (§703.90.) Liquidity risk. An investment’s liquidity or marketability risk is the risk thatinadequate market depth could impede the credit union’s ability to promptly sell theinvestment at a reasonable or fair market price. Generally, Treasury securities have12-5
INVESTMENT ANALYSISgreater liquidity than other securities. Wide bid-ask spreads characterize illiquidsecurities. Current examples of illiquid securities include Small BusinessAdministration (SBA) loan participation certificates and smaller or older mortgagebacked securities (MBS.) Additionally, negotiable CD investments in financiallyweak depository institutions often are less liquid than investments in strongdepository institutions.A credit union must have sufficient liquid assets to meet immediate cash demands.The board should consider current and future liquidity needs based on its businessplan (including budget) and asset-liability management strategy. The board shouldstructure the investment portfolio to help meet normal liquidity needs, as well as anyunexpected cash outflows.Proper classification of held-to-maturity, available-for-sale, and trading securities canenable a credit union to meet its liquidity needs without an accountingreclassification. The examiner may question a credit union’s assertion that it has theintent and ability to hold securities to maturity if the credit union has had to sell ortransfer held-to-maturity securities to meet a liquidity need, especially in instances ofa material sale or transfer. Credit risk. Credit risk is the possible loss that could occur if the issuer of aninvestment defaults or if the market value of an investment declines because themarket perceives an increased probability of default. Credit risk appears most often inuninsured deposits with other (correspondent) financial institutions (e.g., Fed Fundssold.)Credit unions should address credit risk in their investment policies as follows:-List specific permissible institutions, issuers, and counter-parties or specifycriteria for their selection, andSpecify limits on the dollar amounts the credit union may invest in each.Before making investments that exceed an insured limit, are not insured, or not fullyguaranteed as to principal and interest by the U.S. Government or its agencies,enterprises, or corporations, management must perform and document a creditanalysis of the investments. Management must update the analysis at least annuallyas long as the credit union holds the investment. Smaller credit unions that cannotperform a detailed credit analysis should invest funds in appropriate alternatives(e.g., corporate credit unions), albeit, they still must perform due diligence.12-6
INVESTMENT ANALYSIS Concentration risk. Concentration risk results when the credit union does notproperly address diversification in the investment portfolio. Concentration risk canoccur when the investments in a portfolio have similar characteristics, such asidentical call dates and provisions, the same or related issuers, or the same geographicdistribution. Concentrations in investments can increase a credit union’s exposure tointerest rate, credit, and liquidity risk. The investment policy should specify dollarlimits for holdings of obligations with similar characteristics (e.g., fixed vs. variable,type of floating rate index, geographical distribution, etc.) Significant concentrationswith individual broker-dealers or safekeepers present risk if management has notperformed adequate due diligence. Losses can result when unscrupulous brokerdealers or safekeepers resort to fraud and deceit. Delegation of authority to officials or employees. The credit union board ofdirectors may delegate the authority, but not the responsibility, for making investmentdecisions. The board must retain ultimate responsibility. The board may authorize anofficial of the credit union (normally the president or an investment officer) to investor divest funds according to the investment policy on a continuing basis. For example,the policy may authorize the manager to transfer funds to an overnight investmentaccount whenever the checking account cash balance exceeds a specified amount oraverage daily balance. Board policy must state explicitly the authority it has delegatedto the manager; §703.30(g) requires professional qualifications by education orexperience for individuals given investment authority.In other situations, the board may delegate only limited authority to a credit unionemployee (e.g., complete and sign the necessary papers related to investmenttransactions.) The board should sufficiently define the delegation of authority so theindividual receiving the investment instructions cannot exercise discretionary powers.This individual should report all transactions to the board, investment committee, orexecutive committee at least monthly. Board policies and procedures should addresshow the credit union will comply with §703.120 (e.g., the prohibition on acceptanceof cash bonuses, merchandise premiums, etc., from broker-dealers.) Delegation of authority to a third-party. §703.40(c) permits the board to delegateits authority for investing credit union funds to a third party. However, the creditunion must ensure that the third party is an investment adviser registered with theSecurities and Exchange Commission (SEC), and limit the aggregate amount of suchdelegations (e.g., dollar amount of investments) to 100 percent of net worth. Thisrestriction does not apply to investments in mutual funds. Also, the 100 percentlimitation does not apply to credit unions meeting the Reg Flex requirements of Part742.12-7
INVESTMENT ANALYSISThe board should exercise caution when delegating investment decision authority toSEC-registered investment advisers. The board should perform the followingadditional procedures:- Investigate the integrity and financial condition of any investment adviser beforedelegating investment authority;Reduce the delegation of authority to writing and explicitly state in board policythe authority delegated to the investment adviser; andUnderstand that the board must set policy limits, approve procedures, understandthe overall risks associated with the investments, and receive reports assessingwhether the portfolio has remained within established limits.Broker-dealer. A federal credit union may use a third party (i.e., a broker-dealer) topurchase and sell investments if the broker-dealer holds a current registration as abroker-dealer with (1) the SEC or (2) a depository institution for which a federalregulatory agency regulates the broker-dealer activities. CUSOs that provide brokerdealer services to credit unions must meet the requirements of §703.50.A credit union making an investment in a certificate of deposit (CD) must either sendfunds directly to the issuing depository institution or use a broker-dealer. A federalcredit union may use a third party (i.e., a CD finder) to locate institutions offeringhigh CD rates, and may compensate the finder for that service, but it must send thefunds directly to the depository institution offering the CD and not through the finder.(Refer to the section of this chapter on Broker-Dealer Analysis; Letter to CreditUnions No. 157, September 1994; and Letter to Credit Unions No. 00-CU-05,September 2000 for additional guidance.) Safekeeping. Either the SEC or a federal or state depository institution regulatoryagency must regulate and supervise any safekeeping institution that a federal creditunion uses for custody of purchased investments. Actual or opportunity losses canresult from inappropriate safekeeping arrangements for investments. (Refer to thesection of this chapter on Safekeeping for guidance.) Surveillance and divestiture. For investments that fail to meet the requirements ofthe FCU Act, NCUA Rules and Regulations, or board policy, the policy must addresshow the credit union will handle these investments. The policy should includeprovisions for monitoring and reporting of high-risk investments.12-8
INVESTMENT ANALYSIS Trading account. Federal credit unions engaging in investment trading must adoptexpanded policies that address the trading issue, and sufficient resources, knowledge,systems, and procedures to manage the risks. The policy should address sizelimitations of the trading account, stop loss or sale provisions, and limits on the lengthof time the credit union may hold an investment in the trading account. Operational risks. In addition to the requirements above, credit unions' investmentpolicies should address the various types of risks inherent in the investment process,including:-Management risk. Management risk is the loss potential resulting from lack ofknowledge about various characteristics of the intended investment instrument.Before making any investment, management must thoroughly understand theintended security and ensure that the investment’s risk characteristics areconsistent with the credit union’s overall investment objectives and businessgoals. Management’s unfamiliarity with the pricing of an investment or terms ofthe investment transaction can result in losses if the price management paidexceeds the fair value. Therefore, management must understand how theinvestment instrument reacts to changes in market interest rates.-Transactional or operational risk. This risk arises from deficiencies in informationsystems or internal controls that can result in unexpected loss. Sources ofoperational risk include inadequate procedures, human error, system failure, andfraud. The first line of defense in controlling operating risks is effective internalcontrols, including separation of duties and supervision of persons executinginvestment transactions from those responsible for processing transactions andaccounting for investments; and-Compliance or legal risk. Federal credit unions must ensure that investmentscomply with the FCU Act, NCUA Rules and Regulations, and other applicablelaws. Legal risk includes the risk that contracts, such as custodial agreements andrepurchase agreements, are not legally enforceable or properly documented.Federal credit unions should adequately evaluate agreements before entering intoa contract to ensure (1) compliance with applicable laws, and (2) inclusion of allbargained for duties and provisions, such as the ordinary duty of care for asafekeeper, or the requirement for a perfected first priority security interest inrepurchase collateral.During the review of the board and the executive committee minutes, examiners shoulddetermine that the board fulfills its responsibilities and that any individual to whom the12-9
ExaminationGuidanceClassificationof SecuritiesSFAS 115INVESTMENT ANALYSISboard has delegated its authority submits the proper reports. Board minutes should clearlyoutline to whom the board has delegated authority and the extent of that authority.Examiners should review such delegations during each examination.In summary, credit unions can reduce investment risks by: Fully evaluating each type of investment before purchase, including thecreditworthiness and/or the financial condition of the issuer and the potential IRR ofthe proposed investment;Analyzing the financial condition and reputation of any intermediary to thetransaction, such as a broker-dealer; andDiversifying the investment portfolio by type, maturity, geographical location,guarantor, etc.Examiners should complete the “Investment Controls” questionnaire before determiningthe extent of investment risk. The examiner may decide to expand the review if (1) thecredit union has changed its investment policies since the last examination, (2) theexaminer or auditor noted investment internal control or other weaknesses, (3) the creditunion changed substantially its investment mix, or (4) the credit union has materialamounts of complex investments in its investment portfolio.If the examiner and supervisory examiner determine the necessity of reviewinginvestments, the examiners should sample each investment type. For example, if thecredit union has 100 CDs, the examiner may review a sample of five CDs. If problemsexist, examiners should expand their analysis to the point of determining the severity ofthe problems and developing plans for correction.Examiners may review broker/dealer activity, when applicable, to determine the existenceand extent of any resulting problems. Examiners may also review a sample ofinvestments made through a new broker/dealer.Federal credit unions must report securities in accordance with generally acceptedaccounting principles (GAAP), which require categorizing a security in one of threeclassifications: Trading securities - debt and equity securities that the credit union bought and holdsprimarily for the purpose of selling in the near term (held for only a short period of12-10
Broker-DealerAnalysisINVESTMENT ANALYSIStime.) The credit union reports trading securities at fair value through the incomestatement; Held-To-Maturity securities - debt securities that the credit union has the positiveintent and ability to hold to maturity. The credit union reports held-to-maturitysecurities at amortized cost; and Available-For-Sale securities - debt and equity securities not classified as eithertrading or held-to-maturity securities. Credit unions report available-for-sale securitiesat fair value through a separate component of equity on the balance sheet,Accumulated Unrealized Gains/Losses on Available-for-Sale Securities.Absent evidence to the contrary, examiners normally should accept the credit union’sdesignations, especially if the examiner considers the external audit adequate and doesnot take exception. (Contradictory evidence could include a pattern of intermittent salesor transfers of held-to-maturity securities, suggesting that the securities are actuallyavailable-for-sale.) The examiner should focus on evaluating the risks in the securitiesholdings and activities and on the credit union’s managemen
analysis of the investments. Management must update the analysis at least annually as long as the credit union holds the investment. Smaller credit unions that cannot perform a detailed credit analysis should invest funds in appropriate alternatives (e.g., corporate credit unions), albeit, they still must perform due diligence.
