The Savings and Community Bankers of America is urging banking regulators to review the effects of the Federal Financial Institutions Examination Council's latest pronouncement on its Supervisory Policy Statement on Securities Activities, which SCBA insists will reduce both available capital and profits.

In a letter to banking regulators dated April 22, the association expressed concern over the policy's language allowing the "orderly divestiture" of collateralized mortgage obligations designated as high-risk mortgage securities in a held-to-maturity portfolio.

"In the interim policy statement, the FFIEC changes, but does not remove, this requirement," SCBA wrote. "Instead, the statement describes a set of safety and soundness circumstances in which an examiner may seek divestiture."

Regulators haven't responded to SCBA's request, but SCBA said it was concerned that regulators and FASB won't reach a conclusion on the issue in time to meet its "drop-dead date," - May 15, which is when its public institution members must make their Securities and Exchange Commission filings.

According to the association, the auditing industry and the Financial Accounting Standards Board believe the policy statement is inconsistent with FAS 115, Accounting for Certain Investments in Debt and Equity Securities, "even under a more narrowly defined reference to divestiture."

"SCBA's chief concern is the inability of FFIEC and FASB to reach agreement on language that would be consistent with FAS 115," the letter states. "Because of this deadlock, financial institutions will be forced to mark to market CMOs that have been purchased with the intent to hold to maturity regardless of the FFIEC risk test status, and report attendant unrealized gains and losses in capital."

The meeting between SCBA and regulators has yet to be scheduled, but bankers are increasingly worried that under the FASB rule, unrealized losses and gains in CMOs held for sale would not only affect their capital, it also would affect the profit for banks holding them for trading - especially in light of the rapid decline in CMO values brought on by the spike in interest rates.

"It's going to kill the market for CMOs," said Marti Sworobuk, SCBA program manager. "If financial institutions have to hold CMOs as available for sale, it's unlikely they will ever consider [investing in] a CMO beyond a duration of two years."

That may not bode well for the CMO market, especially after mortgage interest rates have slowed the market to a crawl (see chart below). One mortgage strategist with Merrill Lynch characterized the CMO market as "dead." "It all happened after the Askin crash," he added, speaking of former Wall Street bond trader David Askin's $600 million mortgage security blunder in March. "Back in January, we saw $29 billion priced [in the CMO market]," he said. "And in February $28 billion were priced. But in March it dropped to $17.5 billion, and so far in April its just $7 billion - if we break $10 billion, we'll be lucky.

"Its like there's a state of trauma here," he said, adding that spreads between mortgage and Treasuries were now about 29 to 30 basis points wider than before the Fed's action on shortterm interest rates. "So even though collateral is cheaper, there's a lot fewer deals getting done," he said. "But stabilization in the market is approaching the point where [CMOs] are becoming a pretty good value, but it's not there yet - the market doesn't find bottom that easily."

Adrian Katz, an analyst with Prudential Securities, said the low costs of CMOs is likely to re-attract investors once the market stabilizes. But if the FASB ruling stands, banks may not be in line for those instruments, at least not those longer than two years in duration. The traditional investors in mortgage-backed securities, CMOs and Remics - depository institutions, pension funds and life insurance companies - have sought out other investment through securities, Katz said. But Sworobuk said the trend toward the suddenly more-popular pass throughs might cause a problem as well.

"Ironically, mortgage-backed securities are more risky than many CMOs - at least with CMOs you can choose your durations and characteristics," she said, adding that with pass throughs, lenders typically don't have that option.

Depository institutions make up about 18% of all CMO investors.

Sworobuk suggested that effected financial institutions talk to their auditors to determine if they would be allowed to hold CMOs to maturity "because different auditing firms are interpreting [this rule] differently."

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