WASHINGTON -- The Comptroller of the Currency yesterday warned national banks against investing in structured securities such as inverse floaters unless they fully understand the associated risks.
These derivative products "are inappropriate investments for most national banks" because of their risks and the difficulty in assessing the risks, the comptroller said in an advisory letter that was sent to the 3,300 national banks it regulates.
"The determination of whether a particular instrument is appropriate depends on the bank's ability to understand, measure, monitor, and control that instrument's risks ..." the letter said.
The advisory letter was issued after the comptroller's office discovered that some community banks had invested in structured securities without realizing they could suffer substantial losses, said Douglas Harris, the OCC's senior deputy comptroller for capital markets.
Structured securities are tax-exempt or taxable debt obligations that contain embedded forwards or options or that have coupons or other cash flow characteristics that are based one or more indexes.
They can be structured to create an unlimited number of potential risks and rewards for investors. But their risks are tough to assess because of the embedded products or reliance on indexes. Some products have initially high "teaser" rates that entice investors to overlook future risks in pursuit of high short-term yields.
Among the largest issuers of structured securities are government-sponsored agencies such as the Federal National Mortgage Association [Fannie Mae] and the Student Loan Marketing Association.
The comptroller's office discovered that some small banks had purchased structured securities under the mistaken impression that they were not risky because they were issued by a government-sponsored agency or some other creditworthy party, Harris said.
The banks were focusing only on credit risk and did not fully understand that they could end up with illiquid investments and major losses if the market moved against them, he said.
Bank investments in these products have increased because structured securities are marketed as floating-rate issues, have strong credit ratings, and pose risks that are not easily measured, the advisory letter said.
Even though these products are marketed as variable-rate securities, their interest rates can fluctuate wildly with changes in the markets, the letter said.
The letter warned about six structured security products that have caused problems for banks. They are:
* Inverse floaters: These bonds have coupons, based on a formula, that increase as rates decline and decrease as rates rise;
* Dual index notes: These bonds have coupon rates that are determined by the difference between two market indexes. They often have a fixed coupon rate for a brief period, followed by variable rates for a longer period of time.
* Deleveraged bonds: These bonds pay investors according to a formula that is based upon a fraction of the increase or decrease in a specified index. A deleveraging multiplier causes the coupon of the bonds to lag behind overall movements in market yields.
* Range bonds [also called accrual bonds]: These bonds pay the investor an above-market coupon rate as long as the reference rate is between levels established at the time of issue. For each day that the reference rate is outside this range, the bonds earn no interest.
* Step-up bonds: These bonds initially pay the investor an above-market yield for a short, noncallable period. The yield is higher because the investor has implicitly sold a call option. If the bonds are not called, there is a "step up" to a higher coupon rate that is below current market rates;
* Index Amortizing Notes [IANs]:IANs repay principal according to a predetermined amortization schedule that is linked to the level of a specific index. As market interest rates increase and prepayments decrease, the maturity of an IAN extends like that of a collateralized mortgage obligation.
Banks should be especially careful about secondary market purchases of structured securities that may have poor liquidity and, as a result, pricing discrepancies.
"To obtain the fairest possible prices, banks should have several investment firms provide competitive price quotations," the letter said.