Some market experts believe the stress test developed by the Federal Financial Institutions Examination Council is forcing portfolio managers to pass up good buys among derivatives of mortgage-backed securities.

"It's not a market killer, but it is having an effect," said Stephen W. Joynt, executive vice president for financial institutions at New York-based Fitch Investors Service Inc.

In general, Joynt and other market observers report that portfolio managers are giving MBS derivatives more careful scrutiny as a result of the FFIEC supervisory statement on suitable investments. The four bank and thrift regulatory agencies and the National Credit Union Administration implemented regulations last February based on the policy statement.

"It has been an educational process, both for the regulators and the portfolio managers," said Mark Littrell, vice president for fixed-income research for Morgan Keegan & Co., a Memphis brokerage house.

Littrell, however, said it pains him when what he regards as a suitable investment alternative fails the FFIEC test.

Littrell cited a recent tranche where the average life was expected to be about seven years on collateral with a weighted average maturity of just over 13 years. There was little extension risk in the tranche and from these levels the estimated prepayment speeds for the down-300-basis-point scenario caused the bond to appreciate more than 17%, thus failing the test. Therefore, a bond with very little extension risk failed the test because the investor would realize too much gain in the down-300 scenario.

Bonnie Caldwell, vice president for government relations at the Public Securities Association, said if the number of anomalies continues to grow, it is likely that PSA members will ask the relevant PSA committees to review the situation.

Several brokerage houses and investment services have developed computer software to apply the FFIEC stress test to tranches. They are quite sensitive to prepayment assumptions. Bloomberg Financial Services, for example, has two different tests with different sets of prepayment assumptions. Thus, it is possible for a tranche to pass one test by Bloomberg and fail another.

Fitch, which has developed its own system for gauging the relative risk of MBS derivatives, has found that the FFIEC stress test correlates fairly well in practice with its methodology.

The Fitch methodology uses as a benchmark the volatility of current coupon participation certificates issued by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation. and the Government National Mortgage Corporation. Tranches are assigned volatility ranges of V1 through V5, with the higher rankings indicating more volatility. Most tranches that pass the FFIEC stress test fall into the V1 and V2 categories, Joynt said. According to Littrell. the examiner typically questions the portfolio manager to make sure he or she has a credible investment strategy that includes the particular investment. "They can't get away with handing the examiner the stress test report and my card," said Littrell.

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