In one of the most vivid examples of the potential pitfalls of mortgage-backed derivatives, officials of a small New York credit union are claiming that mortgage prepayments eroded the value of their interest-only strips so much that it cost the credit union more than half its $3.2 million investment.

The losses, estimated at more than $1.6 million, 18% of the total investment portfolio, forced the $17 million Tobay Credit Union in Syosset, N.Y., to merge with Nassau County Credit Union.

More credit unions are being burned by mortgage-backed derivatives, mostly interest-only and principal-only strips. These bonds are derived from segregated streams of interest or principal payments from pools of mortgages. They are highly susceptible to the recent spate of mortgage refinancings, which upset prepayment projections.

Legal Restraints

Under the Federal Credit Union Act, credit unions with federal charters may only purchase IOs and POs as hedges against interest rate risk and not for income-producing purposes. And few, if any, IOs or POs would pass muster under the three-part CMO suitability rules passed by the National Credit Union Administration.

But regulators say many credit unions still hold this kind of instrument because they were grandfathered in when the three-part test was passed.

According to a former official of Tobay, who did not want to be identified, the broker, then with Plainview, N.Y.-based Redstone Securities, approached the credit union and represented the bonds as safe.

Examiner Urged Divestment

"He [the salesman] said they were NCUA approved," the former officer said. "When the NCUA examiner came in, he said we should get rid of them, but he didn't force us to. When we went back to [the salesman] he told us to hold them, that they would come back."

All the while, record mortgage refinancings caused a rush of prepayments on all mortgage-backed bonds, eroding values.

By the time NCUA examiners came back to the credit union, the IOs were under water and sinking fast. The examiner told the supervisory committee of Tobay. to either sell them or write them down to market value to reflect the fair value of the bonds on the balance sheet.

When Tobay finally agreed to sell the IOs last March, it took a $1.6 million loss, which erased all its capital reserves and any potential customer dividends.

Lawsuit Considered

While officials of Tobay considered suing the broker, the credit union was forced into the July 31 merger with. Nassau County Credit Union, a $134 million institution in Garden City, N.Y. It is not clear whether Nassau County will attempt to recover any damages from the broker. Douglas Wolf, the president of Nassau County, declined to comment.

After an investigation, the NCUA on Nov. 15 issued a cease and desist order and a civil money penalty of $35,000 against Redstone Securities, and a cease and desist order and a civil money $10,000 penalty against Frank Intagliata, the Redstone broker alleged to have sold the securities. The NCUA charged that the securities were sold at excessive commissions. Mr. Intagliata allegedly charged a 20% commission.

Mr. Intagliata had a relationship with Tobay from 1986 to 1992 and employment with four brokerage companies, NCUA said.

Settlement Offered

Ironically, the former Tobay treasurer said lawyers for Redstone offered the credit union $100,000 to settle any potential claims of broker dishonesty.

Officials of Redstone Securities would not comment, and Mr. Intagliata could not be reached for comment.

Under the consent agreement with the NCUA, Redstone agreed not to solicit any new business from a federally insured credit union for one year and to limit its commissions on fixed instrument investments to existing credit union clients to no more than 2.5%.

The NCUA also reported that Mr. Intagliata agreed not to solicit new business from federally insured credit unions for six months and not to charge a commission of more than 2.5% on a fixed instrument investment to a credit union for 2 1/2 years.

The Tobay incident offers several lessons about investments. First, officials say, credit unions should not buy instruments they do not understand. Second, they should be wary of sales pitches.

The three-part test is supposed to limit these kinds of investments for credit unions, but some brokers are misrepresenting unsuitable investments as proper, NCUA officials say.

NCUA figures reveal that credit union investments in mortgage-backed derivatives have been growing rapidly over the past few years, amounting to $9.4 billion, about 8.3% of total investment portfolios. For credit unions with more than $50 million in assets, the figure is closer to 10% of portfolios.

NCUA officials have been urging credit unions to be cautious with this kind of instrument, which is new on the credit union landscape. They note that while CMOs can be profitable during periods of high interest rates, often performing better than Treasury notes, during periods of low interest rates, they can be dangerous.

Mr. Roberts is editor of NCUA Watch and Credit Union Accountant, which are produced by American Banker Newsletters. For information about the newsletters, call 800-733-4371.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.