The Public Securities Association has been meeting with bank and thrift regulatory staff in an attempt to produce more flexibility in the implementation of the suitable investment policy of the Federal Financial Institutions Examination Council. One portion of the policy applies a three-part stress test to determine mortgage-backed derivatives that are too risky for thrifts and banks.

One result of the meetings could be a series of educational seminars attended by examiners, brokers and investors, according to James F. Faust Jr., chairman of the sales and marketing committee of PSA's Mortgage Division.

"We are attempting to bring issues before the regulators that are coming up as the policy is put into operation ," said Faust, who is a vice president in the bond department of First Tennessee Bank NA of Memphis.

PSA itself is considering publishing a consensus report by analyst of the impact on specific derivatives of the FFIEC stress test, added Faust. Marianna, general counsel of PSA, said the issue is under consideration by the research committee of the Mortgage Securities Division.

Faust said PSA has met with staff officials of the Office of the Comptroller of the Currency and the Office of Thrift Supervision, who, along with the Federal Deposit Insurance Corporation, the Federal Reserve Board and the National Credit Union Administration, make up the FFIEC.

Some market experts believe the stress test has caused portfolio managers to pass up some good buys because of the stress test. One broker 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% causing it to fail the test. Thus, a bond with very little extension risk failed the test because the investor would realize too much gain in the down-300 scenario.

Anomalies like this are examples of the type of issues raised with regulatory staff officials, Faust said. He also said PSA would like to see a formula developed under which certain derivatives would be determined to be so obviously safe that the stress test would not have to be applied for purchases.

One regulator is skeptical that the need for change has been demonstrated to date.

"We're still in the shakedown stage," said William A. Stark, assistant director of the FDIC in charge of the Office of Capital Markets. "Except for a couple of minor glitches, the policy seems to be working pretty well."

The regulators considered tightening the application of the stress test for some floaters but ultimately decided they were still covered by an exemption from two of the three parts of the stress test. The exemption was based on the assumption that the floater would be tied to a commonly used index, such as the London interbank offered rate (Libor). The regulators became concerned when the coupon rate of some tranches was tied to a more volatile index, such as seven-and 10-year Treasury bonds.

The short-term floaters are exempt from:

* The average-life test, under which the mortgage product has an expected average life of greater than 10 years, and

* The average life sensitivity test, under which the expected average life of the mortgage derivative product extends by more than four years, assuming an immediate, sustained parallel shift in the yield curve of plus 300 basis points, or shortens by more than six years if the yield curve falls by 300 bp.

All mortgage derivative products are subject to a price sensitivity test, under which the derivative cannot change by more than 17% due top a shift in the yield curve of plus or minus 300 bp.

Investments that fail the high-risk tests must be placed in trading or held-for-sale accounts and used only for hedging.

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