NEW YORK -- Banks and thrifts will soon be allowed to buy the full spectrum of mortgage securities after regulators lift a ban imposed six years ago because some of the securities were too risky.
The change opens the door to purchases of securities such as inverse floaters, "Z" bonds, supports and interest-only bonds which often carry high yields and whose prices can fluctuate differently than traditional notes and bonds.
"People have a better understanding of bonds' structures today and they are sophisticated enough to realize in a broad context the risks they are taking," said Michael Buttner, who manages $26 billion of mortgage securities for First Union, the Charlotte, N.C., bank. "Everybody has learned their lessons the hard way." Instead of a ban on some kinds of mortgage securities, regulators will check the risk of portfolios relative to the capital of banks and thrifts and their ability to assess and control the risks. Bankers complained the tests were too rigid and ignored the fact that some institutions were savvy enough to understand the risks associated with these securities. "The tests did an excellent job of keeping a lot of smaller banks out of trouble in the early 1990s, when people didn't know what inverse-floaters were," said Jim Embersit, manager of capital markets at the Federal Reserve Board's division of banking supervision and regulation. "But regulators can't be expected to come up with hard- and-fast rules any more. It's up to the banks to get their own policies in place." The test used by regulators was criticized because it misled some investors to believe that securities which passed the test were automatically safe. Also, the tests led Wall Street firms to devise securities that would circumvent the rules, though they would still pose unfamiliar risks for many buyers. The changes come as mergers sweep the banking industry, leading to institutions that are larger and more sophisticated, particularly in terms of managing risk. Regulators are adapting to these changes by moving away from detailed descriptions of what banks may or may not do, and emphasizing that banks should have procedures to measure and control their risks. The test to decide if mortgage securities were eligible investments for banks and thrifts was developed by a council of regulators consisting of the Office of the Comptroller of the Currency, the Fed, the Federal Deposit Insurance Corp., the Office of Thrift Supervision, and the National Credit Union Administration. The test was known as the FFIEC test, after the Federal Financial Institutions Examination Council. The new policy to drop the test took effect May 1 for corporate credit unions. The ban will be lifted for banks and thrifts on May 26, and for all other credit unions on Oct. 1. When interest rates soared in 1994, ending the mortgage refinancing boom that started in 1993, dozens of banks took losses on mortgage securities that were deemed eligible by regulators. The slowdown in refinancings caused by higher interest rates extended the lives of the securities, delaying payments to investors and causing large, unexpected declines. …