Appeal of Violations of Law (Second Quarter 2010)
A bank appealed to the Ombudsman the violations of law cited in the most recent Report of Examination (ROE) regarding 12 U.S.C. § 24 (Seventh) and 12 C.F.R. Part 1. The violations related to the purchase of seven collateralized mortgage obligations (CMOs).
The appeal asserted that the investments met the definition of an investment security and should be considered as Type III securities with a 10% limit of capital and surplus per obligor. Although the securities were rated below investment grade, the appeal asserts that the credit quality of the securities had improved such that they were the credit equivalent of investment grade at the time of purchase. Additional reasons provided in the appeal as to the permissibility of these securities were:
- "...certain securities not rated as investment grade by a nationally recognized statistical rating organization (NRSRO) may also be not predominantly speculative in nature."
- The securities were not predominantly speculative because the bank expected to receive 100% of principal.
The Ombudsman reviewed the information submitted by the bank and by the supervisory office as well as the requirements of 12 U.S.C. § 24 (Seventh) and 12 C.F.R. Part 1.
Under 12 C.F.R. § 1.2(e), an investment security means a marketable debt obligation that is not predominantly speculative in nature. A security is not predominantly speculative in nature if it is rated investment grade by a nationally recognized statistical rating organization (NRSRO). 12 C.F.R. § 1.3(i) states that a national bank may treat a debt security as an investment security for purposes of this part if the security is marketable and the bank concludes, on the basis of estimates that the bank reasonably believes are reliable, that the obligor will be able to satisfy its obligations under that security.
The ombudsman concluded that the violations of law were supported. At the time of purchase, the securities were rated below investment grade by an NRSRO. Therefore, they did not meet the definition of an investment security under 12 CFR § 1.2(e). Because they did not meet the definition of an investment security, they could not be Type III securities. While 12 CFR § 1.3(i) allows a bank to acquire securities rated below investment grade, based on reliable estimates of the obligor’s performance, the aggregate amount of such purchases can not exceed 5% of capital and surplus. Even if the bank had met the criterion under this section, it would have exceeded the 5% aggregate limit beginning with the second CMO purchase. Therefore, the investments were not legally permissible under 12 U.S.C. § 24 and 12 C.F.R. Part 1.