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Trust Examination Manual

Section 3 - Asset Management - Part I

Investment Principles, Policies and Products

Table of Contents

A.  Trust Investment Principles

B.  Suitability

C.  Prudent Investments

D.  Principal and Income

E.  Trust Investment Policies

     1.     Investment Policy Components

     2.      Discretionary Asset Review Policies

F.  Types of Investments

     1.      Cash Management

            a.      Money Market Funds

            b.     External Sweep Arrangements

            c.      Deposits

            d.      Overdrafts

     2.      Fixed Income Products

            a.     Corporate Debt Issues

            b.     Municipal Bond Issues

             c.    Collateralized Mortgage Obligations (CMO)/ Real Estate Investment Conduits (REMIC)

             d.    Asset-Backed Securities

            e.    Structured Notes

            f.    Trust Preferred Securities (TPS)

            g.    Church Bonds

    3.   Equity Securities

            a.     Financial Derivatives

            b.    Variable Annuities

            c.     Insurance Company Ratings

            d.    Exchange Traded Funds

             e.    Economically Targeted Investments

    4.       Mutual Funds

            a.        Investing in Proprietary Mutual Funds

            b.       Due Diligence Standards

            c.        Other Mutual Fund Considerations (Fees, Expenses, Taxes)

            d.        Receipt of 12b-1 Fees

                1.  Receipt of 12b-1 fees in ERISA Accounts

                2.  Receipt of 12b-1 fees in Personal and Non-ERISA Employee Benefit Accounts (EBs)

     5.      Hedge Funds

     6.      Notes and Mortgages

     7.      Real Estate

             a.  1031 Exchanges

             b.  Environmental Liability

             c.  Land Trusts

             d.   Real Estate Investment Trusts (REITs)

             e.   Mineral Interests

       8.  Limited Partnerships

       9.  Family Limited Partnerships

     10.  Master Notes

     11.   Business Interests

     12.   Worthless Securities

      13.   Tangible Assets and "Collectibles"

      14.  Repurchase Agreements

     15.   Securities Lending

A.  Trust Investment Principles

The management of property for others is one of the principal functions of a fiduciary. Fiduciaries administering personal or corporate accounts, either as trustee or agent, are guided by state statutes and the principles embodied in common law. For employee benefit accounts, ERISA, with its implementing Department of Labor (DOL) regulations and opinions, provides statutory and regulatory guidance.

The primary investment guidance given to fiduciaries is found in the terms of each account's governing instrument. There are major differences in the fiduciary's responsibilities under different types of accounts.

  • When the fiduciary has discretion to select investments for an account, or makes recommendations for the selection of investments, the investments selected must both follow the terms of the governing instrument and be suitable investments given the needs of the beneficiaries  or the purpose of the trust.
  • When the trust department has no discretion in choosing investments (such as for self-directed or custodial accounts), the institution's sole responsibility is to follow the provisions of the governing account instrument.

Accounts subject to ERISA, diversification standards, parties in interest, and co-fiduciaries and investment managers are presented in Sections 404 through 406.  Refer to specific sections of ERISA  in Appendix E - Statute 404 through 406 and Section 5 of this Manual for further discussion.

B.  Suitability

In enacting the Prudent Investor Act, states should have repealed legal list statutes, which specified permissible investments types. (However, guardianship and conservatorship accounts generally remain limited by specific state law.)  In those states which adopted part or all of the Prudent Investor Act, investments must be chosen based on their suitability for each account's beneficiaries or, as appropriate, the customer.  Although specific criteria for determining "suitability" does not exist, it is generally acknowledged, that the following items should be considered as they pertain to account beneficiaries:

  • financial situation;
  • current investment portfolio;
  • need for income;
  • tax status and bracket;
  • investment objective; and
  • risk tolerance.

C.  Prudent Investments

There are two fiduciary standards governing the prudence of  the individual investments selected by a fiduciary:   the Prudent Investor Act and the Prudent Man Rule.   The Prudent Investor Act, which was adopted in 1990 by the American Law Institute's Third Restatement of the Law of Trusts ("Restatement of Trust 3d"), reflects a "modern portfolio theory" and "total return" approach to the exercise of fiduciary investment discretion. This approach allows fiduciaries to utilize modern portfolio theory to guide investment decisions and requires risk versus return analysis. Therefore, a fiduciary's performance is measured on the performance of the entire portfolio, rather than individual investments.  As of May 2004, the Prudent Investor Act has been adopted in 41 States and the District of Columbia. Other states may have adopted parts of the Act, but not the entire Act.  According to the National Conference of Commissioners on Uniform State Laws, the most common portion of the Act excluded by states concerns the delegation of investment decisions to qualified and supervised agents.   

The Prudent Investor Act differs from the Prudent Man Rule in four major ways:

  • A trust account's entire investment portfolio is considered when determining the prudence of an individual investment. Under the Prudent Investor Act standard, a fiduciary would not be held liable for individual investment losses, so long as the investment, at the time of acquisition, is consistent with the overall portfolio objectives of the account.
  • Diversification is explicitly required as a duty for prudent fiduciary investing.
  • No category or type of investment is deemed inherently imprudent. Instead, suitability to the trust account's purposes and beneficiaries' needs is considered the determinant. As a result, junior lien loans, investments in limited partnerships, derivatives, futures, and similar investment vehicles, are not per se  considered imprudent. However, while the fiduciary is now permitted, even encouraged, to develop greater flexibility in overall portfolio management, speculation and outright risk taking is not sanctioned by the rule either, and they remain subject to criticism and possible liability.
  • A fiduciary is permitted to delegate investment management and other functions to third parties.

A copy of the model Uniform Prudent Investor Act, together with explanatory notes, is included in Appendix  C. A list of states adopting the Uniform Prudent Investor Act is also included.  States, however, may and often do, modify uniform model laws when enacting legislation. For states that have adopted a version of the Prudent Investor Rule, this portfolio management approach supersedes the Prudent Man Rule.

The Prudent Man Rule is based on common law, stemming from the 1830 Massachusetts court decision -- Harvard College v. Armory, 9 Pick. (26 Mass.)446, 461 (1830). The Prudent Man Rule directs trustees "to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested." Id. A copy of the Prudent Man Rule, also known as the Restatement of Trusts 2d, together with explanatory notes, is included in Appendix C. 

Under the Prudent Man Rule, when the governing trust instrument or state law is silent concerning the types of investments permitted, the fiduciary is required to invest trust assets as a "prudent man" would invest his own property, keeping in mind: the needs of the beneficiaries, the need to preserve the estate (or corpus of the trust) and the amount and regularity of income. The application of these general principles depends on the type of account administered. This continues to be the prevailing statute in a small number of states.

The Prudent Man Rule requires that each investment be judged on its own merits. Thus, a fiduciary could be held liable for a loss in one investment, which when viewed in isolation may have been imprudent at the time it was acquired, but as a part of a total investment strategy, was a prudent investment in the context of the investment portfolio taken as a whole. Under the Prudent Man Rule, speculative or risky investments must be avoided. Certain types of investments, such as second mortgages or new business ventures, are viewed as intrinsically speculative, and, therefore, prohibited as fiduciary investments.  

Since the Prudent Man Rule was last revised in 1959, numerous investment products have been introduced or have come into the mainstream.  For example, in 1959, there were 155 mutual funds with nearly $16 billion in assets.  By year-end 2000, mutual funds had grown to 10,725, with $6.9 trillion in assets (as reported by CDA/Wiesenberger).  In addition, investors have become more sophisticated is more attuned to investments, since the last revision.  As these two concepts converged, the Prudent Man Rule became less relevant. 

Prudent Investments in Court-appointed Accounts

State statutes may outline specific permissible investments for certain types of accounts, such as guardianships for minor children or incompetents.  Under some state statutes, prudence is more narrowly defined for guardianship accounts, than under the Prudent Man Rule. 

Trust departments can be appointed as a conservator for veterans.  In general, prudent investments for veteran accounts are defined as an interest or dividend paying account at a Federally-insured institution, or in court-appointed cases, in securities issued or guaranteed by the United States.  Under 38 CFR13.103, veteran benefits paid to legal custodians on behalf of a beneficiary may only be invested in U.S. savings bonds, pre-need burials trusts, or interest or dividend paying accounts, which are Federally insured.  Department of Veterans Affairs benefits that are paid on behalf of an incompetent veteran to an institution via an institutional award payment arrangement may not be invested in any asset.  Pursuant to 38 USC 501, Section 13.106 states that court-appointed fiduciaries must invest income or an estate derived from the Department of Veterans Affairs benefits only in legal investments which have safety, assured income, stability of principal, and ready convertibility for the requirements of the beneficiary and his or her dependents. 

Prudent Investments in Employee Benefit Accounts

Employee benefit accounts subject to ERISA are governed by the prudence requirement of ERISA Section 404(a)(1)(B), as well as by DOL Regulation 2550.404a-1. Also see recap of ERISA prudence interpretations and opinions. In implementing ERISA requirements, the Labor Department has generally followed the Prudent Investor approach outlined above.

 D.  Principal and Income

As discussed more fully in Section 2 - Operations and Internal Controls, there may exist different classes of beneficiaries in a personal trust account that may only be entitled to a trust's principal, or income, but not both. In these situations, it is important that fiduciaries maintain accounting records that clearly distinguish assets as either principal or income.

Principal (corpus) consists of cash and other property transferred to the fiduciary. Income is the return derived from the investment of principal. Income must also be distinguished from capital gains, which are not investment yields or returns on principal, but gains or appreciation of the value of the principal itself. Capital gains are added to the value of principal (capital losses reduce the value of principal), and inure to the benefit of principal beneficiaries. Depending on the terms of the trust, and a variety of other factors including the needs of the beneficiaries, income may be distributed as cash, or reinvested and held (for the benefit of income beneficiaries) as invested income. Unless clearly distinguished from other investments, invested income may appear to the observer to be principal. Consequently, it is imperative that fiduciary records distinguish between the two, as failure to do so could result in giving one set of beneficiaries funds that belong to another set of beneficiaries, creating a Contingent Liability. Separate records of principal and income are customary, and can be used for the preparation of accountings and tax returns. A further discussion of principal and income may be found in  Principal and Income, located in Section 2.

E.  Trust Investment Policies

The ultimate responsibility for establishing an overall investment policy remains with the board of directors or a trust committee appointed by the board. The basis of any investment policy should be sound fiduciary principles, including "prudence", the preservation of capital, diversification, and a rate of return commensurate with the level of risk assumed.  The review of the department's investment policies and practices are of major importance in the trust examination.

Many trust departments have a separate trust investment committee which develops and administers investment policy, although smaller departments may utilize the board of directors or the trust committee for this purpose. The committee reviews and either approves or rejects recommendations made by a research division, an outside investment advisor, or the department's investment officer. Often the committee has the responsibility of reviewing individual account portfolios and determining whether assets are invested in compliance with the trust department's overall investment policy.

Accounts for which the department exercises investment discretion should receive an investment review in accordance with the Statement of Principles of Trust Department Management. An initial asset review should, in most cases, be conducted promptly following acceptance, and should establish an investment program for the account. Reviews should include securities and other types of assets received with the account. The initial review is of great importance, as the fiduciary may be required to act quickly to protect assets from loss or erosion of principal, or to take immediate action to protect tangible assets from creditors, insurable losses or physical damage. A fiduciary may have to compensate accounts that sustain investment losses due to the fiduciary's negligence such as a failure on the part of the fiduciary to act in a timely manner.

The department's overall investment policy should be flexible enough to accommodate the types of fiduciary appointments accepted. For example, individual trusts under will or agreement are usually established for the purpose of providing income to the income beneficiary and leaving principal (corpus) to the remainderman at the termination of the trust. By contrast, employee benefit trusts need to generate sufficient growth and income to provide the promised retirement benefits to participants and their beneficiaries.  Conversely, investment management agency accounts normally desire capital growth rather than income. 

When the governing instrument is silent, investment authority or directions default to state law, which must be followed.  When the governing instrument's language concerning investments is unclear, court approval should be obtained. 

E.1.  Investment Policy Components
Investment policies should clearly set forth a framework for the selection, retention, review, and management of assets over which the department holds investment discretion. The policies should discuss the overall structure of the department's investment management responsibilities.  They should provide for: appointing qualified officers to supervise daily investment activities; the monitoring of discretionary transactions, including the reporting of such transactions to the appropriate supervisory officers and committees; procedures for handling exceptions; and, formal procedures for reviewing and revising investment policies and practices. Depending on a department's size, complexity, and the types of appointments accepted, the following elements may also need to be addressed:

  • Management's investment philosophy and standards of practice.
  • A code of conduct for employees, officers, and directors who by their duties or supervisory roles have knowledge of, or access to: (1) discretionary investment transactions; or (2) the department's approved list of securities, or changes to the approved list of securities. FDIC Part 344 requires that bank officers and employees who make investment recommendations or decisions for accounts of customers file a report with the bank on a quarterly basis.
  • Investments and investment practices deemed appropriate, or inappropriate, with regard to the management of discretionary accounts.
  • The nature and size of accounts the department is qualified to administer, and the minimum standards required for the acceptance of new accounts.
  • Pre-acceptance review of the transferred assets for new accounts.
  • The initial review of newly accepted accounts.
  • Investment reviews of existing accounts.
  • Procedures for documenting investment reviews.
  • Whether the department will prepare its own research in-house, or purchase investment research from outside investment advisors.
  • Guidelines governing the use of outside investment advisor  refer to Section 10.G.6) including:
    • Procedures for adopting and/or amending an approved list of investments recommended by outside advisors, if appropriate,
    • Procedures for diverging from outside advisor recommendations when appropriate, and
    • Procedures for monitoring purchases and sales to ensure compliance with the approved lists.  
  • Procedures for adopting and amending an approved list of equity investments based on in-house research, including:
    • Criteria for selecting the investments to be included on approved lists,
    • Criteria for monitoring the investments included on approved lists,
    • Description of the approval process for adding or deleting investments from approved lists, including specifying the person(s) having authority to make such additions or deletions, and
    • Monitoring purchases and sales to ensure compliance with the approved lists.
    • Procedures for making exceptions to the approved lists.
  • Procedures for adopting and amending an approved list of mutual fund investments (inclusive of proprietary mutual funds, refer to subsection F.4.a, if appropriate) including:
    • Justification for the selection of a load fund over a no-load fund.
    • Criteria for the selection of the mutual funds to be included on approved lists,
    • Criteria for monitoring the mutual funds on the approved lists, and
    • Description of the approval process for adding or deleting mutual funds from the approved lists.
    • Criteria for diverging from the approved lists.
  • Establishment of procedures for adopting and amending an approved list of obligors (corporate and municipal) of fixed income debt investments, if applicable, including:
    • Criteria for evaluating the credit risk of the obligors to be included on the approved lists,
    • Criteria for monitoring the credit risk of the obligors on the approved lists,
    • Description of the approval process for adding or deleting obligors from the approved lists, and
    • Monitoring purchases and sales to ensure compliance with the approved lists.
    • Criteria for making exceptions to the approved list.
  • Guidelines for the development and use of asset allocation models, including:
    • Criteria or methodology for creating and modifying asset allocation models, and
    • Description of the process for supervisory review and approval of the models.
  • Guidelines for the holding, purchasing, and managing of real property, including:
    • The evaluation of environmental risk, initially, and on an ongoing basis, and
    • Initial and periodic reappraisals/inspections of real property.
  • Guidelines and procedures for holding closely held businesses, including:
    • Identification of conditions under which the department would administer such assets.
    • Criteria for contracting with a third party to run a closely-held business. 
    • Methods and procedures for the initial and periodic evaluation of such assets
    • Whether the trust officer should serve on the board.
  • Guidelines and procedures employed in the selection and use of money market mutual funds, including:
    • Periodic reviews of fund performance,
    • Methods for monitoring the use of and reliance on derivative products by such funds, and
    • Guidelines for the selection and use of funds paying 12b-1 fees, including: the appropriateness of such funds for each type of account administered, notification to customers of such fees, the solicitation of customer approvals when appropriate, and the routine disclosure to customers of such fees earned by investment of their accounts in such funds.
  • Guidelines governing the use and monitoring of derivative investment products, as outlined in the FDIC Office of Capital Markets Examination Handbook and the FDIC Statement of Policy on Investment Securities and End-User Derivative Activities.
  • Guidelines for the evaluation and management of assets deemed worthless.
  • Guidelines and procedures for evaluating and monitoring exceptions, such as non-rated, or non-approved list, securities held in accounts.  Refer to the following section.  
  • Guidelines and practices for securities lending.  Refer to F.15 .
  • Guidelines and procedures governing loans from trust accounts (real estate, unsecured promissory notes, etc.).
  • Guidelines and procedures regarding lending to, and permitted indebtedness of, managed accounts.
  • Guidelines providing for the prompt investment of income and principal cash, unless the governing instrument, local law, or parties properly authorized to direct investments provide otherwise.

E.2.  Discretionary Asset Review Policies
It is generally acknowledged that trust departments are liable, to varying degrees, for all assets held, whether or not they possess investment authority. It also follows that greater authority imparts greater risk. Trust departments which are otherwise well managed may sometimes lack appropriate policies with respect to periodic reviews of assets not contained on the approved list. Many departments hold at least some assets in discretionary accounts that were not acquired through the exercise of discretionary authority. These include directed purchases, assets acquired "in-kind," and assets acquired through distributions, corporate re-organizations or liquidations. This is especially true with respect to assets acquired as executor, trustee under will, successor to previous fiduciaries, and through guardianship or conservatorship appointments. The value of these assets may  represent a significant percentage of the market value of an individual account.

Trust management should institute written policies which affirmatively address the routine evaluation of all discretionary assets (refer to subsection G. Account Review Program, of Section 1. This is true whether or not the assets were acquired by virtue of management's fiduciary authority. At least once during the calendar year, all assets held in discretionary accounts should be reviewed and evaluated in light of governing instruments and individual account circumstances. Departments that adopt a "passive" stance over assets received in-kind increase their exposure to fiduciary risk. Trust management may believe it can eliminate this risk by obtaining "direction letters." Although prudent and necessary, at best, this reduces, but cannot eliminate, fiduciary risk. The beneficiaries may change or may lack the legal capacity to release the fiduciary from liability, as in the case of minors or the unborn. Likewise, account circumstances change and economic factors vary over time, sometimes dramatically and with little or no advance warning.

Also, asset management policies should address the retention process for all discretionary holdings.    Investment policies should address minimally acceptable sources for outside research. They should also outline the minimum acceptable standards for documenting and approving the retention of assets and provide guidance for the sale of underperforming assets. Trust departments may fail to include all discretionary assets in their annual review function, thereby increasing fiduciary risk. Trust departments that have adopted an "approved list" approach may be at increased risk if they do not review discretionary assets that are not on their approved list.

Trust departments may hold assets for which they cannot obtain reliable valuations. Such assets may include limited partnership interests, investments in closely held businesses, the common stock of thinly traded or unlisted companies, partnership agreements, hedge funds, royalties, patents and copyrights, oil and mineral interests, etc. Asset pricing is an integral component of an annual portfolio analysis. It is also necessary for the preparation of estate tax returns (IRS Form 706), gift tax returns (IRS Form 709) and annual IRA account filings (refer to Section 5,  F.1.). It is a key factor in the proper calculation of account fees and commissions (department earnings). In these situations, and in situations where management does not have the resources to adequately evaluate certain types of assets, it should seek outside expertise. Management may not, however, be able to pass the cost of these outside services through to the account, particularly when the assets in question were purchased by the department under its discretionary authority. Consequently, examiners should review accounts for inappropriate charges in this context.

F.  Types of Investments

Various investment vehicles are available for the investment of trust funds. The more common types of investments and some newer products are discussed below, along with applicable regulations, examination procedures and other related matters. 

The Capital Markets Handbook defines products not outlined on the following pages and provides examination guidance.  The Capital Markets Branch in the Washington Office can readily provide information concerning most investment products.

F.1.  Cash Management

F.1.a. Money Market Funds
Various money market funds are offered for the short-term investment of idle cash. These funds are mutual funds and have differing portfolios depending on the particular fund. Investments in domestic or foreign certificates of deposits, repurchase agreements, commercial paper, and short-term U.S. Government or agency obligations are some of the more common portfolio components. Although the trustee may have full investment discretion, it should be satisfied that the investment of trust funds in money market funds is permissible under state statutes.  When trustees do not have full discretion, sufficient authority should be sought in state statutes or court decisions, the language of the account's governing instrument, or by obtaining binding consents from all beneficiaries or written instructions from the parties authorized to direct investment selection, before utilizing these funds.  In general, it would not be considered appropriate to permanently place funds in this type of investment vehicle, as money market funds are considered short-term investments.

Money market funds are registered under the Investment Company Act of 1940 and as such, are regulated by the Securities and Exchange Commission.  Fund companies are required to provide a prospectus to the investor prior to purchase.  The funds are required to have external audits. Prior to investing in a money market fund, the prospectus of the fund and portfolio composition should be reviewed to determine that the fund meets the objectives of the trust account. Thereafter, the fund should be reviewed periodically to ensure that the investment objectives continue to be met.  In addition, there have been instances where money market funds have "broken the buck", referring to situations where the fund's net asset value falls below $1 per share.  This issue has recently resurfaced and concerns may be found at in Appendix G,   Interagency Policy on Banks/Thrifts Providing Financial Support to Funds Advised by the Banking Organization or its Affiliates .  Therefore, various risks such as credit, liquidity, concentration, operational, and reputation risks should be assessed by trust department management.  Examiners should determine that money market funds have been properly analyzed prior to investment and that the funds are periodically reviewed. Appropriate comments should be included in the Report of Examination if such funds have not been properly analyzed or if such investments are inappropriate for the accounts involved.

F.1.b.  External Sweep Arrangements
Money market funds generally accrue interest daily and pay interest at the end of the month. Many trust departments now have services which automatically invest available cash exceeding predetermined dollar limits in a money market fund. These are commonly called "sweep" arrangements.

Fiduciaries are obligated to keep funds productive. Uninvested cash of discretionary appointments should be invested "temporarily" until "permanent" investments are chosen, or pending the implementation of an investment program or distribution to beneficiaries.  Uninvested principal cash, including cash not awaiting immediate distribution or payment against a draft, are often "swept" at the close of each business day into some form of interest-bearing investment vehicle. Income cash should be treated in a similar manner. Current technology makes possible, and prudent fiduciary investment philosophies advocate, the full employment of all cash in some form of productive investment. Management's failure to invest cash when appropriate and practicable should be considered imprudent and a breach of fiduciary duty subject to criticism.  In those cases where the fiduciary is responsible for the investment of cash, it is difficult for a fiduciary to justify permitting cash to remain idle when it is possible to make it productive. It would be unusual, given the current state of investor awareness, for customers to be indifferent to a fiduciary's intentional failure to invest large cash balances.

The investment of nondiscretionary cash is largely governed by the terms of the account agreement. There may be instances, however, when the account agreement lacks specific directions concerning how cash is to be invested and the customer has not provided any specific instructions.  Examiners, in such cases, should be careful when "interpreting" a trust department's investment authority with respect to the investment of cash balances. In such cases, management should be encouraged to modify the governing account agreements in a manner to resolve any ambiguity concerning the department's responsibility to invest cash.  In addition, faced with such uncertainty, the fiduciary should contact the account principal and request direction concerning the investment of the cash. 

Examiners may encounter situations in which the trust department charges an additional fee ("sweep fee") for performing cash management services. The taking of such fees is customarily governed by state law and examiners should determine the permissibility of assessing additional fees under local statutes. If permissible under state law and not prohibited by the account agreement, the fee charged should be reasonable for the service performed. Additionally, the department should fully disclose the imposition of the fee to interested parties. The amount of fees charged relative to the sweep arrangement should be disclosed periodically in the account statements sent to customers. The charging of sweep fees in ERISA accounts is not strictly prohibited. Refer to Section 5, subsection H.7.f.(20). Sweep Fees  for additional guidance for ERISA accounts.

F.1.c.  Deposits
Deposits, whether time, savings, or demand, are another common form of investment. The deposits could be in another institution or in the commercial department of the bank under examination. Oftentimes, such investments provide the safety and liquidity needed by the account. However, given the availability of numerous other investment vehicles providing similar safety and liquidity, examiners should determine whether deposit holdings result from a lack of management initiative to seek other investment opportunities. Large holdings of non-interest bearing deposits should be scrutinized, since it is a fiduciary's duty to make trust assets productive. Discretionary deposits with the commercial bank should also be reviewed, given the conflict of interest and self-dealing aspects of such investments.

Some trust departments sweep cash to the commercial department's deposit accounts on an overnight basis, rather than sweep to an external investment vehicle.  In those situations, bank management should have a strategic plan for the activity.  Within that plan, management should not view overnight trust funds as a long-term funding source for the commercial department.  Management should have calculated the costs, including interest on deposits and  the FDIC deposit insurance assessment.  More importantly, trust management should be able to demonstrate that the customer is at least as well compensated, as he would have been with an external sweep, usually a money market fund.  Care should also be taken to assure the deposit account is appropriated titled in the commercial department's records to insure pass-through deposit insurance coverage.  Examiners should be aware that Section 24 of the FDI Act prohibits the pledging of bank securities to secure deposits of trust accounts.  However, an irrevocable letter of credit issued by an agency of the U. S. Government or a surety bond, issued on behalf of the bank or trust department, is allowable under the regulation.

Refer to Section 8. E.3. Use of Own Bank or Affiliate Deposits, of this Manual for additional guidance in this area.

Federal deposit insurance coverage of trust account deposits is discussed in Section 10, subsection L. Deposit Insurance of Trust Funds

F.1.d. Overdrafts
Overdrafts occur for numerous reasons, including timing differences related to cash receipts and disbursements. Overdrafts should be short-term in nature, and rare in occurrence. The department should not be funding securities purchases with overdrafts. Such a practice reflects poor cash management of an account. Likewise, the failure of the department to properly plan for recurring or expected disbursements, resulting in a lack of liquid assets to fund disbursements, reflects poor cash management. These and similar events, if prevalent, should be criticized. The department should have a policy governing overdrafts. The policy should include review procedures, methods for curing overdrafts, and the action(s) that will be taken if an overdraft cannot be cured within a reasonable time period. Overdrafts outstanding for long periods of time should be treated as a loan to the account.

F.2. Fixed Income Products
In those states where the Prudent Investor Act has been adopted, the suitability of the entire portfolio should be reviewed as a whole, and individual investments are not considered inherently good or bad based solely on investment type or credit rating.

In states which operate under the Prudent Man Rule, investments are considered prudent or imprudent on an individual basis. Therefore, investments can be considered inherently prudent or imprudent based solely on investment type or credit rating.

The following is a brief overview of the more common investments and some newer products found in trust departments.  For particular products and their risks not included on the following pages, examiners should refer to the Capital Markets Examination Handbook and the Manual of Examination Policies, used for safety and soundness examinations. 

F.2.a. Corporate Debt Issues
Marketable debt securities (bonds, debentures, etc.) generally comprise a significant portion of a trust department's assets. The selection of acceptable debt instruments for discretionary accounts should be based on research performed in-house, acquired from outside sources, or a combination of the two. The department may also rely on ratings provided by the nationally recognized rating agencies. The rating bands for three of the rating services are outlined in this section.  As seen in recent events, highly rated debt issues can decline into subinvestment quality rating bands or go into default.  Therefore, management should monitor investments on an on-going basis to determine that the issue remains suitable for the account.  As previously stated, the Prudent Investor Act does not preclude the investment in or continued holdings of subinvestment quality securities.  However, speculation is inappropriate for trust accounts.

InterNotes are investment grade, medium-term notes, offered in minimum denominations of $1,000 to retail investors.   InterNotes represent the debt of each respective issuer and are subject to credit and secondary market risk.  The notes are offered via a prospectus and issues are sold at par value.  Each week, new offerings from various corporations are made, and include issues with varying maturities, coupons, and interest payment schedules (monthly, quarterly, semi-annually.)  InterNotes appear to have a shelf registration, meaning that the amount offered in the prospectus is registered once, and the issuer can offer amounts under that prospectus as needed.

An example of an InterNote may be the following: 

  • $6 billion issue from a corporation under a prospectus dated August 2002.
  • Separate CUSIP numbers are assigned to specific terms, such as maturities, coupons, and call provisions, which represent amounts used under the registration.
  • The offer as stated is valid for a week, and the minimum investment (denomination) and increments are $1,000. 
  • The products are rated by nationally recognized rating agencies and the ratings are posted on the InterNotes' website, along with other information concerning terms. 
  • Some InterNotes are based on floating rates, indexed to short-term rates. 
  • The products are directed at small, retail investors, in lieu of certificates of deposits and may be received in-kind.  

F.2.b.  Municipal Bond Issues
The department may invest in debt obligations issued for the benefit of local municipalities, school districts or other small governing authorities.  Industrial revenue bonds may be issued for the benefit of corporate entities.  Frequently, municipal bonds will be received in-kind rather than purchased by the department.  The issues may or may not be rated.  The lack of a rating may result from the expectation that the issue will be sold to a limited number of investors in the local community, or, the cost of acquiring a rating may be expensive in relation to the size of the issue.  However, non-rated, does not necessarily equate with investment quality.  Trust management should analyze prior to purchase and periodically thereafter to determine that the issuer is creditworthy.  Management should establish policies and procedures including selection criteria and investment review procedures when non-rated investments are purchased for discretionary accounts. 

Municipal bond issues may be appropriate for managing the customer's tax position, but normally the investment should not be placed in tax-deferred accounts, such as employee benefit accounts, as the accountholder does not gain any additional tax benefit from the exemption.  Private activity bonds used for funding football stadiums, basketball arenas, etc., are subject to the Alternative Minimum Tax and may affect the customer's income tax liability.   In either of these or other scenarios, management should determine and document the suitability for the accountholder. 

CORPORATE & MUNICIPAL BOND RATINGS

Description

Moody's*

Standard & Poor's**

Fitch**

Highest quality, "gilt-edged"

AAA

AAA

AAA

High quality

Aa

AA

AA

Upper medium grade

A

A

A

Medium grade

Baa

BBB

BBB

Predominantly speculative

Ba

BB

BB

Speculative, low grade

B

B

B

Poor to default

Caa

CCC

CCC

Highest speculation

Ca

CC

CC

Lowest quality, no interest

C

C

C

In default, in arrears, questionable value

 

DDD
DD
D

DDD
DD
D

* Moody's uses numerical modifiers 1 (highest), 2 and 3 in the range Aa1 through Ca3.

** Standard & Poor's and Fitch may use + or - to modify some ratings.

 

F.2.c. Collateralized Mortgage Obligations (CMO)/ Real Estate Investment Conduits (REMIC)
CMOs are a mortgage derivative security consisting of several classes secured by mortgage pass-through securities or whole mortgage loans.  Principal and interest payments from the underlying collateral are divided into separate payment streams that repay investors in the various classes at different rates.  All collateralized mortgage obligations now issued are in Real Estate Mortgage Investment Conduit (REMIC) form.  REMIC classes include sequential pay tranches, planned amortization classes (PAC), and targeted amortization classes (TAC).  These tranches are generally more stable than some of the tranches outlined below. 

The following tranches are generally more sensitive to changes in interest rates:

  • Stripped Mortgage-Backed Securities - The separation of interest or principal cash flows from the underlying mortgage assets give I/Os and P/Os vastly different risk profiles.  These products are highly sensitive to changes in interest rates.

  • Interest-Only Stripped Mortgage-Backed Securities- A pure I/O consists entirely of a premium.  The value of the I/O is the present value of the future interest payments based on the underlying collateral. 

  • Principal-Only Stripped Mortgage-Backed Securities- P/Os are generally sold at a discount, and the investor realizes a return on investment, as principal is returned at par and the discount is returned as income.  (Refer to the Uniform Principal and Income Act for a discussion on determining income.)

  • Inverse Floaters- The coupon varies inversely to an index.  As the floating rate class of securities within the issue is larger than the inverse floating rate tranche, leverage factors or multipliers are used to balance the inverse tranche with the floating rate tranches.  Leverage factors or multipliers can magnify the effect of minor interest rate movements. 

Prior to investing in any product, management should perform the appropriate due diligence.  A copy of the prospectus and pre-purchase analysis should be retained in the trust files.  Subsequent evaluations consisting of total return screens, stress tests, or volatility analyses performed by management should be retained for REMICs.  This documentation should support the continued investment in the product.

The trust investment officer should have expertise in managing these instruments.  Management should be fully aware of all derivative holdings and be able to explain  how  these instruments benefit the individual account.  During account and investment reviews, management's knowledge of the products should be documented and the use in a particular account should be demonstrated through written comments or exhibits retained in file.  Trust departments that cannot adequately demonstrate a reasonable level of knowledge of a derivative investment and its associated risks should be criticized. 

For employee benefit accounts, an apparent violation of ERISA Section 404(a)(1)(B) (prudence), which can be found in Section 5.H.5.c r) should be cited.  The basis for the apparent violation is detailed in the DOL advisory opinion letter issued to the OCC on March 21, 1996, entitled "Investments in Derivatives."  Derivatives are defined in the letter as a financial instrument whose performance is derived in whole or in part from the performance of an underlying asset.  Examples include futures, options, options on futures, forward contracts, swaps, structured notes, and collateralized mortgage obligations.  In that letter, the DOL opined that the products are permissible. However, trust management is responsible for assessing the inherent risks of derivatives by "securing sufficient information to understand the investment prior to making the investment."  The letter discusses the importance of performing stress simulations under normal and abnormal market conditions, the effect of volatility on the plan's portfolio, and the ability to properly analyze the investment.   A copy of this letter is contained in Appendix E .

The trust policy should provide guidance, as to when investments in derivatives are appropriate and how investment risks will be managed. Parameters should be established for the dollar volume and interest rate risk  that is acceptable for accounts, and formal monitoring and reporting mechanisms should be established. Furthermore, management should understand the types of risks involved in each derivative investment and should not rely solely on the statements of the selling broker, as an impartial analysis of such risks. A broker's job is to sell a product, and often the riskier the product being sold, the greater the broker's commission.

Potential risks associated with such derivative investments consist of the following:

  • The investment is bought in a large block and several accounts hold the investment.  An individual account's investment may not be liquid.  For example, when an individual account needs to liquidate the asset, the question becomes how liquid is that individual account's investment.   Also, is the holding in a saleable lot and at what price for a relatively small holding rather than a block transaction?  Management may determine that the particular account's portion is not liquid and may sell the asset to another account.  When inter-account transactions occur, self-dealing or conflicts of interest are a major concern.  Also, management should have documentation supporting the transaction price.  However, the pricing used may be matrix pricing, which is a calculated price.  While matrix pricing should be reliable under normal circumstances, the pricing does not incorporate every conceivable outside factor which may influence pricing.

  • Trust accounting systems should provide for adequate, timely and accurate pricing of derivative investments. Many pricing services do not have sufficient capability in this area. In such cases, trust accounting systems often default to the purchase price or face value of the investment. As products return principal and income, the purchase price may greatly overstate to the value, if the trust accounting system does not accept paydowns.  Each CMO tranche has a factor, indicating the amount outstanding as a percent of the original face amount.  Normally, these factors are available on the payment of principal and interest ticket or for FNMA issued REMICs, on the agency's website.  The Capital Markets Branch in the Washington Office can provide factors and other information regarding these and other products.

F.2.d. Asset-Backed Securities (ABS)
Asset-backed securities are debt instruments secured by installment loans or leases or revolving lines of credit.  Common ABS collateral includes credit card receivables, automobile loans, automobile lease, mobile homes, and home equity loans.  The ABS can be in the form of a pass-through or in a REMIC.  Depending upon the structure, the investor either receives a pro rata share of the principal and interest payment or a structured payment. 

F.2.e. Structured Notes
These are hybrid securities that combine fixed term, fixed or variable rate instruments, and derivative products. Structured notes are debt securities issued by corporations or government-sponsored enterprises, including the Federal Home Loan Bank, the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation. Most corporate structured notes are issued through shelf-registered medium-term note programs. The shelf-registration allows the issuer to issue up to $1billion in debt over a two year period, without re-registering with the SEC.  Structured notes generally contain embedded options and have cash flows that are linked to the indices of various financial variables, such as interest rates, foreign exchange rates, commodity prices, prepayment rates, and other financial variables.  Structured notes can be linked to different market sectors or interest rate scenarios, such as the shape of the yield curve, the relationship between two different yield curves, or foreign exchange rates. 

F.2.f. Trust Preferred Securities (TPS)

Overview
Trust Preferred Securities originated in 1993, with industrial and utility companies being the primary issuers.  Since then, both large and small bank holding companies have issued the hybrid investment product:  The securities have characteristics that resemble both corporate debt and preferred stock.  The debt-like characteristics include the tax deductibility of distributions, a fixed maturity date, a stated coupon or formula for the calculation of the coupon, and the ability of investors to accelerate claims against the company in the event of default.  The securities rank behind both senior and subordinated debt in terms of repayment priority.  The equity-like characteristics include resembling cumulative preferred stock, subordinating to other obligations, and representing a minority interest in a wholly-owned subsidiary.  Currently, TPS issued by bank holding companies are limited to 25 percent of Tier 1 capital.  All TPS have an interest deferral feature of up to 5 years.  In general, TPS have a 30 year maturity, although TPS can be issued with a maturity of up to 50 years.  The securities generally have a par value of $25 for retail investors, a $1,000 for institutional investor is the norm.  A call provision of 5 or 10 years is common for the institutional class investor.

TPS Structure and Flow of Funds

Underlying Structure
First, the parent company establishes a wholly-owned special purpose subsidiary (a grantor trust), whose sole purpose is to issue the securities.  The holding company then acquires all of the special purpose trust's common stock.  Next, the trust issues preferred stock to the public, representing an undivided interest in the trust's assets.  The holding company guarantees, on a subordinated basis, that the trust preferred securities holders will receive interest payments.  The trust then lends the proceeds back to the parent company to purchase junior subordinated deferral debenture with identical terms.  The interest that the trust receives from the funds lent to the parent company is used to pay the dividend on the trust preferred securities.  In general, TPS are considered a variable interest entity and subject to FIN 46 - Special Purpose Entity accounting..      

Common structures:

      Monthly income preferred securities (MIPS)

          Quarterly income preferred securities (QUIPS)

          Pooled Trust Preferred Securitization -

         In a pooled trust preferred offering, an additional trust is added to the structure and is referred to as a business trust.  The business trust issues securities to investors and uses the proceeds to purchase all of the trust preferred securities from the grantor trust, as described above.  The trust preferred securities are then securitized, as the business trust is the sole investor of the securities.  A pooled trust preferred security is a form of a collateralized debt obligation backed by various trust preferred securities.  The pooling crosses geographical lines and therefore, limits concentration risk. 

     Eligible trust preferred securities are issued by bank or financial holding companies, whose subsidiaries' deposits are FDIC insured.  The individual holding company must have assets of at least $200MM or deposits of $100MM.  The entity must have been in operation for at least 5 years, and have a Tier 1 risk-based capital ratio of 10 percent or more. 

Deferral Period
TPS can defer interest payments for 20 consecutive quarters, unless the deferral would extend beyond the stated maturity.  While the deferral period is not considered a default, the reputation of the issuer is harmed.  Further, while the interest may be deferred, it still must be paid.  Therefore, the deferral period is also an accumulation period for interest.  The issuer can enter into a deferral period, pay investors income due, and enter back into another deferral period.  As long as there is a clean-up period, successive deferral periods are allowable.

Investment Considerations 
TPS with fixed rate coupons and lives of 30 to 50 years are sensitive to interest-rate fluctuations.  Coupons for these products are normally high in relation to market rates for long-term Treasury securities and generally yields are higher than those of corporate bonds or preferred stock issued by the same corporation.  While the products contain call provisions, there is usually a lock-out period on the call. 

An alternative to the fixed rate TPS is the floating rate TPS.  The coupon for the floating rate issues may be based on a short-term rate, such as three-month LIBOR plus a spread.  By reducing the interest-rate risk, these products have significantly less attractive coupons than the fixed rate products. 

Trust preferred securities are rated by nationally recognized rating firms.  For the pooled trust preferred issuance, only the senior notes and mezzanine notes are rated, with the senior notes carrying a higher rating.  The income notes are not rated and are similar in concept to a residual. 

Payments may be deferred for up to five years, but that action is not considered a default.  However, TPS are not immune to default.  For example, Enron issued TPS that have since defaulted.  In the event of bankruptcy, the TPS are below all senior and subordinated debt, but above equity securities in priority. 

While the previously mentioned deferral period may harm the issuer's reputation, from an investor's point of view, the deferral period can be significant, also.  During the deferral period, the investor is liable for including the deferred income in gross income for federal income tax purposes, where it is considered original-issue discount.  To collect the accrued but unpaid income, the investor must own the security on the date dividends are finally paid. 

Employee Benefit Account Considerations
Investments in affiliated holding company trust preferred securities should be carefully reviewed.  The transactions may be considered a "party in interest" under ERISA or a "disqualified person" within the meaning of Section 4975 of the Internal Revenue Code with respect to employee benefit plans and individual retirement accounts.  The purchase of trust preferred securities by an employee benefit plan or IRA that is subject to the fiduciary responsibility provisions under ERISA or prohibited transaction provisions under Section 4975(e)(1) of the Internal Revenue Code may constitute a prohibited transaction.  Prior to investing in trust preferred securities issued by the parent company, management should consult with legal counsel knowledgeable of ERISA and the Internal Revenue Code. 

A prohibited transaction may occur when employee benefit accounts or IRAs are transferred from one institution to another.  If the account held a TPS of the second holding company and transferred the asset into an account at a subsidiary of the second holding company, a prohibited transaction may occur. 

F.2.g.  Church Bonds
Church bonds are certificates of indebtedness issued by churches, and proceeds from the sale are used primarily to fund acquisition or expansion of the church property.  Churches use the funding when conventional borrowing is not available; the bonds are secured by mortgages.  In general, the bonds are held by members of a particular church.  Maturities range from 6 months to 15 years, with interest paid or compounded every 6 months.  The bonds are promoted as acceptable investments for Individual Retirement Accounts, although the ability to accurately value the bonds is questioned.  Furthermore, the bonds most likely will not be rated, due to the nationally recognized rating agencies not analyzing this type of investment, nor are the churches willing to pay for a rating, especially when the rating may be less than investment quality. 

F.3.  Equity Securities
Marketable equity securities may comprise a significant portion of a trust department's assets. Equity investments selected for accounts where the trust department exercises investment discretion should be based on research that is either performed in-house, acquired from outside sources, or a combination of the two.

The department may also consider equity ratings assigned by rating agencies and services.  In recent months, various financial service organizations, such as Charles Schwab, have established proprietary equity ratings, in addition to those established by the better known national rating agencies.  While the rating scales used by either the rating agencies or the financial service organizations appear similar to the bond rating scales, equity ratings do not have the same purpose as bond ratings.  The stock rating represents the expected performance of the stock and/or its risk level, while a bond's rating is based on perceived creditworthiness.  Therefore, a "C" rated equity may be considered as a hold, whereas a debt rated "C" is indicative of a security at or nearing default.  Given the numerous entities issuing equity ratings, trust management should maintain a copy (paper or electronic) of the rating criteria and definitions used by the particular rating service. 

The department may develop its own "approved list" based on in-house research; it may adopt the approved list of an outside investment research firm; or it may modify the "approved list" provided by an outside research firm. If the department uses in-house research or adopts its own version of an outside research firm's "approved list," there should be policies describing the criteria used to include investments on the "approved list," as well as procedures for reviewing such selections.  Investments in equity securities should be suitable for the purpose and investment objectives of the account.

Restricted equity securities are not subject to registration under Federal securities laws. The securities certificates usually contain a "legend" stating that they are transferable only upon certain conditions, such as after a certain date or after "x" years. The securities must have been obtained in a transaction not involving a public offering. Normally a trust department acquires such securities in-kind rather than by purchase. To sell such securities, the trust department must comply with the requirements of SEC Rule 144, issued under the Securities Act of 1933 (refer to SEC regulations at 17 C.F.R. Section 230.144). For additional information, refer to Section 3.k.2.  Restricted Equity Securities 

  F.3.a. Financial Derivatives
The following are the four types of Interest Rate Derivative Instruments: interest rate options; interest rate futures and forwards; interest rate swaps; and, interest rate caps, floors, and collars. These instruments are principally designed to transfer price, interest rate, and other market risks without involving the actual holding or conveyance of balance sheet assets or liabilities. Examiners are unlikely to find these types of instruments in a trust department unless the investment portfolio is exposed to some risk that can be mitigated by the use of one of these instruments. Some examples of how these vehicles could be used include: using foreign currency swaps to reduce foreign exchange risk, purchasing a call option to lock in the price of a security which the department expects to purchase in the future, purchasing a put option to establish a future selling price, and writing covered call options to enhance the yield of a portfolio.

Some trust departments use over-the-counter put and call options for accounts as a means of increasing trust account revenue. The writer of put and call options is paid a fee for selling these contracts. The purpose of using exchange traded options would be to take advantage of price fluctuations. Whether engaging in options transactions is legally permissible for trust accounts depends upon the terms of the agreement, and the applicable state law governing the investments permitted for specific types of accounts. Employee benefit trusts are governed by the prudent investment standards in Section 404(a)(1)(B) of ERISA and in DOL regulations at 20 C.F.R. Section 2550.404a-1.

Many departments have restricted option writing activity to covered call options. However, it is recognized that under certain conditions, the writing of put options, within clearly defined policy parameters, may be an acceptable and appropriate investment strategy for some accounts. Prior to approving the utilization of options as an investment strategy, the board of directors, or an appropriately designated committee thereof, should ensure that adequate policies and procedures are established to measure, monitor and control the risks involved. The policies should: address the propriety of option writing for different types of fiduciary accounts; define the permissible option strategies that may be employed; define the dollar volume of options that may be written by individual accounts; establish procedures for reporting and approving such transactions; and prescribe control and record keeping practices. The policies should be reviewed on a regular basis, no less frequently than annually. The trust department should also obtain an opinion from bank counsel as to the legality of these activities.

When a department writes a covered call option on stock held in its trust accounts, it sells to a third party the right (option) to purchase that stock (call) at a specified price until a specific date. Possession of the stock by the trust account makes the written option "covered."

Receipt of cash (fee) paid by the third party for the option provides an additional return on the stock if the market price remains the same, and cushions the potential loss if the market value declines.  An element of risk is involved if the market value of the stock rises above the strike price, in which case the holder of the option will exercise the right to purchase the stock at the previously agreed upon price.  In such instances, by granting of the option, the trust account foregoes any price appreciation over the strike price of the option. If the option contract is written and exercised on a bond, the trust account will receive the cash proceeds resulting from the sale, but reinvestment of these funds in a rising market will likely result in a reduced yield (income) to the account.

The following guidelines should be followed by examiners in reviewing investments in call options: (1) Sufficient authority must exist to make such investments.   Such authority might consist of specific authority in the governing instrument, specific or express authority in applicable state law, the written and binding consent of all account beneficiaries, an order from a court of competent jurisdiction, or in those cases where the governing instruments and state law are silent, applicable Prudent Man or Prudent Investor Rules; (2) Such an investment must be prudent for each trust account involved, coupled with a determination that employment of an option writing strategy is consistent with the needs and investment objectives of the account; and (3) The trust department should have the necessary technical expertise to monitor and execute such transactions, which should be documented in accordance with approved policy by appropriate records, reviews and approvals.

F.3.b.  Variable Annuities

Overview
The Securities and Exchange Commission (SEC) and National Association of Securities Dealers (NASD) regulate the sale of variable annuities, as the products are registered with the SEC as securities.  The variable annuity is a contract between a purchaser and an insurance company, where the latter makes periodic payments to the purchaser beginning either immediately or at some future time.  The purchase can be made by a single, lump-sum payment, or by multiple payments.  All investments in variable annuities should be viewed as a long-term investment. 

A range of investment options are offered, although investments in mutual funds are the most common.  The underlying assets are generally invested in stocks, bonds, or money market funds.  The rate of return varies with the investments selected.  While the investment options may consist of mutual funds, variable annuities differ significantly from mutual funds, by the following: 

  • Variable annuities provide periodic payments and protect the owner from outliving his assets.