4000 - Advisory Opinions
Whether Investments By Federal Savings Associations in Mortgage-Backed Notes Issued by the National Housing Services of America Are Permissible Under the FDI Act
September 18, 1995
Mark A. Mellon, Senior Attorney
This letter responds to your request for FDIC review of proposed investments by federal savings associations in mortgage-backed notes issued by "ABC". Specifically, you wish to ascertain whether such investments are permitted under section 28(d) of the Federal Deposit Insurance Act (the "FDI Act") (12 U.S.C. § 1831e(d)).
ABC is a not-for-profit corporation, tax-exempt under section 501(c)(3) of the Internal Revenue Code (the "IRC") (26 U.S.C. § 501(c)(3)) and chartered under the laws of "State'' that serves as a secondary market for mortgage loans originally issued by local community loan funds to low- and moderate-income persons who would not otherwise be eligible for such credit. In addition, ABC purchases low- and moderate-income mortgage loans originated by for-profit lenders. The purchased mortgage loans are used by ABC to securitize mortgage-backed notes. Loans originated by a community loan fund are purchased by ABC with recourse to the community loan fund. This means that the community loan fund must maintain a pool of non-delinquent loans which can be substituted for loans purchased by ABC which have gone delinquent. Loans purchased from a for-profit lender are without recourse and are instead secured by private mortgage insurance. ABC has also put up cash reserves to further collateralize the mortgage-backed notes. The mortgage-backed notes are purchased by "social investors" who are interested in promoting low- and moderate-income housing. The notes are held for the social investor by an ABC trustee but the mortgage-backed notes are issued by the corporation itself.
Section 28(d) of the FDI Act states that no savings association may, directly or through a subsidiary, acquire or retain any corporate debt security not of investment grade. The term "corporate debt security" is not defined by the FDI Act nor by the FDIC's regulations implementing section 28 (12 C.F.R. § 303.13). "Of investment grade'' is defined by section 28(d)(4) of the FDI Act to mean that a security, when acquired by a savings association or its subsidiary, was rated in one of the 4 highest rating categories by at least one nationally recognized statistical rating organization.
Section 28(d) of the FDI Act was added by section 222 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (the "FIRREA"). The intent of Congress in enacting section 28(d) was to bar savings associations from investing in "junk bonds". See H.R. Conf. Rep. No. 19, 101st Cong., 1st Sess. 326 ("Subsection (d) contains a modified version of subsection (a) applicable to investments in junk bonds . . . as well as a special rule for junk bonds held through subsidiaries"). Congress was concerned that investments by savings association in junk bonds had contributed to the crisis in the savings association industry which the FIRREA was to resolve. 135 Cong. Rec. H2763 (daily ed. June 15, 1989) (statement of Rep. Markey). We can infer from this legislative history that Congress intended section 28(d) of the FDI Act to apply to those investments (corporate debt securities) with the characteristics of junk bonds.
Junk bonds have been defined in various ways as: high-yield securities that include all securities which are either not rated by the major bond rating agencies or are rated at least one investment below investment grade1 ; high-interest bonds issued by new, heavily indebted or otherwise risky corporations2 ; and non-investment grade bonds rated BB+ by Standard and Poor's3 . The one element that all of these definitions have in common is that junk bonds present a significantly greater degree of risk than most other investments. Junk bonds played a significant role in the merger and acquisition boom of the 1980's. As a result, many corporations became highly leveraged and in 1989 the junk bond market almost collapsed because of the high interest being paid on the instruments.4
In order to retain its status as a not-for-profit, tax-exempt corporation, ABC must be operated exclusively for charitable purposes, in this case the promotion of low- and moderate-income housing. Moreover, no part of the net earnings of ABC may inure to the benefit of any private shareholder or individual. See section 501(c)(3) of the IRC. For this reason, even though it is termed a corporation, ABC does not issue stock. ABC therefore does not resemble the publicly-traded, for-profit corporations which trafficked in junk bonds in the 1980s.
A purchaser of the mortgage-backed notes of ABC will acquire a security that is directly and exclusively dependent upon payments of low- and moderate-income housing mortgage loans (private mortgage insurance and cash reserves of ABC will only be relied upon for payments to noteholders in the unlikely event of a shortfall or loss for a particular note). The purchase of the ABC mortgage-backed notes by a savings association would provide funds for community development, as would occur if the savings association engaged directly in making low- and moderate-income mortgage loans. This is a form of activity which federal savings associations have specific legal authority to engage in directly. See section 5(c)(3) (B) of the HOLA, 12 U.S.C. § 1464(c)(3)(B). See also 12 C.F.R. § 545.41.
As noted previously, ABC mortgage-backed notes are protected against default by requiring the community loan fund which sells the mortgage loans to ABC to keep a pool of non-delinquent loans which can be substituted for loans which have gone delinquent. Loans purchased by ABC from a for-profit lender are without recourse and are instead secured by private mortgage insurance. ABC has also put up cash reserves to further collateralize the mortgage-backed notes. Officials of ABC have informed me that no issues of their mortgage-backed notes have defaulted in the past. The debt instruments of ABC therefore do not appear to be high-risk investments of the type which Congress sought to bar savings associations from investing in through section 28(d) of the FDI Act.
ABC mortgage-backed notes are issued for a different goal than the ones usually associated with junk bonds. Rather than being used for the merger and acquisition of publicly-held firms, the ABC mortgage-backed notes are instead used to promote the availability of low- and moderate-income housing. The ABC mortgage-backed notes therefore plainly differ from junk bonds in this respect also. Moreover, the OTS and its predecessor, the Federal Home Loan Bank Board (the "FHLBB"), have long taken the position that the legal authority of federal savings associations to make loans also permits investments in securities representing an interest in or backed by any such loans. See, e.g., The OTS Guide to the Federal Laws and Regulations Governing Community Development Activities of Savings Associations, 1994 at 28, OTS Op. Chief Counsel, Dec. 19, 1991, and FHLBB Op. General Counsel, Oct. 9, 1984.
In view of the above, it is our opinion that the ABC mortgage-backed notes should not be considered to be corporate debt securities under section 28(d) of the FDI Act. Please note that this opinion is limited to the facts of this specific case. It is not our intention to opine that all privately issued asset backed notes fall outside of the requirements of section 28(d). Other types of debt instruments which lack any of the characteristics described herein would have to be evaluated on a case-by-case basis in order to determine whether they fall within the scope of section 28(d).
Please do not hesitate to contact me if you have any questions about this matter.
1A. Auerbach, Mergers and Acquisitions 5 (Nat'l Bureau of Econ. Res. Project Rep. 1988). Go back to Text
2James Buchan, U.S. Finance, Enigmatic Securities, The Financial Times, June 26, 1989 at IV. Go back to Text
3John A. Jones, Industries in the News, Investor's Business Daily, April 21, 1992, at 34. Go back to Text
4Matthew Winkler, Junk Bond Turmoil May Be Here to Stay, Wall St. J., Oct. 24, 1989, at C1, col. 3. Go back to Text