CMS Case Study

AUCTION RATE/MONEY MARKET PREFERRED STOCKS These are preferred stock issues on which the dividend rate is reset periodically (usually every 49 days) via an auction mechanism that also permits the holder to sell its holdings at par. They are generally used as an alternative to commercial paper with superior tax equivalent yields because of the favorable tax treatment accorded dividends. Current risk weight: 100%. TRUST PREFERRED SECURITIES Widely issued by bank and thrift holding companies, trust preferred securities represent hybrid instruments in that they qualify as capital for regulatory purposes and debt for tax purposes. Structures vary in that they can be fixed rate, floating rate (with/without caps), and may have call features (after 5 years). They are typically 30 year maturities. Securities can reflect single entity issues or a group of entities (pooled trust preferred). Securities are rated with pooled issuances often consisting of junior/senior structures as well as “residuals”. These are, in effect, corporate debt from an investor’s perspective. Current risk weight: 100%. MUTUAL FUNDS Shares of interest in a pool of debt and/or equity securities. Mutual funds provide a wide range of investment alternatives that are independently managed (actively or passively). Since each mutual fund is unique the prospectus must be reviewed to understand its objectives, investment strategy, and potential performance. Current risk weight: 20-100% depending on fund investments. EQUITY SECURITIES Common and preferred stocks offer a wide range of alternatives for current yield (dividends) and/or potential capital appreciation. Equities include high-yield, rate sensitive issues (e.g. utilities), providing high after-tax income; and, lower yielding, growth-oriented issues (e.g. industrials) which offer greater potential for dividend growth and price appreciation. Dividends may be subject to a 70% exclusion for income tax purposes. Current risk weight: 100% (FHLB stock = 20%). C. Identification of Risk Investment decisions will be based upon a thorough analysis of each security instrument to determine its quality, inherent risks, fit within the overall asset/liability management objectives of the Bank, effect on the Bank’s risk-based capital measurement and prospects for yield and/or appreciation. Lack of adequate information increases the degree of risk. These risks include the following: Credit (Default) Risk - The potential for failure of a debtor to make timely payments of principal and interest as they become due. Liquidity Risk - The risk that a financial instrument cannot be sold or closed out quickly, at or close to its implicit economic value. As liquidity decreases bid/offer spreads typically widen. Interest Rate Risk - The risk that interest rates will change, causing a decline in either the market price for the security or a decline in yield. Prepayment Risk - The risk that the actual prepayment of principal is different from the expected prepayment speed assumptions, thereby affecting the actual market price and yield of the investment. Market Risk - The risk that the market price of the security will decline substantially for reasons such as market pricing aberrations, and changes in supply and demand characteristics of a particular security market(s). Market risk is also used synonymously for Price Risk which results from some of the previously listed sources as well as other financial variables to which a specific security may be linked for purposes of deriving its interest and principal cashflows. Operating Risk - Potential for loss because of inadequate policies, procedures, controls, error, fraud, etc.

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