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Credit Assessment of Investment Portfolios

he recent financial crisis flexibility in how assess exposed deficiencies in , and how examiners will work with Tratings assigned by nation- banks in their effort to comply with the ally recognized statistical rating rule. The heart of this article discusses organizations (NRSRO) for certain supervisory expectations for the credit fixed-income securities, especially analysis of fixed-income securities, structured products that were tied gives examples of due diligence, and to the residential real estate market. ends with a list of questions that exam- These and other securities depreciated iners may consider when reviewing rapidly when the residential real estate a bank’s practices market collapsed, causing severe losses related to due diligence. to insured depository institutions and contributing to some bank failures. Problems were pronounced in many Background bonds that were assigned strong credit ratings at the time of issuance (i.e., Investors’ overreliance on credit AAA-rated securities), but suffered ratings in the period leading up to significant credit deterioration and the financial crisis contributed to the were subsequently downgraded. widespread underestimation of credit In response, the Dodd-Frank risk in certain fixed-income securities. Wall Street Reform and Consumer Some banks did not adequately under- Protection Act (the Dodd-Frank Act) stand or independently assess the risk addressed this situation by directing characteristics of a ’s obligor, the all federal agencies to remove language underlying , or the payment in banking regulations that called for structure of individual securities. Inad- reliance on external credit ratings to equate due diligence led to purchases form judgments about a fixed-income of what were believed to be “invest- obligor’s repayment capacity.1 The ment-grade” bonds, but were not, as federal agencies were directed to draft initial credit ratings failed to identify rules that replaced external credit the inherent repayment and ratings with uniform standards of cred- weaknesses that were exposed when itworthiness. The new rules pertaining the economy, real estate, and bond to permissible investments went into markets deteriorated. The severity and effect on January 1, 2013.2 magnitude of the financial crisis trig- gered credit impairment in investment Since their issuance, bankers have portfolios, resulting in significant prin- asked for clarification on how the cipal write-downs that affected earn- regulators will interpret the rules. ings and capital. This article discusses why the new investment-grade standard is not a The reliance on credit ratings and paradigm shift from previous supervi- subsequent problems prompted sory guidance, how the rule permits Congress to enact Section 939A of the Dodd-Frank Act, which restricted refer-

1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Section 939A (July 21, 2010).

2 77 Fed. Reg. 43151, 43153 (July 24, 2012) (amending 12 C.F.R. §§ 362.9 and 362.11).

3 Supervisory Insights Summer 2013 Credit Risk Assessment of Bank Investment Portfolios continued from pg. 3

ences to credit ratings in banking regu- standards and due diligence guidance lations. In response, the Office of the that are consistent with those issued Comptroller of the Currency (OCC) by the OCC. The FDIC’s authority to issued a rule on June 13, 2012, Alter- issue such rules to national and state natives to the Use of External Credit savings associations is based in the Ratings in the Regulations of the OCC, Federal Deposit and accompanying guidance that estab- Improvement Act of 1991 in response lished an investment-grade standard in to the savings and crisis. lieu of credit ratings.3

The OCC’s rule requires banks to Supervisory Due Diligence verify that their investment securities - Requirements Have Not with some limited exceptions discussed Changed, but the Focus Has below - meet this standard at purchase. The rule defines “investment grade” as Shifted a with a low risk of and where full and timely payment of prin- From a bond analysis and invest- cipal and is expected. Although ment due diligence perspective, the the OCC rule was directed to nation- need to look beyond the ally chartered financial institutions, is not a new supervisory expectation. state-chartered institutions should also Before the financial crisis, existing adhere to the rule and guidance since guidance stipulated that banks were state banks are generally prohibited expected to have in place a robust from engaging in an investment activ- credit risk management framework for ity not permissible for a national bank.4 securities which entailed appropriate pre-purchase and ongoing monitoring The Dodd-Frank Act required the by a qualified staff that graded a secu- FDIC to issue a rule and guidance rity’s credit risk based upon an analy- directed to savings associations and sis of the repayment capacity of the their investments in corporate bonds.5 issuer and the structure and features 6 Thus, thrift investments in corpo- of the security. rate bonds will be subject to credit

3 Alternatives to the Use of External Credit Ratings in the Regulations of the OCC, 77 Fed. Reg. 35253 (June 13, 2012) (amending 12 C.F.R Parts 1, 16, 28, and 160 to remove references to credit ratings and nationally recognized statistical rating organizations (NRSROs) and replacing references to credit ratings with non-ratings based stan- dards of creditworthiness where appropriate). Final rule available at http://www.gpo.gov/fdsys/pkg/FR-2012-06-13/ pdf/2012-14169.pdf. The OCC concurrently published guidance with the final rule, Guidance on Due Diligence Requirements in Determining Whether Securities Are Eligible for Investment, which is available at http://www. gpo.gov/fdsys/pkg/FR-2012-06-13/pdf/2012-14168.pdf.

4 Part 362 of FDIC Rules and Regulations, Activities of Insured State Banks and Insured Savings Associations, implements Section 24 of the Federal Deposit Insurance Act, which generally prohibits insured state banks and their subsidiaries from engaging in activities and investments not permissible for national banks and their subsid- iaries unless the FDIC determines that the activity would pose no significant risk to the Deposit Insurance Fund.

5 See Permissible Investments for Federal and State Savings Associations: Corporate Securities, 77 Fed. Reg. 43151 (July 24, 2012) available at http://www.gpo.gov/fdsys/pkg/FR-2012-07-24/pdf/2012-17860.pdf. The FDIC also concurrently published guidance with the final rule, Guidance on Due Diligence: Requirements for Savings Associations in Determining Whether a Corporate Debt Security Is Eligible for Investment, available at http:// www.gpo.gov/fdsys/pkg/FR-2012-07-24/pdf/2012-17854.pdf.

6 See Financial Institution Letter (FIL)-70-2004, Uniform Agreement on the Classification of Assets and Appraisal of Securities Held by Banks and Thrifts, issued June 15, 2004, at http://www.fdic.gov/news/news/financial/2004/ fil7004a.html.

4 Supervisory Insights Summer 2013 Therefore, removal of references to securities portfolio. Thus, for example, credit ratings from regulations has not institutions with high concentrations substantively changed the standards of particular types of securities rela- institutions should consider when tive to capital would be expected to evaluating a fixed-income instrument’s perform more comprehensive due dili- creditworthiness, permissibility, and gence and ongoing monitoring. adverse classification. However, the supervisors’ emphasis has shifted with the Dodd-Frank Act and issuance of Exemptions, Flexibility, and the corresponding OCC regulation. Learning Curves As a result, examiners will focus less on credit ratings and more on the Banks have processes and procedures adequacy of pre-purchase analysis, in place to effectively evaluate credit integration of various credit factors risk in their loan portfolios. Similar other than credit ratings, and moni- processes and procedures could be toring procedures. adopted for securities, which would save bankers from creating a credit The Dodd-Frank Act does not risk framework from scratch. In addi- require states to change their laws on tion, the OCC rule’s exemption of permissible investments. Therefore, it many bonds from the investment-grade is likely there will be circumstances standard may also reduce burden. That where a state law requires that an is, banks may purchase obligations of investment meet a credit rating the U.S. government or its agencies threshold (typically, at the NRSRO’s and general obligations of states and lowest investment-grade rating band political subdivisions without having to such as BBB-). In these cases, banks make an investment-grade determina- will need to demonstrate that the tion. This exemption also applies to external credit ratings meet the state revenue bonds that are held by well- criteria and still conduct the due dili- capitalized banks. gence required to meet the new OCC regulation’s investment-grade or safety Therefore, U.S. Treasury securi- and soundness standards. ties and federal agency bonds will not require . Most Three general points about due dili- municipal bonds will also not require gence are worth emphasizing. First, credit analysis to determine if the the OCC and FDIC regulations are investment-grade standard has been not envisioned to significantly change satisfied. However, the supervisors 7 the scope of permissible investments. will expect banks to have a sufficient Second, the Dodd-Frank Act does not understanding of the credit risk of prohibit institutions from consider- municipals to ensure standards for ing credit ratings as part of their due safety and soundness are observed diligence and ongoing review of secu- and maintained. And, as has always rities. And finally, the depth of due been the case, management should diligence that examiners expect will fully understand safety and soundness depend in part on the size, complex- standards related to risk, ity, and risk characteristics of the , , etc.8

7 See FIL-48-2012, Revised Standards of Creditworthiness for Investment Securities, issued November 16, 2012, at http://www.fdic.gov/news/news/financial/2012/fil12048.html.

8 Part 364 of the FDIC’s Rules and Regulations establishes safety and soundness standards for all insured state nonmember banks related to asset quality, credit risk, , and other types of risk.

5 Supervisory Insights Summer 2013 Credit Risk Assessment of Bank Investment Portfolios continued from pg. 5

The OCC purposely did not issue ers should benefit from reviewing this prescriptive guidance that detailed matrix as well as the following section, procedures for every instrument or which shows examples of methodolo- situation. By keeping the guidance gies for analyzing a broad, bankers have greater flexibility and a . The examples to develop due diligence methodolo- that follow are for informational gies that are suitable to their institu- purposes; banks are free, but not tions’ respective risk tolerance and required, to use these due diligence unique situation. templates. Individual securities may require different or a varying degree of Methods for measuring and moni- analysis. Further, bank management toring credit risk in the investment has the flexibility and responsibility to portfolio will evolve, and best practices design its own due diligence processes, will emerge, as bankers, regulators, techniques, and models that are best and investment advisors identify more suited for their institution while meet- effective credit review techniques. As a ing the OCC rule’s requirements. result, the supervisory agencies expect the transition away from reliance on The first example presents a frame- credit ratings to entail a learning curve work that may satisfy the credit risk for both bankers and examiners. As safety-and-soundness standard for a long as management demonstrates municipal bond. General obligation that it has made good-faith progress municipal bonds, and also revenue to comply with the OCC rule, FDIC bonds held by well-capitalized banks, examiners, at their initial examination will not require an investment-grade reviews, will work with banks as they determination, but they will need an transition away from a ratings-centric initial credit assessment and ongo- bond selection and monitoring process. ing reviews to ensure they satisfy Examiners may offer constructive safety and soundness standards. The recommendations or suggestions on corporate bond example in the second due diligence efforts, as appropriate. text box is a description of a frame- work that might be used to determine whether a corporate bond satisfies the Due Diligence investment-grade standard.

The OCC’s regulation was issued with accompanying guidance that listed a matrix of factors to consider as part of a credit risk assessment to meet the investment-grade standard or the safety and soundness standard. Bank-

6 Supervisory Insights Summer 2013 Municipal Bonds

Many municipal bonds held in bank portfolios share two char- „„ Location in a state or geographic region suffering serious acteristics with the majority of held in portfolio: they are not economic stress or stagnation actively traded or publicly rated. That is, neither municipal bonds „„ Poor vintage performance nor loans benefit from an efficient secondary market that provides timely price discovery () and independent, ongoing third- „„ Chronic budget issues party credit surveillance. Even for many rated municipal bonds, surveillance and the reassessment of assigned credit ratings are „„ Illiquidity of the municipal obligor often not conducted on a timely basis. „„ Repeated late filings of financial statements or qualified audits

Given these characteristics, it is important that management’s „„ Unusually wide credit spreads (when there is an active second- due diligence and monitoring process identify bonds with higher ary market) risk characteristics at the time of investment and during the hold- Once a potentially higher-risk bond is identified, whether through ing period. Higher-risk bonds have characteristics that could monitoring of the existing portfolio or the pre-purchase review of a potentially cause them to not meet credit quality safety-and- contemplated bond investment, management can apply more rigor- soundness standards. Examples of characteristics that have the ous credit analysis and financial statement analysis as appropriate potential for higher risk include: to develop a conclusion about its risk and suitability.

„„ Municipal category or type that has incurred historically high The table below depicts a straightforward example for measuring default rates, e.g., community development district bonds, risk and determining if a general obligation bond has met its safety- Mello-Roos bonds (an alternative way for local municipali- and-soundness credit risk benchmark. A bank may find it beneficial ties in California to public improvements, including to grade the bond as it grades commercial loans by assessing and streets, sewer systems, and other infrastructure projects), scoring various factors. Cumulative scores could be generated by sanitary improvement district bonds - all colloquially known adding the specific scores given to each assessment factor. as “dirt bonds”

XYZ MUNICIPALITY

Credit Factor Factor Score (1-5) Health of Local Economy (Per Capita Income, Population Growth, Unemployment Rate, etc.) Location in Low-Risk State or Region Current Financial Statements Budget Performance Degree of Tax Burden Level of Debt and Unfunded Liabilities Payment Performance Credit Enhancement Spreads Comparable to Similar Bonds NRSRO Rating Cumulative Score

Management could create a grading scale and identify the grad- performance of the municipality’s management. (A similar scoring ing band where “Pass” bonds reside, that is, bonds that would system could be designed for securities requiring an investment- satisfy-safety-and-soundness standards. Scoring systems could grade determination. Bonds with cumulative scores at or above be made more robust by weighting each factor and including a certain threshold would be deemed investment grade, thus qualitative factors, e.g., scoring for the reputation and operating permissible for purchase.)

7 Supervisory Insights Summer 2013 Credit Risk Assessment of Bank Investment Portfolios continued from pg. 7

Corporate Bonds

The credit analysis of corporate bonds is similar to the assess- Financial analysis of the corporate borrowing entity also ment of commercial term loans, as both instruments are paid from considers ratio analysis that measures the level and trend of the obligor’s cash flow and can have repayment periods extend- debt service coverage, liquidity, cash flow, leverage, and oper- ing beyond one operating cycle. Such credit analysis attempts ating efficiency. Profitability, earnings prospects, and return on to determine the repayment capacity of the borrower; in other equity analyses can also provide longer-term analytical insight. words, the potential for default risk. This approach is convenient Peer comparison can also add perspective to the comprehen- given the new rule defines investment grade, in part, as a security sive ratio analysis. where default risk is low. Therefore, it is anticipated that the due diligence and monitoring process for corporate bonds will be Management can further enhance the corporate bond review similar to the underwriting and monitoring of commercial loans. by performing an industry analysis. This requires an understand- Plus, most banks have a lending staff that understands business ing of the industry’s outlook, life cycle, competitiveness, and other financial statements, underwrites and assesses default risk using issues that could affect the corporation under review. business financial statements, and is experienced in monitoring commercial entities. Finally, management will need to tie the analysis together to determine whether the credit risk profile of the obligor is suit- Corporate bond analysis (as with all bond analysis) begins with able as an investment and meets the standards established by understanding the terms of the bond. Examiners will expect bank the investment policy. This process could mean using a scoring management to be familiar with the indenture and prospectus system similar to commercial loan grading, the municipal bond which explains the bond’s characteristics including rate informa- scoring matrix shown previously, or another methodology that is tion, maturity, call or convertibility options, amortization or sinking sufficiently robust and well documented. fund features, and collateral information, if applicable. These documents should be part of the security due diligence documen- tation and available for examiner review.

„„ Given the rule’s definition of the Risk Management Practices investment-grade standard, do bank policies establish criteria or In addition to verifying the adequacy benchmarks (by security type) of bond due diligence and the progress that must be met to satisfy the in satisfying the OCC rule, examin- investment-grade standard? ers will also likely focus on related risk management practices. Examin- „„ Are the due diligence procedures ers may seek answers to the following specified in the investment policy questions: sufficiently comprehensive for the identification, measurement, and „„ Are the bank’s revised policies monitoring of credit risk? consistent with the requirements of „„ Are credit risk limits reasonable? the new regulation?

8 Supervisory Insights Summer 2013 „„ Does management have sufficient in-house expertise to manage the Conclusion investment portfolio’s credit risk? Financial institutions should have a „„ Does management devote sufficient process for determining whether their resources to managing the portfolio’s investment securities meet creditwor- credit risk? thiness standards. This process cannot „„ Do minutes of the investment rely exclusively on credit agency committee or board meetings ratings. The new rules became appli- indicate that the directorate and cable for all existing and future bond

management review and monitor holdings on January 1, 2013. Supervi- portfolio credit risk? sors anticipate there will be a learning curve as bankers develop, modify, and „„ Is credit risk accurately reported to enhance due diligence methodolo- the board? gies to meet regulatory expectations. „„ Do the board and senior manage- Examiners will expect to see evidence ment understand the investment of progress toward compliance with portfolio’s credit risk? the rules during initial examination reviews. „„ Are third-party relationships prop- erly managed? Does management Eric W. Reither understand the third party’s credit Senior Capital Markets risk methodology, confirm the third Specialist party’s methodology is sufficiently Division of Risk Management comprehensive, not permit the Supervision delegation of decision-making to the [email protected] third party, and ensure the third party is independent from the secu- The author acknowledges the valu- rities dealer? able contributions made by several reviewers of this article with special „„ If the bank uses credit ratings by a thanks to William R. Baxter, Senior NRSRO as one factor in determining Policy Analyst; and Timothy P. Neeck, whether prudential credit risk stan- Senior Capital Markets Specialist. dards are being met, does manage- ment have a basic understanding of the methodologies the rating agen- cies use and the limitations of those methodologies? Written policies should provide guid- ance on several of the issues raised by these questions. The depth and detail of the policies that guide credit risk management in the investment portfo- lio will vary among banks, contingent on the nature, scope, and complexity of the instruments held.

9 Supervisory Insights Summer 2013