Banking Regulators Issue New Rules Requiring Further Municipal Credit Analysis

The final rules and guidance published recently by the OCC pertaining to credit ratings will require more in-depth analysis of your municipal portfolio.

By Larry M. Wood

Anyone who’s even remotely familiar with the municipal knows how volatile that market has been the last couple of years. Predictions made in 2010 of widespread defaults by municipalities caused investors to flee what once had been considered a safe haven, sending prices down and yields up. Then, when it seemed as if the prophesied defaults were perhaps a false alarm, the municipal bond market experienced a huge rally and performed quite strongly for the first two quarters of 2012. Even in light of that rally, municipal bonds continue to offer the best relative value propositions of any security type a may purchase in its portfolio.

In recent months, however, the California cities of Stockton, San Bernardino and Mammoth Lakes filed for bankruptcy, thereby lending some measure of credence to those earlier forecasts. Depressed property values and lower levels of consumer spending have reduced revenue for local and state municipalities, yet the municipalities still have the same amount of debt to service and the same expenses to cover. Compounding an already tenuous situation, all but one insurer of municipal bond issuers—Assured Guaranty, or AGM—have suffered significant ratings downgrades or have been declared insolvent because of their exposure to the subprime mortgage crisis.

Historically, bankers have relied mostly on a bond’s rating and insurance when purchasing municipal bonds, or they might have done some initial credit review of the bond at purchase but then never reviewed the credit again. As a result of the turmoil in the municipal bond market, this approach to investing in municipal bonds for your bank’s portfolio may no longer be prudent, and the regulators are now requiring more due diligence and ongoing credit analysis.

As you are undoubtedly aware, in accordance with the Dodd-Frank Act, the Office of the Comptroller of the Currency (OCC) published final rules and guidance in June amending the regulatory definition of the term “investment grade” by removing references to credit ratings. The revisions to OCC 2012-18 will take effect in January 2013, at which time will no longer be able to rely exclusively on external credit ratings to determine the creditworthiness of a security. Instead, they will need to devise their own methodology for determining that the likelihood of default by an obligor is minimal and that “full and timely” repayment of principal and can be expected. Furthermore, in addition to conducting due diligence before deciding to purchase an investment, banks will also be responsible for analyzing the creditworthiness of their investment portfolios on an ongoing basis.

Bankers who have attempted to secure financial information for use in analyzing certain municipal bond issuers know how challenging, and often futile, this exercise can be. Quite often you cannot obtain the information you need through the usual channels, such as the MSRB’s’ EMMA, or Bloomberg, and your only choice then is to contact the municipality directly. Municipalities are not held to the same SEC reporting standards as corporations are, so even when financial statements are released, the data points are typically at least six months old. Disclosure of financial statements is even less likely for nonrated municipalities, which, according to a recent article in The New York Times, are those most apt to declare bankruptcy.

Let’s be optimistic and say that you are eventually able to track down a clerk in the municipal treasurer’s office who agrees to send you a somewhat recent set of financial statements. What you could end up with is 150 pages of documentation that may or may not be prepared to GAAP standards. It’s your job, at that point, to sift through the data and figure out what the chances are that the municipality will be able to meet its obligations and repay the debt.

Many community banks simply do not have the time or the manpower to devise and apply the credit methodology required to evaluate the creditworthiness of the issuers of the municipal bonds in their portfolio. Fortunately, the OCC permits banks to rely on analytics provided by third-party institutions to determine whether a security is an appropriate investment.

In the name of expediency, some banks will be tempted to go back to the broker who sold the bond for confirmation that the issuer is, in fact, creditworthy. Many broker dealers will offer a complimentary, albeit cursory analysis, but regulators may not consider this to be an independent analysis. If only a cursory examination of outdated issuer financial data and general economic data for the city or state is conducted, you might not be any better off than where you started. When the OCC’s revisions take effect at the beginning of the year, banks will be required to develop objective criteria for reviewing their entire portfolio, such as state analysis, type of bond (i.e., general obligation, essential service revenue, etc.), ratings (which can be used, but not as the sole criterion), source of repayment and so forth. After reviewing and distilling this information, banks can establish which bonds may require a “deep dive” to truly understand the issuer’s ability to repay the debt.

This deep dive credit review should evaluate the municipality’s existing debt, its revenue versus expenses, its liquidity position, its pension obligations and how much money the municipality is receiving from the state or federal government, and multi-year trends of such, among many other criteria.

The OCC has provided more specific guidance to banks regarding the credit analysis that will be required going forward. It’s very likely that the FDIC and state banking regulators will follow suit and require the same level of review. You will be required to have in place a process for conducting a thorough credit analysis before you purchase securities, including municipal bonds, and then have an ongoing credit review process in place after you purchase them. This is a time-consuming and daunting task that is causing many community banks to look to independent service providers for help. Although it is yet another expense that banks will need to incur in order to comply with Dodd-Frank, in this economic environment, it’s also a prudent approach that will help banks identify any municipal bond holdings that may be problem credits lurking in their portfolio.

Larry Wood is the senior vice president of the financial institutions group at The KeyState Companies. The KeyState Companies and its affiliates provide Municipal Credit Reviews and Portfolio Management for community banks throughout the United States.

Contact KeyState today at 866-246-5322 for a free Municipal Portfolio “Preview” Credit Report and a sample pre-purchase due diligence checklist for municipal bond purchases.