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- Hi, I'm Jim LaPierre,
Regional Director for the FDIC's Kansas City Region.
It's my pleasure to welcome you to this presentation
on The Evaluation of Municipal Securities.
This video is one of several
that are part of the FDIC's Community Banking Initiative.
This presentation was developed
for management of community banks,
and is targeted at those individuals
involved in the supervision of the securities portfolio,
including members of the Investment
and Asset/Liability Management Committees.
Banks continue to invest in municipal securities
to support their local communities.
In recent years, many banks have increased their exposure
to municipal securities in search of higher yields
during a period of low interest rates and limited loan demand.
Meanwhile, many municipalities have been stressed
by declining revenues, rising costs, and budget deficits,
resulting in a few publicized defaults.
However, the overall level of defaults
remains relatively low.
Municipal bonds are a sound investment option
as long as prudent risk limits, credit analysis,
and monitoring procedures are in place.
Increased investment in municipal bonds,
publicized municipal bond defaults,
and regulatory changes have prompted many questions
about supervisory expectations.
We'll address these topics in this presentation,
which is divided into five modules.
In this module, we'll discuss
existing regulatory guidance and recent changes,
supervisory expectations, and industry trends.
Second, we'll discuss
the role of Investment Policies & Procedures.
Then, our presentation will focus on pre-purchase analysis
and ongoing monitoring expectations,
which are covered in two modules,
Basic Analysis, and Expanded Analysis.
We'll end this presentation
with a Review & Additional Resources module.
Joining me in presenting these modules are:
Jeremy Hauser,
the Senior Capital Markets and Securities Specialist
for the Kansas City Region;
Kim Schulte, a Risk Management Examiner
from the Hays, Kansas, Field Office;
Tyler Hosier, a Risk Management Examiner
from the Omaha, Nebraska, Field Office;
and Chasity Dschaak, a Risk Management Examiner
from the Fargo, North Dakota, Field Office.
Let's start off by discussing existing guidance.
The 1998 Supervisory Policy Statement
on Investment Securities and End-User Derivatives Activities
outlines overall regulatory expectations
for effective risk management of the investment portfolio.
More recently:
The Dodd-Frank Act required regulators to remove references
to external credit ratings from regulations.
As a result, in 2012, the Agencies issued
revised investment permissibility rules
and related safety and soundness guidance.
The rules, which apply to all FDIC-insured banks
and savings associations, replaced external credit ratings
with a non-ratings based investment grade standard
to determine eligibility for purchase.
The investment grade standard
does not apply to general obligation bonds,
nor does it apply to revenue obligation bonds
purchased by well-capitalized banks.
However, the investment grade standard does apply
to revenue obligation bonds purchased by banks
that are not well-capitalized.
The related safety and soundness guidance clarified
regulatory expectations regarding investment
pre-purchase analysis and ongoing monitoring.
The guidance applies to all securities
and will be the focus of this presentation.
Additionally, in 2013,
the Agencies issued updated guidelines
for classification of bank investment securities.
The new Uniform Agreement on the Classification
and Appraisal of Securities Held by Depository Institutions
removed references to credit ratings consistent
with the Dodd-Frank Act requirements.
One of the points of the permissibility guidance
and classification guidelines
is that banks cannot rely solely on external credit ratings
to determine creditworthiness.
The FDIC expects banks to supplement any consideration
of external credit ratings with a risk assessment framework
that is appropriate for the size and complexity of the instrument
and the portfolio's risk profile.
Banks should have well-defined investment policy guidelines
and risk management practices.
The FDIC expects bank policies and practices
to be risk focused.
Those banks with potentially higher-risk securities,
or higher exposures relative to capital,
should have advanced policy guidelines
and risk management practices.
As this chart indicates, supervisory expectations
increase as a bank's exposure level rises,
or as the investment portfolio risk profile increases.
We are often asked what constitutes
a higher-risk security or what exposure level
raises supervisory expectations.
There are no set thresholds or bright lines
because the FDIC evaluates each bank and municipal portfolio
on its own merits.
This presentation will assist management teams
in developing a risk management framework
that is appropriate for the bank.
Now Jeremy and Kim will discuss market characteristics
and recent industry trends.
- Thanks, Jim.
We will start by looking at some highlights
of the municipal securities market.
As of December 31st, 2012, the outstanding balance
of municipal bonds totaled 3.7 trillion dollars,
exceeding the Federal Agency Securities market
of 2.7 trillion dollars.
KIM: The average annual volume of municipal bonds being issued
between 2008 and 2012 was approximately
381.2 billion dollars.
The average issuance size during 2011 and 2012
was 27.1 million dollars;
however, nearly 67 percent of the new issuances
were less than 10 million dollars in size.
JEREMY: There are over 1 million
different municipal bonds outstanding,
compared to fewer than 50 thousand corporate bonds.
And, finally, there are over 89,000 different issuers
of municipal bonds.
As we've demonstrated, the market is large, diverse,
and includes many issuers.
As a result, municipal bonds are dependent on a variety
of repayment sources of differing quality.
Therefore, risk and complexity can vary significantly.
- Jeremy, what are some of the unique challenges
associated with municipal risk assessment?
- Well, Kim, there are several unique challenges.
For instance, financial information may not be timely.
It is common for financial statements to be issued
well after their "as of" date, reducing their usefulness.
Also, financial information is presented in accordance
with the Governmental Accounting Standards Board,
also known as GASB.
This information can be difficult to analyze
and understand, because these standards differ
greatly from those issued
by the Financial Accounting Standards Board, or FASB.
Additionally, the amount of unfunded pension liabilities
and other postemployment benefit obligations
is often hard to determine, and this complicates
financial statement analysis.
Further, legal uncertainty has increased
with rising financial stress in some municipalities.
In some cases, the priority of claims on municipal receipts
has been questioned, especially for municipalities
that have substantial unfunded postemployment
benefit obligations.
And, finally, municipal bankruptcy laws
vary from state to state.
Understanding the market characteristics and challenges
has become more important as the banking industry
has increased its investment in municipal bonds
over the last ten years.
KIM: This chart reflects community
and large bank median, or mid-point, investment levels
in municipal securities and loans as a percent
of their capital, from June 2003 through June 2013.
As you can see, the community bank median investment level
is higher than the large bank median, and the overall level
for both groups is rising.
Next, we will discuss historical trends
in municipal bond impairment
by vintage and default by sector.
The vintage analysis chart shown here details
the number of municipal bonds issued since 1990
that have experienced impairment,
listed by the year issued.
An impaired bond has either defaulted, relied upon support,
or experienced other performance-related issues.
Let me define each of these terms.
Default includes a full or partial missed payment.
Support indicates issuers have used emergency funds,
such as reserve funds or bond insurance policies,
to make payments to bondholders.
Other consists of bonds with covenant violations,
developer insolvencies, or other signs of stress.
As illustrated, bonds issued just prior to the onset
of the 2008 financial crisis represent the largest number
of those experiencing impairment.
A majority of these were special assessment bonds,
which funded infrastructure for new housing developments.
These bonds are also commonly known
as community development districts,
sanitary improvement districts, and dirt bonds.
Performance of special assessment bonds deteriorated
after the housing market collapsed.
Although the total number of bonds disclosing impairment
spiked during the crisis, the overall level of default
remains low as a percent of issuers.
Now, let's look at historical municipal bond defaults.
JEREMY: This illustration details all
municipal bond historical defaults categorized by sector
that occurred from 1958 through 2011,
based on a study by the Federal Reserve Bank of New York.
Industrial development bonds have experienced
the most defaults, representing 28 percent of all defaults,
followed by housing, nursing homes, and health care.
Collectively, these four sectors represent 68 percent
of total defaults.
Although a few large municipalities have recently
defaulted on their general obligation bonds,
default levels remain relatively low.
- We will discuss in greater detail the various levels
of credit risk within municipal bond types
commonly held by community banks.
Credit risk can be ranked from lower risk to higher risk
by grouping municipal bonds into four broad categories.
General obligation bonds have historically represented
the lowest risk municipal bond type.
These bonds are typically secured by the taxing authority
of the municipality.
Conversely, revenue obligation bonds are not backed
by the taxing authority of the issuer.
Essential purpose revenue obligation bonds are issued
to fund facilities for essential public services such as water,
sewer, and electrical facilities.
Revenues generated by these services
are typically stable and predictable.
Non-essential purpose revenue obligation bonds may be issued
by a municipal entity on behalf of a private sector party,
such as a hospital or a multi-family housing project.
These projects may be more vulnerable
to economic fluctuations and less stable revenue streams.
As a result, these bonds often exhibit
a comparatively higher degree of credit risk.
Other higher-risk municipal issuances commonly include:
Industrial development bonds, which are issued to fund
private projects to construct new facilities,
rehabilitate existing facilities,
or purchase equipment.
Industrial development bonds also include special
assessment bonds issued to provide infrastructure
for new housing development.
The obligations are repaid through proceeds generated
by the project.
And certificates of participation,
commonly referred to as COPs, where the holder is entitled
to a share of lease payments from a specific project,
subject to an annual appropriation
by the municipality.
JEREMY: In summary, banks should have
a process to determine whether their investment securities
meet creditworthiness standards.
This process cannot rely exclusively
on external credit ratings to determine creditworthiness.
However, credit ratings can represent one component
of a credit analysis.
This analysis may be challenging
as the municipal market is large and diverse,
and credit risk can vary by bond type and purpose.
KIM: Supervisory expectations
are typically based on the portfolio exposure relative
to the bank's capital and the risk profile of the portfolio.
The FDIC's expectations will be higher for banks
with exposures to higher-risk municipal securities,
than for banks that have modest levels
of generally lower-risk municipal securities.