- 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.
