- Hi, I'm Jeremy Hauser,
the Senior Capital Markets
and Securities Specialist
for the FDIC's
Kansas City Region.
- And I am Kim Schulte,
a Risk Management Examiner
in the Hays, Kansas,
Field Office.
- In this module,
we will discuss a basic method
for analyzing municipal
securities that can be used
for both pre-purchase analysis
and on-going monitoring.
This basic framework
may be sufficient
for lower-risk municipal bonds,
and can also be used
to identify higher-risk bonds
where expanded analysis
is warranted.
The Expanded Analysis module
provides additional details.
The framework presented
in this module
is for example purposes only,
as the FDIC expects
industry practices
will continue to evolve.
It is not intended
to be all-inclusive,
nor is it appropriate
for all banks.
Each bank should implement
a framework
consistent
with the complexity
of the Board's approved investment activities.
Similar to other investments,
a pre-purchase analysis
process should be established
for municipal securities.
The extent of the assessment
will depend upon
the risk characteristics
of the individual bond.
This analysis should consider
credit risk, interest rate risk,
and liquidity risk.
We will first discuss credit
risk and some possible factors
to consider as part
of the due diligence process.
- When assessing credit risk,
pre-purchase analysis
should be completed
by bank personnel,
using data obtained by the bank,
from a third party,
or a combination of the two.
Management may rely
on third-party support
when completing this analysis; however,
management must review
and understand the data,
analysis,
and methodology used.
Remember, decision-making
responsibilities
may not be delegated.
If a third party assists
in the credit risk analysis,
management should ensure
the third party is independent,
reliable, and qualified.
Independence can be achieved
in various ways,
including a separation between
the third-party's sales
representatives
and analytical support staff.
Common third-party providers
include securities brokers,
correspondent banks,
and rating agencies.
Basic credit risk analysis
should consider various
factors and can include:
The location of the municipality
issuing the bond
and the current
economic conditions
impacting that municipality.
The type of municipal
bond issuance.
An assessment
of the financial condition
of the municipal bond obligor.
A review of the municipality's
fiscal responsibility.
And an evaluation of ratings
and other reports
issued by rating agencies.
Now, Jeremy will discuss
economic conditions.
- A municipality's location
and the condition of its economy
influences credit risk.
For many banks,
the municipal portfolio
is generally confined
to relatively local issues.
Monitoring
local economic conditions
is part of management's
routine activities
and is generally documented
in the minutes
of the Loan and Asset/Liability Management Committees.
Typically, no additional
structured review is needed.
However, if the local market
is distressed,
an expanded analysis
of all factors is necessary
to ensure the issuer
has the capacity to continue
to perform on its obligations.
If investments are located
outside the local market,
an expanded analysis of economic
conditions is warranted.
This analysis may conclude
that the economic conditions
of the issuer are distressed,
resulting
in an expanded review
of all credit risk
analysis factors.
- The next basic credit factor
to consider is type of issuance.
As discussed in the Overview
& Industry Trends module,
credit risk can generally be
ranked from lower to higher risk
by grouping municipal bonds
into four broad categories.
General obligation bonds
typically have
minimal credit risk.
Essential purpose
revenue obligation bonds,
which may fund water, sewer,
and electrical facilities,
also generally exhibit
lower credit risk.
Basic analysis
is usually sufficient
for these two investment types.
Non-essential purpose
revenue obligation bonds,
which fund projects
such as hospitals
or multi-family
housing facilities,
and other higher-risk
municipal issuances
have less stable repayment streams and greater credit risk.
As a result, expanded analysis
of the obligor's
financial condition and fiscal
responsibility is necessary.
Assessing the obligor's
financial condition
is the third factor
in basic credit risk analysis.
This is often accomplished
by analyzing the issuer's
most recent financial statement,
and calculating
key statistics and ratios.
A table, such as
the one presented here,
is a possible tool
for this analysis.
Other formats may be more
appropriate depending upon
the level of detail management
wishes to present to the Board.
The Debt Per Capita and Debt
To Assessed Value ratios
are measures of leverage,
and are typically associated
with general obligation bonds.
The Debt Service
Coverage Ratio,
a capacity-related ratio,
is typically associated
with revenue obligation bonds.
Management may determine
that other ratios
are more useful and appropriate.
The analysis utilized
should be tailored
to the risk profile of
the bank's municipal portfolio.
- Kim, I see covenant compliance
is listed as an item
that might possibly be reviewed.
What are some common examples
of municipal bond covenants?
- Well, many municipal bond
documents include covenants
to protect investors,
such as restrictions on debt
levels and minimum working capital requirements.
Reviewing compliance
with covenants
could apply to all bond types.
As the table suggests,
all of the measures reviewed
and calculated
should be compared
to Board-approved policy
guidelines to determine
if the bond meets the bank's creditworthiness standards.
Exceptions to policy guidelines
may require expanded analysis,
and will require approval
prior to purchase
as specified in the bank's
investment policy.
There are helpful resources
available to assist banks
in developing policy guidelines.
These resources include
rating agency median reports,
banking associations,
correspondent banks,
and other third parties.
- Assessing fiscal
responsibility
of the municipality
is the next area
we will discuss as part
of the basic analysis,
and may include an evaluation
of budget trends,
audit procedures,
and disclosure practices.
Although this is one of
the most qualitative
and challenging areas to assess,
it can be an important factor for a bank to consider
as an issuer's ineffective
management and governance
can impact performance
and may increase credit risk.
A review of budget trends
is important for assessing
the fiscal soundness
of the municipal bond issuer.
The analysis should determine
whether the issuer
has historically operated
with a balanced budget,
surplus, or deficit.
Recurring deficits
are a potential sign
of increased credit risk.
Reviewing the municipality's
audit procedures
is an important part of
assessing fiscal responsibility.
Preferably, the issuer's
financial statements
are audited annually
by an outside certified
public accountant.
Lack of an independent review
by a qualified party
may affect the reliability
of the information disclosed.
Disclosure practices are another
factor of fiscal responsibility.
Ideally, municipalities
should disclose timely
annual financial statements.
Disclosure delays
can be a cause for concern.
If concerns are identified by
reviewing these three areas,
then expanded analysis
may be warranted.
KIM:
The credit ratings
and associated reports
from the rating agencies
can be one component
of the credit risk analysis;
however, they cannot
be the sole component.
External ratings
for municipal bonds
are not always updated
on a timely basis after issuance
and can vary among
rating agencies.
As a result,
management should understand
the rating methodologies,
investigate any
ratings differences,
and consider the timeliness
of the reports.
- Kim, are other reports available
from the rating agencies that bankers may find useful
in the credit risk
analysis process?
- Yes.
The rating agencies also
produce median reports
for various types
of municipalities grouped
by credit rating.
These reports present median,
or mid-point ratios
and other data for financial
and tax base information.
They can be useful when setting
internal policy guidelines,
and assessing rated
and non-rated securities.
The median reports
are derived
only from that rating agency's universe of rated bonds;
therefore,
the ratios and data
may not reflect
industry medians.
The rating agencies
issue other reports,
which can assist
in assessing individual bond
and overall portfolio risk,
such as sector outlook reports,
default statistics,
and rating methodologies.
These reports can be
beneficial in analyzing
rated
and non-rated securities.
- Next, we will discuss interest
rate and liquidity risks
as part of a bank's
pre-purchase analysis,
focusing first
on interest rate risk.
All bond prices are influenced
by interest rate changes,
but the level of
interest rate risk can vary
depending on the security.
Pre-purchase analysis should
consider how the bond's
individual interest rate risk
profile impacts
the bank's overall position.
Understanding
the various features of a bond
is key to evaluating the
instrument's interest rate risk.
Repricing risk results
from timing differences
between coupon changes
or cash flows.
The long-term maturity
and fixed rate structure
of many municipal bonds
can expose the bank
to repricing risk.
Some municipal bonds are issued
with call features
that allow early repayment
of the bond at the option
of the issuer,
which results in option risk.
Basis risk occurs
when municipal market rates
do not move
in unison with rates
of other balance sheet instruments.
Finally, yield curve risk
is the risk that changes
to the shape of the yield curve
will negatively impact
the value of a bond
or an investment portfolio.
- We will conclude
our discussion on pre-purchase
analysis by reviewing
liquidity risk.
Market liquidity
affects bond prices
and the ability to convert
the instrument into cash.
Among other things,
it is influenced by
issuance size
and market characteristics.
Although the municipal market
is large and diverse,
individual bond liquidity can
vary greatly for many reasons.
Let's examine a few.
Municipal bonds are traded
using a network of dealers.
Only a small number
of municipal bonds
are actively traded in the
secondary market, and in fact,
Securities and Exchange
Commission studies indicate
that 70 percent never trade
after issuance.
There may be few dealers
willing to make a market
for smaller municipalities,
smaller issuances,
and nonrated securities,
resulting in higher bid/ask spreads and less liquidity.
The reduced liquidity of
municipal securities
may limit their eligibility
as collateral
to secure public deposits
and borrowing lines,
as state statutes
and secured lenders
might not allow
municipal securities
to serve as collateral.
Even if eligible, municipal
securities may be subject to
higher collateral margins
than other investment types.
Before concluding our
pre-purchase analysis
discussion,
we would like to address
a question
that the FDIC
frequently receives
from the banking industry.
Jeremy, sometimes brokers will
offer a bank a municipal bond,
but provide only a short
amount of time for management
to make a purchase decision.
How can management perform
a proper pre-purchase analysis
under such limited timeframes?
- Generally speaking,
the FDIC expects
that basic or expanded
pre-purchase analysis
should be performed
for most municipal bonds.
However, to help save time
when making purchase decisions
for general obligation bonds,
the bank's board can approve
a process where an analysis
is prepared in advance.
This analysis can be used
to develop an internal list
of acceptable
municipal investments,
including terms and amounts,
consistent
with the Board's policies.
The FDIC expects that this
list will be limited
to general obligation issuers
in markets that are local,
familiar,
and not distressed.
In most cases, revenue
obligation bonds
will not qualify
for inclusion on the list.
Further, management should
perform ongoing monitoring
to determine what issuers
should be included on,
or removed from, the list
of acceptable investments.
Similar to monitoring
this list,
management should monitor
credit risk
of the entire municipal bond
portfolio on an ongoing basis.
Ongoing monitoring should
assess credit, interest rate,
and liquidity risks.
Interest rate and liquidity
risks are captured
by a bank's routine
asset/liability management
process.
Therefore, our ongoing
monitoring discussion
will focus on credit risk, which
is based on the same factors
as those discussed in the
basic pre-purchase framework.
The ongoing monitoring of the
location and economic conditions
is limited to determining
if the market is distressed.
Expanded analysis is required
in distressed market conditions.
Ongoing monitoring
of the type of issuance
is not necessary as the
bond type does not change.
A regular assessment
of the financial condition
of the municipal bond obligor
is the primary component
of an ongoing credit analysis.
At a minimum, financial reviews
should be conducted annually.
Fiscal responsibility should
also be routinely monitored
as part of the process.
Management should monitor
the municipality's budget,
audit, and continuing disclosure.
Rating agency reports can
assist in the assessment
of the financial condition
and fiscal responsibility
of the issuer.
- Ongoing monitoring should
be completed at least annually
and appropriately documented.
Interim analysis
may be necessary
in certain situations
that suggest increasing risk,
such as:
A ratings downgrade;
Adverse publicity;
A technical default,
including failure to comply
with bond covenants;
An unexpected
reserve fund draw,
which could occur in response
to revenue declines
or spending increases;
And other event notices,
such as payment delinquencies
or unscheduled
credit enhancement draws.
In general, basic analysis
should be performed
on all bonds in the portfolio.
Those bonds where higher-risk
characteristics are identified
should be subject to
some form of expanded analysis.
Some bonds
within the portfolio
will almost always
require expanded analysis,
while others may move
between basic and expanded ongoing monitoring
as risk characteristics change.
The depth of the analysis
and monitoring procedures
should be consistent
with the bond's risk profile.
- Before we conclude
this Basic Analysis module,
we want to discuss
some resources
that may assist in the overall risk management process.
The Electronic Municipal
Market Access website,
or EMMA, is the official
repository for information
on municipal securities.
The Municipal Securities
Rulemaking Board operates
the EMMA website,
which provides free access
to official disclosures,
trade data, credit ratings,
and educational materials.
It also allows users to track
and receive notifications
on specified bonds.
The issuer may also be contacted
to obtain financial information,
such as the annual report
or the official statement.
Many state auditors or attorneys
general, provide information
on municipalities located
within their respective states.
Often, this information can be
accessed via their websites.
Other third parties,
such as securities brokers;
correspondent banks;
rating agencies;
and investment banks,
can also be a valuable
source of information.
If third-party information
is used to supplement
the internal
credit risk analysis,
management should ensure
the third party is independent,
reliable, and qualified.
- To summarize the key points
of this module,
basic pre-purchase analysis
and ongoing monitoring
must be conducted
for each bond purchased.
It should include
an evaluation of credit,
interest rate,
and liquidity risks.
A basic pre-purchase credit
risk analysis should consider
the issuer's location and
related economic conditions,
the type of issuance, and the
obligor's financial condition
and fiscal responsibility.
It can also include a review
of rating agency reports.
- The primary focus of ongoing
monitoring of credit risk
for individual bonds
is an assessment
of the obligor's
financial condition.
Interest rate and liquidity
risks of each bond
should be reviewed
at the time of purchase,
while ongoing monitoring
of these risks
is captured within the bank's routine interest rate risk
and liquidity reports.
If concerns are identified
prior to purchase
or during
the ongoing monitoring,
some form of expanded review should be performed.
The Expanded Analysis module
provides additional information
on this review.
