- Hi, I'm Tyler Hosier,
a Risk Management Examiner
in the Omaha, Nebraska,
Field Office.
- And I'm Chasity Dschaak,
a Risk Management Examiner
in the Fargo, North Dakota,
Field Office.
- In the Basic Analysis module,
we discussed a general process
for evaluating lower-risk
municipal bonds.
If a bond has complex
or unique features,
or appears to have higher
credit risk characteristics,
then some form of expanded
analysis is warranted.
The expanded analysis process should evaluate these features
or characteristics
to ensure the bond meets
the bank's
creditworthiness standards.
In this module,
we will discuss
an expanded
pre-purchase credit analysis
and ongoing credit monitoring framework for municipal bonds.
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.
- The expanded credit risk
analysis process
should consider the same factors
as the basic analysis,
but in greater detail.
The extent of the expanded
analysis will be determined
based on the results
of the basic analysis.
Expanded analysis
may be required at the time
of purchase
or periodically thereafter.
Expanded analysis
of the location
and type of issuance
is not necessary
as these elements
were reviewed in their entirety
during the bank's basic
pre-purchase analysis.
For the remainder
of this module,
we will discuss expanded
credit risk analysis factors,
focusing on economic conditions, the financial condition
and fiscal responsibility
of the obligor,
and rating agency reports.
Let's begin our expanded
pre-purchase analysis discussion
with economic conditions.
- Economic conditions
are a vital component
of credit analysis
for municipal bonds.
There are several
additional areas to consider
when reviewing
the issuer's local economy
on an expanded basis.
First, reviewing employer
trends typically includes
an analysis of the diversity
and stability
of the employment base.
Concentrations by taxpayer
or industry can result
in a more volatile employer base
and local economy.
This is especially true
if employers are centered
in cyclical industries,
such as manufacturing,
hospitality,
agriculture, and energy.
Second,
assessing labor trends
includes a review of
job creation, employment,
and per capita
income levels.
A decline in any or all
of these metrics may serve
as early indicators
of potential economic stress.
Next, analyzing property
trends involves reviewing
assessed and market values,
building permit activity,
and occupancy rates.
Changes in property values
have a significant impact
on tax receipts,
while building and occupancy
levels can be used to gauge
the health of the local
real estate market.
The 2008 housing crisis
and related declines
in property values
were especially painful
for many areas of the nation
and adversely impacted
the financial condition
of many municipalities.
And, finally, other factors
to consider include
an economy's size and growth, competition,
and population trends.
- Tyler, could you tell us more
about these other factors?
- Sure, Chasity.
Some small or less diverse
municipal economies
may be more vulnerable
to economic downturns
or may lack sustainable
economic growth.
Competition relates
to a municipality's ability
to offer employers a favorable
business environment,
which aids in job creation.
And population trends
are important,
as a decline can be problematic for a municipality
as the tax base decreases relative to the issuer's debt.
Economic analysis
should not be confined
to the issuer's local economy.
If the municipality
relies heavily
on state or federal government
payments to operate,
this reliance
should be considered.
Now let's discuss the analysis
of municipal
financial statements.
- A common method for evaluating the financial condition
of municipal obligors
is to perform ratio analysis.
A table, such as
the one presented here,
is a possible tool
for this analysis.
Other formats
or reporting mechanisms
may be more appropriate,
depending upon the level
of detail necessary
for proper assessment
of municipal portfolio risk.
This table lists potentially
useful ratios for reviewing
a general obligation bond.
Management may determine
that other ratios are more useful and appropriate.
The analysis used
should be tailored
to the risk profile of
the bank's municipal portfolio.
We discussed the two
leverage-related ratios,
Debt Per Capita
and Debt to Assessed Value,
in the Basic Analysis module.
In addition to leverage,
the reviewer
could also consider
the other ratios in the table
related to
the obligor's liquidity,
revenue concentration,
repayment capacity,
and debt burden.
Each ratio should be compared
to the bank's internal policy guidelines to determine
if the bond meets
its credit criteria.
When the expanded analysis
of the obligor's financial condition uncovers weaknesses,
third-party credit enhancement may mitigate the risk.
Similar to a commercial
loan guarantee,
the credit enhancement
supports the timely payment
of principal and interest.
Common forms of enhancements
include bond insurance,
bank letters of credit,
and state or federal
credit programs.
The strength
of the enhancement provider
should be considered.
- Chasity, you mentioned a tool
for general obligation bonds,
are there factors related to
revenue obligation bonds
that management should consider?
- Yes, Tyler,
a similar tool could be used
to review
revenue obligation bonds.
Financial review of revenue
obligation bond issuers
is similar to
commercial credit analysis,
especially for non-essential purpose revenue obligation
and industrial
development bonds.
In many cases,
a bank's commercial
credit assessment framework
could be applied to the revenue
obligation bond analysis,
with only minor adjustments.
An example
of a potential framework
for revenue obligation
bond analysis
is presented in this table.
We discussed capacity
and protection
in the Basic Analysis module.
When assessing leverage
and liquidity,
ratios
such as Debt To Capital
and Cash To Total Debt
may be used.
Revenue concentration
and competition
may also be assessed.
Each ratio should be
compared to the bank's
internal policy guidelines
to determine
if the bond meets
its credit criteria.
If financial weaknesses are
identified during the analysis,
any mitigating factors
should be considered.
- Assessing
fiscal responsibility of the
municipality is similar
to assessing
the character of a loan customer.
Although this is one
of the most qualitative
and challenging areas
to assess,
a municipality's ineffective management and governance
can impact performance
and increase credit risk.
We discussed budget, audit,
and disclosure practices
in the Basic Analysis module.
Expanded analysis includes three
additional areas to review.
The first area is capital
planning and debt management.
Ideally,
an obligor should have
a multi-year capital
improvement plan,
including reasonable levels
of projected debt issuance.
Without proper planning,
capital spending
may negatively impact
a municipality's debt levels.
The second area
is operating flexibility.
Many municipalities
have statutory limits
on the tax levies
they can assess,
which can restrict their ability to raise revenue.
And finally, the third area
is labor relations.
Compensation and benefits
frequently comprise
a significant portion
of a municipality's budget
and can affect an obligor's
long-term financial condition.
- Rating agency reports
can serve as one component
of the overall expanded
credit risk analysis.
They are also
an effective tool
summarizing the obligor's
local economic conditions,
financial condition,
and fiscal responsibility.
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 consider
the timeliness
of the reports,
understand
the rating methodologies,
and investigate
any ratings differences.
Credit rating
median reports
present median,
or mid-point, ratios,
as well as financial
and tax base information
for municipalities,
organized by credit rating band.
They can be useful when setting
internal policy guidelines,
and when assessing
the credit risk associated
with non-rated bonds
and bonds with stale ratings.
For example, management
may compare financial
or performance ratios
of a specific bond
to the applicable medians.
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.
Additional information
provided by the rating agencies
that can assist in
assessing individual
and portfolio credit risk
includes sector outlook reports
and rating methodology
reports.
Sector outlook reports provide
that agency's performance expectations for each sector
based on their analysis
of median data.
The reports provide an aggregate
view of financial performance,
fiscal responsibility
trends,
and economic conditions
impacting the sector.
Rating methodology reports
describe the credit risk assessment framework
used by each rating agency.
Bank management can use
the reports to formulate
the bank's own credit risk
assessment framework
and to understand why there
may be differences in ratings
among the rating agencies.
This concludes the discussion
of expanded
pre-purchase analysis
and now Tyler
is going to discuss
expanded ongoing
monitoring expectations.
- Expanded ongoing monitoring
should be completed
at least annually
and documented.
It may cover
economic conditions,
and the obligor's
financial condition
and fiscal responsibility.
Interim analysis may be
necessary in certain situations,
such as a severe ratings downgrade
or a technical default.
Bonds where higher-risk
characteristics are identified
should be subject to some form
of expanded ongoing monitoring.
Certain bonds
within the portfolio
will almost always require
expanded analysis.
Examples include:
industrial development bonds,
non-essential purpose
revenue obligation bonds,
those issued by obligors
located outside the bank's defined geographic area,
and those located
in distressed markets.
Bonds may move between
basic and expanded
ongoing monitoring
as risk characteristics change.
The ongoing monitoring
procedures should be expanded
as the bond's
risk increases.
Monitoring procedures
can become more basic
as the bond's risk level decreases.
The depth of the analysis
and monitoring procedures
should be consistent
with the bond's risk profile.
- As discussed in detail
in the Basic Analysis module,
additional resources
are available
that may assist in the overall
risk management process.
The EMMA website provides free
access to official disclosures,
trade data, credit ratings,
and educational materials.
The issuers, state auditors,
and state attorneys general
may be contacted to obtain
additional information
on municipal entities.
Other third parties,
such as securities brokers;
correspondent banks;
and rating agencies,
may be a source of information.
- To summarize the key points
of this module,
expanded pre-purchase analysis
and ongoing monitoring
should be performed when bonds
with complex, unique,
or higher-risk characteristics are identified
during the basic
credit risk assessment.
The expanded
credit risk analysis process
should consider the same factors
as the basic analysis,
including
the economic conditions,
financial condition,
and fiscal responsibility
of the obligor.
Expanded economic analysis
may involve reviewing employer,
labor,
and property trends,
as well as
other economic factors.
- Ratio analysis is
a common method for evaluating
the financial condition
of municipal obligors.
We provided examples of
possible ratios for assessing
both general obligation
and revenue obligation bonds.
In many cases,
a bank's commercial
credit assessment framework
could be applied to the revenue
obligation bond analysis,
with only
minor adjustments.
- Assessing fiscal
responsibility is similar
to assessing the character
of a loan customer,
and may include reviews
of capital planning
and debt management,
operating flexibility,
and labor relations.
