Banking Regulators Issue New Rules Requiring Further Municipal Bond 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 bond market 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 municipal bond 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 bank 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 banks 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 interest 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.