Pub. 1 2013 Issue 3

www.uba.org 16 E ffective January 1, 2013, bank regula- tors implemented new standards for municipal investments that require most banks to adopt a new approach to the credit analysis process. The biggest take away is clear: credit ratings will no longer serve as sole justification for credit quality. Fortunately for most community banks, credit ratings have become an afterthought in the credit review process. The first blow came several years ago when, in the wake of the financial crisis, the lion’s share of monoline credit insurers lost their AAA ratings and the associated ratings on insured municipal bonds. Investors soon realized the importance of analyzing the underlying credit profile of the municipal- ity, regardless of ratings or credit enhance- ment features. Regulators have also addressed the appro- priateness of using third party research. While the use of a reliable third party to aid the bank in its credit analysis process is acceptable, third party analysis is neither required nor appropriate as the only as- sessment of credit quality. In the same way that it is no longer acceptable to rely solely on credit ratings, a third party can not be the only assurance the institution hato jus- tify credit quality. In the absence of a third party’s credit rationale, using third party data is sufficient so long as the institution can justify a credit opinion internally. Amidst much speculation as to how to implement a robust credit analysis frame- work, the FDIC, OCC, and the Federal Reserve have set out clear guidelines for what they expect in determining the permissibility of municipal investments. Below we have compiled a summary of those guidelines to aid your institution in implementing such a framework. The bot- tom line is this: examiners must see proof of an internal credit analysis process. Key Factors for All Municipal Investments 1.Confirm spread to UST is consistent with bonds of similar credit quality. 2.Confirm risk of default is low and consistent with bonds of simi- lar credit quality. 3.Confirm capacity to pay and assess the financial and operat- ing performance through internal credit analysis. 4.Understand local demographics/ economics. Consider unemploy- ment data, local employers, income indices, and home values. Key Factors for General Obligation Bonds 1.Evaluate the soundness of a municipality’s budgetary position and review management experience. 2.Determine the stability of tax revenues and the issuer’s tax- ing authority. 3.Consider debt profile and level of unfunded liabilities. 4.Identify the diversity of revenue sources. Key Factors for Revenue Bonds 1.Assess the source and strength of the revenue structure for municipal authorities. 2.Consider obligor’s financial condition and reserve levels. 3.Compare annual debt service and debt coverage ratio. 4.Review credit enhancements, legal covenants, and nature of the project. Many banks have already established in- ternal credit analysis procedures, utilizing key credit metrics such as those high- lighted in The Baker Group’s Municipal Credit Profile. As shown in the example below, this allows the investor to perform a pre-purchase credit analysis that is both useful and efficient. These credit metrics are derived from the bond’s official state- ment, financial statements, and other rel- evant filings from the obligor. Hyperlinks to these documents are embedded within the Credit Profile, allowing the investor to perform further analysis. The Credit Profile also provides bond level data such as the purpose of issuance, pledged secu- rity, and tax status; three years of trend data; macroeconomic indicators such as unemployment and income statistics; and the obligor’s pension funding status. This kind of reporting has received posi- tive feedback both from portfolio manag- ers and examiners, especially in light of the regulations imposed by Dodd-Frank. To comply with these regulatory guide- lines, banks are advised to review the rele- vant metrics, establish appropriate bench- marks before the purchase decision, and perform an annual post purchase review of each credit in the portfolio. Clearly, credit analysis has become an important issue for bank investment officers. Now that regulatory expectations are clarified, banks will need to ensure that they have in place the reporting tools, processes, and resources necessary to properly manage the investment portfolio. n New Regulations for Municipals in 2013: Dodd-Frank, Section 939 A By Drew Simmons, The Baker Group LP Since 1979, we’ve helped our clients improve deci- sion-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach oftotalresource integrationutilizingsoftwareandproducts developed by Baker’s Software Solutions* — combined with our solid investment experience and advice—makes us the investment firm of choice for many community financial institutions. For more information, contact Drew Simmons at The Baker Group: 800-937-2257, www.GoBak- er.com, or email: dsimmons@GoBaker.com. *The Baker Group LP is the sole authorized distributor for the products and services developed andprovidedby The Baker Group Software Solutions, Inc. DrewSimmonsVicePresident–FinancialStrategiesGroup The Baker Group LP