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- 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.