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Municipal Bond Due Diligence: 10 Friendly Suggestions

By: Jeff Goble

You are probably aware that Dodd-Frank Section 939A requires banks to conduct additional due diligence on their municipal bond portfolios. An important part of the guidance is that banks can no longer rely solely on bond ratings and must now do their own research. Although the following list of risk mitigation steps may be more than you need, I thought a list of friendly suggestions might be timely:

1) Review your bond rating upgrades/downgrades each month.
Most bond accounting reporting systems disclose rating changes as they occur each month and this can be a valuable early warning tool. In UMB’s system, for example, a report called Status Change Report breaks out credit rating upgrades and downgrades each month. This information can be added to your monthly ALCO/Board reports. 
 
2) Prepare a monthly Sudden Price Change Report.
From your bond accounting Holdings and Pricing report, you can drag the monthly bond price for each municipal issue into an Excel spreadsheet and then compare it side by side with the previous month’s price. While there are legitimate reasons for sudden price changes (call features suddenly coming into play, for instance), look for changes of 5 percent or more from month to month. Next, investigate whether there is any news out about that issue or inquire whether the pricing change is simply a one month exception. The market itself has always been the best indicator of change.

3) Conduct an Annual Credit Review.
You should review all of your municipal credits at least once a year. This financial information is automated now and can be presented in such a way that many issues can be analyzed in an orderly fashion. Separate the general obligation issues (backed by unlimited ad valorem taxes) from the revenue bonds and drill deeper into the audited financials of the revenue issues. March through May is a good time of the year to catch all of the previous year end financials.

4) Conduct a separate, more thorough credit review for any non-rated issues.
Since non-rated issues are often from smaller communities and school districts, it makes sense to conduct a higher level of due diligence on these bonds, both general obligation and revenue issues.  You may wish to conduct this review as a regular part of your loan review committee and presenting a few non–rated issues each meeting is a good way to break up the process over time. You may need to call the local Treasurer directly for current, audited financial statements.

5) Establish underwriting standards.
These are general guidelines for reviewing financials on municipal issues and should include key debt ratios, population trends, tax collection history and other key economic benchmarks. I have written sample underwriting guidelines for both general obligation and revenue issues but am limited by the space in this column. Email me if you would like to receive these sample guidelines.

6) Emphasize general obligation issues.
Following the age-old banking theory that risk belongs in the loan portfolio, I think it makes sense to favor municipal bonds that are backed by unlimited ad valorem property taxes. If anything goes wrong, the issuer can raise property taxes without limit until the bond is repaid. This is an important safety net.  If you are comfortable with revenue bond issues, I think essential purpose issues (water, sewer) make the most sense, especially inside your banking footprint. Of course, everyone needs to develop their own risk tolerance/comfort level in this area as revenue bonds are more like loans.

7) Maintain national/regional or in-state diversification.
Diversification is one of the best ways to reduce your credit exposure with municipal bonds. If the economy turns down in one specific area or region of the United States or in one part of your state, you are less at risk if you are well diversified. Some banks limit potential new issues to their established footprint while others keep their issues within 500 miles or to contiguous states, for example.

8) Set credit exposure limits.
 Most banks establish a maximum dollar amount for any one municipal bond issue and sometimes have larger limits for local issues versus out of market bonds.  It is important to remember that a school district, city and county can often rely on the very same group of taxpayers for repayment so the potential overlap should be monitored as well. As a general rule, your investment in any one taxpayer base should not exceed your legal lending limit.

9) Prepare a Watch List and update it monthly.
Any issues that experience rating downgrades or have sudden price changes in their market values should be added to a Watch List for possible sale. If audited financial statements are not readily available or if information is incomplete, it might make sense to simply sell the issue. This is a great time market-wise to liquidate lower quality issues as you can probably book a gain in the process. That does not happen very often!

10) Use independent financial statement resources.
http://www.emma.msrb.org/ is an excellent tool for obtaining current financial statements on a wide variety of issues and the service is free.

It is important to note that your municipal bond due diligence process should be commensurate with the amount of risk you have in your portfolio and also your bank’s regulatory capital levels. If you own a low risk, general obligation portfolio, you are probably already in good shape in this area.

Hopefully, these friendly suggestions will help you build a more formal process if necessary and also better document the successful practices you already have in place.

Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.

Copyright (c) March 2013 by BankNews Media


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