Congratulations! You re Now in the Bond Ratings Business!

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Congratulations! You’re Now

in the Bond Ratings Business!

Larry M. Wood, SVP – Financial Institutions Group, KeyState Advisory, LLC

Digital Handouts Sponsored By:

2013 Education Summit & Expo

A Whole New World in Community Banking.

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The Fed’s Rules That Got us Here

• 7-22-2010 - Section 939A: – Dodd-Frank Wall Street Reform & Consumer Protection Act

of 2010

• 11-29-2011 - OCC’s 2011-022: Guidance on Due Diligence Requirements in Determining

Whether Investment Securities are Eligible for Investment

• 6-26-2012 - OCC’s 2012-18: Alternatives to the Use of External Credit Ratings in the

Regulations of the OCC

• 11-15-2012 - FRB’s SR 12-15: Investing in Securities Without Reliance on NRSRO’s

• 11-16-2012 - FDIC’s FIL 48-2012: Revised Standards of Creditworthiness for Investment

Securities

• 6-6-2013 - FDIC’s Supervisory Insights: Credit Risk Assessment of Bank Investment

Portfolios. Volume 10, Issue 1, Summer 2013, Author: Eric W. Reither

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Why are the Feds so anti-NRSRO?

• NRSRO: Nationally-Recognized Statistical Ratings Organization

• Issues with MBS / CMO / CDO AAA Ratings

• Issues with US Sovereign Debt Downgrade

• Issues from losses to the FDIC fund

• Issues from taxpayer-funded bailouts

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The Reality Check!

Q:

So……….., if you can’t use credit ratings to evaluate the credit-worthiness

of a bond, and you have to evaluate it yourself,

doesn’t that mean you’re

now your own ratings agency?

A:

YES it does!

The burden has shifted from NRSRO’s to the bank investor. Not from the

NRSRO’s to your broker – to you!

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No. Why? $1.22 Billion in Unfunded Pensions Liabilities

• $170MM workers / $572MM police & fire / $478MM OPEB

• 318% of $383MM net exp. / credit model parameter of < 25%

Exhibit 1

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Exhibit 2

OK, I Get It, I’m a Bond Ratings Agency.

Non-GAAP (Cash-Basis) Accounting Financial Statement

…Partial Snapshot

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263 page O/S Investor Security Unfunded Pensions

Material Event Notices Stale Financials Ratings Changes

Exhibit 3

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OK, I Get It, I’m a Bond Ratings Agency.

Typical “Before” Market Exchange

• Pre- Dodd- Frank:

– Broker: “Boy Have I gotta deal for you. AA-rated-with Insurance, & it’s yield

is X”

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Likely “After” Market Exchange

• Post – Dodd-Frank:

– Broker: “Boy, have I gotta deal for you. Credit works, relative value

is there, & I just sent you our credit profile on the issuer”

– Bank: “Meets policy. I’ll buy it!”

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Your Options

1. Ignore it

• Probably best to focus on items 2 - 5

2. Help from inside

• Get help from your loan department

3. Self-Help

• Develop a credit model & review process yourself

4. Help from outside

• Utilize your sales broker

5. Help from outside

• Use an Independent 3

rd

_party

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Risk Management Framework & Practices

* Processes

* Procedures

* Policies

Pre-Purchase Analysis

Ongoing Analysis

* Monitoring/Action Plan

* Credit Analysis

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Risk Management Framework & Practices

• Answer the Question: Internal or External

• Develop Overall Process

• Investment Policy Changes

• Investment STIPs

• Information Flow Management

• EMMA-Based Monitoring System

Pre-Purchase Analysis

Ongoing Analysis

• Develop Process • Information Flow • Monitoring System • Response Matrix • Review Schedule

Credit Analysis

• Relative-Value Determination • Investment-Grade Determination

Risk Analysis

• Safety & Soundness Determination

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Dodd-Frank Apologies

• Apology 1: …not envisioned to significantly change permissible

investments….just documentation of such…..

• Apology 2: …does not prohibit consideration of credit ratings…

• Apology 3: …depth of due diligence depends on...

– Size;

– Complexity (of security); and

– Risk characteristics of the securities portfolio

– Sufficient to support investor’s conclusions

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Dodd-Frank Caveats

• Caveat 1: …regulator’s focus has shifted...

– From credit ratings To adequacy of pre-purchase analysis & monitoring procedures

• Caveat 2: …won’t override state laws…

– If a state law requires a minimum rating, must still comply

– Focus shift requires demonstration of how your review meets the state’s ratings-based criteria, &

– Must still determine investment-grade and safety & soundness standards

• Caveat 3: …first year – test year...

– Watching what banks are doing – Offering templates / examples

– Assessing what’s key to their future reviews

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Dodd-Frank Exemptions

• US Treasuries

• US Agency Debt

• Revenue Bonds

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Dodd-Frank Caveats to the Exemptions

• Revenue Bonds

– Only exempt if a “well-capitalized institution”

– Fed’s still expect banks to have sufficient understanding of the credit risk of muni’s to ensure safety & soundness guidelines are met.

– How can you only do that, without evaluating the credit-worthiness? Single-source of repayment?

• Unlimited-Tax General Obligation Muni’s (UTGO’s)

– Fed’s still expect banks to have sufficient understanding of the credit risk of muni’s to ensure safety & soundness guidelines are met.

– How can you only do that, without evaluating the credit-worthiness?

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Risk Management Framework & Practices

• EMMA-Based Monitoring System

Pre-Purchase Analysis

Ongoing Analysis

• Develop Process • Information Flow • Monitoring System • Response Matrix • Review Schedule

Credit Analysis

• Relative-Value Determination • Investment-Grade Determination

Risk Analysis

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Given Increase in Requirements, Where Do I Best Invest Limited Resources?

– Utilize Internal Resources? – Utilize External Resources?

• Investment Advisory for entire process

• Independent Credit Evaluation Service for “troubled” holdings – Combination?

– Time (D-F law significantly increases the time requirement for proper analysis and compliance.

Do you have the time?)

– People (#, Abilities, Training, Experience, Time) – Technology (Adequate or increase needed) – Support

Risk Management Framework & Practices

• Answer the Question: Internal or External

• EMMA-Based Portfolio Monitoring

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Given Increase in Requirements, Develop Overall Process BEFORE

Starting

– Risk-Tolerance Levels – Resource Assessment

– Develop Credit Review and Risk Analysis Process – Develop Ongoing Monitoring Process

– Require Complete Documentation Process – Assign Responsibilities & Management – Create Oversight & Feedback Channels

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Risk Management Framework & Practices

• Develop Overall Process

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Make Investment Policy Changes. Focus on:

– Pre-Purchase Language focus on requirements, documentation, & depth of due diligence

– Ongoing Monitoring Language focus on risk-tolerance levels, particularly

concentration & diversification guidelines, requirements when triggered, process for action

– Focus on responsibilities and oversight

Risk Management Framework & Practices

• Investment Policy Changes

• EMMA-Based Portfolio Monitoring

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Use Investment STIPs

– Send to All Broker-Dealers and 3rd_{-Party Advisors}

– Guidelines that reflect your pre-determined risk-tolerance levels regarding credit, liquidity, structure, issuers, information, etc.

– Require all brokers to adhere to your STIPs for all offerings – Establish “no exceptions” rule

– Makes your life easier

– Establishes broker’s / advisor’s focus, responsibility, and buy-in to your processes and risk-tolerance levels

Risk Management Framework & Practices

• Investment STIPs

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MUNI STIPULATIONS (STIPs)

• Unlimited Tax GO’s or Essential-Service Revenue Bonds ONLY

• No ZERO coupons

• No TAWs, BANs, TRANs, Ltd. GOs, Warrants, TANs, COPs, COOs, OPEBs, or RANs

• We do not buy Fire, Library, Park, TIF, MUD, Metro, or other types of Districts, except School or Community College Districts

• If muni bond is insured, we only accept AGM, BAM, BHAC, or state-guaranteed ins. programs • Underlying ratings must be A2 / A or better

• Non-Rated GO’s in local-market only • No Non-Rated Revenue bonds

• All Muni’s must have a complete Official Statement

• We do not buy muni’s that have Limited or No Continuing Disclosure

• We do not buy muni’s that use Cash Basis or Fund Balance Accounting, only GAAP

• Troubled States List: We do not buy municipal bonds in the states of AZ, CA, DC, IL, LA, NJ, NY, NV, RI,

or WA

• “Bankruptcy-Watch1_{” States: We are cautious of buying municipal bonds in the states of AL, AZ, AR,} CA, CO, MN, MO, NE, OK, SC, or TX

• Note1_{: These states are known as “hands-off” states and have authorizing legislation in place to allow for a municipality to file bankruptcy, superseding the federal legislation}

What’ve I gotta Do? Develop a Risk Management Framework?

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• Brokers / Underwriters

– New Deals (Prior Week of Sale)

• POS’s

• New-issue Scales

• NRSRO Ratings Reviews

• Broker Credit Profiles

– Secondary Issues (at offering)

• OS’s

• Current F/S’s

• NRSRO Ratings Reviews

• Broker Credit Profiles

• Issuers (Directly)

– Continuing Disclosure Compliance

– Current F/S’s

• EMMA (discussed on following slide)

Risk Management Framework & Practices

• Information Flow Management

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• www.emma.msrb.org

• Central disclosure / transparency

repository for municipal market, operated

by MSRB – Municipal Securities

Regulatory Board

• Load Portfolio onto EMMA (CUSIPs)

• Determine Level(s) of Disclosure

– Trade Alerts (end-of-day)

– Primary Market Docs (OS’s) – Continuing Disclosure Docs

• Material Event Notices

• Financial Information & Docs Only

• Determine Who Receives Info

• Pre-Determine What to do With Info

– Immediate Response / Action on ALL Notices

– Scheduled Response (i.e., quarterly)

Risk Management Framework & Practices

• EMMA-Based Portfolio Monitoring

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• Set up to receive dealer’s issuance calendar in prior week

• Pre-select & review issues

• Pre-complete scorecard / review

• Require POS’s to be sent early

Pre – Purchase Analysis: Credit

• Information Flow Management

• Determine Relative Value

• Determine Investment-Grade

• Credit Analysis Model

• KeyFactors Example

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Pre-Purchase:

Relative Value Determination

• Determining Relative Value (Across Security Types)

• If none,

STOP

process & move on

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Pre-Purchase:

Relative Value Determination

• Determining Relative Value (Among Like-Securities)

• If none,

STOP

process & move on

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What is Investment-Grade?

• Fed’s Definition:

• Investment-Grade = A security with a low risk of default and where full and timely

payment of principal and interest is expected.

• Your Definition:

• Investment-Grade = A security with a low risk of default and where full and timely

payment of principal and interest is expected without referring to ratings.

AND? I Have to Develop a

Security

Evaluation Process Before I buy?

Pre – Purchase Analysis: Credit

• Determine Investment-Grade

• Credit Analysis Model

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• Determine if Investment-Grade. How?

• Answer: Relevant KeyFactors, by:

– Reviewing New-Issue Scale / Offering

– Determining Relative Value

– Reviewing Official Statement (OS’s)

– Reviewing Financial Statements (FS’s)

– Reviewing NRSRO’s reports

– Reviewing dealer’s credit profile reports

– Pre-complete ScoreCard / assess data

Pre – Purchase Analysis: Credit

• Determine Investment-Grade

• Credit Analysis Model

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Pre-Purchase:

KeyFactors Example

KeyFactors Responses Example

AND? I Have to Develop a

Security

Evaluation Process Before I buy?

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• Determine if Safe & Sound. How?

• Answer Relevant KeyFactors, by:

– Reviewing Security

– Evaluating Liquidity

– Assessing Leverage Use

– Assessing Operating

Environment

– Review Default History

– Evaluate Credit Enhancement(s)

– Review NRSRO Ratings

– Evaluate Concentration /

Diversification

– Assess Interest Rate Risk

– Evaluate Term of Security

– Evaluate Reporting / Disclosure

– Other Risks

– Pre-complete ScoreCard / assess

data

Pre – Purchase Analysis: Risk

• Risk Analysis Model

• Credit ScoreCard

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Ongoing Monitoring & Review Process

• Information Flow Management

• Monitoring System

• Response Matrix

• Review Schedule

• Sources of Information

- EMMA

- Brokers

- Bloomberg / Data Providers

- Direct from Issuer

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Ongoing Monitoring & Review Process

• Information Flow Management

• Monitoring System

• Response Matrix

• Review Schedule

• Information Flow

• Develop Review Criteria Set

• Determine Triggers to Review

• Potential Review Triggers:

• NRSRO Ratings / Outlook

Changes

• Material Event Notices • Continuing Disclosures • Failure-to-File Notices

• Potential NON-Review Triggers:

• Pending Calls • Short Maturities • Pre-Refunded Status

• Escrowed-to-Maturity Status • Low $ and/or % Exposure

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Muni Ongoing Monitoring Report Example

AND? I Have to Have a Monitoring Process After I buy?

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• Level-of-Importance Tests

• Response Timing

• Response Matrix:

– Sale

– Further Evaluation / Review – Hold or Sale

Ongoing Monitoring & Review Process

• Information Flow Management

• Monitoring System

• Response Matrix

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Ongoing Monitoring & Review Process

• Information Flow Management

• Monitoring System

• Response Matrix

• Review Schedule

• Dynamic Reviews as Warranted

• Quarterly Reporting / Monitoring

• Annual Process / Credit / Risk

Reviews

• Response Matrix:

• Evaluation / Review • Hold or Sale

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Conclusion

• Background

• Dodd-Frank Requirements

• KeyState Process Examples

• Contact:

Larry M. Wood – SVP, Registered Investment Advisor 702-598-3738 / lwood@key-state.com

Charles Brooks – Regional Sales Director 866-246-5322 / cbrooks@key-state.com

Visit our Website: www.key-state.com

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