Municipal Bond Worries Spur OCC Scrutiny of Banks' Exposure

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DENVER – Examiners for the Office of the Comptroller of the Currency are worried about concentrations of municipal bonds held by national banks, and have begun asking risk officers to evaluate their exposures, an OCC official said.

Kerri Corn, the OCC’s director for market risk policy, said the agency is in the opening stages of determining how much risk banks could be facing from their holdings of municipal bonds. The $3 trillion municipal bond market has come under pressure in recent months due to predictions that defaults would increase dramatically in 2011 given the fiscal troubles plaguing state and local governments.

Corn gave her remarks Wednesday at the American Bankers Association’s risk management forum in Denver. She was on a panel of regulators discussing how the Dodd-Frank Act is affecting risk management supervision.

“What we’re going to ask our examiners to ask our banks…do you know what you’re holding? What do you have? How do you break it down?” Corn said to about 200 risk and operations leaders in the audience.

“There have not been many defaults,” she said, but “there’s a world of hurt out there. … Overall, it won’t look like a good story to tell.”

New issue volume in March was the lowest for that month in 10 years as some issuers pulled offerings due to unfavorable market conditions. Others have cut back on bond issuance given concerns about rising debt loads and lower tax revenues.

Corn told the ABA forum audience that “25% of national banks have either municipal securities or municipal loans that represent 100% of their capital base.”

Many muni bonds are AAA-rated, but the OCC push comes from new edicts in the Dodd-Frank reform legislation that no longer permit banks and other securities holders to solely depend on credit-agency ratings to measure risk of assets.

The problem for examiners and institutions is that there are practically no underlying financial reporting requirements for many of the bonds from states, cities and other issuing public entities, Corn said.

“I didn’t realize until we started looking into it, there are no current financials on so many of these bonds. They’re not made available, and they don’t have to register with the SEC,” Corn said in an interview following the panel discussion. There have traditionally been no restrictions on the volume of AAA-rated bonds that banks can purchase, but “we’re in a different time and different economic environment.”

Much of what examiners are asking bankers about concerns the geographic concentrations, types of bonds and any potential hurdles for repayment. Rate risk is also a potential trouble spot, if and when market rates rise and “you’re holding a lot of fixed-rate munis,” Corn said.

One of the OCC’s chief questions for banks is whether they have any underlying understanding of the bond issuers’ financial performance such as projected tax collections, said Corn. 

Banks should be able to explain whether they have geographic concentrations “where it’s obvious they are having problems,” and to understand “what type of bond you have,” said Corn. “What is it going to repay you – is it a revenue bond, is it a G.O. [general obligation]? We realized some of these [issuers] don’t even have full taxing authority under them, so what do you know about them?”

“We’re just now sending this [order] out,” Corn said. “I’m not sure if [banks] have had these conversations.”

Corn stressed that the OCC has no plans on making any extracurricular inquiries about muni bonds. Questions about bond credit and valuations will be part of the normal “ongoing supervisory process,” she said.

But independent analysis beyond agency ratings is something banks should already be doing, Corn said.

“Even now under our existing classification guidance, examiners and the banks should be doing their own analysis. We have guidance that says you should be looking at whether or not you should be taking other than temporary impairment on various holdings you have, regardless of credit rating.”

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