Community Banks Face Challenges In Municipal Bonds

Guest Opinion Piece

By Michael Ruvo, President, DPC Data

Community banks have to take a more active role in selecting and monitoring the municipal bonds in their portfolios under new Dodd-Frank regulations which went into effect in January. In the past, community banks have been able to rely on ratings agencies’ grades. But rules from the Office of the Comptroller of the Currency (OCC),  which took effect in January, say that the ratings are no longer enough and banks have to take greater responsibility for due diligence.  

It’s not entirely clear what the bankers will be allowed to rely on — few community banks have a staff of analysts prepared to run the fundamentals of a municipal bond issue. It’s good to see regulators at last making some reduction in the role of the rating agencies which played a significant role in the financial crisis. Matt Taibbi at Rolling Stone who drew on court documents in a recent report on the agencies which including this illuminating quote:   

“Lord help our ******* scam. This has to be the stupidest place I have worked at,” wrote Elwyn Wong, an S&P executive, in an email. Ironically, Wong was later hired by the OCC. 

 So what’s a community bank going to do? It looks like they have three options: Banks can conduct their own financial analysis, use a third party firm to conduct due diligence, or perhaps they will be allowed to depend on their dealers’ advice.    

This rule change comes at a time when the municipal bond market is unsettled with bankruptcy or threats of bankruptcy facing large governments — Detroit, Jefferson County in Alabama, Stockton, California.  Governing magazine reported 28 public bankruptcies in 2011 and 2012. As larger government entities flirt with bankruptcy, it may become a more attractive route for municipalities facing huge liabilities.  

Does California lead the way in changing attitudes toward bankruptcy? Moody’s suggested that could be the case in a report it issued last year. 

“The inability and unwillingness to honor obligations to bondholders is relatively new in US public finance and still remains rare,” said Gail Sussman, Moody’s managing director. “The emergence in California of bankruptcy as a tool to extract bondholder concessions as part of a budgetary solution is a significant new risk for bondholders.”

However, Brookings’ Tracy Gordon suggested the concerns could be overdone and most of the problems may be limited to California, Texas and New York. The complexity of the muni market and the habit of many investors to buy and hold could also reduce volatility, she wrote. 

“A silver lining of less-than-perfect information and higher transaction costs in muni markets may be that shocks are transmitted slowly through the system.”

Just how imperfect that muni bond information is was described in an SEC investigation into issuers and underwriters in California, where more than one in four issuers failed to file their annual financial reports on time. The SEC, which has no jurisdiction over municipal issuers, could be indicating that it is going to hold underwriters and dealers responsible. It does have considerable clout with them, after all. 

In a choppy market, community banks need up-to-date information about their current holdings and the prospective purchases. Are bonds added to the portfolio three years or five years ago still investment grade and how was that determined? Where can banks go for the information? Ask your broker to explain recommendations and don’t be afraid to request evidence. The dealers who do have the research are happy to explain their recommendations. 

Michael Ruvo is president of DPC DATA, Inc., which leading municipal bond dealers use to keep ahead of market developments. 


About Tom Groenfeldt

I write - mostly about finance and technology, sometimes about art, occasionally about politics and the intersection of politics and economics. My work appears on and and occasionally in The American Banker and Banking Technology in London.
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