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The financial crisis exposed deficiencies in credit ratings assigned by the major rating agencies such as Standard & Poor’s and Moody’s. This was especially the case for fixed-income securities tied to real estate. According to industry estimates, nearly 50 percent of non-agency mortgage securities rated below “AAA” that were originated during the height of the housing boom eventually defaulted.
The Federal Deposit Insurance Corp. (FDIC) asserted that financial institutions didn’t understand the risk characteristics of a bond’s underlying collateral or the payment structure of individual securities. The regulator said insufficient due diligence led to purchases of securities that were thought to be “investment-grade” bonds. This turned out not to be the case in many instances, as the initial credit ratings failed to recognize the repayment risks that came to light when the economy went south.
As a result of aftershocks from the Great Recession, Congress enacted the Dodd-Frank Act, which, among other things, restricted references to credit ratings in banking regulations. In response, the regulators issued guidelines for alternatives to the use of credit ratings and also defined a new “investment-grade” standard. The rule requires financial institutions to determine that their investment securities meet this standard prior to purchase. The rule defines “investment grade” as a security with a low risk of default and where full and timely payment of principal and interest is expected.
Even before the crisis, existing regulatory guidance required that institutions have in place a robust credit risk management framework which integrated appropriate pre-purchase analysis and ongoing monitoring that graded a security’s credit risk based on the repayment capacity of the issuer and the characteristics of a security. The supervisors’ focus increased with the Dodd-Frank Act as examiners shifted their attention to the sufficiency of the pre-purchase analysis and ongoing monitoring procedures, rather than on the initial credit rating.
More recently, regulators have reaffirmed that financial institutions must understand the credit risk of investment securities to ensure safety and soundness requirements are maintained. Surprisingly, they did not issue any specific guidance describing procedures for individual securities. By keeping the guidance broad, the regulators wanted to give bankers flexibility to customize their own due diligence procedures. Without specific guidelines, however, many financial institutions were left wondering what the initial due diligence package should look like.
While Dodd-Frank centered mostly on credit standards, the act also requires management to fully appreciate standards related to interest rate risk, liquidity risk and other factors. Accordingly, financial institutions should incorporate the following to help document the investment decision:
- Price volatility
- Initial credit spread
- List of risk factors considered
- Narrative of investment rationale
- Evaluation of key ratios
- Verification of compliance to policy limits
- Itemization of financial reports obtained
- Credit ratings
Management needs to “tie together” the analysis to determine whether the overall risk profile of the security is suitable for the institution. The analysis and conclusions should be documented to demonstrate that the security meets the investment grade standard.
The FDIC has stated that financial institutions should have programs in place to manage the risks related to investment activities. These components include a comprehensive risk management process that effectively identifies, measures, monitors and controls risk.
Robust reporting is an essential part of this process and can serve several useful purposes. To ensure its oversight responsibilities, the board of directors should review portfolio activity and risk levels, and require management to demonstrate compliance with approved risk limits.
Bankers are familiar with watch-list reporting for commercial loans and a similar system may be helpful to track investment securities that may potentially pose higher risk. This type of reporting can provide a mechanism for escalating reviews or implementing action plans for deteriorating credits or underperforming securities.
The following are a few items bankers can track in order to anticipate potential problem situations. These are securities exhibiting:
- Acceleration in prepayment speeds
- Notable extension risk
- Large and persistent market value declines
- Unusual increase in credit spread
- Deterioration in financial situation
- Large change in book yield
Management should note variances in the above factors relative to those that existed at time of purchase. In addition, current trends can be observed for signals about weakening performance.
The investment policy provides the structure to effectively manage investment activities. Policies should identify guidelines for the acquisition and ongoing management of securities, as well as action plans for underperforming securities. Management should ensure that the investment policy accurately reflects the due diligence practices being conducted for each applicable security, while review procedures should be in line with outstanding regulatory guidelines.
Under the Dodd-Frank Act, financial institutions must maintain risk management processes to ensure that credit risk in the investment portfolio is effectively monitored and controlled, and they may wish to have procedures in place which go beyond the regulatory mandates, in order to further mitigate risk and enhance profitability.
