The NCUA on Thursday released a supervisory letter, providingguidance regarding how examiners will supervise compliance with aNovember 2012 final rule that substitutes a narrative standard in place ofcredit rating requirements for investments.

The guidance addresses why ratings have been removed from theregulations in compliance with the Dodd-Frank Act, and providesregulatory expectations for natural person and corporate federalcredit unions when they consider creditworthiness factors. Creditunions may still use credit ratings to augment their due diligence,but per the final rule, cannot use ratings as the sole basis todetermine an investment's suitability, the supervisory lettersaid.

The depth of the due diligence should be a function of thesecurity's credit quality, the complexity of the structure, and thesize of the investment. The more complex a security's structure,the more credit-related due diligence an institution shouldperform, even for investments considered to be of high creditquality, the letter said. “Management must understand thesecurity's structure and how the security may perform in differenteconomic and default environments. Management needs to beparticularly diligent when purchasing structured securities,” theletter said. “For example, an FCU should be able to demonstrate anunderstanding of the effects on cash flows for a structuredsecurity assuming varying default levels of the underlyingassets.”

Federal credit unions may consider risk factors such as creditspreads, internal or external credit risk assessments, defaultstatistics, inclusion on an index, priorities and enhancements,price, yield and/or volume when evaluating securities, the lettersaid.

The supervisory letter also includes additional guidance onstructured securities analysis and investments grandfathered underthe rule.

The guidance is available on the NCUA's website.