Time and Tide: Securities Due Diligence
The tide went out and Congress saw who was swimming naked: some credit unions who relied too much (or only) on credit ratings when evaluating the creditworthiness of securities for their investment portfolios. So, in Section 939A of the Dodd-Frank Act, Lifeguard Uncle Sam ordered credit unions to step into conservative bathing suits before wading back into the fixed-income sea.
Section 939A obligates credit unions to change the way many have long conducted creditworthiness checks when buying securities and to perform ongoing creditworthiness checks for existing securities in their. It effectively prohibits credit unions from relying only on ratings agencies when determining the creditworthiness of securities, and directed federal agencies like the NCUA to draft new creditworthiness rules to replace exclusive reliance on rating agencies.
Those rules became effective June 11, 2013. In a Supervisory Letter published last summer, the NCUA writes that its new rules do not “substantively change” the standards federally chartered credit unions should use when deciding which securities to buy. Rather, the NCUA is replacing the various NRSRO ratings with a standard of “investment grade,” which they define as a security whose “issuer has an adequate capacity to meet all financial commitments under the security for the projected life of the asset or exposure, even under adverse economic conditions. An issuer has an adequate capacity to meet financial commitments if the risk of default by the obligor is low, and the full and timely repayment of principal and interest on the security is expected.”
In a nutshell, the rule now requires FCUs to conduct due diligence (e.g., credit checks) on issuers of securities to ensure the issuers can deliver on their commitments. Federal credit unions may still rely on NRSRO ratings as a part of their due diligence – just not exclusively.
How deep should the due diligence go? The NCUA says that depends on the security's credit quality, its complexity, and size. Management must understand the security's structure and how it “may perform in different economic and default environments.” Federal credit unions should pay particular attention to the cash flows on structured securities in the event they default on the underlying asset. Fortunately, the NCUA lists various securities and the corresponding factors that should be considered, including mortgage-backed securities, municipal bonds (rated and non-rated), bank notes and mutual funds.
Third party analytics may be part of the due diligence process, but the NCUA reminds examiners that credit unions remain responsible for investment decisions and they must ensure that third parties “are independent, reliable, and qualified.”
The NCUA writes that credit unions may consider any or all of the following factors:
Spreads between the yield of the security in question and the yield of comparable securities;
Research relating to whether the issuer will be able to meet its financial commitments;
Credit risk assessments, whether created internally or externally;
Default statistics indicating whether the security in question has a probability of default similar to others;
Whether the security or issuer is part of a recognized index of instruments;
Whether the security is covered by credit enhancements like overcollateralization and reserve accounts; and,
Whether the price and yield of the security is consistent with other similar securities and whether the price resulted from active trading.
The NCUA goes on to say that the more complex the security, the more due diligence is generally required.
Importantly, the NCUA wraps up the Supervisory Letter by stating that as a matter of sound practice, credit unions must monitor the creditworthiness of securities in their investment portfolios on an ongoing basis.
The full text of the NCUA's article can be found on the NCUA's website.
The bottom line:
Focus less on credit ratings and more on the adequacy of your own pre-purchase analyses;
Continue this due diligence after your initial purchase by monitoring the creditworthiness of existing securities in your investment portfolio.
So, hitch up your old bathing trunks because when the tide goes out next time, you don’t want to get caught naked.
David G. Barnes is chairman and president/CEO of Heber Fuger Wendin. He can be reached at firstname.lastname@example.org