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THE BOND PORTFOLIO: MUNICIPAL SECURITIES November 18, 1958 THE BOHD B3IOTOLIO municipal m m x n m By Raymond 1« Hengren, Assistant Chief Division of Research and Statistics Federal Deposit Insurance Corporation Conference of Examiners and Assistant Examiners Ninth Federal Deposit Insurance District Minneapolis, Minnesota November 18, 1958 ffiie Bond Fortfolios Municipal Securities Both dollarwise and relative to total assets the growth In the municipal segment of bank assets has been rapid In the postwar period. The municipal holdings of all Insured commercial banks Increased from about $^ billion to $15i billion and from 2.6 percent to 6.8 percent of total assets. In the ninth FDIC District the growth trend in municipal portfolios has been much the same as for the country as a whole, looking specifically at the State banks not members of the Federal Reserve, the portfolios comprised $29 million of municipals la 1$&6 as compared with $112 million in 195&# or 3 .^ percent of total assets at the beginning of the period as compared with 6.2 percent at the close. Sot only have the banks greatly Increased their holdings of municipal obligations in the postwar period, but in addition, there is good reason to believe that the growth trends will continue for some years to come* The amount of municipal debt outstanding has grown from the order of $16 billion to well over $50 billion since 19&6* The increase reflects the unprecedented volume of new construction in the field of municipal facilities such as schools, highways, sewer and water plants. Currently the pressures resulting from the great postwar expansion in population, the dramatic shifts in industry, and progressively higher standards of living suggest the continuance of these trends in municipal construction and debt volume* Furthermore, it is a fact that from one-fourth to one-third of the amount of municipal debt outstanding has found lodgment in the commercial banks for many years. - a . Am a general rule, any portion of bank asset structure that changes rapidly is worthy of special attention. necessarily a sign of trouble. Change in itself is not But fro® the viewpoint of the bank examiner it is a sign that calls for study. Certainly the expansion in municipal portfolios Is sufficiently dramatic to bring the examiner's attention to focus. To the extent that the credits in a municipal portfolio are evaluated by the recognised investment advisory services such as Moody's or Standard & Poor's, the examiner's task is quite easy. Only in the most unusual circumstances would the ratings by these services be unsatisfactory as guides to quality. But the examiner's task becomes especially difficult because there are literally thousands of small governmental subdivisions whose credits are outside of these rating systems--and many of these obligations find lodgment in bank portfolios. It is wholly impractical for the investment services to evaluate these credits. Pertinent credit information is difficult to obtain; the amount of debt is relatively small, and as a consequence the Investor interest is narrow. nevertheless, it is a fact that unrated municipal credits make up a very substantial part of the municipal portfolios, especially for m i l State banks not members of the Federal Reserve. A sampling of bank examination reports suggests that for municipal portfolios comprising up to $500,000 of securities from two-thirds to four-fifths of the Issues are unrated. Moreover, the same source of information indicates that securities held by these banks are on the average not supported by the credit files and the general knowledge of sound investment principles and policies is meager. - 3 * To be sure, there are exceptions to this generalization but not many in this group of banks. With a substantial proportion of the municipal portfolios held by State nonmember banks unrated by the investment advisory services and with a minimum of information in the credit files of the holders, one would expect a fair portion of the securities to be classified as unsuitable for bank investment. Quite to the contrary, the data suggest that practically all of the unrated securities are deemed to be suitable for bank Investment purposes. Accordingly, the question arises: Is the municipal securities portfolio receiving the scrutiny that it deserves in bank examination work today! Careful study of a few reports suggests that there may be room for more effective work In this area. Why have the municipal holdings been treated so casually by bank investors generally as well as by bank examiners? Probably because there Is an axiom now widely accepted that all municipal obligations are good-*-though some may be considered better than others. This axiom has gained acceptance In the period of some twenty to thirty years that separates us from the time when municipal financing caused an endless amount of trouble. Now virtually forgotten are the many cases of municipal crédité well rated by the investment advisory services that went into default. There semes to be a feeling that misfortunes will not recur in the field of municipal finance, or if troubles do arise, they will "go away" before harm results to the bank portfolio. In my opinion, this no longer is a satisfactory approach for the examiner to take when he is reviewing the municipal segment of a bank's asset structure. Tea years ago it may have been true that almost all of the Items la the investment account were good. Prosperity during the war years had greatly strengthened the finances of municipalities* Furthermore, debt retirement programs had reduced the volume of securities outstanding which could not then be augmented by new flotations to finance construction. Wartime regulations held the construction of new community facilities to a minimum. But that picture has changed completely. The volume of municipal flotations now is at record levels and promises to move higher over the years to come. Henceforth it seems to m that it will be necessary for you as examiners to scrutinise the municipal portfolios carefully and to devote some attention to the quality of each block of securities. By so doing, it is my hope that you will be able to strengthen your comments on page 2 a t the examination report form. The purpose of these comments is to center attention on important questions of investment policy as well as the quality of individual blocks of securities and to lay the foundation for a remedial effort on the part of bank management when that is necessary. Bank Investment Policy Does the bank have a definite investment policy? That is the central question on page 6 of the examination report and the work of the examiner will be largely conditioned by the response to this question. Undoubtedly you are familiar with cases of banks that have formalised a bank investment policy statement and then ignored it in actual practice. These banks are no better off then the ones that manage their securities account in a haphazard fashion. In short, the examiner’s task is - 5 to identity the presence or absence of policy fro® the results and not fro® the files of documentation. Tbm lack of sound policy in the management of securities or elements of weakness in the investment practices is the signal calling for appropriate comments, ty this means the examiner may be able to encourage the bank to remedy defects and to bring about the adoption of sound policy. As an effective tool, it seems to me that the page 2 cem en t in the examination report could be used much more effectively than it has been heretofore in this area of remedial work by the examiners. As regards the content of a bank Investment policy fear the purposes of this discussion, attention will be centered on the following major elements: (1 ) Requirements for credit files (2) The else and composition of the Investment portfolio (3) Qualitative standards (4) Maturity distribution Adequate credit information is needed by the manager of a municipal portfolio to determine the quality of each item* gnaw» progress has been made in recent years to establish standards for credit files. State banks that are members of the federal Reserve and the national banks now are subject to a regulation which furnishes specific guidance on data requirements. Although there are no uniform rules on credit files applicable to all State nonaember banks, it is a fact that examiners for many years have sought to persuade bankers to accumulate credit information testifying to the quality of the bonds. - 6 For municipal securities covered by the services publishing credit information such as Moody's and Bun It Bradstreet there is no data gathering problem. The publications of such agencies present all the information necessary to evaluate the credit quality. As a practical matter, however, only a small proportion of the credits in the municipal portfolios of banks are covered by these sources, and examiners know that the existing files of infozmtion on most credits in the portfolios leave much to be desired. This situation calls for a never-ending effort cm your part as examiners to persuade bankers to assemble at least a minimum of information covering the quality of the credit at the time it is acquired by the bank. A copy of the circular describing the securities at the time of offering would certainly be essential. Thereafter the files should be augmented from time to time with information that demonstrates the continued soundness of the securities, for example, an annual report cm the finances of the issuer-preferably one prepared by a certified public accountant. Precise qualitative standards for testing the else of a bank Investment portfolio and its distribution among the various types of bank quality investments, vis., Federal securities, the obligations of States and subdivisions, and all other Issues would be very useful as guides for portfolio managers. Unfortunately, there are no ideal proportions for the composition of the investment portfolio. Good portfolio management is characterised by sound Judgment and not slavish adherence to rule books. Generally speaking, however, wide departures in the size of any bank portfolio from the pattern followed by similarly situated institutions are a signal for sharp questioning by the examiner. To Illustrate, an examiner - 7 - may find that a hank has a relatively large portfolio of municipal obligations. This, standing by itself, is no cause for alar» if the management has adequate credit information and investment know-how. But if the management lacked credit files and evidenced no skill in handling securities, then even a small portfolio might be elvdence of weakness. In short, banks may be expected to acquire a portfolio of municipals when these securities offer an attractive opportunity for the Investment of bank funds. Whether the portfolio should be relatively large or small depends upon the alternative opportunities for investment, e.g., other securities and loans. It Is the examinervs Job to form a Judgment as to the skill of the management in appraising these alternatives. Exemption from federal taxation on income is an important advantage to a bank in holding municipal securities. However, the extent of the advantage depends upon a bank's entire tax situation. The relative attractiveness of individual municipal Issues to different banks varies with the income subject to taxation. Sometimes the advantage of tax exempt incase is great enough to persuade the bank to acquire issues that otherwise would be Ignored for lack of quality. As a general rule, bank investment in marginal quality or even lower grade securities cannot be Justified. The liabilities of banks are such that they can ill afford to take any risk of loss stemming from lack of quality in their securities. Furthermore, the supply of investment grade issues is more than sufficient to care for all bank requirements. To be sure, banks sometimes buy marginal grade and sub -investment quality securities. This may occur because of the need to support the finances of ~ 8 . municipalities in the area served by the bank. More likely, it is the result of ignorance as regards credit quality or a deliberate effort to increase earnings by sacrificing quality* Especially in dealing with banks whose managements exhibit a A propensity to buy marginal quality issues, a comment on page 2 of the examination report may be helpful* ‘This part of the report gives the examiner an opportunity to point out the dangers inherent in sacrifiées of quality in order to augment earnings* Where the difficulty stems from lack of knowledge regarding quality, the coassent can be phrased to bring out the need for information and analysis. The distribution of maturities in the bank's investment portfolio can be so designed as to free the management from any dependence upon the market as a source of cash from the sale of bonds* Evenly spaced maturities over a period of five to seven years will make funds available for reinvestment or to expand other aspects of the banking business* lot only will the funds become available in balanced amounts at regular intervals, but management will be Insulated somewhat from fluctuations in money rates* Thus, by dividing the portfolio into five equal parts, one portion of which is scheduled to mature in each of the next five years, and reinvesting annually the maturing portion in the longest maturity, the bank will realise a rate of return that ie a five-year moving average of interest rates* Long-term issues have little place in the municipal portfolio of a bank* When the amount is small relative to the total investment account, the distant maturities furnish no cause for concern* • V‘ J But if the investment , ’v in long-dated bonds is more than five or ten percent of the total, then comment on page 2 of the examination report would be appropriate* * 9 Machinery for the sale of municipal securities is chiefly concerned with the distribution of new issues* There is no organised exchange for trading municipals already outstanding and each transaction requires negotiations between buyers and sellers* Furthermore, the details of sales volume and prices on transactions in this secondary market are not reported to the public• As a consequence, banks can rely only to a very limited extent on the secondary market for the liquidation of municipals when cash is needed* there is still another feature of the market for municipal securities that is important to bank examiners* In appraising & portfolio of securities, market value is a significant fact* But information <m prices is limited to the offering t e n s for new issues and the so-called "Blue hist* data* The latter publication, which is designed primarily to serve bond traders, furnishes each day the prices at which specified dealers offer individual blocks of securities for sale* subject to negotiation* These offering prices are As a result, they are merely indicative of price levels* For the municipal obligations that are traded on a nation-wide basis, the offering prices in the *Blue List” would provide & reasonably satisfactory basis for estimating value. However, the pricing of blocks of securities for which there is only a local interest is much more difficult. Tfc value such credits probably there is no substitute for the professional judgment of local traders in these Issues--though it is extremely difficult to obtain "professional** as contrasted with "trader* opinion* - 10 - Broadly speaking, when the examiner reviews a hank investment program, he is searching for the element of balance that distinguishes a good securities account from a weak one. From time to time, it may be quite constructive for the examiner to point out departures from balance that come to his attention as he studies the various aspects of the bank's investment policy. Testing the Credit Quality of Municipal Securities At the outset of any discussion pertaining to the quality of individual issues of municipal bonds in bank portfolios, it is well to note that each obligation presents a question as regards Its legality. This question can only be answered satisfactorily by experts in the field of municipal law. An opinion by a qualified bond attorney pertaining to the legality of each issue should be available when the examiner is reviewing the investment portfolio* Sellers of municipal bonds ordinarily furnish a copy of the legal opinion to the buyer in the regular course of business. Furthermore, the name of the attorney approving the legality of an issue may be found in every well prepared circular offering securities for sale, and municipal bond dealers frequently are helpful in obtaining copies of documents. In any event, the examiner needs assurance that the securities are valid obligations. Qualitative ratings by the investment advisory services, namely, Moody's and Standard & Poor's, are useful guides for the examiner in evaluating the municipal portfolio. By definition, it seems clear that the credits in the three highest rating bands deserve to be considered Investment grade. To be sure, at times during the acute phases of the Great 11 - Depression in the 1930’s some credits in these categories were unsatisfactory as bank investments. But those circumstances should be viewed as quite exceptional. According to the definition, speculative characteristics are recognised as inherent In obligations classified in the fourth rating band by Idle investment advisory services» Nevertheless, the investment characteristics of these credits are supposed to predominate and as a consequence all of the securities so rated are deemed to be suitable for bank investment purposes. The bank supervisory authorities both State and Federal recognised securities In the four highest rating bands as suitable for bank investment in the so-called 1938 agreement concerning the appraisal of bonds for bank examination purposes and the principle was subsequently restated in 19^9* In view of these speculative aspects, however, a substantial commitment in the fourth or marginal grade is deserving of special attention and comment» During prosperous times the yield differentials between securities In the third and the fourth rating bands tend to shrink, probably because investors overlook shortcomings qualitywise in obligations. So, when a bank is under pressure to obtain tax exempt income and the manager of the investment portfolio is very profit-minded a concentration of high yielding securities at the margin of acceptability may develop« As a practical matter, the examiner cannot classify any individual issue rated in the fourth grade as unsuited for investment purposes for that reason alone, but he can recognise the weakness in the basic investment policy and endeavor to persuade the management to follow more orthodox policy by investing funds in the best grade of issues* - 12 - The qualitative ratings by investment advisory services cover general market bonds that are traded more or less actively on a nationwide basis# Unfortunately, there is a very substantial amount of municipal debt floated by literally thousands of governmental subdivisions that falls outside of the rating system# Furthermore, it is a fact that the investment advisory services in recent years have been a bit tardy in rating certain large Issues— e. g. some of the toll roads as well as other business-type enterprises— where operating records are lacking or there is some element of novelty in the situation# Sub-investment quality ratings would be helpful if there are real doubts as to the quality of the credit# Thus, examiners are severely handicapped by the lack of guidance fro© the investment advisory services in evaluating credits in a large area of the municipal field. A preliminary analysis of data obtained from examination reports covering a substantial number of State nonmember banks suggests a sizable concentration in municipal securities deemed to be bank quality that are unrated by the recognized investment advisory services. noticeable In the portfolios of the smaller banks. This is especially But the task that confronts the examiner when he seeks to appraise the quality of the items in these portfolios becomes especially difficult. In certain areas he can obtain some help in evaluating credits from local agencies. now exist, for example, in the Carolines and Oklahoma. Such agencies However, in most instances the examiner is likely to find himself faced with the necessity of forming a judgment as regards the quality of most of the securities--and the credit information is likely to be inadequate or nonexistent. From tide to time people have searched for shortcut tests to ascertain the credit quality of a municipal obligation. As a matter of fact, there are undoubtedly situations for ’which very simple tests are entirely adequate to appraise quality. Sometimes by computing one or two straightforward ratios it is possible to demonstrate that a debt is quite small and well within the ability of the obligor to pay. nevertheless, these tests are likely to have very limited applicability. In appraising a municipal credit, first it is necessaxy to determine precisely the nature of the security under consideration. Is it a general obligation supported by a pledge of the full faith and credit of the Issuer or is it the obligation of a business-type of activity whose revenues are derived from the performance of specific services? In addition, there are flotations that have some of the characteristics of both of the preceding securities, namely, a general pledge of credit together with specific support from revenues such as the Income of a municipal electric or water service or support from the yield of a specified tax. In detail, the pattern of analysis depends upon the precise nature of the obligation. In the evaluation of a municipal credit the starting point should always be the study of the economic background of the obligor with special reference to questions such as the following: 1. Where is the obligor situated? 2. What are the characteristics of population trend? 3. Is there significant evidence of economic strength or weakness? The latter query includes consideration of estimated per capita Income, the nature of industry structure in the area, and the basic facts with respect to transportation and trade. By and large, the obligation of a governmental unit situated la an area that lacks a substantial economic base will be weak irrespective of all efforts to buttress the credit by legal means or otherwise. Or the other hand, many situations that are thin at the outset can be relied upon to overcome these disadvantages if the growth factor is powerful enough. The debt record, that is, the history of performance on securities that have been floated previously by the obligor is always a pertinent element in the appraisal of a municipal credit. A record of default is bad. Nevertheless, old defaults do not necessarily testify to the inability or unwillingness to pay today. More significant, however, are recent defaults, that is, any failure to meet the obligation according to the terns of the bond within the past decade or two. JSven in prosperous times, defaults of a technical nature occur. While undue importance should not be given to these happenings, they are indicative of unsatisfactory financial management. Technical defaults in good times may be the forerunner of serious troubles when business is poor. The debt statement of the obligor is probably the most important single compilation of data for evaluating a municipal security. statement lists all of the obligations now outstanding. This In addition to direct debt, the statement also should include all underlying debt, designated as such. The latter includes the debt of «sailer geographical areas that are completely by the one under consideration. Also, the debt statement will indicate the amount of overlapping debt, namely, the debt of larger geographical areas that comprise the one under consideration, altogether or in part. The direct debt, the overlapping debt, and the - 15 * underlying debt make up the total debt resting on the community* Though the direct debt is the sole burden of the obligor whose credit is being analyzed, the economic resources of the area must furnish the means for supporting the entire debt, irrespective of the obligor. The crucial element in credit analysis is the determination of the margin of protection for the holder of the security under study* The margin of protection concept represents the aggregation of evidence testifying to the ability of the debtor to meet his obligations* evidence relevant to the margin of protection. There are many bits of For example, such measures Include the amount of direct debt expressed as a percentage of assessed value or in dollars per capita* Unfortunately, there are no satisfactory standards for appraising these measures* Viewed in terms of five or ten year trends, however, they become progressively more significant* Thus, it is important to note that an appraisal of the margin of protection for debt service is essentially subjective in character* For the vast majority of the small governmental subdivisions the general property tax is relied upon as the chief source of revenue* The yield from this tax which is levied at a stated rate in dollars per thousand of assessed value is dependent upon the millage and the assessment base* However, assessment practices vary greatly among governmental subdivisions* Sometimes property is valued for tax purposes cm terms that approximate a fair market price while in other instances the valuation for tax purposes may be only a fraction thereof. As a result, ratios of debt to assessed value tend to lose significance in comparisons of cm© community with another. For still another reason the ratio of debt to assessed value is now losing significance. The general property tax appears to be declining in importance as municipalities turn to other sources of revenue such as income and sales taxes. With respect to general obligations, the facts regarding the tax levies in terms of millage as compared with taxation practices elsewhere are indicative of the margin of protection for debt service. If some communities typically assess property at modest figure® and levy low taxes, there is clearly a margin of protection that could be tapped by increasing assessments or tax rates. The summary of current financial operations showing the source of revenues end the nature of disbursements is indicative of the financial strength of the municipality. But the Interpretation and analysis of financial reports requires a knowledge of municipal accounting practices. Typically the accounts are maintained on a cash and fund basis. To indicate some of the difficulties confronting the analyst, inter-fund transfers may give a picture of financial strength to parts of the debt structure, when in aggregate terms the margin of protection is unsatisfactory. To the extent that a community covers the cost of operations and thereby avoids the accumulation of a floating debt, the credit is strong. Furthermore, a margin of protection may be found in the financing of long term capital investments in part from the current income. It is obvious that over a period of years a community should balance Its financial operations without incurring deficits. Failure to do so is evidence of weakness. As compared with obligations supported by an issuer*e pledge of full faith and credit, the analysis with respect to investment quality of - 1? obligations Issued by the business-type of municipal enterprise In some respects Is easier and in others more difficult* It is easier because the determination of credit worthiness is not clouded by the appraisal of intangible features that may be important in a general pledge of credit* Bit at Hie same time, it is more difficult because it depends upon estimates of operating revenues and expenses projected into the future* Governmental subdivisions engaged in business-type activities, for example, the furnishing of gas, electric, and water utilities, or special facilities such as M i d g e s and highways financed by charges for services, entail evaluation with respect to credit quality as any other public service enterprise* Standard textbooks in the field of investment outline the pattern for this type of analysis* The starting point Is always a projection of revenues, operating expenses, and debt service requirements for at least five years* These projections will furnish a basis for estimating the margin of protection for bondholders* To be satisfactory the coverage is expected to range from one and one-half to double the debt service requirements* However, in a very fundamental sense the adequacy of the margin can be evaluated only in terms of performance by similarly situated projects that in the past have been able to manage a debt successfully* In evaluating the quality of municipal credits, the analyst will encounter many complications in addition to the ones covered by these remarks* There are no easy ways to resolve these difficulties* Experience has demonstrated that a sound judgment as to credit quality can always be reached by carefully analysing the pertinent facts* work is time-consuming* Unfortunately, this - 18 Summary and Conclusion To sum up, th en , the municipal segment of the assets held by the insured commercial banks has grown both dollarwise and relative to total assets at a substantial rate over the postwar years. Moreover, the volume of new municipal flotations is high and there is no indication of abatement in the future. The growing importance of municipal holdings suggests that it will be necessary for examiners to devote an increasing amount of attention both to bank investment policy and to the determination of the credit quality of individual securities. Especially will this be true for the State nmmmber banks that are examined by the federal Deposit Insurance Corporation. The bulk of these banks are «sail and they are not likely to be well equipped to handle investment problems. Municipal obligations in the investment portfolios of these banks typically are floated by small governmental units* Furthermore, the size and the location of these obligors for the most part are such that bank examiners do not have the assistance of the investment advisory services for guidance in ascertaining credit quality. When actual or potential trembles are detected by the bank examiner, it Is incumbent upon him to alert management to the difficulties and encourage remedial efforts. Comments on page 2 of the examination report may be very effective for this purpose. In a very real sense, the examiner is the man best situated to bring about improvement in the municipal portfolio. His oral and written comments may bestir the management of a bank to adopt corrective measures.
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