Dodd-Frank: The Gift That Keeps On Giving

December 7, 2012 at 7:19 am 4 comments

imagesNCUA used its last meeting of the year to finalize regulations mandated by the Dodd- Frank Act requiring federal regulators to eliminate any requirement “of reliance on credit rating agencies.”  In other words, no more regulations requiring that financial institutions only invest in securities that receive certain ratings by Moody, Fitch or any other Nationally Recognized Statistical Rating Organization (NRSRO).  Of course, Congress didn’t decide for itself what the alternative to rating organizations should be, but instead made regulators responsible for developing “such standards of credit worthiness as each agency determines is appropriate.”

NCUA is mandating that natural person federal credit unions have policies and procedures in place to determine whether a security is an investment-grade security. Corporate credit unions must ascertain whether a potential security investment is one that has “a minimal amount of credit risk.”  Credit unions would make these determinations based in part on, but not limited to, several criteria provided by NCUA and additional guidance that NCUA plans to release prior to the regulation’s effective date six months after its publication in the Federal Register.

What is an investment-grade security, you ask?  “An investment-grade security is one where the credit union determines that the 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.”  Got that?  Clearly, this is a definition that both examiners and credit unions are going to need help implementing if only to make sure they are interpreting the rules the same way.

How is this going to work? Under existing regulations, a federal credit union seeking to buy a municipal security is only authorized to purchase bonds where “a nationally-recognized statistical rating organization has rated it in one of the four highest rating categories.” Once these regulations take effect, federally chartered credit unions will instead be authorized to purchase a municipal bond only after “it conducts and documents an analysis that reasonably concludes the security is at least investment-grade.”  The suggested criteria include, for example, credit spreads and external credit risk assessments.

But wait, there’s more.  NCUA is imposing concentration limits on permissible investments.  For example, it is mandating that no federally chartered credit union may have aggregate holdings of municipal securities in excess of 75% of the credit union’s net worth.  The system works the same way for Corporates, but some of the numbers are different.

At this point, if you have broken into a cold sweat, wondering how you were going to develop the expertise of a securities analyst in about six months, it’s not quite as bad as it sounds.  Most importantly, credit unions may consider a credit rating agency’s evaluation of a given security when deciding whether or not to purchase it.  It simply can’t be the sole determinant used by the credit union in deciding whether or not to buy it.  In addition, credit unions can retain the services of third-parties in helping to make these decisions.  The bottom line is that you’re going to have to develop policies and procedures commensurate with your own credit union’s investment risk profile that demonstrate how you go about assessing the risk posed by a given security investment.  NCUA correctly points out that credit unions have already been responsible for investment due diligence, but let’s be honest, the credit rating agencies provided a seal of approval that won’t be there to rely on in the future.  On the bright side, your credit union is not going to have to have the expertise of Goldman Sachs and they can still see what Moody and Fitch think of a given municipality’s bonds before investing in them.

Now, for some more  bad news.  On an operational level this regulation is due diligence on steroids.  Even if you use a vendor to help you reach the right conclusion you are still going to need a whole set of new policies and procedures if you plan on investing in any securities in the future.  Secondly, in one of the most telling passages of the preamble, NCUA rejected the suggestion of one commenter that NCUA develop a pre-approved list of permissible investments.  The NCUA explained that such a list would exempt the credit union investor from due diligence responsibilities and be viewed as an endorsement of the suitability of certain types of investments.  It sounds to me as if NCUA doesn’t want to get in the middle of the potential lawsuits and examiner disputes that now will be confronting credit unions deemed to have performed inadequate due diligence when investing in securities.

Entry filed under: Compliance, Legal Watch, Regulatory. Tags: , , , .

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4 Comments Add your own

  • 1. Kay Kwasnik  |  December 7, 2012 at 9:20 am

    Why is it that NCUA has become so identical to the Obama administration? But something in place and then see the ramifications afterward. They are making mountains of regulation, but I don’t see any forecasting of the long term effects on the industry. Isn’t this what got us in this mess in the first place?

  • 2. Anonymous  |  December 7, 2012 at 10:24 am

    Given that many investors were burned buying mortgage backed securities that, unbeknownst to them, contained subprime loans, I understand the NCUA position of not relying solely on these rating agencies. It was Moody’s and S&P afterall that gave their stamp of approval on these securities without fully knowing the extend of the junk contained in them.

    • 3. Henry Meier  |  December 7, 2012 at 12:18 pm

      We all know the ratings agencies needed to be dealt with but the question is how? If a bad driver is steering the bus the solution is to get beter drivers not forbid people from driving. All financial institutions need competent ratings agencies and Dodd Frank ignores that reality.

      • 4. Anonymous  |  December 7, 2012 at 12:33 pm

        Let’s face it. Goldman Sachs, Merrill Lynch and the other high powered Wall Street investment banks set the rules of the game. Don’t forget, Warren Buffet’s Berkshire Hathaway owns (or did) own a majority interest in Moody’s. Do you smell something rotten here? The SEC needs to investigate the infuence Wall Street has over the ratings agencies.

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Authored By:

Henry Meier, Esq., General Counsel, New York Credit Union Association.

The views Henry expresses are Henry’s alone and do not necessarily reflect the views of the Association.

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