The OCC's Kerri Corn says she and other bank regulators once joked that star banking analyst Meredith Whitney had been "caught in a headlock a little too long" when the former Oppenheimer & Co. managing director warned of a mass wave of municipal bond defaults for 2011.
"Just kidding," Corn was quick to add, explaining that the joke refers to Whitney's marriage to a former pro wrestler, not necessarily deep doubts within the Office of the Comptroller of the Currency about Whitney's predictions.
The analyst has forecast hundreds of billions of losses for investors in the $3 trillion muni market, due to the fiscal woes of local and state governments.
And, in fact, of the federal banking overseers, the OCC, where Corn is market policy risk director, seems to have taken municipal bond risk worries most seriously. Speaking to an audience of risk officers at an American Bankers Association conference this spring, Corn said OCC examiners—driven by the headlines of municipal bond troubles—are taking a harder look at the muni holdings of large national banks.
Corn says the OCC has begun asking risk management officers to evaluate the potential for defaults and losses on their munis. Besides looking at growing concentrations of higher-risk holdings (such as revenue or general obligation bonds issued within California or Illinois), examiners are looking for insight into interest-rate risks banks could face in a long-term depressed pricing environment.
The OCC push arrives amid new edicts in the Dodd-Frank Act that disallow the sole use of credit-agency ratings to measure risk in assets—even with traditionally low-risk, AAA-rated municipal bonds. The scrutiny also comes despite a stabilizing bond market and a host of bond analysts dismissing default fears as overblown.
"Municipalities don't generally default because of too little revenue," says Guy LeBas, a fixed-income strategist at Janney Montgomery Scott. Only three municipal defaults have occurred thus far in 2011, he says.
While commercial banks' municipal holdings are relatively small—$246 billion at the end of 2010, representing less than 2 percent of total assets—the concentration levels have increased at some institutions over the last two years as they emerged from the crisis and, in a common strategy to preserve profits, shifted investments toward tax-exempt muni-bond holdings. Adding in municipal loans, Corn notes that one-fourth of national banks have total muni exposure equal to 100 percent of their capital base.
Company reports and SNL Financial figures show that, of the top 25 banks by asset size, the average for muni holdings is 15 percent of Tier 1 capital. Those near or below the average include Bank of America (7 percent) JPMorgan Chase (8 percent), Citigroup (12 percent) and Wells Fargo (17 percent).
Several large banks, though, are well above the average (see graphic).
Corn says banks need to better understand the bond issuers' financial performance and factors such as projected tax collections—which she concedes can be complicated. The securities are not registered with the SEC, and there are "no current financials on so many of these bonds," she says. The agency today offers no clear guidance on how banks might structure muni credit-risk assessments, but Corn says, "I would hope some of the bondholders and investors have called some of these municipalities—'I need to know what's behind this holding of mine'— and better understand the credit capacity to pay."
While the inquiries have just begun, there are already signs banks have been letting some of the air out of their muni portfolios. Of the 25 largest banks that held munis in December 2009, says Janney's LeBas, 16 had cut their holdings by an average of 26 percent as of the end of 2010.
