Creditworthiness Standards Replace Credit Ratings

This is the first in a series of three alerts on investment securities and risk-based capital requirements under Dodd Frank.

On November 18, 2011, the Office of the Comptroller of the Currency (the "OCC") released a notice of proposed rulemaking1 on Alternatives to the Use of External Credit Ratings in the Regulations of the OCC (the "Credit Ratings Alternatives") along with proposed Guidance on Due Diligence Requirements in Determining Whether Investment Securities2 are Eligible for Investment (the "Due Diligence Requirements"). The proposed rulemaking3 would remove the reference to credit ratings4 from three5 of the OCC's regulations and would replace these references with a new creditworthiness standard.

Legal Requirements for Permissible Investment Securities

Part 1 sets forth the legal requirements for determining whether, and under what circumstances, and what limitations an OCC supervised entity6 may permissibly invest in certain investment securities.7 Part 1 is important not only to national banks, federal branches and federal agencies of international banks, but also to state banks and state branches and agencies of such international banks because Part 1 applies to them as well8 To be permissible, the investment must be investment grade.9 Under the proposed Credit Ratings Alternative, a security is considered to be investment grade if the issuer of the security has an adequate capacity to meet financial commitments under the security for the projected life of the asset or exposure.

Legal Requirements of the Credit Ratings Alternatives; SNR Denton Recommendations

To meet the standard set forth in the Credit Ratings Alternatives, banks must determine that the risk of default by the obligor is low and the full and timely repayment of the principal and interest is expected.10 The OCC does not define what it means by "low risk of default" or "expected full and timely repayment". Indeed, neither the Due Diligence Requirements nor the proposed Credit Ratings Alternatives provide specific instructions to banks regarding the actions the banks must take to determine that the risk of default is low or that full and timely repayment is expected.

In the absence of specific guidance from the OCC, we recommend that banks consider developing a process that is substantially similar to their process for making loans, including the development of a policy manual for Credit Ratings Alternatives similar to a credit policy guide used for underwriting extensions of credit. This would mean that before a bank invests in investment securities it would conduct an internal review of the investment, risk grade the investment based upon either internal models or external models that show the likelihood of default and the expectation of repayment. We also recommend that banks consider adopting or amending investment policies and procedures that, among other things, identify the range of investment securities that they will consider (and under what circumstances or conditions) and what investment securities they will not consider, the risk characteristics11 of each of the investment securities that will be considered, the approved investment amounts, the range of expected cash flows, the pricing parameters, the collateral requirements, if any, the internal review and approval process, the documentation requirements, and the recordkeeping requirements. Likewise, we recommend that banks consider implementing investment risk management and compliance reviews, and annual audits of its investment portfolio. Equally importantly, we recommend that banks include investment securities in the scope of their required stress tests and show the impact of each regulatory agency mandated scenario on the capital, earnings and the interest rate profiles of the banks.

OCC commentary in the Due Diligence Requirements12 notes that generally securities with good to very strong credit quality will meet the Credit Ratings Alternatives. The commentary also points out that banks should continue to maintain appropriate ongoing reviews of their investment portfolios to verify that their portfolios continue to meet safety and soundness13 requirements that are appropriate for the bank's risk profile and for the size and complexity of their portfolios.14 The OCC does not specify what it expects in terms of the details of the ongoing reviews.

The Standards and Limitations under Part 1

Part 1 sets forth the standards and limitations under which national banks may purchase, sell, deal in, underwrite, and hold securities, in accordance with 12 U.S.C. 24 (Seventh) and safe and sound banking practices. A national bank may securitize and sell assets that it holds as a part of its banking business and there is no limit that is linked to a specified percentage of the bank's capital and surplus.15 There are limits on a national bank's investment in pooled investments,16 however. A national bank may purchase and sell for its own account investment company shares provided that the portfolio of the investment company consists exclusively of assets that the national bank may purchase and sell for its own account and the bank's holdings of investment company shares do not exceed the concentration limitations in 12 C.F.R. 1.4(e).17 Part I identifies five Types of permissible securities and leaves room for the OCC to permit investments in other securities consistent with 12 U.S.C. 24 (Seventh) and safe and sound banking practices.18

Five Types of Permissible Securities

The five Types of permissible securities range from US government securities which have no limitations on the amount of the investment to securities with limitations linked to a percentage of the amount of capital and surplus of a bank, and to securities that promote certain socially beneficial interests. To simplify the categories, the OCC labels the securities Type I, Type II, Type III, Type IV and Type V.

1. Type I Securities19 (Obligations of the US; Obligations issued, insured or guaranteed by a US department or agency, where the full faith and credit of the US is implicated; Obligations issued by a department or agency of the US, or an agency or political subdivision of a state, that represent an interest in a loan or a pool of loans made to third parties, where the full faith and credit of the US has been implicated; General obligations of the US or state and municipal bonds for well capitalized banks; 12 U.S.C. 24 (Seventh) permissible securities) Pursuant to 12 C.F.R. 1.3(a), a national bank may deal in, underwrite, purchase, and sell Type I securities, such as US government securities, securities issued by the various states, and certain municipal bonds, for its own account and the amount of the investment is not limited to a specified percentage of the bank's capital and surplus.20 As one might expect, Type I securities are considered to have very limited credit risk because the issuer is considered to be extremely creditworthy. Some commentators have observed that this assumption about the creditworthiness of the issuer is debatable in light of the financial condition of many states of the US, and in light of the recent downgrade of the credit rating of the US. Nonetheless, the proposed Credit Ratings Alternative assumption underlying Type I securities21 is that the issuer of the security has an adequate capacity to meet its financial commitments under the security for the projected life of the asset or exposure, which means the risk of default by the obligor is low and the full and timely repayment of principal and interest is expected.22

2. Type II Securities23 (Obligations of a state or state agency for housing, university or dormitory purposes; Obligations of international and multilateral development banks; permissible 12 U.S.C. 24 (Seventh) securities with a 10% limitation) Pursuant to 12 C.F.R. 1.3(b), a national bank may deal in, underwrite, purchase, and sell Type II securities for its own account, provided the aggregate par value of Type II securities issued by any one obligor held by the bank does not exceed 10% of the bank's capital and surplus.24 The percentage limitation linked to the bank's capital and surplus reflects the OCC's view that Type II securities, while certainly considered safe, are not as creditworthy as Type I securities. Examples of Type II securities may include an obligation issued for housing, university, or dormitory purposes.25

3. Type III Securities26 (trust preferred securities; auction rate preferred securities; student loan auction rate securities; money market preferred stock; and other similar investments) Pursuant to 12 C.F.R. 1.3(c), a national bank may purchase and sell Type III securities for its own account, provided the aggregate par value of Type III securities issued by any one obligor held by the bank does not exceed 10% of the bank's capital and surplus.27 A broader range of securities are considered to be Type III securities because they are not restricted to a specific category of issuers or instruments. However, because Type III securities are also perceived to contain more credit risk than Type I securities, they come with a limitation linked to the capital and surplus of the bank. Trust preferred securities,28 auction rate preferred securities and student loan auction rate securities,29 money market preferred stock,30 municipal revenue bonds and mutual fund shares (purchased and held by a bank that is not well capitalized),31 municipal bond tender option certificates,32 bonds convertible into equity,33 each may be Type III securities.

4. Type IV Securities34 (small business related securities; commercial mortgage-related securities; residential mortgage-related securities)...