MuniLand

Expanding the force field

By Cate Long
September 16, 2011

After the financial crisis crescendoed with the failure of Lehman Brothers (who filed Chapter 11 bankruptcy three years ago today) many unsound financial arrangements were exposed.

Many of the arrangements that failed were derivatives that had been created to hedge interest rate volatility for municipal debt. Following Lehman’s failure interest rates spiked rapidly as bond market participants withdrew liquidity and moved to cash. Because of this withdrawal of liquidity a lot of the municipal derivatives arrangements went upside down and exposed school districts and municipalities to large losses. Because of embedded penalties most were too expensive to unwind. A classic case involved interest rate swaps associated with Harvard University borrowings that lost at least $500 million on payments to escape derivatives.

Harvard has a highly professional staff overseeing investments but most municipal entities rely on outside counsel to advise them on municipal debt issuance and help negotiate derivatives arrangements. Although they play a central role these muniland players were not regulated until the Dodd-Frank Wall Street Reform and Consumer Protection Act gave oversight over them to the Municipal Securities Rulemaking Board. Overseeing muni advisors is part of the transformation of the MSRB from a sleepy, backwater financial overseer to an aggressive, forward looking regulator.

In addition to overseeing municipal advisors Congress expanded the authority for the MSRB by adding oversight for the protection of state and local government issuers, public pension plans and others whose credit stands behind municipal bonds, in addition to protecting investors and the public interest.

Until Congress redefined the MSRB’s mission it was generally oriented to the interests of banks and securities dealers. One of the biggest changes for MSRB is the composition of its board of directors and it’s new emphasis on public representation.

Pre Dodd-Frank Post Dodd-Frank
Public reps 5 11
Bank dealer reps 5 3
Muni advisor reps 0 3
Securities firm reps 5 4

Unsurprisingly SIFMA, the trade association for bank dealers, is complaining to the MSRB about the composition of the new board presumably because they have lost a power. In a comment letter SIFMA’s co-head of municipal securities, Michael Decker, argues that expanding the MSRB board from 15 to 21 would be too costly and that there is no rational for creating a 30% minimum representation of muni advisors for the non-public board members. This overlooks the recent predatory behavior of bank dealers who wrote inappropriate municipal derivatives and the need for their influence in rulemaking to be diminished.

I’m all in favor of higher costs for the additional public members and muni advisors serving on the MSRB. State and local governments must be protected from Wall Street. In the aftermath of the greatest financial crisis since the Great Depression Wall Street dealers must be aggressively regulated and now the MSRB seems to have adequate force to do it.

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In Pennsylvania for instance, the banks pitched at least 500 deals involving interest rate swaps, totaling $12 billion. “Most of the transactions – which
occurred outside the state’s largest cities of Philadelphia and Pittsburgh – have been made without public bidding, which means that banks and advisers
privately arranged the deals with small school districts.”

One in five school districts and 86 other local governments in Pennslyvania have swap agreements according to a report issued by the Auditor General’s office. The Department of Community and Economic Development’s records indicate that 626 swap filings were made in Pennsylvania between October 2003 and June 2009, which related to $14.9 billion in debt.
5

No one has yet completely categorized all the outstanding swap deals entered into by local and state governments but a cursory search of a small sample Comprehensive Annual Financial Reports (CAFRs) revealed multiple swaps issued in at least 32 jurisdictions in 12 states.

Table 1 below includes some examples of these swaps within the State of California. Table 2 looks at locations outside of California.

http://www.seiu.org/images/pdfs/Interest %20Rate%20Swap%20Report%2003%2022%202010 .pdf

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