Gallagher’s muniland armageddon

April 24, 2013

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Several professionals in muniland have jumped on SEC Commissioner Dan Gallagher for his recent warnings about the possibility of an “Armageddon” for retail investors in muniland.

Anonymous blogger @munilass berates Gallagher for his statements about retail investors:

In the interview, Gallagher said his concerns mostly relate to retail investors, who hold approximately three-quarters of outstanding municipal bonds. He then called the muni market a bubble (a term that becomes less useful every time someone utters it) and said “there are a lot of investors in the municipal bond market that aren’t supposed to be there.”  I take the latter to be a reference to credit risk, not interest rate risk, but Gallagher did not elaborate, so I am not sure what he meant by that.

I interpreted Gallagher’s concerns to be related to the lack of liquidity in the market and the steep transaction costs that retail investors pay when they have to trade out of a position. Munilass may not know that Commissioner Gallagher, while previously serving at the SEC, went through a muni bond liquidity meltdown when the auction rate securities market collapsed in 2008.

Auction rate securities are municipal securities issued by the biggest dealer banks that conduct internal auctions to reset their short term interest rates. In February of 2008, hundreds of these bank auctions began to fail, culminating on March 28 when UBS announced it was marking down the value of the securities in customer accounts from a few percentage points to more than 20 percent. Customers had been sold these securities as “liquid as cash,” which they certainly were not. This had a very disruptive effect on the municipal bond market.

When the ARS market collapsed, it also had a devastating effect on the balance sheets of the big banks that had to buy them back from their clients. In my view, this was an accelerating factor for the financial crisis. Notice how the dates for the ARS collapse cluster around the failure of Bear Stearns in March, 2008. Retail investors who either took haircuts or had their assets frozen for a period of time were devastated too.

Barrons’ Randall Forsyth thinks Gallagher is a shrieking busybody because most muni bonds have a short duration due to embedded call options:

What Gallagher and the alarmists also miss is that effective maturity of most municipal debt has been shortened by the call features embedded in them. As Citi’s team points out, a typical 10-12 year muni bond will have a 5 percent coupon, which means it will almost certainly be called within three-to-four years. That is, as soon as the issuer can refinance the bonds. Unlike most American homeowners, who have leapt at the opportunity to refinance their mortgages, states and municipalities are precluded from redeeming their bonds before their specified call date.

This call option has a huge impact on the interest-rate sensitivity of most muni bonds. Many munis with long final maturities actually are likely to be redeemed much sooner; that is, two-thirds of the BofAML Master Muni Bond Index. Indeed, 97 percent of those callable bonds were priced on the assumption they would be called.

There is a slight problem with this analysis, because the typical transaction cost for retail investors (typically around 80 basis points or 0.80 percent for trades of $100,000, and 250 basis points or 2.5 percent for trades of $10,000) are greater than the current yields for 3 and 4 year bonds. Thomson Reuters MMD says that 3-year AA paper trades at 51 basis points, or 0.51 percent, and four-year AA paper is trading at 68 basis points, or 0.68 percent. Retail investors face an enormous liquidity penalty if they want to exit their holdings. Here are the transaction costs for various muni bond trade sizes from a paper presented at the SEC’s Fixed Income Roundtable:

Forsyth then gets on the bankruptcy pony to assert that all is benign in muniland. First, his math is way off:

As for defaults this year, Bank of America Merrill Lynch counts some $573.2 million failing to meet their obligations, 0.6 percent of the $3.7 trillion of munis outstanding, compared with 1.01 percent for all of last year.

$572 million is not 0.6 percent of $3.7 trillion. Forsyth is off by several decimal points. As for specific credits, he goes on at length about Yankee parking bonds, which I’ve always thought were a likely fraud, instead of discussing the many cash-starved and poorly managed states and local governments. He wastes nary a breath on Puerto Rico, Detroit, Harrisburg or the numerous California cities that await the outcome of Stockton and San Bernardino before they determine how to handle their gargantuan pension liabilities.

The problem with most muniland commentary is that it assumes the market is efficient and that it self-corrects, which it can be over the long run. But it is also highly susceptible to headline risks and black swans. A lot of this comes from retail being so dominant. Retail investors have so little information at hand, and they tend to react with panic, as we saw with the Meredith Whitney scare in 2011. A handful of dealer banks control about 43 percent of retail trades, and they tend to charge more for trades, according to a paper from the Federal Reserve Board.

Three quarters of muniland is held by retail investors, and their exit strategies could be very costly. I’m 100 percent with Gallagher that there are many risks, and that expanding investor awareness is a must. Will muniland be struck by the Armageddon? The more the possibility is discussed, the more defenses and education can be put in place. Don’t shoot the messenger; let’s work on fixing the market’s weaknesses.

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