In a bond market massacre, liquid products win

It comes as no surprise to those who understand markets that the less liquid a product is, the more its price will decline in a fast market rout. This has happened over the last few days in the municipal bond market.

The buying and selling of individual municipal bonds can be especially illiquid for retail investors because they don’t have much real-time market data. More importantly, they face very steep transaction costs, or markups, that dealers put on bonds sold in small lots. I wrote about this last week:

Securities and Litigation Consulting Group of Fairfax, Virginia, recently published a report that analyzed almost $3.7 trillion worth of municipal bond trades that happened between 2005 and 2013 (page 8). SLCG found that the median markup for a trade up to $25,000 in size is 1.79 percent.

Although markups are a drag for most retail customers, there was an approximately 30 percent increase in customer buys on June 24. Customer buy orders climbed to 24,897, according to MSRB data, from the 30 day average of 17,699. Although the par amount of customer buy trades on June 24 was $5.2 billion – almost the same as the 30 day average. There were more, smaller, buy orders, and this generally reflects increased retail investor activity.

Although the number of customer sell trades was only slightly higher than the thirty-day average, we saw a big increase in the par amount traded. It grew from a 30 day average of $3.4 billion to $5.4 billion on June 24. This tells us that institutions were heavy sellers. We know this from the size of the bid lists that were circulating among dealers. These are lists of securities offered for sale.

Free speech or securities fraud?

Mark Funkhouser, the director of the Governing Institute and a former mayor and auditor of Kansas City, took a few swings at the SEC for its securities fraud prosecution of Harrisburg, Pennsylvania. Funkhouser has three concerns with the SEC’s case.

First, he correctly points out, as the SEC case contends, that the city of Harrisburg did not issue any financial statements between January 2009 and March 2011. The SEC says that because of this, investors had to seek out other statements made by public officials that included material misstatements. Funkhouser blames it on investors for poor diligence. He says:

You’d think it would be obvious to potential investors that if there’s not much current information available about a city’s finances they might want to think twice about buying its securities. But investors don’t always exercise proper diligence, and it wouldn’t have hurt for the SEC to have driven home that point.

Puerto Rico tweets about bankruptcy

The twitter handle for Puerto Rico’s executive branch is @fortalezapr. Here are some of the tweets from Thursday:

We are in pretty grim times when an investment grade government is tweeting about bankruptcy to encourage people to approve big tax and fee hikes.

Who is in line to finance the $2 billion for the Highway Authority? Good luck with that.

When Detroit goes to bankruptcy court

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Detroit Emergency Manager Kevyn Orr predicts that the chances of Detroit entering bankruptcy are about 50/50. But if we consider what the major participants, bondholders, public employees and retirees are likely to do, it’s almost 100 percent certain that Mr. Orr will be entering the federal bankruptcy court house on West Fort Street in Detroit.

The bankruptcy case of Stockton, California provides an indication of how willing bond insurers will be to make upfront concessions. In Stockton, they were totally unwilling to give up anything. From the written ruling of the bankruptcy judge in Stockton, Christopher Klein: (page 17)

Bond insurers are the legal grinding stone of the municipal bond market. They don’t give anything away if litigating would gain them some advantage. They have stables of high-powered attorneys to fight their battles.

Is there such a thing as a ‘fair’ markup in muniland?

It’s well known in muniland that retail investors, who buy smaller lots of bonds than institutional buyers, get hit with high markups. The rule is that dealers must deal “fairly” with investors. Translation: Markups to customers cannot exceed 5 percent. So if a dealer sells a bond worth $5,000, he may not charge the client more than a $250 markup. However, there is no regulatory requirement for the dealer to tell the client how much the bond has been marked up; just that it was marked up. Many believe these differences in bond prices are excessive, but no one has figured out a way to reduce or stop the practice.

Securities and Litigation Consulting Group of Fairfax, Virginia, recently published a report that analyzed almost $3.7 trillion worth of municipal bond trades that happened between 2005 and 2013 (page 8):

SLCG found that the median markup for a trade up to $25,000 in size is 1.79 percent. Here is an example of a trade with an excessive markup, from page 11 of the study:

A call for monitoring municipal heart beats

New York State’s Comptroller Tom DiNapoli has published the results of his Fiscal Stress Monitoring System. Taxpayers in many communities have been identified as having moderate to significant stress. This is a clarion call to those communities to look more closely at their revenues and expenses before a crisis.

DiNapoli started developing the system last year and went through a multistep process. From his press release:

DiNapoli began shining a spotlight on fiscal stress in 2012 after his office noticed a number of alarming trends among local governments. For instance, his auditors found that nearly 300 local governments had deficits in recent years, and more than 100 had inadequate cash on hand to pay their current bills. DiNapoli’s office drafted the ‘early warning’ monitoring system last September and shared details of the proposal with all of the state’s local governments and school districts for their review during a 60-day comment period. More than 100 local government and school district officials, as well as a number of affiliated organizations, provided feedback.

Is the U.S. Treasury bailing out Puerto Rico?

Puerto Rico budget negotiations for fiscal 2014 are in the final stretch for the year’s July 1 start date. A massive $1.5 billion difference between spending and revenues must be closed. Discussion has included expanding the commonwealth’s sales tax to services and transactions between businesses. Local businesses fought hard against this proposal, and eventually, Governor Garcia Padilla switched focus. Reuters explains:

[Puerto Rico Treasurer Melba] Acosta told reporters that policymakers had agreed to scale back by 73 percent the governor’s proposed sales-tax expansion, which was strongly opposed by local businesses. The expanded sales tax will be levied only on a small group of industries and will raise $287 million during fiscal 2014.

To make up for the lost revenue, the government will assess a business tax on gross sales on a sliding scale, depending on sales volume. It is expected to generate $522 million.

Detroit’s 10 cents-on-the-dollar meme

Detroit’s emergency manager, Kevyn Orr, held his big creditor meeting today and presented his Proposal For Creditors Powerpoint (PDF) for how he would like to treat the city’s liabilities. The mainstream media is running with the story that Orr’s proposal will give creditors 10 cents on the dollar, but the proposal is far from having those terms.

The Proposal calls for the following treatment of various classes of debt:

For secured debts:

For the $5.5 billion of secured water and sewer revenue bonds, Orr proposes to issue new bonds with the current full principal amount (with accrued interest) at a lower interest rate (i.e. no haircuts or reduction in principal). (page 101)

For the $411 million of Secured General Obligation Debt (unlimited property tax pledge) Orr says, “Treatment: Subject to negotiation with holders”. So no stated haircut there. (page 104)

Puerto Rico Government Development Bank’s clogged balance sheet

The Puerto Rico Government Development Bank (GDB) has indicated that it could sell up to $2 billion of bonds this year to refinance loans it made to the Puerto Rico Highway and Transportation Authority (PRHTA). These loans on the GDB balance sheet comprise about 24 percent of the GDB’s assets. The PRHTA is a money-losing operation with $4.7 billion of its own debt outstanding. If the GDB is successful in moving these loans off its balance sheet, then the PRHTA could be carrying up to $6.7 billion in debt on a very shaky revenue base.

If you think that you might be interested in participating in a PRHTA bond offering, you really should first talk to Alan Schankel, Managing Director of the Fixed Income Strategy team at Janney Montgomery. He has written an excellent report that looks at the Highway and Transportation Authority. Here are some key takeaways from his report [my comments in brackets]:

    The toll and tax revenue streams securing Highway and Transportation Authority bonds have been pressured by the island’s stagnant economy. [Note that year over year revenues are down] A gross receipts pledge and monthly deposit mechanism represent a strong security framework from bondholders’ perspective, but operating expenses and losses must also be considered in evaluating creditworthiness. [Operating expenses far outstrip revenues after debt service]

    GDB has extended more than $2 billion of short term loans to the authority. The plan is to issue bonds to finance repayment. [In other words, moving the bad loans off their books] Significant revenue increases are needed if the authority is to remain solvent and retain investment grade ratings. [It looks as if revenues would need to increase at least 50 percent to cover operating losses and service additional debt] A series of management stumbles, not typically seen with a $5 billion bond issuer, heighten concerns. [Go on…] It remains to be seen if the political will exists in Puerto Rico to take measures needed to dig PRHTA out of the fiscal hole in which it finds itself. [The political beast rules muniland]

In the breakdown from the PRHTA (page 15), you can see how all revenue streams have fallen over the last five years:

Official says Gensler asked not to be renominated

The media has been increasingly focused on a replacement for Commodities Future Trading Commission chairman Gary Gensler, whose term expired April of 2012. While up until several months ago the White House had made public its desire to renominate him for chairman, there has never been confirmation from Gensler whether he wanted to retain his post or step down. After I posted a piece encouraging President Obama to renominate Gensler I was contacted by a CFTC official who said that Chairman Gensler definitively did not want to be renominated. This appears to be the first public statement about Chairman Gensler’s intentions.

The clearest statement that Chairman Gensler has made previously was in a March 5, 2013 Wall Street Journal article:

Mr. Gensler said in an interview that he plans to keep working on rules to regulate derivatives trading and hasn’t decided whether he will stay at the agency for a second term.

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