MuniLand

Muniland’s regulator hard at work

I heard an economics editor give an amusing response the other day when asked if the U.S. has “free” markets. She responded that, since all markets are regulated, that, pretty much, yes. I had to chuckle because municipal bond markets, although regulated reasonably-well on the primary side when bonds are issued, have minimal supervision or regulation on the secondary or trading side after bonds have been issued. It’s difficult to have confidence that investors are always protected when you read stories about abuses like excessive mark-ups, for example.

Listening to a press call with the MSRB (the municipal market’s overseer), after its quarterly meeting on Friday, I felt a jolt of enthusiasm. The board has been spending a lot of effort untangling the thorny issues that must be addressed to bring more transparency into primary and secondary municipal bond markets. Here is the MSRB’s priority list (my comments in parentheses):

Trade Reporting Concept Release: To support the MSRB’s ongoing commitment to increasing transparency in the municipal market related to pricing of municipal securities, the Board agreed to publish the second concept release in a series of releases on the MSRB’s existing transaction reporting system. The new concept release will seek public comment on improving the quality and usefulness of available post-trade information and the appropriate standards for the collection and dissemination of pre-trade information on the MSRB’s Electronic Municipal Market Access (EMMA®) website. (I can’t wait to see the details)

Fair Pricing: The Board agreed to take a two-step approach to clarifying, and potentially expanding the fair pricing obligations of dealers. First, it agreed to consolidate into a new rule municipal securities dealers’ obligations related to fair pricing outlined in a number of existing rules and interpretations. The Board will seek public comment on condensing relevant requirements described in MSRB Rule G-30 on fair pricing, MSRB Rule G-18 on agency transactions and interpretations to MSRB Rule G-17 on fair dealing. (Consolidating rules would hopefully help market participants understand, follow and enforce fair pricing more easily)

The second part of fair pricing: Best Execution: The Board will seek public comment on a concept proposal relating to the application of ‘best execution’ concepts for transactions in municipal securities. (SIFMA, the dealers trade association, is already out of the box with its “execution-with-diligence” concept release and is urging the MSRB to use it as template for public comment. MSRB reps said that they did not discuss SIFMA’s release at the meeting. A quick read of SIFMAs proposal suggests that it would allow dealers to check with the dealers they always do business with for prices, rather than the broader market)

Inflationumberitis

As the Detroit bankruptcy is prepared to begin in the courtroom of Federal Bankruptcy Judge Steven Rhodes, a lot of debate is taking place in muniland. Many of these arguments are over whether secured bondholders will take haircuts, where the money will come from to pay off the swaps termination fees that are currently being negotiated and whether Detroit Emergency Manager Kevyn Orr has authority to cut the earned pensions of the city’s retirees. Orr has been making the media rounds to bolster his case for why these well-funded pensions should be cut. Of course, the more he cuts retiree benefits, the more he can force cuts on bondholders. Let’s shed a little light on Orr’s pension voodoo. Here is how the Detroit pension funds are represented in the 2012  annual financial report (CAFR) (page 145):

 

We don’t know Detroit’s pension returns for 2012, but it was a good year overall for public pension funds, with an average return of 12.69 percent, according to Wilshire Trust Universe Comparison Service. In 2012, according to the CAFR, Detroit contributed $64 million to the General Retirement System and $50 million to the Police and Fire System (page 146). That is $114 million, or about 10.3 percent of the $1.1 billion of general fund revenues in 2012. The voodoo comes in when Orr projects pension contributions jumping to $285 million in 2017 from $114 million. That is an increase by a factor of about three (June 14 Creditor Proposal page 91):

Who is representing Detroit?

Since Kevyn Orr was appointed Detroit’s emergency manager on March 18, his approach always seemed a little off, especially when bankruptcy is concerned. For a Chapter 9 municipal bankruptcy to work, most of the parties must come to a mutual agreement about what each will sacrifice. Federal bankruptcy judges only have the authority to “cram down” a minority of creditors in a specific class when the majority agrees. Federal bankruptcy judge Steven Rhodes, for example, can’t force all bondholders in a class to take a 50 percent haircut. Absent that power, municipal bankruptcy usually lasts much longer than others, as parties come to an agreement.

This balancing act is no easy task for a bankruptcy leader (city official, receiver, emergency manager or lead attorney). But when Orr laid out his creditor proposal on June 14, his aggressive treatment of retirees and bondholders seemed to me like he was wielding a chainsaw where a paring knife would have been the best tool to begin the work. The law firm Jones Day, the firm Orr left before becoming emergency manager, had been involved in the corporate bankruptcy fight of Chrysler. Orr’s opening punch felt like a move from corporate bankruptcy.

We get a peek into Orr’s thinking through a series of emails between him, while he was still a lawyer at Jones Day, and state officials. The emails were made public by a FOIA request by a Detroit labor activist. A January 31, 2013 email from associate Dan Moss to Orr is a suggestion to “nationalize” Detroit’s bankruptcy issue and provide “cover” for state politicians:

Obama should supercharge manufacturing in broken cities

President Obama’s speech on the economy on Wednesday will be closely watched. My own view is that the president has been consumed with military and surveillance efforts and has lost sight of his role as the nation’s economic leader. His efforts to recharge the economy thus far seem like a re-branding effort. But we need bigger ideas. I hope he has some, a clear schedule and lots of initiative. Charging up the world’s largest economy is no easy task. Reuters Mark Felsenthal and Roberta Rampton tell the story:

Obama has focused much of his energy in the first six months of his second term on an array of domestic and foreign issues. But on Monday, he told a gathering at a downtown Washington hotel that economic issues would now take priority over others, specifically mentioning gun violence and his plan to address climate change.

I’m already sensing a drift in mission. Reducing gun violence and addressing climate change are vital for our nation, but they are rarely thought of as economic issues. And then there is the reality of Congress’ schedule. Congress breaks in August, leaving four weeks of legislative activity before the government funding deadline, according to Reuters.

Has Detroit over-inflated its pension liabilities?

Joshua Pugh, a writer and contributor to the Detroit News Politics Blog, has written about a topic that is a big one among muniland professionals. That is the question of whether Detroit’s Emergency Manager Kevyn Orr inflated pension liabilities to make the city’s debt appear larger, allowing for more aggressive haircuts for bondholders and pension holders. Pugh points out a Bloomberg Businessweek piece on his personal website:

How much does the city owe? Orr says Detroit has nearly $20 billion in debt and long-term obligations. Pension funds and bondholders have said in the past he’s inflating the numbers. Why would Orr do that? Because the more dire the city’s finances seem, the more aggressive he can be in pushing for concessions. Also, to be eligible for bankruptcy protection, the city must prove that it’s insolvent, meaning it has no way to pay its debts.

In 2004 and 2005, Detroit issued two sets of pension obligation bonds (Certificates of Participation) to fully fund the city’s pensions with an additional $1.5 billion. This is why, when I started looking at Detroit about 18 months ago, the pensions were surprisingly well-funded. Those pension bonds have now been lumped with general obligation bond debt, pension shortfalls (unfunded liabilities) and retiree health care as unsecured debt, which Orr intends to haircut.

The fight begins in Detroit

 

As Detroit’s bankruptcy filing this week brings on understandable lamentations about the city’s dwindling population and derelict building, a murky legal challenge is under way. There are many places where state and federal law cross over in municipal bankruptcy proceedings. There are few court rulings about the subject, so it is hard to know which law books to reach for when understanding the ones that will prevail.

The Tenth Amendment, which reserves to the state all powers that are not directly granted to the federal government, is at play when the U.S. Constitution says nothing on a matter. In Detroit’s case, pension rights are enshrined in the Michigan Constitution. It is an unknown if these will be considered a “contract” that Detroit Emergency Manager Kevyn Orr can break or a “constitutional right,” which would be harder to adjust.

Buying bonds in muniland

When I started the Muniland blog in April, 2011, municipal bonds were being affected by a low interest rate environment, making them expensive and offering low yields to investors. Since non-institutional investors usually have to pay big mark-ups to buy them, it didn’t make sense to encourage people to own individual bonds. But the interest rate environment in the next year will be changing, and folks might want to consider good quality municipal bonds as long-term investments. It may start to make more sense that I talk about trading commentaries by muniland professionals.

One of the most-used benchmarks in muniland is the “Municipal-to-Treasury” ratio. Anthony Valeri writing for Learnbonds.com says:

Municipal valuations are at their most attractive levels of the past several years, according to average municipal-to-Treasury yield ratios. Average 10- and 30-year AAA municipal bond yields are 112 percent and 114 percent, respectively, of comparable maturity Treasury yields (using Municipal Market Advisors yield data) as of July 10, 2013. The higher the yield ratio, the more attractive municipal bonds are relative to Treasuries and vice versa. A ratio over 100 percent means that yields on top-rated municipal bonds are exceeding those of comparable Treasuries, and investors get the added tax-benefit to boot.

Bankruptcy in Detroit, and new precedents may be set

The emergency manager of Detroit, Kevyn Orr, with the blessing of the Governor of Michigan Rick Snyder, has gone to the federal courthouse and filed a petition for Chapter 9 municipal bankruptcy. The most important dimension of this filing is that it shields the city from lawsuits that are being filed against it. Already Detroit’s public pension funds and workers have filed state-level lawsuits against Orr and Snyder to halt them from filing for bankruptcy. Undoubtedly a legal judgment was made about the validity of those suits and whether seeking the protection of the federal bankruptcy court was necessary.

It took the municipal market and public by surprise when the filing happened today. The publisher of the Bond Buyer, Mike Stanton, said:

Who is the Development Bank of Puerto Rico’s rumored next president?

In the latest sign of Puerto Rico’s perilous financial footing, The Bond Buyer reported that the president of the Government Development Bank of Puerto Rico, Javier Ferrer, announced his resignation on Wednesday.

In this role Ferrer had the leading role overseeing and advising the debt of the Puerto Rico government and public authorities. The bank also lent to the government and authorities.

Puerto Rico Gov. Alejandro García Padilla announced that Joseph Pagan, currently executive vice president of financing at the GDB, will be the interim president.

Muniland spends 12 percent of U.S. GDP, but not on creating jobs

It’s mind-boggling how much of the national economy is held up by state and local governments. From the Federal Reserve Bank of Atlanta:

State and local governments together spend more on directly consumed public goods and services (excluding grants and national defense) than the federal government does, said Tracy Gordon, a fellow at the Brookings Institution. The economic impact of that spending is significant—state and local governments account for approximately $1.8 trillion, or about 12 percent of U.S. gross domestic product, she added.

The Fed chart above shows data for the southeast states, but it mirrors national trends. State and local governments are not increasing employment. What is increasing is the amount of employee wages that is going to benefits. The Bureau of Labor Statistics wrote:

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