Muniland’s huge Dodd-Frank win
A huge win for muniland was finalized last week when the SEC approved new rules that will shine light on the municipal bond underwriting process. This Bloomberg headline says it all: “Bond-Disclosure Rules Backed by SEC to Protect States From Banks”:
The rules were proposed by the Municipal Securities Rulemaking Board last year and are aimed at preventing Wall Street underwriters from steering public officials toward complicated debt financing without disclosing the risks. They were approved May 4 by the SEC, which will enforce them.
The disclosures are part of the effort to reshape financial regulations to prevent a repeat of the credit-market crisis of 2008, and stem from Congress’s decision to provide added protections for state and local governments. The economic crisis hit taxpayers with billions of dollars in unexpected costs when complex bond deals, once pitched as money savers, backfired as credit markets seized up.
I spent almost a year on Capitol Hill leading an open-source financial reform project as Dodd-Frank was being written. This is about the only area of the legislation in which there was no pushback from banks. Spencer Bachus, the Republican chairman of the House Financial Services Committee, was the committee’s ranking member at the time the legislation was being developed. Bachus’s home district in Alabama includes Jefferson County, the bankrupt county that has been buried under a series of deals with JPMorgan on interest-rate derivatives deals. Whether the banks explicitly held off challenging tighter municipal bond rules out of deference to Representative Bachus or whether they decided other parts of the legislation were higher priority is unknown.
In any event, the new rules are sweeping. Alan Polsky, the chairman of the Municipal Securities Rulemaking Board, said as much in a statement:
These new rules are the biggest development in protection of the financial interests of state and local governments since the MSRB was established in 1975.
The new rules detail a number of ways that underwriters must disclose their conflicts of interest to states, cities and other entities that issue municipal bonds. But the heart of the new rules addresses the sale of interest-rate derivatives tied to municipal bond offerings. Reuters blogger Felix Salmon described the practice like this in 2010:
I can guarantee you that every time a swap was sold, the person selling it got a nice fat up-front commission, and the unsophisticated small municipality buying it wound up getting a very unattractive deal. And the more complex the swap, and the higher the up-front payment to the town, the more the municipality was likely to be ripped off.
The underlying problem here is that interest-rate swaps tend to be sold rather than bought. If municipal treasurers came up with these plans on their own, and then asked a few banks for bids on the exact swap that they wanted, many of the rip-offs would never have happened. But instead, like subprime borrowers encouraged to monetize their home equity, they got talked into bad deals by sleazy financial professionals working on commission.
Some interesting municipal bond trading data
A few times a year, the Municipal Securities Rulemaking Board releases its trade data, giving the rest of us a chance to peer into the murky municipal bond market. Yesterday, we got access to the data for the first quarter of 2012, and a few interesting facts jumped out.
Revenue bonds, or debt issued with the backing of dedicated streams of payment from specific operations, trade a lot more than general obligation bonds. This makes sense because revenue bonds accounted for 69 percent of the municipal debt outstanding as of Mar. 31, 2012, according to Bloomberg. From retail-size trades of less than $25,000 to mid-market ones of up to $2 million, revenue bonds trade at about twice the par of general obligation bonds, or bonds with the “full faith and credit” backing of a governmental entity that has the authority to tax. Once trades become institutional, that is, exceed $2 million, demand triples for revenue bonds. Revenue bonds seem to be much more popular among institutional buyers like pension funds, mutual funds and insurance firms than general obligation bonds.
Within the revenue bond category, we can drill down further into the various sectors. For bonds with a fixed interest rate, the most traded sector was education. For floating rate securities, healthcare debt was most heavily traded in the first quarter.
Among the top 50 traded securities, Puerto Rico bonds dominated the list with approximately one-third of the par traded. Puerto Rico issued $5.3 billion of debt in the first quarter of 2012, and investors traded $22.4 billion of its securities. This is a remarkable showing given that Puerto Rico has the lowest rating of any U.S. state or commonwealth. The island is an exceptionally heavy issuer, having floated 7.45 percent of all long-term municipal debt in the first quarter of 2012 even though its economy only represents 0.4 percent of U.S. GDP. I’ll be looking more closely at its balance sheet.
Measuring the municipal bond market
What are the most important metrics for the municipal bond market? There are the daily interest-rate levels, for which the Thomson Reuters Municipal Market Data (MMD) AAA curves are the industry benchmark. There is the annual ranking of the largest new offerings, which was led by a $9.8 billion Texas issue in 2011. The credit rating agencies publish municipal bond default studies and charts of total securities by rating level. But for the macro view you need to turn to the overseer for muniland, the Municipal Securities Rulemaking Board, which recently published its own metrics in its Fact Book for 2011. At the broadest level, the MSRB metrics looked like this:
In 2011, the MSRB received data on approximately 10.4 million municipal trades, more than 130,000 disclosure documents and nearly one million interest rate resets.
Here’s the board’s answer to the question of why it collects this data:
The MSRB Transaction Reporting Program serves two major functions in the municipal securities market — price transparency and market surveillance. The implementation of RTRS in January 2005 created “realtime” transaction price transparency.
The MSRB has authority to collect and disseminate trade data, basically the price and size levels at which trades happen. I’m not sure what type of trade surveillance the MSRB does, and it would be interesting to learn more. The board’s other function — disclosing documents to benefit investor transparency — derives from its authority to regulate broker-dealers, since the MSRB has no authority to regulate the issuing entities. The interest-rate resets come from variable rate debt, and you can see those here.
The Fact Book chops and dices trade data in every way imaginable. For example, it reveals that the bonds that traded the most volume (par) last year were the two tax-exempt bonds ExxonMobil issued to build its refinery treatment plant in Louisiana. As I wrote last May, these are barely even “municipal” bonds.
Here comes a whole new municipal bond market
How do you shake up the sleepy old municipal bond market? Gather up the most important data, organize it into an easy-to-search format and make it available to retail investors for free. It’s this blogger’s dream, and it is on its way. Muniland’s overseer, the Municipal Securities Rulemaking Board (MSRB), today released its long-range plan outlining the expansion of its free, public-facing disclosure system called EMMA.
The current EMMA system (EMMA 1.0) is already a vital resource for the municipal bond market. It was modeled broadly on the SEC’s EDGAR system for public companies. EDGAR and EMMA both take in public disclosure documents, categorize them and expose the documents through a free Internet portal. EMMA 1.0 is a much richer platform than EDGAR because it provides trade pricing for municipal bonds in addition to document disclosure. The MSRB recently enhanced EMMA 1.0 with credit ratings, making it the most complete public platform for any fixed-income class.
Now it’s time to roll out the plan for EMMA 2.0. Here is how MSRB describes their purpose:
Establishing an integrated set of market transparency products that progress continuously toward achieving the MSRB’s statutory mandate to remove impediments to and perfect the mechanisms of a free and open market in municipal securities and municipal financial products
That’s a mouthful, but 51 percent of municipal bonds are owned directly by individual investors. Prior to EMMA these investors did not have simple access to fundamental data on their securities. If you own stocks or mutual funds, you could easily go to Yahoo Finance, MSN Money or any number of free public websites to look up all the necessary information. Muniland has had no central portal to research and evaluate muni bonds. The municipal bond market will remain a complicated place, but when given the information, smart investors will take the time to dig down and find value in their local general obligation, sewer or school district bonds.
Here is what is on tap for EMMA 2.0:
Free public user accounts — At no charge, public non-professional users would be able to establish user accounts on EMMA that would allow them to: set personal preferences; save frequently used search criteria; create portfolios or categories of securities; manage EMMA alert settings; track documents and data for user-created portfolios of securities through a personal ticker that would flow each selected document, data point, or other tagged event into a “tape” that could be replayed, saved or exported to the users’ own files; and conduct free basic data queries.
Getting paid for municipal risk
Another great chart popped up on Twitter today that shows the historical performance of the two primary types of municipal bonds: general obligation (GO) and revenue. The Bloomberg chart maps the difference in yield between these two categories, which have different legal rights to public revenues. Generally, revenue bonds pay more interest than GO bonds because they only have access to the revenue of the project that issues them. GO bonds (the white line in the Bloomberg chart) are currently trading at an average of 4.12 percent annual interest; revenue bonds (the orange line) are trading at an average of 5.09 percent at present.
Ms. Long: Succinct and very useful information. Thanks.
November 14: Muniland Snaps
The Municipal Securities Rulemaking Board prepared the map above to show how many municipal advisers have registered in each state. Idaho has zero and New York state has 107. Their debt loads probably mirror that ratio, too.
Good Links
NYT: Federal government shores up military contractor pension plans
Bloomberg: Municipal derivatives are muniland’s subprime
MSRB: Fitch and S&P to distribute real-time ratings on MSRB’s EMMA website
Muniland’s dynamic living entities
This is an absolutely perfect muniland discussion between Matt Fabian of Municipal Market Advisors, Tom Keene of Bloomberg Television and David Kotok, chief investment officer at Cumberland Advisors. For people unfamiliar with the muni market it really shows how fluid and dynamic conditions are for state and local issuers. It’s really worth listening to several times.
Matt Fabian is one of muniland’s brightest stars and really does an excellent job debunking some common myths about muniland. For example, some predicted there would be hundreds of billions of dollars lost in municipal defaults this year; so far there has been $1.2 billion. For a year Fabian has been saying we would not have a lot of defaults.
It’s at minute mark 6:50, though, where I would challenge Fabian. Contrary to conventional wisdom, as well as the signals from credit ratings and credit-default swaps, he says he would buy the state bonds of California and Illinois. These two are considered some of the worst of state issuers with very heavy debt burdens. Fabian’s rationale is that there are “structural protections for bondholders,” meaning that state law has deemed interest and principal payments to bondholders more important than any other payments the state is required to make.
But the thing I wonder about and would challenge Fabian on is the increasing use of bank loans by state and local borrowers. For example in July of this year California borrowed $5.4 billion as a bridge loan from Wall Street in case the federal government shut down and halted payments to states. California quickly repaid the loan and they have done a good job of disclosing the terms of their borrowing. Nevertheless, states and municipalities have no legal requirement to disclose these borrowings. They are really off balance sheet, at least until their annual audited financial statements are filed, which can mean a delay of a year or more. The MSRB has been examining muni bank loans and has asked the SEC for more guidance. From Bloomberg:
Officials with the Municipal Securities Rulemaking Board, which writes regulations for the $2.9 trillion tax-exempt bond market, have discussed the issue with the Securities and Exchange Commission, Alan Polsky, chairman of the MSRB, said on a conference call with reporters today.
“The SEC and the MSRB are both concerned about bank loans,” Polsky said.
Standard & Poor’s in July estimated that municipalities may borrow as much as $75 billion from banks this year, while Fitch Ratings has also said localities should disclose information about such direct deals with banks. The MSRB, based in Alexandria, Virginia, said in August that loans could fall under some securities rules. It is urging the SEC to weigh in on the matter.
The loans may leave investors unaware about rising debt obligations that could affect their credit ratings, Polsky said.
So Fabian is right to reference “structural protections” for bond payments. But it’s the dark, unknown borrowing that might have more seniority that we don’t know about.
Untimely data will cost muniland potential investors
If municipal bonds lose their tax-exempt status, as some in the corridors of power in Washington are suggesting, municipalities will increasingly be competing with corporations for investors. As this competition intensifies, municipalities with poor accounting and disclosure practices could find it difficult attracting capital.
Let’s say you’re an investor looking to buy the bonds of either Goldman Sachs or New York City and to help guide your decision, you seek out their most recent financial statements. As a public company, Goldman Sachs is subject to the SEC’s disclosure regulations which mandate the filing of audited annual financial statements 60 days after the end of the year. If Goldman does not file within the 60 day window then the SEC has the authority to restrict certain simplified securities offerings and the New York Stock Exchange, which lists their securities, can take action too.
Contrast that with the Municipal Securities Rulemaking Board, New York’s regulator, which encourages municipalities to make public their audited statements, which are called CAFRs or Comprehensive Annual Financial Report within 120 days of the end of their fiscal year. Unlike the SEC, the MSRB has no authority to discipline issuers who file late, other than suggesting the municipality issue a notification of late filing.
Having to wait additional 60 days to ascertain the fiscal health of municipalities makes them less attractive investments. And if state and local government entities can file after the deadline with impunity, investors will worry — rightly — if they can ever get timely data consistently.
So how big of a delay is there when governmental entities publish their financial statements? MuniNetGuide recently published the results of a study by Merritt Research that measured how fast government entities were publishing their audited financials. Interestingly, the determining factor was not creditworthiness or size; some low-rated issuers got their financials out quickly and other AAA issuers were slow to publish. Merritt’s research suggests that the type of government institution that is reporting affects the speed with which it publishes its audited financial statements. MuniNetGuide has an excellent table which shows the median number of days from the end of the fiscal year until financials are released for various municipal sectors:
The municipal bond market may have most of the data that investors need to evaluate bonds and that citizens need in order to understand the fiscal health of their communities. Government entities would do themselves a favor by beginning to file their financial statements in a more timely manner. Investors have many choices where to invest and muniland needs to pick up it’s game.
Meredith Whitney’s anniversary
Two big events happened on Tuesday in the municipal bond market: it was the annual conference of SIFMA, one of the industry trade associations; and it was also the one-year anniversary when Meredith Whitney began her campaign of predicting the collapse of the muni market. Whitney was of course way off-base with her prediction of hundreds of billions of dollars in bond defaults. In fact less than $1 billion of muni bonds have defaulted so far . But many believe that she did cause substantial damage to retail investors, mutual funds and insurance companies, all of whom were caught up in the downdraft of selling that followed her words of doom.
The reason that her words were so damaging to muniland was that there is little natural elasticity in the ebb and flow of the market structure — or, in market jargon, there is little liquidity. When large sell-offs happen in the equity or U.S. Treasury markets there is always a ready pool of buyers standing ready to pick up those securities at lower levels. These markets are favorites for traders and fast money because they encounter little friction, meaning the price rarely moves against them when entering and exiting the market. In contrast, there are few pools of buyers that understand the muni market and are able to do quick credit analysis of bonds for sale, not to mention the lack of shared pricing data that would let participants see if they are transacting at updated, fair-market prices. Because muniland is not really liquid, when Whitney yelled “fire” there was no orderly way for the crowd to exit the theater.
There are structural reasons why little liquidity exists in muni markets. For example, over 50,000 local and state governments have issued over 700,000 different municipal securities. On a given day only about 15,000 of these individual securities change hands in about 40,000 trades. The Municipal Securities Rulemaking Board stated in their annual fact book that about 10 million muni bond trades happened for the year 2010. In contrast, the New York Stock Exchange had 95 million trades in month of December 2010 alone.
For individual muni bonds there is generally not a daily pattern of buying and selling that would easily help establish a price. Markets instead look at similar bonds that have recently traded and try to extrapolate a current price. When the massive waves of selling happened around Whitney’s market call, the natural process of price discovery was disrupted and dealers didn’t want to take bonds into inventory as markets moved lower day after day.
Whitney’s call for muni apocalpyse scared many retail investors who promptly sold their muni bond funds and fled out the exit door. This mutual-fund selling caused fund-management groups to quickly sell bonds out of their portfolios. Unfortunately there were few buyers waiting to absorb these sales. Whitney’s call created a velocity of supply that hadn’t been seen in muni markets since the general market panic of 2008. Buyers stepped in eventually of course, but it was primarily high net worth individuals and hedge funds who had years of experience with the asset class and believed that the bonds continued to be rock-solid.
Disclosure is the beat
Disclosure is the beat
On Tuesday at the SIFMA Muni Bond Summit in New York, much of the discussion by bond market participants related to transparency and disclosure issues. A lot of this was in response to new requirements in Dodd-Frank, but there was also an acknowledgement that many problems in the crisis of 2007-2009 came from a lack of information and data in many parts of the market. For example small municipal issuers had more trouble accessing the bond market to issue new bonds if their public reporting was deficient or out of date.
The heavy hitter of the bond summit was SEC Commissioner Elise Walter, who appeared by video link and broke news that the SEC would not ask Congress to overturn the Tower Amendment, a 1975 law that bars the SEC from interfering in the fiscal affairs of state and local governments. She discussed current legislation that would skirt the Tower Amendment and give the SEC authority to require municipal issuers to file disclosure, though it would grant no authority to review and approve those filings. From the Bond Buyer:
Walter repeated her call for Congress to increase the SEC’s authority so that it could set “baseline disclosure requirements.”
The Tower Amendment to the Securities Exchange Act of 1934 prohibits the SEC and the Municipal Securities Rulemaking Board from requiring muni issuers to file pre-sale disclosure documents.
A draft bill being circulated by Reps. Mike Quigley, D-Ill., and Patrick McHenry, R-N.C., however, would authorize the SEC to require issuers to disclose primary and secondary market bond documents directly or indirectly through dealers or others. It would also give the commission authority to direct the content and timing of those documents.
She also said that the SEC should more broadly examine the practices of the bond markets. The Bond Buyer reports:
“People who have not previously been tuned into what that board is doing really should pay attention,” [SEC Commissioner Walter] said.
Separately, Walter said the SEC’s muni hearings revealed “certain softnesses in practices.”
She said state and local governments need better training in municipal disclosure and better disclosure practices. In addition, she noted there are significant conflicts of interest that affect the pricing of swaps, as well as indications many muni officials do not understand swaps.
Walter said she also wants to persuade the SEC to take a “long-term, deep-dive look” at the fixed-income market and its current structure, but added that such a study and any resulting recommendations may not be completed until after she leaves the commission.
Walter was sworn in as commissioner on July 9, 2008. Her term expires in June 2012.
I’ll write more about the issues raised at the bond summit over the next few days. Although much of what was discussed was complex, the conversation helped illuminate many of the market moves that don’t necessarily make sense on the surface. Many of these issues are the bedrock of a more open and stable market structure.
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Resident Muniland expert
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