MuniLand

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

Bond Buyer: Huge $12 billion week for municipal bond issuance will set yearly high

WSJ: SEC looks at use of segregated funds by cities

Atlanta Journal-Constitution: Although they paid $86M to banks for bad swaps deals, Atlanta flaunts fiscal prudence

RI NPR: To get things done, Raimondo embraces the bully pulpit

Global Economic Intersection: Jefferson County: Dirty bankers and good old boy crooks

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.

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.

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.

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.”

Op Twist and demand

The Federal Reserve announced further efforts to stimulate the U.S. economy yesterday by reapportioning the maturity of the bonds in its $2.6 trillion portfolio. The operation has been dubbed “Operation Twist” because it twists the yield curve by raising short-term rates and lowering long-term rates. This is another attempt by the Fed to goose consumers into spending and borrowing at higher levels in the hopes that it will increase demand and get the national economic engine running at a higher speed. Reuters reports:

The Federal Reserve’s latest effort to push down long-term U.S. borrowing costs may not do much for the central bank’s main worry — persistently high unemployment that could leave lasting scars on the economy.

Economists are increasingly anxious that the 9.1 percent jobless rate in the United States could become entrenched, as the skills of those out of work atrophy and their connections to the job market wane, sidelining them and chipping away at the U.S. economy’s capacity to produce.

The state of Vermont is struggling to gather funds to repair the flood damage from Hurricane Irene, the state’s worst natural disaster since the floods of 1927. Generally the state would rely on support from the federal government to replace and repair this infrastructure, but the U.S. Congress is locked in a fight over funding the Federal Emergency Management Agency as part of a larger fiscal battle that could shut down the federal government. From CBS News:

Congress is headed for a showdown over disaster relief funding that could bring the government to the brink of a government shutdown again.

House Speaker John Boehner has scheduled a vote tomorrow on a bill that would keep the government operating through Nov. 18. If the Senate and the House do not approve the stopgap measure, known as a continuing resolution, before the fiscal year ends Sept 30, the government would be forced to shutdown.

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.

That “loan” may be a “bond”

In a groundbreaking announcement, the Municipal Securities Rulemaking Board (MSRB) has advised municipal bond market participants that many “bank loans” currently being structured for state and local governments are likely to be classified as municipal securities, even though these “bank loans” are often being privately placed.

In the market advisory the MSRB makes reference to the Exchange Act and a landmark Supreme Court case about the definition of a “security.” From the MSRB:

Many loans are evidenced by notes.  Section 3(a)(10) of the Exchange Act includes “notes” within the definition of “security.”  The principal legal authority on the distinction between a note that is a security from one that is not is the U.S. Supreme Court case of Reves v. Ernst & Young, Inc.[6] A note is presumed to be a security under the Supreme Court’s opinion in Reves unless it is of a type specifically identified as a non-security.

The municipal bond market is often thought of as complex and murky. This is understandable; after all, there are over 50,000 issuers of bonds and a million plus specific municipal-bond issues. It’s staggering to imagine so many different securities.

A specific bond issue can be as small as the $995,000 offer that the city of Moose Lake, MN has coming to market this week, or as big as last week’s jumbo-sized $10 billion “State of Texas Tax and Revenue Anticipation Notes, Series 2011A”. (The Texas notes mature in one year and are paying 2.50 percent interest — they’re hot as griddle cakes.)

Municipal bonds also come in many different shapes because there is very little standardization of structure among municipal bonds. A straight bond generally has a fixed interest rate, or yield, and a set maturity date, or time of repayment. But many municipal bonds have floating interest rates; many others can be called or refinanced when interest rates go down. Regulatory agencies like the MSRB or the SEC don’t require that bonds have a certain structure or feature, only that the details are fully and accurately disclosed.