MuniLand

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.”

Operation Twist, or Operation Shout?

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.

Vermont rebuilds while Congress fights

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.

Expanding the force field

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”

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 gusher of municipal bond information

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.

Harrisburg, PA next?

Bankruptcy for Harrisburg finally?

The fiscal troubles plaguing Harrisburg, Pennsylvania have been well telegraphed in muniland. Reuters detailed the problems earlier this month:

Pennsylvania’s state capital, a city of 50,000 about 100 miles west of Philadelphia, has been flirting with bankruptcy as it struggles to pay off $300 million in debt incurred through a financing scheme used to fund a revamp of its trash-burning plant.

In July, the city council rejected a rescue plan put forward by a state-appointed advisor that called on the city to sell the incinerator, renegotiate labor deals, cut jobs, and sell or lease its parking garage.

New leadership for muniland’s regulator

New chair for muniland’s regulator

New leadership has been announced at the Municipal Securities Rulemaking Board, muniland’s primary regulator. Alan Polsky of Dougherty & Co., the incoming MSRB chairman, has spent much of his career working towards increased transparency in the muni secondary market where bonds trade after issuance. This is great news. From the Bond Buyer:

Alan D. Polsky, senior vice president of Minneapolis-based Dougherty & Co. LLC and former chair of the National Federation of Municipal Analysts, will be the next chairman of the Municipal Securities Rulemaking Board beginning Oct. 1, according to market sources.

Polsky spent a great deal of time trying to improve secondary market disclosure when he chaired the NFMA in 2001. During that year, the NFMA issued several “best practice” disclosure documents recommending how issuers, borrowers, and other market participants could improve disclosure in various sectors of the market. Polsky also was a member of the Muni Council, a group of about 20 muni market group representatives dedicated to improving secondary market disclosure. The group was responsible for the creation of the Central Post Office facility which temporarily served as a one-stop place for issuers to file their disclosure documents.

Lending by banks is running ahead of the law

Thou know’st that all my fortunes are at sea;
Neither have I money nor commodity
To raise a present sum: therefore go forth;
Try what my credit can in Venice do

Antonio, The Merchant of Venice

Sovereign borrowing from powerful banks is centuries old. Venice was the Wall Street of the early Renaissance. The banks located in the watery grandeur there loaned money to faraway kings and traders. Kings didn’t regulate banks but they did often force repayment by raising an army.

Our government reaches far beyond the actions of kings, who merely wanted their money back, and attempts to regulate banks. The government borrows and it oversees. It’s a big effort as the new financial reform law, Dodd-Frank, more strictly regulates the capital adequacy of banks and enforces “fair dealing” and transparency. Reining in the practices of banks and securities firms is hard work but it’s vital to protect our public institutions, taxpayers and investors. Well regulated banks and the rule of law cancels the need for armies to be raised to have a functional financial system.

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