MuniLand

In 2010, the small town of Moberly, Missouri issued $39 million in municipal bonds for a private manufacturing facility that the town hoped would add 600 jobs to its community of 14,000. Yesterday the Missouri Attorney General Chris Koster filed felony theft and securities fraud charges stemming from the collapse of that project, the Mamtek sweetener factory. The charges were made against California businessman Bruce Cole who was the CEO of Mamtek. Cole was arrested at his home in Dana Point, California and Attorney General Koster said extradition proceedings would begin immediately.

In short, Cole is alleged to have used proceeds of the municipal bond offering for personal expenses. The Moberly Monitor has the details:

The probable cause affidavit alleges that shortly before the sale of the Mamtek bonds, Cole directed a Mametk consultant to prepare an invoice purporting to come from “Ramwell Industrial, Inc.” This invoice requested payment of $4,062,500 for Ramwell’s services, including $3,562,500 for “Design, acquisition, and installation of five production lines,” $325,000 for engineering and design, and $175,000 for project supervision.

Cole directed that this invoice be submitted for payment even though Ramwell was never incorporated, never had any employees, never owned any property, and never provided any goods or services to Mamtek U.S. The day after the invoice was submitted, it is alleged, Cole instructed a bookkeeper for Mamtek U.S. to wire $700,000 to Cole’s wife, Nanette.

Within 48 hours of receiving the $700,000 wire from Mamtek, Nanette Cole wrote a $281,046.30 check to cash. The Coles immediately made a payment on their mortgage in the amount of $243,018.73. Shortly thereafter, the scheduled foreclosure auction of the Coles’ Beverly Hills home was canceled.

Municipal bond trading volumes are on a downward march. The Municipal Securities Rulemaking Board (MSRB), which oversees muniland, publishes trade statistics on its website. You can see on the chart below, which shows daily trade volumes, how “customer bought” trades especially have been trending down. These are trades done by retail and institutional clients to acquire bonds.

“Customer sold” trades, which generally represent funds or brokers selling bonds out of client accounts to be replaced with other bonds, have been relatively steady. Bonds are sold to raise cash and to move assets to other classes. Interdealer trades are done between dealers to transfer bonds that are sold onto clients who are not dealers (think retail and institutional investors).

There are several reasons for declining trade volumes, but foremost is the very low level of yields on municipal bonds today. Taylor Riggs of the Bond Buyer, who reports dealer trading desk activity, tweeted this on Tuesday:

Now that three California towns have declared bankruptcy in the past few weeks, the mainstream media is abuzz with headlines of imminent doom for state and local governments. Adding fuel to the fire were Warren Buffett’s comments on Bloomberg TV about how cities may find it easier to declare bankruptcy after seeing others do it:

“The stigma has probably been reduced when you get very sizeable cities like Stockton or San Bernardino to do it,” Buffett, 81, said in an interview today on “In the Loop with Betty Liu” on Bloomberg Television. “The very fact they do it makes it more likely.”

He said the nation isn’t on the brink of hundreds of billions of dollars in defaults, as banking analyst Meredith Whitney predicted in 2010. “I don’t think we’re at the precipice,” Buffett said. “People will use the threat of bankruptcy to try and negotiate, particularly pension contracts, with their employees.”

I’m often critical of municipal bond issues that either appear to be configured to avoid the necessary approval processes or appear to benefit private interests over public interests. The opacity of muniland creates plenty of dark places for odd dealings to occur. But earlier this week I read about the small Massachusetts town of Leverett, which had just conducted the most open and transparent bond approval process that I’ve seen. What was being decided was a $3.6 million project to build a broadband network connecting the 632 households in the community. The whole process is about as commendable as you could hope for.

From the Daily Hampshire Gazette:

Construction of a municipal fiber-optic cable network is expected to begin later this year after residents Saturday voted overwhelmingly in favor of a $3.6 million bond measure to finance the project.

Bids are expected by the end of the summer with construction to begin soon after, officials said.

A little-known provision in the Dodd-Frank financial reform law expanded the board of directors of the Municipal Securities Rulemaking Board (MSRB), the self-regulatory organization that oversees muniland. The board used to be composed of employees of municipal bond dealers and big banks, and many would say privately that MSRB rulemaking favored industry players rather the public. Dodd-Frank radically altered the board’s composition to balance representation from the municipal industry and the public. The law firm Duane Morris explained the change (emphasis mine):

The [Dodd Frank] Act alters the composition of the MSRB so that a majority of the minimum 15-member Board are independent of municipal securities brokers, dealers or advisors. The new composition of the Board meets the stated goal of the Act, to ensure that the public interest is better protected on the Board. The Board has a new charge to protect the public interest in addition to municipal entities and investors. The Board will consist of eight individuals known as “public representatives,” independent of any municipal securities broker, municipal securities dealer or municipal securities advisor. At least one of the public representatives must be a representative of institutional or retail investors in municipal securities. At least one of the public representatives must also represent municipal entities, and another of the public representatives must have knowledge or experience in the municipal securities industries.

The remaining seven “regulated representatives” will consist of individuals associated with a broker, dealer, municipal securities dealer or municipal advisor. At least one of the regulated representatives will be a “broker-dealer,” representative of nonbank brokers, dealers or municipal securities dealers. At least one individual must be a representative of banks, and at least one individual must be associated with a municipal advisor. The number of public representatives on the Board must always exceed the number of regulated representatives.

Like U.S. Treasury debt, muniland securities have been hot, hot, hot. Investors have been piling into municipal bonds for about 16 consecutive months. At first, demand was driven by investors who were attracted to the high yields in the wake of Meredith Whitney’s predictions of default, which scared retail investors out of the market between November 2010 and February 2011. Demand then accelerated as the Federal Reserve kept interest rates at artificially low levels, driving investors out of Treasuries and into riskier assets. Steady municipal bond mutual-fund flows, coupled with the reinvestment of muniland proceeds into new bond issues, has also helped keep demand elevated.

On the supply side, municipal bond issuance in 2011 slowed to $295 billion, down 32 percent from 2010 and the lowest level since 2001. This lack of supply, along with massive demand, has covered over a lot of issuer weaknesses that would normally drive yields higher. Bloomberg reports:

“There’s a shortage of bonds out there,” said Paul Mansour, managing director at Hartford, Connecticut-based Conning, which oversees about $10 billion of municipal bonds. At the same time, “there’s a rush for yield, and it’s masking the differences” in issuers’ credit quality, he said.

This is a guest post from Joe Rosenblum, the director of Municipal Bond Credit Research at AllianceBernstein.

Is the municipal bond market on the verge of collapse? You might think so, given the blaring headlines about a few big disasters in the last year. But the truth is that poor decision making, not systemic issues, has caused the most serious problems.

Jefferson County, Alabama, and Vallejo, California, filed for Chapter 9 bankruptcy protection. Receivers were appointed for Central Falls, Rhode Island, and Harrisburg, Pennsylvania. Stockton, California, is deferring debt-service payments (though bondholders continue to get paid from other sources) as it goes through a state-authorized mediation process with its creditors. And most recently, Detroit agreed with the State of Michigan on a shared fiscal oversight process to avoid bankruptcy.

I’ve previously featured a guest post about the advantage to retail investors of buying municipal bond mutual funds. Retail investors can also directly buy individual municipal bonds. This is a tiny part of muniland, but I could see it growing in the future. Today, I welcome a guest post from Andrew Wels, the head of retail fixed income and vice-president for retail at E*Trade Securities. Wels writes about the advantage of buying individual bonds and “laddering” them.

Buying individual bonds
by Andrew Wels

Most financial professionals would agree that a mix of stocks and bonds is essential to a well diversified portfolio. Stocks provide growth potential, and bonds offer both regular income and return of principal upon maturity. Many individual investors are familiar with selecting stocks, but bond investing tends to be viewed as more complex.

Bond funds vs. bond ladders

A bond fund, an investment in a portfolio of individual bonds, is a popular investment vehicle for accessing the fixed-income markets. Bond funds offer diversification and some characteristics of the underlying individual bonds in which they invest. Unlike individual bonds, the interest income from a bond fund is not fixed, so there is no fixed maturity date. For the past several decades, declining interest rates have generally boosted the net asset value of bond funds. Consider the inverse: When interest rates rise, bond fund values tend to decline, exposing an investor’s principal to risk.

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A small but growing corner of muniland consists of municipal bond exchange traded funds (ETFs). I know very little about these products and asked Matt Tucker, a managing director on BlackRock’s fixed income portfolio management team, to write a short introduction to the product.

ETFs: The new way to access the municipal bond market

Traditionally, the only two options available for those who wanted to invest in the municipal bond market were through mutual funds or laddered bond portfolios. In the past five years, though, exchange traded funds (ETFs) have come on to the scene. They provide a combination of diversification, index performance and exchange liquidity, making them a compelling addition to anyone’s municipal bond investments.

Chris Mauro, head of U.S. municipal strategy at RBC Capital Markets, sent around a comment note suggesting that the media coverage of the Senate Finance Committee hearing Wednesday that included discussion of possible changes to the taxation of municipal bonds was overheated:

Yesterday, the Senate Finance Committee held a hearing entitled “Tax Reform: What It Means for State and Local Tax and Fiscal Policy”. A simple reading of the media accounts of this hearing would lead one to believe that the entire event was dedicated to a detailed discussion of the future of the tax-exempt status of municipal bond interest. So we decided to review the tape of the hearing in order to see what in fact was discussed. In reality, the vast majority of the hearing was focused on two issues – the deductibility of state and local taxes by federal taxpayers and the ability of state and local governments to collect sales taxes on internet and catalog purchases.

Both Committee Chairman Max Baucus and Ranking Member Orrin Hatch made some passing comments about tax-exempt bonds and the federally subsidized taxable Build America Bond (BABs) program, with Baucus making generally positive statements about BABs and Hatch making generally negative ones. Senator Maria Cantwell of Washington State expressed some concern about the importance of tax-exempt bond financing to public power utilities in the northwest, but beyond that, there wasn’t a whole lot of discussion about the muni tax exemption.