Puerto Rico’s pain stretches to its lack of assets

Juan Carlos Batlle, President of the Government Development Bank for Puerto Rico, does not like the way I characterized his comments at the Bloomberg State & Municipal Finance Conference last week.  Here is the transcript of the panel he appeared on, so you can read his comments for yourself.

My criticism of Mr. Batlle was that the citizens of Puerto Rico were getting very little benefit from the government’s auction of a 40 year concession to the Luis Munoz Marin International Airport (LMM). But as I delved further, the situation became much more troubling than I had thought. It appears that Mr. Batlle and Puerto Rico are desperate to raise funds to pay down their massive debt load. Here is what Batlle said at the Bloomberg conference about leasing the LMM (from the transcript):

BATTLE [sic]: So we – for that we need to – I mean, we have I guess many people here know Puerto Rico’s situation in terms of her high debt load. So we have to tackle the issue and we have to start lowering our debt load.

[Former Washington, D.C. Mayor Anthony Williams]: Right.

BATTLE: So we’re using most of the money, and we did it the same with the toll road -


BATTLE: – we use most of the money to pay down debt.

The Puerto Rico Port Authority, which includes LMM airport, raised $669 million in bonds on December 16, 2011, and warned investors that the LMM lease arrangement must be completed. The Official Statement (page 5) warned investors that unless the deal to lease LMM were complete, then the Government Development Bank (GDB) would have to make principal and interest payments on the LMM bonds under GDB’s Letter of Credit.

CDS in muniland – There is no “there” there


Kamakura Corporation, a risk management firm in Honolulu, Hawaii, has updated their analysis of the volume of trading in municipal credit default swaps (CDS). Here is what they say:

On January 11, 2012, we looked at weekly credit default swap trading volume for subsovereigns and municipals among 1,090 90 reference names that had traded in the 77 weeks ended December 30, 2011.  We found, unfortunately, that (in the words of Gertrude Stein) “there is no there there.” In this blog,  we update our CDS volume analysis for subsovereigns and municipals for the 103 weeks ended June 29, 2012. Alas, our conclusion is unchanged.

Kamakura documents that there is very little volume in muni CDS trading, and most of it is done between dealers. Essentially it’s an artificial market with very few trades outside the dealer community.  Kamakura, in their analysis, strips away the trades that dealers are doing between themselves:

A new push for transparency in muniland

SEC Commissioner Elisse Walter spoke at the SIFMA Municipal Bond Summit yesterday, and her message came across loud and clear. She said that despite enormous advances in technology, decentralized muniland trading is still too hard to understand from the outside. She said that although 75% of municipal bonds are held by retail investors through direct ownership, money market funds, mutual funds and closed end funds, retail investors are still “afforded second class treatment.”

Walter led a two-year effort to assess the hurdles that retail investors face in the municipal bond market. The SEC held three field hearings on the municipal market over the last two years, and Walter said one thing that struck her were the retail investors who said that they couldn’t get pricing for their municipal bonds. Walter seems dedicated to fixing that problem. Transparent bond pricing – the bedrock of a stable and fair market – has been unavailable to investors for decades in muniland.

Walter’s statements echoed the findings of the SEC muni report (summarized by the law firm Bingham):

What are muniland’s biggest players?

The retail investor is king in muniland, holding about $1.81 trillion of municipal securities in the second quarter of 2012, according to the Federal Reserve Flow of Funds report. But where are the other big players in the municipal bond market, and what are their investment objectives? Here’s a quick rundown of the different parts of the financial business that held $1.789 trillion in muni bonds in the second quarter of this year.

Securities dealers

Big bank dealers like Citi, JP Morgan Chase, Bank of America Merrill Lynch, Morgan Stanley and Goldman Sachs held a relatively small amount of municipal bonds this year, with $31 billion in the second quarter. But they play an outsized role in muniland. The dealer banks underwrite a vast majority of new municipal bonds, they write derivative contracts to municipal issuers and they control the flow of trading between market participants. Their basic advantage comes from knowing who bought bonds in the underwriting process, and who might be willing to trade old bonds out for new ones. Bank dealers hold their bonds typically as trading inventory. Securities dealers have decreased their holdings, down from $51 billion in 2006.

Government-Sponsored Enterprises (GSEs)

The GSEs held a tiny amount of municipal bonds, $19 billion in the second quarter. This number only seems tiny because the bonds somehow snuck onto the $6.351 trillion portfolios of GSEs. It makes me wonder if some traders there just made a mistake when choosing which bonds to buy.

Muniland’s sour fraudster

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.

As trading activity declines, new routes to liquidity emerge

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:

Do muniland’s flare-ups signal a bigger fire?

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.”

Leverett’s commendable municipal bond issue

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.

Muniland retail bond buying is getting more attention

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.

Winners and losers in a hot municipal market

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.

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