Relevance to Today's Economy

A response to Congressman Barney Frank's recent call for greater regulation of the rating agencies is posted in the analysis section. 

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Recent Events in Municipal Finance

The proceeding are articles collected from around the country highlighting key issues and trends in contemporary municipal bond markets.

Index
2008: March || February || January

"Auction Supply `Tsunami' Portends Municipal Losses," Bloomberg, Michael McDonald, March 3, 2008

U.S. states and local governments may extend the worst slump in municipal bonds on record as they replace as much as $166 billion of auction-rate securities. California, Boston's biggest hospital and Duke Energy Corp. are converting bonds to other types of tax-exempt debt after auction failures drove rates as high as 20 percent. The potential supply equals almost 40 percent of the municipal securities sold last year, overwhelming a market that tumbled 4.9 percent last month, according to indexes maintained by Merrill Lynch & Co., which began compiling market data in 1989.

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"Jefferson County, Alabama ignored boring-is-best rule of bonds," The Birmingham News, Jerry Underwood, Sunday, March 02, 2008

There is a reason municipal finance is supposed to be a snooze. The financial crisis that's bringing Jefferson County to its knees illustrates why that has long been the rule. County governments are supposed to issue boring, plain-vanilla bonds. They're not exciting but at least you know how much you owe and when those payments are due. Plus, it's never a good idea to pile on any more debt that you have to, because you just never know what treacherous curve lurks just around the corner.

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"The Overnight Report: Muni Market Meltdown," Greg Peel, FN Arena News, March 01, 2008

Up by the stairs and down by the elevator - after a week of tentative gains Wall Street gave it all back on Friday as a wave of bad news hit the markets. If you want to make it sound really disastrous, it was the worst leap day on Wall Street since the nineteenth century, but in nominal terms that 's a bit sensationalist. Friday saw a meltdown in the municipal bond market. The subprime mortgage crisis which the bulls called a storm in a tea cup last July has spread from CDOs into all asset-backed securities, private equity debt, all non-prime mortgages, corporate debt, credit default securities, bond insurance, and now municipal bonds. There are trillions of dollars of municipal bonds on issue in the US, and the asset class is considered in many cases to be second only to US Treasuries in terms of capital security.

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"Goldman, Bear Stearns Bankers Targeted in Muni Criminal Probe,"
By Martin Z. Braun and William Selway, Bloomberg.com, February 29, 2008.

Feb. 29 (Bloomberg) -- Goldman Sachs Group Inc. and Bear Stearns Cos. bankers are under investigation in the U.S. Justice Department's criminal probe of the municipal derivatives business, regulatory documents show. Bear Stearns's Stephen Salvadore and former JPMorgan Chase & Co. banker James Hertz are targets of the antitrust investigation of Wall Street's sales of derivatives and investment contracts to state and local governments, Financial Industry Regulatory Authority records show. Goldman's Shlomi Raz also disclosed to Finra that he is being investigated, without saying whether he is a target.

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"Ex-Piper exec target of federal probe," Star Tribune, February 29, 2008

A former Piper Jaffray executive, as well as other investment bankers around the country, are targets of a two-year federal investigation of collusion in the municipal bond market. Minneapolis-based Piper Jaffray disclosed Thursday that it has received demands for information from the Securities and Exchange Commission (SEC) and the antitrust division of the U.S. Department of Justice in connection with an industrywide investigation of anticompetitive practices involving the sales of investment contracts and securities that local governments buy using the proceeds of bond sales.

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"Wachovia employees targeted in muni bond probe," Birmingham Business Journal, Thursday, February 28, 2008

The U.S. Department of Justice is investigating two Wachovia Corp. employees for improper conduct as part of the agency's investigation into competitive-bid practices in the municipal bond market. In its annual report, Wachovia (NYSE: WB) disclosed it has received subpoenas from the DOJ and the U.S. Securities and Exchange Commission seeking documents and information from its municipal derivatives group. The two agencies told Wachovia they believe the employees engaged in improper conduct in the bond market.

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"Wachovia, Deutsche Bank Employees Targeted in Probe (Update1)," Martin Z. Braun, Bloomberg.com, February 28, 2008

Feb. 28 (Bloomberg) -- A senior Deutsche Bank AG banker and employees at two other firms were notified by the U.S. Justice Department that they are targets in a municipal bid-rigging probe. Patrick Marsh, head of municipal structuring at Deutsche Bank, Germany's biggest bank, disclosed in employment records filed with U.S. regulators that he is a target of the criminal antitrust investigation. Wachovia Corp. and Piper Jaffray Cos. also disclosed in regulatory filings today that they had employees targeted in the investigation.

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"VRDOs Spell More Trouble For Banks," Forbes, Liz Moyer, February 28, 2008

Yes, we've heard all about the problems in the mortgage derivatives markets, with the bond insurers, and in an arcane and little understood corner of the debt markets: auction rate securities. But a form of municipal money market security called the variable rate demand obligation (VRDO) and related tender option bonds and Dutch auction structure securities are also wrecking havoc.

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Swap Market Is No Place for School Districts to Play," Bloomberg, Commentary by Joe Mysak, February 5, 2008.

Feb. 5 (Bloomberg) -- Whoever thought it was a good idea to allow all municipalities to engage in interest-rate swaps and derivatives? The Pennsylvania legislature, for one. In 2003, the state enacted a law giving its municipalities the power to use swaps, as long as they hired an independent financial adviser to help them figure the transactions out. The bill was passed 197-0 in the House and 45-0 in the Senate, and was signed by Governor Edward Rendell.

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Analysis of Issues in Municipal Finance

THE FRUITS OF REGULATION

AND WHAT CAN BE DONE TO PREVENT IT

             Municipalities use the bond market to get the funds needed to construct schools, hospitals, roads and sewer systems. Basically, any infrastructure in use today was funded with the proceeds of municipal bonds. From the beginning of modern finance in the 1930’s until the middle of the 1990’s, this market was very efficient and the issuers very conservative. But something happened.

             Suddenly in February of 2008, the municipal bond market went from being in the dust bin of the financial system to center stage in a financial crisis. Insurance companies that had insured the municipal bonds were on the verge of collapse because of poor business decisions; structured financial products like those sold by municipalities were shunned by investors; various municipalities had entered derivative transactions ill advisedly; and the risk premium investors demanded skyrocketed.

             Among the few national figures addressing the crisis in the municipal bond market is Congressman Barney Frank (MA-D), Chairman of the House Financial Services Committee. Congressman Frank recently stated his desire to reform the manner in which the firms that rate municipal bonds such as Moody’s apply their standards. Congressman Frank has given the rating agencies thirty days to “fix” the standards they use and threatened federal intervention if the standards are not changed. Speaking on March 20, Frank voiced his desire to see stronger government regulation of these markets and even proposed a federal agency to monitor financial market risks.

             While Congressman Frank’s intentions are well meant, they may make a bad situation even worse. The rating agencies admit that there is a double standard for rating bond issues, one for corporate and another for municipal. It has been claimed that if the municipal issuers were rated on the same scale as the corporate issuers, they would mostly have a rating of at least “A” in their own right, with most qualifying for a much higher rating. With a higher natural rating, most issuers would not buy bond insurance, theoretically saving money. But that is not the problem. A change in rating system will not guarantee a reduction in the rate municipalities will have to pay on their bonds.

             Investors act to minimize risk and maximize the return. This is the basic truism of portfolio management, managing the risk-return trade-off. It is through this process that the cost of money is determined. But the government has interfered with this process. That interference has created an element of risk both for the investor as well as the issuer. That risk has led to the growth of the municipal bond insurance companies.

             In 1986, the percentage of municipal bonds insured was about 16%. Then the federal government passed the Tax Reform Act of 1986 which imposed substantial restrictions on municipal bond issuers.

             Between 1987 and 1993, municipalities responded to pressures in the market and substantially increase the percentage of bonds they insured, from 16% to about 34%. Then the IRS introduced the 1993 Final Arbitrage Regulations which markedly increased the risks associated with issuing and purchasing municipal bonds.

             The measures imposed by the new regulations were harsh and compliance difficult. Municipal bond investors never knew if their bonds may be declared taxable. Issuers never knew if the interest they earned and sent to the IRS was enough to pass an audit. Failure to pass an audit results in a demand for money from the IRS, while failure to pay results in the municipal bond issue being declared taxable by the Service. Since the introduction of the Final Arbitrage Regulations, the percentage of municipal bonds insured has climbed steadily to 50% today.

             Enforcement of the Arbitrage Regulations is done by the Tax Exempt Bond Division. TEB, as it is known, produces approximately $100 million per year in enforcement, taking funds from the municipalities, for a cost of about $250 million per year in the IRS budget.

             Assume it costs the municipalities $250 million per year to comply with the regulations, the same as its costs to enforce them. When added to the IRS imposed audit charges, municipalities are spending about $350 million per year. The total costs of the Arbitrage Regulations, both enforcement and compliance, are therefore approximately $600 million. For comparison, Moody’s fee income for rating municipal bonds is $86 million.

             Even if the rating agencies change their model as Mr. Frank requests and all the municipal issuers rated at least “AA”, without reform at the federal level, there will be no savings. The risks will continue.

             If Congressman Frank is really interested in saving money he ought to investigate the revocation or substantial revision of the arbitrage regulations. Moreover, if Congressman Frank or any other Congressman is interested in alleviating the financial burden on the taxpayers, unnecessary and burdensome regulations like these must be rewritten.

 

 

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