MuniLand

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.

In addition to overseeing municipal advisors Congress expanded the authority for the MSRB by adding oversight for the protection of state and local government issuers, public pension plans and others whose credit stands behind municipal bonds, in addition to protecting investors and the public interest.

Until Congress redefined the MSRB’s mission it was generally oriented to the interests of banks and securities dealers. One of the biggest changes for MSRB is the composition of its board of directors and it’s new emphasis on public representation.

Unsurprisingly SIFMA, the trade association for bank dealers, is complaining to the MSRB about the composition of the new board presumably because they have lost a power. In a comment letter SIFMA’s co-head of municipal securities, Michael Decker, argues that expanding the MSRB board from 15 to 21 would be too costly and that there is no rational for creating a 30% minimum representation of muni advisors for the non-public board members. This overlooks the recent predatory behavior of bank dealers who wrote inappropriate municipal derivatives and the need for their influence in rulemaking to be diminished.

I’m all in favor of higher costs for the additional public members and muni advisors serving on the MSRB. State and local governments must be protected from Wall Street. In the aftermath of the greatest financial crisis since the Great Depression Wall Street dealers must be aggressively regulated and now the MSRB seems to have adequate force to do it.

Where are muniland’s cross-over buyers?

It’s an odd moment in muniland. There is an irregularity in the pricing of municipal bonds. Generally muni bonds have a lower yield than U.S. Treasuries because munis give investors a tax advantage. Investors use them to shield their investment income since coupon payments on municipal bonds from their state of residence are generally triple-tax-free — that is, they are not taxed at the local, state or federal level.

In this Bloomberg video Timothy Pynchon, a portfolio manager at Pioneer Investment Management, talks about how 30-year muni bonds are trading at 105 percent of the value of the 30-year Treasury. These bonds would usually trade at less than 100 percent of Treasuries because of their tax advantages.  This is a very unusual situation and would usually attract so-called “cross-over” buyers from other parts of the bond market. In the video, Cumberland Advisors’ David Kotok suggests that since U.S. Treasuries are mispriced (too expensive with low yields as a result of a flight to quality) it’s having a carry-over effect for long-dated municipal bonds. Basically the long end of the municipal bond market has moved away from its normal pricing relationships and is cheap relative to Treasuries.

Further:

Bloomberg: Colorado Refunds Transport Debt as Yield at Lowest Since 1994: Muni Credit

Bond Buyer: Muni Funds See Outflows for Fifth Straight Week

“What we had here was a wholly corrupt situation”

Wall Street’s deepest muniland fear

Wall Street’s deepest muniland fear

Although credit rating downgrades for municipal bonds are grabbing the headlines, that is not a real worry for Wall Street. Underwriters and traders are used to adjusting their models and formulas for changes in ratings and interest rates; after all, they are extremely skilled at that. However, forces are taking aim at the way they are compensated, and that is Wall Street’s deepest muniland fear. It’s all about how they are paid to underwrite municipal bonds, and the state of Maine is leading the charge.

When states or municipalities issue bonds they use Wall Street banks to underwrite them. Wall Street banks or dealers either compete against each other for these mandates in a competitive process or one bank or dealer privately negotiates the terms of the bond offering with the issuer. A privately negotiated underwriting happens in approximately 80% of municipal bond deals. This often costs municipalities and states more in fees. Bloomberg has an outstanding piece about how the state of Maine is choosing the competitive style of bond underwriting and the political struggle that happened to get there:

Banks promote negotiated sales as letting them offer the lowest cost by tailoring the debt to specific types of investors. Yet academic studies of the municipal market show such sales often raise costs by as much as $4.80 on every $1,000 borrowed, according to Mark D. Robbins and Bill Simonsen of the University of Connecticut in West Hartford.

$4.80 extra in issuing costs across the $4 trillion muni market equals about $19 billion in additional profits for Wall Street. Hmmm… this story is getting really interesting.

Now of course Wall Street will defend this practice, but this quote explaining the practice in the Bloomberg article is very weak. A Wells Fargo muni banker says negotiated sales happen because the issuers want it even though it’s more expensive:

“If you look at the percentages, most are negotiated sales,” [Craig Hrinkevich, a Wells Fargo banker in New York] said about U.S. municipal bond deals in a telephone interview. “That’s not the bank’s preference. That’s the client’s preference.”

Maine will pay an annual average interest rate of 1.9 percent on the bonds it sold competitively, less than the 2.1 percent it would have paid in a negotiated offering, according to the treasurer’s office. By rejecting the offer from Wells Fargo, it saved $1.65 million in interest over 10 years, [Maine Treasurer Bruce] Poliquin said.

“This is Maine,” he said. “That is a lot of money.”

Wall Street drives a truck through mile-wide hole in the rules

The Wall Street Journal and my fellow Reuters blogger Felix Salmon have both addressed the issue of the Bank of New York Mellon giving off-market or false prices on foreign-exchange trades to one of their clients, namely California pension fund Calpers.

Morally the actions of BONY, if true, are reprehensible. But are they illegal?  Felix describes the specific problem:

BNY Mellon’s clients put in FX orders, the bank executed those orders and reported back a price. Only it lied to its clients about the price it was getting, padding its own profits while so doing. This is doubly evil: not only did the bank lie, but it lied while serving as a fiduciary to its clients, with an affirmative duty to give them “best execution.”

Point one: OTC markets are barely regulated

Foreign-exchange trades are conducted “over the counter” (OTC). OTC is basically two parties coming together in some manner and the opposite of an “exchange market” where a multitude of buyers and sellers come together for regulated dealing. For example, exchanges require market-makers to provide certain levels of liquidity, trade reporting and standards of fair dealing.

OTC markets lack these requirements, and regulators have yet to address many of these issues. There are lots of opportunities for custodians or dealers to provide “off-market” or inflated trade prices to clients because trade reporting is not public. Can we blame dealers for driving the truck through a mile-wide hole in the rules?