“In Municipals We Trust?”

Justin Formas, Director of Municipal Credit Research, summarizes the key points of the market update below. For an introduction to Justin Formas, please read the November 2010 President’s Letter. The United States municipal bond market has drawn a great deal of media attention recently, and for good reason. Weakened revenue streams, looming pension problems, historically large operating deficits in states like California and Illinois, and municipal bankruptcy threats – or actual filing in Vallejo, California’s case – have led many analysts to predict that the municipal bond market will be the epicenter of the next financial meltdown. Meanwhile, many industry professionals have countered by highlighting the traditional safety and security municipal bonds have provided over the decades. Regardless of the opinion, the considerable amount of noise has been at best unsettling to the individual municipal investor. Through the second quarter of 2010, individual investors held approximately 36.0% of outstanding municipal securities directly. An additional 33.8% of municipal securities were held indirectly through money market funds, mutual funds, and closed end funds. Take into account that level of individual ownership and it is not surprising to see investors advocating for greater accountability by the municipal market. This paper will focus on recent events that have emphasized the need for greater transparency, while examining the steps the federal government has taken to ensure municipal securities are held to the same disclosure standards as their corporate counterparts. Market growth outpaced disclosure According to the Securities Industry and Financial Markets Association (SIFMA), the size of the United States bond market through the second quarter of 2010 was $35.34 trillion. Municipal bonds accounted for $2.8334 trillion or 8.0% over that time period. All things considered, municipals are a fraction of the U.S. bond market that includes Treasuries ($8.508 trillion), mortgage-related debt ($8.9), and corporate debt ($7.27) totaling 69.8%. However, a closer look reveals interesting facts that clearly show how the bond market growth has outpaced the speed at which municipal disclosure standards have been set. Since 1996, the total US bond market has grown exponentially – increasing 189%. Meanwhile the municipal market has grown 125%. Additionally, there are reports that approximately $5 billion in municipal bonds are in default today. That figure would represent 0.18% of the total municipal market. Following the Great Depression, Congress passed the Securities Act of 1933 and the Securities and Exchange Act of 1934. The laws were enacted in an effort to provide investors with full disclosure regarding offered securities and to create a regulatory entity in the form of the Securities and Exchange Commission (SEC). Interestingly, municipal securities received special exemptions based on a preference to avoid federal and state jurisdictional interference. For the next several decades, debt issued by state and local governments was widely considered to be very low risk. The market consisted primarily of general obligation bonds, which carried a full faith and credit pledge of governmental entities. As a result, disclosure was minimal. The turning point However, with the introduction of new credit pledges, debt structures, and New York City’s financial crisis in the 1970s, municipal disclosure came to the forefront. An SEC investigation into New York City’s disclosure documents concluded that the City’s disclosures did not provide “the measure of disclosure mandated under the federal securities laws in the interests of the investing public” and “although municipalities have certain unique attributes by virtue of their political nature insofar as they are issuers of securities they are subject to the proscription against false and misleading disclosures.” These were important findings as they laid the foundation for one of the SEC’s rare filings against a municipality more than 30 years later. Subsequently in 1975, Congress passed amends to the Securities Exchange Act of 1934, essentially expanding the definition of “person” to include issuers of municipal securities. The amendment also made it clear that municipal entities were NOT exempt from the fraud provisions under prior Securities Acts. As part of the amendments in 1975, Congress established a limited regulatory scheme for municipal securities intermediaries. This included mandatory registration of municipal securities brokers and dealers, and the creation of the Municipal Securities Rulemaking Board (“MSRB”). Furthermore, in what could have been a watershed moment in terms of regulatory authority over issuers of municipal securities, Congress elected to approve Section 15B(d)(1) of the Exchange Act (commonly known as the Tower Amendment, after the late Republican Senator John Tower of Texas). The Tower Amendment specifically prohibits the SEC and the MSRB from requiring any issuer of municipal securities, either directly or indirectly, to make any filings with the Commission or the MSRB prior to the sale of securities. The MSRB was further limited in its ability to require any municipal issuer to furnish it or any purchaser or prospective purchaser with any documents. Fast-forward to 1983, and the $2.45 billion revenue bond default by the Washington Public Power Supply System. This particular default brought about SEC Rule 15c2-12, which requires underwriters participating in primary offerings of municipal securities of $1,000,000 or more to obtain, review, and distribute to investors copies of the issuer’s disclosure documents. The SEC also issued interpretative guidance concerning the due diligence obligations of underwriters of municipal securities. Derivatives lead to a default The municipal market once again evolved in the early 1990s as issuers developed a taste for sophisticated and complex interest rate products to hedge their overall debt portfolios. The most well known instance of municipal default and bankruptcy, Orange County, California’s involvement in the derivatives market caused an estimated loss of $1.7 billion of public funds. Prior to 1994, no major issuer had ever defaulted on a general obligation bond. Also along the lines of municipal derivative transactions gone wrong is Jefferson County, Alabama. Jefferson County had accumulated a municipal debt portfolio of approximately $4.6 billion. Of that amount, $3.2 billion was directly related to the County’s sewer system. The County’s refinancing arranged in 2002 and 2003 by JPMorgan Chase & Co. collapsed in 2008 when companies guaranteeing the floating-rate debt lost their top credit ratings because of losses on unrelated mortgage-backed securities. Interest rates on the sewer bonds rose to as much as 10 percent and derivatives tied to the debt worsened the crisis by further increasing borrowing costs. On March 7, 2008, Jefferson County failed to post $184 million collateral as required under its sewer bond agreements, thereby moving into technical default. Earlier this year, Jefferson County defaulted on $227 million of general-obligation warrants. If Jefferson County files for bankruptcy protection, it will be by far the biggest financial failure of a government entity in U.S. history. Recent municipal disclosure progress During the last few years the MSRB, in concert with the SEC, FINRA, and the Federal Reserve have made strides to improve municipal disclosure. For instance, last year the MSRB became the sole recognized information repository for municipal securities information. The MSRB’s Electronic Municipal Market Access, or EMMA, online repository system has received 126,200 continuing disclosure documents from 7,800 registrants. Of that total, about 85%, or 107,200, were mandatory disclosures. Around 41%, or 51,300, were for bond calls, while 32%, or 40,500, were annual audited financial statements. Roughly 9%, or 11,100, were for rating changes and 5%, or 6,900, were quarterly financial statements. During calendar 2009, the MSRB made more than 15,000 new official statements available to the public, bringing the number of official statements available on EMMA to nearly 300,000. The MSRB also collected data on more than 10 million municipal transactions worth close to $3.8 trillion. During the seven months ended December 31, 2009, the MSRB collected more than 61,000 continuing disclosure documents. However, until recently the historical lack of enforcement has diminished any true ability to adequately hold municipal issuers responsible. Specifically, the Tower Amendments have created a complicated set of disclosure rules without enforcement, as well as regulations that don’t directly address the issuers responsible for the disclosure. Three events show promise of better disclosure While it’s safe to remain fairly skeptical given the progression of municipal disclosures over the last 80 years, three events have occurred that show a modicum of promise. First, in November 2006, the SEC entered an order sanctioning the City of San Diego for committing securities fraud by failing to disclose to the investing public important information about its pension and retiree health care obligations in the sale of its municipal bonds in 2002 and 2003. This was the first time the SEC had ever formally filed charges against a municipality. To settle the action, the City agreed to cease and desist from future securities fraud violations and to retain an independent consultant for three years to foster compliance with its disclosure obligations under the federal securities laws. In formal offering documents, the City failed to inform investors that the City’s unfunded liability to its pension plan was projected to grow from $284 million at the beginning of 2002 to $2 billion by 2009. The City also failed to show that its liability for retiree health care was projected to grow to more than $1 billion. While it could be argued that the punishment doled out did not fit the crime, the SEC’s willingness to even charge a municipality with misleading investors was a milestone in and of itself. In August of 2010, the SEC charged the State of New Jersey with securities fraud. Similar to the San Diego case, the filing related to the State’s claim that it had historically been properly funding and accurately disclosing public employee pensions. The SEC contended that in addition to inadequately funding pension obligations dating back to at least 2001, the State’s disclosure documents omitted certain pieces of information critical to analyzing the pension systems overall financial condition. The SEC settled its suit with New Jersey by issuing a cease-and-desist order. The State accepted the order without admitting or denying the findings and no penalties were imposed. Furthermore, the SEC’s order did not name any individual state officials, nor the bond underwriters or other professionals associated the State’s financial statements and disclosure. Again, it would appear that all parties involved escaped with nothing more than a slap on the wrist, for now. The point here is that the SEC sanctioned a state. The third and most critical step in improving enforcement of municipal securities disclosure made its way into the Restoring American Financial Stability Act of 2010. As part of the 2010 Financial Reform Bill relating to municipal disclosure, section 976 (b)(4) states: “make recommendations relating to disclosure requirements for municipal issuers, including the advisability of the repeal or retention of section 15B(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78o-4(d)), commonly known as the Tower Amendment. As the SEC pointed out in 2009 legislation proposing to repeal the Tower Amendments, the main goals are to gain greater control of municipal accounting standards, enhanced regulation of market intermediaries, and possibly changes to the composition of the MSRB that would make it a more “independent” self-regulator. The importance of issuers increasing the frequency of disseminating timely financial information to the municipal marketplace cannot be underscored. It does appear, in the near term, that many issuers will continue to struggle financially – making better disclosure standards a very high priority in our view. Munis remain attractive – but know thy bonds Municipal bonds will remain an attractive investment for many investors, especially given the probability of higher marginal income tax rates in the years ahead. For investors, the conflict at the center of the argument on whether to improve municipal disclosure comes from the registration exemption granted to municipal securities under the Securities Acts of 1933 and 1934. Historically, most retail and institutional investors have relied on the credit rating agencies and monoline bond insurers to perform the necessary due diligence and provide an adequate level of credit surveillance. As a result of the credit crisis, few monolines exist today and the faith in the rating agencies abilities to adequately represent creditworthiness has been shaken. Earlier this summer, shortly after the Restoring American Financial Stability Act was signed, a very unique thing happened in the marketplace. The credit rating agencies began asking issuers of all types of securities to not list their rating on offering documents for fear it could lead to an influx of lawsuits in the event that security soured. Markets were placed in a holding pattern. Few deals were priced until a resolution was found several days later. Initially, the credit rating agencies included municipal securities in their request, but upon further review came to the conclusion that because municipals are not registered securities under Acts of 1933 and 1934, they would not be exposed to the same legal concerns. This underscores an earlier point on municipal security ownership. It would appear that the government is pushing more responsibility on the investor by weakening third-party research firms and, therefore, it is sensible to make the necessary improvements to transparency and disclosure. The municipal bond marketplace is forever changed and will remain a very challenging financing environment for some time, in our view. The current dynamic underscores our long-held belief in the importance of knowing the underlying credit quality, deal purpose and deal structure of your municipal bond investments. At Bernardi Securities, Inc., our credit research analysts spend hours each week reviewing and updating our research database in these areas. Our experience from decades past tells us that this is still the best practice today and for the decades ahead. We hope you found this commentary helpful and thank you for your continued confidence. Sincerely, Justin Formas, CAIA Director, Municipal Bond Credit Research Department November 11, 2010