For many months, we at Bernardi Securities have closely followed the issue of municipal securities and their status as a high-quality liquid asset (HQLA) for commercial banks and nonbank systemically important financial institutions, or SIFIs (those with total assets exceeding $250 billion). We have been adjusting our portfolio management strategy somewhat in trying to anticipate a market change and reaction to an implemented, final rule. As you may know, the rule has not yet been finalized and the situation remains fluid (an August 28th letter from Bond Dealers of America, or BDA, on the situation follows).
Proposed HQLA excludes municipal bonds
Earlier this year the Federal Reserve Bank, OCC and FDIC proposed new liquidity requirements consistent with the Basel III liquidity coverage standard. The proposed rule excluded municipal bonds from qualifying as a HQLA, which would be a negative demand factor for the market.
Regulators proposed three classes of HQLA:
- Level 1. Sovereign securities, including U.S. government securities and U.S. guaranteed securities. These assets are not subject to a haircut.
- Level 2A. Securities issued by U.S, government sponsored enterprises and specific other sovereign entities (Fannie Mae, Freddie Mac, as examples). Assets subject to 15% haircut.
- Level 2B. Investment grade corporate debt having certain characteristics and equities in the Standard and Poor’s 500 Index. Assets subject to a 50% haircut.
Level 2 assets are limited to 40% of coverage requirement and Level 2B assets cannot exceed 15% of the total.
The proposed rule seeks to include qualifying assets that can be liquidated quickly in large amounts with little impact on prices.
Bond Dealers of America has been an active participant in the ongoing discussion with regulators and elected officials since the rule was proposed. I sit on the municipal bond technical committee of BDA and have contributed a bit to this effort.
Here are some additional facts and my thoughts on the issue as it has developed over the past 7-8 months.
Rash of selling by affected banks unlikely
U.S. commercial banks hold approximately $425 billion worth of municipal securities. Bank demand has been very strong over the last 4-5 years, increasing municipal holdings 60-70%. This has helped to keep prices up and yields low. $425 billion represents approximately 10%-12% of the total municipal market. Strong bank profitability and weak loan demand were important contributing factors to this increase in bank holdings.
A good portion of this $425 billion is held by commercial banks not subject to the proposed rule. As long as these institutions remain profitable, they will continue to hold most of their current positions. We believe that profitable banks subject to Basel III should also continue to hold significant positions in municipal securities, especially if loan demand remains tepid. The after-tax yield advantage produced by current municipal bond returns versus comparable high-quality taxable securities (given a near zero cost of deposits) for these banks will be difficult to let go.
While bank participation in the market is significant and important, we do not foresee a rash of selling by affected banks in the near term. Longer term, we do expect certain, affected banks to pare holdings as time passes. Everything else being equal, less demand will cause prices to fall, and yields to increase. In a normal functioning market, any such paring activity should be absorbed by other investors given the current out of balance dynamic between supply and demand without driving prices down significantly.
Lower volume should offset possible price declines
Keeping in mind new issuance volume of municipal bonds declined 10%-15% in 2013, and that 2014 volume is shaping up similarly, this dynamic will partially offset declining prices from a rash of bank selling, if such activity were to occur. We do not foresee significant increases in new issuance volume in the next year or two.
We disagree on municipal bond illiquidity
We disagree that certain municipal bonds are not readily marketable. It is generally true that an individual municipal bond CUSIP has a low daily trading volume, but this does not mean necessarily a security is illiquid. General market, recognizable bonds of the same issuer, but with different maturities generally trade in tandem with multiple market participants willing to make a market in these securities. It is these issuers that should be recognized as HQLA, in our view. As an example, a State of Virginia General Obligation bond due in one to five years is a highly liquid investment — certainly comparable to many, if not most, Level 2B assets allowed under the proposed rule.
Undoubtedly, certain municipal bonds are less liquid than the proposed allowable Level 1 and 2 assets. We understand what these are and manage a portfolio accordingly. Municipal bond investment products that hold dominant positions in these issues/sectors are, in particular, potentially vulnerable to a market sell-off resulting from HQLA induced selling by banks. This type of forced selling, if it occurs, will present an attractive investment opportunity for us and our clients for a period of time.
Liquidity case in point — 2009-2009 financial crisis
Our most recent — and best — experience with municipal bond market liquidity occurred in Q4 2008 and throughout much of 2009. During this tumultuous trading period, historical trading charts show that spreads of high-grade municipal securities remained fairly steady unlike the spreads of many “AA” rated corporate issues.
Additionally, some of our clients called us during this period requesting partial portfolio liquidations to raise capital to meet margin calls, hedge fund capital calls, etc. I do not recall one instance where raising the required capital by selling municipal holdings was problematical or unduly costly to the client. Make no mistake, the process was not always an easy one during this period. But it was efficient, timely and fair to our investor clients because the portfolios were constructed with sufficient, liquid options. Our separate account strategy of investing in quality, fixed maturity, fixed coupon issues was greatly responsible for this. I do not see HQLA rule passage alone altering this dynamic.
I hope this is helpful. Keep in mind that there may be last minute amendments to the proposed rule. Please share with your colleagues and clients, and call me with any questions.
Ronald P. Bernardi
President and CEO
September 2, 2014
BDA Contacts Regulators:
Urges Inclusion of Municipal Securities as High Quality Liquid Assets
U.S. Regulators are expected to vote September 3, on a proposal which would require banks to hold enough liquid assets in order to fund their operations for 30 days if other funding is not available. Under the proposal, municipal securities would not count as a High Quality Liquid Asset (HQLA).
We are learning of new reports which indicate the Federal Reserve may be changing its mind about this decision. Specifically, according to an article in today’s Wall Street Journal here, “The Federal Reserve, under pressure from lawmakers and state officials, is considering allowing banks to use certain types of municipal debt to satisfy a new postcrisis financing rule, according to a person familiar with the process.” However, according to the article, “It is unclear if the Fed could act unilaterally to alter the rules, which are being written jointly with the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency.”
Just today, the BDA contacted individuals at the Federal Reserve and FDIC’s Board of Directors to express our continued desire to have municipal securities included as high quality liquid assets. Our outreach included a request to consider the the merit of including municipal securities as HQLA, as well as the impact on state and local governments should municipal bonds fail to be classified as HQLA or to otherwise oppose the proposal in its current form.
Earlier this year, the BDA comments on this issue, which you can find here. Specifically, our comment letter focused on:
- The strong performance of highly-rated municipal bonds in times of market stress.
- That the proposed rulemaking gives a cursory dismissal of the marketability of securities that are the building block of U.S. infrastructure and for which there is strong demand from investors seeking a stable and well-understood form of domestic investment.
- A request that municipal bonds merit examination for potential HQLA qualification, just as foreign sovereign state obligations can be determined to meet the HQLA criteria.
We will continue to work with other interested trade groups similarly positioned on this topic and will keep you updated with any new developments regarding the Federal Reserve’s potential consideration of including municipal securities as HQLA.
We hope this information is helpful. Feel free to contact the BDA with any questions.