Date: 1/31/2011
Author: Charlie Paviolitis, Vice President, Municipal Bond Trading, Incapital LLC

A Trader's Perspective on the Muni Market

With all of the talk and concern about the current municipal bond market, it makes sense to take a look back in time and put some things in perspective.

Over a long career, I have been witness to a wide array of market events that have shocked the muni market. Here's a partial list: the near-collapse of New York City in the 1970s, a 21.25% federal funds rate, the attempted assassination of President Reagan in 1981, Bob Packwood's infamous "no more tax-exempts," the stock market meltdown of 1987, Desert Storm in 1991, Steve Forbes' flat tax proposal, the Internet bubble, the Sept. 11 attacks, the second Gulf War, the housing-credit bubble and contraction ... and now, the "Muni Crisis."

Munis survived all of those events, although not always gracefully or without market disruption.

The key element in addressing each "crisis" was a clear understanding by market participants, both buyers and sellers, that there is a binding contract on the part of the municipal issuing entity to pay bondholders their interest and principal when it came due. 

Since 1977, when I first came into the municipal arena, the volume of new issues coming to market has grown dramatically. During this 35-year period, there has only been one major bond default: the debt issued  for nuclear units 4 and 5 by the Washington Public Power Supply System, or WPPSS - infamously pronounced Whoops!

Of course, what has evolved is certainly not your grandfather's municipal market. We have seen muni issues involving land deals, amusement parks, golf courses, museums, tobacco settlements, certificates of participation (too many varieties to mention), hospital bonds, airport bonds, and redevelopment agencies. Many of these types of issuers were able to get the "monoline" insurance wrap and thus gain access to the market. We all know now that those muni insurance companies were not really monoline companies at all.

Here's the question I ask myself: "Is this the muni market or not?" The answer always comes to me that the real muni market is the one that helps build roads, schools, public transportation, and other essential services like water and sewer. The market has gotten away from itself, and the good munis are being tossed overboard without a lot of common sense being applied. 

Municipal bonds are dependent upon individual investors who invest primarily for safety of principal and a steady income stream. These investors do not time the market. Over the past two months, investors have seen significant losses in their individual muni bond or mutual fund holdings - due in part to pundit hyperbole.

Many causes have been given for this sell-off, but it is primarily fear-motivated selling - fear of losing principal. Selling municipals to go into a money market fund doesn't seem like a wise trade to me, except if investors are solely concerned about protecting their principal.

Recent press accounts have offered few solutions to the current muni "crisis," other than "things will get better." Since hope alone is not a good strategy, I'd like to offer a few suggestions.

The muni underwriting process is cumbersome in its current form. Municipal bond issuance could be streamlined with shelf offerings similar to corporate and government-sponsored enterprise issuers, creating a less expensive and more efficient process. This would mean savings for municipalities and taxpayers, and would create a more transparent market.

Commercial banks should be allowed to invest in municipals without concern for the de minimus rule. In fact, it should be mandatory that commercial banks invest in any deal they underwrite, and not just with their proprietary trading book.

And let's consider the return of industrial developments bonds. These bonds can help cities attract industry with an efficient cost of financing, in lieu of tax credits. This would help promote economic growth while creating jobs and accelerating the return to economic well-being.

A federal insurance wrap for municipals being issued for traditional purposes could be created. The issuer would have to carry an A-rating or better in order to be able to apply for this insurance. These bonds could only be used for new projects - schools, roads, etc. - and not to refund outstanding debt. We could call these new bonds MMAs: Munis Making America. A National Municipal Insurance Agency could help small- to mid-size issuers gain access to the market and expand the muni investor base.

As for the longer-term issue of OPEBs - other post-employment benefits - state and local governments need to come clean. This is a national crisis, not just an isolated state or local one. States and local entities should make public their pension fund performance over the last decade, measured against their ­actuarial assumptions. If their assumptions are erroneous and their performance is below expectations, decisive action must be taken. However, this can not be done easily or quickly - the overhang of potential Chapter 9 filings is too large for the market to handle.

It's in everyone's interest for the current municipal credit crisis to be addressed now by those in the financial industry and our elected leaders. This is not about Wall Street making more money. It is imperative that market participants have faith in the contract municipal issuers have with their investors and their residents. Perception often becomes reality. It's time for the muni market to get real, and leave the perceptions behind.

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