When Virginia Beach, Va., went out to the municipal bond market in late April to refinance $52 million in general obligation bonds, finance officials were pleased by the market’s reaction. A record 13 bidders took part, and the city was rewarded with more than $2.4 million in savings. “There were good conditions for a refunding,” says Patricia Phillips, the city’s director of finance.
Of course, Virginia Beach’s top-notch AAA rating did not hurt a bit. With some cities tottering on the brink of bankruptcy because of market turmoil, states arguing with rating agencies about the fairness of their ratings, and even the municipal bond insurers themselves staring at balance sheets replete with over-valued securities, a solid gold rating is needed to receive any respect in a financing world that many have been taking for granted.
In today’s municipal bond market, even Virginia Beach’s high rating has its limits. The city had several other candidates for refunding that it decided to delay for another time. “The market was too choppy,” says Richard Dunford, the city’s debt financial service administrator.
While Virginia Beach has managed to save money in the market, many more cities have not been as fortunate. With borrowers (mostly mutual funds and hedge funds) concerned about the credit markets in general, government offerings have carried a higher interest rate — as compared to U.S. Treasury securities — some of the highest in a decade. Those unwilling to pay the higher rate, like some of the bonds in Virginia Beach, are waiting for market conditions to improve.
Meanwhile, the California Treasurer is arguing that investment ratings from New York-based Moody’s Investors Service and Standard & Poor’s are hurting bond offerings and taxpayers, and the rating methods should change. In addition, subprime mortgage failures and risky investments have called into question the safety net municipal bond insurers offer. The typically calm industry that many were content to leave to the number crunchers has turned rocky, and local governments are holding on for a topsy-turvy ride.
Not worth the cost of paper
It might seem a long way from the wobbly balance sheet of the United Bank of Switzerland or Bear Stearns to a sewer project on Main Street. Yet, the entire subprime mess that has plagued the world since last summer has demonstrated that the credit markets essential for the workings of the world economy are part of a vast global soup. The $2.6 trillion municipal bond market is just part of the mix.
The subprime crisis affects the municipal bond market in several ways. First, the banks that are the first tier of the credit markets are so consumed with the falling value of the mortgage bonds on their books that they are reluctant to lend out money to any borrower, regardless of their creditworthiness. Second, cities and counties with low credit ratings rely on bond insurers to guarantee the payment of the security’s principal when they issue bonds. Though they pay premiums to the insurers, cities and counties can borrow at a lower cost than if they had to rely on their own credit rating. But, the two biggest municipal bond insurers — Ambac Financial Group and MBIA — revealed late last year that their own balance sheets were filled with overvalued securities, and the market grew less certain about whether they could make good on the municipal securities they backed.
Third, local governments that had been wooed by Wall Street with promises that “auction-rate” bonds would cost less than traditional fixed-rate bonds learned that what sounds too good to be true usually is. Auction-rate securities are long-term bonds that are treated as short-term securities because investors sell them at auctions that take place every few weeks, which also resets the interest rate the bonds pay.
With lenders skittish, cities and counties that had relied on weekly auction rates rather than fixed interest rates for their bonds found out why they had been receiving such good news about what they paid on their bonds: They had been taking huge risks. Once the credit markets were frozen, no bankers wanted to bid on the floating rate securities. Unfortunately for the cities and counties that had them, the loans had provisions that if there were no auction-rate borrowers, they were obligated to pay unsustainable rates at two and three times previous levels.
Jefferson County, Ala., which used auction-rate bonds to finance sewer system repairs, is tottering on bankruptcy because its $3.2 billion in sewer bonds are costing far beyond the amount of revenue that could be expected from its user fees. At a minimum, county residents will be paying higher fees for many years to bail out the securities. (In addition, the Securities and Exchange Commission (SEC) sued the mayor of Birmingham, located in Jefferson County, in late April for his cozy relationship with the firm that sold the bonds. He has denied wrongdoing.)
The silver lining
Ironically, the problems of communities like Jefferson County may actually benefit others with sounder investment policies. Huntsville, Ala., about 100 miles north of Birmingham, is cautiously optimistic about its prospects for a bond offering in the fall. With its AA+ rating, the city’s debt always has been attractive, says Randy Taylor, the city’s director of finance. “We may be more so,” he says. “With all of the news about the derivative-related markets, we’re hoping that the market will see us as a safer bet.”
Huntsville goes to the market every three to four years, on a planned schedule. “We’re optimistic that the competition for our securities will be as high as in the past,” Taylor says. “We understand that this is not the best of times. We hope the market improves.”
As finance director, Taylor says the city’s financial disclosure and budgetary prudence are critical, especially in tough market conditions. “We are a transparent organization,” he says. “We exercise prudent, careful management. We have a conservative philosophy at the city.”
Major buyers in the municipal market agree that the market has seen significant turmoil, but that the volatility has not been without rewards for savvy buyers. Michael Pietronico, a veteran municipal bond manager and the chief executive officer for Miller Tabak Asset Management, a New York-based municipal bond adviser, says that the strength of the issuer will be more critical than ever in the marketplace. “From the investor’s point of view, what kind of financial operation they run will determine what kind of interest they will be paying,” he says.
Rebuilding the system
In responding to the unsettled markets, state and federal officials have proposed changes that they argue will improve the bond market’s efficiency. Last July, SEC Chairman Christopher Cox called for Congress to set new disclosure rules for municipal borrowers, saying there is an “urgent need” to improve the information that investors receive. The SEC has been concerned about disclosure because of instances where inadequate information led to defaults, such as in Orange County, Calif.’s bankruptcy in 1994. However, only 0.1 percent of municipal bonds have defaulted since 1970.
Others say that greater SEC regulation is not a panacea. “We advocate for the investor, and we’re always for more disclosure,” Pietronico says. “But, I wouldn’t be too comfortable thinking that the government wouldn’t make a mistake. After all, the subprime situation was a case of too little oversight. The idea that a government agency can handle the books rings hollow when you consider where it’s coming from.”
California Treasurer Bill Lockyer supports another proposal, where the rating agencies treat the municipal market the same way that they review private corporations’ debt. “Under the current system, [ratings are] applied to corporate bonds on one yardstick, but municipal bonds on a very different yardstick,” he wrote in a letter to Moody’s Investors Service. He said treating the two markets with similar ratings would lower interest costs for municipal investors and “enable the market to function more efficiently.”
Moody’s has said that it intends to increase the availability of the corporate rating system for municipal bonds. The other rating agencies are studying the request.
Pietronico notes that the entire rating system has to be considered in light of an arrangement where the issuing municipality pays the agency to rate its bonds. Still, he says there is merit in some of what Lockyer is proposing, but again, the situation should be placed in context. “Municipals are safer than corporates,” Pietronico says. “But when an issuer goes to an agency in an attempt to strong arm them into a higher rating and [the agency submits], it reflects poorly on the agency. And, it could backfire on the issuer.”
That the municipal bond market can be convulsed by events both of its making and beyond its control has to be disturbing to the many staid investors who have relied on its dependability. But, like most bumps in the financial markets, many say the problems will eventually work themselves out. In the interim, cities and counties will have to tread lightly and learn from the mistakes that were made. “The market will snap back,” Pietronico says, “but there’s no question that the subprime problems are weighing heavy on the economy.”
— Robert Barkin is a Bethesda, Md.-based freelance writer.
Supreme Court preserves needed break for local governments
As if the municipal bond market did not have enough worries in 2008, a case before the U.S. Supreme Court threatened to bring debt financing in state and local governments to a complete halt. Fortunately, the court ruled 7-2 in May to keep the world of municipal finance spinning. “The Supreme Court reaffirmed that government’s floating debt securities for public works is a quintessential public function,” says Jeffrey Esser, executive director/CEO of the Chicago-based Government Finance Officers Association (GFOA), a membership organization for public finance officials.
The ruling upholds the tax-free status for state-issued municipal bonds bought by residents of the issuing state. For example, New Yorkers who buy New York City bonds or Californians who buy California bonds do not pay any local or federal taxes on those investments. The state tax exemption for those residents does not apply to out-of-state bonds. Investors who buy out-of-state municipal bonds get federal tax breaks, but no breaks from their states or cities.
A Kentucky investor brought the case, claiming that the state’s decision to tax him for out-of-state bonds was discriminatory. The Supreme Court heard arguments on the case late last year and reached its decision only a few months later. GFOA argued in a brief before the court that small and local governments need intrastate markets because they do not have access to national capital markets that larger issuers do. “The court recognized the effect that a contrary decision would have on small, local governments,” Esser says, adding that the 7-2 decision “doesn’t leave any doubt about the issue.”
— Robert Barkin