Guarantees for Muni Bonds
Timely congressional action could double the infrastructure stimulus.
It's rare for a freshman congressman to introduce financial legislation that could help stop a recession from becoming worse. Yet that could be the result of a bill introduced by Representative Gerald Connolly of Virginia. The "Federal Municipal Bond Marketing Support and Securitization Act of 2009" (H.R. 1669) would charge the U.S. Treasury Department, the Federal Financing Bank (FFB) and the Federal Reserve with responsibility to assure fluid capital markets in the municipal sector. This would provide the necessary authority to guarantee municipal securities or purchase them outright.
If municipal bonds were federally guaranteed, they could be sold immediately at record-low interest rates. That, in turn, could fuel a surge in locally underwritten capital projects that could double or triple the original $120 billion allocated in the ARRTA stimulus act. These lower municipal rates would compliment the 'quantitative easing' initiatives of the Federal Reserve in the private sector. I discussed the potential power of this idea in a previous column urging governors and municipal officials to start planning this kind of initiative, and Representative Connolly has now opened the door for them to get to work on the Hill and at home.
This week, Moody's Investors Service took two actions that could raise the heat for a municipal bond guarantee and re-insurance bill. The ratings service assigned a negative credit outlook to all local governments in a national announcement. Almost simultaneously, Moody's downgraded the credit rating of insurance giant Berkshire Hathaway, which has been one of the few remaining high-grade insurers of municipal bonds, thereby reducing the private sector's capacity for credit enhancements. These actions will likely raise the cost of capital for municipalities and for some, could keep them out of the market.
Here's some background on what you need to know to follow what's going on with the guarantee idea.
What's the FFB? For readers unfamiliar with the Federal Financing Bank, this entity was created by Congress in 1973 and has authority to tap the U.S. Treasury for low-cost money that it can re-lend to federal agencies and instrumentalities and other qualified borrowers. The 1973 statute included provisions for tax-exempt borrowers, so the legal foundations are already available for this legislation to re-open the municipal markets more quickly than a start-up agency could. I give the drafters of this bill an A+ for doing their homework on this.
This entire deal should not be a free ride for municipalities, by the way. The Treasury or the FFB should charge a fair, risk-based fee for the credit guarantee, depending on the creditworthiness of the borrower. To protect federal taxpayers, other reasonable and prudent credit requirements should also be imposed on borrowers.
Congress needs to act quickly. The stimulus effects of state and local government infrastructure projects take months to get underway, as we already know from the original stimulus bill. This bill and others now pending in Congress could have the perverse effect of delaying some bond issues. Many states and localities will be reluctant to sell infrastructure bonds now if they might become guaranteed later. This unfortunate "rational expectations" effect of the legislative process could undermine the current stimulus initiatives. So Congress needs to either pass or kill a bill quickly to eliminate uncertainty in the markets.
Specifics of the Frank bill. House Financial Services Committee chairman Barney Frank is championing a tightly focused bill that would accomplish many of the same objectives as the Connolly bill but in a somewhat different way. Specifically, the separate drafting now underway at chairman Frank's direction would reportedly provide for:
o Federal guarantees for newly issued general obligation bonds used for capital projects. The guarantee would be for the life of the bonds. The Frank plan would cost the municipal G.O. issuer something like 5 basis points (0.05 percent of principal annually) for the first five years and then assess a risk-based fee after that.
o Reinsurance for newly issued tax-exempt bonds of all types.
o Federal Reserve authority to provide a letter-of-credit facility for existing variable rate debt.
One problem with Frank's bill is that it may not be introduced until later this spring at the earliest. That will unduly prolong the uncertainty for prospective issuers. Capital spending by municipalities could be put on hold too long if the committee chairs wait that long. Another potential shortcoming is the draft's breadth -- it needs to include a broader range of municipal securities, as the Connolly bill does. Also, I think we'll find that 5 basis points is really too cheap a premium for lower-rated municipal credits.
Nothing will happen without prompt Treasury action. Connolly's bill simply establishes authority. It does not write any rules or determine any processes. Treasury Secretary Timothy Geithner needs to quickly assemble a team of municipal finance experts to write the regulations to put this authority into action within weeks -- not months -- after Congress enacts a bill. I urge a fast-track regulatory procedure with temporary authority for federal bond guarantees while the full due process of announcement-review-comment-review-adoption is completed. In this financial crisis, delays are far more costly to the national economy than a hasty and possibly mistaken municipal bond guarantee.
State and local government policy organizations, financial advisory professionals and bond attorneys would be well advised to launch a task force to model a recommended regulatory structure to help Treasury hit the ground running. Given the short staffing at Treasury, Geithner's tiny team can use all the help they get right now.
Start with housing. The primary intent of this legislation is to unlock the general municipal bond market so that states, cities, school districts and counties can fund their capital facilities. That is the easiest task ahead. Once a structure and process for guaranteeing those bond issues is agreed upon, that activity will flourish. But that's not the only stimulus this bill can provide.
Connolly's distinctive proposal can have an immediate and positive impact on the housing market. Housing and mortgages are the twin undertow currents in this mega-recession. If housing prices fall below equilibrium levels, many banks will exhaust their remaining capital, and we would then face the potential for actual depression. That is why immediate and multi-pronged action in the mortgage markets is required.
The state and local government housing finance authorities have immense capacity to provide low-cost financing to deserving households seeking to refinance existing mortgages and to purchase new homes. Using the federal guarantees of their tax-exempt bonds for a finite 8- or 12-month period, these housing agencies could obtain the lowest-cost capital available in the country -- if federal and state leaders work together. That means 4 percent mortgage money could be made available to viable, qualified borrowers, including jumbo mortgage holders whose properties are equally illiquid in today's real-estate death spiral.
As recommended in my previous column, the authorizing regulations could step up the borrowers' rate to the current market rates (now 5 percent for conventional, around 6 percent for jumbo loans) after ten years. Taxpayers don't need to subsidize anybody for longer than that. The bill could also authorize a federal subsidy-recapture through a 25 percent capital gains tax or Treasury could require a federal 25 percent profit-sharing lien on homes that benefit from this subsidy, so it's not a giveaway program but rather a genuine partnership. To effectively impact the housing markets, the bill may need to waive the statewide volume caps on private-activity housing bonds.
Require rainy day funds. My second policy pointer is that Congress or the Treasury should require recipients of these guarantees and loans to establish rainy day budget stabilization funds as well as a debt reserve -- once their revenues recover to former pre-recessionary levels. For example, the Treasury or the FFB could require, as any prudent lender or guarantor should, that the borrowers reserve a fraction of future general revenues they receive in excess of prior-peak (e.g., 2007) per capita levels.
The rainy day reserves will provide operating cash in future recessions. The debt reserves will protect taxpayers' interests and could form the base of a future inter-governmental credit facility (as explained below). Financial officials may determine that even higher reserve levels are necessary to absorb an "average" recession based on their historical analysis of local revenue cycles. The point of this exercise is that these reserve funds will protect federal and local taxpayers from future profligacy by state and local politicians who will forget about these loans and guarantees and spend every dime they get in the next economic expansion.
Facing the deepest recession in the past 70 years, public officials at all levels of government must now construct a disciplined countercyclical funding system that helps us avoid resorting to these extraordinary measures every time the economy sneezes. The Governmental Accounting Standards Board has foresightedly paved the way with its recent Statement 54 on financial reporting for rainy day funds and budget stabilization reserves.
Failure to establish or fund a proper rainy day reserve could (1) result in suspension of federal assistance in other programs and (2) accelerate the repayment of any direct loans. These requirements are similar to corporate bond covenants, and the reserve requirements of many municipal revenue bond issues. In addition, a default on this requirement should disqualify the recipient government from receiving similar federal assistance in the future.
Lend less, guarantee more. The Connolly bill provides "Depression insurance" by authorizing the Treasury, FFB and the Fed to make direct loans to state and local governments. I hope we don't need to go that far. The tax-exempt municipal bond industry should thrive on federally guaranteed tax-exempt paper, and I can already see the vast potential for federally guaranteed muni bond mutual funds and investment trusts.
From a taxpayer perspective, it may be less costly to federal taxpayers if certain municipalities sell privately insured bonds to the FFB than through the market for tax-exempt securities. This is a puzzle that the Treasury staff will need to solve when they write their regulations and ground rules, and it can wait a while if necessary. A direct lending facility should be the fifth priority after housing and infrastructure bond guarantees, and establishing a prudent general framework for guaranteeing other municipal bonds and investment pools.
Require private bond insurance before granting federal guarantees. Let's protect the federal taxpayers as much as possible. For high-quality state and municipal bond issuers who sell general obligation bonds with ratings of AAA or AA, the federal guarantees should be sufficiently secured if rainy-day fund requirements are invoked. For revenue bond issues and lower-rated municipal bonds, the feds would be prudent to require the applying government to first obtain private credit enhancements through insurance or other arrangements that bring their credit at least to an AA level. Those who buy AAA insurance should pay a lower fee to the Treasury or FFB than those who come in with AA ratings, to reward better credits. In addition to protecting the interests of the federal taxpayer, this arrangement will also breathe fresh air into the lungs of the troubled bond insurance industry, which could use a solid flow of new underwriting business that is backstopped by Uncle Sam. For more details on this idea, click here.
Establish a sunset date or an "on-off switch." One flaw in the Connolly bill is its open-endedness. There is no sunset provision -- although Congress can shut these facilities off any time through the budget process. However, taxpayers deserve a more definitive structure. Most of these provisions should apply only during recessions or during financial market crises when the muni market is frozen. The federal government should be the guarantor of last resort, not a permanent competitor to private bond insurance during normal markets.
As suggested in my earlier thoughts on rainy day funds, nobody should get to return to these windows if they fail to establish the required reserve funds during periods of economic expansion. One exception: The investment pool guarantees are best managed like an insurance fund on an ongoing basis, so that reserves are built properly during benign periods. Otherwise, the federal guarantees will become unfunded bailouts, if they operate only during the worst of times.
Seed a self-sustaining intergovernmental credit enhancement facility. As noted in a previous column that discussed the NLC-NACo Blue Ribbon Commission's report on Credit Enhancement, any action by the FFB or the Fed to provide the initial guarantees necessary to inaugurate a self-sustaining local government credit enhancement consortium is worth the investment. Such an ongoing facility could provide a permanent solution to this problem so that the feds never again need to play such an extensive role. As noted above, the mandatory bond reserve funds could eventually provide the seed capital for this kind of permanent facility so that states and localities can collectively backstop their own bonds in the future.
Build America Bonds: A double subsidy? Treasury will need to decide how to treat Build America Bonds, which were discussed extensively in my prior column last month. These bonds can receive a 35 percent federal tax credit if issued as taxable securities, and there could be a policy question as to whether they would also be qualified to receive federal repayment guarantees. My view is "yes," because this will reduce borrowing costs for local governments and thus reduce the tax subsidy that Treasury will ultimately pay.
Hidden treasures? Three other aspects of the Connolly bill are worth pointing out. First, the term "municipal security" has a special meaning in federal law. Obligations and issuances of states and local governments are exempt from various federal securities laws, as they are historically viewed as the issue of sovereign states in a federalist system. As now written, the guarantees under this bill could also be extended to such "municipal securities" as state and local government investment pools which combine the working capital and operating cash of municipalities, as well as certain so-called "529" college savings trusts that are operated by the states.
I'm sure that many state treasurers and the thousands of local governments who invest in their pooled funds would appreciate federal guarantees in the future, especially after the run on a large state pool last year and the previous collapse of a similar county fund a decade ago. Private operators of intergovernmental investment pools will be watching this feature closely as well. Hopefully any guarantees and backstops will be granted only to funds that operate within the strict money market mutual fund (SEC Rule 2a-7) rules. Some of the state pools have always been a little loosey-goosey, and I don't see any reason for federal taxpayers to guarantee or backstop a lack of portfolio discipline.
Second, as for 529 plans, it's really not the job of the federal government to provide investment insurance to college savers who put money into portfolios that include stocks, so it will be interesting to see what applications the Congress and the Treasury might consider.
Third, unlike the Frank approach, the Connolly language would include taxable municipal bonds -- which may also warrant having access to federal guarantees. For example, bond attorneys and financial advisers tell me that there are many deals that have a small segment or "tail" of taxable bonds that may remain frozen in the market unless the legislation is broad enough to include them in the guarantee program. In a subsequent column, I will explain how these and other taxable bonds could come into play and make a huge positive difference in the finances of state and local governments and their retirement funds.
Local officials need to get up to speed on the importance of this bill and others that will follow, and start contacting their representatives and senators. Supporting the Connolly bill out of the gate is an important first step and will help raise visibility of this issue. Most Americans will have no idea what this legislation really means to them, so the personal calls from elected officials to the congressional offices are absolutely essential here. Local officials need to cite specific projects and actual dollar amounts they would expect to fund with federal guarantees, and the cost savings they would enjoy over the life of the bond issue. That enables each member of Congress to fathom the magnitude of the funding logjam they can help clean up. State municipal and professional associations should start collecting this data immediately to buttress their pitches to congressional offices.
There is immense potential here. But the devil will be in the details, which is why the wordsmithing and technical lobbying at Treasury will be intense and why Congress should not get mired down in details. Any oversight that the joint finance committees wish to require seems reasonable in this case, as long as they don't get in the way of putting state and local governments and especially the housing authorities back to work before summer ends.
Savvy Washington insiders handicap Connolly's bill as an "also ran," suggesting that his bill will eventually be subsumed into other bills sponsored by more-powerful members of Congress, such as House Financial Services chairman Barney Frank and Ways and Means Chairman Charles Rangel. So let's not fixate the particulars of Connolly's bill as much as its direction and the attention this issue needs to draw on Capitol Hill in order to pass. For a copy of the full text, click here.
A tip of the hat to Congressman Connolly and the House financial services committee staff for their technical work and breadth of thinking. You're off to a great start, regardless of whose bill ultimately prevails. For once, state and local government leaders can feel that somebody in Washington really understands their world.