Time to cry UNCLE!!

After almost 35 years of effort by the federal government, it may be time for the municipal bond market to cry uncle and give up the “benefit” of tax-exempt status on municipal bonds. Since 1974, the federal government has been placing a stronger and more vicious stranglehold on the muni market. It appears that the government’s long quest for the holy grail of no tax-exempt bond issues may be close at hand.

Recently, the United States Supreme Court held that the state of Kentucky could tax the interest paid by another state to a Kentucky resident. According to the Court, such taxation does not run afoul of the “Commerce Clause” of the U.S. Constitution. While this decision may be seen as a victory for Kentucky, it realistically should be viewed as a substantial setback for the proponents of maintaining the tax-exempt interest on municipal bonds.The Opinion is here.

Between the chipping away at the municipal market by the government through the operation of the arbitrage regulations and the self-destruct mode the muni market has been in for the last few years, it really is just a matter of time before all municipalities lose the right to sell tax-exempt bonds.

While this may be greeted with glee from some parties, Joe Mysak, Bloomberg, the halls of Congress and the SEC, we taxpayers will wind up shouldering most of the cost.

At this time, the spread between municipal and corporate rates is about 1%. In percentage terms, municipal rates are about 81% of AAA corporate rates. With approximately $200 billion in municipal debt being issued this year, the increase in borrowing costs will be about $2 billion annually.

But rather than trying to defend and keep the tax-exempt status, the municipal market would be well served to attempt to fashion a plan whereby they give up exempt status in return for other items.

For example, the elimination of the arbitrage regulations could be first on the list to be eliminated. It has been estimated that the costs of compliance with these regulations costs the tax-exempt market approximately $600 million a year.

Next, the federal government should be willing to eliminate its own tax-exempt status on the bonds it sells. Currently, municipalities cannot tax the interest on US government bonds; imposing an effective 5% rate on the interest paid on those bonds could generate almost a billion dollars per year. And that amount is only going up as the growth in federal borrowing exceeds the growth in municipal borrowing.

Lastly, eliminating the tax-exempt status of municipal bonds would open a huge new market of investors. Pension funds, IRA’s, Keogh’s, and other tax-exempt investors would all now be attracted to municipal bonds. The increase of efficiency and tradability in the market would assist municipalities in the issuance of their bonds.

Borrowing Costs

Recently, a lot of attention has been placed upon the borrowing costs of municipalities. Congressman Barney Frank has held hearings and has threatened the rating agencies, attempting to cajole them into rating municipal bonds on the same plane as corporate bonds.

At the same time, California State Treasurer Bill Lockyer has stated a campaign to have that state start its own insurance program to insure municipal bonds issued by California municipalities. His analysis suggests that municipal borrowing costs could be reduced if the state operated its own insurance program.

It is very easy to fall into the trap of more government oversight and government sponsored enterprises will benefit the taxpayer. But the facts make one question whether these efforts are really sound.

According to data published by the Federal Reserve, from 1977 until 1986, the yield of the Bond Buyer index averaged 76% of the yield of "AAA" Corporate bonds. The range was 64% to 92%.

After the tax reform act of 1986 reduced marginal tax rates, the average from 1987 until June of 1993 was 79% with a high of 90% and a low of 72%.

In June of 1993, the Internal Revenue Service issued its "Final" Arbitrage Regulations. Even that did not materially change the spreads. From June of 1993 until the end of 2003, municipal yields averaged 77% of "AAA" corporate with a maximum of 88% and a minimum of 70%.

Since 2003, the average spread has been 81% with a maximum of 91% and a minimum of 76%. It does seem that the level has risen but not markedly so.

Proposals to "fix" the municipal market have been around for decades. Fortunately, most of them have not been put in place. And I seriously question whether more government programs will materially affect the municipal borrower's cost of funds. The "AAA" corporate and the Bond Buyer yield spreads have been among the most stable and consistent over the last 40 years.

Be careful not to fix something that is not broken.

JP Morgan's Wells Notice

Recently JP Morgan has received a Wells notice from the Securities Exchange Commission. A Well's notice is official notification that regulatory action is being considered. But what's interesting about this is there is some question whether the SEC actually has jurisdiction for the action it is considering.

 

The SEC has the responsibility to insure the effective and honest operation of the securities markets. Their primary jurisdiction is contained in the US Code at Title 15 Sections 77q(a) and 78j(b) and Rule 10b-5. It is a well settle point of law that fraudulent activity under these sections must happen in the "offer, purchase or sale" of a security. The problem the SEC has is that the security owned by the municipalities was sold to them at market value pursuant to the government's own regulations.

 

It is possible for the Commission to claim that if Morgan violated the bidding procedure detailed in the arbitrage regulations (see the following post), that the market value of the derivative in question was misrepresented. But first, the SEC would have to show what the correct market value should have been and how Morgan's alleged misbehavior caused the market value to be misrepresented.

 

It appears that the jurisdiction for this case may not rest with the SEC. The crux of the government's argument is that Morgan may not have followed bidding procedure, not that the derivative was sold at other than market value. The IRS may have a claim against Morgan, because Morgan's actions may have cost the government some measure of arbitrage profit, but that is a claim not involving the SEC. What should not be forgotten is that the owner of the derivative, the municipality, probably acquired the derivative at fair market value.

Bid Rigging Lawsuits

On April 24, 2008, the City of Oakland California instituted a class action lawsuit against many of the largest financial firms in the country. The list of those sued reads like a Who’s Who of finance. Bank of America, Wachovia, J.P. Morgan Chase, Bear Stearns, AIG Financial Products Corp., Merrill Lynch, Morgan Stanley, Société Générale and UBS among others were alleged to have conspired to fix the prices of guaranteed investment contracts. A copy of the complaint can be found at: http://www.lieffcabraser.com/pdf/20080400-gic-complaint.pdf

This lawsuit follows right behind another suit against essentially the same parties, but filed by Fairfax County Virginia, City of Chicago, State of Mississippi and others also alleging the financial firms of conspiring to fix the price of derivatives sold to the municipalities.

What appears to be missing from both suits is any allegation that any of the municipalities actually lost money due to the alleged misbehavior of the financial institutions. Sure there are allegations that the institutions conspired to fix the prices of the derivatives, but neither complaint states how this harmed the municipalities. To understand this, you must have an understanding of the IRS arbitrage regulations. The easiest way to understand this is through an example.

Assume that the City of Chicago borrowed funds in the tax exempt market at 1% on $100 million for a year. These suits would have us believe that if the financial institutions had not conspired, the earnings on the investments would have been higher, producing an increase in earnings. In fact, that could not happen.

Assume that the free market yield of the derivatives would have been 3% and that through the conspiracy the actual yield was reduced to 1.5%. Through the operation of the arbitrage regulations, the City of Chicago must pay to the IRS $500,000, the profit it earned by investing for a profit. Now assume the market was not fixed and the City was able to invest at 3%. Now they would get to pay the IRS $1,500,000. In other words, the conspiracy, if it existed, did not harm the municipalities that filed the lawsuits.

One would have to question why file the lawsuit. Is it possible the municipalities are attempting to distance themselves from the financial firms that supported them and rush onto the side of the federal government that has instituted an investigation of the municipal market?