Bonds Gone Wild
The financial turmoil that began with
subprime mortgage defaults is also affecting municipal borrowing.
Recent changes include: fewer institutional buyers, loss of triple-A
rated bond insurers, and weakening issuer credit. The credit crunch is
making it difficult for some local governments to obtain borrowed funds. The
difference in yields between non-rated municipal securities and rated
securities is now historically high. Local governments may be left with
a choice to either delay a financing (although there is no assurance
that the market will improve in the foreseeable future) or pay interest
at higher rates than originally budgeted. This paper is intended to help
political subdivisions understand the recent financial turmoil as it
relates to the sale of municipal bonds and lease obligations and
outlines actions that can be taken to improve access to the capital
The following is a timeline of events that
have specifically affected the sale of municipal securities:
1987-2007 – Mortgages are bundled into new
securities called Collateralized Debt Obligations (CDOs) by Drexel
Burnham Lambert in 1987 and over two decades gain in popularity and
volume. During this time another financial product, the municipal
derivative, is also developed. A derivative is an unregulated contract
tied to the value of a securities index or interest rates. Derivatives
produce fees that are often 10 times higher than the underwriting fees
for traditional fixed rate municipal bonds.
February 2007 – New home sales fall sharply;
a 20.1% decline from the prior year.
February 2007 – Assets underlying CDOs begin
May 2007 – New Century Financial, the
largest subprime mortgage company, declares bankruptcy and other
subprime mortgage lenders file for bankruptcy throughout the year.
November 2007 – Bond insurers that insured CDOs begin taking losses due to default exposure.
February 2008 – Several triple-A bond
insurers have their ratings downgraded or are placed on review for
February 2008 – The $330 billion Auction
Rate Securities market collapses.
March 2008 – Financially troubled Bear
Stearns is acquired by JP Morgan. (In 2007, Bear Stearns ranked 3rd
by dollar volume of municipal bond issues completed.)
April 2008 - Jefferson County, Alabama,
declares that it is on the verge of bankruptcy and that $3.2 billion of
sewer debt may go into default. The crisis evolved following the
collapse of auction rate securities and the use of interest rate swaps
which required the County to post $184 million of collateral.
May 2008 – Vallejo, California, with a
population of approximately 117,000 and $200 million of outstanding
debt, files for bankruptcy as a result of rising operating expenses and
declining housing construction.
May 2008 – UBS AG discontinues public
finance operations. (In 2007, UBS AG ranked 4th by dollar
volume of municipal bond issues completed.)
July 2008 – Five of the seven triple-A rated
bond insurers are downgraded due to deteriorating mortgage backed
securities. The remaining two, Assured Guaranty Corp. and Financial
Security Assurance, are placed on negative watch by Moody’s.
September 2008 – Five Wisconsin school
districts report losses of $150 million in connection with derivative
investments and file a lawsuit against the bank and investment bank
that arranged the transaction. The losses evolved from a 2006 post
employment benefit fund program whereby the schools invested $35 million
of their own funds and $165 million of borrowed funds in synthetic
collateralized debt obligations. In addition, other municipal derivative
programs, including interest rate swaps, are resulting in substantial
costs to other issuers throughout the country.
September 2008 – By mid-September, as a
result of regulatory investigations and lawsuits, more than a dozen
banks and investment banks agree to redeem in excess of $65 billion of
Auction Rate Securities and pay more than $500 million in fines.
September 2008 – Securitized investment
holdings, rating downgrades and mortgage loan defaults lead to major
financial institution bankruptcies, liquidations and takeovers. American
International Group (AIG),
which ranked among the top five tax-exempt investors in 2007, files for bankruptcy
and is rescued by the Federal Reserve.
Lehman Brothers goes bankrupt and the brokerage portion of its business
is acquired by Barclays, Wachovia is bought by Wells Fargo, and Bank of
America agrees to acquire Merrill Lynch. (Lehman Brothers, Wachovia and
Merrill Lynch each ranked among the top ten municipal bond underwriters
September 2008 – There is a run on money
market funds that caused the funds to “break the buck.” (Breaking the
buck means that a $1.00
investment returns less than $1.00 upon withdrawal from the fund.) Money
market funds liquidate holdings to increase cash for payouts. This
includes tax-exempt money
market funds which liquidate municipal bond holdings to increase cash for
payouts thereby flooding the market with securities and increasing the
yields on municipal bonds. To stabilize the market, the government
implements a temporary government guarantee of money market funds
including tax-exempt funds. The guarantee covers funds on deposit as of
the close of business on September 19, 2008.
October 2008 – Firms that agreed to
settlements on Auction Rate Securities begin to buy back the securities
October 2008 – Beginning in mid-September
the bond market comes to a virtual halt. Few institutions have an
interest in buying municipal bonds, some issuers postpone sales due to
higher than expected borrowing rates, and securities firms are unwilling
to take underwriting risks and convince issuers to postpone sales.
November 2008 – Assured Guaranty Corp. announces plans to acquire
Financial Security Assurance.
November 21, 2008 – May be remembered as the
day municipal bond insurance died. On this date Moody’s downgraded the
ratings of Financial Security Assurance and Assured Guaranty Corp.
Consequently there are no longer any insurers rated triple-A by all
three rating agencies.
December 2008 – Double-A general obligation bonds have yields as
much as two times higher than yields on comparable maturities of
January 2009 – Citigroup announces plans to
merge its brokerage unit, Smith Barney, with Morgan Stanley’s brokerage
unit and to split into two operating firms. (Citigroup, ranked 1st among municipal bond underwriters
in 2008, stated that the proposed changes will not affect its municipal
Present – Highly rated municipal bonds are
selling at record high yields compared to Treasury bonds (yields on
double-A rated municipal bonds are as high 150% of Treasury yields,
while prior to 2008 yields were less than 90% of Treasury yields). A
“credit spread crisis” is evolving in which bonds rated lower than A and
unrated securities are selling with record high yields compared to bonds
with higher credit ratings.
Prior to 2008 more than half of all bonds
were insured by triple-A rated bond insurers. To boost profits, the
bond insurers insured Collateralized Debt Obligations (CDOs) and other
obligations that used subprime mortgage loans as collateral. In 2007
there were seven bond insurers that had triple-A ratings from all three
major rating agencies (Moody’s, Standard & Poor’s and Fitch). As a
result of CDO write-downs, by July 2008 five of the seven insurers were
downgraded. In November 2008 the remaining two (Assured Guaranty Corp.
and Financial Security Assurance) were downgraded principally due to a
loss of confidence in bond insurers that has eroded their business.
Many issues that previously would have been
insured must now be marketed with low credit ratings or as unrated
securities. Without insurance, lower rated issuers will have to pay
higher interest costs.
In February 2008, the $330 billion Auction
Rate Securities (ARS) market collapsed. Auction Rate Securities are
long-term bonds that have the rates reset through auctions every 1 to 35
days. Since the rates on ARS were based on short-term rates, issuers
expected to obtain lower borrowing rates. Investors thought they were
buying something equivalent to highly liquid money-market funds.
Investor demand diminished when the bond insurers, that backed the
securities, began getting rating downgrades. Underwriters that were
already suffering from their own capital write-downs and liquidity
issues were unable or unwilling to participate in the auctions which
would have forced them to purchase the ARS that didn’t sell. When an
auction failed the rate was set according to the ARS’ documents which,
for some issuers, resulted in rates as high as 20% and as low as 0%.
Issuers suffered from unexpectedly high interest costs and investors
were left holding securities they could not sell.
Investors, unable to liquidate their
holdings, filed regulatory complaints and lawsuits that have resulted in
a massive buy back of the securities and the assessment of over $500
million in fines against major banks and securities firms thereby
reducing capital for the purchase of other tax-exempt securities.
The subprime crisis has drawn great
attention to credit quality. In 2007, investors began losing interest
in purchasing all but the highest rated bonds. Just as banks
only want to lend to individuals and corporations with the highest
credit ratings, institutional investors (mutual funds, insurance
companies and banks) are now avoiding insured bonds and tax-exempt
securities rated less than double-A. As a result, only individual
investors remain as significant buyers of lower credit quality and
Credit concerns are mounting as attention is
now turning to the impact that a declining economy will have on
municipal credit. The decline in new housing construction, decline in
housing values and reduced consumer spending means less property taxes,
sales taxes and building permit fees. While general obligation bonds
are insulated from economic downturns, annual appropriation financings
(lease obligations) and special purpose obligations (such as
tax-increment financing, community improvement district and
transportation development district bonds) are at substantially higher
risk of default during an economic downturn.
As a result of evolving credit concerns, the
spread between high rated bonds and lower rated bonds (credit spread)
has increased to historically high levels. In addition, the sale of
lease obligations and special purpose obligations is becoming
The Market is
The credit crisis is continuing to evolve.
Some events may have a positive impact on municipal bonds including the
Higher Tax Rates: If president Obama
raises tax rates for the highest income tax brackets, as proposed, the
demand for tax-exempt securities should increase.
Enticing Municipal Bond Yields: The
yields on Treasury bonds are at historically low levels which may make
the significantly higher yields on municipal bonds enticing and increase
On a less positive note, several evolving
events may put further pressure on the municipal market which could
result in higher yields over an extended period of time and a loss of
demand for lower rated and unrated municipal securities. These events
are described below:
Increased Bond Defaults and Bankruptcies:
If there is a series of municipal bankruptcies or defaults there will be
a loss of confidence in the bond market. The speculative financing that
has led to the demise of Jefferson County, Alabama, the
budgetary constraints of Vallejo, California and the $150 million
derivative losses by five Wisconsin School Districts may be the tip of the
iceberg. In Missouri, for example, from January 2007 to January 2009,
several housing related issues had payment delinquencies and seven
issues (three tax increment revenue bond issues and four transportation
development district bond issues) had unscheduled draws on debt service
reserves. If the economy continues to deteriorate, these issues could
Fewer Investors: Mergers and
bankruptcies are reducing the number of institutional investors thereby
reducing demand and pushing yields higher.
Less Demand for "Tax-Free" Income:
As a result of financial losses by wall-street and main-street fewer
investors need tax-free income. Consequently, the yields on municipal
bonds must remain higher than Treasury bonds in order to entice
investors to invest in the less secure municipal bonds.
Increased Treasury Borrowing:
Although Treasury yields are presently at historically low levels,
increased borrowing by the Treasury to fund the $700 billion
Troubled Asset Relief Program (TARP) and other government initiatives intended to restore the health
of the economy may push the yields on both Treasury and municipal bonds
Settlements of Auction Rate Securities:
Settlements of Auction Rate Securities will put money back into the
hands of investors while taking funds from the banks and investment
banks that are
making settlements. At this time it is unclear whether the settlement
funds will be reinvested in tax-exempt bonds or will place additional
capital constraints on the banks making the settlements thereby further reducing the pool of
institutional buyers. Lawsuits are still pending against several firms
and it is unclear what will be the outcome of the lawsuits or the impact
on the market.
What This Means
With the passage of time the current cycle
of credit concerns should dissipate and the market for bonds and lease
obligations should improve. However, due to the intense disruption of
the economy there is no assurance that the municipal market will return
to "normal" anytime soon and it is possible that the market may never
return to its prior condition.
In recent months, the yields on municipal
securities rose at the same time that yields on Treasury bonds were
declining. Although municipal bond yields declined from
December 2008 until mid January 2009, the
decrease has not kept pace with Treasury bonds. If this trend continues
all municipal issuers will pay proportionately higher interest costs
than in the past. The demand for lower rated and unrated securities has
declined and this trend is likely to continue for some time. The market
for lease obligations has contracted significantly. If this trend
continues, the market for unrated lease obligations may disappear.
You Can Do
Take actions to maintain or improve your
rating including the following:
Prepare Comprehensive Annual
Establish a formal reserve
Take budgetary actions to
maintain reserves consistent with the reserve policy.
Establish a formal capital
Establish an investment
Engage an independent
financial advisor, like WM Financial Strategies, to identify areas of
credit weakness that will be identified by rating agencies and mitigate
these factors if possible.
Do not delay your financing if the funds are
needed. It may be years before the market returns to
"normal." Work with an independent financial advisor
to help you locate an underwriter or bank willing to
complete your transaction. Be prepared to terminate the
underwriter if the firm is unwilling to proceed with your
Engage an independent financial advisor that can provide
objective advice regarding the best approach to raising
Educate yourself. Beware of bankers or underwriters
that recommend a newfangled financing. While some
financial innovations may have fabulous results, be
skeptical when you hear the following phrases describing a
financing: first of its kind, below market rates,
borrow to make money, or derivative.
Thinking about issuing lease obligations?
Consider issuing general obligation bonds. General
obligation bonds are insulated from economic downturns and
will get sold. Although there is a possibility that general
obligation bonds will not obtain the required voter
approval, lease obligations are not a viable alternative if
they can’t be sold. While there continues to be a
market for many issuers' lease obligations, careful consideration should
be given to the added costs associated with this form of financing.
Prepared by Joy A. Howard,
principal of WM Financial Strategies, and presented at the 2009 Missouri
Government Finance Officers
Association's winter seminar in Columbia, Missouri. Last updated