S&P’s decision not to downgrade a whole bunch of municipal issuers, and its claim that “the fiscal autonomy, political independence, and generally strong credit cultures of U.S. states and local governments can support ratings above that of the U.S. sovereign” reminded us of all the other good news about state and local government financial genius. Such as the Maine municipal authority who swears through bites of bank-sponsored filet mignon that closing dinners for negotiated bond deals aren’t costing his state anything (hint: bankers aren't buying you dinner because they're dying to hear about your fishing trip!). But our favorite muni news is Gretchen Morgenson’s story from this weekend about her favorite topic, municipal derivatives.
The action here is a report on a July SEC hearing on municipal bond and derivatives topics in Birmingham, Ala., scene of the smoldering remains of Jefferson County, which is not triple-A rated because it blew $3 billion that it didn't have swapping its sewers into floaters or something. Andrew Kalotay, a debt management advisor and repeat Gretchen enabler, testified at the hearing about a deal done by the Denver public schools, who sold a taxable 30-year bond with a floating rate determined by a weekly or monthly auction mechanism. They then entered into a LIBOR swap with three banks where the schools paid fixed and received floating.
We never worked in munis but this strikes us as kind of nuts. It creates a synthetic instrument that pays interest equal to (1) a fixed risk-free rate plus (2) a variable credit spread. So Denver has no ability to take advantage of falling interest rates (like in say a recession), but its funding costs do go up - weekly! - if it becomes a worse credit (because of say a recession). It’s like issuing fixed-rate bonds and then selling CDS on yourself because you really want to keep exposure to your credit risk. As Kalotay pointed out, no corporate has ever done this. And that’s not even to mention what Gretchen and Kalotay are most worked up about, that these swaps are supposedly way overpriced relative to mid-market levels. (Which we have no problem with. The swaps are priced based on among other things the credit risk the banks are taking, and you should be compensated for taking exposure to a credit this dumb.)
So if this isn’t such a great idea, how did it happen? Gretchen and Kalotay place the blame squarely on evil bankers. But bankers are greedy everywhere, and we never had the impression that munis bankers are unusually evil for investment bankers – if anything, they’re nicer, more public spirited, happy to work in lower-fee muni businesses because they’d rather raise money for school districts than tobacco companies. As another speaker at the SEC hearing, Robert Brooks of the University of Alabama, testified:
The regulatory environment influences who chooses to enter this vocation. If the municipal finance landscape resembles a prison environment, then we should not be surprised that many highly ethical, competent, creative professionals opt for an alternative finance profession rather than be strip-searched every day, told what to eat, and when they can relieve themselves. Particularly in the financial derivatives space, we need highly ethical, innovative and creative professionals like never before. We do not want to risk stifling financial innovation where solutions could be developed to mitigate risk at dramatically lower cost and with increased precision and effectiveness. There are young aspiring American patriots who desire to invest their very lives in public service to our exceptional country. We should make every effort to provide a municipal finance environment where they can flourish and serve our country well.
Riiight. Anyway, though, if you exclude the idea that municipal bankers are exponentially more evil than corporate bankers, you’re left with the conclusion that municipalities are exponentially less able to make intelligent financing decisions than corporations are. Gretchen ends her piece with a call for swap pricing transparency but we're not sure that solves much. Perhaps we need the full Elizabeth Warren approach, with municipalities encouraged to do "plain vanilla" financings unless they can satisfy federal regulators that they have some idea of what they're doing? Or do the "generally strong credit cultures" of municipal issuers suggest that they should be telling the feds how to run their business, rather than the reverse?