Municipal Bond Discussion - Munis Stable, California Budget, IRS Audit

June 1, 2010

Interviewee: Matt Fabian, Managing Director at
Municipal Market Advisors

• Interviewer: Jim Towne, Senior Vice President at DerivActiv, LLC

• Duration: 7 minutes, 23 seconds

Available for download at www.mma-research.com and on ITunes

Jim – Welcome Matt.

Matt– Hi Jim.

Jim – The big news this week is the announcement by the IRS that they will audit about 50% of the Build America Bond deals that have been issued. What do you think is behind that announcement and what has been the reaction to it?

Matt– Actually this really may be a really big deal, it may be not so much a big deal. It’s really going to depend on what the IRS is really after. In the end for investors, this is really a modest concern because the issue is are underwriters and issuers bringing Build America Bond issues in the way that the IRS is comfortable with them bringing them. To the extent that they’re not and that there’s a problem, the dealer community, the issuer community, will adjust and will be able to reformat how they’re selling these bonds to make the IRS comfortable. A big part of it is just the IRS trying to verify that there isn’t excessive premium being put into the bonds because the higher the premium, you know that implies that the federal government is paying too much of a subsidy for the transactions. In theory it could cause issuers to think twice about bringing a Build America Bond sale. It could be something where going forward issuers are perhaps a little more cautious whether going Build America. They may look for a little more yield to address the risk if they think that the IRS is taking this a bit more seriously. But in the longer run this is something that’s neutral for BABs versus tax-exempts. Because in the long run any kind of inquiry that’s coming through the BAB market related to this IRS study will ultimately come over to the tax-exempt market too. The IRS group, these are the same people who also do the tax-exempt enforcement group. They have increased their staff by 100 people so it’s a much bigger operation than it was before and the idea is to increase enforcement overall. So we are starting off with the BAB market but ultimately we’ll see these kinds of procedures and these kinds of inquiry applied into tax-exempts generally. In the near term maybe it’s a slight depressive affect to BAB issuance, but overall probably pretty neutral.

Jim – When we spoke to you last week, you said the muni market was mostly stable. Has it been more of the same?

Matt– It has. The muni market got a little bit stronger when Treasuries were a lot stronger, it got a little bit weaker when Treasuries where a lot weaker. Fundamentally we have the same issues of we’re expecting very good demand next month with the reinvestment flow. Issuance is still very much manageable versus the amount of demand that’s out there. Nominal yields are still extremely low so it’s hard to see munis rallying more even if Treasuries begin to rally. At the same time it’s hard to see munis selling-off. There are numerous factors out there in the market that make you think that the yield curve will stay fairly steep so it’s really hard to see much changing at all. For the investor that means that the cost of waiting continues to increase. You know one of the things we’re going to start talking about is rather than waiting for munis to cheapen-up with respect to some kind of credit crisis or fundamental problem related to rates, the muni curve won’t be this steep forever. So it’s probably a reasonable time to extend out a maturity or two and grab that extra yield just by going a little bit further out on the yield curve.

Jim – What’s happening with the California budget debate?

Matt– The Governor put out his budget proposal in January, he did his May revision on May 15th as always. The Governor’s approach to closing a $19 billion funding gap over the next 18 months was to almost entirely address that budget gap through spending cuts. In theory that’s a good thing for budget sustainability, making more structural adjustment in state spending. However, from the majority democrats it really is a non-starter. So it implies a very difficult budget season going forward, almost surely the political groups will begin to resort to more budget gimmicks and one-time sources of revenue, which could very well create rating pressure. We think that it could drive an entry point for investors who want to get back into the state of California and related paper, if the state were to go on some kind of rating watch or even a downgrade, if budget debate gets really difficult

Jim – The Senate passed its regulatory reform bill last week, what are some of the key points affecting the municipal market?

Matt– It’s very interesting because it could be massive changes to the market but more likely will have actually a very modest affect. The two biggest things with respect to our market are probably the government’s attempts to better regulate derivatives generally, and possibly to separate banks from their proprietary trading operations. In both cases what it will do is likely increase the cost to issuers: First for derivatives, it will make derivatives slightly more expensive for the banks to structure, and therefore for issuers to use. We think that regardless of what the final outcome is, whether there’s talk about requiring banks to be fiduciaries if you’re also a derivatives counterparty. There are other standards, will muni derivatives need to be centrally cleared or not? But really regardless of where these things come out, in general derivatives are going to be more difficult for issuers to use going forward, which means that fewer of them will use them and that means that there will be less derivative-oriented bond issuance like variable rate demand obligations going forward. The market is slowly migrating away from the more exotic structures and the more exotic credits of the past few years into a more plain vanilla market going forward, so I think this legislation only continues that trend. The separation of proprietary trading from commercial banks, it could have been a big factor a few years ago, probably a lot less of a factor going forward, although it does mean that dealers may have less ability to manage unsold bond proceeds in the primary market. And that could mean that yields in the primary are slightly higher. Again, a lot of what the federal government is doing is saying, well we will be increasing costs a little bit to end users, but in the end it should a market that is more resilient and less vulnerable to systemic risks. So that’s the trade-off that we’re seeing and it’s very similar munis as opposed to the rest of the market.

Jim – Can you give us an update on the extension of Build America Bonds?

Matt– Sure, just a few minutes ago the House of Representatives did approve the extension of Build America Bond Program in part of their tax extender bill. The Senate will be voting on it after the Memorial Day weekend on June 7th when they reconvene. If the Senate makes changes in it because among the senate republicans there has been a lot of discontent with, not the Build America provisions, but other provisions in the Bill, if they make substantial changes then it’s going to have to go back to the House through some kind of reconciliation, so the overall process could be dragged out. It becomes a lot longer than what people in the industry would have liked. To this point, we really haven’t seen any organized opposition to extending the BABs Program, so we still think it’s almost a sure thing, albeit at slightly lower subsidy rates than what we had in the past.

Jim – Thanks Matt, we’ll talk to you again soon.

Matt– Thanks Jim.