Municipal Bond Market Summary - January 11, 2010

January 11, 2010

Interviewees: Tom Doe, Founder and CEO and Matt Fabian, Managing Director and Lead Analyst at Municipal Market Advisors

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

Available for download at www.mma-research.com

Tom – Yes, Jim, as always great to be with you. Yes, last year in December of 2008 we started off with a very weak December and then had a tremendous rally at the end of the year that then carried in to early January. And in December 2009, we had certainly less volatility, but a inverse of the pattern whereas we started very strongly at the beginning of December led by some aggressive pricing on primary loans, namely issues from Tennessee and Maryland that were priced very strongly and allowed a lot of dealers to mark up inventories. We saw a couple of BAB loans, Build American Bond issues, that were priced aggressively by Massachusetts and Connecticut and that strength carried over into the overall tax-exempt market. Then again you had dealers trying to position for what they thought would be a very strong seasonal pattern over the year-end and here to the start of January. That strength that we saw kind of lasted until about December 18. We saw some astute institutions investors namely started selling into that strength and where there was some liquidity and all of a sudden we got to the 18 of December and interest in the market started to taper, and as you know we had two major holidays on Fridays and that really curtailed activity and no investor or dealer really wanted to make any substantial moves at year-end. What was notable was that our technical indices from our data started to reflect a negative price trend emerging about December 22 nd as Treasury yields rose dramatically through December, that resulted in the cross-market ratio that many people use to measure municipal value, dropping precipitously actually to the lowest level since July 2007, before the whole subprime crisis emerged. And really started to have investors not so interested in the municipal market, low absolute yields, and again general hesitations about inflation and what was going on in the Treasury market. So we kind of ended on a whimper at the start of this year for a few days into January into 2010, still a little bit of weakness. But overall $36 billion issued into the municipal market, combination of tax-exempt and BABs, and a good first two weeks and then just kind of a tempered reaction for the balance of the year.

Jim – That year-end weakness was a little bit troubling. Is there risk as we open the new year?

Tom –Yes. As I mentioned it kind of extended into the first days and I think we're seeing those dynamics that I just referred to, the low ratios and the low absolute yields, a very strong equity market in 2009 which we've all noted, higher yields in the Treasury market, still headlines about municipal credit risk, which I think we'll get to a little bit later as we're talking. It has really put the traditional investors, made them a little bit hesitant looking into this marketplace and by some of our measures I will say that if we're just looking at a cash investor coming to the municipal market, that there is some opportunity in the front of the yield curve where there is this negative price trend. So I think if investors can be selective and they have cash they want to put to work, there is an opportunity of getting some value. But I think with the negative price trend in place right now and with no leadership yet from the primary market of anything meaningful, and this non-farm number that's going to be released tomorrow, I think there's a degree of hesitation. So I think you have to respect there is risk here in the marketplace and investors will be hesitant.

Jim – BABs and credit issues were two key themes in 2009 and I suspect they will continue to be significant talking points in 2010. Matt, you've written extensively on both subjects, care to weigh in?

Matt– Sure as always I care to weigh in. I think that BABs will become a much bigger part of our market in 2010. $64 billion of BABs were sold in 2009. Our current estimate for 2010 is anywhere from $100 to $150 billion of BABs and part of that will hinge on the reauthorization extension and expansion of the BAB program. Some kind of reauthorization is almost guaranteed looking at the political support that the program has. I think how long it gets extended for will depend on the calculated cost or the perceived cost by Congress. It's going to come down to the numbers. If the Joint Committee on Taxation puts a high cost level on it, which would reflect a large degree of foreign ownership of BABs that we've seen, then look for a shorter extension. But if they go for more of a program benign cost, maybe a longer extension. The subsidy rate will probably fall somewhere closer to a 27% level. And then we'll also see the tax credit programs like CREBs, QZABs, QECBs, will be expanded to BABs. There's also a potential for hospitals to begin to use BABs. And then there's also some talk, a very low probability I'd say, but there's been some talk of allowing BABs to be used to refund tax-exempt bonds that are outstanding. So these are major, major considerations and it's really going to depend on how far the reauthorization and expansion goes to drive how much debt is actually sold this year.

As far as credit issues, credit is continuing to get worse for pretty much every credit in the municipal sector. You're looking at the things that are actually defaulting in the municipal bond market and there's just about $5 billion of bonds that have filed some sort of payment default message since July 1st. That's where there's been an actual interruption of payments to bond holders. None of those involve credits within a safe sector like general obligation or sales tax or water sewer or airports. The largest sectors that are struggling are things dependent on growth in the real estate market like land speculation or land secured transactions, hotels, casinos, multi-family housing or retirement homes, and also a bunch of corporate-backed bonds. Those are the sectors that are showing the most pronounced weakness. That's probably going to continue into the next year, although with this new budget season, I think we're going to see the states looking to use possibly even more one-time and budget gimmick type solutions to patch budget gaps by the end of fiscal year June 30th. The rating agencies, which were pretty permissive last time around on the assumption that there was going to be a quick rebound in the economy, let a lot of that pass. This time with any kind of expectation that the economy is going to bounce are probably pretty fanciful, so I think that the rating agencies are going to take a harder line. You will see many more downgrades coming this spring. That could temper performance for those bonds downgraded, it could create a performance upside for the bonds that are not downgraded, but overall I don't think it's going to influence a risk of default very much.

Jim – Following up on BABs, Tom you've written that the program might have more significant implications. Can you expound on your thoughts?

Tom – As we start looking at when crises or major investment trends or issues start hitting the municipal market you need to pay attention if there isn't something more systemic going on. So as BABs really being a representation of the Federal Government providing stimulus money to states, is that you start looking back in time of when there have been some major events in the financial marketplace. And I thought back into during the peak of the dot-com era and the peak was marked by that 38 trading platforms existed that had a dot-com business associated with it in the municipal industry. And any of us involved in the municipal market certainly recognized that those were unsustainable business models and maybe should have given us all some idea that that equity bubble was about to burst. Similarly between 2003 and 2007, as Jim you and I have talked about, and that was the leveraged era in the municipal market. And maybe we should have all thought about, well if leverage is really coming into the municipal market and being a mainstay in the municipal industry, perhaps that's a warning of something greater or a greater systemic risk that exists. And certainly it was a pre-cursor to the subprime bubble bursting. And so here we are as we start 2010 and this Build America Bond program, which has been wonderfully successful from a public relations standpoint in providing low interest rates through this federal subsidy to essentially high investment grade issuers, is that telling us that we've hit a peak of the bubble with the federal government spending? Will this be a marker? And my thought is after seeing some analysts from Morgan Stanley and Nobel Prize economist, Joseph Stiglitz talking about inflation pressures that could emerge in 2012, could you kind of think ahead and think two years from now, gee that Build America Bonds was telling us something that a stress or a negative consequence was soon to emerge as a result of the federal government essentially just printing cash and handing it out in an aggressive manner. And finally just on this point, it's noteworthy too that the Build America Bond concept was created in 1968 and again, it never formulated into a formal program as it is today. But that was also to help fund domestic programs, it was a way of stimulating an economy that was in trouble. And the 1970s as we all know from looking back at interest rates, was a steady rise in rates through the 1970s and then that historic spike at the end of that decade. I think that sometimes municipals can help us focus a little bit more carefully on the larger picture. So when something makes it to the municipal industry, it may not be as good as it seems or it may be telling us something in a broader sense.

Jim – At the end of 2008 all eyes were on Washington DC and regulatory reform. Where's the municipal market on the priority list for DC in 2010?

Matt– There are clearly more pressing matters. The municipal market, if you look at where we are today, 2009 had the second highest level of borrowing ever. You have either record low yields or near record low yields across most of the yield curve for highly rated issuers. Credit spreads have tightened aggressively all year and are likely to continue to do so for tax-exempt securities. So you have a market that is largely fixed, it's hard to say that we need much more intervention than we have already had. And there are clearly other areas of the economy and of the government that need more attention. That being said, looking at what they might do for municipals, the broad regulatory reform proposals that have been put out are still very much in flux. So it's hard to come away with the distinct opinion about what might happen. But I think overall from what I've seen of what could happen and we assume that anything that's going to happen from here on out will probably be a watered down of what are already fairly moderate proposals. The impact probably isn't going to be that big. And in areas where there will be an impact, very likely they will give the large banks and hedge funds and any other part of the community that's affected, a very long-term integration period. So you know looking for immediate consequences for munis, I just don't see a lot of them, simply from that perspective. The areas where we could see some effect, there is still a very real hope for rating reform with municipals and by that I mean forcing the rating agencies to rate municipal bonds on par with any other bond that's out there, any other corporate or US government bond, and to stop rating municipals on a different and more conservative rating scale. I think there is a real possibility of that actually happening. You know looking at the fiscal distress around the country, it probably won't result in as many upgrades as it might have two or three years ago, but still knowing that we're coming into the market from a position of parity, that could add some kind of performance upside to our market. In particular for lower rated, safe-sector credits, like "A" rated school districts and "A" rated states. Beyond that, the other principal area of Washington issues is disclosure reform for municipals, forcing state and local issuers to disclose more and better information. I just don't see that going anywhere this year. I think that the states can very easily argue against the incremental cost of doing that so I just can't see that really impacting our market. So the disclosure we have is probably the disclosure that we're going to have, at least for the next few years.

Jim – Finally to conclude, as you look ahead to 2010, what do you envision as the key demand components for the municipal market and what is supply apt to look like?

Tom – I think Matt already kind of touched on issuance and supply next year. I think we're all looking for plus $400 billion depending on whether BABs get extended and to what degree and what that all looks like. But regarding the demand component Jim, the mutual funds continue to attract steady assets all year long and of course that was prompted by being able to market higher yields or the opportunity for higher yields and attracted investment at the start of 2009. And then with the returns being so positive at the end of 2009, the leading funds were up over 50% on the high yield, those were the same funds that were down 40 to 50% in 2008. But even some general and basic, safe, national investment grade type funds were up 10% to 15%, so that will be able to be marketed a little bit in the first quarter so you expect to see fund inflows continue even though our low absolute yields are unattractive for most individuals. We are also seeing some indications that property and casualty companies are apt to return to the municipal market and even though they're showing a little bit of concern involving some of the credit headlines and specifically some concerns around what's going on in pensions, still they're profitable entities and that usually makes them a pretty good participant in the market. I think if we don't have too much adversity in the first or second quarter you might see a little bit of leverage in some of the proprietary trading operations that emerged in 2009 expand and take a little bit bigger role in the market. Municipal issuance can be in excess of $400 billion. Tax-exempt issuance, which was off 5% in 2009 relative to 2008, if we're seeing something like $300 billion in terms of tax-exempt munis, and we see higher income tax rates are garnering headlines and momentum and that's something that might be an eventuality in 2011, then I think you can see the individual investor really start pursuing munis as a tax shelter and that could get enlarged quite a bit. What are your thoughts Matt?

Matt – I totally agree. I think that the demand component introduced by the Build America Bonds has created a much more issuer friendly environment in that the issuers will be hard pressed not to issue a lot more bonds. For sure the dealers and financial advisors will encourage more transactions and with rates so low as they are right now, in particular, with a very generous federal subsidy through the BAB program, I think that you will see a tremendous amount of issuance coming. So you have the mutual funds which will continue to benefit from these long-term reallocation away from risk and the stock market, into fixed income and safety and tax shelter with tax rates going up. You do have the potential for the money funds, if zero interest rates can become not zero any more and something positive, it could begin to pull some of that money away from the mutual funds back into the cash equivalents program. But you know that's still a ways off. And then you have the other institutional buyers getting interested as well. So although the municipal market is in the headlines every single day about some kind of new financial crisis or other, unless we see a major financial problem with one of the states, which there's always risk of that happening, but a risk of a financial trouble translating into an actual problem for bondholders is really low. So long as that's the case, I think that you'll see very strong and steady demand for munis and an awful lot of supply produced to feed that demand. You're going to see state and local governments borrowing an awful lot more money this year.

Jim – Well thanks Tom, thanks Matt.

Tom & Matt – Thanks Jim, always fun. Happy New Year.