Reduce liability for losses on commercial accounts by adhering to four requirements.
As Samuel Clemens Wrote…
Samuel Clemens reportedly wrote, “The rumors of my death have been greatly exaggerated.” Those who are close followers of the municipal bond market and knowledgeable of its process would heartily second this famous quote as it applies to that market and, particularly, the bank-qualified sector. We know that the financial crisis since 2007 has significantly impacted the flow of revenues to public entities. However, headlines pronouncing municipal defaults to the tune of hundreds of billions of dollars paints an inaccurate picture of the market in general. While there are problem credits, as there always have been, the large percentage of municipal bond debt is not in peril.
The municipal bond market consists of about $2.7 trillion in debt, which is comprised of obligations issued by 50 states and almost 40,000 political entities. The basic categories are two in number. First are general obligation issues that pledge all or specific revenues from taxes and fees for bond maintenance and repayment. Secondly, there are revenue issues that depend on income from a particular utility, hospital or project to pay the bondholders.
Referring to general obligation issues, residents normally pay their real estate taxes in order to remain in their homes. With utility revenue bonds, residents normally pay their utility bills to enjoy heat, water and electricity. In both cases, the bonds are considered “essential purpose” debt.
Because municipal bonds are loans that just happen to be securitized, the rules of risk and reward that we live with so intimately in our loan portfolios apply here as well. Consequently, the further one moves from certainty and predictability of revenue receipts to the issuer, the greater the risk to the funds to pay principal and interest. As dire as some widely publicized situations may be, such as the states of Illinois and California, there are also many thousands of issuers that are not seriously stressed and continue to exercise prudence in the annual budgeting process. Importantly, according to the National League of Cities, all but one state and a few local governments have balanced budget requirements. An important point to consider is that the overwhelming percentage of outstanding municipal debt is issued in serial format. This means that the total amount borrowed is paid back gradually over a number of consecutive years. This spreads the payment of principal over an extended period and thus eliminates the shock of a large bullet maturity at an inopportune time of stress.
From an economic standpoint, many believe the worst has been seen concerning tax and revenue shortfalls for good-quality, historically sound issuers of general obligation and essential-purpose revenue bonds.
Responsible municipalities have taken measures to improve budgetary matters where they exist. This includes many smaller entities that issue bank-qualified bonds that we purchase for our investment portfolios. What will continue is the reduction of issuer services, job eliminations and tax increases. These measures will continue as budgets are brought into alignment with revenues.
No magic here; this will be an uncomfortable process until the fundamentals change. Nevertheless, the quality issuers, as in the past, should continue to pay coupon interest and principal when due.
For bank-qualified municipals, a significant development is the expiration of a provision enacted in the American Recovery and Reinvestment Act of 2009, which allowed issuers to borrow up to $30 million annually and still qualify for bank-qualified status. Bonds issued after Dec. 31, 2010, are subject to the old limit of $10 million annually; thus the supply of bank-qualified bonds is now greatly reduced. Other things being equal, this should mean that the relative value of your BQ municipals has improved. Additionally, taxable Build America Bonds, which are subsidized by the government and also were created as a part of the stimulus package, were not extended past the same sunset date of Dec. 31, 2010. Therefore, the relative value of this category of debt has also improved.
If you are a holder of municipal debt issued by governmental entities with sound financial operating standards, those assets should continue to provide a consistent stream of tax-free or taxable income to your institution. As a well-respected municipal bond industry participant stated many times, the quality of the issue remains long after price is forgotten. Samuel Clemens would surely agree.
Larry Russell is senior vice president in the Capital Markets Group of Country Club Bank, Kansas City.
Copyright © March 2011 BankNews Media