Guest post: New Federal Banking Regulations Undermine Obama Infrastructure Stance
This is a guest post by Marc Joffe, a former Senior Director at Moody’s Analytics, who founded Public Sector Credit Solutions in 2011 to educate the public about the risk – or lack of risk – in government securities. Marc published an open source government bond rating tool in 2012 and launched a transparent credit scoring platform for California cities in 2013. Currently, Marc blogs for Bitvore, a company which sifts the internet to provide market intelligence to municipal bond investors.
Obama administration officials frequently talk about the need to improve the nation’s infrastructure. Yet new regulations published by the Federal Reserve, FDIC and OCC run counter to this policy by limiting the market for municipal bonds.
On Wednesday, bank regulators published a new rule requiring large banks to hold a minimum level of high quality liquid assets (HQLAs). This requirement is intended to protect banks during a financial crisis, and thus reduce the risk of a bank failure or government bailout. Just about everyone would agree that that’s a good thing.
The problem is that regulators allow banks to use foreign government securities, corporate bonds and even stocks as HQLAs, but not US municipal bonds. Unless this changes, banks will have to unload their municipal holdings and won’t be able to purchase new state and local government bonds when they’re issued. The new regulation will thereby reduce the demand for bonds needed to finance roads, bridges, airports, schools and other infrastructure projects. Less demand for these bonds will mean higher interest rates.
Municipal bond issuance is already depressed. According to data from SIFMA, total municipal bonds outstanding are lower now than in 2009 – and this is in nominal dollar terms. Scary headlines about Detroit and Puerto Rico, rating agency downgrades and negative pronouncements from market analysts have scared off many investors. Now with banks exiting the market, the premium that local governments have to pay relative to Treasury bonds will likely increase.
If the new rule had limited HQLA’s to just Treasuries, I could have understood it. But since the regulators are letting banks hold assets that are as risky as or even riskier than municipal bonds, I am missing the logic. Consider the following:
- No state has defaulted on a general obligation bond since 1933. Defaults on bonds issued by cities are also extremely rare – affecting about one in one thousand bonds per year. Other classes of municipal bonds have higher default rates, but not radically different from those of corporate bonds.
- Bonds issued by foreign governments can and do default. For example, private investors took a 70% haircut when Greek debt was restructured in 2012.
- Regulators explained their decision to exclude municipal bonds because of thin trading volumes, but this is also the case with corporate bonds. On Tuesday, FINRA reported a total of only 6446 daily corporate bond trades across a universe of perhaps 300,000 issues. So, in other words, the average corporate bond trades less than once per day. Not very liquid.
- Stocks are more liquid, but can lose value very rapidly during a crisis as we saw in 1929, 1987 and again in 2008-2009. Trading in individual stocks can also be halted.
Perhaps the most ironic result of the regulation involves municipal bond insurance. Under the new rules, a bank can purchase bonds or stock issued by Assured Guaranty or MBIA – two major municipal bond insurers – but they can’t buy state and local government bonds insured by those companies. Since these insurance companies would have to pay interest and principal on defaulted municipal securities before they pay interest and dividends to their own investors, their securities are clearly more risky than the insured municipal bonds.
Regulators have expressed a willingness to tweak the new HQLA regulations now that they are in place. I hope this is one area they will reconsider. Mandating that banks hold safe securities is a good thing; now we need a more data-driven definition of just what safe means. By including municipal securities in HQLA, bank regulators can also get on the same page as the rest of the Obama administration.
mathbabe 
I don’t know that we should be encouraging municipalities to borrow more (probably shouldn’t be encouraging companies either).
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Agreed. Most cities here in California are bonded out to the maximum and every few years they refund creating lots of churn and generating fees, etc. Municipal bonds are never put out to vote by the public so results in increased taxes and less services. While the bonds are mostly for capital infrastructure, in my experience, big infrastructure projects are ripe for corruption.
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Thanks for commenting. I agree that many municipalities carry too much debt, but some have little or no debt. The benefits of bridges and other expensive infrastructure are realized over a long time frame, so it makes sense to pay for these projects over time. My argument is simply that banks should not be compelled to discriminate against municipal debt viz-a-viz other categories. @John: Having gone through California city finances in great detail, I can tell you that a substantial number of cities carry little or no debt, but, I do agree, that overall, California has more local debt per capita than other states.
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If you want to support infrastructure you can directly do so (just give municipalities cash, if you like you can earmark it for infrastructure). There’s no particular need for indirectly subsidized debt issuance, which causes a variety of agency issues (for multiple definitions of agency).
I agree with you that for the most part, corporate bonds are more risky than munis, and so the different treatment is not a good thing.
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The Fed should buy municipal bonds. IIUC, they are legally allowed to do so. Why they have not done so as part of quantitative easing is a mystery to me.
Infrastructure projects are a time honored way of economic recovery. Wall Street got its bailout, why not Main Street?
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Stocks, corporate bonds good? States, munis bad? Go long Public/Private Partnerships.
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For more comment read:
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I sympathize with the need for municipalities to borrow money for crucial projects, but munis are in fact not liquid, no matter how safe they are. If a bank had to raise a lot of money in a hurry, it’s unlikely that it would be able to do it quickly enough by selling munis.
I in fact agree with the statement “If the new rule had limited HQLA’s to just Treasuries, I could have understood it”. Corporate bonds are more liquid than munis, but that’s not saying much. There are perhaps a few sovereigns that are as safe as Treasuries (maybe only German bonds), but I agree that the rest are not as safe and liquid as Treasuries.
That HQLA has such a loose definition shows how effectively Wall Street is able to lobby the regulatory agencies. Banks keep making the same argument over and over again: “We won’t be able to make as much profit as before” And Congress and the regulators fall for this over and over. But as anyone with basic knowledge of finance knows, there is always a trade-off between risk and return. If we’re going to make the banks safer, we have no choice but to reduce their return on capital. Banking used to be a very boring business, and it should go back to being that way.
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Here’s a response from a economist friend — I’m not endorsing his views, just reporting them: “It reads like something a muni-lobbyist would write. The rule only applies to banks over $250 billion in assets and requires they to hold in HQLAs the equivalent of 30 days of net cash flow, I’m pretty sure most banks comply with that already so there isn’t likely to be a fire sale of muni bonds and, indeed, the banks have been adding to their portfolios because taxes are going up generally and the Detroit fiasco and slow motion train wreck in PR are pushing up yields in a search for yield environment.”
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I am indeed only worried about large banks, as is the Fed. The too-big-to-fail banks in particular.
On Sat, Sep 13, 2014 at 10:15 AM, mathbabe wrote:
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