How US munis markets were stumped by European crisis?

This note by Gene Amromin and Anna Paulson looks at how municipal bonds are  responding to ongoing economic crisis. There were concerns in 2010 (and even in 2008) over these bonds and fears arose over defaults.

This paper says there can never be a default as munis structure is different. First, they are governed by states and 26 states do not allow municipality bankruptcy:

The bankruptcy process for municipalities is governed by Chapter 9 of the U.S. Bankruptcy Code, which allows local governments to voluntarily seek bankruptcy protection in the federal courts. However, since municipalities are  instrumentalities of states that retain certain sovereign rights under the Tenth Amendment, their eligibility for Chapter 9  protection is controlled exclusively by each state. Presently, Chapter 9 filings are either prohibited or not expressly permitted in 26 states (see fi gure 2). Many of the remaining states further restrict eligibility by requiring explicit authorization by various elected or appointed bodies. For instance, Louisiana requires the governor and the attorney general to pre-approve a bankruptcy petition, while in New Jersey such approval must be granted by a municipal fi nance commission.

Even in 25 startes which allow, the procedures are different:

Chapter 9 fi lings are also substantially different from the more familiar corporate bankruptcy proceedings. The municipality cannot be forced to declare bankruptcy by its creditors. While the municipality is able to restructure its contracts, its assets cannot be liquidated. Furthermore, only the municipality, and not its creditors, can propose an exit plan. The bankruptcy court has very limited authority to force any specific restructuring changes. In fact, unlike with corporate bankruptcies, the court for the most part is a passive observer of the Chapter 9 proces.

Then even if there is bankruptcy, it does not lead to much losses for bond investors. Bonds are backed by assets like toll roads/bridges etc whcih are usually secure

 Municipal bankruptcies do not generally result in any losses for bond investors. In  each of the approximately 300 Chapter 9 filings over the past 40 years, bond investors were repaid in full, if sometimes late. In some cases, the payments were made not by the issuers but by fi nancial institutions that had provided letters of credit or bond insurance. An important reason why municipal bondholders are typically repaid even when a local government defaults is that debt service costs are usually small, averaging just over 4% of revenue flows. In addition, many municipal bonds are backed by dedicated revenue sources, such as toll roads or sewer systems. These sources are considered secured assets in bankruptcy, severely limiting issuers’ ability to divert their cash fl ows away from repaying bondholders.

Then recent financial engineering implies these munis bonds come with a liquidity cover provided by a bank. So in case no takers the whole bond issue becomes a bank owned issue. These are called variable-rate debt obligations (VRDOs). Instead of issuing these bonds for a longer time period at fixed coupon rate they are issued with daily/weekly resets.

A sizable share of long-term municipal debt is funded in variable-rate markets with daily or weekly interest rate resets. A common contract feature of these variable-rate debt obligations (VRDOs) is that investors have the right to return the obligation to the issuer with short advance notice. In other words, an investor can refuse to roll over a VRDO at any given reset date and demand that the issuer buy it back. This clearly presents a significant rollover risk  for the VRDO issuer that is mitigated by obtaining external liquidity support.

So to cover this roll over risk banks provide a liquidity cover. In a way they are undewriters of the issue and if the bond does not roll over, it comes on their balance sheet.

Here comes the interesting part. The composition of banks providing this liquidity cover has changed from US to European banks. So when the European crisis hit these banks, some munis found they are in trouble without any fault of theirs:

Many of these lenders were based in Europe and their expansion into the U.S. municipal market was rather rapid. By some estimates, by the fall of 2008, lenders  like Depfa, Dexia, Allied Irish, and various German landesbanken  (state-owned banks) accounted for about $90 billion in liquidity support. Most of these financial  institutions have been winding down their facilities at a brisk pace, so that by the first quarter of 2011 their commitments had fallen by about one-third. This has been especially true for institutions that found themselves in financial distress.

The Greek debt crisis spurred downgrades in the credit outlook for some European banks with large direct exposure to Greece. Some of these banks, like Dexia, also happen to provide liquidity facilities to U.S. municipal issuers. Thus, when VRDOs backed by Dexia came due for repricing in June 2011, investors demanded sharply higher rates of return. In some cases, they refused to reprice altogether, causing Dexia to take back the VRDOs, convert them to bankowned bonds, and reset loan terms to the issuers. Some small U.S. towns and municipal agencies thus ended up bearing  some of the costs of the European sovereign debt crisis, without ever having participated directly in those markets.  

Superb this. How linterlinked fin markets are and can create spillovers anywhere.

Anyways, the states had to communicate the message to investors that all is well on 201o and explained these features of munis. This settled markets and access to capital markets resumed…

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One Response to “How US munis markets were stumped by European crisis?”

  1. How US munis markets were stumped by European crisis? « Mostly … | Bankruptcy Proceedings Says:

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