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Picking Up the Pieces

CARLSBAD, Calif. — The municipal bond market is slowly recovering from the financial panic of 2008, but it’s still a long way from healed.

That’s the conclusion of a range of speakers and participants at The Bond Buyer’s California Public Finance Conference and a pre-conference hosted by the California Debt and Investment Advisory Commission.

Most of them were at last year’s conference when Lehman Brothers filed bankruptcy, setting off a cascade of financial destruction that froze the municipal market for months and pushed an already recession-battered economy into the deepest slump since the Great Depression.

Ed Burdett — a managing director at Bank of America Merrill Lynch, which was created in a shotgun wedding officiated by former Treasury Secretary Hank Paulson at one of the deepest moments of the financial crisis — likened the current scene to the aftermath of a tornado tearing through a town.

“People come out of their storm cellars,” he said. “We’re looking around and trying to figure out how to pick up the pieces and move forward.”

What muni market participants see is that massive federal government intervention in the financial markets — in the form of bank bailouts under the Troubled Asset Relief Program and economic stimulus of the American Recovery and Reinvestment Act — and the natural healing process have revived the flow of capital to highly rated municipal issuers.

“There’s only going to be one end of the world, and this probably wasn’t it,” said Tim Schaefer, principal of Magis Advisors, a financial advisory firm that he founded 13 days before Lehman’s bankruptcy.

But it has been a wrenching year in the muni market, including the near-total failure of the bond insurance industry, several months when the market was essentially frozen, the drying up of bank liquidity support for short-term debt, and round after round of layoffs. The market remains impaired.

“We have a two-tiered market,” said Keith Curry, a managing director at Public Financial Management. The market for debt rated double-A and above is “functioning well,” he said, adding: “For everyone else, it is a challenging, in fact very difficult, market.”

The spread between 10-year triple-B rated and triple-A rated general obligation bonds widened to about 350 basis points in the months after Lehman’s collapse, according to Municipal Market Data. That’s more than three-times the average 92 basis point spread over the past decade. The spread retreated to a 2009 low of 227 basis points on Monday, but remains elevated by historical standards.

The American Recovery and Reinvestment Act, which created taxable Build America Bonds in February, is helping restore equilibrium to the market. By offering a 35% subsidy to interest on taxable muni bonds in the place of the traditional tax exemption, the federal government reduced tax-exempt supply just as risk appetites were starting to return.

“The good news is that we’re seeing recovery on the investor side,” said Eileen Gallagher, a managing director at Stone & Youngberg in San Francisco. “On the basic municipal bond fund, we’ve seen a reversal of that major outflow that we saw last year and really a dramatic inflow this year. There are a lot of investors out there looking for bonds amid reduced supply.”

“The people that have good credit are out there borrowing and taking advantage of the Build America Bonds,” she said. “For those that don’t have revenues to pledge or have lower credit ratings, the volume has been down.”

San Diego has been among the busiest issuers. It issued more than $1.5 billion of debt in five sales over the first six months of the year, most of it for its highly rated water and sewer systems.

The city had a long backlog of issuance needs because it was locked out of the public finance market as new political and financial management cleaned up the aftereffects of a 2004 pension accounting scandal.

Chief operating officer Jay Goldstone told the audience he’s just trying to keep structures simple and to minimize the amount of debt that’s issued for the city’s general fund. He’s developed a new skepticism of complex structures, bond insurance, and anything that includes counterparty risk. He’s even hesitant to trust that the federal government will make good on its promise to pay BAB subsidies.

“Issuers, myself included, will probably be more reluctant to try some of these exotic structures,” Goldstone said. “Issuers are going to have to do more and more homework and due diligence …. There’s no sure thing in this business anymore, if there ever was.”

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