WASHINGTON - Market participants are continuing to push for a federal backstop for the roughly $500 billion variable-rate demand obligation market, warning that the availability of already-scarce bank liquidity facilities will continue to decline if issuers experience downgrades to their credit ratings in the coming months.
"In this environment, it's hard to predict where we're going to be a year from now, but if the current trend continues, there's going to be even less capacity for issuers to obtain [bank letters of credit], which is going to be very negative for municipal issuers," Michael Decker, co-chief executive officer of the Regional Bond Dealers Association, said yesterday after speaking to state treasurers.
The issue is one of the top concerns for member of the National Association of State Treasurers, which is holding its annual legislative conference here through tomorrow.
Vermont Treasurer Jeb Spalding yesterday asked market participants addressing his group - Decker, as well as Hal Johnson, deputy executive director of the Municipal Securities Rulemaking Board - if there is any prospect of the federal government addressing "the difficulties people are having accessing affordable quality liquidity providers," particularly for the housing and the student loans sectors of the VRDO market.
Decker noted that the Obama administration has indicated that they would like to create a backstop for the VRDO market soon. But the Treasury Department is too short-staffed and consumed with propping up banks to worry about the muni market, sources have said.
Still, Decker said it remains a good idea for the federal government to back VRDOs with letters of credit or standby purchase agreements. By charging a reasonable LOC fee, the Treasury could actually make money on the program and it is unlikely that issuers would ever need to put their VRDOs back to Treasury, he said.
"One of the reasons why you had a run on variable-rate deals in the fall and you saw a lot of investors putting their VRDOs back to the liquidity banks is because there was serious concern about the health and viability of the liquidity banks," he said. "You wouldn't see that kind of behavior if the liquidity provider is the Treasury Department."
But Mississippi Treasurer Tate Reeves said that issuers should be careful seeking federal assistance because it could be a slippery slope and lead to direct federal regulation of the muni bond market. "We should tread carefully," he told the group.
Matt Fabian, managing director at Municipal Market Advisors, said that the lack of affordable and widely available LOCs may signal that "the market is telling us that this sector should shrink."
Rather than prop up VRDOs, Fabian suggested that Treasury give the market incentives to come up with its own solutions to its liquidity problems.
One solution might be for the Treasury to give subsidized loans to issuers to pay for termination fees on their interest-rate swaps that are often entered into in conjunction with VRDOs.
Treasury also could levy a surcharge on future interest-rate swaps to repay taxpayers for the cost of the loans to issuers, and the surcharge would increase the more it is used.
But Decker stressed that a federal backstop would be temporary, and is "more a factor of a crisis in the banking industry" than in the market deciding that the VRDO market is too large.
