ORLANDO — The Federal Reserve is studying Puerto Rico as an indicator of the level of risk in the muni market, where heavy retail investor presence can make behavior unpredictable, an economist with one its banks told municipal analysts on Thursday.
Paula Tkac, a vice president and senior economist at the Federal Reserve Bank of Atlanta told attendees of the National Federation of Municipal Analysts' annual conference that the Fed continues to monitor the situation in the financially distressed American territory in order to assess if and how Puerto Rico's situation might cause wider financial instability.
Tkac and other Fed speakers said the board is concerned about inter-connectedness of markets and their ability to destabilize one another, and continues to look into that in the muni market.
"The muni market is certainly big enough for people to pay attention to," said Tkac, pointing to the market's roughly $3.7 trillion size. Munis are connected to the wider financial system through underwriters insurers, money market funds, and other vehicles, and is also unique in being dominated by relatively unsophisticated retail investors, Tkac said. That contrasts with the market for U.S. Treasury securities, which is dominated by institutional investors. The Fed is interested in this because the behavior of retail investors is not well-understood and possibly more prone to panic, she said.
"They will act with a herd mentality," she said, pointing out that sophisticated investors have long known about Puerto Rico's struggles but that the island's bond yields spiked as soon as press coverage about the risks of investing in Puerto Rican debt became more prominent.
Tkac said that there is a tendency to view munis as relatively opaque and illiquid. The liquidity issue has become a hot debate, since the rules proposed by federal banking regulators to implement Basel III governing high-quality liquid assets would exclude munis as HQLAs, making them a less attractive investment, many market participants have warned.
Karin Kimbrough, a vice president at the New York Fed, said that rule and others exist to essentially make banks more resilient to the kinds of shocks that they experienced during the recent economic crisis. Liquidity is important to the survival of those institutions, she said.
"The minute they're seen as illiquid, its over," she told the audience.
The Fed has found relatively small bank exposure to Puerto Rico securities, Tkac said, although there is evidence that Puerto Rican banks may be much more exposed. Puerto Rican bonds are also common investments for mutual funds because they offer their tax-exempt status to all U.S. investors.
An analyst at the session asked if the Fed's analysis of Puerto Rico was done with an eye toward providing financial assistance to the island — something Treasury and White House officials have repeatedly said they will not do.
Jason Bram, a research officer at the New York Fed, said that is not possible from his perspective.
"There's very limited Fed ability to do much of anything," Bram said.
Eric Parsons, vice president and manager of collateral risk at the New York Fed, agreed.
"By its charter, the Fed can't loan to governments," he said.
