WASHINGTON — Kristin H. R. Franceschi, a partner at DLA Piper LLP in Baltimore, takes over the helm of the National Association of Bond Lawyers Wednesday amid uncertainty about how the municipal market will be affected by the European financial crisis, the U.S. political environment, and federal regulatory and legislative changes.
“There are so many things going on in the world right now and we’re all linked together,” Franceschi said last week in an interview just before news reports about the financial troubles of Franco-Belgian lender Dexia Group spawned concerns among muni issuers with bonds backed by its letters of credit and liquidity facilities.
“It’s tempting to think about the municipal bond market as just state and local governments and not what’s happening in Europe and the various financial counterparties out there. Remember, a lot of those foreign banks provided letters of credit or were participants with domestic banks on credit enhancement, and if they go down, there may be exposure to borrowers or U.S. banks,” said Franceschi, who reads European newspapers.
She lived in France for two years, is fluent in French and has some knowledge of German, Spanish, ancient Greek and Latin.
“The reality is we caused a recession in Europe with our financial crisis when their banks were basically still fine and they suffered because of it,” Franceschi said. “Now they are having a banking crisis related to European sovereign debt issues. To what extent are we really going to be walled off when we consider they are lenders and counterparties in our transactions?”
So it’s not surprising that, when asked about the challenges facing the muni market or what the market will look like in five years, she responded, “There’s a lot of fog in the crystal ball right now.”
Franceschi, who holds both an MBA and a law degree that she simultaneously received from Stanford University, remembers that in late 2007 everyone thought the subprime mortgage crisis was limited to subprime mortgages.
But then the auction-rate securities market froze, the monoline insurers failed and the interest rate swaps and credit default swaps they insured were terminated. Bear Stearns was sold to JPMorgan, Merrill Lynch was sold to Bank of America, and Lehman Brothers filed for bankruptcy protection. “The subprime crisis became a completely different animal than we all thought it was going to be,” Franceschi said. “What happens with Europe? It’s going to be very interesting to find out.”
Not that there isn’t plenty to worry about here in the U.S., where lawmakers are at odds over how to reduce the nation’s debt and reform the federal tax code, legislative and other proposals threatening tax-exemption abound, and an unprecedented amount of new regulations are being implemented under the Dodd-Frank Act.
“The way I see it, from talking to clients, it’s not just what Washington is or isn’t doing. Across the nation there’s a group of people who think debt is bad,” said Franceschi. “They read about bonds in Europe, they read about debt everywhere, the Treasury debt ceiling. And I think there’s a reluctance among some elected officials and nonprofits to go to their boards and say, 'I want to borrow money.’ It’s not a thing that’s in vogue and it causes questions and concerns.”
Some might compare the current environment in Congress to the one that existed before the Tax Reform Act of 1986. Franceschi began her career in public finance at Piper & Marbury LLP, now DLA Piper, in early 1987, just after the law was enacted. Her first assignment was to plow through the law and detail the changes in tax law requirements for muni bonds.
But Franceschi, who notes she missed the build-up to that act, sees some major differences between now and the late 1980s and 1990s.
She remembers individual lawmakers during those two decades offering bills seeking to curb certain kinds of tax-exempt bonds for specific projects, such as residential rental housing for nonprofits. Often the legislation would not move forward or would get watered down.
Now, administration officials and some lawmakers are taking a more expansive view of the tax-exempt bond market with proposals targeting the whole market.
The American Jobs Act that President Obama proposed earlier this month to create jobs through a newly established American Infrastructure Financing Authority would have been paid for with spending cuts, including limits on the value of tax-exempt interest, as well as other tax preferences and deductions. Senate Democrats have since modified the legislation, taking out the spending cuts and replacing them with a millionaire’s surtax.
But Obama’s draft debt-reduction bill would direct the White House Office of Management and Budget to set annual debt-to-gross-domestic-product ratios that decrease each year. If they were not met in any given year, cuts in spending and tax preferences, including tax-exempt interest, would be triggered.
“It’s a different thing to hate one type of bond as opposed to putting the whole shooting match in the hopper,” Franceschi said. “It’s ironic that both proposals would hurt the governmental units that are supposed to get all of this infrastructure money.”
Also, Reps. Mike Quigley, D-Ill. and Patrick McHenry, R-N.C., are circulating draft legislation among regulators and market participants for input that for the first time would give the Securities and Exchange Commission the authority to require issuers to disclose primary and secondary market information and to dictate the timing and content of disclosure documents. Asked about that bill, Franceschi joked that it’s “dangerous” to ask a tax lawyer about securities issues.
“Some people would say, 'It’s perfect. We want more disclosure, we want more continuing disclosure, and we want it faster,’ ” she said. “But some of what they’re asking for, I don’t think is realistic.”
Then there are numerous proposed rules pending that would implement the Dodd-Frank Act, including new regulatory schemes for muni advisors and derivatives. NABL is “tracking all of that,” Franceschi said.
Asked about claims by some market observers that state and local governments don’t really understand interest rate swaps, Franceschi, who is on her firm’s derivatives committee, said: “Everybody — taxable, tax-exempt, and corporate market participants, as well as real estate developers — has had a major learning experience over the last three years about what derivatives transactions mean.”
“Nobody really understood how their swap could be terminated when Lehman Brothers had a problem. No one fully understood the consequences of the downgrade of a counterparty. There are a lot of entities of all types, not just in our marketplace, who have been assessing what their policies and procedures should be for entering into derivatives transactions.”
Besides tracking legislative and regulatory developments, NABL has several ongoing tax and securities law projects. One, led by the group’s outgoing president, John McNally of Hawkins, Delafield & Wood, and Ken Artin of Bryant Miller Olive, is focused on working with other muni groups to develop guidance that would boost disclosure about state and local government pension liabilities.
Franceschi said it’s possible that NABL could do similar projects in other areas in the future, depending on how this one goes. “This is certainly one path,” she said. “I think we need to see where it ends up.”
She said she would like NABL to take an “exploratory” look at the idea of a national infrastructure bank and what that would mean. Obama’s jobs bill, lawmakers and think tanks have proposed variations of such a bank.
“We often think of ourselves as honest brokers,” she said, pointing to past NABL bids to look at tax-credit bonds and how to refund bonds authorized by the American Recovery and Reinvestment Act.
Obama’s proposed infrastructure bank “looks like it permits private borrowers, but how does that work with the tax rules if it’s for only one piece of a project?” she asked. “Is there something that we think we can point out to people along the lines of: 'If you go down this path, there’s some sort of fatal problem, you’ll never be able to do it because of 'x?’ ”
Asked about the Internal Revenue Service’s current “soft contact” approach and focus on post-issuance compliance with tax laws and rules, Franceschi said, “My guess is that they’ve managed to raise a lot of boats floating in a way that is less confrontational and less expensive for the issuer than audits.”
The IRS has been sending issuers a series of questionnaires that asks them, among other things, if they have written policies and procedures to comply with the tax laws and rules after they have issued bonds.
“I would guess the IRS has been very successful in terms of getting issuers and borrowers of various sorts to think about post-issuance compliance,” Franceschi said. “They’ve probably moved the needle through these initiatives more than they did since the Tax Reform Act of 1986 or through audits.”
Franceschi also applauded IRS officials for “reaching out to professionals and participating in seminars,” adding: “In a way they’ve managed to use us as some of their evangelists to help spread the word.”