WASHINGTON — Municipal analysts and market participants warned that the re-election of President Barack Obama and the status quo with a divided Congress will likely make threats to tax exemption more plausible.

When the Republican-led House and Democratic-led Senate return to Washington Nov. 13 after a six-week recess, they will immediately be faced with tackling the so-called “fiscal cliff” —  the $600 billion of tax increases and more than $1 trillion in automatic across-the-board spending cuts that are slated to go into effect on Jan. 1. 2013 — as well as the need for an increase in the U.S. debt limit.

Fitch Ratings warned Wednesday that Obama’s failure to quickly secure agreement on avoiding the fiscal cliff, raising the debt ceiling, and reducing the deficit, “will likely result in a rating downgrade in 2013.” Moody’s Investors Service warned in September that the failure to reach a deficit reduction deal would likely result in a credit downgrade for U.S. debt as well.

There is a general consensus among economists that sequestration and the fiscal cliff would trigger another recession in the U.S.

“There is a lot of pressure to undertake significant fiscal reform,” said Michael Decker, co-head of municipal securities at the Securities Industry and Financial Markets Association. “Given that there is no change in the White House and ... no change in leadership in Congress, the outlook for fiscal policy in terms of the roles that the various parties will play probably hasn’t changed that much.”

There is a real risk that Congress will take action to curtail or eliminate tax exemption in the context of some kind of fiscal or tax reform, he said.

Mike Nicholas, chief executive officer at Bond Dealers of America, said also that Obama’s reelection means muni bonds may be “under the gun” for the foreseeable future.

Chuck Samuels, a lawyer at Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC, said the fiscal issues may not get addressed until next year but that munis will likely be in the mix. “I think there will be a partial grand bargain, which means they will kick the can down the road on sequestration but it won’t just be a pure push the thing down the road.” If the lawmakers take action on expenditures, it’s likely that will include the exclusion for tax-exempt interest, he added.

Obama has already proposed a 28% cap on the value of tax-exempt interest for the wealthy, rattling muni market participants who warned it would increase borrowing costs for state and local governments and erode the value of investors’ portfolios.

Market participants said that, now that the election is over, Republicans may be more likely to try to reach common ground with the president and Democratic-led Senate. Both House Speaker John Boehner, R-Ohio. and Senate Finance Chairman Max Baucus, D-Mont. issued statements on Wednesday calling for more compromise.

Senate Republicans on tax writing committees have been saying in private that the 28% cap plan “has legs,” Municipal Market Advisors told subscribers on Wednesday. MMA said the best chance to avert the 28% cap is if participants can make the case that Build America Bonds are not a viable alternative for tax-exempts and convince Democrats of the need to retain full tax-exemption for munis.

“The Democratic leadership’s position is that, while diluting the exemption, it is offering a better financing alternative via BABs,” the group said, strongly advising market participants who want to preserve the full tax-exemption to “forward anti-BAB research and commentary to Democratic leadership in DC.”

DOLD

Decker and Nicholas expressed disappointment at the failed reelection campaign of Rep. Robert Dold, R-Ill. who lost to Democratic challenger Brad Schneider. Dold, a member of the House Financial Services Committee, introduced a bill in 2011 that would redefine the term “municipal advisor.”

Decker said Dold’s MA bill may still be alive. The bill, which would amend the Securities and Exchange Commission’s initial MA definition, passed the House in September and was referred to the Senate Banking Committee, where Sen. Roger Wicker, R-Miss., has introduced a companion bill. It would define MAs as those engaged in muni advisory activities for compensation and would create exceptions for underwriters, bankers and swap dealers, as well as those who provide advice related to those activities.

“It’s too early to say the issue is dead in the current Congress,” Decker said. “I think there is some desire in the Senate to at least look at this issue as a possible area of action during the lame duck session.”  He noted the bill received broad bipartisan support in the House and backing from Rep. Gwen Moore, D-Wis., who “seems committed to finding a solution in this area.”

Nicholas said Dold’s bill has been successful regardless of whether it moves further in Congress. The bill has “drawn a lot of attention from the industry and the SEC” and likely will continue to influence the commission as it finalizes its definition of MA, he said.

Transportation

The election results offered no fundamental shakeup of most of the legislators controlling transportation policy and finance, but term limit restrictions and a retirement will bring in some new Republicans.

Sens. Barbara Boxer, D-Calif. and Jay Rockefeller, D-W.Va., chairs of the Senate Environment and Public Works Committee and Senate Committee on Commerce, Science, and Transportation respectively, will remain in place.

Sen. James Inhofe, R-Okla., the ranking Republican on the EPW Committee, faces GOP-implemented term limits that will force him to step down as ranking member. Sen Kay Bailey Hutchison, R-Tex., did not seek reelection and will be replaced as ranking Republican on Rockefeller’s committee. Sen. Jim DeMint, R- S.C., is in line to replace her.

Rep. John Mica, R-Fla. won reelection but is term-limited by the same rules forcing Inhofe to step down. Mica, who currently chairs the House Transportation Committee, said he hopes to chair another committee. It is widely assumed that Rep. Bill Shuster, R-Pa., will take Mica’s place as chair of that committee. Rep. Jeff Denham, R-Calif. survived a tight election contest and will remain on the transportation committee as a vocal opponent of California’s controversial and partially bond-funded high-speed rail project.

U.S. Transportation Secretary Ray LaHood, a former Republican congressman from Illinois, announced last year that he would not serve beyond 2012 regardless of Obama’s electoral fortunes. 

In recent months, however, he has been coy with the media and has said he will need to discuss his future with the president.

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