WASHINGTON — The Municipal Securities Rulemaking Board Tuesday urged the Federal Reserve Board, the Securities and Exchange Commission and other financial regulators to exempt all municipal securities from the Volcker Rule, warning the failure to do so would bifurcate and hurt the municipal market without increasing the soundness of the banking system.
The Volcker Rule, named after former Federal Reserve chief Paul Volcker, was mandated by the Dodd-Frank Act and proposed jointly by four financial regulators. It would prohibit banks from proprietary trading and would restrict their investments in private equity and hedge funds. However, it would exempt short-term trading for market-making or to hedge risks.
In an 11-page letter, the MSRB warned four federal regulators that the failure to adopt a broader exemption for municipal securities from the rule “will have a significant material adverse effect on the primary market pricing and secondary market trading of securities issued by agencies and authorities of states and their political subdivisions.”
“Issuers and investors (primarily retail) will bear the cost,” said the letter, which was signed by MSRB chairman Alan Polsky and sent to the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp., along with the Fed and SEC.
The banking entities covered by the Volcker Rule “represent a very large percentage of the municipal securities market,” the MSRB said. Of the firms that underwrote 98% of the muni securities issued in fiscal 2011 by principal amount, almost 76% were covered bank entities, it said. Of the firms that reported 98% of the trades executed during fiscal year 2011 by principal amount, 75% were covered banking entities.
The joint proposal would currently exempt from the Volcker Rule muni securities issued by states, counties and cities. It would not exempt housing or turnpike authorities, water and sewer districts, school districts or other such entities, some of which were established because their governments did not have the authority to issue revenue bonds.
About 41.4% of the muni securities issued in fiscal 2011 were issued by such agencies, authorities and districts, based on data from Thomson Reuters, the MSRB said.
“Most of the debt issued by agencies and authorities is clearly public purpose in nature,” the board said. “It finances schools, roads, bridges, water systems and other major infrastructure projects. There is no indication that Congress meant to bifurcate the municipal securities market by means of the Volcker Rule simply because a state or political subdivision has chosen to finance its key infrastructure needs through the issuances of bonds by its agencies [or] authorities ... rather than directly through the issuance of identical bonds by the state or political subdivision.”
The MSRB recommended the federal regulators adopt the definition of municipal securities that appears in the Securities Exchange Act of 1934, which covers all munis.
The joint proposal by federal regulators also would exempt market making from the Volcker Rule. But the MSRB said the exemption would be of little use to the muni market, where many bonds are infrequently traded.
On a typical given day, about 39,000 trades in 14,000 different securities occur, according to the board. “This means that over 99% of municipal securities do not trade on a given day,” it said. “In fact, over 90% typically do not trade in a given month.”
“Dealers in municipal securities do not typically post bid-ask prices for a significant number of municipal securities on a regular basis,” the MSRB added, “Most municipal market participants consider a primary function of market making to be the generation of liquidity in the market by taking securities into inventory.”
Meanwhile, George Friedlander, a managing director of municipal strategy at Citi, told market participants during a conference call on Tuesday, that the joint proposal for the Volcker Rule, “has massive potential to do serious damage to the functioning markets,” including the muni market.
“There is a powerful case for exempting all municipal bonds [from the Volcker Rule], as they do for direct obligations,” he said.
Failing to exclude authorities and agencies would impair liquidity and raise borrowing costs in the muni market, he and others said.
“We don’t believe that the vast amount of what goes on in the muni market is proprietary trading,” Friedlander added.
He also said munis would have trouble under the joint proposal’s exemption for making exemption. Broker-dealers often buy muni bonds that have no bidders, with the expectation that they will find bidders for them in the future, he said.
Citi sent the four financial regulators a 19-page letter, which urged them to exempt all munis from the Volcker Rule.
Like the MSRB, the firm recommended the federal regulators adopt the definition of municipal securities that appears in the Securities Exchange Act of 1934.
Citi said the current joint proposal conflicts with existing statutes and guidance, is inconsistent with state definitions of political subdivisions, would restrict market liquidity, and could “penalize small municipalities all over the country that routinely issue direct general obligations and revenue bonds through pooled bond programs.”
The firm used Virginia Resources Authority and the State of New York Municipal Bond Bank Agency as examples of authorities that help local governments muni access the market through pooled programs.
“Furthermore, we request that [tender option bonds] be excluded from the scope of the Volcker Proposal so that banks, their affiliates and customers will continue to have access to a critical financing vehicle that provides them with secured short-term financing, encourages their participation as investors in the municipal market, and preserves an important low-risk class of municipal assets for ... money market investors,” said the letter, which was signed by Howard Marsh, a managing director and head of the municipal securities division at Citi.
Attached to that letter are lists of state authorities or agencies that are also considered to be political subdivisions under state law. Examples included the Port Authority of New York and New Jersey, the Florida Municipal Power Agency and the Louisiana Housing Finance Agency.
Citi officials urged muni market participants to write the financial regulators to ask for a full muni exclusion from the Volcker Rule. The deadline for comments is Feb. 13. The rule is to take affect in mid-July but banks would have two years to implement it.
