Liquidity Breakthrough for the Municipal Market

During the 2008 Financial Crisis liquidity conditions tightened for the entire banking industry in a very short time span.  Many financial institutions were caught off-guard as the impact was far greater than they had modeled.  Various liquidity counterparties shut off funding lines in an effort to preserve their own balance sheets.  Unlike commercial banks and brokerage firms, the Federal Home Loan Bank system continued to be a reliable provider of liquidity eventually helping stabilize the market.

Since the 2008 Financial Crisis a lot of attention has been directed toward the municipal market.   Everyone remembers Meredith Whitney and her 2010 bold prediction of dozens of massive municipal defaults and the introduction of the Dodd-Frank Act calling the municipal investment rating system into question.  It seemed as if municipalities would struggle to issue debt in the years to come.  The opposite has happened, financial institutions have increased their allocation to this sector and now own $1.1 trillion of the $3.6 trillion municipal market.

High-grade municipals have been a very good asset class due to wider spreads, virtually zero loss rates, call protection, and favorable price performance vs. taxable securities.  Another big benefit is General Obligation securities carry 20% risk weighting for capital, same as Agencies and MBS.  However, investors have generally thought of the municipal sector as one with lower liquidity mainly because of fewer pledging (repo) options.  This dogma has been changing with more counterparties accepting municipal bonds as collateral, and we recently saw a breakthrough in the new issue market we discuss below.

Over the last several years, various Federal Home Loan Banks across the country have slowly been accepting certain municipals as collateral for borrowings.  The caveat being that a portion, if not all the debt issued in each series be used for real estate purposes.  Where the challenge comes is that this can be difficult to identify when pouring through a prospectus, or official statement that does not clearly define the use of proceeds.

Taylor Advisors has been working hard to not only help our clients, but the entire real estate municipal market.  In September of 2017, The National Association of State Treasurers, State Debt Management Network, Federal Home Loan Bank of Indiana and Taylor Advisors hosted a webinar encouraging municipal issuers to incorporate clearer language into their official statements.  The goal was to improve liquidity for Federal Home Loan Bank members and lower the cost of capital for our communities.

Since the webinar, we have seen more issuers incorporating language into their prospectus’ that is specifically written to improve liquidity at the Federal Home Loan Bank.  An example of this was a 2018 series issued by the Mississippi Development Bank with the following language.

 

“TO ASSIST INVESTORS WITH COMPLYING WITH APPLICABLE FHLB COLLATERAL REGULATIONS, THE CITY PRESENTLY CONTEMPLATES THAT APPROXIMATELY 95% OF THE NET PROCEEDS OF THE SERIES 2018 BONDS WILL BE USED TO FINANCE OR REFINANCE THE ACQUISITION, DEVELOPMENT, AND/OR IMPROVEMENT OF REAL ESTATE.”

 

Another recent example of a deal with real estate verbiage was the Bryan County, GA School District issue that ended up being heavily oversubscribed.   As a result of the demand, the issuer’s weighted average cost of capital ended up being lower versus preliminary price talk.  Certainly, the real estate verbiage was not sole reason of the higher deal demand, but it certainly contributed to the success of the deal.

The secondary market has also taken notice of “FHLB-friendly” securities.  As part of the offering description, certain broker/dealers are starting to note the FHLB verbiage as an enhanced liquidity feature of these securities making them more desirable among bank and insurance buyers further improving market liquidity.

Municipal bonds have already proven to be a good investment choice and most depositories carry a healthy allocation.  With the added ability to obtain liquidity at FHLB for qualifying deals, it makes this sector even more compelling.  And let’s not forget, even if not pledged, municipal bonds go into the regulatory Liquidity Ratio calculation for banks (not to be confused with LCR for large banks).

The Federal Home Loan Bank system’s membership of 7,000 members comprises $22.6 trillion in total assets with JP Morgan Chase, Wells Fargo, Bank of America and Citibank as its largest members.  As Congress debates whether to allow municipals investments to be considered High Quality Liquid Assets, Municipal Issuers, Bond Underwriters, and Investment Advisors are taking the bull by the horns and creating an outlet for municipals to become more liquid with the most stable lender of next-to-last resort, the Federal Home Loan Bank.

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