The groups made their pleas in two separate letters sent just before Wednesday’s Senate Finance Committee hearing and how tax reform affects state and local government fiscal policy. Here is the 1st rather interesting letter.

April 23, 2012
The Honorable Max Baucus Chairman, Committee on Finance United States Senate 219 Dirksen Senate Office Building Washington, D.C. 20510

The Honorable Orrin Hatch Ranking Member, Committee on Finance United States Senate 219 Dirksen Senate Office Building Washington, D.C. 20510

Dear Chairman Baucus and Senator Hatch:

The state and local government associations and other organizations listed above representing participants involved in the municipal bond market, commend you for holding a hearing on the impact of tax reform proposals on state and local governments. Our associations look forward to testifying in future hearings as government representatives and market participants. This submission is limited to a discussion of the importance of tax-exempt bonds. We urge Congress’ continuing support and commitment to tax-exempt bond financing in recognition of the critical role it plays in the ability of state and local governments to fund national priorities, particularly infrastructure.

Maintaining the tax-exempt status of municipal bonds is essential to help our national economy grow, create jobs, and best serve the constituencies of every community. Three-quarters of the total United States investment in infrastructure is provided by state and local governments, and tax-exempt bonds are the primary financing tool used by over 50,000 state and local governments to accomplish these infrastructure goals.

Our citizens and communities benefit in many ways from the issuance of tax-exempt bonds. They are used to build and maintain elementary and secondary schools, as well as colleges and universities, which help develop an educated workforce. They are used to build our roads and airports, all of which are essential for supporting commerce. They address the country’s water infrastructure, electric utility and affordable housing needs. Tax-exempt bonds also finance public safety infrastructure that ensures local and national security. Nearly four million miles of roadways, 500,000 bridges, 1,000 mass transit systems, 16,000 airports, 25,000 miles of intercoastal waterways, 70,000 dams, 900,000 miles of pipe in water systems, and 15,000 waste water treatment plants have been financed through municipal bonds. (National League of Cities)
States and localities determine if bonds should be issued to meet the needs of their citizens, generally through a vote by elected officials or through voter referenda. Placing the decision-making at the state and local levels ensures effective resource allocation and avoids inefficient decisions due to federal bureaucracy, cumbersome grant programs, earmarking and similar processes. An extensive federal legislative and regulatory regime exists under the Internal Revenue Code to ensure that tax-exempt bonds are used properly.

State and local governmental bonds have been issued since the mid-1800s, and the federal tax exemption was included in the country’s income tax code since its promulgation in 1913. Through the tax- exemption, the federal government continues to provide critical support for the development and maintenance of essential facilities and services, which it cannot practically replicate by other means. Without the tax-exemption, state and local governments would pay more to raise capital, a cost that ultimately would be borne by taxpayers, through reduced infrastructure spending, decreased economic development, higher taxes or higher user fees.
The ability to sell bonds with interest exempt from federal income taxes reduces the interest paid for borrowed funds by approximately 25 percent (SIFMA). Tax-exempt bond issuance has remained stable compared to GDP over the past 10 years, averaging around 14.8%, and has actually declined since the 1980s. State and local governments are not overextended in debt. In fact, debt service is typically only about 5% of the general fund budgets of state and municipal governments. The tax-exemption represents a fair allocation of the cost of projects between the federal and state/local levels of government. State and local borrowers are responsible for repaying the principal and interest on a bond. The federal contribution is provided in the form of theoretically foregone tax revenue and represents an important, but relatively small portion of total project costs. As a result, the federal contribution is significantly leveraged.

Municipal bonds offer a healthy investment for American families in America’s communities. Seventy percent of municipal bonds are held by individuals, directly or through mutual funds (Thompsen Reuters). Investors choose to purchase municipal bonds, even though the investment return is less than if they purchased corporate or other taxable bonds, because the tax-exemption results in an equivalent after-tax benefit. Furthermore, as a class of investment, all investment grades of municipal bonds have proven to be safer investments than AAA corporate bonds (Municipal Market Advisors).

Our experience informs that tax-exempt financing is a well-established market providing a cost-effective mechanism for financing infrastructure and meeting needs of our citizens. Any changes that would replace, compromise, dampen or eliminate tax-exempt financing immediately or retroactively, particularly those offered as deficit reduction alternatives, should be carefully and cautiously analyzed by the committee.
Thank you again for the opportunity to comment on this important issue. We look forward to continuing conversations with you and your staff about these important issues.

Sincerely,

International City/County Management Association, Elizabeth Kellar, 202-289-4262

National Association of Counties, Michael Belarimo, 202-942-4254

National League of Cities, Lars Etzkorn, 202-626-3173

U.S. Conference of Mayors, Larry Jones, 202-861-6709

Government Finance Officers Association, Susan Gaffney, 202-393-8468

National Assn of State Auditors, Comptrollers and Treasurers, Cornelia Chebinou, 202-624-5451

National Association of State Treasurers, Jon Lawniczak, 859-244-8175

American Public Gas Association, Dave Schryver, 202-464-0835

American Public Power Association, Joy Ditto, 202.467.2954

Council of Development Finance Agencies, Toby Rittner, 614-224-1300

Council of Infrastructure Financing Authorities, Rick Farrell, 202-547-1866

Education Finance Council, Vince Sampson, 202-955-5510 International

Municipal Lawyers Association, Chuck Thompson, 202-742-1016 Large Public

Power Council, Noreen Roche-Carter, 916-732-6509 National Association of

College and University Business Officers, Liz Clark, 202-861-2553

National Assn of Health & Higher Education Facilities Authorities, Chuck Samuels, 202-434-7311

National Association of Local Housing Finance Agencies, John Murphy, 202-367-1197

National Association of School Administrators, Bruce Hunter, 703-875-0738

National Council of State Housing Agencies, Garth Riemen, 202-624-7710

National School Boards Association, Deborah Rigsby, 703-838-6208

Bond Dealers of America, Mike Nicholas, 202-204-7901

Investment Company Institute, Jane Heinrichs, 202-371-5410

National Association of Bond Lawyers, Bill Daly, 202-503-3303

National Association of Independent Public Finance Advisors, Colette Irwin-Knott, 317-465-1504

Securities Industry and Financial Markets Association, Michael Decker, 202-962-7430

Illinois’ woes have been well documented. The state has a severe backlog of unpaid bills, both to vendors and to Medicaid, totaling $8 billion+. Many vendors are being paid with IOUs. The state’s pension fund system is reported by Bloomberg to be the lowest-funded state pension system in the US, with assets equaling only a little over 44% of projected obligations. These unfunded pension obligations total over $80 billion. The state covered its payments to the pension fund in 2010 and 2011 through borrowing.

The stress in the state can be seen in some widening in the value of the state’s bonds. In the taxable bond market, its general-obligation bonds (5.10s of 2033, with over $7 billion issued in 2003) have recently widened out to +250 basis points over US Treasury bonds, compared to roughly +220 a few weeks ago. To put this in perspective, these pension obligation bonds came to market in June of 2003 at a spread to US Treasuries of 72 basis points. Tax-exempt bonds have seen similar widening in the past few weeks.

The consternation over the state’s finances can also be witnessed in the market for credit default swaps, where 10-year credit default swaps (“CDSs”) for Illinois have widened this month from 240 basis points to 275 – a rise of 35 basis points. To be fair, all municipal-credit default swaps have widened this month, as concern over Europe has put some of the flight-from-risk trade back into the Treasury market. But compare this to California, a state rated A- by S&P, which saw its 10-year CDSs rise from 206 basis points to 235 – a rise of only 29 basis points.

So what has Illinois done to stem the tide? Last year the Illinois state legislature raised the state’s top income tax rate from 3% to 5%. That has provided additional funds, but not enough to reduce the drag created by pension costs and the reduction of federal funding to the state. The governor has introduced a plan that looks to increase employee contributions to pensions, limiting cost-of-living increases and extending retirement ages.

Clearly, more needs to be done across the whole spectrum of revenue raising as well as cost reduction. Illinois is planning to bring a $1.8 billion general-obligation deal this week (April 30th, 2012). The price talk on the deal is 175 to 200 basis points over the AAA scale (Municipal Market Data). This compares to a smaller $500-million-dollar deal in March of this year, which came at a spread of 150 basis points over MMD. Thus the markets are now saying things are going to get worse before they get better.

Aside from the state itself, who is getting hurt? Answer: all the local-governmental units within the State of Illinois that issue bonds. From the University of Chicago, to the City of Peoria, to Lincoln’s home of Springfield, to smaller towns and villages, all are paying higher debt-service costs because of the poor financial management at the state level.

At some point these issuers, sick of paying these additional interest costs, will take up the famous line from the movie Network, when Peter Finch shouts from the window, “I’m mad as hell, and I’m not going to take this anymore!” And call for real change.

Thanks to our friends at Cumberland Advisors

Talk about petty politics further ruining the city. Hopefully the voters can throw both of these quacks out of office come November and bring in someone that has the best interest of the public at heart. Here are some ruined Harrisburg bonds that are in default.

We have seen 1st hand that Puerto Rico bonds have been some of the 1st to to drop in value during recent downturns with some essential service bonds loosing as much as 40% on the dollar.

To drill down deeper into this issue, we turned the really smart folks at The Center for the New Economy who did a revealing look at Puerto Rico’s deficit issues. We provide a summary below:

For purposes of this analysis we adopt the definition of structural deficit used by the rating agencies. Under that definition we estimate the Commonwealth’s deficit for fiscal year 2012 to be at least $1.449 billion. Our analysis is based on the government’s recent disclosure to its bondholders. In the Preliminary Official Statement for its recent offering of $1,500,000,000 of Commonwealth of Puerto Rico Public Improvement Refunding Bonds, Series 2012 A (General Obligation Bonds), the government of Puerto Rico makes the following disclosure:

“The deficit for fiscal year 2012 is projected to be approximately $610 million, excluding approximately $685.2 million of principal and interest payments on Commonwealth general obligation bonds that were refinanced through GDB financings (the “GDB Lines of Credit”), which financings are expected to be repaid from the proceeds of the Bonds and the Series B Bonds, and $154 million of interest payments on Commonwealth guaranteed Public Building Authority Bonds that were refinanced through GDB financings, which financings are expected to be repaid from the proceeds of the issuance of Public Building Authority Bonds. In addition, the Office of Management and Budget (“OMB”) has indicated that the sectors of health and public safety carry the risk of budget overruns for fiscal year 2012 as they are undergoing operational changes that were not considered during the preparation of the 2012 budget.”

In our view, debt service is a recurring expenditure. Therefore, the difference between general fund recurring revenues and recurring spending for fiscal year 2012 is at least $1.449 billion ($610 million + $685.2 million + $154 million) plus any budget overruns in the public health and safety sectors.

The municipal bond analysts at UBS Wealth Management Research based in New York seem to agree. In their most recent analysis of the Commonwealth’s finances (dated January 11, 2012) they estimate the Commonwealth’s structural deficit at $1.429 billion.

According to UBS’s analysts, “as UBS WMR defines a structural budget deficit as the excess of recurring expenditures over recurring revenues and views debt service as a recurring expenditure, we feel that the representation shown in Table 7 –Budget deficit (December 2011) is more appropriate from an analytical perspective.”

In sum, it appears to us that given (1) the government’s own disclosures and (2) the financial analysts’ definition and use of the term “structural deficit”, it is difficult for the administration in Puerto Rico to claim that the deficit for fiscal year 2012 is only $610 million. Intellectual honesty demands that the people in charge of our public finances be consistent, they cannot use one budget deficit figure for bondholders and another one in Puerto Rico.

The fact is there is still enormous demand for Puerto Rico Bonds and with yields hovering around 4% for 10 year maturity dates, these bonds are very cheap compared to other states. The income from Puerto Rico bonds, and by the way most other US territories, is triple tax free regardless of what state you reside. While a New Yorker might have to pay state and city income taxes on a municipal bond issued in California, they do not on Puerto Rican debt. Plus investors get improved diversification if they own too many single state bonds.

Like most states, the constitution of Puerto Rico requires that debt holders be paid before any other expenditures. In theory, bondholders get precedence over paying government workers and pensioners.

Some say the Federal government would step in to make payments, if the Puerto Rico could not. However, when major municipal governments faced loan defaults in the past like the New York City when federal government said Drop Dead to NY’s request.

So what is the risk of owning Puerto Rico bonds? Here is what the naysayers claim…

Puerto Rico is running a budget deficit (the difference between revenues and expenditures) and has amassed about $50 billion in debt and forward obligations (pension liabilities). This is over 100% of the state’s Gross National Product (GNP). This is over 5 times the amount of most states. If every dollar of state government revenue went to repaying debt, and the state did have any expenses, it would take over 8 years to repay the debt, and that doesn’t even include interest costs.

The economy of Puerto Rico is hurting. They are not on path to eliminate the budget deficit which will continue to add to their debt burdon.
Puerto Rico is completely dependent on the continued willingness of investors to lend it more and more money every year. At some point, the appetite of investors will turn away from their bonds, which become increasingly more risky every year as their debt load increases. Until then, investors will enjoy after tax yields that are over twice as much as other Municipal bonds.

More to come on the risks of owning Puerto Rico bonds.

President Obama’s 2013 budget, released mid Feb 2012, could affect municipal bond prices. Two proposals that raise tax rates would make tax-exempt bonds more attractive: replacing the alternative minimum tax with a “Buffett Rule” 30% tax that applies to those making more than $1 million annually, and allowing the Bush tax cuts to expire for individuals with taxable income in excess of $200,000 and married filers over $250,000. Another proposal, the revival of the Build America Bonds (BAB) program that was active in 2009 and 2010, and encouraged municipalities to issue taxable bonds with interest subsidies, could also be seen as positive; in its previous incarnation, the BAB program bolstered the tax-exempt market by holding down supply.

A troubling for the muni market is one that limits the value of tax-exempt interest for the $200,000/$250,000 group to that available to taxpayers in the 28% bracket, essentially applying a 7.0% tax to income that is now fully exempt. Should the top tax rate return to the pre-Bush 39.6%, then the size of this additional tax rises to 11.6%.

While these proposals certainly leave much to consider for municipal market participants and bondholders, the market reacted fine since passage of these bills seems highly unlikely as written. However, even if these proposals do not get far collectively or individually in the near future, their mere existence supports the notion that “tax-code risk” in the form of the longevity of the current federal tax exemption will likely shroud the market through and beyond the November elections.

Every year, as the April tax deadline approaches, the muni market comes under pressure from investors selling bonds to raise cash for taxes. Given near-record-low yields, relatively high prices and the availability of a favorable capital-gains tax rate, tax-related sales could be especially attractive this year.

Morgan says its time to consider some selective selling and lightening up on 25- to 30-year debt with sub-5% coupons, as well as low-BBB-rated and sub-investment grade paper where demand from yield-hungry investors has been robust.

For buyers, they prefer state-level general obligation bonds, state-level appropriated paper, local general-obligation bonds and essential-service revenue bonds with mid-tier A ratings and higher, as well as AA-rated hospital debt within a maturity band of six to 14 years.

Using the AAA Municipal Market Advisors Scale, bonds due in 2022 were marked at 2.53% at year-end and at 2.17% on January 27th. Certainly some of this 36 basis point drop is due to the “roll”. Thirty-year AAA bonds tumbled from 4.22% to 4.06%. And many new issues are now seeing longer bonds well through 4%.

This is more remarkable when one factors in US Treasury yields rising slightly for the month with ten-year governments rising 3 basis points to 1.91% and thirty-year yields rising 18 basis points to 3.08.

In our opinion, there were four parts of the kindling which was lit by the year-end supply/demand imbalance:

1) Credit. The muni market spent most of last year recovering from the hammering it received a year ago when yields spiked due to the Whitney 60 Minutes piece. Quarter by quarter, municipal receipts continued to improve and, more importantly, the public perception of municipal credit improved as well. Defaults – even with the “one-off” events of Harrisburg, PA and Jefferson County, AL – were lower in 2011 than the year before.

2) Overall Supply. Overall tax-exempt supply ended the year at approximately $300 billion. This is a far cry from recent years’ supply of $400 billion and would have been even lower except that low interest rates spurred issuance in the fourth quarter. Certainly, supply was down early in 2011, as many issuers did not want to issue debt into a dysfunctional market. But greater austerity among issuers certainly contributed to the downswing in overall supply.

3) Bond Fund Flows. Bond fund outflows following the Whitney piece were responsible for most of last winter’s meltdown. It took until late spring for the outflows to level off and finally, in the fall, bond fund net inflows resumed. This was a large addition to incremental demand as year-end approached.

4) Crazy Muni/Treasury Ratios. The ratio between thirty-year AAA Muni Bonds and long US Treasuries reached greater than 150% this past fall. These were easily the cheapest ratios the municipal market has seen since the aftermath of the post-Lehman meltdown. This absurdity was a result over the rush into Treasuries following the downgrade of the United States by Standard and Poor’s and the concern over continued problems in Europe. Meanwhile, the muni market was still in recovery mode and yields remained stickily high. Many new issues were over 160% ratios. Crossover buyers (traditional taxable bond buyers who will buy tax-free bonds at high ratios) woke up and entered the market.

The spark that set this rally off was the usual year-end supply distortion, with an estimated $35 billion of coupon payments, called bonds, and maturing bonds in the combined months of December 2011 and January 2012. And, of course, the normal slowdown in issuance that occurs at year-end. The last few years have not always been “normal”. But with the above-mentioned factors in place there were extremely favorable conditions for a muni rally to start the new year.

With fairly low NOMINAL yield levels Cumberland is starting to ratchet down some our durations and maturities. We are starting to add more short-term bonds, cushion bonds (bonds with larger coupons yielding to fairly short call dates) and municipal inflation indexed bonds (MIPS). These low yields should spur on issuance later in the year and we feel that continued economic growth, while slow, should result in overall higher yield levels later in 2012.

Thanks to our friends at Cumberland Advisors for.

“New Jersey won’t approve Chapter 9 bankruptcy filings by distressed municipalities, according to Thomas Neff, director of the state Division of Local Government Services. New Jersey law requires state approval of all municipal bankruptcies, Neff said in an interview at a conference of mayors in Atlantic City. His division would look to use state aid and possible takeovers of city finances to avert such filings, he said. “It’s more likely to snow in July than for us to approve a bankruptcy,’’ Neff said. “I can’t even see myself posting it for consideration.’’

Many readers have asked for a perspective on the Chapter 9 Municipal Bankruptcy of Jefferson County, Alabama. Others have e-mailed us concerning Harrisburg, Pennsylvania. Over the course of the year we have written about these situations. Our view remains that these are one-off events brought about by failures of the local political systems and disappointing governance. Sometimes corruption is added to that toxic combination.

We argue that most Munis are mostly safe most of the time. The key is to research them and understand the construction of each of these idiosyncratic credits.

Specific bankruptcies, like Jeffco and Harrisburg, are the final actions of a process that began several years previously. They were the result of poor decision making on the part of elected public officials. However, not every bad Muni deal ends in a bankruptcy. Many can be worked out. In those cases the political officials realize that avoidance of bankruptcy is “less worse” than choosing what appears politically to be an easy way out; they are mistakes that were made either by the elected officials or others involved in the process.

Portions reprinted from our friends at Cumberland Advisors

The municipal bond market has been expecting this for some time. For the past three years this situation has been deteriorating. Its roots involve a sewer system grossly expanded under federal mandate, and corruption among county officials. It also involves the downgrade of municipal bond insurers in 2008, which caused the county’s many ill-advised swaps to skyrocket in interest costs.

Through much of the summer and fall, Jefferson County has been trying, to no avail, to negotiate a haircut on the principal of their bonds. With $3 billion involved, there will be some effects, mainly on lower-rated debt, but the market has been prepared for this. Most market participants were hoping that something could be worked out. The Governor of Alabama, Robert Bentley, had been trying to forge a solution between bondholders and the county. This solution would have included bonds backed by the state, but would also have resulted in much higher sewer fees in the county. The bankruptcy action may be an impetus toward crafting a solution.

Where have Jefferson County bonds been trading?

We expect to see little market impact on trading in Jefferson County bonds. The county has refunded most of its fixed-rate sewer debt with VRDBs and ARS in 2002 and 2003. The trades we have seen and local dealer quotes have been at high interest-rate levels. Participants most affected are the Letter of Credit banks that hold the failed remarketed debt and bond insurers, not bondholders. And with the Chapter 9 filing, we would expect to see more trading in the bonds.

What does Jefferson County do next?

They need to demonstrate to the bankruptcy judge that they cannot pay their bills. The judge will then determine what obligations they must fulfill, and at what level. JPMorgan, as well as the bond insurers FGIC and Syncora (formerly XLCA), face the largest losses.

Does this morph into a Meredith Whitney-like falloff?

We think not. Jefferson County has been developing for over three years. This is a result that almost happened in September. It was staved off by tentative settlements with creditors that did not get legislative approvals. Municipal bankruptcies are running at about 30% of last year’s totals. Problems such as Harrisburg, PA and Central Falls, RI have been known for a while; they represent specific mismanagement. Furthermore, the improvement in municipal credit this year has been very good.

Through the courtesy of our friends at Raymond James, we show two graphs:

State Taxes Grow

Property Tax Weakness

The first shows year-over-year changes in state and local taxes. The other shows specific tax revenue changes. You can see the strong rebound in state taxes, which are now back to pre-financial-crisis levels after seven quarters of gains (following five quarters of declines). Growth in local taxes – specifically property taxes – has been falling but held up better than other types of taxes when the recession hit, as it does in most recessions. The overall municipal market has rebounded smartly in the past nine months.

We will stay abreast of the next developments.

The right thing to do is for bondholders and the county to work this out. The wrong thing to do is for the county commissioners to in effect to approve a “walk out”. To imply the entire county has no assets to sell off now or in the future is plain silly. How about selling off or privatizing local government assets like city hall, office buildings, vacant land? Or what about securitizing future revenues from parking garage revenue and sales taxes?

There is plenty of time to make annual payouts over the next 30 years. As the economy improves so will Jefferson Country. But to just take the money and run is just plain wrong. Oh and by the way, its illegal.

“I am disappointed by the commission’s decision… as bankruptcy will negatively impact not only the Birmingham region, but also the entire state,” Gov. Robert Bentley said in a statement moments after the County Commission voted. “By filing for bankruptcy, the county commission now relinquishes control of its affairs into the hands of a federal bankruptcy judge,” Bentley said.

Despite a tentative deal with creditors reached in September to settle $3.14 billion of debt, county commissioners this week resurrected the threat of a Chapter 9 bankruptcy filing largely because the estimated savings from the September agreement had shrunk by about $140 million. The filing could add to heightened concerns in the $3.7 trillion U.S. municipal bond market, which has recently been hit hard by the high-profile debt crisis in Pennsylvania’s capital of Harrisburg. Creditors such as JPMorgan Chase & Co and the county in September reached a tentative deal calling for Jefferson County’s sewer-system debt to be substantially reduced, but final terms were not reached.

A sticking point discussed in a commissioners’ meeting on Monday was adjustment of a $140 million difference between the originally agreed-upon $2.05 billion the county must repay the creditors. That figure recently crept up to $2.19 billion. The September agreement was seen as a turning point for Jefferson County, which since 2008 has teetered on the edge of a bankruptcy that would have surpassed that filed by Orange County, California, in 1994. Jefferson County’s debt escalated in the mid-2000s with interest and auction rate bond deals as it sought to refinance an upgrade of its sewer system. Should Jefferson file Chapter 9 bankruptcy, at over $5 billion for the county’s total indebtedness, it will be the largest municipal filing in U.S. history.