Public Finance Update - December 2009

Since September 2009, California has sold more than $21 billion in municipal debt in an effort to shore up its budget deficit and pay for voter-approved capital improvements.  Some analysts worry that this flood of debt might stall the bond market’s recovery by boosting yields too rapidly.  For instance, in September 2009, California paid a 2.48% yield for a 3-year note issue, while in early December, an issue with the same maturity cost the State 4%.  Although investors may enjoy the higher yields, demand for the recent California issue has slowed, indicating that the bull is not quite out of the pen.

California Treasurer Bill Lockyer recently appeared before the California Assembly Budget Committee and reiterated his warning that the State’s debt burden and debt service obligations are rising too rapidly.  According to Lockyer, California has sold approximately $36.6 billion of bonded debt so far this year, including nearly $20 billion in long-term debt.  Moreover, the State’s debt service payments have increased 143% since 1999, while its revenues have increased only by 22% during the same period.  Lockyer underlined the Catch-22:  budget pressures require debt issuance, but more debt equals higher debt service, which puts additional pressure on the State’s budget.  Issuing more debt also drives up the yield cost, which puts even more pressure on the budget.  The answer, according to Lockyer, is an “old-fashioned balanced budget,” which would require, among other things, limiting and prioritizing infrastructure spending and debt programs.

On December 11, 2009, the House of Representatives passed H.R. 4173, a bill designed to reform the current financial regulatory system with the goal of preventing future Wall Street failures like the ones that precipitated our current recession.  The vote was 223 to 202, with no Republicans voting aye.  The bill is broad in scope, seeking to regulate a wide range of financial entities.

The centerpiece of the bill is the formation of a new federal watchdog agency called the Financial Services Oversight Council, which will take over the regulatory functions of many existing entities, including banking regulators.  The Council will be comprised of the Secretary of the Treasury, the Chairman of the Federal Reserve, and the heads of certain other regulatory agencies.

As first introduced, H.R. 4173 sought to regulate the derivatives market without restriction. As passed, the bill retains the power to regulate derivatives, but includes some exceptions for smaller companies and certain types of securities.  The bill also provides shareholders the power to vote on executive compensation.

The Senate is expected to consider its own version of regulatory reform in early 2010.

The recession has not been kind to municipal bond insurers.  With the acquisition of Financial Security Assurance by Assured Guaranty Ltd. last July, Assured became the only company writing insurance for the municipal bond market.  Only a short while ago, more than a half dozen insurance companies competed in the bond insurance market, including Ambac, MBIA, and FGIC.  As the recession gained momentum and certain underlying securities began to falter, especially mortgage-backed securities, most insurers could not keep up with mounting claims.  The New York Insurance Department has given FGIC until January 5, 2010, to devise a plan to restore its reserves to statutory levels or face possible liquidation. Ambac, the first monoline insurance company to enter the bond insuring business back in 1971, indicated in a November SEC filing that it may be forced to seek bankruptcy protection in 2011.

While the surviving insurers regroup, Assured is taking full advantage of its current monopoly.  In light of the rising yield differential between insured and uninsured bond issues, and given its triple-A rating from Standard & Poor’s (double-A from Fitch and Moody’s), Assured recently raised its premiums to approximately $1.39 for every $100 issued (as compared to $0.63 per $100 in 2006).  In 2006, the average yield differential between bonds carrying a single-A rating versus bonds rated AA was 17 basis points.  Today, the average differential is 100 basis points.  Consequently, A-rated issuers can afford Assured’s higher premiums and still realize some savings by insuring their deals.

The yield on AAA-rated municipal bonds dipped slightly in December 2009 to 4.47% for 30-year bonds and 3.17% for 10-year bonds. During the same period, the yield on Treasuries increased slightly to 4.43% on 30-year bonds and 3.52% on 10-year notes, pushing the 10-year muni-treasury yield ratio back under 100% to 90.1%.

Source: Bloomberg (www.bloomberg.com)

Some indicators relevant to the bond market have improved slightly in late 2009.  The Consumer Price Index rose 0.4% in November, and 1.8% during the past 12 months, which is the first positive 12-month change since February 2009.  Unemployment dropped from 10.2% to 10.0% in November.  Both existing and new home sales increased in October by 10.1% and 6.2%, respectively, and housing starts rose in November by 8.9%.  Here are the official numbers:

Sources: Unemployment Rate and Consumer Price Index: U.S. Bureau of Labor Statistics (www.bls.gov)
                 Existing/New Home Sales and Housing Starts: National Association of Realtors (www.realtor.org)