We can still remember when people were telling us that the subprime crisis was confined to U.S. housing — that it was not a big deal in the final analysis.  Well, the final analysis is not in yet, but oh were they wrong. 

Not only is the subprime crisis not confined to U.S. housing — it is rippling through the entire U.S. and world economy. The Federal Reserve, European Central Bank (ECB), and the Bank of Japan (BOJ) have injected liquidity .  The ECB and BOJ have talked about deferring expected short-term interest rate increases.  The People’s Bank of China has been talking up the dollar in response the crisis.

One U.S. money market fund issuer has filed for bankruptcy and the large French insurer, AXA, had to infuse money to avoid “breaking a buck” on one of its money market funds.

The U.S subprime crisis is not just a U.S. housing problem, it is an overall problem for the U.S. and world economy.  For a further example, yesterday, the Bank of China (#2 bank in China) announced that it holds $9.7 billion of U.S. subprime mortgage debt and has begun putting up new loss reserves for that.  The reserves are only $152 million so far, but when Chinese banks start having U.S. subprime problems, we’d say the problem is not domestic, is not contained and is not likely fully revealed.

We’d like to add an anecdote from our firm’s direct experience to further illuminate the situation.

Yesterday, we managed the bid process for a municipal bond refinancing and the market information was astounding.

In a municipal bond refinancing a city that has muni bond proceeds that need temporary investment prior to use will invest the bond proceeds to generate income to pay the coupon on the muni bonds.  One method — the one we were hired to manage — is to ask a major institution to provide a guaranteed fixed return for a specified period for a particular sum of money, but with full flexibility for the municipality to withdraw funds as may be required during the life of the guarantee. That is called a “flexible bond repurchase (repo) agreement”.

Normally, the bid manager (that’s us) would send a request for proposal to a significant number of large, high credit quality banking, insurance and investment banking institutions; and then sort through the responses, organize the data in a consistent way and recommend to the municipality which to chose.

The selected repo issuer then puts Treasury securities in the amount of the guarantee in the hands of a third party custodian, and the custodian passes the muni bond proceeds to the repo issuer.

Normally, there is serious competition from institutions to get the business, but not yesterday.  We sent proposal requests to 20 major institutions that routinely do muni flexible repo business asking for a 90 day repo for $20 million and a 1 year repo for another $20 million.  Of the 20 institutions only 3 submitted a proposal, while 17 (85%) sent declinations.  That level of non-availability is unprecedented.

The reasons given in the responses from the 85% that did not make an offer were of two types: “We have no collateral available” or “We are not currently offering collateralized products.”

NO COLLATERAL!  NO COLLATERALIZED PRODUCTS!  Those two statements represent a depletion of resources for new investment in the first case, and a general shift away from risk in the second case.  The problem is popping up everywhere, and everybody is impacted.

Richard Shaw
QVM Group LLC

One of our clients who invests substantial amounts in individual tax exempt municipal bonds asked us how municipal bond issuers assure that they will have the investment interest available to pay the bond interest rate due during the time between the bond issuance and the time the money is put to its public purpose. In other words, how do they match assets and liabilities for temporary investments before they must rely on tax revenue to pay bond interest?

For most people, even municipal bond investors, the question is a bit esoteric, but it is also of potential interest to town, city and state officials and legislators who may not be directly involved in the bond process, but who are concerned about the very question.

Our firm is actually involved in helping governments select investment solutions to solve that very asset and liability matching problem. Here’s how it generally works:

Let’s say a city issues a long-term tax-exempt bond for 10’s of millions of dollars to build a school, road, bridge, sewer plant, or some other public facility. When they issue the bond, they get all the money at one time, but they will not disburse the money immediately, and will pay it out in stages as the project is completed in stages. They will have a development schedule and a disbursement plan, but life being the way it is, reality and plans are seldom exactly the same. The city has a need for a delayed and periodic but irregular and not entirely precisely timed future of making payments toward the development project.

Therein lies the problem. The bond calls for just the opposite — immediate, periodic, regular and precisely timed payments of interest at a fixed rate. How does the city avoid the risk of having to use tax revenue to pay any portion of those interest payments before the money is disbursed for the public project?

The solution is a flexible withdrawal, guaranteed investment rate contract from an institution that can manage the cash flow vagaries of a flexible withdrawal feature. The city gets the bond money in and immediately invests it in such a flexible GIC.

Examples of companies that provide flexible GICs for this purpose include: AIG, Citicorp, Morgan Stanley, Bank of America, MBIA, Berkshire Hathaway, and others.

The law limits the vehicles available for investment of municipal bond cash, to rock solid things like U.S. Treasuries. Therefore, the alternative to the flexible withdrawal GIC would be for the city to build its own Treasury ladder, but then they would have other risks — market risk if cash were needed before rungs on the ladder matured, or reinvestment risk if rungs of the ladder matured before cash is needed. The flexible withdrawal GIC eliminates both of those problems.

Bond issuers may have internal staff to analyze GIC bids to select flexible GIC providers, or they may call on advisors, such as our own firm, to analyze the proposals from various GIC providers bidding for the investment. That analysis makes sure that the detailed terms of the contracts, which are complex documents, actually respond suitably to the bond issuer’s needs and specifications. It organizes the various formats of data from the bidders to allow a meaningful side-by-side comparison of the bids. The investment advisor then recommends which of the bidders is the best choice for the city. Finally, the advisor coordinates activities to make sure that the winning GIC bidder gets the contracts issued timely and in conformity with the bid proposals.

The story is not yet over, however. The Tax Reform Act of 1986 created an effective 100% tax on excess interest earnings in repurchase agreements by municipal bond issuers. Simply put, if the GIC pays more interest than the municipal bond pays out, the bond issuer must surrender (rebate) the excess to the U.S. Treasury. However, if the GIC pays less interest than the municipal bond pays out (and that happens in some circumstances) the bond issuer is just out of luck and the U.S. Treasury does not refund prior excess payments. There are some rules that allow offset between a current losing GIC and a current winning GIC, but the noteworthy fact is that the Treasury generally intends to share in the bond issuer’s reinvestment profits, but stand back from its losses.

As a result of this federal regulation, the Internal Revenue Service issued IRS 26 CFR Part 1, Section 1.148-5, which allows municipal bond issuers to deduct the cost of advisors in the GIC selection process from any calculation of excess interest that the bond issuer may be liable to pay the U.S. Treasury. That is why the GIC providers are the ones who are now required to pay the advisor to the bond issuer. It keeps things nice and simple for the bond issuer to receive interest net of the advisory fee before it figures out if it owes Uncle Sam money

That is how governments manage temporary municipal bond investments to match assets and liabilities.

Richard Shaw
QVM Group LLC

Disclosure: Author does not own any of the companies listed.