“I believe it was the Harrisburg case where enforcement action said, absent providing timely information to the market, any of the comments by issuers in their budgets is speaking to the market. It reminded me of going in as an expert witness case against a big city mayor, who kept saying to the market, we are in pretty good shape. But back home, she was saying, if we don’t do the following things with pension reform, we will be bankrupt. I said, you can’t do that. You are speaking to the market and not going to the bond rating agencies and giving consistent information. As a politician, she had a great newspaper comment after that: that is why we don’t have professors running cities.”
W. Bartley Hildreth, June 4, 2015 The Remaking of the Municipal Markets
Despite some scandals, innovative issuers, and notable defaults, the municipal sector retained a reputation as a straightforward and conservative market into the 1980s. During that decade, tax reform and new economic forces remade the municipal market, resulting by the 1990s in new problems and increased regulatory attention.
Project-funded revenue bonds were at the leading edge of the transformation. During the 1960s, revenue bonds accounted for only half the value of general obligation offerings. In the early 1970s, however, as accepted definitions of “public purpose” widened even as voters turned more tax-averse, municipalities issued revenue bonds to finance housing developments, pollution control projects and even sports stadiums. By 1975, revenue bonds represented nearly half of all issues.
Industrial development bonds, essentially revenue bonds funded by private entities, experienced explosive growth even as their future remained in doubt. The close of every year brought a flurry of IDB activity as issuers sought to stay ahead of tax laws that continually narrowed their applicability.
The revenue bond surge gave momentum to a parallel trend away from competitive bidding and toward negotiated offers. Municipal officials preferred to work with familiar underwriters, but in most cases, statute required that general obligation bonds be put out for bid. This was not the case for revenue bonds. Additionally, it was more difficult to evaluate and understand the funding capacity of revenue issues than it was to rely on the full faith and credit of a municipality. Because revenue bonds were “story bonds,” issuers preferred negotiated bids with familiar underwriters.
As particular projects were more likely to default than cities and states, purchasers sought protection from a growing “credit enhancement” market. Bond counsel opinions and letters of credit were long-standing comforts, but nothing smoothed the rough edges of uncertainties of revenue bonds better than bond insurance, first offered in 1971. By the 1990s, bond insurance put a patina of reliability over about 50 percent of an increasingly complex market.
It was harder to guarantee the security of the municipal tax exemption. By the late 1960s, support was growing for cancellation of the IDB exemption, if not the municipal exemption entirely, and the momentum of the market shifted. Banks, already prevented from underwriting revenue bonds by the Glass-Steagall Act, began to retreat from the general obligation municipal market.
The status of arbitrage was also changing. State and local governments seldom needed bond sale proceeds immediately, so they customarily reinvested the proceeds, earning enough to cover the cost of financing and sometimes more. In 1969, Congress, considering exceptional profit-taking a misuse of the federal tax exemption, imposed arbitrage restrictions, which the Internal Revenue Service revisited during the 1970s.
More fundamental changes came in the 1980s. The 1982 Tax Equity and Fiscal Responsibility Act allowed for book entry only of municipal bonds. Certificates and bearer bonds gave way to more flexible electronic recordkeeping, helping to modernize the municipal market. In 1983, comprehensive tax reform, a priority of the Reagan administration, got underway with both parties introducing legislation.
As Congress considered tax reform, the municipal market roared ahead, from a total value of about $80 billion in 1981 to some $225 billion in 1985. The growth was fueled by cities nationwide competing to offer special purpose financing. By 1985, some 50 percent of all issues were IDB-type bonds. With restrictive legislation in the offing, industry participants raced toward the close of 1985, trying to complete issues under existing laws.
The Tax Reform Act of 1986 transformed the market. Because the tax code had provided for the deduction of interest earned on municipal bonds, banks had been the prevalent buyers of these securities. The Act removed this provision entirely. It put a cap on IDBs, greatly curtailing that market, and sharply restricted arbitrage, dictating that excessive earnings be returned to the Treasury. The municipal market was suddenly smaller and more competitive. Spreads were much narrower. The effects on market participants were profound.
Some old-line bond firms did not have the tenacity or tolerance for lower returns; Salomon Brothers closed its municipal department in October 1987. Bond law also changed. Issuers had favored a handful of firms based mostly in New York, but as spreads narrowed, they began going after bargains. Large firms unwilling, and small firms unable, to continue despite thinner profit margins gave way to a new breed of specialists.
With banks legislated out of the business, there was new space in the municipal bond market for growing numbers of individual investors. In the early 1980s, 44 percent of municipals were held by individuals, either personally or through mutual funds. In the early 1990s, individuals held 76 percent of municipals. The rise of bond funds, which were required by law to affix a net asset value to portfolio holdings, put new price discovery demands on the formerly murky market.
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