CUTTING THROUGH THE NOISE: MUNICIPAL FINANCE & EXEMPTION: 2013 Thomas G. Doe, Founder and CEO February 23, 2013 MMA Page 1 www. mma research.com
Municipal bonds should not be thought of as a security to buy and sell; but rather as a loan for a long term infrastructure product. Thomas Doe, CEO & Founder. Conversation with the Pew Foundation in response to the question, What is the one thing you would tell a municipal bond holder? Page 2
What We Know for 2013 and The Exemption Municipal exemption was untouched in December, absolute and relative value has increased. Administration budget discussions have included exemption cap of 28% and BAB s remain a favorite of Democrats. Tax reform still advocated by Republicans. Narrowing of tax exemption still likely away from certain type of issuers and purposes. Corporate tax reform could include reduction of tax exempt corporate borrowing. Page 3
What Is Not Part of the Discussion Regarding the Exemption $3 trillion infrastructure need for US competitiveness. $300B $400B tax exempt financing limit. Cost of the ill conceived BAB program $100B subsidy payments on $200B issued. Prudent fiscal management has retained strong credit quality. Individual investment has provided keen local oversight of borrower unlike subprime a direct connection between lender and borrower. Municipal bond investment has sustained community banks during US economic recovery. Page 4
This is the most serious threat to tax exempt bonds since Roosevelt, in the late 1930s, tried to repeal the exemption across the board, John L. Buckley, a professor of taxation at Georgetown University and former chief counsel to the House Ways and Means Committee. New York Times, December 19, 2012 Page 5
Municipal Ownership Who Makes Loans for US Infrastructure When capital is needed for a project and a loan is required, one goes to entities who have capital. Capital is provided on the basis of the return, credit worthiness and emotional investment. Since the federal tax code was instituted, individuals have been a source of low interest funding for pubic entities. Mutual funds aggregated capital and provided access for lower rated credits. Credit worthiness sustained community banks since 2008. Page 6
Banks Are Now the Third Largest Holders of Municipals Ownership of Municipal Bonds by Investor Segment $ Outstanding ($B) as of 3Q12 $B's $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 $1,750-7% $624 +16 % +23 % $353 $330 $272 +1% -7% Households Mutual Funds Banks Prop/Cas. Ins. Money Funds -$141 +$86 +$66 +$2 -$20
35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% Percent: Yield Pick up Over G.O. January, 1980 to January, 2013 0.0% Jan 80 Jan 85 Jan 90 Jan 95 Jan 00 Jan 05 Jan 10 Percent Source: Bond Buyer Page 8
Municipal Issuance Access to Capital Since 1988, annual issuance has averaged $277B. Highest periods of issuance were facilitated by leveraged investor demand and the BAB program. Since 2008, municipal issuance has been dependent on traditional investors individuals (or their proxy) and banks. In periods, when issuers have been dependent on individuals shocks either from headlines, change in the economy or tax policy uncertainty; access to capital has been disrupted. 1994, sharp losses drove individual investors from municipals and issuance dropped sharply for 6 to 8 months, costs rose. Page 9
February vs. January Issuance Change vs. Annual Total Issuance (By Era of Demand) *MMA Est. February vs. January Change % 80.0% 60.0% 40.0% 20.0% 0.0% 20.0% 40.0% 60.0% $277 13% 15% $178 7% $206 26% $283 $394 $389 20% 8% $421 9% 32% $294 38% $350 $350 $600 $500 $400 $300 $200 $100 Avg Annual Issuance $B's 80.0% $0 February vs. January Annual Average Page 10
6.00 5.60 Loss of Fund Investors Coincided with Higher Yields and Less Issuance: 1994 $350 $300 Yield (%) 5.20 4.80 $250 $200 Issuance 4.40 $150 4.00 $100 10yr Municipal Yield 12 Month Total ($B's) Page 11
Municipal Credit Condition Headline Risk Meredith Whitney s long shadow has finally dissipated as facts have prevailed. $14B of the $3.7T market in default. $3.4B AMR. $8.7B were issues that were initially unrated. $3.3B in safe sectors BUT Jefferson Co. AL Water & Sewer represents $3.2B. December 2012, PR downgrade reminded participants of the fragile demand component $3B exited the mutual funds. Pension reforms remain an area of investor focus IL & PR. Page 12
Par (and #) of Outstanding Muni Bonds With an Uncured Default, Reserve Draw, or Other Impairment ($MM) Support Detail: Sector Last Wk All Notices DEFAULT Support Other Insurer/LOC Pay ALL $794 (22) $46,478 (733) $14,346 (395) $21,826 (213) $10,307 (125) $4,845 (48) IDB $338 (2) $5,592 (55) $4,404 (30) $676 (16) $512 (9) $429 (4) Land Secured $34 (8) $4,981 (308) $3,408 (195) $1,227 (95) $345 (18) $176 (9) Toll Road/Transit none $3,662 (3) $90 (1) $1,339 (1) $2,233 (1) $1,339 (1) Local Housing $38 (4) $749 (64) $614 (49) $43 (7) $92 (8) $3 (2) Retirement $13 (1) $1,723 (68) $407 (30) $395 (12) $921 (26) $82 (3) Hospital $59 (1) $1,547 (30) $436 (15) $223 (3) $887 (12) $99 (1) Hotel none $814 (13) $342 (7) $373 (5) $98 (1) $3 (1) Other Risky Sectors $312 (6) $20,500 (141) $1,318 (60) $15,290 (55) $3,892 (26) $604 (15) Safe Sectors (GO, Non Go, Wtr, etc) $545 () $6,912 (51) $3,326 (8) $2,259 (19) $1,327 (24) $2,111 (12) Initially Non Rated Bonds $545 (17) $13,494 (546) $8,741 (342) $2,856 (134) $1,896 (70) Initially Insured/LOC Bonds $234 (4) $20,227 (85) $3,387 (7) $11,277 (55) $5,563 (23) Initially Rated, Uninsured Bonds $15 (1) $12,115 (75) $1,641 (25) $7,681 (23) $2,793 (27) Page 13
The concern is that Puerto Rico is a systemic risk to the municipal bond market because it s so widely held, Robert Donahue, a managing director with Municipal Market Advisors. New York Times, November 26, 2012 Page 14
1.010 Major Municipal Mutual Fund & ETF Prices, Indexed from November 28, 2012 1.000 0.990 0.980 0.970 0.960 0.950 28 Nov 3 Dec 8 Dec 13 Dec 18 Dec 23 Dec VWIUX FKTIX ORNAX MUB HYD Page 15
Four Themes for Municipal Financing: 2013 Preservation of the exemption to remain an industry focus through budget, sequestration and debt ceiling debate. Changes that disrupt prevailing demand component have historically limited issuer access to capital for 6 to 8 month period. Issuers should have maximum flexibility in issuance to allow for alternative means of financing, but not to the detriment of losing individual oversight of issuers fiscal management or mechanisms that allow the aggregation of capital and expertise. Secondary liquidity and price discovery critical for demand component confidence. Page 16
Looking Forward Five Keys Rebuild existing infrastructure key to economic sustainability. Maintain the close connection between borrower and lender. Preserve the market structure that encourages fiscal discipline. Recognize that all infrastructure needs not met at once and public pension reform must be ever present for investor confidence. New infrastructure associated with climate change. Page 17