Dodd-Frank Impact: Know Your Municipal Bonds

Credit ratings no longer the sole determinant of strength

Weekly market view from New Oak.

by James Frischling, President & Ron D’Vari, CEO

Over-reliance on ratings was one of the factors contributing to the financial crisis and helped drive the need for financial regulatory reform. The Dodd-Frank Act doesn’t rule out the use of credit ratings, but it does prevent an investor from relying on them as the sole determinant of a bond’s credit worthiness.

While the Dodd-Frank provision was largely driven by the opaque nature of non-agency residential mortgage-backed securities, its effect on regional and community banks will be greater because of the municipal bond market rather than the asset-backed securities market. The reason is municipal bonds make up a much larger percentage of the holdings of these smaller banks and therefore the asset class requires greater scrutiny and focus.

In addition to ratings, municipal bond investors also benefited from the enhancement often provided by an insurance company. The combination of a credit rating and an insurance policy was often deemed sufficient for investment decisions regarding municipal bonds as well as other credit products. To be clear, Dodd-Frank has not ruled out the use of credit ratings or insurance protection, but it does say that complete reliance on ratings and credit enhancement is no longer acceptable.

There is about $3.5 trillion in municipal bonds outstanding, and bankers and investors alike are trying to figure out what is needed at the pre-purchase stage and during the holding period to meet the new regulatory requirements. Full credit analysis and write-ups weren’t often embraced and the municipal bond market is in process of establishing best practices. When it comes to credit, best practices require the deployment of the 5 C’s – character, capacity, capital, conditions and collateral. It’s not complicated, but it remains the vital work that needs to get done—and done correctly.

Detroit Swap City: Is Latest Settlement a Model for Future Negotiations?

To be clear, Dodd-Frank has not ruled out the use of credit ratings or insurance protection, but it does say that complete reliance on ratings and credit enhancement is no longer acceptable

Detroit reached a negotiated settlement with Merrill Lynch and UBS (the counterparties) on collateralized swaps hedging about $800 million of $1.4 billion of pension securities in legal dispute. The city is pursuing a separate lawsuit to consider the $1.4 billion of pension certificates that the swaps hedge as illegal.

The swap payments are secured by casino revenue, the third largest and most stable source of income for the city. As a result, Detroit officials are highly motivated to avoid a lengthy litigation that could end up being costly and tie up the casino revenues. More importantly, this settlement, once approved by the court, will open the way for Detroit debtor-in-position financing being negotiated with Barclays Capital. Equally important, the settlement will help Detroit pursue a cram-down plan with other creditors who have objected to previous settlements.

The latest settlement requires Detroit to pay the counterparties $85 million over the next seven months. This settlement amount was negotiated down from the previous deal of $165 million in January, which was rejected. Last October, Detroit initially had proposed paying the counterparties $230 million. The market value of the swaps is $288 million due to a drop in interest rates and high contractual coupon obligations of the city. As part of the settlement, Detroit will agree to indemnify the counterparties from any litigation against them or the casino revenues.

The swap settlement, if approved by the court, is a good example of how banks and investors may decide to compromise their legitimate claims to avoid time-consuming litigation that can prevent bankrupt entities from restructuring their finances. However, there is no doubt there are others that hold out in hopes of receiving further compensation.