Friday, April 1, 2011

Municipal Bonds and the FDR Framework

The applicability of the FDR Framework is not restricted to financial institutions and structured finance securities.  It applies globally to all financial markets, their participants and their securities.

The US municipal securities market is a $2.7 trillion market.  It is a source of funds for local governments, including towns, cities and states.

There are two basic types of municipal securities

  • General obligations bonds that are supported by the taxing power of the issuer; and
  • Revenue bonds that are supported by revenue generated by the specific project they were issued to finance.
Does the municipal securities market comply with the FDR Framework?


Under the FDR Framework, all markets are built on the philosophy of disclosure combined with the principle of caveat emptor [buyer beware].  
  • It is the responsibility of the government to assure that all market participants have access to all the useful, relevant information in an appropriate, timely manner.  
  • It is the responsibility of market participant to do their homework as they know that it is buyer beware when they make an investment.
For the municipal securities market, the government and the issuer fail to provide access to all useful, relevant information in an appropriate, timely manner.

In a paper, Transparency Problems in the Municipal Debt Market and Their Effect on Fiscal Conditions, Kelly Shea observes
While many cities  in the U.S. are in trouble financially, the true state of their fiscal affairs is often hidden.
Why is all the useful, relevant information not made available in an appropriate, timely manner?

According to Kelly,

... cities and states are not subject to the same disclosure requirements of specific financial information before offering bonds publicly, this [is] due to a 1975 amendment to the Securities and Exchange Act of 1934 known as the Tower Amendment. This Tower Amendment effectively limits regulation by the Securities and Exchange Commission and other federal oversight authorities.  In some cases, this allows municipalities to simply not disclose important financial obligation information before a bond offering.
Just like we saw for structured finance securities and financial institutions, Kelly observes that the absence of all useful, relevant information in an appropriate, timely manner results in mis-pricing.

... Because of a lack of accurate financial information, the municipal bond market has not
yet reflected these [rising revenue shortfalls, soaring pension liabilities, and a host of other fiscal issues] risks.
 Cities and states are not held to the same financial disclosure standards
as corporations when issuing bonds .... The lack of consistency and transparency in state and municipal financial disclosures has caused the municipal bond market to become more risky than most investors believe. Due to this lack of transparency, it is impossible to accurately gauge to what extent cities and states are misstating their financial health until it is too late.

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