Muni HQLA Update

On April 1st, the Federal Reserve Board passed a rule change to include select municipal general obligation debt in the HQLA (High Quality Liquid Assets) category for the LCR (Liquidity Coverage Ratio) requirements component of the Dodd Frank Act. The bonds that qualify will count as level 2B, which get a 50% haircut and are capped at 5% of HQLA assets. Similar to corporate securities, the limits on which securities qualify are dictated by trading volumes. While this is a step in the right direction, the actual impact is negligible for a couple of reasons. First and foremost, the Fed is only one of three regulators, and in instances of disagreement, the strictest rule(s) apply. Therefore, unless the other two regulators get on board, this change will have almost no impact. Second, the rule only allows for general obligation debt, excluding large portions of the market that are just as high quality and liquid such as large highly rated public utilities. Third, the rule’s requirement for eligibility being based on trading volumes seems to demonstrate a fundamental lack of understanding of the way the municipal market functions insofar as the vast majority of participants tend to be “buy and hold” oriented investors, and the vast majority of most bonds’ trading volume occurs within the first couple months of issuance. While there is no expected immediate impact from the original rule, or from this change, it is important to recall that banks have been the largest marginal buyer of municipal bonds over the last few years, and that this build-up of exposure could potentially be an issue for the market during times of market stress. It is during such periods that a bank would most likely become LCR constrained and thus need to raise cash. It follows that, rather than providing support for the market as a buyer, a bank would have the opposite role and further stress the market as a seller. In February, the House passed a bill that would require the inclusion of all investment grade, readily marketable municipal securities in the HQLA category. The Senate version has yet to pass. At this time, the bill is unlikely to have any impact on the market. However, unless congressional intervention forces regulators to view municipal bonds more favorably, it is likely that the Dodd Frank legislation will ultimately exacerbate sell-offs of municipal bonds, which we hope will create opportunities for prepared investors.

Source: Citigroup