Mike & Co. –
One week ago, the House passed a bill that could alter and perhaps ease the way state and local infrastructure is financed in the capital markets, when HR.2209, a bill to “require the appropriate Federal banking agencies to treat certain municipal obligations as level 2A liquid assets, and for other purposes” was adopted by the House with a voice vote.
Thought the bill has flown below the media radar, it is significant. Municipal obligations, including bonds, are at the heart of infrastructure investment in America. And infrastructure investment has been a large focus of this primary. Both Democratic candidates have proposed multi-hundred billion dollar infrastructure investment proposals.
Infrastructure is mostly funded at the state or local level through the use of municipal bonds. Between 2003 and 2012, counties, states, and other localities invested $3.2 trillion in infrastructure through long-term tax-exempt municipal bonds, 2.5 times more than the federal investment.
HR 2209 requires federal banking regulators to include municipal bonds under the Liquidity Coverage Ratio (LCR). The LCR is designed to ensure that financial institutions have the necessary assets available to handle a liquidity disruption. Local officials have said that if the new rules aren’t changed, it will saddle them with higher borrowing costs by eliminating incentives banks have to purchase their bonds. Without bonds, these governments will lose a significant source of their funding. Per Indiana State Treasurer Kelly Mitchell: “This bill helps ensure cash-strapped school districts and municipalities will continue to have access to bonds to finance projects they think are best for their communities.”
Rep. Luke Messer, an Indiana Republican who wrote the bill: “Put simply, our bill requires the federal government to recognize the obvious, that our municipal bonds are some of the safest investments in the world and that we shouldn’t have rules that give preferential treatment to corporate bonds or other countries’ bonds over our own.”
After passing the House with unanimous bipartisan support, a companion bill is expected to be introduced in the Senate this year.
Municipal Bond Issue
After the crisis of 2008, federal regulators adopted international banking standards that require banks to have enough “High-Quality Liquid Assets” to cover their cash outflows for 30 days in case of a future financial meltdown. Now, municipal bonds are not considered liquid assets and therefore cannot be included under the LCR. As a result, financial institutions have been discouraged from holding municipal debt, which means that cash strapped municipalities and school districts may eventually be forced to reduce or even stop work on projects financed with municipal bonds.
Infrastructure Financing — Alternative Financing
- Tax-exempt bonds: Exemption from federal taxes and many state and local taxes is possible through the use of municipal bonds. In recent years, with the increasing use of PPPs, barriers to this tax exemption have arisen. Treasury has reviewed relevant tax rules and based on their findings and have put forth a proposal for an expanded and permanent America Fast Forward Bond Program as an alternative to tax-exempt bonds. Based on the successful Build America Bond program, “would provide an efficient borrowing subsidy to state and local governments while appealing to a broader investor base than traditional tax-exempt bonds [and] would cover a broad range of projects for which tax-exempt bonds can be used.”
- Obama’s budget proposal: Obama has also put forth a plan to strengthen local and state government infrastructure projects. His plan relies on a new Federal credit program to support public-private partnerships within the Department of the Treasury. It will provide direct loans to US infrastructure projects developed through PPPs. The Obama Administration believes that private investment is crucial for infrastructure development moving forward, so there should be more flexibility in regards to what PPP is subject to. In addition to that, President Obama has proposed the taxable, direct-pay America Fast Forward bond program to help finance infrastructure.
State Infrastructure Banks
Local governments receive financing in a number of ways. Traditional sources such as tax revenues have been dwindling and local authorities have been relying on federal government loan programs, public-private partnerships, and State Revolving Funds (SRFs). State Infrastructure Banks (SIBs) are a subset of SRFs — the funds act like a bank, because they don’t own the infrastructure asset, but act as a lender or guarantor to the project sponsor. Per Brookings: “SRFs rely on principal repayments, bonds, interest and fees to re-capitalize and replenish the fund as a perpetual source of debt financing.”
SIBs generate more investment per dollar than traditional federal and state grant programs. They only exist in 33 states and 10 of those SIBs are currently inactive. A large problem may be compliance with federal regulations. Brookings again:
“We found that many SIB officials cite compliance with federal regulations as slowing down the investment process either because of environmental and contractual requirements or due to the lack of flexibility in projects that are not Title 23 or 49 eligible. For states with smaller projects, this may be prohibitively costly compared to the advantage of using the low-cost SIB financing.”
Just being called a bank subjects SIBs to regulations that commercial banks are subject to. SIBs are non-for-profit organizations with a goal of increasing infrastructure investment, so they don’t quite fit into the category of the average bank. SIBs may be more successful outside this classification.
For or Against Dodd-Frank
Before Dodd-Frank, particularly in the case of relatively small municipalities, many underwriters forged long-term relationships with municipalities and would provide financial advice before and after a bond issuance. With Dodd-Frank, that relationship changed, with a new “municipal adviser” category that must register with the SEC and be regulated by the Municipal Securities Rulemaking Board (MSR). Now, it is widely illegal to provide advice to governmental entities concerning the issuance of municipal bonds, the use of financial derivatives, and the investment of the proceeds of a bond issue to, or on behalf, of a municipal entity or an obligated person unless the adviser is registered with the SEC.
HR 2209 appears to address a problem within Dodd-Frank, but it is unclear if it vitiates the law materially. At face value, it appears to be more a technical fix. Dodd-Frank expanded regulations for banking institutions, but the entities that fund state and local governments are far unlike the TBTF institutions that Dodd-Frank was meant to regulate.
Groups like Americans for Financial Reform oppose HR 2209: “While we sympathize with the belief that municipal debt was incorrectly treated under the initial LCR rule, we believe that it is inappropriate to classify such debt as a Level 2A asset. AFR therefore opposes this bill unless a more appropriate liquidity classification is used.” AFR has previously said it supports treating municipal bonds as more liquid and does not approve the type of classification used in HR 2209, because it goes too far in its treatment of municipal debt as level 2A liquid assets and specifically with micromanaging regulators with this kind of detail and they prefer a Level 2B classification.
The bill could provide relief for smaller institutions, so that they can fund infrastructure investment more easily. In terms of Dodd-Frank, it is yet to be decided if it is simply a necessary tweak or a criticism.
HR 2209 could end up being an important issue in the national infrastructure discussion. It brings up questions about how far a state or local government can go before its activities begin to resemble an actual bank. With the growth of PPPs, the private sector is being even more integrated into the process – should those companies be given tax exemptions, as well?