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By Lisa Lambert and David Gaffen
February 22, 2012 9:14 AM EST
Some public agencies that rely on the municipal bond market for financing fear that a landmark financial reform rule will cripple their ability to sell bonds and make it more expensive to raise money for crucial services.
The Volcker Rule was designed to curb the risks that banks take with depositor dollars, a practice known as proprietary trading. But the rule risks ensnaring public agencies ranging from housing agencies to hospital authorities because the way muni bonds are sold and traded results in banks risking their own capital -- the very practice banned under the Volcker Rule.
And although the rule, a key component of the Dodd-Frank reform law passed in the wake of the 2008 financial crisis, did include an exemption to ensure that state and local governments would still be able to raise money in the municipal bond market, it left a gaping hole.
As a result, state and local authorities are worried that the rule will inhibit banks from underwriting bonds and trading, inadvertently driving up water and sewer bills, delaying public transportation projects and making affordable housing scarcer unless changes are made.
The rule exempts about 60 percent of municipal bonds from the restrictions on banks' proprietary trading.
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Bonds issued by states and their political sub-divisions - such as counties and cities - will be excluded from the ban, but debt issued by public agencies or authorities would be subject to the restriction.
"It could have a very detrimental effect on trying to make the investments in public infrastructure that many of us have felt could be and should be the core of economic recovery," said Washington State Treasurer James McIntire, who otherwise supports the Volcker Rule.
While proprietary trading in many markets is associated with dealers taking positions to try to profit from movements in a security, in the highly illiquid $3.7 trillion municipal market dealers are usually risking their own capital just to facilitate trades, said the Municipal Securities Rulemaking Board, in a letter to federal regulators last month.
That would hurt issuers' abilities to even sell debt in the first place, as three-quarters of the new bond issues in 2011 were underwritten by banks that would have to follow the rule.
That in turn will force issuers to delay projects or pass on hefty bills to taxpayers because of a distinction brokers, dealers, underwriters and issuers describe as arbitrary, unclear and unintentional. Most blame the narrow definition on oversights in drafting the proposal.
The MSRB, the market's self-regulatory organization, openly criticized the definition last month, and many believe that because it took the rare steps of objecting to a federal proposal, the final plan will be less stringent. The chairman of the Securities and Exchange Commission, Mary Schapiro, signaled recently the commission is considering widening the exemption.
"I think their intention was to try to restrict esoteric, non-traditional stuff. I do think it will create a bifurcated market if it were to occur," said Tom Metzold, co-director of the municipal bond department at Eaton Vance in Boston. "I really do believe they will correct their mistake."
TALE OF TWO WATER AUTHORITIES
Many states require what is known as "competitive underwritings" in the muni market, where underwriters bid on a bond issue with the expectation that investors will later buy the debt. That assumption means banks run the risk of holding a lot of unsold debt - and risking their own capital, which would be banned under the Volcker rule.
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