UPDATE to The Municipal Market Goes to Court:

In the May 28, 2007 edition of this publication, we informed investors that the U.S. Supreme Court had agreed to hear the case of Davis vs. Kentucky. An investor (Davis) sued the state of Kentucky for taxing his out-of-state municipal bonds while simultaneously offering a tax exemption to Kentucky-issued municipal bonds. Davis claimed this violated the Interstate Commerce Clause. Initially Davis lost the case, only to win on appeal, setting the stage for a U.S. Supreme Court decision.

This past week, two legal scholars released a paper1 touting their opinion of what the Court’s outcome may be. Ethan Hale from Georgetown University and Brian Galle from Florida State published in the periodical “Tax Notes” that they believed the outcome of the Court will rule in favor of Davis, meaning the taxes over 42 state governments impose on out-of-state municipal bonds would be deemed unconstitutional. These authors claim that the U.S. Supreme Court has consistently found that state tax rules discriminating in favor of in-state activities are unconstitutional. If that indeed is the outcome, these states would have to decide whether to not tax out-of-state bonds or start taxing their own in-state bonds - decisions that would likely have a profound impact on the $2.3 trillion municipal bond market. Given that there are almost 500 single-state municipal bond funds with assets of more than $155 billion, an outcome as predicted by these professors would leave little reason for investors to choose these bond funds. Another, more significant issue arises when one considers that this outcome may force states to choose to tax all municipal bonds, pushing their borrowing costs of issuing additional municipal bonds to rise significantly, as investors would not have a tax-advantaged reason for buying these bonds. Speculation has also ensued about the potential for bond investors to sue states for reimbursement of taxes they have paid on out-of-state bonds in past years.

The reality is that this case may have profound and significant impact to the municipal bond market; an important investment vehicle to the nation’s banking system. Stay tuned for further updates.

The Municipal Market Goes to Court

Last week, the US Supreme Court agreed to hear a case involving the nation’s municipal bond market, which could lead to profound changes in the $2.3 trillion muni market. The announcement stemmed from a case involving a Kentucky investor who sued the state of Kentucky, claiming that Kentucky’s taxing of out-of-state muni bonds the investor held unconstitutionally discriminated against interstate commerce by taxing income from out-of-state bonds while exempting earnings on local bonds. The local judge on the case initially ruled against the investor, only to have the outcome reversed by the Kentucky Court of Appeals in a 3-0 vote. When the Kentucky Supreme Court refused to hear the case, the stage was set for a possible US Supreme Court review, which will come about in their next 9-month term beginning in October. Possible effects on the muni market if the court rules against Kentucky, is that it may force the 42 states who give their own bonds special tax treatment to either eliminate their local tax breaks or extend them to out-of-state bonds.

According to experts of the US Supreme Court, the Court has on a number of occasions has said states may not use their tax codes to provide commercial advantages to local companies. However the Court rules this time, look for this case to gain stature and importance over the next several months, as the muni market awaits the outcome.

Government at Work for the People

In what is sure to be viewed as a regulatory effort far overdue, the Securities & Exchange Commission (SEC) announced today that they were (finally) launching an investigation into insider trading abuses in the burgeoning (and totally unregulated) Credit Default Swap (CDS) market. CDS are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay its debt. The contracts pay if a borrower fails to meet its debt obligations on time. Hedge funds and other investors have increasingly turned to the CDS market to make bets (investments) because they’re cheaper and easier to trade, plus the market is completely unregulated. Both the SEC and the Commodity Futures Trading Commission (CFTC) have argued over which regulator has authority over the market. Absent a clear regulator, little to no regulatory action has been initiated to date.

Hardly a buyout over the past year or so, either by private equity or public companies has not been reported as experiencing surging trading in the takeover target’s CDS contracts. This has led to what appears to be significant, unrestrained and illegal use of insider information to profit from these swings. While government regulation is never a good thing, allowing some “investors” an unfair advantage over others and compromising the nation’s financial markets is even worse.

Global Competition in Bond Yields

It’s a well-known economic story where the financial press has in recent years increased its coverage of the global economy and the U.S.’s place in it. Still the largest global economy by far as measured by GDP, the U.S. is critically dependent on other economies to buy our debt. Without foreign purchases of U.S. securities, the GDP growth we have would not be possible and certainly, U.S. interest rates would be significantly higher than they are now. Within this context and the U.S.’s need to finance its debt, it’s a reasonable proposition to keep an eye on the competition, particularly the competition for bond yields. With other global economies achieving higher GDP levels than the U.S., their own bond yields and inflation rates have increased, giving our debt markets some serious competition. When you consider that the potential downside of any foreign investment in U.S. securities includes currency risk and when you see that the value of the U.S. dollar has been down over the past year, hurting foreign investor’s returns, it’s a wonder these foreigners continue to invest in the U.S. Granted, significant benefits accrue to these investors, such as greater security and liquidity, but this advantage to U.S. markets is eroding as well. The answers come in the form of the need of the U.S. to reduce its debt burden significantly and soon, tackling the federal budget deficit as well as consumer indebtedness. Simultaneously, domestic savings rates need to rise to provide needed investment funds, while the Fed should remain diligent in its quest for price stability. Absent these efforts and others, in order to remain competitive and finance our debt, domestic interest rates would likely be forced to rise – to what level is another debate, but rise they would, just to finance the debt we have outstanding. To back this discussion up with statistics, view the following:
Country Current Yield Yield 1 Year Ago Difference CPI GDP GDP Rank
U.S. 5.03% 5.14% -0.11% 2.7% 1.9% 1
Japan 1.87% 1.83% +0.04% 0.0% 2.6% 2
Germany 4.56% 4.30% +0.26% 1.9% 3.6% 3
China 4.43% 3.13% +1.30% 3.4% 11.1% 4
U.K. 5.46% 4.60% +0.86% 2.5% 6.2% 5
France 4.62% 4.08% +0.54% 1.2% 4.0% 6
Italy 4.77% 4.24% +0.53% 1.9% 5.2% 7
Canada 4.55% 4.61% -0.06% 2.2% 2.3% 8
Spain 4.62% 4.06% +0.56% 2.3% 7.6% 9
Russia 6.05% 6.78% -0.73% 7.8% 7.9% 10
India 8.15% 8.19% -0.04% 7.7% 9.1% 12
Brazil 6.10% 7.11% -0.99% 3.2% 4.3% 11
Australia6.26% 5.78% +0.48% 2.4% 3.8% 15

While market yields in some countries have turned down over the past year, in general, most yields are up, particularly in those countries where economic growth has been the strongest, providing increasing competition between the U.S. and other countries for their investment funds.

The Fed’s Inflation Measurement is Questioned

The Federal Reserve Bank’s PRIMARY mission is conducting monetary policy, which is focused on employment, price stability and long-term interest rates. That may catch some as a surprise, given the popular belief that the Fed is primarily focused on steering the economy towards growth, but that is an ancillary outcome of carrying out their primary mission. Directly from the Fed, their mission is described as:
• conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates;
• supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers;
• maintaining the stability of the financial system and containing systemic risk that may arise in financial markets; and
• providing financial services to depository institutions, the U.S. government, and foreign official institutions including playing a major role in operating the nation’s payments system
In carrying out their mission, the Fed uses a multitude of economic statistics to gauge their success and survey for potential problem areas before they can negatively impact their mission. Towards price stability, the Fed under Chairman Greenspan focused on the Personal Consumption Expenditures (PCE) Index, away from the CPI, because the PCE was believed to more accurately reflect current-day consumer buying patterns. Things have changed under new Chairman Bernanke who has focused on the traditional CPI reading while injecting his long-standing views that the Fed should identify a targeted inflation rate, discussed as being between 1-2% annually. This is a dramatic departure from Greenspan’s views and the Fed’s primary mission of stable prices, because it accepts a 1-2% inflation rate as being allowable and acceptable. More disturbing is that it redefines the meaning of the word stable. Under Greenspan stable prices meant 0% inflation. Despite this significant shift in views, the bond market still hasn’t caught on to this. If they ever do, one should expect a 1-2% increase in long-term rates to compensate investors for this so-called price stability.

A causal view to this lack of market response is that debt issuers are currently getting an even better deal than they may realize, through a cheap interest rate.

Last week, market controversy did surface, not on the issue of targeted inflation, but on the issue of the Fed’s use of “core” inflation versus the total inflation picture. Core inflation is defined as price changes stemming from every area of consumption except for food and energy categories. In the past, these areas were deemed too volatile on a short-term basis and were heavily impacted by their respective supply chains, such as short-term fluctuations in food prices caused by summer droughts or a winter freeze, or short-term fluctuations in energy prices caused by hurricanes or maintenance shutdowns at gasoline refineries. At issue with the market is that the volatility in these 2 categories is no longer looked upon as being short-term and predominantly caused by supply, but rather by demand issues. The difference in core and total CPI is significant, averaging 0.3% over the past 10 years and currently showing a spread of 0.5%. Investors have recently questioned does the Fed use the lower Core CPI to measure against its targeted inflation rate, or the total CPI rate? The market is currently moving towards using the total CPI figure, given the shift from short to long-term volatility and the shift from supply-generated to demand-generated pricing pressures. In fact the demand-generated move is expected to continue as rising world economies increase the global demand for energy, such as that demand coming from China. Food prices are expected to continue rising due to changing dietary habits of traditionally western foods, as these rising economies become more affluent. Demand for food as an energy source (ethanol) is also viewed as a long-term move.

If the market wins out and the Fed changes its focus from Core to Total CPI, how the market views Fed policy should change as well as the actual CPI would be further out from their targeted level, possibly requiring even higher short-term rates to bring the total CPI inflation into the realm of a “stable” prices.