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Muni Bond Issuers Say Volcker Rule Will Drive Up Costs

At the Pike Place Market in Seattle, where fishmongers fling fresh salmon through the air to the cheers of tourists, the public authority that maintains the century-old landmark has long been able to borrow at the low costs of the muni market.

So has the Seattle Art Museum, where a city-chartered authority issued $61 million in debt for expansion in 2005. Both face higher borrowing costs under a proposed federal rule that would no longer treat them the same as state and local governments.

“They would probably have to pay a higher interest rate because there’s a smaller market,” Washington Treasurer James McIntire said in a telephone interview. “The banks that would typically buy and hold those bonds are not going to be participating in the demand for them.”

McIntire and municipal-bond issuers including the biggest U.S. transit agency say the so-called Volcker Rule may limit trading in at least 40 percent of the $3.7 trillion municipal market, driving up costs to finance airports and schools. They joined Citigroup Inc., the second largest U.S. muni underwriter last year, which in January said the proposal was arbitrary and unnecessary.

The Volcker Rule is among the most contentious pieces of the Dodd-Frank financial overhaul law, enacted by Congress in 2010 to set rules policing Wall Street and aimed at preventing a repeat of the 2008 financial crisis. The rule, named after former Federal Reserve Chairman Paul Volcker, would ban banks from proprietary trading, or making bets with their own money.

Agency-Issued Debt

Bond underwriters typically buy the securities with their own funds, with the expectation of selling them to investors. Under the Volcker Rule, that would be allowed for debt issued by municipalities, though not for agency-issued debt.

“It would significantly affect the demand for those securities and, as a result, drive up the borrowing costs,” McIntire said in one of dozens of letters to regulators criticizing the proposal. A spokesman, Andrew Smith, said the treasurer’s office didn’t have an estimate for the potential increase.

A 298-page draft of the rule was released for public comment in October by the Fed, the Securities and Exchange Commission, the Federal Deposit Insurance Corp. and the Treasury Department’s Office of the Comptroller of the Currency.

Among the more than 18,000 comments received by regulators, dozens focus on the Volcker Rule’s impact on the $3.7 trillion municipal-securities market, said Mary Miller, the Treasury Department’s undersecretary for domestic finance.

Markets ‘Distorted’

The comments “raised concerns that municipal markets could be distorted by the differential treatment of direct obligations and agency obligations,” she said at a municipal analysts conference in Las Vegas on April 18.

Issuers called on regulators to use the definition of a municipal security in the Securities Exchange Act of 1934, which includes debt issued by agencies and municipalities.

There are signs that the SEC may be willing to do so because municipals don’t raise the same concerns about short-term buying and selling that other propriety trading does, said Peter DeGroot, head of municipal research at New York-based JP Morgan Securities LLC, in a May 4 note to investors. Judith Burns, an SEC spokeswoman, declined to comment on changing the definition.

The Metropolitan Transportation Authority, which runs New York City’s subways, buses and commuter rail and has more than $30 billion in outstanding debt, would be subject to the Volcker Rule restrictions under the draft plan, Patrick McCoy, the authority’s finance director, said in a Feb. 13 letter to regulators.

Liquidity Issue

“We believe this narrow interpretation included in the Volcker Rule exemption will have significant material adverse impacts on the liquidity of securities issued by these entities and, in turn, the primary market pricing and secondary market trading of their securities,” McCoy wrote.

The municipal securities market consists of more than 50,000 issuers, with smaller issue sizes than the corporate debt market, Alan Polsky, chairman of the Municipal Securities Rulemaking Board, which writes regulations for the market, said in a Jan. 31 letter.

Exempting agency debt will affect “the primary market pricing and secondary market trading of securities issued by agencies and authorities of states and their political subdivisions,” he wrote. “Issuers and investors (primarily retail) will bear the cost.”

Jennifer Galloway, an MSRB spokeswoman, said the board doesn’t have an estimate on the potential cost.

In a Feb. 13 letter to regulators, North Carolina Treasurer Janet Cowell said banks hold nearly 9 percent of all outstanding municipal debt.

“We are aware of no cases in which municipal securities holdings have caused safety and soundness problems for either individual banks or on a systemic basis,” Cowell said.

To contact the reporter on this story: Alison Vekshin in San Francisco at avekshin@bloomberg.net.

To contact the editor responsible for this story: Stephen Merelman in New York at smerelman@bloomberg.net.

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