LA Conduit-fidential [updated]

Posted by John McDermott on Jun 16 18:31. 4 comments | Share

The Los Angeles Times and the Bond Buyer have done some interesting reporting in the last three weeks, shedding light on a dark corner of the municipal markets: conduit bonds.What are conduit bonds? Not for the first time, More…

The Los Angeles Times and the Bond Buyer have done some interesting reporting in the last three weeks, shedding light on a dark corner of the municipal markets: conduit bonds.

What are conduit bonds? Not for the first time, we recommend this post from Bond Girl, which describes how these bonds are different from both vanilla GO bonds issued by governments and from bonds secured by a defined revenue stream, say from a utility. In contrast, conduit bonds are private debts issued by governments or government-sponsored entities. In theory, governments judge that the public gain from the project is greater than the cost in lost tax revenue. Here’s more from Bond Girl:

In a conduit bond issue, the government issues the bonds on behalf of a third party, generally a nonprofit entity (such as a hospital or college), a developer of government-subsidized housing projects, or a for-profit corporate entity (called industrial revenue bonds). Conduit bonds are not government debt; they are private debts. The bonds are actually secured by the revenues generated by the project being financed, the credit of the conduit borrower, and/or a mortgage on the property – and that is it.

On May 25,  the LA Times profiled HB Capital Resources, a private firm that operates the California Statewide Communities Development Authority, a conduit bond issuer:

The CSCDA has emerged as one of the nation’s municipal bond kings, issuing $8.1 billion in debt in the last two years — more than the states of Texas and Florida, according to Thomson Reuters, the New York data company.

Though the CSCDA is overseen by a board of public officials, the board farms out almost all of the work to HB Capital Resources, the private firm Hamill and Burke run out of a seventh-floor office suite in Walnut Creek. In addition, Hamill and Burke serve as the agency’s general managers.

The CSCDA has collected nearly $32 million in fees from borrowers in the last two years, most of which has gone to HB Capital, public records show.

The concern, writes the LA Times, is that HB Capital is using “a public process for private gain” and encouraging a “pay to play” model for issuing municipal bonds for businesses, many of which have “questionable public benefit”. (It’s also expanding this model to other states such as Wisconsin.) The paper also says that the firm’s incentive structure — more fees for more debt issued — does not favour Californians. There’s no allegation that HB Capital is doing anything illegal.

The Bond Buyer followed up with an excellent article on Friday. It’s worth a read in full as it does a good job at getting quotes from both sides of the argument. Here is HB Capital’s take:

James Hamill, a program manager for the CSCDA and nephew of one of its founders, Stephen Hamill, in an interview at HB Capital’s Walnut Creek, Calif., office, said the firm’s compensation must be weighed against its public benefit over a long history.

He said the CSCDA has helped facilitate a great deal of affordable housing, heath care facilities and manufacturing jobs.

“There are no taxpayer dollars going into this, there are no public pensions,” Hamill said. “It is at the risk to us. If the tax-exempt market drops off tomorrow and there are no deals for three years, we are not here, we go away.”

While this may be true in the narrow sense, the use of tax-exempt bond issuance obviously leads to a cost in foregone revenue — $10bn according to the LA Times. (And at least by UK budgeting rules this would be defined as a “cost”.)

And there’s a wider point, too. We learn from Bond Girl’s post that conduit bonds are riskier and more likely to default than GO or revenue bonds:

These are generally far riskier credits, and a large fraction of the defaults that actually take place in the municipal bond market are defaults on conduit bonds. Recoveries are also likely to be smaller. (You are more likely to see things like multiple-lien structures with this kind of debt.)

To put it crudely, they’re more like corporate bonds than what many people think of as municipal bonds — both in terms of default rates and what they’re backed with. Depending on what figures you use (conduit bonds are not always rated) and whether you include property-backed bonds, conduit bonds could represent up to 70 per cent of all municipal defaults. A high amount, given that they make up only about 20 per cent of the overall market, according to Thomson Reuters.

Which brings us to Meredith Whitney…

Without passing judgement on the specific cases in the LA Times and Bond Buyer articles, for a relative amateur in all things muni, there is something troubling about the rise of conduits. Our logic goes a little like this: (1) conduits have relatively high default rates; (2) conduits could be confused with other muni bonds; (3) conduit default rates are conflated with the general rise in headline risk; (4) borrowing costs for all munis rise — “good” bonds suffer; (5) the tax-payer is, after all, left with a higher bill because of these structures, which in some cases are financing debt that shouldn’t be tax-exempt.

Not perfect but it’s a thought. Go ahead and destroy.

If only there was someone to tell us more. Oh wait, here’s our indispensable guide, once again:

(It is worth noting that the increased use of public-private partnerships has somewhat blurred this distinction – at a high price to state and local governments – but I could write a book on that topic. I probably should – it would be the most politically scandalous book that three people ever read.)

Make that four.

Update: Michael Stanton, Publisher of the Bond Buyer, writes in the comments:

John: Thanks for the kind words on The Bond Buyer’s reporting.

I just wanted to point out that the LAT’s conclusions about growth in conduit debt is somewhat misleading. “Conduit” bonds include borrowings by private nonprofit hospitals and higher-education institutions that need to partner with a public entity to access tax-exempt financing. These institutions were responsible for most of the 5-year growth the LAT cites, and not because they’re expanding their balance sheets: Most of that volume was tied to refinancing auction-rate securities and other floating-rate exposures that got hammered in the credit crisis … not net new issuance.

And there’s a reason for that — the Federal tax code includes a pretty hard cap on tax-exempt bond sales by the truly “private” borrowers that use conduits — which includes airlines financing airport facilities for their own use, affordable housing developers, and corporations financing small manufacturing facilities or water-treatment plants at their factories.

There clearly will be a debate on whether any of the entities that gain access to the tax-exempt bond markets through conduits should continue to get that benefit. But going in, it’s important to recognize that that universe is extremely diverse, with similarly diverse credit profiles (Harvard’s conduit borrowings are certainly not hurting the market’s reputation).

– Mike Stanton, Publisher
The Bond Buyer


Related links:
Conduit Sparks a Row – Bond Buyer
Problems in municipal market extend beyond California firm – Money & Company
IRS panel recommends greater oversight of conduit bonds – LA Times

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