Eight years ago Wall Street’s Meredith Whitney predicted “50 to 100 sizeable defaults” in the municipal bond market within the next year.  Ms. Whitney is noted for her correct call in 2007 that Citibank would incur massive loan losses in the 2008 financial crisis on toxic mortgage loans.  Ms. Whitney’s calls on muni debt were wrong —- or as some people now believe —- too early!

A recent Wall Street Journal article (https://www.wsj.com/articles/prophet-of-muni-market-doom-wasnt-wrongjust-early-1540554098?mod=searchresults&page=1&pos=1) points out that today there is $8 trillion of municipal debt outstanding, half owed to bondholders and half owed to pensioners.

The half owed to pensioners is especially troubling since $1.4 trillion (34%) is unfunded.(https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2018/04/the-state-pension-funding-gap-2016) Pew Charitable Trust (PEW) points out that this “deficit represents a $295 billion jump from 2015 (to 2016) and the 15th annual increase in pension debt since 2000”. States and municipalities have failed to adequately fund their pension plans to meet the employee benefits they have promised.

Compounding this Pension GAP problem is that most public pension funds use rosy assumptions as to future investment yield in the calculation of their liabilities to their pensioners. PEW reports that the median investment assumption is a 7.5% annual yield. With 2 to 3% US Treasury yields today, 4% corporate bonds, and 5.5% junk bond yields, stocks and alternative investments are the only way to reach a 7.5% annual compound yield on a portfolio today.

PEW reports “In 2016, half of plan assets were invested in equities, a quarter in alternative investments, and another quarter in bonds and cash”. (https://www.pewtrusts.org/en/research-and-analysis/issue-briefs/2018/09/state-public-pension-funds–investment-practices-and–performance-2016-data-update) Equities and alternative investments are inherently more risky than investment grade corporate bonds. Equity and alternative investments (real estate, private equity and hedge funds) have risen from 5% of pension fund assets in 1956 to 74% of assets in 2016.

PEW reports: “Ten-year total investment returns for the 44 funds in our study that report performance net of fees as of June 30, 2016, ranged from 3.8 percent to 6.8 percent, with an average yield of 5.5 percent. Given that the average target return for these plans was 7.5 percent, the long-term variability is significant. Notably, none of these plans met or exceeded investment return targets over the 10-year period ending in 2016.”

Such large deviations from the 7.5% annual compound investment assumption can have major consequences for any portfolio.  Pew applied a 6.5% return assumption, instead of the median assumption of 7.5%, to estimate the total liability for state pension plans and found that it would increase to $4.4 trillion—$382 billion more than the current amount. The funding gap would then jump to $1.7trillion.

The State of Illinois is a prime example of the difficulties beginning to show up in the tax exempt bond market. (https://money.cnn.com/2017/06/29/investing/illinois-budget-crisis-downgrade/index.html)  Reportedly Illinois has $15 billon of unpaid bills and a $250 billion pension liability ($162 billion unfunded).  Illinois is at risk of losing its investment grade credit rating with a downgrade to “junk” status. In July, after two years, Illinois finally passed a state budget with a $5 billion tax increase.  (https://slate.com/news-and-politics/2017/07/after-two-years-illinois-finally-passed-a-budget.html) Nevertheless, Illinois is still not out of the woods. The huge unfunded pension liability will hang over the state for years requiring future tax increases to meet funding needs as baby boomers retire.

What does this all mean for the market for tax exempt securities? 

 Any large defaults or credit downgrades will affect all tax exempt borrowers resulting in higher borrowing rates and more restrictive loan terms. In a severe credit crisis the tax exempt bond market may freeze up for an extended period of time as it did in the 2008 financial crisis.

 This is especially problematic for the tax exempt market because the typical bond buyer is an individual retail buyer or a tax exempt fund buying on behalf of individual retail buyers.  Individual buyers and buyers’ funds rely on credit ratings, restrictive loan terms, and collateralized escrow deposits as security for the bond. If more near defaults, credit downgrades and actual defaults occur such as Detroit, Stockton, and San Bernardino, faith in the credit rating agencies will degrade.

This happened before in the 2008 financial crisis when AAA rated mortgage bond pools went into default with little warning.  Faith in the credit rating agencies was severely degraded when it came to underwriting real estate mortgage bond risk.

How can Midwest Credit Lease help?

MCL sells private mortgage bonds exclusively to professional investors at life insurance companies and other institutional investors.  These investors rely upon the balance sheet of the borrower and the borrower’s mission and operation.  Unlike retail buyers, they do not rely exclusively on the borrower’s credit rating. They perform their own credit analysis. 

 Private bonds sold to life insurance companies can fully amortize within the term of the loan. Maturities can be as long as 30 years with fixed rates for the term of the loan.

 Our investors are in the market when retail buyers and funds are not.CTL terms are reasonable with no restrictive covenants or costly collateralized escrows.  Upfront costs are lower than public bond issues and loan maturities longer than loans available from banks.

 For your next development call Midwest Credit Lease for a quote.

Recently there has been much discussion regarding the Federal Reserve’s policy of Interest Rate Normalization.  The Fed has raised the Fed Funds Rate seven times from ½% in December 2015 to 2.25% in September of this year with indications of more to come.

The goal of the Federal Reserve is to raise short term interest rates gradually to the Neutral Rate of Interest.  The Neutral Rate of Interest as defined by Federal Reserve Board member Lael Brainard is “Intuitively, I think of the nominal neutral interest rate as the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation.”

In a recent speech Lael Brainard goes on to explain that while there are shorter run Neutral Interest Rates which fluctuate with current economic conditions, the long run Equilibrium Neutral Rate “generally refers to the output growing at its longer-run trend, after transitory forces reflecting headwinds or tailwinds have played out, in an environment of full employment and inflation running at the FOMC objective” The FOMC inflation rate objective has been 2% since 2008.

 The Equilibrium Neutral Rate is not directly observable, so it must be estimated or inferred from the movements of variables that are observed, such as market interest rates, inflation, the unemployment rate, and GDP.  The Federal Reserve Board of Governors estimates this rate to be in the range of 2.5% to 3.5% in nominal terms. This level of Equilibrium Neutral Rate provides ample room for further Federal Funds rate increases in 2018 and 2019.

What does Normalization Mean for Longer Term Interest Rates?

On October 1^th Federal Reserve Chairman Jerome Powell made the following comment at the Atlantic Festival, “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore.”  He went on to say, “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point.” The reaction of the markets was swift and dramatic. The 10-year Treasury note rose from 3.06% on Tuesday, October 2nd to 3.23% on Friday, October 5^th, its highest yield since 2011.

Since short term rates may rise to Neutral of 2.5% to 3.5% or more, we can expect long term investors to lift their required yield rates to maintain a Normal Yield Curve. According to Investopedia, “The normal yield curve is a yield curve in which short-term debt instruments have a lower yield than long-term debt instruments of the same credit quality. This gives the yield curve an upward slope. This is the most often seen yield curve shape, and it’s sometimes referred to as the “positive yield curve””

 Long Term Interest Rate Rule of Thumb

There is a close relationship between the yield on the ten year US Government Treasury Bond rate and the US national nominal GNP as show below.

Since 1953, the US Treasury 10-Year Bond Yield has approximated the yearly per cent change in the Nominal GDP.  Real GDP growth in the 1^st quarter of 2018 was 2.2% and in the 2^nd quarter was 4.2%.  Estimates for the year are about 3.0%.  This rate of real growth plus the Federal Reserve’s inflation target of 2% imply a Nominal GDP for 2018 of 5.0% and eventually a corresponding rise in ten year Treasury securities.

 While the relationship between Nominal GDP and 10-Year US Treasury securities is not precise, there is ample evidence to conclude that long term rates will rise as the economy continues to grow.

Federal Reserve to “Normalize” Balance Sheet

Long term rates will rise not only due to inflation which is now running at 2.3% (PCE Deflator) and robust growth, but also from an unwinding of QE stimulus by the Federal Reserve. The phrase “unwinding” is often used because of the slow and gradual nature of reducing the Fed’s balance sheet. St. Louis Fed Research Director Chris Waller recently compared it to slowly opening the stopper in a drain and letting water run out.

In a May 2018 Dialogue with the Fed presentation, Waller explained that the Fed is taking a capped, controlled approach to unwinding its balance sheet: letting Treasury securities “run off” at about $6 billion a month and letting mortgage-backed securities run off at about $4 billion a month. “And then it’s going to increase at every three months,” he said, “to where there’s a maximum of $30 billion a month in Treasuries running off, and $20 billion a month in mortgage-backed securities” running off.

Unwinding of the stimulus held in bank excess reserves at the Fed will raise short and medium term (3-7 year) interest rates pushing long bond buyers to demand higher rates for 10 year securities.

Since tax exempt municipal bond rates follow Treasury rates as shown below,

 

both Treasury securities and tax exempt rates should rise in 2019 with significant increases in 2020 and beyond.  Current long term Treasury rates are a bargain given the probability that they will rise in the near future. The reduction of the Federal Reserve’s balance sheet along with low and negative interest rates in Europe and Japan has depressed the US long term rates. This condition cannot last. 

The Federal Reserve is expected to reduce their balance sheet to about $3.0 trillion from the current $4.0 trillion through reductions of $50 billion/month.  At this rate the balance sheet should be reduced to the desired amount in about 20 months, sometime in 2020. Both Europe and Japan will eventually raise their interest rates as their economies recover from the Great Recession.  The European Central Bank has completed their QE and is expected to begin normalization of their interest rates and balance sheet in 2019. Japan will follow. The completion of QE is a signal to markets that growth in the underlying economy is now underway.

Midwest Credit Lease LLC can help you take advantage of current low long term interest rates through a CTL loan that will be easy to execute, low cost, and flexible enough to meet your needs.  We can provide both permanent financing and construction/permanent financing.

Please see the Contacts page to call us for a quote.

Recent developments in CTL financing involve providing greater levels of leverage through financing the fee interest in a site when the site is not subordinated to the ground lease.  Typically the debt service coverage for a site that is not subordinated to the ground lease will be 3 to 4 times the debt service on the site loan, since the cash flow available from the development free of the the ground lease and before any leasehold financing, will be available to the ground owner and his lender in the event of a default. This is because the site is primary in title to the improvements.

The primary position of the fee interest allows for 100% financing of the value of the fee at an attractive long term fixed interest rate.  The loan is non-recourse and investors are the typical CTL lenders such as national life insurance companies and pension funds. The costs for a CTL ground lease execution are similar to any other long term real estate financing.

Non-Profit Borrowers should consider this financing in P2P deals where they retain ownership of the site with a long term ground lease from the developer of their facility.

On May 14, 2018 the Municipal Securities Rulemaking Board and the Financial Industry Regulatory Authority issued a new rule meant to curb abusive sales practices by municipal and corporate bond brokers.  Brokers will have to disclose their purchase price when they buy bonds and sell them to retail customers a higher price later that same day.  The general rule is that these dealer “Mark-Ups” must be reasonable.  Mark-ups of 3% or greater will draw additional scrutiny from regulators but are not prohibited.  Some tax exempt bond issues have mark-ups of 4% or more.

While the method of disclosure through paper confirmations mailed to customers has been criticized as inadequate disclosure, over time customers should benefit from lower prices.  While this is good news for investors, this will be bad news for issuers.

Municipal and tax exempt bond houses are unlikely to accept diminished compensation without attempting to pass this profit loss on to issuers in some form of additional issuance costs.  Lower dealer mark-ups will lead to higher costs to issuers over time.

For a more detailed discussion of this new disclosure rule see the following Wall Street Journal article.  Starting Next Week You Can See Brokers Profits From Bond Sales