Washington focuses on muni market: much legislative, regulatory, and judicial attention has been focused on the problems municipal bond issuers are facing as a result of disruption in the capital markets.

Congress, the Securities Exchange Commission (SEC), and other regulatory bodies, as well as the U.S. Supreme Court, have been actively addressing issues that are important to municipal bond issuers. While most of the activity has been in reaction to the problems municipal bond issuers are facing as a result of disruption in the capital markets, the Supreme Court's decision for the Commonwealth of Kentucky in Davis v. Kentucky brought a collective sigh of relief from state and local governments and the tax-exempt bond community This case centered around whether states violate the U.S. Commerce Clause when they tax a resident's out-of-state municipal bond interest while exempting in-state tax-exempt bond interest from taxation. Most states' tax policies are similar

to Kentucky's, making this case fundamental and significant. The court, in a 7-2 decision, ruled that states have the right to exempt taxation on in-state municipal bond interest while taxing interest on out-of-state municipal bonds without violating the U.S. Commerce Clause. Justice David Souter delivered the opinion, with Justices Kennedy and Alito dissenting.

The Court ruled that because issuing bonds is a traditional government function, and because setting different tax policies does not constitute economic protectionism, there is no violation of the dormant commerce clause. The opinion also states that invalidating a century-old taxing practice would cause "financing for long-term municipal improvements to change radically," noting specifically the hardship that would be borne by smaller municipal bond issuers that benefit from single-state municipal bond investment funds that are currently available to investors. The court did not consider whether preferential tax treatment for private activity or 501(c)3 bonds is in violation of the commerce clause. However, a footnote remarks that such a determination could "disrupt important projects that the states have deemed to have for public purpose." The Government Finance Officers Association (GFOA) and other state and local government organizations filed an amicus brief with the court in support of Kentucky's position. A copy of the court's opinion and the GFOA's amicus brief can be found on the federal government relations page on the GFOA's Web site, at www.gfoa.org.

Earlier this spring, the House

Financial Services Committee held two hearings to address the turmoil in the municipal bond market. The hearings called into question the practices and regulations of the municipal bond insurers and credit ratings agencies. In announcing the hearings, the committee's chairman, Barney Frank (D-Mass.), a longtime champion of state and local governments, said: "It is now clear that state and local governments have become the innocent victims of the credit crisis, and they are being unfairly punished for market conditions far beyond their control. Municipal bonds are among the safest--second only to US Treasuries--in terms of losses to investors, and it will be of particular concern to this committee that they not be punished by the worsening credit market and overall economic picture."

The chairman took the rating agency representatives to task for their longstanding practice of using two separate credit rating scales. According to Frank, these practices have unfairly penalized municipal bond ratings because default rates on municipal securities are far lower than those of similarly rated corporate securities, yet, on average, municipal bond issues are rated lower than corporate bonds. Lower-rated municipal credits are costly to state and local governments for several reasons: Issuers may have to pay for bond insurance or other credit enhancements to upgrade their issue in order to attract more investors; certain money market mutual funds may not be able to purchase the issues because of the SEC's current rule that a security must be rated double-A or better; and the issues may not attract the best yield when going to market. Frank said: "It is an outrage that mistakes and indiscretions in the private financial sector have contributed to an increase in the interest rates that state and local governments have to pay for important projects. Full faith in credit general obligation municipal bonds are not getting the credit they deserve in the marketplace for the degree of security they offer the investor."

Additionally, the committee questioned practices of the bond insurance industry noting that their products outside of the municipal bond insurance business and their internal investment decisions caused many of the major bond insurers to be downgraded. The bond insurance downgrades have caused hundreds of thousands of municipal bond issues to also be downgraded solely because the municipal bond issue is wrapped in insurance--not because there are any problems with the underlying credit. This new burden on many state and local governments also has caught the chairman's attention.

In response to these hearings and the information gathered by the chairman, the House Financial Services Committee approved legislation on July 30, The Municipal Bond Fairness Act. The legislation, H.R. 6308, limits the ability of the rating agencies to use separate standards for municipal bonds and other bonds by "requiring those credit rating agencies that choose to seek designation as a nationally recognized statistical rating organization (NRSRO) to use rating symbols consistently for every security to which they are assigned." The legislation also directs the Secretary of Treasury to gather information on the financial stability of the bond insurance industry and report back to Congress. Currently, no companion legislation has been introduced in the Senate. The GFOA submitted testimony to the House Financial Services Committee explaining how the current market conditions affect state and local governments, as well as a letter supporting H.R. 6308. Both of these documents, which were co-signed by other state and local government organizations, can be found on the federal government relations page of the GFOA's Web site.

REGULATORY ACTION

Disruption in the short-term auction rate securities (ARS) and variable-rate demand bond obligation (VRDO) markets was also addressed at the Congressional hearings, although a legislative solution is unlikely because the IRS, Treasury, and the SEC have provided guidance that attends to the most significant problems associated with the disruption in this market. The IRS issued guidance that allows most auction-rate securities and variable-rate demand bonds to be converted into other types of securities without the transaction being defined as a reissuance, thus alleviating many tax concerns. Additionally, the Treasury Department and the SEC provided assistance to issuers of auction-rate securities by allowing them to bid on their own auctions without running afoul with tax or securities laws. Many issuers faced failed auctions earlier in the year when there were no bids on their auction-rate bonds, which reset every 7, 28, or 35 days. This caused the bonds to reset at the contractual default rate, which in many cases was significantly higher than anticipated--sometimes 15 percent or above. The Treasury and SEC actions allow governments to bid on their own bonds to avoid having the bonds reset at the higher default rate. In order to avoid concerns about market manipulation, the SEC guidance sets forth specific bidding disclosure rules for issuers, including providing information about past auctions and publicly announcing their intent to bid at least two business days prior to the sale. IRS, Treasury and SEC guidance can be found on the federal government relations page of the GFOA's Web site.

The SEC has proposed regulations aimed at various rating agencies' practices and investor reliance on credit ratings. The SEC is now recognizing that investors and the SEC itself have placed too great a significance on ratings, and the agency has proposed rules to "increase investor protections by reducing reliance on credit ratings." The proposed rules note that "the SEC has considered whether the inclusion of requirements related to ratings in its rules and forms has, in effect, placed an 'official seal of approval' on ratings that could adversely affect the quality of due diligence and investment analysis. The SEC's proposal would reduce undue reliance on credit ratings and result in improvements in the analysis that underlies investment decisions." The GFOA plans to comment on the proposed rules this summer. Eliminating the need for a rating may make many municipal securities eligible to purchasers that could not purchase them before, including the afore-mentioned money market mutual funds.

Although Congress has few legislative days left this year, legislation affecting the municipal bond market--especially Barney Frank's efforts--may gain traction. Furthermore, the SEC's attention to the credit ratings agencies and the need to address continuing crises in the capital markets will mandate state and local government attention on these issues. As guidance, rulemaking, and legislative efforts move forward, up-to-date information will be posted on the federal government relations page at the GFOA's Web site.

SUSAN GAFFNEY is director of the GFOA's Federal Liaison Center in Washington, D.C.