A proposal to fix illiquidity, disclosure woes: cut down number of issuers

It may be time to revisit an old but compelling solution to clean up the $4 trillion municipal bond market — state-based bond banks that take over borrowing responsibilities from the thousands of small local governments that dominate the market.

That’s the proposal from a pair of high-profile muni market experts: Kent Hiteshew, former director of the Office State and Local Finance in the U.S. Department of the Treasury, and Ivan Ivanov, senior economist in the economic research division of the Federal Reserve Bank of Chicago.

“I think the biggest problem with the muni market is that we have too many small issuers and that creates all the illiquidity,” Hiteshew said. “I’m a fan of bond banks not only to improve disclosure, but also to reduce the number of issues and CUSIPs out there that contribute mightily to the illiquidity.”

The pair proposed the idea Monday in an article — carrying what Hiteshew says is an admittedly “provocative” title, “Should Every Town and Village Have Unfettered Access to the Municipal Bond Market?” — posted on ProMarket. It’s one of a series of pieces focused on municipal finance.

The idea of state-based bond banks that pool small financings into larger borrowings remains relevant as the muni market continues to struggle with fragmentation, poor liquidity, and inadequate disclosure, the authors said.

“Issuance in this market is dominated by small local governments that issue infrequently in small denominations resulting in over three million distinct CUSIPs between 2000 and early 2023,” Hiteshew and Ivanov wrote. “Most of the outstanding par amount of bonds were issued by just several hundred of the largest issuers, while the overwhelming balance of issuers account for only a fraction of outstanding debt,” the piece said. “Pricing, liquidity, and transparency in the municipal bond market would benefit from a reduction in the number of these smaller issuers as it is easier for larger, more frequent, and sophisticated issuers to comply with the robust and timely disclosures required of well-functioning capital markets.”

To illustrate the well-publicized lack of adequate disclosure, Hiteshew cites a “stunning” statistic: issuers failed to report 50% to 60% of material events related to private placements. The statistic was reported in a separate article by Ivanov as well as Tom Zimmerman of the University of Cologne and Nathan Heinrich of the Board of Governors of the Federal Reserve System.

State bond banks would need to act as more than conduits, however; they would need to carry credit enhancements, the authors said.

“This enhancement would serve to homogenize the underlying pooled borrowers into a single, strong credit reflecting the quality of both the diversified underlying pool of borrowers and the state credit support feature,” eliminating the need for every small issuer to meet disclosure requirements.  “A strong state-backed credit with larger, more frequent issuance would also support improved secondary market liquidity that, together with more robust and timely ongoing disclosure, would further reduce small government interest costs.”

The move would lower capital costs for local governments and reduce administrative burdens, they say. The bond banks would require fiscal reporting and the local governments would provide the banks with the same types of pledges, like general obligation, that they use to enter the capital markets.

“There’s nothing new about this idea,” Hiteshew noted. But only a handful of states, like Vermont, New Hampshire and Maine, have implemented such banks, though together they have issued “billions” on behalf of their local governments for more than 25 years.

The likelihood of the proposal suddenly gaining momentum is slim, Hiteshew added, partly because cities and towns “guard their independence quite aggressively.”

But as insufficient disclosure and secondary market illiquidity continue to plague the muni market, it may be time to resurrect the proposal, he said.