Friedlander: Adverse HQLA Ruling Could Hurt Munis

BOSTON — An unfavorable ruling by federal regulators on high quality liquid asset status for municipal bonds under Basel III regulations would significantly reduce new bank appetite for the $3.7 trillion muni market "at the very least," according to an economist.

"If a substantial proportion of munis are not given level 2A status under the rules, it will certainly reduce net new demand for munis by major banks," said George Friedlander, managing director and senior municipal strategist of Citigroup Inc.

The larger banks subject to Basel III could find out soon whether municipal bonds qualify as HQLAs, "which they should," said Friedlander.

Speaking Thursday at a municipal finance conference at the Park Plaza Hotel in downtown Boston, co-hosted by Brandeis International Business School and The Bond Buyer, Friedlander said commercial bank demand for munis was particularly strong from 2010 through the first quarter of 2014, with bank holdings increasing from $254 billion at the end of 2009 to $435 billion in first quarter 2014, up 67%.

"During much of that period, banks were the dominant source of demand," said Friedlander, who cited the need to rebuild holdings after the implosion of 2008 and 2009; the impressive "yield advantage" the difference between muni yields and the near-zero cost of deposits provides amid soaring deposits; and limited loan activity after the crisis hit.

Also, said Friedlander, should interest rates and muni yields spike, individual investors and crossover buyers would probably move in quickly to fill the breach as they did last August and September.

Friedlander, who presented a paper at the conference, cited the household sector in particular. Household, essentially the consuming population of the economy, mostly consists of retail investors but also includes some domestic hedge funds, private equity funds and personal trusts, a Federal Reserve official said recently.

The household sector held $1.62 trillion in the fourth quarter of 2013, down about $450 billion from the previous quarter.

"There is this pent-up demand for munis in the household sector that will play out if interest rates do rise," Friedlander said.

Miles Barnett, a director with Municipal Market Advisors, envisions the return of short-term securities.

"If and when rates begin to rise again, shorter-term securities are likely to return, and investor demand is apt to emerge for higher yielding and shorter maturity issues and products," he said.

The conference, which involves academics and finance professionals discussing recent developments in the municipal credit markets, ends Friday.