The Financial Data Transparency Act (FDTA) passed by Congress in December 2022 mandated the use of a common, non-proprietary legal entity identifier for municipal issuers. Although Congress' legislative intent continues to be a matter of debate, we argue that any implementation of this new mandate will have to satisfy a basic market need: the correct identification of obligors for every municipal transaction and their inter-relationships, as appropriate.
What is the LEI System?
The current Global Legal Entity Identifier System (LEI) was created 10 years ago, in the aftermath of the Financial Crisis of 2008. With the collapse of Lehman Brothers in September 2008, regulators and private-sector firms found themselves unable to accurately assess market participants' exposure to Lehman and the inter-connections within the vast network of financial market participants. Thus arose the need for a global system to identify financial connections, so regulators and private sector firms could better understand the true nature of risk exposures across the financial system.
Any entity that is a party to a financial transaction, including financial institutions, corporations, government bodies, and investment funds can apply for an LEI from so-called Local Operating Units (LOUs), entities accredited by the Global LEI Foundation (GLEIF) to issue and manage LEIs. They are responsible for registering entities, validating their information, and ensuring that LEIs are regularly updated. The GLEIF for its part ensures the operational integrity of the LEI system and maintains a centralized database of LEIs.
The LEI itself is a 20-character, alphanumeric code linked to key reference information that allows clear and unique identification of legal entities participating in financial transactions.
Municipal issuers and LEIs
It should be noted that the current LEI system is already available to public entities, including states, local governments, and other governmental bodies. The LEI application process is the same as for corporations.
For public entities, the advertised benefits of an LEI include: (1) transparency and accountability in financial dealings; and (2) better risk management and compliance with regulatory requirements.
Yet, as of this writing, only a handful of municipal issuers have reportedly applied for an LEI. Why? Because no one has been able to articulate the use case for a public entity to voluntarily apply for this identifier. More importantly, not every obligor in muniland is a "legal" entity that can be registered in the LEI system database, based on the current legal entity definition.
The obligor identification issue
In the corporate sector, a company like General Motors would only issue GM bonds, not "Chevrolet" or "Cadillac" bonds. There would be very little ambiguity as to who the legal entity/credit obligor is. In contrast, a municipal "obligor" can be any of the following:
• The issuer itself, if the issuer is the party directly responsible for repayment of the debt (e.g., the City of Chicago for City of Chicago G.O. bonds)
• The enterprise or business-activity fund, i.e. an accounting entity of a primary government, which receives and holds the revenues pledged for debt service (e.g., City of Chicago Water Fund)
• A defined source of revenues pledged for debt service, in the case of Dedicated Revenue Bonds (e.g., "NYS Personal Income Tax")
• The "lessee" in the case of a lease transaction involving an issuer, a lessor and a lessee
As a result, a typical municipal bond issue may involve as many as three or more separate and distinct entities: an issuer, a nominal borrower and, often, another third party whose revenues are pledged to repayment of the bonds.
The 'DASNY Problem'
The prevalence of so-called "conduit issuance" is at the root of this problem. Many different types of entities, even private corporations, can seek tax-exempt financing through the municipal market. To do so, many must issue their bonds through a conduit issuer, which usually has no financial obligation related to the bonds.
The poster child for conduit issuance would have to be the Dormitory Authority of the State of New York, aka "DASNY". As one of the largest issuers in our market, DASNY has issued bonds on its own behalf (i.e. where it's the obligor), as well as on behalf of as many as 408 distinct obligors, spanning such diverse sectors as local school districts, healthcare systems, universities and continuing care retirement communities (CCRC). In other words, if you invested in a DASNY bond, you have no idea what you own until you figure out who the actual obligor is. A school district would certainly be at the opposite end of the risk spectrum from a CCRC, for example.
Interestingly, the Lehman Bros collapse, which ostensibly led to the creation of the current LEI system, also provided a lesson in obligor identification.
Some of you may recall the Main Street Prepaid Gas issue from Georgia, with a complex security structure which was effectively dependent on Lehman's creditworthiness, even though Lehman's name never appeared in the security description. Many holders of the Main Street bonds, who thought they held gas utility bonds, found out, to their dismay, that the actual obligor was Lehman, a financial services company. It was a painful lesson to learn as the Main Street Prepaid Gas bonds traded down to mere cents on the dollar once Lehman went into bankruptcy.
What is needed
As the above examples show, an LEI system that strictly deals with legal entities would not adequately capture all the various types of municipal obligors.
What the industry needs, we believe, is a comprehensive relational database linking every single bond issue to its correct "direct obligor," at the individual CUSIP-9 level, based on a rigorous and consistent credit-driven methodology. Once identified, the "direct obligor" would be used to classify the bond issue into the correct sector/subsector.
Such a database will have to not only correctly identify the obligated parties for every municipal bond transaction, but also to capture relationships between obligors, if any. For instance, enterprise fund obligors can be linked to the appropriate primary government in a parent-child relationship. All such relationships can then be rolled up into the capital structure for every primary government.
This new classification scheme would allow market participants, both on the buy and sell sides, to correctly identify the source and nature of credit risk in their holdings and to aggregate such risk into meaningful sectors that share common risk drivers.
It wouldn't require much of a stretch of the imagination to see how such a system would enhance the information flow and perhaps even improve liquidity in a market as heterogeneous as the municipal sector.
Obligor identification and the FDTA
What exactly did legislators have in mind by mandating the use of a common, nonproprietary legal entity identifier? Among market participants and the agencies tasked with implementing the FDTA, confusion reigns.
What is clear is that Congress never fully appreciated the complexity of the municipal market. If the intent was to correctly identify all parties in a municipal transaction and their inter-connections, and prevent future systemic risk, then the LEI concept must be expanded to accommodate other non-legal entities to be truly useful in our market.
Although no single technology has been explicitly endorsed by the regulators at this time, Inline XBRL appears to hold great promise in terms of allowing financial data capture in machine-readable, structured format. The same technology also offers features that can be used to tag and link obligors, a potential solution to our industry's problem.
Of course, as is the case with any new legislative mandate, basic questions such as "who should pay for this?" must be resolved before the industry can move forward with any potential solution.
Seizing the moment
As the prior discussion shows, the LEI system, as currently implemented in the corporate world, would be of limited usefulness to municipal market participants. Nevertheless, the use of a legal entity identifier mandate from the FDTA could be an opportunity for the tax-exempt market to finally address one of its most egregious data gaps, the lack of a standardized obligor identification system, one based on a transparent credit-based methodology and accessible in machine-readable format.
Will market participants and regulators seize this moment and solve this vexing problem once and for all? The next few months will be telling.
