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Fed's muni backstop eases investor worries, but market not 'out of the woods'

Two months since its doors opened, the Federal Reserve's new Municipal Liquidity Facility has still only had one customer: the state of Illinois.

New Jersey and Hawaii have considered it, but few other state and local governments appear interested right now in the Fed's offer of loans of up to three years. None of that is surprising to analysts, who note the Fed's lending facility is intended to be a backstop and that municipal bond markets are wide open again for states and local governments to borrow.

Municipal markets have mostly healed from the turmoil in mid-March, when investors' worries over the coronavirus pandemic led to a dash for cash and caused widespread pullbacks on any investments — even the safest ones. Analysts attribute the muni market recovery partly to the Fed's announcement of a lending backstop for eligible state and local governments, which ensures someone will be there to lend to them at reasonable rates if markets seize up again. Like other Fed backstops, the muni facility charges an above-market rate in normal market conditions that would look more attractive if market stress drives private borrowing rates higher.

That scenario is not necessarily out of the question given that municipal markets are "functioning but fragile," according to Matt Fabian, a partner at the research firm Municipal Market Analytics. Some potential catalysts for more stress: a tepid response from Congress to states' fiscal woes and more details from municipal bond issuers on how squeezed their budgets will become.

"That may be a trigger for investors to go back to the sidelines, which started this all in the first place," said Emily Brock, director of the federal liaison center at the Government Finance Officers Association.

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Democrats call for more changes to MLF

The $500 billion Fed facility is open to U.S. states, cities with more than 250,000 residents and counties with more than 500,000 residents. Governors can also designate up to two revenue bond issuers as MLF borrowers, including transit authorities and water districts, and pass along funds borrowed from the MLF to smaller jurisdictions.

But the Fed is facing pressure from Democrats and some local leaders to expand the MLF further, including by making it available to smaller local governments as well as U.S. territories, none of which are currently deemed investment-grade and are therefore ineligible.

"Under current rules, the length of lending period for MLF funds is too short, the price of the credit is too high, and the scope of entities for which credit support is available is too narrow," a group of local leaders, labor unions and left-leaning organizations wrote in a July 14 letter to the Fed.

The Fed, which has expanded access to the MLF several times, has signaled it is open to making more changes. Fed Chairman Jerome Powell told lawmakers at a June 30 hearing the Fed is reviewing whether it can adjust the MLF program to include potentially eligible issuers within territories.

Advocates pushing for the changes say direct grants from Congress, rather than Fed loans, would be more beneficial. But they also say the Fed can help alleviate current budget pressures by making the muni facility cheaper.

"It is unconscionable that as cities and states battle these dual public health and economic crises, relief would be conditioned on accepting punitive interest rates," Rep. Ayanna Pressley, D-Mass., wrote in a recent CNBC op-ed.

Layoffs in the public sector have already begun, which economists say will put more pressure on any economic recovery. State and local governments have shed nearly 1.5 million jobs since February, according to the Bureau of Labor Statistics.

"If this virus continues to move as it has been ... to further balance budgets, we'd expect further cuts to employment numbers," said Cooper Howard, who is director of fixed income strategy at Charles Schwab and focuses on muni bonds.

Some muni bond issuers are considering the Fed's lending facility as an option. New York Governor Andrew Cuomo designated the Metropolitan Transportation Authority as an eligible MLF borrower, and Hawaii lawmakers have authorized the state to borrow up to $2.1 billion from the MLF, according to the Honolulu Star-Advertiser. New Jersey could secure an additional $1.4 billion for its budget through the MLF, according to a study its lawmakers commissioned.

The penalty rate on the Fed facility may limit its usage, but its pricing as of early July was "favorable for New Jersey and Illinois, the two states with the lowest credit ratings and largest unfunded pension liabilities per capita," the Pew Charitable Trusts report said.

Muni bond issuance is up, but banks lending more too

But the revival of confidence in municipal bond markets has also made borrowing from there a viable option again, whether issuers do so for short-term purposes or longer-term projects.

For example, the city of Portland, Oregon, tapped markets for roughly $176 million this year for general-obligation bonds that will fund affordable housing and parks projects. Matt Gierach, the city's debt manager, recalled the volatility that muni markets saw in March and said the Fed's MLF appears to have helped give investors "some reassurance" and brought back calm.

In all, about $201.5 billion in municipal bonds were issued during the first half of the year, up from $173.3 billion during the first half of 2019, according to Thomson Reuters data.

Bank loans to municipal bond issuers also appear to have picked up this year, analysts say. Municipal issuers filed more than 1,220 disclosure documents to investors between April and June indicating they had entered into a new financial obligation or made changes to existing agreements, according to the Electronic Municipal Market Access database. That number lumps in loan agreements between muni issuers and nonbanks, as well.

Portland is one example of the increase in bank lending. With market conditions still somewhat fragile in April, the bank that Portland works with to underwrite its bond offerings decided to lend the city money directly for an urban renewal area refunding rather than seeking out bond investors.

Municipal lending proved to be a source of strength for Zions Bancorp NA in the second quarter. The Salt Lake City-based bank's municipal loans jumped by $476 million during the quarter, a roughly 23% increase year over year even as other loan categories came under pressure.

Although funding sources are open, a top Fed official said at a recent Brookings Institution conference the central bank will "remain vigilant" for further signs of stress and is willing to take more action if needed.

"We don't think we're necessarily out of the woods," said Kent Hiteshew, a municipal bond veteran the Fed hired in March to advise on the market.

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