Fed Considers Muni Bonds as HQLA

2014 was a great year for municipal investors, who earned a return of 9.8%, their best since 2011. Municipal issuance was down from its long-term averages in 2014, and the market’s ample appetite quickly scooped them up. 2015 looks like it is headed in the same direction, as memories of those big returns have spurred investors to add about $1 billion to their investments in municipal ETFs.

Increased demand for municipal securities outside of investor portfolios may also be coming in 2015, as the Federal Reserve weighs whether or not to count them as high quality liquid assets for the purposes of determining capital and liquidity ratios for the banks it (and other regulators - which issued the same final rules in unison) oversees.

The new liquidity coverage ratio is an extension of the new, globally-proposed standards known as Basel III, which include bank supervision standards meant to prevent and address some of the problems that emerged during the credit crisis. One aspect of this supervision concerns bank capital -- that is, the difference between its assets and liabilities, or the financial cushion that is available to absorb losses before the firm is rendered insolvent. The other aspect concerns liquidity -- the ease with which banks can convert assets into cash in order to meet expected (or unexpected) demands.

The final Liquidity Coverage Ratio (LCR) rule adopted by the Fed takes total prospective net cash outflows over the next 30 days as its denominator. Its numerator is defined as all High Quality Liquid Assets (HQLA), which is broken out as follows:

All HQLA assets must be "liquid and readily marketable" with an active secondary market featuring high volume levels. HQLA have to be unencumbered, and cannot be obligations of a financial sector entity.

Level 1 Liquid Assets - For the most part cash, government securities and deposits at the Federal Reserve. A minimum of 60% of a firm's total HQLA must come from this category.

Level 2a Liquid Assets - GSE claims that are investment grade or preferred stock, or some foreign guaranteed debt securities. Because these securities have a higher risk weighting under the Basel III standards, they are subject to a 15% haircut from their GAAP fair value before they are added to the HQLA total.

Level 2b Liquid Assets - Investment grade corporate debt securities, equities that are included in the Russell 1000 Index. As they carry a higher risk weighting than level 2a assets, they are subject to a 50% haircut from GAAP fair value before they are added to the HQLA total. The total contribution of level 2b assets cannot exceed 15% of the total HQLA.

Non-investment-grade debt, private label MBS and municipal bonds were all initially excluded from the HQLA calculation. However, some municipal bonds are still being considered for inclusion, which could lead to an additional source of demand in 2015. Municipals were previously excluded due to concerns that they are not sufficiently liquid during periods of high stress in markets.

The final rule went into effect January 1, 2015, with firms needing to have an 80% LCR by year-end (holding high quality liquid assets that cover 80% of their prospective net cash outflows over the next 30 days). By 2016, they are expected to be at a 90% coverage ratio, moving to fully covered in 2017 and beyond. If municipal securities are included as HQLA, how much will demand increase? An interesting analysis by Bank of America Merrill Lynch suggests that the impact will be minimal, noting that about half of all municipal securities held by banks currently are held at banks small enough to avoid regulation under the new rules anyway, suggesting (as regulators have also indicated) that most municipals are held by banks for profit rather than for liquidity or capital considerations.

If they were to be included, municipal securities would be considered level 2a assets.