Volcker Rule could prove to be 'devastating' for munis

By James Colby

Mar 13, 2012 @ 12:01 am (Updated 4:52 pm) EST

Municipal bonds are "Main Street investments," with an estimated 73% of the $3.7 trillion in outstanding principal owned by households or mutual funds1. On the other hand, municipal bonds are traded in an over-the-counter (OTC) market where dealers create liquidity. Main Street depends on Wall Street, and vice versa, with both sides benefitting.

Enter the Volcker Rule, named for former Fed Chairman Paul Volcker, and proposed in response to the devastating 2008 economic crisis. The Rule seeks, among other things, to limit proprietary portfolio trading by banks, especially activities of the speculative or rogue variety that could harm investors. Certain securities are exempt—U.S. Treasuries/Agencies and General Obligation municipals. However, thousands of revenue muni bonds that depend on dealer liquidity are not exempt, and are vulnerable to the Rule's unintended consequences.

Muni proponents are objecting that the Rule goes too far and could create a loss of confidence in thinly traded issues. In a recent letter, Citigroup Global Markets stated: "If this (Rule) were to occur in an environment where dealers' abilities to provide liquidity were severely compromised by the Volcker Proposal, the effect of individuals liquidating into a distressed, illiquid market would be devastating for existing bondholders and issuers."

In response to the avalanche of dissent, Volcker Rule implementation has been pushed back from its summer deadline. For now, I believe that the symbiotic relationship between Main Street investors and muni dealers is working well, and markets are trading efficiently. I expect that Congress and financial regulators will listen to the rising chorus of voices and leave well enough alone.

James Colby is the senior municipal strategist, fixed Income at Van Eck Global. To read more from Colby, click here

  @IN Wire

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