Justin Formas, Director of Municipal Credit Research, summarizes the key points of the market update below. For an introduction to Justin Formas, please read the November 2010 President’s Letter. The United States municipal bond market has drawn a great deal of media attention recently, and for good reason. Weakened revenue streams, looming pension problems, historically large operating deficits in states like California and Illinois, and municipal bankruptcy threats – or actual filing in Vallejo, California’s case – have led many analysts to predict that the municipal bond market will be the epicenter of the next financial meltdown. Meanwhile, many industry professionals have countered by highlighting the traditional safety and security municipal bonds have provided over the decades. Regardless of the opinion, the considerable amount of noise has been at best unsettling to the individual municipal investor. Through the second quarter of 2010, individual investors held approximately 36.0% of outstanding municipal securities directly. An additional 33.8% of municipal securities were held indirectly through money market funds, mutual funds, and closed end funds. Take into account that level of individual ownership and it is not surprising to see investors advocating for greater accountability by the municipal market. This paper will focus on recent events that have emphasized the need for greater transparency, while examining the steps the federal government has taken to ensure municipal securities are held to the same disclosure standards as their corporate counterparts. Market growth outpaced disclosure According to the Securities Industry and Financial Markets Association (SIFMA), the size of the United States bond market through the second quarter of 2010 was $35.34 trillion. Municipal bonds accounted for $2.8334 trillion or 8.0% over that time period. All things considered, municipals are a fraction of the U.S. bond market that includes Treasuries ($8.508 trillion), mortgage-related debt ($8.9), and corporate debt ($7.27) totaling 69.8%. However, a closer look reveals interesting facts that clearly show how the bond market growth has outpaced the speed at which municipal disclosure standards have been set. Since 1996, the total US bond market has grown exponentially – increasing 189%. Meanwhile the municipal market has grown 125%. Additionally, there are reports that approximately $5 billion in municipal bonds are in default today. That figure would represent 0.18% of the total municipal market. Following the Great Depression, Congress passed the Securities Act of 1933 and the Securities and Exchange Act of 1934. The laws were enacted in an effort to provide investors with full disclosure regarding offered securities and to create a regulatory entity in the form of the Securities and Exchange Commission (SEC). Interestingly, municipal securities received special exemptions based on a preference to avoid federal and state jurisdictional interference. For the next several decades, debt issued by state and local governments was widely considered to be very low risk. The market consisted primarily of general obligation bonds, which carried a full faith and credit pledge of governmental entities. As a result, disclosure was minimal. The turning point However, with the introduction of new credit pledges, debt structures, and New York City’s financial crisis in the 1970s, municipal disclosure came to the forefront. An SEC investigation into New York City’s disclosure documents concluded that the City’s disclosures did not provide “the measure of disclosure mandated under the federal securities laws in the interests of the investing public” and “although municipalities have certain unique attributes by virtue of their political nature insofar as they are issuers of securities they are subject to the proscription against false and misleading disclosures.” These were important findings as they laid the foundation for one of the SEC’s rare filings against a municipality more than 30 years later. Subsequently in 1975, Congress passed amends to the Securities Exchange Act of 1934, essentially expanding the definition of “person” to include issuers of municipal securities. The amendment also made it clear that municipal entities were NOT exempt from the fraud provisions under prior Securities Acts. As part of the amendments in 1975, Congress established a limited regulatory scheme for municipal securities intermediaries. This included mandatory registration of municipal securities brokers and dealers, and the creation of the Municipal Securities Rulemaking Board (“MSRB”). Furthermore, in what could have been a watershed moment in terms of regulatory authority over issuers of municipal securities, Congress elected to approve Section 15B(d)(1) of the Exchange Act (commonly known as the Tower Amendment, after the late Republican Senator John Tower of Texas). The Tower Amendment specifically prohibits the SEC and the MSRB from requiring any issuer of municipal securities, either directly or indirectly, to make any filings with the Commission or the MSRB prior to the sale of securities. The MSRB was further limited in its ability to require any municipal issuer to furnish it or any purchaser or prospective purchaser with any documents. Fast-forward to 1983, and the $2.45 billion revenue bond default by the Washington Public Power Supply System. This particular default brought about SEC Rule 15c2-12, which requires underwriters participating in primary offerings of municipal securities of $1,000,000 or more to obtain, review, and distribute to investors copies of the issuer’s disclosure documents. The SEC also issued interpretative guidance concerning the due diligence obligations of underwriters of municipal securities. Derivatives lead to a default The municipal market once again evolved in the early 1990s as issuers developed a taste for sophisticated and complex interest rate products to hedge their overall debt portfolios. The most well known instance of municipal default and bankruptcy, Orange County, California’s involvement in the derivatives market caused an estimated loss of $1.7 billion of public funds. Prior to 1994, no major issuer had ever defaulted on a general obligation bond. Also along the lines of municipal derivative transactions gone wrong is Jefferson County, Alabama. Jefferson County had accumulated a municipal debt portfolio of approximately $4.6 billion. Of that amount, $3.2 billion was directly related to the County’s sewer system. The County’s refinancing arranged in 2002 and 2003 by JPMorgan Chase & Co. collapsed in 2008 when companies guaranteeing the floating-rate debt lost their top credit ratings because of losses on unrelated mortgage-backed securities. Interest rates on the sewer bonds rose to as much as 10 percent and derivatives tied to the debt worsened the crisis by further increasing borrowing costs. On March 7, 2008, Jefferson County failed to post $184 million collateral as required under its sewer bond agreements, thereby moving into technical default. Earlier this year, Jefferson County defaulted on $227 million of general-obligation warrants. If Jefferson County files for bankruptcy protection, it will be by far the biggest financial failure of a government entity in U.S. history. Recent municipal disclosure progress During the last few years the MSRB, in concert with the SEC, FINRA, and the Federal Reserve have made strides to improve municipal disclosure. For instance, last year the MSRB became the sole recognized information repository for municipal securities information. The MSRB’s Electronic Municipal Market Access, or EMMA, online repository system has received 126,200 continuing disclosure documents from 7,800 registrants. Of that total, about 85%, or 107,200, were mandatory disclosures. Around 41%, or 51,300, were for bond calls, while 32%, or 40,500, were annual audited financial statements. Roughly 9%, or 11,100, were for rating changes and 5%, or 6,900, were quarterly financial statements. During calendar 2009, the MSRB made more than 15,000 new official statements available to the public, bringing the number of official statements available on EMMA to nearly 300,000. The MSRB also collected data on more than 10 million municipal transactions worth close to $3.8 trillion. During the seven months ended December 31, 2009, the MSRB collected more than 61,000 continuing disclosure documents. However, until recently the historical lack of enforcement has diminished any true ability to adequately hold municipal issuers responsible. Specifically, the Tower Amendments have created a complicated set of disclosure rules without enforcement, as well as regulations that don’t directly address the issuers responsible for the disclosure. Three events show promise of better disclosure While it’s safe to remain fairly skeptical given the progression of municipal disclosures over the last 80 years, three events have occurred that show a modicum of promise. First, in November 2006, the SEC entered an order sanctioning the City of San Diego for committing securities fraud by failing to disclose to the investing public important information about its pension and retiree health care obligations in the sale of its municipal bonds in 2002 and 2003. This was the first time the SEC had ever formally filed charges against a municipality. To settle the action, the City agreed to cease and desist from future securities fraud violations and to retain an independent consultant for three years to foster compliance with its disclosure obligations under the federal securities laws. In formal offering documents, the City failed to inform investors that the City’s unfunded liability to its pension plan was projected to grow from $284 million at the beginning of 2002 to $2 billion by 2009. The City also failed to show that its liability for retiree health care was projected to grow to more than $1 billion. While it could be argued that the punishment doled out did not fit the crime, the SEC’s willingness to even charge a municipality with misleading investors was a milestone in and of itself. In August of 2010, the SEC charged the State of New Jersey with securities fraud. Similar to the San Diego case, the filing related to the State’s claim that it had historically been properly funding and accurately disclosing public employee pensions. The SEC contended that in addition to inadequately funding pension obligations dating back to at least 2001, the State’s disclosure documents omitted certain pieces of information critical to analyzing the pension systems overall financial condition. The SEC settled its suit with New Jersey by issuing a cease-and-desist order. The State accepted the order without admitting or denying the findings and no penalties were imposed. Furthermore, the SEC’s order did not name any individual state officials, nor the bond underwriters or other professionals associated the State’s financial statements and disclosure. Again, it would appear that all parties involved escaped with nothing more than a slap on the wrist, for now. The point here is that the SEC sanctioned a state. The third and most critical step in improving enforcement of municipal securities disclosure made its way into the Restoring American Financial Stability Act of 2010. As part of the 2010 Financial Reform Bill relating to municipal disclosure, section 976 (b)(4) states: “make recommendations relating to disclosure requirements for municipal issuers, including the advisability of the repeal or retention of section 15B(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78o-4(d)), commonly known as the Tower Amendment. As the SEC pointed out in 2009 legislation proposing to repeal the Tower Amendments, the main goals are to gain greater control of municipal accounting standards, enhanced regulation of market intermediaries, and possibly changes to the composition of the MSRB that would make it a more “independent” self-regulator. The importance of issuers increasing the frequency of disseminating timely financial information to the municipal marketplace cannot be underscored. It does appear, in the near term, that many issuers will continue to struggle financially – making better disclosure standards a very high priority in our view. Munis remain attractive – but know thy bonds Municipal bonds will remain an attractive investment for many investors, especially given the probability of higher marginal income tax rates in the years ahead. For investors, the conflict at the center of the argument on whether to improve municipal disclosure comes from the registration exemption granted to municipal securities under the Securities Acts of 1933 and 1934. Historically, most retail and institutional investors have relied on the credit rating agencies and monoline bond insurers to perform the necessary due diligence and provide an adequate level of credit surveillance. As a result of the credit crisis, few monolines exist today and the faith in the rating agencies abilities to adequately represent creditworthiness has been shaken. Earlier this summer, shortly after the Restoring American Financial Stability Act was signed, a very unique thing happened in the marketplace. The credit rating agencies began asking issuers of all types of securities to not list their rating on offering documents for fear it could lead to an influx of lawsuits in the event that security soured. Markets were placed in a holding pattern. Few deals were priced until a resolution was found several days later. Initially, the credit rating agencies included municipal securities in their request, but upon further review came to the conclusion that because municipals are not registered securities under Acts of 1933 and 1934, they would not be exposed to the same legal concerns. This underscores an earlier point on municipal security ownership. It would appear that the government is pushing more responsibility on the investor by weakening third-party research firms and, therefore, it is sensible to make the necessary improvements to transparency and disclosure. The municipal bond marketplace is forever changed and will remain a very challenging financing environment for some time, in our view. The current dynamic underscores our long-held belief in the importance of knowing the underlying credit quality, deal purpose and deal structure of your municipal bond investments. At Bernardi Securities, Inc., our credit research analysts spend hours each week reviewing and updating our research database in these areas. Our experience from decades past tells us that this is still the best practice today and for the decades ahead. We hope you found this commentary helpful and thank you for your continued confidence. Sincerely, Justin Formas, CAIA Director, Municipal Bond Credit Research Department November 11, 2010

March 2, 2018
By Matthew P. Bernardi

Warren Buffett’s annual letter is one of the best insights into the mind of perhaps the greatest stock picker in history. His letters offer a great window into how he built a $500 billion conglomerate of businesses from a mere, mid-size textile manufacturing company. Today, Berkshire Hathaway intersects with our lives in myriad ways from auto insurance to underpants to home brokerage services. The man, however, is not without his biases as it pertains to financial markets and asset allocation, including a distaste for active stock management, investment bankers, and bonds.

The latter is the focus of this commentary and why individual investors should understand the context of Warren’s words when he stated bonds were “a really dumb” investment compared to stocks. Undoubtedly, he teaches us much about identifying attractive equity market business models- but remember that his investment objectives, risk tolerance, and investment time horizon are likely different than the average investor.

The composition of assets within a portfolio is primarily driven by the investor’s objectives. Objectives are primarily designed around achieving or maintaining a particular lifestyle. This may be a specific figure of net worth, income, gifting, or philanthropic activity. Mr. Buffett is driven by a very different purpose. His objective is driven by stockholders, who require continual quarter-over-quarter, year-over-year growth…in perpetuity. In a sense, Warren the man is really Warren the corporation and since a corporation’s lifespan is essentially endless, he will necessarily have different objectives than the ordinary investor. For most investors, income or net worth goals can be finite and established in order to get across the peace-of-mind finish line. Total return in perpetuity is not the sole driver of objectives for your average individual. Instead, locking in a fixed income and higher bond allocation is often necessary to achieve the peace of mind at a particular stage of life.

Objectives and time horizon drive portfolio risk, and risk drives security selection. Mr. Buffett needs to build a portfolio of assets that are likely to provide high levels of cash-flow far into the future and that can offset catastrophe insurance losses, which typically occur irregularly. On the other hand, our average investor holds a portion of their wealth in fixed income for two different life scenarios. Firstly, when they want to shelter a portion of the wealth they have accumulated throughout life. The second scenario is for investors who want serenity and optionality regarding their investment portfolios up to that point of ultimate wealth accumulation. This is in case of a job loss, large health expense, or even to take advantage of a stock market swoon during times of elevated valuations. Perhaps, the latter is why Mr. Buffett’s portfolio is currently 37% invested in cash and bonds, providing a bit of an incongruity to his “dumb” investment comment. That said, he has an added benefit of earning cash-flows from his various wholly-owned, underlying businesses to cover large one-off expenses. As for an individual investor, the potential of incurring an emergency or large one-time expense will drive an allocation to fixed rate, creditworthy bond assets.

To understand where Mr. Buffett falls on the risk-tolerance spectrum, look no further than the concentration of his stock ownership- both as a percent of his overall investment portfolio and in individual holdings.[1] This demonstrates Mr. Buffett is willing to stomach a much higher hit to principal than that of his competitors and even your average hedge fund manager. Of his insurance company counterparts, my calculations show Progressive Corporation having the next highest allocation to stocks at only 12% vs. 63% for Berkshire.[2] The fact he has been so successful designing a portfolio in such a way for so long is the essence of his genius. That said, this level of risk tolerance is unique and relatively very high.

Shareholder returns are directly connected to this portfolio risk and have experienced significant volatility in times of stress.

Source: Berkshire Hathaway 2017 Annual Report

Though long-term holders have obviously been rewarded, these types of stock swoons may be unpalatable for investors with a low tolerance for volatility. Also, most investors do not carry a perpetual investment horizon like that of Berkshire Hathaway, which will continue long after Warren Buffett and should invest as such. Assuming continued, long-term, economic growth and proper security selection, the company has time on its side to recover from economic calamities and short term volatility. Individual investors do not always have this benefit. Take for instance 1999-2009, which was a lost decade of stock returns – unlike for bonds.

To sum it up, Mr. Buffett’s anti-bond attitude must be understood in the context of his unique investment objectives, high tolerance for risk, and his perpetual holding period. He said it best while being interview on Monday morning by CNBC: “You will not be way happier if you double your net worth.” Is trying to achieve this with unnecessary or concentrated risk in any market worth sacrificing your peace of mind and long term goals?

[1] Buffett’s top 15 holdings of his publicly traded portfolio are 85.75% of the overall portfolio. Wells Fargo is the largest holding, followed by Apple at 17.16% and 16.47%, respectively.

[2] Source: Bloomberg