Bond Insurers Decry Revival of Federally Subsidized Entities’ Pitch

June 18, 2020

The Honorable David J. Kautter
Assistant Secretary for Tax Policy
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Re: Federal Home Loan Banks Proposal to Credit Enhance Municipal Bonds

Dear Assistant Secretary Kautter:

This letter, on behalf of the Association of Financial Guaranty Insurers (AFGI), respectfully asks that you oppose a proposal to unfairly allow Federal Home Loan Banks (“FHLBanks”) to credit enhance municipal bonds — a proposal that has been in circulation as far back as 1998 without being enacted.

The FHLBanks propose to amend Section 149(b) of the Internal Revenue Code (IRC) to allow municipal bonds to keep their tax-exempt status even when credit enhanced by a FHLBank. Section 149(b) provides that municipal bonds lose their tax-exempt status if such bonds are credit enhanced or insured by the federal government or any of its agencies, including the FHLBanks.

In enacting Section 149(b), Congress sought to keep federally supported entities such as FHLBanks from having an unfair advantage over private entities in the private credit enhancement and bond insurance businesses. The FHLBanks proposal would create precisely the unfair advantage Congress wisely sought to prevent.

About AFGI

AFGI is the trade association of companies that insure municipal bonds and other types of public and private debt. AFGI members, also known as “bond insurers” or “monoline insurers,” guaranty the timely payment of principal and interest as due on insured securities in the event of a payment default by the issuer.

Financial guaranty insurance saves issuers money, improves their access to capital markets, and protects investors from the risk of non-payment and the burden of taking remedial action, even in cases of municipal bankruptcy.

Even during these unprecedented times, the municipal bond market is well served by competitive private sector financial guaranty insurers.

Issue

Section 149(b) of the IRC provides that interest on municipal bonds that would be exempt from federal income tax lose that exemption in the event the bonds are guarantied by the United States or any agency or instrumentality thereof — including the FHLBanks.

The Federal Housing Finance Board (“Finance Board”) and its member FHLBanks are, once again¹, seeking to amend Section 149(b) of the IRC to maintain the tax-exempt status of municipal bonds if the FHLBanks guaranty those bonds by providing letters of credit and other credit facilities.

We strongly object to the proposal for three reasons:

Improper Diversion of Federal Subsidies

The FHLBanks receive substantial federal subsidies, including —

• an implicit Federal government guaranty of FHLBank obligations;

• a state and local income tax exemption for holders of FHLBank obligations; and

• an exemption from Federal, state and local income taxes on FHLBank earnings.

The FHLBanks use much of their federal subsidy to invest heavily in assets unrelated to the purpose of the System. If the proposed amendment to Section 149(b) were to be enacted, the Finance Board would further divert the FHLBanks from their primary purpose of providing advances to their members. The FHLBanks would be able to use their subsidized status to enter a new market for federal guaranties, i.e., the use of letters of credit to support municipal bonds.

The Treasury Department has long objected to the combination of federal guaranties with tax exemption for municipal bonds on several policy grounds. Most importantly to the Treasury, the double subsidy of federal guaranties of tax exempt bonds would make U.S. government securities less attractive than municipal bonds, thereby making it more expensive for the Federal government to raise needed funds. Secondly, federal tax exemptions and federal guaranties are both scarce resources that should be judiciously made available to all states, localities, and taxpayers based on clear public policy considerations. The federal government loses leverage to raise funds at the lowest possible rates if these subsidies are combined to assist a few highly privileged obligations and their holders. The contemplated legislation encourages the FHLBanks to issue standby letters of credit or confirmations to increase their own profitability, rather than for any public policy considerations.

The value of a financial guaranty is manifested in the reduced interest rate at which the guarantied security can be issued. In return for guarantying the timely payment of the security, which enables this reduction in interest rate borne by the municipal issuer, the financial guarantor is paid an insurance premium equal to a portion of the issuer's interest rate savings. Accordingly, the value of a financial guaranty is a function of the “trading level” of the guarantor. The “trading level” of municipal bonds guarantied by FHLBanks would be significantly lower (i.e., better) than those guarantied by private sector financial guarantors, even though both may be highly rated. This differential is due to the implied federal government guaranty/subsidy provided to the FHLBanks. Given the low premiums already charged by financial guarantors in the state and local bond markets, and given the more favorable tradable levels that the FHLBanks would be able to provide (as compared to private sector companies), the FHLBanks would have a material competitive advantage over private sector companies based on their substantial federal subsidies outlined above.

Accordingly, the FHLBanks' proposal to use their federal subsidies to compete with, and ultimately overwhelm, the existing private sector participants that provide financial support for the billions in municipal bonds now privately insured on an annual basis (financial guaranty insurers insured nearly $24 billion in municipal bonds in 2019). Such subsidized displacement is not only unfair but does not meet any public policy goal. In fact, the displacement of private financial guaranty insurers and commercial banks issuing letters of credit by federally subsidized FHLBanks would harm municipal issuers, rather than help them – particularly now as COVID-19 challenges may limit those issuers' ability to access the capital markets.

Issuers of municipal bonds have benefited tremendously from the intense competition that now exists in the marketplace between private sector participants. For example, private bond insurers often compete within a thousandth of a percentage point difference in pricing when bidding on transactions. This intense competition has worked to ensure that issuers receive the benefit of competitive pricing and underwriting standards and has resulted in a very wide and deep market being served currently without any government subsidy.

Inadequate Taxpayer Protection

The FHLBanks receive a portion of their subsidies by combining their implicit federal guaranty with below-market capital standards. Unlike commercial banks that issue letters of credit and bond insurers, the FHLBanks operate with substandard capital requirements.

This problem is compounded when one recognizes that the FHLBanks will enter the municipal bond guaranty business on the basis of federal subsidies, rather than having capital at risk. The FHLBanks do not have the experience to judge the financial and operational risks in this broad new area that they will enter if their proposal is enacted.

By contrast, financial guaranty insurers operate under the intense scrutiny of the major rating agencies and under the strict risk-based capital provisions of Article 69 of the New York Insurance Law.

In summary, AFGI and its member companies believe that the proposed legislation is unwarranted, and we request that the proposal be rejected.

Thank you for your consideration of our views. We would be happy to discuss any of this further. You can contact us through our Executive Director, Teresa Casey (tcasey@mackinco.com; 518.449.4698).

Sincerely,

Adam Bergonzi, AFGI
Chair
Managing Director,
National Public Finance Guarantee Corporation

Jorge Gana, AFGI
Vice Chair
Senior Managing
Director, Assured Guaranty

Gary Greendale, AFGI
Secretary/Treasurer
Managing Director, Ambac Assurance Corporation

Association of Financial Guaranty Insurers

cc:
J. Alex

Attachments:
1. A copy of the comment letter filed by the Department of the Treasury, October 20, 1998.
2. A copy of the comment letter filed by the Association of Financial Guaranty Insurers, August 6, 1998.