Richard Ellis

It’s been a crazy couple of weeks on the campaign trail. That has made it difficult to keep the blog up. Today I would like to let you know my position on certain issues that have come to me in the form of questions from delegates.

The first issue concerns the assertion that I was instrumental in rejecting a $50 million settlement offer by the Workers’ Compensation Fund to the state that would have allowed WCF to privatize. The settlement offer was first presented to Governor Leavitt in 2003, and to Governor Walker in 2004. Both rejected the offer and the efforts to privatize, along with the attorney general, lieutenant governor, auditor, treasurer, and ultimately the legislature, who refused to pass a privatization bill sponsored by Senator Bramble because ALL determined it was not in the best interests of the state to allow WCF to privatize. The reasons are involved, but the bottom line is that it is at best an oversimplification, and at worst a political manipulation of the facts, to assert that I had a leading role in the rejection of the $50 million.

The second issue concerns the assertion that I am opposed to spending limits and revenue earmarks. While it is true, it is again a political manipulation of the facts to assert that, as a result, I am not a fiscal conservative. I am a fiscal conservative. Spending limits and earmarks restrict the ability of the state to adjust to its always-changing needs. What those touting the virtue of spending limits and earmarks do not understand, because they do not have the experience I have with bond-rating agencies, is that bond-rating agencies closely monitor the constitutional and statutory limits placed on the financial flexibility of the state. States like Washington and Oregon, for example, that are otherwise well-managed, will never receive the AAA bond rating like the state of Utah (one of only seven states to enjoy such rating) because they have adopted spending limits and revenue earmarks that limit their flexibility. We elect our legislative representatives to make the tough decisions EACH YEAR on how to allocate resources. Each year the legislature should have the courage and the flexibility to respond to current situations and employ its majority preference for fiscal conservatism.

Finally, let me state outright that I am not opposed to tax cuts as is being represented. What is more important, however, is the lack of understanding of the treasurer’s role that is obvious by my opposition’s focus on this, and the other issues. The legislature and the governor determine tax policy, NOT the state treasurer. While the state treasurer should (and does) provide input, and help educate lawmakers concerning the effects of their policies on the state’s bond rating, the state treasurer ultimately is NOT a lawmaker. It is lamentable that my opposition is attempting to turn this race with misrepresentations on issues that the state treasurer’s office does not, and indeed, cannot, decide.

As your State Treasurer, I will continue to use my expertise in investing public funds and my established relationships with the bond-rating agencies to ensure that the State of Utah maintains its rare AAA bond rating and its position as one of the best financially-managed states in the country. As Deputy State Treasurer, I was an integral part of the team that achieved those accomplishments; I will appreciate your support in allowing me to help maintain them.

I remember last summer when the first concerns about the sub-prime mortgage market were raised. The public was reassured that the damage was “contained” and wouldn’t ripple through to other segments of the capital markets. How wrong that has proven to be.

Now, nearly a year later, issuers of taxable and tax-exempt debt are scrambling to refinance variable rate bonds issued as Auction Rate Securities (ARS). For 20 years issuers have issued long-term debt at short-term rates using ARS. In other words, the bonds might mature in 20 years, but the interest rate paid was based on a 7, 28 or 35 day auction rate. On the remarketing date, the bonds would go through an auction process to establish a new interest rate.

One advantage to this type of variable rate debt is the lack of the need for a liquidity facility. The bonds were issued with bond insurance which guaranteed the payment of principal and interest in the event of default. This saved 15 or 20 basis points (1 basis point = 1/100 of a percent) in fees, which means a lot when the remarketing rates are in the 2 to 3 percent range.

Since February 12, the vast majority of auctions have failed, meaning there was not enough demand from buyers to match the supply from sellers. The result is the seller is stuck with a bond that they don’t want.

So how did we get to this point? The bond insurers expanded their business to insure structured investments that included sub-prime mortgages. As these investments have started to fail, the capital of the bond insurers is consumed covering these losses. This led to the bond rating agencies downgrading the bond insurers because they no longer had sufficient capital to cover their liabilities.

With the bond insurer having a lower rating, investors can no longer legally purchase, or may refuse to purchase, the ARS. The investment banks that remarket the ARS, which have traditionally made a market for ARS securities, have their own capital problems as they are forced to write down billions of dollars of losses. With no one buying, the securities have no liquidity and the seller is left holding the unwanted bond.

This is an over simplification, but reflects the realities of the market. The ARS market, which has thrived for over 20 years, appears to be headed to complete collapse. Ironically, many of the credits backing the ARS securities are very strong, but the buyers are gone. As a result, the municipal bond market is flooded with refinancing or conversions of ARS into fixed rate bonds or other types of variable rate bonds that are more expensive. 

Treasurer Bill Lockyer of California is pushing the bond rating agencies to eliminate separate rating scales for tax-exempt and corporate bonds. In March, he circulated a letter to all state treasurers asking them to join him in his efforts. His work has not gone unnoticed by the rating agencies (at least Moody’s and Fitch). Even Congress has held hearings regarding this topic.

His argument is based on default rates. A single A rated tax-exempt issuer has a similar default history as that of a triple A rated corporate issuer. Single A municipal issuers end up purchasing bond insurance so they can receive the lower interest rate associated with a triple A rating (that was before the recent implosion of the monoline insurers). A common scale would eliminate this cost for lower rated municipal issuers because they would be triple A.

Having a global scale seems to make some sense then. However, the rating agencies consider factors, other than default rate, when assigning ratings. Four general areas are considered in a rating agency analysis: 1) Economic factors; 2) Debt structure; 3) Financial factors; and 4) Management strategy.

So what does this mean if Treasurer Lockyer is successful in his quest? We would see all issuers of bonds, both municipal and corporate, on the same rating scale. But I wonder if the world is unchanged in practical terms.

From Shakespeare’s Romeo and Juliet we read, “What’s in a name? that which we call a rose by any other name would smell so sweet.” The same applies here. Municipal credits will still need to be differentiated from one another. Both California and Virginia could be triple A, but they are still not the same credit. It doesn’t matter what you call them there is a difference in the credits. As a bondholder, I would much prefer a Virginia bond over a California bond. The rating agencies will still have to differentiate by expanding the scale to quadruple A or adding a 1-5 designation to the triple A scale.

This leads to market pricing. Even if the credits have the same rating, I have to believe that the market will continue to price credits differently. Large institutional buyers do their own credit analysis. They will make their own differentiation. The best credits will continue to issue debt at an interest rate that is lower than the weaker credits. Will the best credits get an even lower interest rate? I doubt it. Municipal bond credits will continue to trade at the same levels as they have historically. Again, the need for bond insurance will continue.

This will play out over the next several months. The nice thing about Utah is we don’t have a dog in this fight because we already have a gilt-edged AAA bond rating. It saves us millions of dollars per year.