A Watched Pot Never Boils: the Need for SEC Supervision of Fixed Income Liquidity, Market Structure, and Pension Accounting

Commissioner Daniel M. Gallagher

New York, NY

March 10, 2015

Thank you, Susan [Axelrod], for that kind introduction.  Today´s conference could not be timelier.  As many of you know, I have spoken repeatedly about the significant risks that have been brewing in the fixed income markets.[1]

I am pleased to report that the public debate, and the Commission focus, on the topic of fixed income reforms has dramatically increased since I first started talking about these issues in 2012.[2]

At the Commission level, there has been a lot of discussion about issues such as enhanced pre and post trade disclosures and transparency,[3] and market structure issues relating to increased liquidity and the facilitation of electronic trading.[4]

The SEC has plenary authority over the corporate fixed income markets, and important, though limited, authority over the muni markets.  If the Commission does not take the lead in seeking reforms in these markets, they will continue to operate as they have for decades, and despite the historical vibrancy of the markets, that is not necessarily a good thing.

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As we consider fixed income market reforms, it is important to reflect on the importance of these markets to our economy.

Debt financing is crucial to the U.S. capital markets.  The numbers speak for themselves.  Municipal bonds, of which there are approximately $3.7 trillion in principal amount outstanding,[5] allow state and local governments to finance their infrastructure projects and to provide for cash flow and other governmental needs.  They also constitute a large percentage of retail investors´ retirement assets.  Meanwhile, the corporate bond market enables companies to operate and grow their business through capital investments.  There is over $11 trillion outstanding in the corporate debt market.[6]  The value of U.S. corporate bond issuances in 2014 reached a record of more than $1.4 trillion.[7]  The average daily trading volume for fixed income securities of all kinds in February 2015 was 818 billion.[8]

The search for yield arising from over six years of near-zero interest rates is driving investors to the debt markets.[9]  Yet, as I have pointed out several times before, despite record issuances of corporate bonds, dealer inventory and liquidity in the secondary markets has dramatically decreased.  Even the Chair of the Financial Stability Board – the "shadow parent of the FSOC" — Mark Carney has acknowledged that new prudential regulations have caused dealer inventories to drop.[10]  By my calculation, inventories are down over 75% since the pre-crisis period.[11]  Chair Carney has noted that the "time to liquidate a given position is now seven times as long as in 2008, reflecting much smaller trade sizes in fixed income markets."[12]

With a record notional amount of outstanding corporate debt and dealers unable to commit capital and hold significant inventories, there is a real liquidity crisis brewing.  The significant risk is that when the Fed starts to hike interest rates, which some tea leaves tell us could happen as early as this June[13] — investors may rush to exit their positions in high yielding and less liquid debt and may have severe difficulty in doing so.

Interestingly, while the biggest banks have cut back on their positions in more risky debt, insurance companies and mutual funds have increased their positions in those assets.[14]  These firms have boosted their holdings of corporate and foreign bonds to $5.1 trillion, a 65% increase since the end of 2008.[15]  This has offset the $800 billion decline in holdings at banks and securities firms in the same period.[16]  Rather than banks holding the inventory, there are now "ballooning bond funds that own more and more risky debt," and it is unclear how institutional asset managers and their clients will react when interest rates rise.[17]

Although the SEC may not have a silver bullet to address these issues, there are some discrete steps the agency can take to address the liquidity risks that plague the debt markets.  For example, the Commission should be looking at all options for facilitating electronic and on-exchange transactions of these products.

Last fall, I called on the Commission to engage market participants and other interested parties to develop creative solutions to increase liquidity in the secondary fixed income markets.[18]  I am very pleased to report that a number of firms have been meeting with the SEC staff and among themselves to discuss ways to facilitate electronic trading.[19]

The Commission also must commit the necessary resources to determine how to incentivize standardized primary offerings to further facilitate secondary liquidity.  Today, most corporate bonds are highly differential and bespoke.  Electronic and on-exchange transactions could be facilitated through products that are substantially standardized.  However, we should not wait until standardization of issuances occurs to begin the migration to electronic platforms.  Today, options exchanges handle massive volumes of trading in thousands of unique options.  Electronic and exchange trading can be done and should be considered in parts of the fixed income markets also.  Indeed, in the early part of the twentieth century, there was an active market in corporate and municipal bonds on the New York Stock Exchange.  Obviously, technology has improved at least somewhat since then — if you don´t believe me, you can go read Flash Boys!

We all need to recognize that the status quo is not sufficient.  I fear that if more progress is not made, Congress could respond in a draconian way, for example by mandating that all corporate bond transactions be executed on exchange platforms.  This is exactly what happened in another over-the-counter market, the swaps markets, in the Rube Goldberg machine known as Title VII of Dodd-Frank.[20]  I cannot say it loudly enough — the industry must get together and create private market solutions, solutions that actually work and are efficient, before the government imposes its worldview.

While this potential liquidity crisis is a serious risk that warrants serious attention, there is a more discrete and addressable issue in the fixed income markets, an issue that disproportionately impacts retail investors.  That issue is the lack of transparency.  Retail participation in the municipal and corporate bond market is very high:  over 70% in the municipal markets and 40% in the corporate markets.[21]  And yet, these markets are incredibly opaque to retail investors.

One of my gravest concerns with respect to munis is that retail investors do not understand exactly what they pay in bond transactions.  Municipal bond dealers execute virtually all transactions in a principal capacity, with a portion of these principal trades effected on a "riskless principal" basis.[22]  In a "riskless principal" transaction, a dealer who has received a customer order immediately executes an identical order in the marketplace, while taking on the role of principal, in order to fill the customer order.[23]  By doing so, the dealer takes on very little risk that the market will move against it.

The dealers typically charge their customer a markup to execute their order.  But a dealer acting as a principal is not required to disclose its markup on a confirmation, even for a riskless principal transaction.[24]  Given that "riskless principal" is basically just a fancy name for "agency," there is no real reason to perpetuate this dichotomy.  Disclosure of the markup or markdown in riskless principal transactions would enable customers to assess the fairness of the execution prices.[25]

I am pleased that FINRA and the MSRB are actively engaging this issue.  I applaud Rick Ketchum and Lynnette Kelly for their leadership on those initiatives.  Late last year, both SROs issued proposals that would require dealers in retail-sized fixed income transactions to disclose on trade confirmations the price of the dealer´s same-day principal trades in the same security, as well as the difference between this reference price and the customer's price.[26]  As expected, these proposals generated a hearty response from the industry!  And separately, the SEC recently approved the MSRB´s best execution rule and I understand that the MSRB and FINRA are working together to provide further guidance.[27]  These are positive steps in bringing transparency to a market whose depiction in another older Michael Lewis book, Liar´s Poker, remains accurate to this day.

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In addition to bringing much-needed transparency, there have been growing calls for changes to the bond disclosure regime, particularly in the muni space.  The SEC´s authority in this area is of course limited; the Tower Amendment famously restricts the Commission´s ability to require presale filings of documents with the SEC, and there is no statutory grant of authority to otherwise regulate directly the form and content of disclosures by muni issuers.  And so the SEC´s regulatory regime is cobbled together from other sources of authority — in particular, generalized antifraud authority over municipal issuers and their principals, and more comprehensive authority over intermediaries, including Rule 15c2-12.

The SEC recently has been making better use of this existing authority to improve municipal disclosure practices.  For example, the SEC through the Municipalities Continuing Disclosure Cooperation Initiative, or MCDC, has been testing compliance with Rule 15c2-12, and holding muni issuers accountable for representations in offering documents, and for compliance with their continuing disclosure obligations.[28]  I will note that there has been a 40% increase in the financial and operating documents filed on EMMA between June 2013 and 2014, perhaps due to our MCDC program.[29]

The SEC´s Municipal Securities and Public Pension Unit, led by the very able LeeAnn Gaunt, is, in addition to administering the MCDC, actively pursuing muni issuers and related individuals who commit fraud.  For example, in June of last year, the SEC secured an emergency order to stop a bond offering by the City of Harvey, Illinois, based on evidence that the proceeds of the bond issuance were to be fraudulently diverted with some of those sums directed to pay the city´s comptroller and muni bond adviser, Joseph Letke.  In December, the City agreed to a settlement enjoining it from violating the antifraud provisions of the federal securities laws, and also to an undertaking to stay out of the muni markets for as many as three years.  The SEC also obtained a default antifraud judgment against Letke, along with a bar against participating in future municipal securities offerings as an adviser.  This case was an outstanding use of agency resources, and I fully support prohibiting municipalities that cannot or will not comply with the law from accessing the securities markets, as well as pursuing the culpable officials who perpetrate the fraud.

The SEC is also bringing cases against state and local entities — San Diego, New Jersey, Illinois, and most recently Kansas — for making misleading disclosures about the funding of their pension plans.  The failure by municipal issuers to provide adequate disclosures of underfunded pension plans is an unpardonable sin.  Politically-powerful state workers´ unions, and state constitutional protections for benefits, make the reduction of these liabilities extremely difficult.  The failure to set aside adequate funds to cover these liabilities creates a material risk that future payments to bondholders would need to be sacrificed.  This risk is not merely theoretical; we have seen it play out already in Detroit´s bankruptcy.[30]  Pension liabilities are a true systemic risk, but don´t hold your breath waiting for FSOC to address it.  They are probably too busy with Stage 3 assessments of lemonade stands anyway![31]

This leads me to another topic that deeply concerns me:  accounting for municipal pension and other post-employment benefit, or OPEB, liabilities.  Little did I know when I started this job, as a broker-dealer lawyer, that I´d be taking an interest in anything accounting-related, much less pension and OPEB accounting.  And yet, here we are.  As I noted in a speech last year, municipalities have taken advantage of heretofore lax governmental accounting standards to hide the yawning chasm in their balance sheets.  Those standards permitted municipalities to discount their pension liability using a projected rate of return on assets, which is contrary to economic fundamentals.  Rather, the discount rate should reflect the risk of repayment.[32]  If one used a proper discount rate, along with some other more-realistic valuation premises, we would have seen as of 2012 approximately $4 trillion of unfunded pension liabilities, instead of the more commonly-cited $1 trillion.[33]

New GASB standards for accounting for pension liabilities are a step in the right direction.  Rather than discounting all pension liabilities using an unrealistic rate of return on assets, municipalities are permitted to use that rate only for "funded" liabilities — liabilities covered by existing and expected future assets.  Unfunded liabilities must be valued using the high-yield, tax-exempt 20-year general obligation bond rate of the governmental sponsor.

Implementation of these standards is currently underway, and already it has been bringing some much-needed transparency.  For example, New Jersey´s two largest pension funds — retired state employees and teachers — saw their funded ratios drop from approximately 50% to approximately 25%.[34]  Overall, under the new rules, New Jersey´s unfunded pension liabilities are tripling from $37 billion to $83 billion.^[35]  It will be very interesting to continue to watch these newly-calculated results roll in.

That said, the new GASB standards are still only a portion of the answer.  By permitting partial use of the rate of return on assets for funded liabilities, the new GASB standards allow for some political gamesmanship, such as legislation asserting that lawmakers in the future will make back-loaded catch-up contributions to fully fund the liability.  The new approach may also increase the volatility of the liability.  The strong market returns of the past couple of years, juiced by the Fed´s monetary policy of course, have increased retirement fund asset valuations, thereby increasing the portion of the liabilities that can be discounted at the higher rate of return on assets — a figure which itself may be inflated by the bull market.[36]  Unfortunately, I worry that, if we slip into a bear market, asset valuations will decrease and more of the liability may have to be discounted at the lower, unfunded rate.  Falling assets and rising liabilities could cause funded ratios to drop dramatically.[37]

To be clear, GASB standards can result in better disclosure of pension liabilities, but it takes political leadership at the state and local government level to allocate resources to fully fund the plans.[38]  Here is where the GASB standards might be able to help again.  The new GASB standards eliminated disclosure of the ARC, or Annual Required Contribution, which previously was an easy point of reference to help investors and voters compare the contribution that would be required to steadily chip away at these accumulated liabilities with that which was actually appropriated.  Bringing back the ARC can help hold accountable governments whose contributions are insufficient to make good on their pension promises.  Those decisions are truly hard — they require cutting employee benefits, or making budgetary trade-offs, and yet they have to be made.  Muni bond investors, in turn, need to know if these hard decisions are being shirked, because they are in direct competition with these pension funds when it comes time for repayment.[39]

While I have spoken a lot about GASB´s pension standard, I should note that the GASB also has an ongoing project to update its standard for OPEB liabilities, to require better measurement of the liability and recognition of the net liability on the face of the financial statement.  This project is already proving controversial, with some protesting that municipalities can cease providing or cut OPEB benefits at any time, and therefore do not need to recognize a liability other than the current year´s funding requirement.[40]  I will believe that when I see it.  Thus, it will be much more meaningful for investors to see the full liability presented on the balance sheet, and let municipalities provide disclosure about the possibility that such liability could be reduced or eliminated.  I hope the GASB moves forward expeditiously with its OPEB project.[41]

Keep in mind that all the good work that GASB is doing in this area means nothing if jurisdictions do not follow GASB standards.  According to the most recent information I could locate, just over two-thirds of the 30,000 or so largest state and local municipal issuers use GASB standards.[42]  Data were not available for the extent to which an additional 20,000 smaller municipal issuers use GASB standards, but I would hazard a guess that their rate of compliance with GASB is lower than the larger issuers.[43]

We need a legislative fix to mandate the use of GASB standards for municipal issuers — whether it is a grant of authority to the Commission to recognize GASB standards as they do the FASB´s, or as a condition placed on the bonds´ exempt status.[44]  This should help drive better transparency for investors in the muni market.

I have spoken time and again about the Commission´s need to pursue a rational agenda given the myriad shiny objects, the politically motivated initiatives such as Conflict Minerals, that seek our attention ahead of our core blocking and tackling duties.[45]  It is critical that we make progress on fixed income market reforms as soon as possible.[46]

As my friend and colleague Commissioner Piwowar aptly stated in a recent speech, the SEC´s stove does indeed seem to have 50 front burners.[47]  This is at least an improvement from the SEC´s old model, where all the important pots were boiling over on the backburner, while we carefully tended to irrelevant Dodd-Frank saucepans.  The fixed income market pot is at a steady simmer — and at last we have a chance to intervene in an issue before another mess occurs.  I am optimistic that we can move in the right direction to address all the issues I´ve discussed today, but there´s a lot to do and a long way to go.

Thank you for your time today, and I hope you enjoy the rest of the conference.