(Reuters) - Some public agencies that rely on the municipal bond market for financing fear that a landmark financial reform rule will cripple their ability to sell bonds and make it more expensive to raise money for crucial services.
The Volcker Rule was designed to curb the risks that banks take with depositor dollars, a practice known as proprietary trading. But the rule risks ensnaring public agencies ranging from housing agencies to hospital authorities because the way muni bonds are sold and traded results in banks risking their own capital -- the very practice banned under the Volcker Rule.
And although the rule, a key component of the Dodd-Frank reform law passed in the wake of the 2008 financial crisis, did include an exemption to ensure that state and local governments would still be able to raise money in the municipal bond market, it left a gaping hole.
As a result, state and local authorities are worried that the rule will inhibit banks from underwriting bonds and trading, inadvertently driving up water and sewer bills, delaying public transportation projects and making affordable housing scarcer unless changes are made.
The rule exempts about 60 percent of municipal bonds from the restrictions on banks' proprietary trading.
Bonds issued by states and their political sub-divisions - such as counties and cities - will be excluded from the ban, but debt issued by public agencies or authorities would be subject to the restriction.
"It could have a very detrimental effect on trying to make the investments in public infrastructure that many of us have felt could be and should be the core of economic recovery," said Washington State Treasurer James McIntire, who otherwise supports the Volcker Rule.
While proprietary trading in many markets is associated with dealers taking positions to try to profit from movements in a security, in the highly illiquid $3.7 trillion municipal market dealers are usually risking their own capital just to facilitate trades, said the Municipal Securities Rulemaking Board, in a letter to federal regulators last month.
That would hurt issuers' abilities to even sell debt in the first place, as three-quarters of the new bond issues in 2011 were underwritten by banks that would have to follow the rule.
That in turn will force issuers to delay projects or pass on hefty bills to taxpayers because of a distinction brokers, dealers, underwriters and issuers describe as arbitrary, unclear and unintentional. Most blame the narrow definition on oversights in drafting the proposal.
The MSRB, the market's self-regulatory organization, openly criticized the definition last month, and many believe that because it took the rare steps of objecting to a federal proposal, the final plan will be less stringent. The chairman of the Securities and Exchange Commission, Mary Schapiro, signaled recently the commission is considering widening the exemption.
"I think their intention was to try to restrict esoteric, non-traditional stuff. I do think it will create a bifurcated market if it were to occur," said Tom Metzold, co-director of the municipal bond department at Eaton Vance in Boston. "I really do believe they will correct their mistake."
Many states require what is known as "competitive underwritings" in the muni market, where underwriters bid on a bond issue with the expectation that investors will later buy the debt. That assumption means banks run the risk of holding a lot of unsold debt - and risking their own capital, which would be banned under the Volcker rule.
George Friedlander, a Citigroup municipal bond strategist, said this would diminish price discovery, increase volatility, push up yields, and threaten liquidity because most banks would be banned from market-making activities.
Agencies that are not exempt will also have to spend more on underwriting and legal counsel in properly structuring their bond issues, or simply in going through regulatory fine print to confirm the law applies to them.
The rules could lead to inconsistencies. For example, the District of Columbia Water and Sewer Authority and the Washington Suburban Sanitary Commission in neighboring Maryland are more than similar.
They are linked through a joint $2 billion project to clean up nitrogen at the Blue Plains wastewater treatment plant that serves Washington, Virginia and Maryland. The Washington suburban commission is a customer of the D.C. water authority as well, said Timothy Firestine, chief administrator for Maryland's Montgomery County and vice chairman of the D.C. authority.
But the city authority could end up paying more when it borrows for projects - including the nitrogen clean-up - than its suburban sister. Because the agencies have slightly different relationships with their local governments, they could end up on opposite sides of the Volcker Rule, Firestine said.
"Homeowners in the District, and even the federal government, would pay higher rates on their water and sewer rates," Firestine said. There is confusion about "who's in and who's out," he added.
Washington State's McIntire pointed to two public corporations created by local governments in his state as examples: authorities for the famous Pike Place Market and for the Seattle Art Museum. Their bonds would be hit by those restrictions, even if guaranteed by the city. But bonds sold by the city for the same purpose would be exempt.
For those not exempt, it would be "more difficult for many of these entities to get to market. There wouldn't be as many banks that would be able to work with them," he said.
Investors, knowing they were buying bonds that would have limited liquidity, would likely want higher yields. Individual buyers might begin to spurn municipal securities if some are deemed too risky for banks to buy, said the treasurer for Iowa, Michael Fitzgerald.
"When there's confusion, grandma or anyone else buying bonds stay away," he said. "This is more work for the underwriters to do and the costs go up."
After the federal agencies sift through comments, they will release a final plan for enforcement beginning in July.
One of few voices calling to maintain the narrow definition is Occupy the SEC, an Occupy Wall Street offshoot that submitted a 325-page comment on the proposal. It cited Alabama's Jefferson County sewer authority, which pushed an entire county into bankruptcy through complicated financing, and to scandals where banks overcharged municipalities for investments.
"Stated plainly, an additional exemption for municipal agency bonds would be harmful to the banking system, as it would encourage banks to continue...their attention on remote, highly unregulated markets in quasi-governmental securities that are already rife with abuse," the group said.
In the call for a wider exemption from the Volcker Rule, housing authorities are among those making the strongest pleas.
All 50 states have agencies to finance affordable housing, which like some other agencies were created so that investors would know governments were not being profligate with general debt issuance.
The National Council of State Housing Agencies in a letter to federal agencies seeking an exemption cited the debt's "proven track record of safe and sound performance." Without an exemption, it said, agencies could struggle paying for rental and down-payment aid, loan servicing, and homeless programs.
Fitzgerald of Iowa noted that his state created its housing authority in the 1970s to handle borrowing instead of issuing direct state bonds in order "to pacify the public and say 'we're conservative Iowans - we're not plunging the state into debt.'"
Iowa state still relies heavily on agencies to borrow for its various needs and could "suffer a little more proportionately" if the proposed definition becomes final, he said.
"Does the public understand the difference? I don't think so," Fitzgerald said about the distinction between agency and general obligation debt. "Look at what these agencies are doing. They're financing essential public purposes...that doesn't seem to be the source of wild speculation in the markets that caused the problems."
Additional Reporting by Karen Pierog in Chicago and Joan Gralla in New York; Editing by Leslie Adler