September 13, 2013 / 7:05 PM / 4 years ago

U.S. government wades back into municipal arbitrage rules

WASHINGTON, Sept 13 (Reuters) - The federal government is taking up proposals it first introduced six years ago to change how it evaluates U.S. municipal bond prices and potential arbitrage.

A notice published by the Internal Revenue Service on Friday with the Treasury Department said they “are concerned that certain aspects of the existing regulations for determining the issue price of tax-exempt bonds are no longer appropriate in light of market developments.”

Representatives from the IRS were not immediately available for comment.

Arbitrage restrictions in the U.S. municipal bond market have existed for decades. The concern is that the proceeds of tax-exempt bond sales, used to finance long-term infrastructure needs, will instead be invested in higher-yielding securities for a profit. Municipal bond issuers must make investments with limited returns.

In September 2007, the federal government began updating the restrictions. But then came a pause that spanned the financial crisis, the meltdown of auction-rate securities and bond insurance, and turbulence in the variable-rate market, as well as creation of new regulations on providing greater information on municipal bonds.

Now, the federal government is revising the proposals, with a hearing scheduled for February.

The advent of the centralized trading and information website known as EMMA “has led to heightened scrutiny of issue price standards,” the notice said.

“The reported data has shown, in certain instances, actual sales to the public at prices that differed significantly from the issue price used by the issuer,” it said.

EMMA, which stands for Electronic Municipal Market Access, is run by the Municipal Securities Rulemaking Board.

The issue price is key in determining refunding prices and also in ensuring investments do not have overly high yields that would lead to arbitrage.

The IRS and Treasury are proposing issuers base the issue price on what the public paid for 25 percent of the bonds in an offering - as opposed to the current standard of the “reasonably expected” price for 10 percent of the bonds sold to the public.

At the same time, they would like to remove a restriction on creating working capital reserves, saying it penalizes issuers who may have bona fide needs for a reserve to cover expenses.

The proposals also encompass hedges that issuers use against possible interest rate increases. Specifically, terminating a hedge can create a profit that regulators may deem arbitrage.

“Issues have arisen in this area as a result of market conditions during the last several years. State and local governments have faced a number of circumstances that have put pressure on issuers to modify or terminate their existing qualified hedges,” according to the notice.

The federal government is proposing that the amount of a termination payment on a hedge be equal to the fair market value of that hedge on the termination date. It is also looking into allowing issuers to keep hedges on bonds when they refinance. Currently, when bonds are refunded, their hedges must be terminated. Under the proposals, the hedges could continue with the refunding bonds.

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