High-yield/macroeconomics (fka YIELD)

[DewDiligence]

Muni's Status: Quo or Quake?

[The lawsuit described in this article was the answer to one of the questions in the muni quiz I posted a couple of weeks ago.]

http://online.barrons.com/article/SB119283381814865423.html

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By JIM MCTAGUE
20-Oct-2007

The largest earthquake ever recorded was in Chile in 1960. That big boy tipped the Richter scale at 9.5, left 2 million homeless, and did $550 million in property damage, the equivalent of $3.8 billion today. But the Supreme Court could set off an even larger quake in the municipal-bond market if it rules against tax-free treatment of interest from in-state bonds, a practice that is more than 100 years old.

Forty-two states don't tax interest from in-state bonds. By the reckoning of one Wall Street firm, the impact would be close to $6 billion in higher costs of funds for New York, New Jersey and California alone. Even so, the muni markets are barely shaking. Investors assume that the justices won't change the status quo, no matter how strong the legal and economic arguments against it. "If you try to unwind it, it's just too big a mess," says Bill Thomas, a former House Ways and Means Committee chairman and now a visiting fellow at the American Enterprise Institute.

Tort lawyer John Wylie and his colleagues at Futterman, Howard, Watkin, Wylie & Ashley in Chicago dreamed up the class-action suit after reading a law-review article on the topic. They recruited investors George and Catherine Davis of Louisville as lead plaintiffs. The couple sued Kentucky's revenue department in 2003 for taxing interest on out-of-state bonds, claiming this violates the U.S. Constitution's commerce clause by discriminating against other states' bonds, whose interest Kentucky taxes. A lower state court dismissed the suit, ruling that states have a legitimate interest in attracting local funds for local public-works projects. A state appeals court reversed that decision, claiming that the bond tax system is unconstitutional. In 2006, the Kentucky Supreme Court refused to overturn that decision.

Municipal-bond critics claim that state laws favoring local issuers have resulted in an inefficient, Balkanized market that actually costs the states money and leads to silly financial products like state-specific muni funds.

To Walter Hellerstein, a state tax expert who teaches at the University of Georgia Law School, the commerce clause is vague enough to allow the Supreme Court to make a decision that is technically wrong but nevertheless commonsensical. "There's no question there's discrimination. That's a no-brainer," he said last week at a panel discussion hosted by the American Enterprise Institute. "The question is: Will it be allowed to continue? I think for reasons that don't have to do with law or economics, the court won't upset the apple cart."

Alan Viard, a former Fed economist who's now an AEI resident scholar, says the muni market isn't only protectionist but anachronistic in an era when U.S. Treasury funds and corporate money flow freely across international borders.

You hear a different song on Wall Street, which has a vested interest in the current system. Gerard Lian, an executive director with the Morgan Stanley/Van Kampen Tax-Exempt Mutual Fund Group, says the in-state exemption lowers borrowing costs significantly, especially in high-tax states (20 basis points -- each equal to 1/100th of a percentage point -- for New Jersey, 10 for California and 8 for New York). He claims that California alone would lose $2.43 billion in interest-rate advantage over 10 years if the Supreme Court changes the rules. The court takes up this case on Nov. 5.
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