By Pam Martens and Russ Martens: September 3, 2014

The continuing perversions and disfigurement of an entire nation’s financial system to accommodate insanely complex mega banks – the same ones who brought the country to the brink of financial collapse six years ago – takes center stage in Washington, D.C. again today.

Because Federal regulators do not want to have egg on their face if one of these global behemoths has to be rescued by taxpayers again, the Federal Reserve Board of Governors, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency are set to release new liquidity rules today. The rules will redefine the types of liquid assets these giant Wall Street banks must hold to meet the new Basel III Liquidity Coverage Rule set by the international banking body known as the Basel Committee on Banking Supervision, a group made up predominantly of global central banks.

The Federal regulators are expected to adopt rules that put a heavy reliance on banks holding short-term U.S. Treasury securities, one of the most liquid security classes around the world, in order to meet a bank run or credit crunch lasting 30 days.

The state treasurers’ panic over the rule is justified. According to press reports, the Federal regulators may exclude municipal bonds issued by states, counties, cities and school districts from the category “high quality liquid assets” (HQLA) which could be easily liquidated should a mega bank experience a run on its assets. These municipal bonds fund critical projects like roads, schools, and bridges. Given the deteriorating infrastructure of the nation, these new rules may critically impact the economic interests of the U.S. while regulators show growing fealty to the wishes of foreign central banks.

In a January 31, 2014 letter to the Federal banking regulators, the National Association of State Treasurers could barely contain their outrage, writing:

“[Banks] are an important portion of this vitally-important market, and their absence would be detrimental to its efficient functioning. We believe that the immediate and direct consequence of this exclusion to municipal issuers and their taxpaying constituents is unnecessary, and in many instances unbearable, increasing the cost of financing desperately needed [projects] for repair and replacement of existing municipal infrastructure.  Such public works projects are critical to a vibrant and expanding U.S. economy in an increasingly competitive world-wide economy…

“The Federal Reserve currently accepts all municipal securities (not just those that are rated investment grade) at a 2%-5% haircut when pledged at the central bank, depending upon the maturity of the securities.  Thus, the Federal Reserve already acknowledges the sound credit, diversification, and liquidity value of municipal securities by accepting them at the same haircut as U.S. agency securities and GSEs and at better haircuts than U.S. corporate bonds (which would be included as HQLA under the proposed rule)…

“We also protest that the proposed rule would permit foreign sovereign state obligations to be categorized as HQLA, while obligations of the 50 U.S. states and their various political subdivisions would be excluded from consideration in any category of HQLA.  Such a dichotomy would discriminate against the U.S. states and their political subdivisions and effectively penalize regulated companies for servicing domestic public sector clients…”

The liquidity rule coming out of Washington, D.C. today will show just how much hypocrisy the Federal regulators are capable of. If corporate bonds are included in the high quality liquid assets category but municipal bonds are excluded, they’re capable of extreme hypocrisy and hubris. Here’s why:

Municipal bonds came through the Great Depression with an extremely low default rate. General obligation municipal bonds are backed by the full faith and credit and taxing power of a jurisdiction like a state or county or city while municipal bonds issued to finance a project are classified as revenue bonds and are frequently backed just by the revenues of that project, such as a toll bridge. Clearly, general obligation municipal bonds that carry good credit ratings are generally safer than revenue bonds.

The municipal bond market is huge, roughly $3.7 trillion. However, municipal bonds are not just in the hands of large institutions like banks but also in the hands of mom and pop investors all over the country, frequently in lots as small as $5,000 or $10,000 or $25,000.

In the midst of a bank run or credit crisis, where a mega bank needs to instantly raise cash to meet outflows of $10 billion or $100 billion or $500 billion, the muni market with its wide spreads and fragmentation is not going to come through in the clinches.

But neither is the corporate bond market – in fact, that market could trade even worse than the municipal bond market because just what a corporation is worth comes under great questioning when its stock is plunging in the midst of a credit crisis.

The final hypocrisy is the Federal regulators’ proposition that a bank experiencing a bank run needs 30 days liquidity to weather the storm and make alternate arrangements. As recent experience has demonstrated – if one of the monster mega banks gets into serious trouble, it’s going to be drained of its saleable assets in one week’s time because of collateral demands from counterparties.

The Federal regulators should not need to be reminded of what happened to Citigroup in the week of November 17 to 21 in 2008. As Wall Street On Parade previously reported:

“Citigroup was showing serious strains in 2007 but the meltdown came the week of November 17, 2008.  On Monday, the firm called a Town Hall meeting with employees and announced the sacking of 52,000 workers.  On Tuesday, November 18, Citigroup announced it had lost 53 per cent of an internal hedge fund’s money in a month’s time and that it was bringing $17 billion of off-balance sheet assets back onto its balance sheet. The next day brought the unwelcome tidings that a law firm was alleging that Citigroup peddled the MAT Five Fund as ‘safe’ and ‘secure’ then watched it lose 80 per cent of its value. On Thursday, Saudi Prince Walid bin Talal, a major shareholder, stepped forward to reassure the public that Citigroup was  ‘undervalued’ and he was buying more shares. The next day the stock dropped another 20 percent to close at $3.77.

“All told, Citigroup lost 60 per cent of its market value that week and 87 percent for the year to date. The company’s market value went from $250 billion in 2006 to $20.5 billion on Friday, November 21, 2008.”

Having already received $25 billion in taxpayer bailout funds, Citigroup then got another infusion of $20 billion, more than $300 billion in government asset guarantees, and secret back door loans from the New York Fed of over $2 trillion dollars – much of which was at interest rates below 1 percent.

The incredible tale of hubris by our banking regulators in propping up Citigroup to threaten financial stability again another day has been painstakingly pieced together for our readers in “The Untold Story of the Bailout of Citigroup.”

Which brings us to today. Citigroup has flunked its stress test with its Federal regulators, has been found to not have a credible plan to unwind itself in an emergency, and who is potentially going to pay the price for this mess: the nation’s state treasurers and schools, and roads and bridges which had absolutely nothing to do with bringing the country to its knees in 2008.