104 Abstract Under the combined pressure of increased urbanization, fi scal adjustments and decentral- ization, central governments were pushed to- wards accepting the idea of local government accessing the private fi nance sources for their public infrastructure and service development investments. While the importance of borrowing increases for local developments, the main chal- lenge many small municipalities have to face is the diffi culty to access private fi nancing sources. One obstacle is related to the creditworthiness of the municipal debtor or bond issuer. Sub-na- tional governments can overcome the problem of creditworthiness through the use of credit enhancement mechanisms or techniques. The present paper is the fi rst to discuss the situation of credit enhancements for Romanian municipal bond fi nancing, its consequences and the path that might be followed for their further devel- opment. The absence of appropriate credit en- hancements can be considered among the fac- tors that contributed to the underdevelopment of the Romanian municipal bond market segment mainly between 2011 and 2014. In order to im- prove the municipal bond market profi le, Roma- nian local governments should not ignore credit enhancements for any future bond issue and a combination of internal credit enhancements and bond pooling, as external credit enhancements seem to provide a feasible solution. Keywords: bonds, municipalities, credit en- hancement, Romania. CREDIT ENHANCEMENTS AND THE ROMANIAN MUNICIPAL BOND MARKET Cornelia POP Maria-Andrada GEORGESCU Cornelia POP Professor, PhD, Department of Business, Faculty of Business, Babes-Bolyai University, Cluj-Napoca, Romania E-mail: cornelia.pop@tbs.ubbcluj.ro Maria-Andrada GEORGESCU Associate Professor, PhD, Department of Economics and Public Policies, Faculty of Public Administration, National University of Political Studies and Public Administration, Bucharest, Romania E-mail: maria-andrada.georgescu@administratiepublica.eu Transylvanian Review of Administrative Sciences, No. 48 E/2016, pp. 104-123 105 1. Introduction and literature review The importance of sub-national borrowing as an element of development strate- gy at municipal or local level is continually increasing given three important trends identifi ed since the 1980s and discussed by Peterson (2000), Magrassi (2000), Ven- katachalam (2005), Kehew, Matsukawa and Petersen (2005), Martell and Guess (2006), Canuto and Liu (2010), and USAID (2009). These trends are: a) the growing pace of ur- banization which requires considerable infrastructure and urban services expansion; therefore the need for local investments is mounting and the demand for fi nancial re- sources to support them increases accordingly; b) the decentralization trend, a process through which sub-national governments are granted increased responsibilities and more important roles in planning capital investments, establishing priorities, and im- plementing chosen projects; also the diffi cult responsibility for fi nancing the needed investments is transferred to local governments; c) fi scal adjustments which require governments at all levels to reduce budget defi cits; one of the favored instrument is the cut back of central government subsidies for local infrastructure fi nancing; since sub-national governments rarely maintain cash surpluses necessary for medium and large-scale investment projects, this trend also enhances the need of local authorities for alternative fi nancial resources as a way to support their development projects. As highlighted by Venkatachalam (2005), these three trends have challenged the traditional approach of fi scal federalism, under which borrowing at sub-nation- al levels was not favored, especially in developing economies. Under the combined pressure of increased urbanization, fi scal adjustments and decentralization, central governments were pushed towards accepting the idea of local governments access- ing private fi nancing sources for their public infrastructure and service development investments. Moreover, the use of credit for these developments is supported by the idea of inter-temporal equity which requires future generations to partake in sup- porting the costs of current infrastructure investments, as highlighted by Peterson (2000) and Venkatachalam (2005). This inter-temporal equity is ensured through the standard rule holding that the period of a local debt repayment should approximate the useful life of the project, as such matching the time profi le of costs and benefi ts (Peterson, 2000). While the importance of borrowing increases for local developments, the main challenge many small municipalities have to face is the diffi culty to access private fi nancing sources. The hardship is generated mainly by the relative small amount of capital needed for (potentially profi table) projects/developments, often combined with the lack of frequency in accessing market sources, which limit or even deny the access of local governments to market fi nancing at att ractive (borrowing) rates. Other factors that increase the diffi culty of accessing private fi nance sources are: the limited credit experience, the limited knowledge of fi nancial markets, and, when available, poor credit ratings. This diffi culty of small local governments in accessing the mar- ket fi nancing alternatives is briefl y discussed by Noel (2000), Petersen (2006), Blom- mestein and Rhee (2009), and Schmith et al. (2011). 106 Another problem that impairs local government access to capital market resources arises from the fact that investors are not always fully aware of the true credit quality of the municipal borrower/issuer given the infrequent access to capital market, which reduces the investors’ familiarity with the respective entity; moreover, the analysis of a local government fi nancial performances is a daunting task given the diffi cult access to fi nancial information, as highlighted by Peng (2002). This problem is related to the creditworthiness of the municipal debtor or bond issuer. Sub-national governments can overcome the problem of creditworthiness through the use of credit enhancement mechanisms or techniques. Moreover, through credit enhancements the problem of small borrowed amounts can also be surmounted, since these mechanisms can help the issuer to market their debt to investors (Platz , 2009). Credit enhancements consist of a variety of provisions used to reduce the credit risk of a municipal debtor or municipal bond issuer, by providing additional collat- eral, insurance, and/or a third party guarantee that the debtor/issuer will meet its obligations (Petitt , Pinto and Pirie, 2015). Few academic papers are dedicated to discuss credit enhancement only since these mechanisms are closely linked with the credit market developments relative to sub-national borrowers. Among the most recent academic works discussing the credit enhancements are Platz (2009), Mandel, Morgan and Wei (2012), Schmit et al. (2011), and Petitt , Pinto and Pirie (2015). A comprehensive presentation of credit en- hancements can be found in Ziegler (1985). Two main types of credit enhancements exist: internal, put in place by the debtor or bond issuer, and external, provided by a third party to the debtor or bond issuer. The internal credit enhancements rely either on the collateral value or on the structural features concerning the priority of payments (Petitt , Pinto and Pirie, 2015). According to Fabozzi et al. (2005) these credit enhancements infl uence the cash fl ow characteristics of the loan, even in the absence of default. Being put in place by the debtor, these credit enhancements are less costly, except the opportunity costs for reserve funds. Often, at least a form of credit enhancement is required to exist before external credit enhancements are put in place by a third party. The following types of internal credit enhancements are the most common in case of local governments borrowing: overcollateralization, reserve accounts or reserve funds, and debt sub- ordination. These three types of internal credit enhancements are briefl y presented below. The overcollateralization represents the practice through which the debtor or issuer of bonds off ers collateral that has a greater value than the borrowed amount (Craw- ford, 2005; Banks, 2005; Petitt , Pinto and Pirie, 2015). The excess collateral pledged by the debtor creates a buff er that can cover a series of unexpected risks. Through over- collateralization, the debtor’s credit profi le becomes stronger and this might trigger a higher credit rating and lower interest rates for the borrowed amount. Thus, over- collateralization might prove to be expensive if the tied up collateral (mainly in the case of assets) cannot be used for other purposes. A supplementary mechanism that 107 completes the overcollateralization is represented by the intercept of (central) state aid to local governments dedicated to meet debt service payments. Reserve accounts or reserve funds. A reserve account/fund is established either vol- untarily by the debtor/bond issuer or at the request of the lender or guarantor. Such an account/fund might come in one of the two forms: a) a cash reserve fund1 (Craw- ford, 2005) is a deposit of cash resulting from the cash proceedings; a portion of the obtained loan is placed in an escrow reserve account, out of the debtor’s reach; a drawn against such account or fund is made if a loan installment is not paid when due; it might take the form of a hypothecated fund that typically is invested in mon- ey market instruments, and it is held at a custodian or trustee; this cash reserve ac- count/fund is often used in conjunction with a lett er of credit, an external form of enhancement; b) excess spread account (Petitt , Pinto and Pirie, 2015) is a reserve ac- count funded by the excess spread; the excess spread is the diff erence between the cash fl ow received from the assets used to secure the issue and the interest paid to the investors; also, it can be funded by an extra interest paid by the debtor or bond issuer. The excess spread account is most often established in the case of debt subordination and is considered the fi rst line of protection against credit losses; this account must be completely used (exhausted) before even the most subordinated tranches incur losses (Mandel, Morgan and Wei, 2012). Moreover, in a process called turboing, the excess spread account might be used to retire the principal (to pay the principal in advance) and thus, to reduce the default risk for the respective issue. Debt subordination, also called senior/subordinated structure, refers to the ordering of claims over a loan. According to Petitt , Pinto and Pirie (2015) and Crawford (2005) the loan/debt is structured in at least two tranches: a senior tranche (called class A) and a subordinate or junior tranche (called class B). The subordinated/junior tranche acts as a protective layer to the senior tranche; the subordinated/junior tranche will absorb any potential losses. Basically, the subordinated/junior is a buff er or collateral to the senior tranche. The senior tranche has priority claims, and is the fi rst repaid in case of default, while the junior tranche incurs the losses. Moreover, the senior tranche is unaff ected by losses unless these exceed the amount of the subordinated/ junior tranche. Due to this structure, the senior tranche has a high credit quality, a high rating, and a low yield. The junior tranche, given its high credit risk and the greater default risk exposure, is supposed to have a higher yield. Furthermore, the subordinated/junior tranche will have a low rating or no rating at all. Debt subordina- tion is also known as waterfall structure and more than one senior and junior tranche might exist with various levels of claim priorities. 1 An alternative form of this cash collateral account is funded by the debt issuer not with a portion of loan proceedings but with another loan from a third party bank or affi liate. The amount of this fund is immediately invested in high rated, short term commercial papers. Thus, this alternative is seldom used as municipal bond credit enhancement. 108 The external credit enhancements, provided by a third party, increase the credit- worthiness of the debtor. External credit enhancements bear a high cost, mainly for small local borrowers. Moreover, they expose both the borrower and the investors to the third party credit risk. The debtor benefi ting from external credit enhancements fi nds its creditworthiness strongly related to that of the credit enhancement provider, any downgrading of this entity will trigger a downgrading of the borrower, as dis- cussed by Fabozzi et al. (2005) and Petitt , Pinto and Pirie (2015). Moreover, the inves- tors have a double task: to perform a credit analysis on the debtor, and another credit analysis on the third-party, the credit enhancement provider, by bearing in mind the extreme situation that the respective provider might not be able to meet its obliga- tions, as highlighted by Fabozzi et al. (2005) and Petitt et al. (2015). The most common types of external credit enhancements are: stand-by lett ers of credit, various types of guarantees, surety bonds, credit wraps, and bond pooling. These types of external credit enhancements are briefl y presented below. The stand-by lett er of credit is a contingent lett er of credit representing an obliga- tion of the issuing bank on a designated third party (the benefi ciary) that becomes eff ective only if the drawing customer fails to perform on a specifi c transaction or under the terms of a contract with the benefi ciary (Banks, 2005; Petitt , Pinto and Pi- rie, 2015; Mandel, Morgan and Wei, 2012). The stand-by lett er of credit obligates the bank to ensure that investors receive timely payment on the issued debt/bond, or to ensure that investors receive payment in the event of market disruptions; later, the bank will att empt to recover the loss from the customer. The issuance of the lett er of credit implies the payment of a fee; the fee depends on the required credit enhance- ment amount which becomes the lett er of credit balance. The issuance of a lett er of credit may also require the existence of a reserve account or an excess spread account and/or other forms of internal and external credit enhancements. The stand-by lett er of credit can provide coverage based on the remaining outstanding in the pool, which would be constantly decreasing or could be based on the original amount issued that would provide an increased percentage of coverage as the balance of the pool de- creases (Banks, 2005; Petitt , Pinto and Pirie, 2015). The rating of the lett er of credit issuer is important for the rating of its customer. Various types of guarantees: a guarantee is a contractual agreement where the guar- antor provides payment to the benefi ciary should the contracting party default on its obligations. Through the provision of the guarantee, the obligations of the con- tracting party assume the credit rating of the guarantor (Banks, 2005). The guarantees are off ered mainly by international fi nancial institutions, highly rated banks or espe- cially created/dedicated funds. The main types of guarantees are: a) comprehensive guarantees or full credit guarantees that cover the principal and the interest payment regardless of the cause of debt service default; they are very seldom off ered given the risk of municipal debts; b) partial credit guarantees where a guarantor covers a por- tion of debt service payments regardless of the cause of debt service default; there are also partial risk guarantees when the sharing of borrower default risk is based on the 109 cause of such default; the partial credit guarantees are more often used, the guarantee being expressed as a percentage of the principal and it amortizes in proportion to the bond or loan; the percentage of the guarantee can increase or decrease in the later years depending upon the needs of the borrower or creditor. Surety bond is a fi nancial agreement under the form of a policy writt en by an insur- ance company to protect another party against loss or violation of a contract; the in- surer assumes the role of the contracting party in completing a transaction or project in the event the contracting party defaults on its performance obligation (McElravey, 2005; Banks, 2005). The surety bond is similar to an insurance policy designed to cover the benefi ciary against losses, and is provided by a multiline rated and regulated in- surance company. Usually, one or more levels of credit enhancements are required to cover losses before the surety bond is used. Often, this type of guarantee is provided only for securities rated BBB or higher. Surety bonds (sometimes called performance bonds) are commonly used in project fi nancing, and in municipal or governmental developments. A surety bond includes three parties (Banks, 2005; Tavakoli, 2003): a) the principal or the obligor (the purchaser of the bond) is the entity responsible for per- forming on the underlying contract, task or transaction; it has the primary responsi- bility to perform the obligation; b) the surety or the insurer (multiline insurance com- pany that backs the bond) performs upon the default of the principal; it is the part with the secondary responsibility of performing the obligation if the principal/obligor fails to perform; c) the obligee (the entity that requires the bond) is the party to whom the right of performance is owed. The rating of a surety bond is strongly related to the rating of the insurance company, and has an important infl uence upon the rating of the debt or bond issue for which it was purchased. Credit wrapping is an external guarantee whereby a monoline bond insurer2 agrees to cover the interest and principal payments if the debtor or bond issuer cannot fulfi ll its obligations (Banks, 2005). It refers to a specifi c loan or debt, and the amount of the enhancement depends on the deal structure, and is expressed as a multiple of the expected loss level (Tavakoli, 2003). The monoline insurance company may choose to pay back a certain amount of interest or principal on the defaulted loan or may buy back a portion of the loan. The credit wraps are considered fi nancial guarantees and are used to supplement other forms of credit enhancements. The highest rating possi- ble on a wrapped loan is the rating of credit wrapping provider. Bond pool or pool fi nancing is a technique through which small loans are aggregat- ed or pooled into a larger and more effi cient grouping. The main idea is to create a portfolio of loans that can be remarketed in bulk towards the security market as the obligation (bond) of a specialized fi nancial institution. Through loan pooling a required ‘critical mass’ can be att ained in order to bring att ractive market fi nancing 2 Monoline insurance companies off er only guarantees to bond issuers, mainly in the form of cred- it wraps. These insurance companies do not off er other insurance lines such as life, property or causality. 110 within the reach of small local government entities (Schmit et al., 2011). Based on this loan portfolio the sponsor sells an issue of bonds and the proceeds of the issuer are divided between the small borrowers, cities or organizations of public interest. The pooling allows small sub-national borrowers, which individually are of no interest to private capital markets, to achieve economies of scale related to underwriting costs, credit enhancement costs, and interest rates as highlighted by Gilbert and Pike (1998). The bond issue based on loan portfolio (pool) is carrying a variety of other credit enhancements like reserve funds, intercept provisions, and bond insurance. The pool diversity provides fi nancial stability and mitigates the overall credit risk. Usually a combination of internal and external credit enhancements is used in or- der to obtain the desired creditworthiness in order to achieve the targeted debt rating (when used) and interest rate. The use of a type or another of the credit enhancements is closely related to the type of credit systems that support the development of local credit markets. Two main systems were identifi ed according to Peterson (2000) and Schmit et al. (2011): one based on credit institutions and one based on municipal bond fi nancing. A brief description of these two models is presented below. Credit institutions model: Within this model, two main subtypes can be identi- fi ed: a) the model based on specialized municipal credit institutions (MCIs), and b) the model based on commercial banks. a) MCIs represent a specialized niche of lending institutions and, in some coun- tries (e.g. Netherlands), such institutions are over a century old. An MCI can be either a municipal bank or a funding agency specialized in providing fi nancial services to municipalities; the main goal is to reduce the borrowing cost for local governments through the MCI complex activity (Schmit et al., 2011). The main service that an MCI off ers is debt fi nancing for local governments and other public entities, usually within a given region like a province or county. MCIs also off er loans for local infrastruc- ture project fi nancing and for public-private partnership projects (Schmit et al., 2011). Moreover, MCIs off er a wide range of support services acting as advisers and assis- tants for various aspects related to local investment projects. In fact, MCIs develop a quasi-permanent relationship with local governments; this evolved into the philos- ophy of relationship banking and bundled services as described by Peterson (2000) and Peterson (2003). MCIs were established either as customer-oriented entities or member-owned credit cooperatives3 (Schmit et al., 2011). In the case of customer-ori- ented entities the equity capital is owned either by the state (central government), lo- cal governments or by both, as in the case of Austria and Norway (Schmit et al., 2011). In the case of credit cooperatives, the equity capital is formed by members, mainly 3 Schmit et al. (2011) also mention the Bank Nederlandese Gemeenten as a third type of structure. This institution is a two-tier company under Dutch law, with 50% of its equity capital owned by the Dutch State, and the remaining half owned by municipal and provincial authorities, and by a water board (Schmit et al., 2011). 111 local governments, which are also the benefi ciaries of the provided fi nancial services, as in the case of Sweden and Denmark (Schmit et al., 2011). A detailed description of MCIs in Western Europe is provided by Peterson (2000), Magrassi (2000) and Anders- son (2014). In all cases, MCIs benefi ted by a special status enforced by law which al- lowed these institutions to access cheap long-term fi nancial resources in order to ful- fi ll their goal of providing low cost fi nancing to local governments. Moreover, MCIs benefi ted by some form of state guarantee, either explicit or implicit, under the form of maintenance statement (Schmit et al., 2011). The deregulation process within the fi - nancial sector of the 1980s put an end to this special status of MCIs, mainly in France, Germany, and forced them to compete against other banks for funds on the fi nancial markets. Thus, the aftermath of the recent fi nancial crisis forced regulators and cen- tral governments to reconsider the special status of MCIs taking into consideration the paramount importance of infrastructure projects for the economic development. According to Andersson (2014) and FMDV (2012) countries like France, Germany, Great Britain, and Italy are reconsidering the model of Nordic countries (Denmark, Finland, Norway and Sweden), and the creation of Local Government Funding Agen- cies (LGFAs) was proposed as a way to enhance local governments’ possibilities to access the capital markets while maintaining costs at the lowest levels. b) The lending model based on commercial banks developed mainly in emerging economies where the MCIs were virtually unknown (Peterson, 2003), and where the deregulation of fi nancial services did not allow the creation of lending institutions with a special status. Due to the fact that for commercial banks municipal lending represents only a fraction of their operation portfolio, the range of products dedicated to local governments is narrower, and the lending period is shorter. Since municipal lending is included in a larger operation portfolio, commercial banks often allocate litt le time and fewer resources to develop the needed special understanding and ex- pertise in municipal fi nancing. Therefore, commercial banks seldom off er support services, and the relationship banking with local governments is virtually inexistent. Moreover, standard commercial banking loans have the tendency to be more costly given the fi nancial resources accessed. Municipal bond fi nancing model: The model of municipal bond fi nancing is based on the direct access to capital market fi nancing through bond issuance. Therefore, the system is based on competition among lenders, and public disclosure of munici- pal information. The relationship banking and bundle services disappear under this model, as highlighted by Peterson (2000, 2003). Nevertheless, municipal bond fi nanc- ing has proven to be a diffi cult process mainly for small local governments or enti- ties which access the capital market with a low frequency and for modest amounts, compared to large municipalities. These small municipalities incurred high borrow- ing costs by trying to access capital market fi nancial resources. In order to overcome this problem, in 1956 Canada launched the municipal fi nancial corporation/authority model; the model was followed by the opening of the fi rst bond bank in the US in 112 19704 (Gilbert and Pike, 1995; Blommestein and Rhee, 2009). These institutions, gener- ically called municipal bond banks or MBBs, have been created for a similar reason as MCIs: to lower the borrowing costs of local governments. Thus, their role is achieved in a diff erent manner than in the case of MCIs. MBBs operate as credit enhancement institutions by pooling the borrowing needs of small local governments and public institutions, adding credit enhancements at local level and issuing bank bond debts into national or international markets (Gilbert and Pike, 1995; Blommestein and Rhee, 2009). The main benefi ts for sub-national borrowers are represented by the economies of scale that result from the reduction of the interest rates, and also from the dimin- ished administrative cost and credit enhancement costs. In October 2011, the Europe 2020 Project Bond Initiative was launched and became operational during the second half of 2012. The Initiative has two main objectives (Rosales and Vassallo, 2012): a) to reopen debt capital markets as fi nancing sources; b) to help individual infrastructure projects to att ract the needed fi nancing resources. The LGFAs mentioned in relation with MCIs are also connected to this initiative, and LGFAs are expected to play a role not only as classic lenders but also to pool Europe- an sub-national borrowers needs similar to MBBs. The credit institution model was prevalent in Western European countries while the municipal bond fi nancing is traditionally linked to the US and Canada (Peterson, 2000). The system based on credit institutions which provides most of the fi nancing under the form of long-term (bank) loans is linked with the use of internal credit enhancements. The municipal bond fi nancing gives preference to external credit enhancements5 which, in turn, require some form of internal credit enhancements. Therefore municipal bond fi nancing implies the use of a combination of internal and external credit enhancements. Developing countries have the choice between the two main credit system models, or bett er still a combination of both in order to build their local credit systems. As Pe- terson (2000) shows, the existence of municipal credit institutions or commercial bank lending to local governments can operate side by side with a municipal bond mar- ket. In order to encourage this kind of development, in many developing countries municipal development funds (MDFs)6 were established. A presentation in extenso of various countries’ experiences is given by Peterson (2000). Romania, as a developing country, needed also to follow the path of munici- pal credit system development. At the end of the 1990s, Peterson (2000) mentions 4 Peterson (2000) presents a detailed evolution of bond banks in the US. 5 The importance of bond insurance as credit enhancement was discussed in extenso by Godfrey and York (1994) and Peng (2002). 6 Municipal development funds (MDFs) were established with the assistance of international fi - nancial institutions and were mainly used to on-lend international program funding to local au- thorities; MDFs were seen as transitional institutions which were supposed to pave the way for self-sustaining municipal credit systems (Peterson, 2000). 113 that Romania was taking tentative steps towards establishing a municipal develop- ment fund based on external support. However, this initiative never took shape and through Law no. 189/1998, Romanian sub-national governments were allowed to bor- row money from capital markets based on bond issuance, within a ceiling based on their revenues. While this development seemed to be in line with the trends on inter- national markets, for sure it was relatively a too large step for the unprepared and underdeveloped Romanian capital market. Moreover, the development was pursued in complete ignorance of the importance of internal and external credit enhancements and overlooked the signifi cance of bond rating mainly for the international investors, dominant within the Romanian investing environment. This paper is the fi rst to discuss the situation of credit enhancements for Romanian municipal bond fi nancing, its consequences and the path that might be followed for their further development. 2. Romanian municipal bond market and the virtual absence of credit enhancements The introduction of municipal bonds on the Romanian main capital market, Bu- charest Stock Exchange (BVB), was made in November 2001, and it aimed to open the access of local governments to private fi nancing, and also to diversify the securities traded on the market, which were represented only by domestic shares as of October 2001. A brief evolution of the municipal bond market segment within BVB is present- ed in Table 1 and refl ects the modest position of this sector. After a slow start, a more promising evolution followed between 2004 and 2007. The peak reached in 2008 was generated by the investors’ desire to exit the equity market and purchase alternative securities less infl uenced by the fi nancial crisis turmoil. The interest towards the mu- nicipal bond sector dwindled between 2009 and 2011 and reached the lowest level in 2012. The years 2013 and 2014 show also modest evolutions indicating a lack of in- terest. In depth analyses of this sector evolutions and causes can be found in Lăcătuș and Văduva (2009), Pop and Georgescu (2011, 2015). At the launch of the municipal bond market, Romania had in place the following two regulation mechanisms, of the four identifi ed by Ter-Minassian and Craig (1997), according to NALAS (2010) based on a questionnaire investigation: direct control through which borrowing at local level is subject to approval by the central govern- ment; in the case of Romania this approval is given by the Commission for the Autho- rization of Local Loans, functioning within the Ministry of Finance; and, the rule-based approach, a ceiling on the level of indebtedness is set by the legislation; the fi rst set of Romanian regulations established the ceiling of local debt ratio at 20%; this limit was later increased at 30%, level currently in place; more details regarding the calculation of the debt ratio are available in Moșteanu and Lăcătuș (2008a, 2008b), and Pop and Georgescu (2011). The att empt to identify the credit enhancements available for the listed municipal bonds revealed the following aspects: a) Romania is among the countries where an 114 Table 1: Municipal bond sector at BVB Year Listed bonds New listings Traded bonds Number of trades Volume Value (EUR mil.) % of total BVB bond sector 2001 2 2 2 5 45 0.00 100.00 2002 4 2 3 10 59,050 0.25 100.00 2003 9 8 7 12 29,310 0.34 95.66 2004 19 12 12 85 51,945 1.32 10.02 2005 13 5 11 60 25,632 0.71 2.38 2006 11 3 10 60 80,658 2.04 3.80 2007 16 7 12 58 119,695 2.96 2.00 2008 20 9 18 175 323,793 8.51 15.92 2009 31 13 18 154 221,394 4.57 1.65 2010 35 5 19 88 254,207 5.46 0.99 2011 36 2 16 47 107,839 2.01 1.91 2012 36 0 6 8 5,992 0.10 0.04 2013 37 1 9 111 64,548 0.62 0.65 2014 35 0 12 150 74,382 0.58 1.65 Source: Author’s calculations based on data available online at www.bvb.ro explicit declaration exists regarding the fact that state guarantees are not available in any circumstances; this situation is also highlighted by NALAS (2010); b) within every municipal bond prospect, in the guarantee section, there is a standard declara- tion that the respective local government pledges all its collected revenues to support any payment default7; nevertheless, this collateral cannot be drawn on directly when the default occurs; further details show that in order for a lender to receive the due payments based on the collateral, a commercial court order is required8. Therefore, the usefulness of the established collateral is diminished due to administrative pro- cedures. Based on point b) presented above, only this form of overcollateralization could be identifi ed as credit enhancement for the Romanian listed municipal bonds; its exis- tence is hindered by administrative procedures. No other form of credit enhancement could be identifi ed. 7 All municipal bond issued between 2001 and 2003 and two issues of 2004 (DEV08A and SAC07) included in their prospect the following general formula regarding their promise to repay the principal and coupons: ‘the local government guarantees with its full taxing power’. The only ex- ception is the local government of the city of Arad (ARA06) which specifi es the revenues pledged as collateral. For the majority of the municipal bonds issued in 2004 and for all the other issues launched between 2005 and 2012, the formula changed as such: ‘the local government guarantees the entire payment of principal and coupons with a part of its own revenues (for the period of loan maturity) through the assignment of claim or interest over these revenues disclosed in the accounts opened at the local Treasury unit’. 8 The requirement for a court order is in fact an administrative procedure through which an offi - cial statement is made that the respective local government failed to fulfi ll its payment promises/ obligations and that the lender can proceed further by drawing on the collateral. Another reason, given the Romanian experience, is that this administrative procedure is also a way of protection against abusive lender conducts. 115 The absence of other credit enhancements, with the exception of overcollateraliza- tion by pledging the local governments’ own revenues, derived from a combination of lack of knowledge and lack of market sophistication, the absence of a rating sys- tem, and the intention to maintain the borrowing costs at the lowest possible levels. Moreover, when the municipal bonds were launched on the market and the listing started, the demand for new securities largely overpassed the off er. The main inves- tors seeking and buying large quantities of local government bonds were the domes- tic institutional investors as highlighted by Pop and Georgescu (2015). The overcollat- eralization was considered enough despite the high interest rates, given the relative small amount borrowed and the short-term maturities9. The absence of rating10, a common situation for Central and Eastern Europe, as highlighted by Szilagyi, Fetherston and Batt ern (2004), generated the lack of external credit enhancements. In Romania the monoline insurance companies remained virtu- ally unknown, as are the bond pooling system and the bond banks. By off ering only a simple form of internal credit enhancement, Romanian local governments using bond fi nancing, kept their cost related to collateral at zero since the pledged collateral was never insulated in a reserve account. Between 2001 and 2008 no problems were reported in the frequency of coupon and installment payments for the outstanding municipal bonds listed at BVB. The situation changed in 2009. Two small municipalities, Băile Herculane (BHR20) and Oravița (ORV27) announced delays in meeting coupon and installment payments (Miricescu, 2009, Bunescu, 2010, Pop and Georgescu, 2015). An unanswered question persists: why was BHR20 accepted to be listed at BVB (listing started on December 23rd 2009) if doubts existed regarding its capacity to meet the announced payments? No offi cial explanation was ever provided. An educated guess points towards the unsatisfi ed demand for listed municipal bonds. Later on, it was brought to the surface that BHR20 had not met its scheduled coupon and in- stallment payments since June 2009 while sending periodic reports to BVB that the payments were made (Musgociu, 2013). The case of BHR20 became public at the end of June 2013 when an offi cial complaint was fi led by an investor with the Financial Supervisory Authority (FSA) showing that the local government of Băile Herculane ceased the payments; FSA launched an investigation at the end of July 2013, accord- ing to Musgociu (2013). BVB suspended BHR20 for fi ve hours during July 25th 2013. Starting with July 26th 2013, BHR20 was again tradable; no trade was registered with 9 Between 2001 and 2005 the average outstanding principal was of RON 22.34 million, the average coupon of 24.03% and the average maturity of 40 months. For the period 2006-2012, the average outstanding principal was of RON 515.18 million, the average coupon of 9.11% and the average maturity of 208 months. 10 The only two municipalities that have an international rating provided by Fitch are Bucharest for its international bond issue of 2005 through which an amount of EUR 500 million was borrowed (Bursa, 2015), and Oradea which required the Fitch rating in 2007 at the initiative of its mayor (BihorStri.ro, 2014). Currently, Oradea has no outstanding municipal bond issue. 116 BHR20 between February 26th and November 7th 2013 when it was last traded on the main market. The mayor of Băile Herculane was fi ned as of December 10th 2013 by FSA with the amount of RON 10,000 (EUR 2,245)11 for failing to announce the default on payments12. BVB announced that starting with December 23rd 2013, BHR20 was under monitoring due to the absence of a designated intermediary to handle the pay- ments13; a period of six months was established as limit for the situation to be solved. No mention was made to the arrears and BHR20 remained tradable. As of July 3rd 2014 no intermediary was appointed, therefore BVB suspended BHR20; as of July 28th 2014 BHR20 was transferred on the unlisted segment; since then no transaction was registered. In December 2014, it was announced that the town of Băile Herculane had paid a fraction (about 20%) of its arrears (Pricop, 2014). No further information was made available during 2015. In November 2013, the mayor of Băile Herculane declared to the media that a re- quest was forwarded to Caraș-Severin county government in order to assist the town with the payments of its arrears (Radu, 2013). In fact, this declaration was an indirect acknowledgement that Băile Herculane’s own revenues were insuffi cient to cover the debt arrears and, therefore, the declared overcollateralization did not exist de facto. The media also announced that only one institutional domestic investor, Certin- vest14, used the existing administrative procedure and recuperated the due coupons and installments through foreclosure (Musgociu, 2013; Pricop, 2014). The actions of Certinvest were motivated by the ownership of what it considered to be an import- ant number of BHR20 bonds. It is not clear when the legal action had taken place; the media mention the year of 2012. In February 2013, Certinvest sold the majority of its BHR20 bonds, according to Radu (2013), and the trading history indicated in February 15th 2013 a number of 14 transactions with a total volume of 6,275 bonds. The closing price for February 15th 2013 of BHR20 dropped by almost 12% compared to the previous day. It is not clear if Certinvest had notifi ed FSA and, if notifi ed, why the authority had not taken any action before July 2013. According to Certinvest rep- resentative, the security market regulator body was informed about the BHR20 situa- tion; though it is not clear when (Musgociu, 2013; Pricop, 2014). The only explanation for any action or investigation in the case of BHR20 can be given by the creation of an integrated supervisory authority and by the transfer of responsibilities that took place at the end of 2012 and during the fi rst months of 2013. This clarifi cation off ers 11 The offi cial exchange rate on December 10th 2013 was EUR/RON = 4.4536, National Bank of Ro- mania, [Online] available at www.bnro.ro. 12 According to Autoritatea de Supraveghere Financiară (Financial Supervisory Authority), [On- line] available at htt p://www.bvb.ro/infocont/infocont13/BHR20_101213.pdf. 13 According to Bursa de Valori București S.A. (Bucharest Stock Exchange), [Online] available at htt p://www.bvb.ro/press/2013/Anunt_Primaria_Baile_Heculane_20122013.pdf. 14 Certinvest is a Romanian investment management company currently operating as fund man- ager for 11 open-end and closed-end domestic funds and also off ering management services for private portfolios larger than RON 100,000. 117 no justifi cation for what can be (mildly) interpreted as an indiff erent att itude of the supervisory body. It only increased the mistrust of domestic individual investors re- garding the protection of their rights. During 2013, allegations emerged regarding Certinvest BHR20 bond selling based on inside information. Given Romania’s lack of clear regulations and procedures, these allegations cannot be proved. Moreover, the fact that BVB did not suspend BHR20 after the declaration of default, and only put it under monitoring due to the absence of a dedicated intermediary for handling (the absent) payments, indicates that there are no clear procedures for default even at the trading market level. The complicated situation of BHR20 only reveals the fragility of the overcollateral- ization used as credit enhancement by Romanian local governments. The need for at least a reserve account or fund cannot be disputed. The case of the town of Oravița (ORV27) seems simpler; Oravița managed to cover its missed payments, still the mistrust in its capacity to pay the coupons and install- ments persisted. During 2014 ORV27 was frequently traded and the price decreased abruptly from 92.32% as of May 2014 to 46.08% as of December 2014. The minimum price of 42% was reached on October 23rd after 12 trades, and a volume of 5,564 traded bonds; the activity on that day was 14 times larger than that on an average trading day for ORV27. Currently, as of the end of April 2015, the price of ORV27 recovered slightly, reaching 57%. In November 2014, another small municipality, the town of Siret (SRE28), an- nounced that it has diffi culties in meeting the payments for the respective year; how- ever, no default was declared (Ionescu, 2014). The announcement triggered a rapid reaction on the market and SRE28 price dropped from 98.99% as of October 2014 to 24% as of December 2014, with a minimum price of 23.90% reached on December 2nd. Currently, as of the end of April 2015, the price has begun slightly to recover, reaching 31.29%. The low price level continues to refl ect the investors’ mistrust de- spite the fact that the local government of Siret managed to pay the small arrears that occurred. During 2014, several other municipal bonds fell under the infl uence of investors’ mistrust concerning their issuers’ capacity to meet the scheduled payments; these were: Predeal (PRD26), Alba-Iulia (ALB25A), Timișoara (TIM26), and the county of Hunedoara (HUE26). PRD26 is the only bond issued by a small municipality. ALB25A is issued by a medium-size town with other three outstanding series of bonds. TIM26 is issued by the city of Timișoara with a growing economy; thus the city also has four other outstanding series of bonds. HUE26 is issued by the county of Hunedoara; this county is one with a moderate poverty risk and a relative high unemployment rate due to the closure of the mining fi elds and of other industries within its territory. The situations presented above show that Romania experienced what the academ- ic literature has already revealed: that the bonds issued by small municipalities and underdeveloped counties represent risky investments. The absence of credit enhance- 118 ments, along with the absence of clear procedures to be followed, and the absence of a law regarding the default of municipalities, increase the respective risk even further. 3. Discussions and conclusion Romanian authorities made an important change in 1998 when the new regulation allowed sub-national governments to use the capital market in order to access pri- vate fi nancing sources. However, this important step followed by the opening of the municipal bond market segment at BVB, did not yield the expected results. In 2001, Romania’s capital market had a low level of development as shown by Skully and Brown (2006), and Pop and Georgescu (2015), being defi cient in providing important information like the risk free rate and easy accessible information regarding the reve- nue level for borrowing municipalities. Moreover, the Romanian domestic investors lacked the knowledge and sophistication for requiring and accepting the debt subor- dination as credit enhancement. Since the bond rating was not required, the need of external credit enhancement was completely ignored by the Romanian municipali- ties. The absence of appropriate credit enhancements can be considered among the factors that contributed to the underdevelopment of the Romanian municipal bond market segment mainly between 2011 and 2014. Avoiding the transitional step represented by the municipal development funds (MDFs) in establishing a local credit market, Romania also missed out the expertise it could have acquired for the future growth of the municipal credit sector. Therefore, seeking to prove its new openness towards decentralization, Romania allowed any municipality, regardless of associated risk, to access the capital market through mu- nicipal bond fi nancing, moreover without any appropriate credit enhancements. As presented in section 2, the capacity to reimburse the money borrowed by small mu- nicipalities came under pressure starting with 2009, in the aftermath of the fi nancial crisis; the slowdown of economic growth and the diffi culties in collecting local reve- nues generated cash fl ow gaps and delays in scheduled payments or, as in the case of Băile Herculane, the cessation of payments. More appropriate for the Romanian municipalities would have been a segmen- tation of the local credit market, similar to the Czech Republic and Columbia, where the smallest municipalities borrow primarily from parastatal lenders, mid-size towns borrow principally from commercial banks, and large cities mainly use municipal bond fi nancing, as shown by Peterson (2000). Similar to the Czech experience, Romanian municipalities can borrow from com- mercial banks. However, the number of domestic banks that could be identifi ed as of- fering loans for local governments through a special dedicated section on their web- sites is small, only fi ve banks out of 28. The fi ve banks are the Romanian Commercial Bank, Raiff eisen Bank, Bancpost, CEC Bank, and Eximbank; the last bank specifi es that it off ers only investment loans for municipalities. The dominant position of the Romanian Commercial Bank on the domestic credit market is highlighted by NALAS (2010). Also a German bank, Dexia Kommunalbank Deutschland is an active lender 119 to Romanian municipalities through its subsidiary Dexia Kommunalkredit Roma- nia Ltd15. Given the relative small number of outstanding municipal bond issues, of which about one third are successive series launched by the same local government, it is reasonable to believe that currently, the bulk of private borrowing at local level relies on commercial banking. Due to the private nature of bank contracts, the collat- eral required by banks could not be determined. In order to improve the municipal bond market profi le, Romanian local govern- ments should not ignore credit enhancements for any future bond issue. At the level of the internal credit enhancements, the existing overcollateralization should be complet- ed by a reserve fund or account that can be rolled over at the level of every year, hold- ing in reserve only the amount needed to cover the payments for the respective year. The problems that occurred in 2013-2014 with the small municipalities of Băile Herculane (BHR20), Oravița (ORV27) and Siret (SRE28), and to some extent with Predeal (PRD26) indicate that these local governments need to be monitored even if the amount they borrow is small and their access to municipal bond fi nancing is in- frequent. Concerning this matt er, for Romania the most appropriate solution is bond pooling, with all of its advantages. Given the recent evolutions in European Union countries such as Germany, France and Italy, the creation of a central Local Govern- ment Funding Agency (LGFA) or several LGFAs at regional level would be an im- portant step ahead. Moreover, the creation of LGFAs in Romania could be supported by Europe 2020 Project Bond Initiative. LGFAs could either act as parastatal lenders or could be shaped using the model of municipal bond banks (MBBs). Either way, they will increase the sub-national governments’ possibilities to access private fi nanc- ing sources at low costs, off ering external credit enhancements and assistance, while lowering the risks for investors through the creation of a diversifi ed loan portfolio. Nevertheless, Romanian central and local authorities should also increase their transparency, mainly at sub-national level, through a standardized disclosure format of respective government fi nancial position and audited fi nancial situations. More- over, the diff usion of accurate and timely information is of outmost importance in order to keep the investors’ trust and interest alive. Last but not least, there is a need for a clear legislation, monitoring and informa- tion release procedures in the case of local governments’ default or bankruptcy. The three municipalities with problems during 2013-2014 will have to face an in- creased investors’ aversion in the years to come if they will consider municipal bond fi nancing again. An external credit enhancement as bond pooling will be a bett er op- tion, if it will be available. 15 According to European Banking Resources – ecbs.org, [Online] available at htt p://www.ecbs.org/ banks/romania/dexia-kommunalkredit-romania-s.r.l./view-details.html, and Dexia Group, 2012; [Online] available at htt p://www.dexia-creditlocal.fr/DCL/informations-juridiques-fi nancieres/ annual-report/Documents/RA_2012_VA.pdf. 120 The future evolutions will reveal the path(s) chosen by Romanian local govern- ments, and if there is a true willingness to develop a sustainable municipal bond mar- ket. Currently, as of the end of April 2015, four municipal bond issues launched by the municipality of Bucharest undergone a successful public off ering and their list- ing started May 4th 2015. 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