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Congressional gridlock will likely continue, but compromise on fiscal cliff may be ahead

By Darla Mercado

November 8, 2012

With Election Day in the rearview mirror and President Barack Obama ready to kick off a second term, advisers and investors are shifting their focus to the realities of the looming fiscal cliff.

Top-of-mind worries for financial advisers include contending with the flurry of spending cuts and higher taxes that will go into effect in January unless Congress and the White House reach a compromise — the dreaded “fiscal cliff” that will hit in 54 days — according to panelists on InvestmentNews’ post-election webcast “The Day After: What does the outcome of the election mean for financial advisers and their clients?”

While other issues, such as the effect on business costs in the event the Financial Industry Regulatory Authority Inc. becomes the chief regulator of all types of financial advisers or what will happen if a universal fiduciary standard is applied, are likely to be hot topics in the second Obama administration, the most immediate worry is preparing clients for the ill effects of the fiscal cliff.

Talk with clients

“The thing to fixate on right now is what the market is doing, and talking to clients to help them understand the tax issues if a lame-duck [congressional] session punts these issues down the road,” said panelist Duane R. Thompson, senior policy analyst at fi360 Inc.

The effects of the fiscal cliff are twofold: Not only will the Bush-era tax cuts expire, but steep automatic cuts in spending — known as sequestration — will take place if Congress fails to come up with a deficit reduction plan.

Lately, investors have been feeling paralyzed, fearing that there may be another pullback in the market. However, panelists on the Wednesday webcast were cautiously optimistic that there may be a compromise that will soften the blow.

“[House Speaker] John Boehner has said that the Republicans are willing to take new revenue under the right conditions,” said Neil Simon, vice president for government relations at the Investment Adviser Association.

“To me, that means that part of this deal that’s talked about quietly would leave marginal tax rates alone,” he added. “They could raise revenue from ending deductions and as part of that, Democrats will have to concede on entitlements.”

Investment opportunity

Jeffrey Kleintop, chief market strategist at LPL Financial LLC, also said he believes that a compromise would have some combination of spending cuts and taxes, which could lead to some optimism if the solutions address long-term fiscal concerns. That can turn into an investment opportunity.

“Stock valuations are lower now than they were in 2008 and 2009, as the markets are braced for pain,” Mr. Kleintop said. “There might be some room for upside.”

Naturally, it’s also possible that Congress could kick the can further down the road and come up with an extension that will postpone sequestration, Mr. Simon said.

Tax breaks that hang in the balance due to the fiscal cliff include a 2% payroll tax cut, which Mr. Kleintop says “is not on the table” in Congress. “Nobody cares about the payroll tax cut; it’s a sugar high,” he said.

The real worry is the alternative minimum tax, which without congressional action will hit an additional 26 million households in the 2012 tax year and add an average of $3,700 to their tax bills. This is a prospect both parties would want to avoid, Mr. Simon said.

The legislative and regulatory picture for the next two to four years is the status quo, the panelists noted, with the GOP maintaining control of the House of Representatives and the Democrats adding a seat in the Senate. Some shuffling in the committees and at the federal agencies, however, will affect financial advisers.

Rep. Jeb Hensarling, R-Texas, is favored to replace Rep. Spencer Bachus, R-Ala., as chairman of the House Financial Services Committee. Meanwhile, Rep. Maxine Waters, D-Calif., is expected to replace the retiring Barney Frank, D-Mass., as the top Democrat on that committee.

Ms. Waters is a strong advocate of investment adviser oversight, namely of imposing user fees on advisers to fund enhanced examinations by the Securities and Exchange Commission, said Mr. Simon, adding that she is poised to rally committee Democrats on that issue.

Mr. Thompson said that Ms. Waters’ bill for user fees on advisers likely won’t go anywhere because Republicans control the House.

However, it’s questionable whether Mr. Hensarling will continue Mr. Bachus’ crusade for an adviser self-regulatory organization. Reform of government-sponsored enterprises, namely Fannie Mae and Freddie Mac, is Mr. Hensarling’s priority, and though Mr. Bachus will remain on the committee, he won’t have the chairman’s firepower to push legislation, Mr. Simon added.

Over the next two years, advisers ought to pay attention to revolving doors at the SEC and the Federal Reserve. The panelists forecast that SEC Chairman Mary Schapiro would leave her post well in advance of her term’s ending in January 2014. They did not suggest any possible contenders for a successor.

Panelists did agree, however, that Federal Reserve Chairman Ben Bernanke, whose term is also up in January 2014, will be succeeded by Janet L. Yellen, currently the vice chairwoman. Mr. Obama has not indicated whether he intends to reappoint Mr. Bernanke to a third term.

Limit on tax deduction might send investors rushing to the exits; ‘lot of vectors’ would spoil appeal

By Jason Kephart

November 8, 2012

The tax-exempt status of municipal bonds, which makes them particularly attractive to high-net-worth investors, is up in the air as Congress wrestles with the fiscal cliff.

“This election makes the administration’s proposal for a 28% cap much more plausible,” said Matt Posner, legislative coordinator at Municipal Market Advisors, at the Bloomberg Portfolio Manager Mash-Up in New York on Thursday. “In the Senate, even before this election, there was bipartisan talk already that this 28% idea had legs.”

Any changes to the tax status of the bonds could send notoriously fickle municipal bond fund investors fleeing for the exits.

“There’s going to be a negative reaction [to a change in the tax-exempt status of munis] and it could lead to sustained redemptions,” Peter Coffin, president of Breckinridge Capital Advisors Inc., said.

Municipal bond investors have shown already that they’re susceptible to factors that have nothing to do with the underlying fundamentals of the market. In late 2010, for example, a massive sell-off in the market was triggered by analyst Meredith Whitney, founder of an eponymous firm, who predicted a near-apocalyptic scenario for the asset class. To date, the raft of defaults predicted by Ms. Whitney has failed to materialize.

But sustained withdrawals would mean sustained losses in municipal bond funds. Because of their illiquid nature, the performance of municipal bonds is largely tied to flows into and out of the funds. That illiquidity could get even worse if the tax exemption were threatened, as it would make the narrow investor base even narrower.

“If you start limiting the exemption you’re only going to make the market less efficient and more vulnerable,” Mr. Coffin said.

Although the form is uncertain, some kind of a change to the tax exemption seems fairly likely, given the fiscal challenges the government faces. Mr. Posner, said the most likely scenario is a cap on the amount of interest high-net-worth investors can deduct.

“There are a lot of vectors moving toward limiting the tax exemption,” he said.

In the short term, some of the selling pressures brought on by the potential changes could be offset by so-called crossover buyers, such as institutions, which don’t benefit from the tax exemption but still find the current prices attractive.

Investors aren’t the only ones at risk if the tax exemption is altered. Small issuers may find it harder to find buyers for their bonds, thus increasing borrowing costs and putting more pressure on their ability to pay back the debt.

The possibility of altering the tax status of municipal bonds was first raised by the National Commission on Fiscal Responsibility and Reform created by President Barack Obama in 2010.