A recent report in The Bond Buyer indicates that municipal investors and analysts welcome the heat that Standard & Poor's is putting on governmental issuers to disclose their direct loan exposure. The need for more transparency has become a top concern for market participants as the use of direct loans (rather than publicly-offered bonds) has boomed in 2014, totaling $117.45 billion for states and political subdivisions overseen by the FDIC in the first quarter, the most the FDIC has ever reported.

S&P started its campaign for more disclosure around direct loans several years ago, and stepped up pressure on issuers in May when Steve Murphy, national head of public finance at the rating agency, sent out a letter to the estimated 24,000 issuers S&P rates, telling them their ratings will be lowered if they didn't inform S&P of their outstanding direct loans, and terms and conditions contained within the loans. S&P recently reiterated the importance of direct loan disclosure when it released an article called "Not All Loans Are Created Equal" discussing some of the terms and agreements in the loans it finds alarming.

"We're seeing covenants [in loans] that could trigger [the loan's] immediate acceleration," Mal Fallon, managing director at S&P, said in an interview. "Some of the risks of these covenants are more events that could lead to an acceleration. One example is failure to observe any term, covenant, or agreement, which is very broad and leaves a lot of room to call for early payment."

Other loan covenants may trigger acceleration for failure to maintain specific debt service coverage ratios or meet other financial metrics, he said.

"If issuers do not comply with one of these covenants it could put tremendous pressure on a borrowers' liquidity if failure to comply leads to rapid acceleration," Fallon said. S&P has "some level of concern" over smaller banks getting into the direct loan business, Murphy said. "[T]hey're not as sophisticated as the big banks and you have to be careful of the terms, you have to be careful of what you are signing because an event could lead to an impact on their outstanding rating," he said. "It's not a lot different than what we saw with swaps a few years back: less sophisticated entities get into these things and unfortunately they sign something they don't understand."

Fallon said one reason municipal issuers have gotten comfortable with direct loans is because they are comfortable with their local banks, and trust that relationship. This relationship is not permanent, according to Murphy. Bank loans can be transferred to "qualified investors," defined by SEC's Rule 501 of Regulation D as market entities ranging from bank and registered investment companies, to individuals such as a person with an income over $200,000 or even a trust with assets over $5 million whose purchases are made by a "sophisticated person."

"[I]f the loan is transferred to a large financial institution where the obligor does not have a longer term financial relationship, that institution might not be as forgiving if certain covenants are breached," Fallon said. "I am not sure if municipal issuers have to be notified if a bank sells their direct loan."

Matthew Fabian, managing director at Municipal Market Advisors, said in an interview that as long as loans are being transferred to other banks, it's not much of a concern, because they are still going to be overseen by federal banking regulators. Some banks have protocols to prevent direct loans from being transferred to entities that are not larger banks.

Fallon said that in the documents he has reviewed he has not seen specific clauses preventing direct loans from being transferred to hedge funds, mutual funds and qualified issuers. Tom Jacobs, vice president and senior credit officer at Moody's, said in a June interview that Moody's has asked for direct loans to be disclosed for a long time, and most issuers send information about their direct loans to Moody's as a matter of course. Who the loans are transferred to "is not really something we've focused on; we expect investors to enforce rights equally," Jacobs said in an interview on Tuesday.

"We don't think who an investor is will make a difference in terms of enforcing a right that's within a loan. My understanding is that one of largest lenders in this space has made it clear to me that they restrict transferability to banks that have $5 billion [or more] in capital. They do it for several reasons, one is that they like to account for these as loans rather than bonds, and limitation on liquidity is something that makes them look more like loans."