Bloomberg News

Morgan Stanley, Citigroup Advise Lockyer After Critical Report

June 28, 2011

June 28 (Bloomberg) -- Morgan Stanley and Citigroup Inc., criticized by California for arranging investment bets against state bonds, pitched Treasurer Bill Lockyer on ideas for legislation to sell $25 “minibonds” to expand sales to individuals, records from his office show.

Lockyer, a Democrat, came up with the proposal to sell bonds in smaller increments than the usual $1,000 denominations after reviewing solicitations from Morgan Stanley, Citigroup, Wells Fargo & Co. and RBC Capital Markets in late 2009 and early 2010, according to documents obtained by Bloomberg News under a public-records request.

Lockyer’s spokesman, Tom Dresslar, said the treasurer would be remiss not to consider ideas from banks, even those whose credit-default swap practices he challenged. Banks collect fees on bond transactions and would stand to profit if California shifted a $1,000 bond sale into 40 sales of $25 each.

“It would be counterproductive to completely shut the door to any ideas brought forward by a bank just because we had concerns about some of their market activities,” Dresslar said in a telephone interview.

Lockyer, a 70-year-old who served in the state Senate and the Assembly, was the major force behind the minibonds bill, Dresslar said. The treasurer, who oversaw more than $27 billion in bond sales in 2010, believes that the lower denominations would expand the market for California bonds beyond professionally managed funds, his spokesman said.

Awkward Position

Assemblywoman Diane Harkey, a Republican from Dana Point who voted against the minibond bill, said taking advice from the same banks he criticized put Lockyer in an awkward position.

“It is amusing that we beat up the Wall Street banks -- which I think is worthy when you look at their fees -- and then you go to the same banks for them to suggest creative vehicles for the investment markets,” she said. The bill passed the Assembly on May 23 and is now before the Senate.

Morgan Stanley and Citigroup were among six investment banks that Lockyer investigated in 2010 for offering credit- default swaps on state debt while at the same time underwriting California bonds. The contracts had the potential to inflate borrowing costs for the largest issuer of U.S. municipal debt by exaggerating credit risk, the treasurer said.

Credit-default swaps are derivatives based on bonds and loans that were created to protect debt holders against default. The insurance contracts, now commonly used by traders to speculate on an issuer’s creditworthiness, pay off if a borrower fails to meet its debt agreements.

CDS Contracts Rise

While California has never defaulted on its debt, the number of credit-default contracts on California bonds has grown to 1,064 from 522 a year earlier, according to the Depository Trust & Clearing Corp., which monitors the market.

The price of credit-default contracts on 10-year California bonds has risen 29 percent since May 26 to $192,580 yesterday to protect $10 million of bonds, according to data compiled by Bloomberg.

Lockyer’s probe concluded that Morgan Stanley, Citigroup, Goldman Sachs Group Inc., JPMorgan Chase & Co., Bank of America Merrill Lynch and Barclays Plc had traded $27.5 billion of the derivatives between 2007 and April 2010. Morgan Stanley made $9.4 billion in such trades, the most of the six, and Citigroup got $3.3 billion, third-highest, according to a statement from Lockyer based on bank information.

While he criticized the banks for profiting on bets against the bonds they were paid to underwrite, Lockyer said in an April 2010 statement that the effect on California securities prices was “not significant enough to cause concern at this time.” The final three words were underlined.

Gauging Market

Lockyer’s office hasn’t gauged the market for $25 municipal bonds, Dresslar said. In Wells Fargo’s pitch to the treasurer, its securities division said California’s initial transaction could be in the $500 million to $750 million range, with issuance ultimately as much as $2 billion as investors become more familiar with the product.

California is a prominent debt issuer that “could be a highly sought-after name” in the $25 market, Wells Fargo wrote to Lockyer.

The treasurer’s support of minibond legislation doesn’t necessarily mean California is poised for an issue, Dresslar said. Lockyer’s office has yet to analyze transaction costs and the potential market, he said, and wouldn’t attempt a deal that would raise borrowing expenses.

Spokeswomen for three banks that made their cases to Lockyer declined to comment when contacted by Bloomberg News: Danielle Romero-Apsilos of New York-based Citigroup, Elisa Marks of RBC Capital Markets in New York, and Mary Claire Delaney, of Morgan Stanley in New York.

Wells Fargo Pitch

A Wells Fargo spokesman in Charlotte, Michael McCoy, wouldn’t say whether the bank has promoted low-denomination bonds to states other than California.

“What we try to do with all of our customers is to educate them on what their options are,” McCoy said in a telephone interview.

Lockyer’s courting of small investors suggests that traditional municipal bond buyers are balking at California, Harkey said. The most-populous state has the lowest credit rating of any state from Standard & Poor’s, an A-, and the state’s leaders remain deadlocked over how to deal with an estimated $10 billion budget deficit.

“Is it because we want to open up new markets or is it because our existing investor base is tapped out?” Harkey asked in a phone interview. “It appears to me that we’re having trouble reaching our usual market.”

Dresslar said California, which hasn’t gone to the market this year, found buyers for all of the bonds it sold last year.

Lockyer, now in his second term as treasurer, has marketed state bonds to individual investors using radio ads.

‘Not Concerned’

“We’re not concerned about selling bonds,” Dresslar said. “We’re just looking for potential ways to expand the retail base in a way that expands the market and keeps borrowing costs down for taxpayers.”

No state has issued such low-priced general obligations, Dresslar said.

In their pitches to Lockyer, Citigroup and RBC Capital cited two previous issues of $25 municipal bonds. The most recent was a $100 million sale of pension-obligation bonds by San Diego County in 2002. The other was for $225 million by the Philadelphia Authority for Industrial Development in 1999, also for pension funding.

Citigroup said it placed 61 percent of the 4 million shares of the San Diego debt with individual investors. Neither bank provided data on the Philadelphia bonds, marketed by Paine Webber, which was acquired by UBS AG in 2000. Spokeswoman Karina Byrne in New York said UBS no longer has a municipal bond unit and couldn’t locate anyone involved in the sale.

San Diego Bonds

The San Diego County bonds, known as Public Income Notes or PINES, allowed the county to access individual investors it otherwise couldn’t reach, said Michael Workman, a spokesman for the state’s second most-populous county.

The lower-denomination bonds have higher costs of issuance than conventional debt, Workman said, although he couldn’t provide specifics. The Lockyer-backed legislation would provide flexibility for instruments like PINES at the state level, Workman said in an e-mail message, “if they ever do become a cost-effective option.”

Charles C. Jones, executive director of the Philadelphia Sinking Fund Commission, said he couldn’t comment on the 1999 bond sale as he wasn’t with the city at that time.

In the past, small-denomination bonds weren’t successful because transaction costs ate up yields, said Bart Hildreth, a professor at Georgia State University in Atlanta and editor-in- chief of the Municipal Finance Journal.

Improved Technology

Improved technology has lowered transaction costs, making the concept worth a try, Hildreth said in a telephone interview.

“We see that individual investors have been a steady part of the market, especially in this turmoil,” he said, referring to the economic recession. “It would take an issuer such as California to pull it off, to have the infrastructure and the standing to do this.”

--With assistance from Sowjana Sivalognathan in New York. Editors: Pete Young, William Glasgall

To contact the reporter on this story: James Nash in Sacramento at Jnash24@bloomberg.net;

To contact the editor responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net


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