THE TROUBLE WITH MUNIS
It was a routine deal, one of thousands that take place every year in the sprawling municipal-bond market. Last February, the state of Louisiana sold $604 million in general obligation munis to investors. The underwriting was co-managed by investment banks Lazard Fr res & Co. and First Boston Corp.
But in an arrangement that some critics say has also become routine, there was a lucrative, hidden side deal. Lazard and First Boston sent half of their fees, $233,983, to First Commonwealth Securities, a New Orleans minority-owned firm, which was among the deal's underwriters. Despite the payment, First Commonwealth, which has just one employee, sold no bonds, says State Treasurer Mary L. Landrieu.
The explanation? In letters to Landrieu, First Boston and Lazard say they were told by state officials that they had to give First Commonwealth 50% of their fees to win the job, ostensibly to allow the state to fulfill affirmative-action goals. But the U.S. Attorney's Office in Baton Rouge is investigating whether members of the state's Bond Commission, which chooses underwriters, may have selected First Commonwealth for political reasons. "Why would any firm give away 50% of their fees unless they felt politically held hostage?" says Treasurer Landrieu. "This kind of business deal costs the state of Louisiana hundreds of thousands of dollars."
A spokesman for First Commonwealth, President Norbert A. Simmons, insists such a fee-splitting arrangement is not unusual and that the firm did sell some bonds. First Boston and Lazard declined BUSINESS WEEK's request for further comment.
Beyond New Orleans' newspapers, the Louisiana deal received little notice. Yet a perusal of the media in other cities and many smaller communities over the past year or so shows dozens of other questionable muni dealings: how city officials pressed investment bankers for campaign contributions in return for appointments as muni underwriters; how investment bankers, hired to be objective advisers to municipalities, had secret back-scratching arrangements with underwriters.
A thorough reader would also come across reports of other apparent muni abuses and questionable practices: how investment bankers sold exorbitantly priced investment services such as swaps to unsophisticated city treasurers; how muni investors, after receiving only sketchy information on their issues, lost thousands of dollars when the bonds abruptly went into default.
Cumulatively, such episodes raise serious questions about the integrity of the $1.2 trillion muni market. "As volume and trading have increased, these problems and abuses have increased," says Securities & Exchange Commissioner Richard Y. Roberts. "The danger is ultimately that the muni securities marketplace may not be viewed as safe, sound, and conservative." Congressional hearings scheduled for September will focus on several reform proposals.
BOOM TIMES. Yet to many people, the muni market has never looked more inviting. Munis enjoy an overall record as very safe investments. The default rate for rated muni bonds is extremely low, with most defaults limited to riskier, unrated bonds. Munis' tax-exempt status is a growing lure, because of higher income tax rates mandated by the Clinton budget. And the muni market, once viewed as about as law-abiding as a 19th century frontier town, has cleaned up its act somewhat in the last few decades. In 1975, the Municipal Securities Rulemaking Board, a self-regulatory organization for underwriters, was established. The Tax Reform Act of 1986, which capped the value of revenue bonds states could issue, helped reduce the number of riskier marginal issues.
A number of experts argue that abuses in the market are small and scattered. "Something like $250 billion of municipal bonds will be sold this year, and if the market were a mess, that wouldn't be happening. The market is vibrant, and it's growing," says Leo C. O'Neill, president of rating agency Standard & Poor's Corp., a division of McGraw-Hill Inc., which publishes BUSINESS WEEK. Indeed, new muni bonds are being issued at a breakneck pace to finance the building of schools, highways, and hospitals and to refinance older issues at today's low rates. To states and cities all over the country, the market has never been more important.
Other evidence, though, suggests that questionable dealings in the muni market may be more widespread than is commonly believed. Over the past few months, reports of abuses have aroused growing concerns. Some congressmen are organizing probes, and a few states are discussing reforms. The threat of tough new regulation from Washington helped prod the MSRB on Aug. 4 to propose disclosure rules on political contributions by bond underwriters. But wholesale reform will not be easy. "The vested interests will fight tooth and nail to keep the status quo," says Richard Lehmann, president of the Bond Investors Assn. in Miami Lakes, Fla., which monitors defaulted bonds.
The main reason the wrongdoing has received so little national attention and caused so little outcry derives from the market's localized character. The market consists of 1.5 million issues sold by as many as 50,000 municipal entities--many, many times more than the issues listed on all the U.S. stock exchanges. In the muni world, the bad guys are not high-profile villains such as Michael Milken and Ivan Boesky but typically small-time city comptrollers who tap their investment bankers and bond counsels for campaign contributions in exchange for roles in muni-bond issues.
INVISIBILITY. Despite its reach into many of the smallest communities, the muni market in many ways is invisible (page 55). Getting a price quotation almost always involves calling a broker. Only a handful of the most actively traded muni bonds' prices are listed in the newspaper, while the vast majority of prices go unpublished. "There's a whole infrastructure that isn't there," says James J. Cooner, the Bank of New York's head of tax-exempt bonds. The price of the same bond can range widely among dealers. "No one knows exactly what their bonds are worth," says Zane B. Mann, publisher of California Municipal Bond Advisor.
In some cases, overly aggressive brokers have grossly overcharged investors. In one typical arbitration decision in March, 1991, a Chicago investor, John Otto, won $30,000 from Evans Trading Co. for selling munis to Otto at prices that were "significantly higher than the prevailing market." Neither Otto nor Evans could be reached for comment. Says New York attorney Bruce S. Schaeffer: "The reason why so much fraud goes on is because commissions aren't disclosed on confirmations or brokerage statements." He adds that "bad brokers that overcharge aren't disclosed," since many muni disputes are resolved through out-of-court settlements that require the customer to keep the dispute secret.
UNEVEN DISCLOSURE. The abuses mostly affect not sophisticated institutions but individuals, the largest muni holders. Both directly and through muni-bond mutual funds, small investors own a record 74.4% of muni issues, up from 37.3% a decade ago.
Disclosure about muni issuers' financial condition is very uneven. Unlike corporations, state and local bond issuers are exempt from the Securities & Exchange Commission's registration and reporting requirements. There are voluntary guidelines, but while many large, frequent issuers lavish information on bondholders, small, infrequent issuers can go for years without releasing data. Says Jerry Webman, who oversees $13 billion in muni investments for Prudential Insurance Co.: "It's a big problem. The lack mf information makes the market riskier."
Regulation of the market ranges from cursory to nonexistent. By law, muni issuers--and their lawyers and independent financial advisers--are exempt from federal oversight except in cases of serious fraud. The MSRB, the market's main overseer, is governed by a board of industry volunteers and relies for enforcement authority on the National Association of Securities Dealers, which regulates broker-dealers. The MSRB is prohibited from regulating issuers. "Issuers have total discretion," says Ed McCool, executive director of the New Jersey division of Common Cause. "There is no public accountability. It's a situation custom-made for abuse."
A kind of conspiracy of silence about malfeasance reigns in the muni market because so many powerful groups benefit from the market's current structure. Its few critics tend to be academics and officials from watchdog groups. Politicians are happy with the lush flow of campaign contributions. Executives at Wall Street firms, while fed up with local officials extending their palms, keep playing the game to get business. Muni dealers can reap handsome profits from the market's inefficiencies.
At the heart of some of the muni market's worst troubles is the extent to which it is pervaded by politics. Campaign costs are rising, creating incentives for politicians to look to sell-heeled bankers and lawyers for contributions. Too often, public officials dole out bond business on the basis of financial favors, not merit. "Each municipality is paying a little extra over the life of the bond to make up for political contributions," says Robert B. Lamb, professor of finance at New York University's Stern School of Business. "The taxpayers are the ones who ultimately have to pay."
Washington's interest in reform got a boost last spring from publicity about a cozy arrangement between Wall Street firms and New Jersey Governor James J. Florio's chief of staff, Joseph C. Salema. The U.S. Attorney for New York's Southern District is investigating whether Merrill Lynch & Co. bestowed financial favors on Armacon Securities, a tiny Clementon (N.J.) brokerage part-owned by Salema, to secure $2.9 billion in state bond business, confirms Merrill and Armacon attorney Thomas Puccio. Despite almost nonexistent capital, sales staff, and customers, Armacon was part of the underwriting syndicate for state issues. Merrill denies any criminal misconduct by its employees. Salema also denies wrongdoing, saying his Armacon holdings were in a blind trust after he joined the governor's staff. He resigned his state position in May.
Numerous other questionable situations have recently come to light. New York City Comptroller Elizabeth Holtzman has come under fire for allegedly giving underwriting business to Fleet Bank's securities unit in exchange for a $450,000 loan to her U.S. Senate campaign fund last fall. Several months later, her office recommended Fleet as an underwriter of city bonds. Last May, the city removed the Fleet unit as a bond underwriter. Holtzman says she was unaware that her staff had selected Fleet as underwriters. A Fleet spokesman says the terms of the loan "met all our credit-underwriting standards."
Politicians solicit contributions even more boldly in Illinois' Cook County, which includes Chicago. Last September, just as a $210 million Cook County bond issue was about to hit the market, underwriters and attorneys on the deal got a message from County Board President Richard J. Phelan's chief fund-raiser: Pony up, please. On stationery emblazoned with "Citizens for Phelan," a Democratic fund-raising committee, Mary Beth Sova, Phelan's chief fund-raiser, asked bond advisers for $1,500 contributions to three Phelan political allies. It's not clear how much money the solicitation, which stirred a brief press uproar, brought in. Phelan did not return calls on this subject. Sova says she was merely sending a letter to those firms that had already expressed interest in giving.
"YOU HAVE TO GIVE." Citizens for Phelan, though, has already collected over $400,000 from bond professionals who work on Cook County deals, including $91,500 from Goldman, Sachs & Co. and its employees. That's almost 25% of Phelan's entire $1.75 million campaign war chest, according to a study by dissident County Commissioner Maria Pappas. "It's a quid pro quo," she says. "You give to me, and I'll give to you." Adds the head of one firm that handles county business: "If you want to be involved in a bond deal in Cook County, you have to give money to the politicians." Goldman Sachs denies any quid pro quo. It confirms that it gave $9,500 but won't comment on employees' contributions.
Lawyers are also players in political deals. Last April, an investment banker received a letter from a Lansing (Mich.) law firm, Dykema Gossett, that often works as the state's bond counsel. The pitch, on the law firm's stationery, was for $100 donations to Republican Governor John Engler's "Governor's Club," to cover Engler's office expenses. "I have enclosed 25 membership forms and would appreciate your assistance in encouraging individuals in your office to join," wrote an attorney at the firm.
James P. Kiefer, the Dykema Gossett attorney, says his letter was a "personal voluntary effort" that had nothing to do with his firm. Engler spokesman John Truscott says the $200,000 to $300,000 the club raises annually from many firms saves taxpayers money by covering expenses that the state might otherwise have had to pay for. "Anybody who knows John Engler knows there is no quid pro quo," Truscott adds.
No one knows the cost to taxpayers from such arrangements. Although the SEC is trying to gather data, it's difficult to figure out how much muni-bond underwriters give to state and local officials. But in the 1991-92 election cycle, the top 12 municipal-bond underwriting firms' political action committees alone contributed as much as $2.3 million to state and local politicians, estimates Political Finance & Lobby Reporter, a Washington newsletter. That doesn't include contributions by individuals at those firms, which is believed to be an even larger honey pot.
Taxpayers may take another hit when securities firms that work as advisers to muni issuers also serve as underwriters or have links to them. Such an arrangement can give the securities firm an incentive to recommend excessively costly or unnecessary services. Research by Securities Data Co. shows that financial advisers have simultaneously acted as underwriters on 265 muni deals already this year. Having one firm serve dual roles creates a huge conflict of interest, says F. John White, chief executive officer of Public Financial Management Inc., a Philadelphia advisory firm. "We take the position that it's hard to be in both businesses, let alone do both things on the same deal," he argues. Some interlocking relationships go further. One case involved Mark S. Ferber, who for several years acted as adviser and banker to the Massachusetts Water Resources Authority. He was dismissed by the authority in July under a cloud of conflict-of-interest allegations.
Lawyers and securities firms often dazzle small municipalities with exotic--and expensive--financial strategies used by larger issuers that unsophisticated officials may not fully understand. "There's a herd mentality about new structures," says Allen Proctor, executive director of the New York City Financial Control Board. In Michigan, for example, dozens of school districts have issued deferred-interest bonds whose final cost will likely far exceed what the tab would have been for conventional bonds (page 46). One of the school districts was advised by a law firm that, unbeknownst to the district, worked for both the district and its underwriter.
Many municipalities get burned by venturing into swaps--contracts designed to help municipalities guard against changing interest rates. Consider the Pittsburgh Parking Authority, which sold a $62.1 million bond issue in June, 1989. It then entered into an interest-rate swap agreement with Merrill Lynch for a hefty $4.7 million fee. A study by Lehman Brothers concluded that the PPA's swap could cost as much as $812,000 rather than saving the authority $809,000 as Merrill had predicted. Merrill disputed the Lehman study. After the PPA threatened legal action, the dispute was resolved to both parties' "mutual satisfaction," says Merrill. Marion Wise, the PPA's current finance director, says the PPA "just got in way over their heads."
HIDDEN RISKS. Although taxpayers pick up much of the tab for muni abuses, investors also suffer painful hits. To be sure, except for the inevitable risks from interest-rate movements, owning rated muni bonds is relatively safe. In dollar value, about 90% of the $157 billion in munis issued in 1991 were rated by at least one of the major rating agencies.
But owning unrated muni bonds, which make up nearly one-third of the total number of bonds in the market in 1991, can be risky. Investors often don't realize that higher yields on unrated muni bonds mean they are taking more credit, or default, risk. Muni insurers protect buyers of many large issues against default, but some 60% of all muni issues--including many rated as well as unrated--are not insured. "It's a real quagmire. Investors are not informed. When they hear of a muni bond with a good coupon, and it's tax-free, they don't understand the risks," says Dr. George Massell, 70, of Seabright, N.J., who lost $130,000 when unrated bonds issued by two nursing homes
The default rate for unrated bonds is a controversial issue. Muni-bond information and brokerage firm J.J. Kenny Co., a part of S&P, says 1.93% of unrated munis defaulted from 1980 to 1991. The Bond Investors Assn. pegs it at a sky-high 7% for a similar period. Whatever the default rate, tax-exempt health-care bonds figure prominently, making up 76% of all nonrated bond defaults, says J.J. Kenny. In Florida, $20 million in unrated health-care bonds went sour about one year after the offering, leaving investors with big losses and spurring lawsuits alleging fraud and poor disclosure (page 54).
Similar charges surrounded $21 million in unrated bonds issued by Patriots Point Development Authority to finance a hotel and marina development in Charles-ton, S.C. In August, 1988, the half-finished project stopped making interest payments. A report by state auditor Edgar A. Vaughn found "little evidence of accurate projections, poorly documented contractual arrangements...and a general lack of any strong, cost-conscious oversight." The authority and other parties recently settled a bondholders' suit alleging insufficient disclosure without admitting liability. A Patriots Point investment banker named in the suit was John Reardon, the son-in-law of Senator Ernest F. Hollings (D-S.C.), who, along with Senator Strom Thurmond and other politicians, appoints the authority's members. Says Lawrence J. Fox, an attorney for Reardon's investment bank, J.B. Hanauer & Co.: "We think the authority should have gone forward and completed the project and paid the bondholders." A Hollings spokesman says there is no connection between his family tie to Reardon and Hanauer's selection as Patriots Point's underwriter.
Momentum is building to clean up the muni market. States including New Jersey and Florida are implementing reforms. Although many state and local politicians defend the current system and are trying to prevent any federal regulation, some useful reforms can be made without unduly diminishing states' independence. Measures might include stiffer disclosure requirements for issuers and a ban on campaign contributions from firms involved in muni deals.
Politicians and muni-industry partisans who argue that much of the muni market is free of abuse have a point. Yet the evidence suggests there are still far too many illicit or unseemly practices. If allowed to persist, these problems could irreparably damage the vitality of a market that has become central to the health of the U.S. financial system.THE MOST GRIEVOUS PROBLEMS
VEXING THE MARKET
POLITICAL INFLUENCE State and local politicians are often too close to
investment bankers, lawyers, and others who help underwrite their muni bonds.
Business is sometimes awarded on the basis of campaign contributions and other
favors, not merit.
INSUFFICIENT DISCLOSURE Investors often can't get even basic information about
the health and operations of muni issuers.
POOR PRICING Since the muni market has no central price-setting mechanism,
there are almost no publicly posted prices for muni bonds. Quotes from brokers
can vary widely.
LAX REGULATION Muni issuers are not subject to federal regulation. The sole
regulatory body is governed by industry volunteers and defers to the NASD on
DATA: BUSINESS WEEK
Leah Nathans Spiro and Kelley Holland, with Larry Light in New York, David Greising in Chicago, and Michael Schroeder in Washington