Tighter Rules Are Issued on Municipal Bond Deals
Federal regulators trying to prevent more debt disasters like the one in Jefferson County, Ala., issued new rules on Friday for the brokerage firms that help cities and states raise billions of dollars every year.
Jonathan Alcorn/Bloomberg News
Bill Lockyer, California’s treasurer, has called for stricter rules for underwriters.
The rules are intended to rein in practices like Wall Street firms’ underwriting a state’s bonds while simultaneously helping other customers trade against the bonds, or taking municipal officials on lavish junkets and billing the costs to unsuspecting local taxpayers.
Underwriters will also be required under the rules adopted Friday to pay municipalities a fair and reasonable price for their bonds, a first.
There are already rules against “deceptive practices,” but the need for tighter controls became clear during the financial crisis of 2008, when many municipalities were left struggling to extricate themselves from costly and intricate bond deals whose risks they had not understood. Many said they signed up for the deals because they thought they were saving their residents money.
The Municipal Securities Rulemaking Board, a self-regulatory body for market participants, wrote the new rules. The Securities and Exchange Commission approved the rules on Friday and will enforce them as federal law.
“These new rules are the biggest development in protection of the financial interests of state and local governments since the M.S.R.B. was established in 1975,” said Alan D. Polsky, chairman of the rulemaking board.
The rules, which will take effect in August, do not ban outright the complex and risky transactions. But they require bond underwriters to properly disclose the risks of the deals, as well as any potential conflicts of interest.
Until now, the underwriters were required only to charge investors who bought a municipality’s bonds a fair price. They had no such obligation for their dealings with states and cities.
Many bond deals over the last decade were so complex it was hard for local officials to even understand how they worked, much less confirm that the terms were fair.
Underwriters will also be required to tell their municipal clients about any payments received from other firms like bond insurers taking part in bond transactions.
That requirement responds to episodes like the long-running bribery case in Jefferson County, Ala., now the biggest municipal bankruptcy case in United States history. Two officials of J. P. Morgan Securities, eager to underwrite a $5 billion bond and derivatives deal in 2003, paid more than $8 million to broker-dealers in Alabama who did no work on the transaction but could help steer the business to J. P. Morgan. The bankers then charged the cost of their illicit payments to the county’s taxpayers by inflating the interest rate the county paid on an interest-rate swap.
The two bankers were fired. Charges against them are pending.
The rules against wining and dining officials, then sending their taxpayers the bills, grow out of the practice of flying local officials to New York to meet with the credit analysts who would rate their communities’ bonds. Such meetings might take a day or two, but some underwriters invited the municipal officials to bring their wives, children and other relatives, stay on for the week and be taken to Broadway shows, sports events and expensive restaurants.
The rule-makers cited a 2009 case in which the S.E.C. fined RBC Capital Markets $125,000 for factoring the cost of such entertainment into the debt being taken on by Mesquite, Tex.
The S.E.C. has only limited authority over state and local finances, but in the last few years federal officials have sought ways to expand their oversight, saying the municipal bond market had grown too big to be so lightly regulated.
The S.E.C. could act in the municipal market only in cases of fraud, when it could prove intent. Now it will be able to act without that burden of proof.
Some of the most forceful calls for more federal involvement in municipal bond issuing came from California, which issues more bonds and debt most years than any other state.
The state treasurer there, Bill Lockyer, discovered during the turmoil of 2008 that Goldman Sachs had issued a research report telling clients how they might bet against the creditworthiness of states, including California, by using derivatives known as credit-default swaps.
The report ranked states by the degree of distress they were in, and by which appeared to have the most unsustainable public pension funds.
California was having difficulty issuing short-term debt that fall because the markets were nearly frozen. Mr. Lockyer was incensed to learn that Goldman Sachs, an important underwriter of California’s debt, was telling clients how they might take a position against it.
Goldman and half a dozen other financial institutions responded to Mr. Lockyer’s questions by confirming that they were dealing in credit-default swaps but arguing that the swaps had many valid uses and might even lower California’s borrowing costs.
Mr. Lockyer did not believe it and began lobbying the architects of the 2010 financial reform legislation to ban the use of credit-default swaps for speculation.
The new rules do not ban such activity but require underwriters to give cities and states current information about their involvement in it, in time for local officials to decide whether to find a different underwriter.
“I’d like to see an outright ban against having the investment bank bet against the bond issuer with whom they’re working,” Mr. Lockyer said in an interview on Friday. “But if we can’t have that, robust disclosure is at least a good start.”