Muniland’s huge Dodd-Frank win
A huge win for muniland was finalized last week when the SEC approved new rules that will shine light on the municipal bond underwriting process. This Bloomberg headline says it all: “Bond-Disclosure Rules Backed by SEC to Protect States From Banks”:
The rules were proposed by the Municipal Securities Rulemaking Board last year and are aimed at preventing Wall Street underwriters from steering public officials toward complicated debt financing without disclosing the risks. They were approved May 4 by the SEC, which will enforce them.
The disclosures are part of the effort to reshape financial regulations to prevent a repeat of the credit-market crisis of 2008, and stem from Congress’s decision to provide added protections for state and local governments. The economic crisis hit taxpayers with billions of dollars in unexpected costs when complex bond deals, once pitched as money savers, backfired as credit markets seized up.
I spent almost a year on Capitol Hill leading an open-source financial reform project as Dodd-Frank was being written. This is about the only area of the legislation in which there was no pushback from banks. Spencer Bachus, the Republican chairman of the House Financial Services Committee, was the committee’s ranking member at the time the legislation was being developed. Bachus’s home district in Alabama includes Jefferson County, the bankrupt county that has been buried under a series of deals with JPMorgan on interest-rate derivatives deals. Whether the banks explicitly held off challenging tighter municipal bond rules out of deference to Representative Bachus or whether they decided other parts of the legislation were higher priority is unknown.
In any event, the new rules are sweeping. Alan Polsky, the chairman of the Municipal Securities Rulemaking Board, said as much in a statement:
These new rules are the biggest development in protection of the financial interests of state and local governments since the MSRB was established in 1975.
The new rules detail a number of ways that underwriters must disclose their conflicts of interest to states, cities and other entities that issue municipal bonds. But the heart of the new rules addresses the sale of interest-rate derivatives tied to municipal bond offerings. Reuters blogger Felix Salmon described the practice like this in 2010:
I can guarantee you that every time a swap was sold, the person selling it got a nice fat up-front commission, and the unsophisticated small municipality buying it wound up getting a very unattractive deal. And the more complex the swap, and the higher the up-front payment to the town, the more the municipality was likely to be ripped off.
The underlying problem here is that interest-rate swaps tend to be sold rather than bought. If municipal treasurers came up with these plans on their own, and then asked a few banks for bids on the exact swap that they wanted, many of the rip-offs would never have happened. But instead, like subprime borrowers encouraged to monetize their home equity, they got talked into bad deals by sleazy financial professionals working on commission.
Now I’m sure a lot of egos would be hurt in muniland if I said, as Felix did, “they got talked into bad deals by sleazy financial professionals working on commission.” But it seems as if every week we get another story of a city or public entity paying a multimillion-dollar fee to unwind interest-rate swaps that have gone against the municipal issuer. Sometimes in these deals, like the one involving Denver Public Schools that I wrote about last month, the public official tries to justify a bad deal with financial market mumbo jumbo. Other times public officials had little understanding of how these deals worked and the conflicts the banks had in selling the interest-rate swaps.
There is another piece of transparency in the pipeline, because the CFTC is working on making interest-rate swaps prices public. This way issuers can see how the price they are paying compares with the market price. Transparency tends to deflate bad deals.
The only weakness in the new rules is that they only apply to municipal bond offerings and don’t include loans that banks are making directly to cities and states. This could be muniland’s new regulatory arbitrage play. I hope the SEC addresses this massive loophole when it releases its big municipal bond market study in the coming months. Even so, muniland took a huge step forward with these new Dodd-Frank rules, and taxpayers will benefit.