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.
The SEC’s startling refresher on due diligence
The SEC’s Office of Compliance Inspections and Examinations, muniland’s uber-regulator, issued a “Risk Alert” yesterday directed at underwriters of municipal bond offerings. The alert basically said: If you offer new bonds for sale, you must perform due diligence on the issuer. And you better document what you did.
I have to wonder about all the sudden fuss. The SEC’s “Risk Alert” was just restating a fundamental law in securities markets that requires securities dealers to investigate and verify what they are offering to investors. In other words, dealers must know their product, because there is no immunity for selling bad stuff. It’s a little shocking that the SEC has to remind securities dealers that they are required to do due diligence, but they went further and detailed some specifics on what had to be done (Page 3, emphasis mine):
the Commission also stated that sole reliance on an issuer will not suffice in meeting an underwriter’s “reasonable basis” obligations.
What the SEC insists on, and what is stated in the law, is that securities firms go beyond the surface facts presented by issuers and verify the underlying facts. And here they point their finger at unnamed broker-dealers who are not performing to standard and scold them for not maintaining records of their due diligence (Page 4):
[The staff] has observed instances where municipal underwriters have not maintained, nor did they require the creation and maintenance of, adequate written evidence that they complied with their due diligence obligations, including those under Rule 15c2-12 and applicable Commission interpretive guidance. Indeed, some firms have asserted that it is their specific policy not to maintain any due diligence records and have stated that “it is not industry practice” or that they are following advice from outside counsel … This approach might lead to lax due diligence practices at a time when there are growing concerns over the fiscal well-being of some municipalities.
How crazy is that? You get the sense of some cocky broker-dealer telling the sheriff of Wall Street to buzz off because some attorney they hired told them that they didn’t have to keep records. Sorry unnamed broker-dealer, that is not how it works. And you should never diss the sheriff.
Of the municipal bond defaults I have written about in the last year, several jumped to mind after seeing the alert because I had wondered at the time if the underwriters had done their due diligence. The first and craziest deal was $38 million in revenue bonds issued in Missouri for Project Sugar, a substitute sugar manufacturing plant. Basically the whole deal was misrepresented (read: fraudulent), and no one — from state and local officials to the underwriter, Morgan Keegan — seemed to do any due diligence.
Troubles in Volcker land?
My post last week about ditching the Volcker Rule and returning to some form of Glass-Steagall got a lot of positive responses. Back then I wrote that the Volcker Rule, which requires regulators to cleave risky trading for a bank’s house account from deposits insured by the FDIC, is immensely complex and that it will never be properly defined or enforced. Several regulators in the past week have agonized publicly over the need to get the rule “right.”
First among them was Fed Chairman Ben Bernanke. In the three minutes of C-Span video above, Bernanke says: “We are going to try and do our best to clarify the distinction between proprietary trading and market making.” It’s clear that even to our top banking regulator, defining Volcker properly is nearly impossible.
SEC Chairman Mary Schapiro had this to say on Volcker, via The Hill:
When asked by Rep. Mario Diaz-Balart (R-Fla.) if regulators would be better off scrapping the proposal and starting over, Schapiro was noncommital.
“Whether we start right from the beginning again or not, I can tell you we will and are reviewing all the comments letters carefully and rethinking how we should approach the statutory requirement,” she said. “We have a lot of issues to work through.”
And here’s SEC Commissioner Dan Gallagher, via Reuters:
Dan Gallagher, a Republican commissioner at the U.S. Securities and Exchange Commission, said on Monday that a quick review of the thousands of [Volcker] comment letters revealed widespread fears about the rule’s potential impact.
“These comments provide powerful evidence that the benefits the proposed rule was designed to provide may come at an unacceptably high cost,” Gallagher said in prepared remarks for a speech at the Institute of International Bankers conference in Washington.
He said regulators must be willing to re-examine their initial efforts and “if necessary” go back to the drawing board on the proposal.
. . . “Prior to joining SIFMA, Mr. Ryan was Vice Chairman, Financial Institutions and Governments, at J.P. Morgan where he was a member of the firm’s senior leadership” . . you know – prior to 2009 . . .
No doubt Tim Ryan has the US taxpayer top of mind when he provides his “deep concerns” . . . time to enforce the rules before the next SH*T SHOW!
Forget Volcker — bring back Glass-Steagall
Imagine you are a financial regulator whose agency is underfunded, understaffed and under-trained and that firms under your jurisdiction are likely to pick off your best employees by offering them triple the salary you pay them.
Furthermore, imagine that Congress has written an 800-page law that instructs you to write and enforce new regulations on banks and securities firms to ensure financial stability for the system. The most complex part of this new law, the Volcker Rule, would require you to cooperate with three other agencies to jointly issue a 530-page Proposed Rule that asks 1,300 questions.
Now imagine that in the course of honing this rule, 17,000 comment letters will flow into your agency, the majority of which promote the status quo.
After going through this thought experiment, you’d probably say: “What a headache! Why can’t we just bring back Glass-Steagall and split up banks into risky trading machines and safe depository institutions? This monstrosity of a regulatory fiat will never be properly defined or adequately enforced.”
The Volcker Rule is supposed to isolate the risk of a bank trading its own assets and separate that from depositors’ assets. In other words, the Volcker Rule should isolate the risk of a big derivatives or fixed-income loss on the house account from the cash savings of retired teachers and other customers of the bank. By design, it is aimed at the heart of the nation’s largest banks, the five institutions that use their enormous staffs and FDIC-insured balance sheets to dominate trading and commercial banking.
Take JPMorgan Chase, for instance. Tuesday it released the employee headcount of its investment bank: 2,500 salespeople and 2,000 traders on 110 trading desks in 20 trading centers, in addition to its 2,000 investment bankers. JPMorgan trades securities in 12 asset classes using its risk-weighted assets of $467 billion. Although JPMorgan and other banks are less leveraged than they were prior to the financial crisis, they are still pumped up trading engines attached to slow-moving, deposit-taking banks. In the derivative space alone JP Morgan’s total credit exposure was 285 percent of its risk-based capital in Q3 2011, according to the Office of the Comptroller of the Currency (graph 5A).
The core issue in attempting to define the Volcker Rule is that federal securities and banking regulators have never really supervised the fixed-income and derivatives markets. Dodd-Frank has many provisions for the regulation of derivatives but entirely skips over any requirement to regulate bond trading. The SEC heavily regulates stock trading but conducts little to no oversight of bond markets. Bonds are an enormous, dark market that few people understand, hence all the laments that eliminating prop trading of bonds will dry up liquidity — a ridiculous idea. If there are larger profits in bond trading because the five major banks are limited, new entrants will expand into the market to capture those profits and provide liquidity.
It’s true that there aren’t quote reporting requirements in the bond markets like there are in the stock markets. But that’s because there are literally millions of distinct bonds outstanding versus around 8,000 equities. It is impossible to quote all bonds actively as is done with equities. Dealers only provide bond quotes when their customers ask. And, there are detailed FINRA and MSRB markup and fair pricing rules that apply to the prices dealers dealers can charge for bonds. Moreover, the rules related to price transparency are completely unrelated to Gramm Leach Bliley and wouldn’t change if Glass Stegall came back. The GLBA had practically nothing to do with regulating the bond markets.
Even more important, there are extensive regulations that apply to almost all aspects of the bond markets. The SEC, FINRA and the MSRB all have thick rule books that relate to the bond business, and those rule books are getting thicker as Dodd-Frank is implemented. It simply isn’t the case that regulators conduct “little to no oversight of bond markets.”
Finally, under Glass-Stegall before the GLBA, banks were heavily involved in the fixed income markets. Government, agency, mortgage-backed and most municipal securities were all “bank eligible,” meaning that commercial banks could underwrite and trade them. Bringing back Glass-Stegall as it was before the GLBA wouldn’t keep banks out of the fixed income business.
Lessons from MF Global
The October bankruptcy of MF Global has been the subject of several Congressional hearings recently. 38,000 MF Global clients lost $1.2 billion in the collapse, and numerous regulators, as well as the Department of Justice, have been trying to unravel hundreds of thousands of transactions to discover how this client money disappeared. Weeks later, it’s still unknown whether clients will have their funds returned or whether any laws were broken. What is certain, though, is that even after the passage of Dodd-Frank, our regulatory system has large supervisory gaps.
The derivatives and futures businesses in which MF Global operated are complex, and it’s easiest to understand the firm as a large transaction processor that served its futures clients by connecting them to exchanges around the world. MF Global was both a broker-dealer and a futures commission merchant, meaning it was regulated by the SEC as well as the CFTC. In addition, MF Global was overseen by the Financial Industry Regulatory Authority (FINRA) and the CME, two self-regulatory organizations empowered by the SEC.
The big problem with oversight of MF Global within the U.S. is that there were too many regulators with only a small window into the firm’s activities and none with the ability to see the full scope of risks and capital of the holding company. How can we fix this?
I would disagree with the idea that regulators are not paid enough and that is why they do a bad job. The laws that they work with are written by the people they are regulating. The outcome of such a corrupt system is what we have today. Furthermore, the notion that the system is too “complex” and we need smarter people regulating is laughable. Credit default swaps are not complex. They are insurance policies and should be regulated as car or home insurance. The problem is clearly the entire legal system and the unabashed corruption in writing laws that restrict financial institutions’ activities then expecting an equally corrupt judicial and executive branch to do anything that changes the status quo.
Cutting the ratings agencies the tiniest bit of slack
After polluting the global financial system with hundreds of billions of dollars of overrated mortgage-backed securities and helping bring down the world economy, the credit rating agencies have been struggling mightily to repair their reputations. It’s been an uphill climb, and they were dealt another blow on Friday when a Bloomberg piece detailed academic research showing how fees influenced the assignment of higher ratings. Municipal issuers got the harshest ratings because they paid the lowest fees, according to the article.
Although higher fees definitely played a part in inflated ratings, I think there are a lot more powerful market forces at work than the study and article suggest. The academic study that the Bloomberg piece highlighted – Jess Cornaggia, Kimberly Cornaggia and John Hund’s “Credit ratings across asset classes: A ≡ A?” — focused on 30 years of data from one rating agency, Moody’s. From that data, the authors extrapolated the results to all the major raters. Here’s what Bloomberg had to say:
While the study was based on Moody’s data, it would find about identical results with data from S&P and Fitch because each firm’s grades closely track each other, Cornaggia said in an Oct. 14 e-mail.
If you work around credit markets you realize that although raters can track each other, there are often “split ratings,” or situations where the raters assign different levels to the same security or issuer. Another difference between the raters is that some move faster than others to downgrade. Fitch is typically known as the most aggressive rater in downgrading.
Practically every law and regulation that references credit ratings has a requirement for two ratings. If every rater were identical to the others, it would be redundant for laws to require two. The need for two ratings reflects the undesirability of relying on only one agency.
But put that all to the side for now. The biggest miss in the Corneggia study and the Bloomberg article is the behavior of issuers who “rating shop” and push the different agencies to inflate ratings. The Corneggia study essentially lays all the blame on the agencies for ratings inflation, but I’d suggest that the behavior of sophisticated issuers contributes a lot to the problem, too. Here’s what Columbia Law professor John Coffee told the Senate Banking Committee in September 2007:
In “Myth #13: It’s Best to Follow Expert Advice” of my book “Jackass Investing: Don’t do it. Profit from it.,” I recount the key role the credit ratings agencies played in causing the financial crisis of ’08. You can read that chapter using this complimentary link:
http://JackassInvesting.com/lookinside/l ookinside_myth_13-31.php
Mike Dever
Untimely data will cost muniland potential investors
If municipal bonds lose their tax-exempt status, as some in the corridors of power in Washington are suggesting, municipalities will increasingly be competing with corporations for investors. As this competition intensifies, municipalities with poor accounting and disclosure practices could find it difficult attracting capital.
Let’s say you’re an investor looking to buy the bonds of either Goldman Sachs or New York City and to help guide your decision, you seek out their most recent financial statements. As a public company, Goldman Sachs is subject to the SEC’s disclosure regulations which mandate the filing of audited annual financial statements 60 days after the end of the year. If Goldman does not file within the 60 day window then the SEC has the authority to restrict certain simplified securities offerings and the New York Stock Exchange, which lists their securities, can take action too.
Contrast that with the Municipal Securities Rulemaking Board, New York’s regulator, which encourages municipalities to make public their audited statements, which are called CAFRs or Comprehensive Annual Financial Report within 120 days of the end of their fiscal year. Unlike the SEC, the MSRB has no authority to discipline issuers who file late, other than suggesting the municipality issue a notification of late filing.
Having to wait additional 60 days to ascertain the fiscal health of municipalities makes them less attractive investments. And if state and local government entities can file after the deadline with impunity, investors will worry — rightly — if they can ever get timely data consistently.
So how big of a delay is there when governmental entities publish their financial statements? MuniNetGuide recently published the results of a study by Merritt Research that measured how fast government entities were publishing their audited financials. Interestingly, the determining factor was not creditworthiness or size; some low-rated issuers got their financials out quickly and other AAA issuers were slow to publish. Merritt’s research suggests that the type of government institution that is reporting affects the speed with which it publishes its audited financial statements. MuniNetGuide has an excellent table which shows the median number of days from the end of the fiscal year until financials are released for various municipal sectors:
The municipal bond market may have most of the data that investors need to evaluate bonds and that citizens need in order to understand the fiscal health of their communities. Government entities would do themselves a favor by beginning to file their financial statements in a more timely manner. Investors have many choices where to invest and muniland needs to pick up it’s game.
Disclosure is the beat
Disclosure is the beat
On Tuesday at the SIFMA Muni Bond Summit in New York, much of the discussion by bond market participants related to transparency and disclosure issues. A lot of this was in response to new requirements in Dodd-Frank, but there was also an acknowledgement that many problems in the crisis of 2007-2009 came from a lack of information and data in many parts of the market. For example small municipal issuers had more trouble accessing the bond market to issue new bonds if their public reporting was deficient or out of date.
The heavy hitter of the bond summit was SEC Commissioner Elise Walter, who appeared by video link and broke news that the SEC would not ask Congress to overturn the Tower Amendment, a 1975 law that bars the SEC from interfering in the fiscal affairs of state and local governments. She discussed current legislation that would skirt the Tower Amendment and give the SEC authority to require municipal issuers to file disclosure, though it would grant no authority to review and approve those filings. From the Bond Buyer:
Walter repeated her call for Congress to increase the SEC’s authority so that it could set “baseline disclosure requirements.”
The Tower Amendment to the Securities Exchange Act of 1934 prohibits the SEC and the Municipal Securities Rulemaking Board from requiring muni issuers to file pre-sale disclosure documents.
A draft bill being circulated by Reps. Mike Quigley, D-Ill., and Patrick McHenry, R-N.C., however, would authorize the SEC to require issuers to disclose primary and secondary market bond documents directly or indirectly through dealers or others. It would also give the commission authority to direct the content and timing of those documents.
She also said that the SEC should more broadly examine the practices of the bond markets. The Bond Buyer reports:
“People who have not previously been tuned into what that board is doing really should pay attention,” [SEC Commissioner Walter] said.
Separately, Walter said the SEC’s muni hearings revealed “certain softnesses in practices.”
She said state and local governments need better training in municipal disclosure and better disclosure practices. In addition, she noted there are significant conflicts of interest that affect the pricing of swaps, as well as indications many muni officials do not understand swaps.
Walter said she also wants to persuade the SEC to take a “long-term, deep-dive look” at the fixed-income market and its current structure, but added that such a study and any resulting recommendations may not be completed until after she leaves the commission.
Walter was sworn in as commissioner on July 9, 2008. Her term expires in June 2012.
I’ll write more about the issues raised at the bond summit over the next few days. Although much of what was discussed was complex, the conversation helped illuminate many of the market moves that don’t necessarily make sense on the surface. Many of these issues are the bedrock of a more open and stable market structure.
The gusher of municipal bond information
The municipal bond market is often thought of as complex and murky. This is understandable; after all, there are over 50,000 issuers of bonds and a million plus specific municipal-bond issues. It’s staggering to imagine so many different securities.
A specific bond issue can be as small as the $995,000 offer that the city of Moose Lake, MN has coming to market this week, or as big as last week’s jumbo-sized $10 billion “State of Texas Tax and Revenue Anticipation Notes, Series 2011A”. (The Texas notes mature in one year and are paying 2.50 percent interest — they’re hot as griddle cakes.)
Municipal bonds also come in many different shapes because there is very little standardization of structure among municipal bonds. A straight bond generally has a fixed interest rate, or yield, and a set maturity date, or time of repayment. But many municipal bonds have floating interest rates; many others can be called or refinanced when interest rates go down. Regulatory agencies like the MSRB or the SEC don’t require that bonds have a certain structure or feature, only that the details are fully and accurately disclosed.
Beyond understanding the structure of a specific bond most investors want to review the health of its issuer. The Bond Buyer describes what information investors need to access to:
Investors will need to understand the issuer’s underlying finance structure, sources and uses of cash, and the cost structure of an issuer’s budget, as well as their own economic and legal rights as investors — in and out of court — in the event of a bond default.
Several regulatory changes in the last few years have increased the flow of information about issuers in muniland. With the full implementation of the Municipal Securities Rulemaking Board’s EMMA system, investors now have near real-time disclosure of the offering details of bonds and continuing disclosure of the financial condition of bond issuers.
The middle sadness
The middle sadness
Paul Mason, the economics editor of the BBC’s Newsnight program, recently retraced John Steinbeck’s footsteps during America’s Great Depression. What he found was a broad swath of sadness as he observed many citizens who have lost jobs and homes. It’s the invisible America. From the BBC:
I drop down into Albuquerque, into Joy Junction, which in the red dusk looks like a scene from Steinbeck. There are 300 homeless people staying here, all families.
Jeremy Reynalds, an expat Brit who runs the place, tells me frankly that the mainstay of the place are people with drug, alcohol and domestic violence issues. But as the years of crisis have dragged on, there is a new phenomenon – the homeless middle-class.
I meet some of them on the floor of an old gym, strewn with about 80 mattresses.
Sonya and Tim – he was a manager at McDonald’s but the branch closed and she worked at Subway but they cut her shifts – lost their home and moved into a small apartment, but when the unemployment money ended they lost that too.
“We slept in our car, it was scary,” says Sonya. “Then we came here.”
The other muni bankruptcy
There is massive attention on Jefferson County, but the other long-running bankruptcy — Vallejo, California — was finally concluded yesterday. From Bloomberg:
Vallejo, California, the biggest U.S. city in bankruptcy, won approval of a plan to exit court protection by cutting interest payments to its bank and reducing benefits to retirees.
The approval comes on the same day that elected officials in Jefferson County, Alabama, agreed put off for at least a week a decision on whether to file the largest municipal bankruptcy in U.S. history in order to negotiate with state officials and creditors.
Bankruptcy saved Vallejo tens of millions of dollars in reduced labor costs, said attorney R. Dale Ginter, who represented retirees in the case who were forced to accept reduced benefits.
“At the end of the day the city did save more than they spent,” on legal and other fees on the case, Ginter said in an interview.
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Resident Muniland expert
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