MuniLand

The SEC released its long-awaited report on muniland disclosure and price transparency yesterday. Ten years from now, every retail investor will want to say a word of thanks to Commissioner Elisse Walter, even if only half her recommendations on transparency and investor protection are implemented. Unfortunately, her term as SEC commissioner expires June 5, 2013, which leaves her less than a year to get the ball rolling on her proposals.

The report is composed of two primary areas: The first part concerns better disclosures by municipal bond issuers about their finances, and the second addresses the market structure for trading municipal bonds. It’s the second part that contains the really game-changing parts of the report.

On disclosure, the report recommends institutional changes, such as the requirement that muniland participants adopt the standards of the Government Accounting Standards Board and make timely and audited financial disclosures. The report recommends that conduit borrowers (think non-public entities like non-profit hospitals and private colleges) be subject to the same registration and disclosure standards as corporate securities and barred from using exemptions that municipal issuers rely on. Conduit issuers happen to have the highest incidence of defaults, and investors need the greatest level of disclosure for these securities.

On market structure, Walter’s proposals attempt to fill a void, as there is almost no regulation in the muniland secondary market. Dealers usually push retail-size orders to alternative trading systems like Bonddesk, the MuniCenter or Tradeweb Retail. The report recommends that the rules be changed to require these systems to publicly disseminate the bid-offer prices for securities they have on their platforms. Furthermore, the report proposes that the MSRB could compile the bid-offer prices across these alternative trading systems into a quote feed, making the systems more like equity markets. That would be a giant step forward for the municipal markets. Here is the regulatory version:

Although there have been improvements in the availability of pricing information about completed trades (i.e., post-trade information), the secondary market for municipal securities remains opaque. Investors have very limited access to information regarding which market participants would be interested in buying or selling a municipal security, and at what prices (i.e., pre-trade information).

Municipal advisers, those muniland professionals who are hired by public officials to evaluate their needs for financing and guide them through the underwriting process, don’t receive enough attention. Generally, they are paid by a government entity but also receive fees from the banks who underwrite the deals. Dodd-Frank set out to restrain potential conflicts in this space by requiring municipal advisers to register as such and imposing a fiduciary duty on their activities.

Now, however, some members of the House of Representatives are trying to roll back the portion of Dodd-Frank that would impose this fiduciary duty. A first-term congressman from Illinois, Robert J. Dold, whose prior professional experience was operating a pest-control business, has proposed legislation to strip the fiduciary duty requirement from Dodd-Frank. His bill currently has 35 co-sponsors.

Typically, municipal officials have little to no experience in financial markets. A financial adviser is on hand to untangle the complexities of different financing structures, guaranteed investment contracts (GICs) and derivatives. For public entities to get a fair deal, it’s critical that they get conflict-free advice from their financial advisers. The big Wall Street banks have for years sold highly complex and expensive products to poorly informed governments. See, for instance, these episodes from 2008:

Matt Taibbi, a contributing editor at Rolling Stone, talks to radio personality Don Imus about municipal bid-rigging.

Cheers to Matt Taibbi for “The Scam Wall Street Learned from the Mafia,” his detailed Rolling Stone article about a municipal bid-rigging scandal that has already resulted in fines totaling nearly $700 million as well as 15 convictions for antitrust violations and wire fraud. A muniland bombshell that first became public over five years ago, the scheme reached its culmination in May when three former executives at GE Capital, General Electric’s finance arm, were convicted on charges of colluding to rig the public bids on muni bonds.

Taibbi laid out the larger picture of the scandal with his characteristic flair:

Charlie Gasparino of Fox Business News seems to have scooped a muniland story yesterday when he reported that JPMorgan had failed to include material facts in a municipal bond offering on which it was the lead underwriter.

Lead underwriters have a special role in muniland. The Tower Amendment, passed in 1975, prohibited the federal government from requiring issuers of municipal debt to make specific disclosures to investors prior to offering securities for sale. Underwriters, however, do not enjoy the same protection, so the law has evolved to make them liable for the contents of the offering document for municipal debt. This requirement is administrated by the Municipal Rulemaking Board through Rule G-17, or the fair-dealing rule.

MSRB’s Rule G-17 is the Ten Commandments of muniland (emphasis mine):

Rule G-17 precludes a dealer, in the conduct of its municipal securities activities, from engaging in any deceptive, dishonest, or unfair practice with any person, including an issuer of municipal securities. The rule contains an anti-fraud prohibition. Thus, an underwriter must not misrepresent or omit the facts, risks, potential benefits, or other material information about municipal securities activities undertaken with a municipal issuer.

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.

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.

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.

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.

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?

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.