Lack of Muni Transparency Leading to Suspect Trades
In light of the credit and housing crisis, there has been a move in Washington toward ensuring greater transparency and protection for market participant, but for nearly the past decade, in the municipal bond market, there has been an unnerving trend that has some parties expressing concern.
Bond issuers in the $2.6 trillion municipal bond market are supposed to make annual filings of financial information or a material event like a downgrade or default, as well as a number of other events. Since municipal bonds are issued by states, the Constitution prevents the federal government from enforcing regulations, meaning the responsibilities for disclosing this information falls onto the shoulders of bond underwriters and dealers. The Securities and Exchange Commission (SEC) and the buffer entity the Municipal Securities Rulemaking Board (MSRB) are supposed to oversee that these disclosures are made, but it's a practice that is apparently failing, leading to a lack of or suspect information.
"As far as I'm concerned, this was 100% avoidable," said Peter Schmitt, CEO, DPC DATA. "I think now, if you're an investor, you've got to hope that something is going to be coming out of this movement in Washington for greater regulatory reform so that problems like this can be addressed."
In the mid-1970s, the government created a limited regulatory scheme for the municipal securities market that included the mandatory registration of securities brokers and dealers. In 1989, because of the slow dissemination of information regarding primary offerings, the SEC adopted new rules concerning the due diligence obligations of underwriters. This was again revised in 1993 and secondary market disclosure concerns were raised.
Over the last year, as the municipal bond market struggled and rating agency failures came to light, the bond insurance industry was torpedoed. "Up until last year, more than 50% of new issues came with bond insurance with automatic AAAs on it," explained Schmitt. "That homogenized the risk for investors until the bond insurance industry essentially melted down. Now, the latest figure I've seen is 17% of new issues are coming with some form of bond insurance, but it's viewed with great skepticism because how can a corporate credit improve a municipal credit? People are finally asking that question after all these decades."
This makes the need for disclosures all the more important. A recent study by DPC DATA uncovered hundreds of trades in bonds in 2008 that were questionable in terms of meeting regulatory standards for investor protection. DPC, one of four Nationally Recognized Municipal Securities Information Repositories (NRMSIR), found 667 dealer-to-customer sales that were executed at par or higher after a default or other stress notice was filed by the issuer or obligor. The majority of these trades occurred during the tumultuous months of September through November when credit markets were in the throes of implosion. Schmitt admitted that he didn't know the exact terms of these deals, but suggested that it was a failure by dealers to ensure suitability or fair pricing in trades.
In half of these sales, there was no way for investors to protect themselves with independent research because no financial statements had been made publicly available in the official disclosure system during the 2007 or 2008 calendar years.
Schmitt doesn't think there is much hope for municipal bond market disclosures on the horizon. On July 1st, the MSRB will become the sole clearinghouse for municipal bond disclosure data—the only NRMSIR. He thinks it is a role the MSRB is incapable of handling.
"They have dropped the ball when it comes to disclosures," said Schmitt. "And if they treat this building block of investor protection that lightly, it doesn't give me any confidence that they should have a broader mandate, that they should regulate other parties in the market. I'm not saying those other parties ought not to be regulated. I'm just saying that I don't think the MSRB is where you want to go with it. Just look at their track record."
He added, "By consolidating this clearinghouse under the MSRB, they have solved the wrong problem. There are so many other more important things going on that they're ignoring, and it's going to be less likely that those problems will see the light of day."
Schmitt admitted the multiple repository system was far from perfect, but it at least ensured there were practically no worries about violating the Tower Amendment.
Transparency has been an issue that has haunted the municipal bond market for some time. A report last year by DPC showed that for bonds issued between 1996 and 2005, across all bond classes, market sectors and issuer geographies, more than 50% of bonds outstanding for nine or more years have one or more years of disclosure delinquency. Of those, 25% were chronically delinquent, missing three or more years of disclosures. The study also found that the riskier the bond, the more likely there was a failure to meet disclosure compliance.
Matthew Carr, NACM staff writer