How Corrupt Is the Muni-Bond Business?

When the Securities and Exchange Commission charged New Jersey with fraud last month for failing to disclose certain fiscal dealings to bond buyers, observers were quick to note that this might be the first of several actions from the agency, which has established a new, 30-person unit to pursue corruption in municipal finance.

But to anyone who follows the business, the SEC's move must seem the equivalent of a Hail Mary pass. That's because the undermanned, often-outgunned agency, whose oversight of the muni business is limited by Congress, has launched other initiatives over the decades to squeeze some of the sleaze out of an industry which sometimes seems to operate at the expense of bondholders and taxpayers. Whether regulators are any more successful in this go-round at scaring this industry into better practices is an open question. In the mean time, buyers beware, and heaven help the taxpayer.

Recessions tend to expose more of the abuses in this industry because declines in tax revenues prompt more dicey deals to blow up in taxpayers' faces. Like today, in the early 1990s downturn regulators tried to bring some respectability to the industry, rocked at the time by major scandals, by enforcing new regulations, including banning so-called ‘pay-to-play,' which is the process where firms gave heavily to the campaign coffers of politicians responsible for deciding on municipal issues and selecting underwriting teams.

The new regs came at a time of a number of prominent prosecutions and big fines. White-shoe investment bank Lazard Freres took blows to its reputation when several of its bankers were snared in fraud and corruption schemes in connection with bribes paid to win muni business around the country, including a high-profile trial in Boston in which one Lazard partner, Mark Ferber, was found guilty on 58 of 61 counts and sentenced to 33 months in prison for what a judge described as "nothing more than a grandiose kickback scheme." The firm eventually exited the business.

Investigations found that corruption in munis was part of a larger pattern of misdeeds in municipal finance. When FBI agents cornered Howard Gary, a former Miami official who had started a small Florida investment firm that specialized in muni finance, and confronted him with evidence that he'd been involved in a bribery and kickback scheme, Gary turned informant and the material he provided led to a series of indictments against Miami officials in what prosecutors described as "a stunningly mismanaged city on the brink of financial ruin." Eventually, Miami's operations were turned over to a fiscal monitor to put its finances back in shape.

Problems in the muni business gained more attention as Wall Street rolled out increasingly more sophisticated financing techniques, which politicians were too quick to agree to even when they didn't understand how these techniques actually worked.

In 1997 Smith Barney paid $5 million in fines to settle charges it misled Dade County on the potential savings of a refinancing technique. The case led to a national investigation of so-called ‘yield-burning' in the municipal markets, a complex maneuver to drive up the prices of Treasury bonds sold to local governments in municipal refinancings, which drives down or "burns" the yields. Eventually securities firms paid some $200 million in fines for the practice.

"When I joined Smith Barney, people were not getting rich doing public finance," one of the whistleblowers in the yield-burning investigations said. "Now it's caveat emptor against people who are dumb. It's a whole different ballgame."

The investigations came with warnings from the SEC about the double standard in municipal finance, a result of the fact that this business is more lightly regulated than others in the securities industry. As the head of the SEC's enforcement division said at the time, the industry condoned practices that "would never have passed muster in other markets."

Among those practices was the blatant hiring of politicians and political operatives by securities firms to lobby their fellow elected officials and associates for municipal work. Smith Barney employed Chicago Mayor Richard Daley's brother as a ‘consultant' to lobby on state and local municipal deals in Illinois, and in Texas the firm hired the Democratic Party's former statewide chairman as its representative. In Ohio Lehman employed one of the GOP's top fundraisers as a ‘consultant' on muni deals, where he pitched politicians whose campaign warchests he helped to fill. Goldman Sachs employed Rahm Emanuel, current White House chief of staff, as a muni consultant while he also worked as a political fundraiser for President Clinton. After he exited prison, disgraced former Washington Mayor Marion Barry even gained a job as a muni consultant.

What helps makes the industry so susceptible to abuses is that the major players in it often are driven by perverse incentives. Wall Street firms, which are supposed to advise politicians on what financing strategies suit their governments best, have a stake in urging them to go ahead with the biggest and most expensive deals because of the fees these transactions generate. Firms that serve as advisers to potential borrowers can even then bid to underwrite new issues they helped to tout, thereby creating widespread potential for conflict of interest.

Meanwhile, politicians find debt an increasingly attractive way to kick fiscal problems far enough down the road so that when the obligations become due, they are often someone else's headache. You can't get a better formula for dysfunction than that, which is one reason why municipal debt has exploded in America, up to an estimated $2.8 trillion, from $1.5 trillion in 2000.

We've already seen in this recession the first of a series of high-profile deals blow up in taxpayers' faces. Scandal has rocked the city of Birmingham and Jefferson County in Alabama, where what started as a modest scheme to install a new sewer system was upsized through corruption, bad planning and bribery into a $3 billion boondoggle financed by muni bonds that has rendered the county functionally insolvent and forced severe cutbacks in services.

Already the former mayor of Birmingham, the head of a small local investment bank, and a lobbyist have been sentenced for bribery and corruption associated with the muni offerings. And JPMorgan Chase agreed to pay $75 million in civil fines and give back $647 million in fees after the SEC charged it with making payments to friends of public officials to win municipal bond business.

Meanwhile, around the country complicated financing techniques, many revolving around swaps transactions created by investment firms and authorized by public officials who had little idea what they were doing, have detonated, costing governments millions of dollars in additional payments at a time of fiscal stress. In Pennsylvania alone more than 100 school districts used swaps to hedge against interest-rate swings on their muni bonds, and the steep decline of rates since 2008 has cost one district alone, Bethlehem, more than $12 million.

The case against Jersey is also provocative because the SEC essentially charged the state with misleading investors by not disclosing fiscal gimmicks that other states have been engaging in, too.

The enormous and rapidly growing size of our municipal debt ought to make this toxic combination of investment banks and politicians alarming to the average taxpayer and to Washington. Unfortunately, Congress is composed of people who represent states and districts made up of cities and towns, and they are reluctant to regulate a market which is a gravy train for their own political colleagues at the municipal level. If Congress weren't, we would have long ago had a serious discussion in Washington about narrowing the limits of federal tax deductibility of muni bonds, a subsidy which gives this market its life.

Instead it's up to understaffed agencies like the SEC to fight a rearguard action against corruption and patronage, while bad deals erupt in the faces of bondholders and taxpayers.