Municipal Bond Investors Flee Stocks and Find Bigger Perils The Perils of The Municipal Bond Market

Phoenix, Aug. 27 (Bloomberg) — Five years ago, Don Burns and his wife, Gerry, sank $160,000 of retirement money into municipal bonds sold to build the Oaks at Medina nursing home in Medina, Ohio. Three years later, the home defaulted, leaving the Burnses with $2,000 of their investment.

The Phoenix retirees say they didn’t see a prospectus, a financial statement or pricing information. They say their broker, Mike Weidt of Parker/Hunter Inc. in Pittsburgh, assured them municipal bonds were safe.

The couple never suspected they could lose most of their principal. ��Who would think that a nursing home would go bankrupt?” says Gerry Burns, 70. ��I’ve worked in a few, and I never saw a bed empty.” Weidt declined to comment, as did Parker/Hunter Senior Vice President Jay Yard.

With the Standard & Poor’s 500 Index at a five-year low, investors are scooping up municipal bonds, attracted by steady payments of tax-exempt interest and the perception of low risk. Issuers sold a record $160.2 billion of munis in the first half of 2002.

Private investors owned $572.9 billion of the bonds at the end of March, a 33 percent rise in six years and a 7.5 percent rise from a year ago. Mutual funds hold $610.8 billion, a surge of 46 percent since 1996 and 8.9 percent in the past year. Banks, insurance companies, pension funds and securities brokers hold another $450 billion, according to the U.S. Federal Reserve Board.

Investors who view municipal bonds as a sanctuary from this year’s 12 percent drop in the Dow Jones Industrial Average may instead find themselves in a dark corner of the U.S. financial markets, where the rules that govern equity investing don’t apply.

Inadequate Disclosure

Unlike public companies, muni bond issuers � typically states and city governments — aren’t required to file quarterly financial statements with the U.S. Securities and Exchange Commission or reveal information about their ability to make interest and principal payments.

About 40 percent of issuers provide inadequate disclosure, according to a May study by the National Federation of Municipal Analysts, which represents big institutional investors.

Pricing is largely at the discretion of the dealer that buys and sells the bonds. Some prices aren’t published until a week after a trade. Regulation and enforcement efforts trail other markets.

The municipal bond market is worse than the Wild West,” says Kevin Olson, 41, founder of MunicipalBonds.com, one of the few Web sites that offer free price data to individual investors. ��There are laws and rules in the securities markets, but none seem to directly apply to the municipal bond market. There is no cavalry that will come to your rescue.”

Issuers and Underwriters

Olson says issuers and underwriters are preventing investors from making sound decisions by denying them timely information on prices and financial performance. Among the offenders are big Wall Street brokerages, he says.

So far this year, Citigroup Inc.’s Salomon Smith Barney; UBS PaineWebber; Lehman Brothers Inc.; Merrill Lynch & Co.; and Bear, Stearns & Co. have handled 51 percent of all muni deals. They’re poised to capture the bulk of the $4 billion in fees generated from new issues, which are on target to exceed $200 billion in 2002, according to Thomson Financial, which tracks muni sales.

The bond boom is a turnaround from the stock market’s glory years, which had relegated munis to a financial backwater. In November 2000, Prudential Securities Inc. shut its municipal department. In April 2001, Merrill Lynch fired 29 muni bond investment bankers, a third of its investment banking staff.

Now, as demand wanes for initial public offerings and merger advice, munis are one of Wall Street’s bright spots. U.S. securities firms have cut 45,300 jobs in the past 12 months, according to the Bureau of Labor Statistics; they’ve spared their muni teams.

One Sales Person

Bear Stearns added one institutional sales person in munis, even as it fired 1,200 workers company wide, according to spokesman Russell Sherman.

Daniel Keating, Bear Stearns’s senior managing director and head of public finance, says disclosure in the muni market has never been better. Investors can get price information that wasn’t available four years ago, and rule makers are pressing to release data more quickly.

”The system’s great,” says Keating, who adds that disclosure requirements for corporate bond trades just went into effect July 1.

Bond issuers say investors must bear some responsibility when they buy munis.

Level of Disclosure

”If they don’t like the level of disclosure, they need to take their money and put it into something where they like the disclosure,” says Tom Glaser, vice chairman of the debt committee of the Government Finance Officers Association, a group of bond issuers.

Glaser, who’s also finance chief of Cook County, Illinois, says that in the past six years, he recalls four times when investors requested information beyond what the county, which includes Chicago, provided on its $1.8 billion of bonds.

Some of the big U.S. mutual funds side with investors in seeking better disclosure. In 1983, they created the 1,000-member National Federation of Municipal Analysts trade group that comprises muni fund analysts and ratings companies.

Ranked by total fund assets, Vanguard Group Inc., Franklin Advisors Inc., American Express Financial Corp., Scudder Asset Management and Fidelity Management & Research run the five largest municipal bond funds. Analysts at some of these funds say they face a constant battle to get issuers to provide useful information in a timely way.

Always Late

”Financial reports are always late,” says Philip Condon, co manager of the $4.9 billion Scudder Managed Municipal Bond Fund. ”We prefer to buy issues where we don’t have to wait three or four months to get financial reports.”

Mutual funds, like individual investors, can get caught holding municipal bonds of questionable value. When Denver’s Colorado Ocean Journey Aquarium defaulted on $57 million of bonds in July 2001 because of low attendance, Putnam Investments was holding more than two-thirds of the bonds in its portfolio, according to Bloomberg data. Putnam is awaiting the outcome of the aquarium’s case in bankruptcy court to learn how much of investors’ money it will get back.

In the U.S. stock market, the SEC requires that public companies file financial reports and disseminate news that could affect their financial health. The SEC enforces the regulations. That doesn’t happen with munis. The SEC can’t require disclosure.

Disclosure Rules

The Securities Act of 1933 and the Securities Exchange Act of 1934, which set out filing and disclosure rules for public companies after the 1929 stock market crash, exclude municipalities from such reporting.

”The SEC can do little in terms of direct regulation,” says Paul Maco, former director of the SEC Office of Municipal Securities and now a partner at the law firm of Vinson & Elkins LLP in Washington, D.C.

Scrutiny of the muni market falls short in another area. The 15-member Municipal Securities Rulemaking Board, which makes the rules that govern munis, is run by the dealers and issuers it oversees. The MSRB has no enforcement power.

Bush Signs Law

The setup is similar to that of the Financial Accounting Standards Board, which makes rules on accounting practices yet has no authority to police auditors. U.S. Representative Billy Tauzin, the Louisiana Republican who chairs the House Energy and Commerce Committee, is questioning FASB’s effectiveness after audit failures at Enron Corp., Global Crossing Ltd. and WorldCom Inc.

On July 30, President George W. Bush signed into law tougher rules to police the accounting industry. The SEC plans to appoint a five-member board that will set standards for accountants and review their audits.

The SEC and the National Association of Securities Dealers get involved in the muni market in cases in which they suspect fraud. Munis get a low priority. The NASD Web site lists about 280 instances in which it has taken enforcement action involving sales of municipal bonds since 1996 — about 1/10 of its 2,561 actions in other markets.

At the SEC, 67, or 4.4 percent, of the agency’s 1,513 enforcement cases in the past three years involved the sale of municipal bonds.

”I don’t think there is any real regulation of the municipal market,” says Steve Watson, who was with both the SEC and the NASD before becoming a securities lawyer in Dallas.

Haphazard muni trading and pricing systems contribute to the market’s murkiness.

No Central Exchange

Unlike most stocks, munis don’t trade on a central exchange. About $9.5 billion of the securities change hands each day via traders who phone each other armed with lists of bonds they’re either offering or trying to buy.

Real-time quotes, common in the stock market, don’t exist. The MSRB discloses prices for actively traded bonds — about 50 percent of the total — the next day. For others, it releases prices a week after they trade.

Dealers can price munis any way they want — as long as the price falls into what the MSRB deems ”fair and reasonable,” an expression the board says it doesn’t quantify. Dealers can use their discretion in the markups they pay themselves for trades, and they aren’t required to tell investors how much they earn.

Insiders Know

”Insiders know what these bonds are worth, but no one else does,” says Larry Greene, a former NASD supervisor who became a critic of the agency after working there 25 years.

Olson wants to change the system. He set up his Web site in his apartment in San Francisco’s Marina district to provide investors with daily pricing information and to point out markups he says are excessive.

Olson’s role as self-appointed watchdog comes after 10 years on the West Coast municipal bond trading desks of Bank of America Securities, Sutro & Co. and PaineWebber. During his tenure, the only pricing data available was from a firm’s own trades, he says.

Olson puts the daily MSRB price reports online. Then he flags dealers’ markups, known as spreads, that exceed 4 percent of the bond’s face value. Bonds generally sell in $5,000 denominations, and so a 1 percent markup — or one point, as traders call it — equals $50.

Normal muni markups range from 1 point to 3.5 points, same as for corporate bonds, the Bond Market Association says. U.S. Treasury note markups are typically less than a point.

I’m Going to Get Ripped Off

Muni bond markups often exceed accepted practices. On Aug. 5, Olson’s Web site listed 38 bonds with markups of more than 4 points among the more than 2,000 that traded at least three times that day. The highest spread was 10.655 points.

Stephen de Vore, a New York attorney, was so worried that markups would cut into his profit, that he opted not to buy munis this year.

De Vore, 39, says he talked to dealers and decided that paying $100 on a $5,000 trade was too much.

”If the buying and selling is opaque to me, I’m going to get ripped off,” he says.

In addition to markups, prices can vary widely for the same bond. On June 8, 2001, Olson found that most investors were paying 99-101 cents on the dollar for Broward County, Florida, school board bonds. That same day, one dealer — pricing reports don’t say who — paid about 25 cents. That means the dealer could have tripled its investment if it sold at the market price, while the seller sold the bond for 74 percent less than it was worth.

Staple of Finance

Municipal bonds have been a staple of finance since the Middle Ages, when Italian city-states sold securities. In the early 1800s, New York sold bonds secured by taxes on salt to build the 363-mile Erie Canal, one of the first big American public works projects.

When the U.S. imposed an income tax in 1913, states and cities gained a tax exemption for interest that investors earned on municipal bonds. Local governments expanded munis’ uses from the financing of roads and water systems to the funding of public housing, sports stadiums and economic development. As the market grew, investors began to seek greater transparency. In 1993, Arthur Levitt, then SEC chairman and a current Bloomberg LP board member, called for more disclosure. He cited the lack of official statements and investors’ difficulty in figuring out whether prices were fair.

Orange County

The MSRB and the SEC pushed harder for change after 1994, when Orange County, California, filed the largest municipal bankruptcy in U.S. history. The collapse threw the county’s bonds into default and cost investors millions of dollars.

The county lost $1.7 billion on its investments in derivative securities, which are financial obligations derived from debt or equity securities, commodities or currencies. Private investors and mutual funds said they didn’t know about the risky investments, which lost value when interest rates rose.

In November 1996, California Superior Court Judge Stephen Czuleger sentenced County Treasurer Robert Citron to a year in prison for fraud in his handling of the investments.

Long after the debacle, muni investors still get burned. On one day — Oct. 13, 2000 — shares of Heartland Advisors Inc.’s Heartland High-Yield Municipal Bond Fund tumbled 69 percent and shares of its Heartland Short Duration High-Yield Municipal Fund dropped 44 percent, when Heartland wrote down the value of the bonds because many of them were approaching default.

Face Value

Heartland had been carrying the bonds on its books at face value. The firm settled investors’ class-action lawsuit in July 2002, agreeing to pay $14 million in cash.

Getting a price for a municipal bond isn’t as easy as finding a stock quote or a Treasury bond price in the newspaper or going to the Edgar Web site for SEC filings. After Orange County, the MSRB began requiring that securities dealers report every trade — including price and transaction size — to the board at the end of the day. It began making the data public in 1998.

Investors can download daily at no charge a report from the MSRB’s Web site. Finding what they need is tougher: Some of the reports are 400 pages.

As a stock investor, 70-year-old Merrill Peacock says he had enough knowledge to do his own research. When he retired in 1997, the former construction worker wanted to keep his principal and earn tax-exempt interest. He began buying munis and says he trusted his broker, Dane Stephen Faber, because he didn’t know where else to look.

Preserve My Principal

”I gave my broker $25,000 and told him I wanted tax-free bonds and to preserve my principal,” says Peacock, who lives in Lucerne, California.

Peacock says that from January 1998 to December 1999, he poured a total of $200,000 into munis on the advice of Faber, who was at Smith Culver Investments in San Francisco and then at First Securities USA’s Incline Village, Nevada, office.

Peacock says Faber recommended almost $36,000 of bonds sold by the Marineland Foundation, which ran an aquarium in Florida. A month later, Peacock got a notice from Marineland’s trustee saying the attraction had failed to maintain required reserves and was in default.

On March 9, 2001, Peacock sold his bonds for $5,350, or 12 cents on the dollar, racking up a $30,623 loss. All told, he says, he lost $53,000 on munis.

Faber declined to comment, citing a threat of legal action. ”I have a lengthy laundry list of comments I would like to make,” Faber says.

Unsuitable Investments

In March 1996, the NASD disciplined Faber for recommending unsuitable investments for a customer’s needs, according to agency records. In May, the NASD fined him $35,000 for making improper price predictions and assurances of success, the records show. Faber is appealing.

Even though Peacock’s nephew is Craig Barrett, chief executive of Intel Corp., Peacock doesn’t own a computer, says his attorney, Paul Jess of Sonoma, California. For stocks, Peacock could monitor prices in the newspaper, watch financial news shows and get research reports from his broker. Jess says Peacock knew that the bonds he bought didn’t have the highest rating; he didn’t know a municipal bond investment could lose money.

”Brokers who engage in municipal transactions don’t want to make it visible,” Jess says.

One trader says that he and his counterparts bear responsibility for troubles like Peacock’s if they advise clients to buy high-risk bonds.

Little Old Ladies

”If you’re selling junk bonds to little old ladies and get caught, you should get screwed,” says Dennis Beezley, a vice president at Glen Rauch Securities Inc. in New York.

MSRB Executive Director Christopher Taylor says the board is making headway in the disclosure of pricing data. Within two years, it expects to be reporting prices every 15 minutes.

The MSRB also set up seven databases to handle documents from municipal bond issuers: Bloomberg Municipal Repository, DPC Data Inc., FT Interactive Data, Municipal Advisory Council of Michigan, Municipal Advisory Council of Texas, Ohio Municipal Advisory Council and Standard & Poor’s J. J. Kenny Repository.

”The board has made significant improvement in what’s available to the public,” says MSRB chairman Howard Marsh, who also runs Salomon Smith Barney’s muni division.

Even so, investors must pay as much as $25 for the reports. With equities, they can tap the SEC’s Edgar system for free via the Internet.

Kmart Quest

More disclosure might have helped Michael Schroeder, who manages $400 million in muni investments at Naples, Florida-based Wasmer Schroeder & Co. In January 2002, as Kmart Corp. faced bankruptcy, Schroeder sought information about industrial revenue bonds for which the retailer had guaranteed repayment.

City governments sell the bonds to finance development such as new stores, to attract jobs or to gain tax revenue. A retailer like Kmart gets the proceeds and guarantees repayment of the bonds at a lower interest rate than it would receive in the corporate market.

Kmart refused to provide data on specific stores, so Schroeder, whose company held five of the issues, says he called a hundred store managers to compile sales information. Initially, they complied, until Kmart made them stop doing so.

”Small and infrequent issuers are just horrible about providing information,” says Schroeder. ��They need to learn to disclose things as they happen, not six months later in the footnote of a financial statement.”

Specific Stores

Kmart doesn’t disclose sales on specific stores, says Jack Ferry, Kmart spokesman.

So far, Schroeder says, he’s recovered his company’s investment in four of the five issues.

Levitt and his SEC successor, Harvey Pitt, support the MSRB plan for 15-minute pricing and improved financial disclosure. On May 25, Pitt told the Bond Market Association that the municipal bond market is farther along than the corporate bond market on disclosure issues.

”But it has yet to achieve the ultimate goal of transparency: real-time reporting of transactions,” he said. Muni investors may not get much help from the SEC. The agency has its hands full, with the fallout from another self- regulated industry: accounting.

Collapse of Enron

The SEC is investigating the collapse of Enron and the $7.18 billion accounting fraud at WorldCom. It assisted in the U.S. Justice Department’s case against Enron’s auditor, Arthur Andersen LLP.

”I don’t know how much effort the SEC will really put into the municipal bond market now, because they are so distracted by corporate governance,” Schroeder says.

For Don and Gerry Burns, the dangers of the muni market proved as devastating as buying stock in Enron, Global Crossing or WorldCom.

The Oaks at Medina nursing home that sold them their bonds had a fire during construction, and occupancy increased more slowly than the offering documents had projected.

If the Burnses had read an official statement, they might have learned they were buying Series C securities. Series Cs were subordinate to $29.5 million of Series A and B bonds, meaning that they were last to get paid.

In December, the Burnses sold their bonds for a penny on the dollar.

”We took a pretty good bath,” Don Burns says.

They probably won’t be the last, as more equity investors flee declining stocks and wade into the murky market for municipal bonds.

2002-08-27 00:15 (New York)