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.
Indadequate 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 back-water. 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 companywide, 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,
comanager 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. For
equities, the NASD limits markups to 5 percent of the stock's
price.
`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.
