Scrutiny of muni bonds

Kathleen Pender,
San Francisco Chronicle
Sunday, February 8, 2004

If the state of California gets voter approval in March to sell $15 billion in municipal bonds to refinance its bloated deficit, it will need a lot of new customers -- including individual investors -- to buy the record-breaking deal.

The bonds, if approved, will come to market at the same time federal and industry regulators are investigating abuses that hurt small investors in municipal bonds.

The investigations center on trading in the secondary market for previously issued municipal bonds that have not yet matured.

If an investor buys a muni bond when it is first issued and holds it until maturity, there is little, if any, potential for trading abuses.

The problems occur when an investor buys a bond after the original issue or sells a bond before it matures. In this case, he'll have to trade in the secondary market, a loose affiliation of brokers and dealers who trade bonds for themselves and customers.

About two weeks ago, the Municipal Securities Rulemaking Board, a self- regulatory organization, sent out a strongly worded warning that some bond traders are ripping off investors by charging prices that bear no relation to market value.

The National Association of Securities Dealers and the Securities and Exchange Commission, which enforce MSRB rules, have confirmed they are investigating municipal bond pricing, though not necessarily in reaction to the board's warning.

Bond brokers and dealers make money buying a bond from one customer and selling it to another at a slightly higher price. The difference -- essentially their commission or markup -- is not disclosed to the customer. It is embedded in the price of the bond.

Investors don't always know if they're getting a fair price. There are thousands of muni bonds on the market; no two are exactly alike. Many trade infrequently, making them harder to value. Until recently, the price at which bonds traded was not even made public. Now it is, but not until the next day.

Investors who want to buy or sell a bond can attempt to get a fair price by checking Web sites that post trades from previous days, such as www.investinginbonds.com or www.municipalbonds.com. They also could call several brokers and ask for a quote, although getting a bond transferred from one broker to another to sell it can be a pain.

Most individual investors simply call their broker and take whatever price is offered. Brokers are required to try to get their customers the "market price." Most do, some don't.

After reviewing trade data, the MSRB found that "a relatively small number of issues each day trade with intraday differentials (the difference between the high and low price of the day) that are abnormally wide." While small in number, these trades "are sufficiently problematic to require regulatory review," the memo said.

The NASD says it has been investigating the issue for some time. "Pricing in the municipal bond market has been a focus of ours since well before the MSRB release," says Steve Luparello, the NASD's executive vice president for market regulation.

The most egregious cases cited by the MSRB involved "transaction chains" where a retail customer sold a bond to a broker, who sold it to a middleman called a broker's broker, who sold it to another middleman, who sold it to a retail customer on the same day.

In some cases, the difference between the price received by the first retail customer and the price paid by retail customer at the other end of the chain exceeded 10 percent.

Even if the retail brokers did not make an excessive profit on their piece of the transaction, they could have broken MSRB rules requiring them to "effect transactions" at market prices.

Christopher Taylor, the MSRB's executive director, estimates that only 30 out of 30,000 trades per day involve price disparities greater than 10 percent. But those are not those only ones that might be abusive.

"Anything over 5 percent is clearly egregious," Taylor said.

In a speech to bond professionals this week, he warned that dealer markups of less than 5 percent could face regulatory scrutiny, if they result in unfair prices to the customer.

Muni watchdog
Kevin Olson, a self-appointed municipal bond watchdog in San Francisco, has been crusading against wide spreads for years.

Each day, his Web site (www.municipalbonds.com) crunches the previous day's trade data from MSRB. (Since 2000, dealers have been required to submit daily trade data to the MSRB, which gradually began making the data public.)

Each day, his site red-flags trades from the previous day in which the difference between the price a seller received and the price a buyer paid was greater than four percentage points.

On Friday, his site had red-flagged 35 different California municipal bonds.

Olson also has begun highlighting bonds with what he calls "negative yields." Municipal bonds are quoted in terms of price and yield. As the price goes up, the yield goes down, and vice versa. A negative yield occurs when the price goes so high the yield is less than zero.

Some negative yields could be the result of data entry errors or could be on bonds that have unusual features that might warrant a negative yield, Olson says. But they also could be the result of abusive pricing.

Olson has been trying -- with little success -- to get state treasurers to take an interest in wide spreads and negative yields. Many treasurers have been crusading against other market practices that hurt investors. But they haven't done anything on the municipal bond side, which may not be surprising, since they're usually in charge of issuing their state's municipal bonds.

"I think there's a conflict of interest," says Olson. "They get up there, they want their headlines. I say, 'OK, great. I appreciate what you're doing on the mutual fund side, the corporate governance side. But what about you as an issuer of securities? Why can't I talk to you about helping municipal bond investors? Why can't you be an advocate like you are on the equity side?' " he says.

Real-time quotes

Regulators hope enforcement action, plus new disclosure rules that take effect next year, will lead to better pricing.

Starting in January 2005, muni bond brokers and dealers must report all trades to the MSRB within 15 minutes, instead of at the end of the day, as they do now.

The MSRB plans to start disseminating those price quotes on a "real-time" basis, but it has not yet decided on a timetable.

The Bond Market Association, the trade group for bond dealers, will begin disseminating real-time quotes, when available, on its Web site, www.investinginbonds.com.

The association, however, has asked the MSRB to make an exception to real- time price dissemination for trades of more than $1 million in municipal bonds rated lower than A.

Lynnette Kelly Hotchkiss, the association's senior vice president, says that bonds rated lower than A are already illiquid, and real-time reporting of large trades would make it even harder for big investors to get a fair price.

She says the exception would apply to only 4 to 10 percent of muni trading volume.

Large trades in California's general obligation bonds -- rated lower than A by all three credit rating agencies -- would be covered by the exception.

In a speech to the Bond Market Association this week, SEC Commissioner Cynthia Glassman urged the industry to move promptly toward real-time pricing for all bonds, including low-rated, high-yield issues.

It is these types of bonds "where pricing decisions are the most difficult and where real-time information would be most beneficial,'' she said.

"In this day of global access and technological innovation, any degree of opaqueness in our bond markets is anachronistic and potentially problematic," Glassman added.

"Further delays in making your markets fully transparent may not be the wisest course in terms of minimizing regulatory and reputational risk," she warned.

Net Worth runs Tuesdays, Thursdays and Sundays. E-mail Kathleen Pender at kpender@sfchronicle.com.