Joe Mysak is a columnist for Bloomberg News. The opinions expressed are his own.

Regulator Details How Bond Buyers Are Shortchanged: Joe Mysak

July 7 (Bloomberg) -- The National Association of Securities Dealers last week punished eight securities firms for not treating their customers fairly when it came to pricing their municipal bonds.

This should convince the doubters.

Ever since Kevin Olson began listing wide price disparities on his Web site, Municipalbonds.com, in 2000, skeptics have criticized it. They have been angry about his pointing out those price disparities. Some have even denied they occurred at all. Dealer error was responsible, they said.

The thing about the transactions listed on the Municipal Securities Rulemaking Board's daily transaction reports is that you don't know who did what. The parties to the transactions are only listed as customers or dealers. This made the reports all a little surreal.

The reports have made the municipal market -- that is, the secondary municipal market, where bonds trade, compared with the new issue market, where bonds are first priced -- transparent. We now know that the reports have aided regulatory surveillance.

We now know this because the NASD fined eight securities firms $310,000 and ordered them to pay $300,000 in restitution to customers.

Art of Pricing
Here's what happened. Customers asked the firms to sell their municipal bond holdings. The securities firms contacted an interdealer broker, or ``broker's broker,'' as they are called, and obtained bids for the customer's securities. The firm then purchased the securities, and resold them to the broker ``at a nominal gain.''

That's key. The securities firms didn't get in trouble with the NASD for profiteering. They got in trouble for not giving a damn, for not getting their customers the best price for their municipal bonds.

Prices in the municipal market are squirrelly things. There are no standards for markups or markdowns. MSRB rule G-30 requires dealers to execute transactions ``at prices that are fair and reasonable, taking into consideration all relevant factors.'' It's more of an art than a science. That doesn't mean dealers can get away with finger-painting. Shortchanged

The NASD looked at transactions that took place from July 2002 through June 2003. They examined trades with par values of anywhere from $5,000, which is the usual face value of one bond, to $200,000. Of the 60 lots the NASD scrutinized, 15 were $5,000, 12 were $10,000, and five for $15,000. Total par value was $1.4 million.

Customers were shortchanged anywhere from 6.57 percent to 142.55 percent, according to the NASD. Let's take a look at a few of them.

The largest face amount of bonds was $200,000 in Beaver County, Pennsylvania, pollution control revenue bonds. The bonds were originally issued in 1979, and carry a 6.8 percent coupon due in 2009. On Oct. 17, 2002, UBS Financial Services paid their customer 40.625 cents on the dollar for the bonds. The NASD says a fair market value price was 77.91 cents on the dollar. The customer lost $74,570.

The biggest difference between prices also occurred at UBS, on $5,000 in Antigo, Wisconsin, housing revenue bonds, first sold in 1993 and carrying a 7.125 percent coupon due in 2018. On Oct. 1, 2002, UBS paid 40 cents on the dollar for the bonds, and sold them for 42 cents on the dollar. The NASD says a fair price would have been 97.02. Later that same day, the bond traded at a price of 99. It was called in January 2003 at a price of 102. Next, Brokers

Or consider the Capital Projects Finance Authority, Florida, 8 percent revenue bonds due in 2019. The bonds were issued in 1999. On Sept. 12, 2002, Charles Schwab said a $40,000 lot of the bonds were worth 72.325 cents on the dollar. The NASD says a fair price for the bonds was 92.50. On the same day, buyers of $20,000 of the bonds paid 93.30, while buyers of single bonds, $5,000 worth, paid 96.30.

The securities firms involved in the NASD sweep were First Trust Portfolios of Lisle, Ill., Edward Jones, Merrill Lynch & Co., Morgan Stanley, Prudential Equity Group, Charles Schwab, UBS and Wachovia Securities. The NASD said it isn't finished scrutinizing the market, and is looking at more securities firms, as well as the interdealer brokers involved in the transactions.

So there are three examples of wide price disparities on municipal bonds. There are 57 more in the exhibits to the NASD enforcement action, all laid out in excruciating detail. Doubt no longer.

To contact the writer of this column: Joe Mysak in New York jmysakjr@bloomberg.net. To contact the editor responsible for this column: Bill Ahearn at bahearn@bloomberg.net. Last Updated: July 7, 2004 00:06 EDT