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

NASD Shows Broker Bids on Bonds Can Be Funny Things: Joe Mysak

July 9 (Bloomberg) -- ``Buyer beware'' has no place in the municipal bond market. Neither does ``Seller beware.''

If you want to invest in municipal bonds, you don't have to master the intricacies of the thousands of credits trading in the municipal market every day. If you want to sell your bonds, you shouldn't have to worry about being ripped off.

That was the very clear message sent by the National Association of Securities Dealers last week when it fined eight securities firms for not getting the best price for customers who wanted to sell their bonds. The good news is that the NASD isn't done yet and that the regulator is going to drag more guilty parties across the stage.

The bad news, especially, it seems, for some interdealer brokers, is that the game is over.

The eight firms penalized by the NASD neither admitted nor denied the allegations. Yet by signing the NASD's letter of acceptance, waiver and consent, the firms agreed not to deny the ``factual basis'' of the violations.

All made restitution to their customers and most said they implemented new procedures to ensure that it won't happen again.

Bond Stories
The exhibits to the NASD action tell a little story, a scary one if you sold your bonds within recent memory. What the NASD did was take a snapshot of activity at each of the eight securities firms involved, over a period of from four months to almost 12 months in 2002 and 2003.

The exhibits make compelling reading for anyone who has ever studied the Municipal Securities Rulemaking Board's transaction reports and wondered about the wide price disparities that can be seen in the municipal market. Consider a $10,000 lot of bonds. On one day, the bonds were bought from a customer for 52.375 cents on the dollar. The same bonds later traded at 100.54, and a day later, were sold to a customer at 103.25. That didn't happen, did it?

Broker's Broker
Yes, it did. And courtesy of the NASD, we know exactly how it happened. In January 2003, someone asked Merrill Lynch & Co. to sell their municipal bonds.

In this case, the person had $10,000 in South Carolina Jobs -- Economic Development Authority health facilities revenue bonds sold in 1993 for the Laurel Crest Center project.

These are unrated nursing home bonds secured by a first mortgage on the property. They carry a 7.25 percent coupon and mature in 2017. Merrill Lynch, which didn't originally underwrite the bonds, got a bid from a broker who specializes in doing business between securities firms, a ``brokers' broker,'' as they are called.

Maybe the broker was feeling in a puckish mood that day. Maybe this is just how some brokers do business. They just throw funny bids out there on odd lots and see if anyone takes them up on it. The broker said he would pay 53.5 cents on the dollar for the South Carolina nursing home bonds. Maybe the broker had no idea how much the bonds were worth. For one thing, they are unrated, which is never an encouraging sign. For another, they carry a coupon over 7 percent. That's high yield in the municipal market, a junk-bond yield. Finally, it's difficult if not impossible to get financial information from nursing home operators, to see how the facility is doing. On the other hand, these bonds had changed hands back on Oct. 25, 2002, at prices ranging between 96.06 and 100.

Funny Bid
So what happened here? Did the broker decide to make a funny bid? I'll pay you 53.50 -- ha ha ha?

We know what happened next. Merrill Lynch said: You bought them. They gave their customer 52.375, and sold them to the broker for 53.50. The broker who bought them for 53.50 sold them for 55.50, to another dealer, who sold them for 99.04, to another dealer, who sold them for 100.54. The next day, those bonds were finally sold to a customer for 102.338. If this was funny, the joke was on the customer. Somebody, it seems, wanted those $10,000 in nursing home bonds.

Enter the NASD. The NASD told Merrill an accurate price for those South Carolina bonds would have been 97.375 -- not 52.375. Merrill Lynch made restitution to its customer of $4,500.

There are probably all kinds of excuses for that bid of 53.50. The bonds are unrated, they are nursing home bonds, they are in an odd lot.

If this is your business, though, there is no excuse, according to the NASD. There was no excuse for Merrill Lynch to accept it, and there was no excuse for the broker to make it. This is going to come as a big shock to some broker's brokers, especially the guys who make funny bids.

To contact the editor responsible for this column: Bill Ahearn at bahearn@bloomberg.net. Last Updated: July 9, 2004 00:05 EDT