Wall Street Bankers Face Bond Disclosure Rules to Protect States, Cities
By William Selway – Aug 3, 2011 12:01 AM ET
Wall Street banks setting up bond sales for U.S. states and cities would be required to tell public officials about potentially costly risks and conflicts of interest involved in the deals under rules proposed yesterday.
The Municipal Securities Rulemaking Board, which writes regulations for banks that work in the tax-exempt debt market, said yesterday that it asked the U.S. Securities and Exchange Commission to approve the proposed rules placing greater disclosure requirements on bond underwriters.
The proposal is among moves to reshape regulation of the $2.9 trillion municipal-securities market following the 2008 financial crisis. Since then, state and local taxpayers have been stuck with billions of dollars in unexpected costs because complex bond deals, pitched as money-savers, backfired instead.
“A lot of obligations are placed on underwriters that weren’t there,” said David Lipton, a former rulemaking board member who teaches law at Catholic University of America in Washington. “That’s good for the investors, and that’s good for the industry.”
The rules would require banks to disclose all “material risks” associated with bond financings, including the floating- rate securities coupled with interest-rate swaps that once flourished. Banks also would have to disclose potential conflicts of interest, including the incentive they have to recommend such transactions, payments they may get from other parties in the deal, and whether banks are betting on derivative contracts that only pay off if the borrower defaults.
The 2008 financial crisis revealed cracks in oversight of the municipal-bond market that regulators are taking steps to fix since passage of the Dodd-Frank financial-overhaul law last year. Before the law passed, regulators provided no supervision of interest-rate swaps that proved costly to state and local governments or the financial advisers who recommended the deals.
“This proposal is a groundbreaking effort in ensuring the interests of state- and local-government bond issuers are further protected in their transactions with underwriters,” Lynnette Kelly Hotchkiss, the executive director of the board, known as the MSRB, said in a statement.
Rules aimed at protecting municipalities make sense, given that investors are also potentially hurt when financings unravel, Lipton said.
In Jefferson County, Alabama, officials are considering whether to declare bankruptcy because of bond deals laden with swaps that unraveled.
“If the issuers are torpedoed by an underwriter’s failed scheme, the investors are going to be torpedoed,” Lipton said.
The U.S. Commodity Futures Trading Commission is drafting rules that would force banks that pitch interest-rate derivative deals to also disclose details about the risks, act in the customers best interests, and ensure that they have the financial wherewithal to handle the potential impacts of wrong- way bets. The MSRB and the SEC are putting in place regulations for financial advisers.
As much as $300 billion of interest-rate swaps were sold to municipalities a year before the financial crisis, according to an estimate from the rulemaking board. The swaps were paired with floating-rate bonds such as auction-rate securities, whose interest rates climbed when banks began hoarding cash and stopped propping up that market. The swaps often failed to produce the protection from rate changes that they were designed to provide and required penalty fees to break.
Protection for Officials
The Dodd-Frank law also empowers the rulemaking board to draft protections for local-government officials, broadening its mandate beyond investors.
The disclosure requirements proposed yesterday are part of that push, the rulemaking board said.
The proposal also would make explicit that underwriters must pay a fair and reasonable price for bonds they buy directly from localities. That step would potentially prevent banks from reaping outsized profits or steering quick gains to favored clients by providing them with bonds that were underpriced in the initial offering.
“Dodd-Frank explicitly requires the MSRB to protect municipal entities,” Hotchkiss said. “This gives us the ability to establish detailed requirements for underwriters and make important information more readily available to state and local governments that sell bonds.”
The rulemaking board’s proposal is subject to the SEC’s review and approval.
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