Muni Finance Observer

This must be stopped!!

2008-10-11T11:10:00.001-04:00

On Friday evening, Treasury Secretary Paulson made the most stunning disclosure to date on the Treasury's plan to bail out the banking system. A video of that disclosure is available from the BBC. The statements are between the 3:30 and 4:10 minute marks on the video.

Treasury, according to the video, is twisting the bail out legislation into an ability to acquire from "troubled" financial institutions, non-voting preferred or common stock. I cannot believe that any legislator that voted for the bail out bill ever intended for the legislation to be viewed as a means of granting unsecured loans. At least there was the facade that securities were being acquired at "market" and would be disposed of in a timely fashion, hopefully at a profit. Now, with this latest interpretation, all appearance of fiscal responsibility will be eliminated.

I have argued before that the only solution to the financial mess created was to authorize the Treasury to purchase preferred stock in the financial institutions. However, that stock was always to be cumulative and voting. Any other type of "investment" is guaranteed to fail because there is no mechanism requiring the accountability of management.

What a difference between acquiring distressed securities at market value, which was the was the bail out bill was promoted, and making an unsecured loan to a "troubled" institution plus keeping management in place. The same management that caused the problem in the first place!

It is time to stop doing "business as usual". It is time to start cleaning up the mess. Take a voting equity position in the banks, at least the taxpayer will have a say in replacing management, controlling the direction of the business in the future and participate in the rewards of a successful enterprise, if that should happen.

The acquisition of non-voting equity in lieu of acquiring securities is just a means of guaranteeing the taxpayer will end up the biggest loser in the game.

The Plan

2008-09-27T15:43:00.001-04:00

After my posting this morning, I ran into a copy of the Paulson plan on Paul Kedrosky's web site. The "full" plan is available on Paul's web site.

The entire "plan" comprises three whole pages. And the bottom line is the Treasury Secretary has the right to do anything he feels is appropriate.

The proposal gives the Secretary complete discretion in managing the assets acquired. He may exercise rights, buy or sell the securities including arranging another form of borrowing through repurchase agreements, and he may create any "vehicle" to buy and sell securities.

But the most important part is section 8. "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

In other words, he is unaccountable for the management of over $700 billion!

Oh yes. Section 10 requests that the Congress increase the debt limit by $3 TRILLION to $11.3 TRILLION. That's about $40,000 for each citizen.

We have an energy czar, now we have a money czar.

Time for some honesty

2008-09-27T09:16:00.001-04:00

This certainly has been a week for the record books. As another blogger said, "Our grandchildren will read about this week." While they may be reading, I hope it's not too much because they had better be working to pay off the debt this generation will be leaving them. By the end of this year, this country will be $12 TRILLION in debt. That's $40,000 for each man, woman and child in this country. Over $1,000 per year of each person's taxes will go just to pay the interest.

It's bad enough that we will be so far in debt, but the rhetoric this week of "mark to maturity", "this is another RTC and look how successful that was" and the really good one, "the government can be a patient investor awaiting his profits." All this is just so much crap.

Face it, the "plan" proposed by Bush, Paulson and Bernake is incredibly expensive. We are being asked to mortgage our children's future based upon a four page plan and a lot of uninformed discussion. Listening to the discussions, I couldn't help remembering the line "A battle of wits among unarmed opponents."

There are no securities being acquired from the banks that are anywhere near their market value. If they were at market, however you want to calculate it, we would not have a problem that needs to be solved. And to continue stating that the assets will mature and repay the government is absurd and probably deceitful.

Look at the type of assets the government will be acquiring.

It's 2005 and a mortgage broker just granted a teaser rate mortgage that has an initial low interest rate for 3 years then "resets" in 2008. Within minutes that mortgage has been sold to a Wall Street firm which along with other mortgages will be sliced and diced into pieces and sold to investors. But for this example, assume there were only 2 pieces; the principal portion was sold to a bank in Ohio while the interest portion was sold to a bank in Texas. Everything was sold at market values and the two loans performed as they should for three years.

Then default. No more payments on the mortgage are made. The owner is gone and what's left is the real estate, depreciating daily. And of course the two securities...owned by two different investors maybe thousands of miles away.

Now the regulators and auditors start to question the value of the two securities. The question the regulator in Texas asks is: "What is the value of a security whose value is derived from the cash flow from the interest only portion of a mortgage that is in default?" [I know default is such a harsh word, that's why it's now called "non-performing"...I guess that's more politically correct.]

If there is no expected cash flow, more than likely the regulator will require the bank to reduce the value of the security...but that hurts the equity of the bank. Bank failure, lines to redeem deposits, run on the bank...but wait, just like in the old westerns, just when Pauline is tied to the tracks, over the hill comes Hank, Ben and George to save the day. They tell the bank, "We will buy that security from you at an 'agreed price' so your equity won't be impaired. We can do this because we can wait forever until the interest on that defaulted mortgage starts to pay." [What goes unsaid is if the interest is never paid, the taxpayer will foot the bill.]

For any of you left reading, I'm getting to the point. As of September 26, 2008, the total net worth of the US banking system was about $1.2 Trillion, according the the Federal Reserve Bank. The taxpayers are being asked to "invest" $700 Billion to keep the system afloat. To me, it appears that the taxpayers will be the major owner of the financial system.

It is time to start talking about the 800 pound gorilla in the room. It may be time to nationalize those banks that have proven that management is or was incapable of managing. [BTW you have no idea how much it hurts to say that.]

And the friends of Paulson, Bernake and Bush will be rewarded when the government privatizes the banking system in the future. Hopefully the taxpayer will then be rewarded.

We Don't Need No Stinking Accounting

2008-09-16T08:13:00.001-04:00

I just sat through 15 minutes of the most senseless banter ever conducted on national television. It was an interview of Steve Forbes on CNBC. In that interview, Forbes advanced a novel idea for addressing the problems befalling our debt laden economy...don't mark assets to the market!

What a brilliant solution! In one fell swoop, with a single stroke of the pen, all of our problems could be resolved. The entire financial mess has been rectified. Bear Sterns can be resurrected. Lehman does not need bankruptcy protection. And AIG can remain unscathed.

Just think of the simplicity. No rating agencies to worry about. Certainly no reporting problems to the stockholders. With one bold pronouncement, all counter party risk is eliminated. Gone are the days of accountability. All we have to do is say we intend to hold these assets to maturity and all the mark to market problems are resolved.

With thinking like this, there ought to be a public outcry for Forbes for President...or Chairman of the SEC...or president of the Financial Accounting Standards Board...at least mayor of some town somewhere.

This is the kind of advise the McCain campaign is getting. This is a recommendation from one of this countries financial leaders. It's time to pray for the republic.

Tzolov and Butler

2008-09-10T11:36:00.001-04:00

On September 3, 2008 the US Securities Exchange Commission filed a Complaint in US District Court for the Southern District of New York against Julian T. Tzolov and Eric S. Butler, two former employees of Credit Suisse Securities. The Commission requested the court to restrain and enjoin the defendants from violating various sections of the securities laws; order the payment of civil penalties; order the disgorgement of "ill-gotten" gains; and anything else the SEC could want.

But what did these two "bad actors" really do? What was it that they did that violated the laws of the United States?

According to the complaint filed, there two nefarious characters had contracted with certain customers to purchase auction rate securities backed by student loans. Instead, from February of 2005 until August of 2007, these two breached the contracts and purchased auction rate securities backed by non-student loan assets.

Because of the breach of contract, the customers "...were stuck with at least $817 million..." in securities. Presumably, the SEC is saying these two owe their customers the entire $817 million since no loss is claimed.

The SEC is claiming that the breach of contract is a violation of the securities laws which prohibit fraudulent interstate transactions [15 USC Section 77q(a)] or to employ, in connection with the purchase or sale of a security, any manipulative or deceptive device [15 USC Section 78j(b)].

But what does the complaint allege? Only that these two breached a contract. What the complaint does not state is:

1. What gives the SEC jurisdiction over contract violations;

2. What gives a federal court jurisdiction over contract violations;

3. What was the fair market value of the auction rates securities owned by the customers versus the acquisition price;

4. What was the device employed in misrepresenting the price.

These are relatively simple questions that I know the Commission is reluctant to answer. [Hint to SEC: Try an ex parte proceeding in the Western District of Pa.]

Hopefully, defense attorneys will ask the questions.

SEC probes Wachovia

2008-09-06T10:55:00.001-04:00

The Securities and Exchange Commission enforcement division is expected to recommend to the Commission that it file civil proceedings against Wachovia for "anti-competitive" practices in the bidding for the investment of proceeds from tax exempt bonds issued by municipalities. But possibly in these instances, the SEC has managed to exceed its jurisdiction. It must be remembered that the SEC does not have jurisdiction over contracts. As a matter of fact, there is no federal jurisdiction over civil contracts.

From the SEC's own web site: "The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."

Look at the transaction the SEC is attempting to control. The municipalities solicited Wachovia and at least two other firms to enter into an agreement with the municipality to guarantee a rate of return on the municipality's investment of fund borrowed at tax exempt rates. The terms of the contract were prepared by the municipality pursuant to federal regulations. The fair market value of the contract was determined pursuant to those regulations.

So now we have a two party contract that the SEC is attempting to state falls under their jurisdiction. But that's not all.

The SEC is investigating because there may have been some bidding irregularities, specifically some sort of collusion. Assume the SEC is right and there was collusion. So what. Was the investor, the entity the SEC is to protect, harmed? There has not been such an allegation made in any investigation to date. And there is a reason.

Under federal regulations, the municipality that invests bond proceeds is limited to the amount of earnings it is allowed to keep. The balance must be sent to the IRS. That is why there has never been an allegation that the municipality was harmed. In all likelihood, even if there were collusion, did that event harm the municipality.

Now I'm sure that the SEC can overcome the problem of extending its jurisdiction to private contracts. All they have to do is find a friendly judge, in an ex parte proceeding, to say it is an investment contract. Of course that judge will find that a private two party contract was really "...an investment in a common enterprise with an expectation of profits to be generated through the efforts of others...." [HINT: To the SEC, try the Third Circuit]

But where the SEC will fail, is not stating what the market value of the investment contract should have been, but for the alleged collusion, and how that difference in market value really hurt the investor.

Enough for today. Sorry it has been such a long time between posts. I will do better in the future.

Stay tuned...lots more to come.

Massachusetts v Merrill Lynch

2008-08-04T11:18:00.001-04:00

On July 31, 2008 the Commonwealth of Massachusetts filed an Administrative Complaint against Merrill Lynch. Secretary of the Commonwealth William Galvin alleged that Merrill had acted in a fraudulent, dishonest and unethical manner which ultimately resulted in "...thousands of investors being abandoned with illiquid investment." Those investments were the now infamous Auction Rate Securities.

The complaint filed, which can be read on Sec. Galvin's web site, is an interesting piece of reading. It is huge for a complaint, 80 pages long with 188 pages of exhibits. The introductory summary alone is over 12 pages. It will be quite a while before anyone could read the entire document and give an impartial opinion.

An observation, isn't it amazing how the press can read something as complicated as this complaint and write a story summarizing what was filed. Almost makes you think that they were given a release prepared by the government.

Regardless of the length, to me one thing stood out after reading the summary. The Commonwealth of Massachusetts is not accusing Merrill of having offered, purchased or sold the auction rate securities at non-market values. Sure the complaint alleges that Merrill did some things that appear to be improper, such as issuing reports that may have been overly exuberant.

From what I've read there does not appear to be anything that Merrill did wrong in a transaction. Sure people lost money and yes some are still holding the securities. No one like to lose money.

It must be remembered that Merrill is a publicly owned company and as such owes a fiduciary duty to its stockholders. It appears that Mr. Galvin's claim is that Merrill should have put itself out of business rather than having investors lose money.

At some point, the investors must take responsibility for their own actions.

As time permits, I will attempt to analyze the complaint and post my analysis.

An Interesting Week

2008-08-02T10:03:00.001-04:00

What a week it was for the legal system as everybody involved in the potential bid rigging scandal, the auction rate securities fiasco, and the municipal derivatives investigation all ran to their local courts to file lawsuits against every financial institution of any size.

Los Angeles sued the mono-line insurance companies (as if they need any more problems) and also sued a laundry list of financial firms ranging from Merrill, Bank of America, Wachovia, Morgan all the way down to a relatively small firm, Investment Management Advisory Group (IMAGE). Just to make sure they got everyone, LA also included "Does 1-50".

Massachusetts sued Merrill, Connecticut and Florida are investigating, Stockton Ca sued anyone they could find while New York sued UBS. The hits just keep coming.

As far as the lawsuits involving municipal bid rigging, I will again state my position that these law suits brought by the municipalities seem to be more an effort to cast themselves as a party harmed. Especially since the federal government is very close to bringing its own action. The last thing the municipalities want is to be charged with some form of complicity in the bidding procedure.

Despite the bravado of LA City Attorney Rocky Delgadillo, ["Today we're sending the message that if you cheat the city, we will come at you with everything we've got, whether you're a gang banger or a Wall Street titan"], I think most of these suits should be dismissed because the plaintiffs will have a hard time proving they were harmed.

On July 29, in a piece written by Michael B. Marois, Bloomberg stated that US "Tax rules also stipulate that profits made by selling bonds at tax-exempt rates and then investing the proceeds at higher yields must be repaid as taxes."

While the profits on investing is not really a tax, more of a confiscation because the federal government takes everything, the concept is correct. The municipalities cannot keep the profits from investing. They cannot use that money generated through their own investing activities as any other citizen for the building of schools, roads, hospitals or any other worthwhile project. They must send the money to the IRS.

The bottom line is: the plaintiffs in the bid rigging lawsuits probably got all the profits they could get. The actions by the financial community probably did not harm those who filed the complaints. But what is unknown is how much did the municipalities know about the bidding procedure they are now challenging.

Eventually, we may all know the answer to that.

Analysis of the Indictment

2008-07-15T18:26:00.001-04:00

The indictment filed against Cioffi and Tannin appears to be a further step in the ongoing effort on the part of employees of the Department of Justice to thoroughly punish those whose businesses fail resulting in the loss of investor funds. Despite the opinions of all the "experts" on CNBC or the members of the press or any other members of the blogging community, what the government is attempting to accomplish here is not in the best interests of either the investing community, business owners or investment advisors.

A case can be made that if the government should be successful in this prosecution, the result will be a further deterioration of the financial markets...but that is for another day.

What the government is trying to do is pin the loss of "...approximately $1.4 billion" on the two Bear Stearns hedge fund managers. However, the indictment fails to draw the necessary lines to connect the dots.

Count one of the indictment alleges violations of the securities laws, specifically 15 USC Sections 78j(b) and 78ff. It also alleges violations of 18 USC Sec. 1341 for wire fraud.

First the easy one...for there to be a violation of wire fraud, Cioffi and Tannin must "...knowingly and intentionally devise a scheme and artifice to defraud...." Therefore there must have been a scheme. [Wire fraud requires the existence of a "scheme" in order for there to be wire fraud.]

So now the government must prove that the two actors created a "scheme or device" designed to take money from investors. In other words, the government "...must prove (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation."

And what does the government offer as violations?

1. Cioffi said to a Bear Stearns broker on 3/3/2007 that the funds represented an awesome opportunity.

2. Tannin said on 3/21/2007 he was going to invest more.

3. Cioffi and Tannin on 4/25/2007 was on a conference call and did not tell everyone on the call that the market and the funds were not in good shape.

4. Tannin told a counter-party he expected no large redemptions on 5/3/2007

5. In May of 2007, Cioffi told a Bear broker he had $5.5 million invested in the funds.

This indictment is a sham. The government has failed to even get close to meeting its burden of alleging a crime.

It is obvious the government must go back to the drawing boards and try to produce an indictment that alleges that these two men caused the investors in the two funds to lose money. Without causation, this indictment must be dismissed.

More later....

What Cioffi and Tannin are Facing

2008-07-06T11:23:00.005-04:00

In Cioffi and Tannin’s indictment, at paragraph 55, the government states “Eventually, investors were told that the Funds had both lost 100% of their respective values, resulting in a total investor loss of approximately $1.4 billion."

So what penalty are these two men facing? That answer is contained in the United States Sentencing Guidelines. Those guidelines contain the convoluted method of assigning points to the dollars lost and certain surrounding events. A full version of the Fraud section of the Sentencing Guidelines are here. This is a copy of the table for crimes of “Basic Economic Offenses” (Non applicable sections have been deleted):

1. THEFT, EMBEZZLEMENT, RECEIPT OF STOLEN PROPERTY, PROPERTY DESTRUCTION, AND OFFENSES INVOLVING FRAUD OR DECEIT

§2B1.1. Larceny, Embezzlement, and Other Forms of Theft; Offenses Involving Stolen Property; Property Damage or Destruction; Fraud and Deceit; Forgery; Offenses Involving Altered or Counterfeit Instruments Other than Counterfeit Bearer Obligations of the United States

(a) Base Offense Level:

…

(2) 6, otherwise.

(b) Specific Offense Characteristics

	Loss(Apply the Greatest)	Increase in Level
(A)	$5,000 or less	no increase
(B)	More than $5,000	add 2
(C)	More than $10,000	add 4
(D)	More than $30,000	add 6
(E)	More than $70,000	add 8
(F)	More than $120,000	add 10
(G)	More than $200,000	add 12
(H)	More than $400,000	add 14
(I)	More than $1,000,000	add 16
(J)	More than $2,500,000	add 18
(K)	More than $7,000,000	add 20
(L)	More than $20,000,000	add 22
(M)	More than $50,000,000	add 24
(N)	More than $100,000,000	add 26
(O)	More than $200,000,000	add 28
(P)	More than $400,000,000	add 30

(2) (Apply the greatest) If the offense—

(A) (i) involved 10 or more victims; or (ii) was committed through mass-marketing, increase by 2 levels;

(B) involved 50 or more victims, increase by 4 levels; or

…

(13) (Apply the greater) If—

(A) the defendant derived more than $1,000,000 in gross receipts from one or more financial institutions as a result of the offense, increase by 2 levels; or

(B) the offense (i) substantially jeopardized the safety and soundness of a financial institution; (ii) substantially endangered the solvency or financial security of an organization that, at any time during the offense, (I) was a publicly traded company; or (II) had 1,000 or more employees; or (iii) substantially endangered the solvency or financial security of 100 or more victims, increase by 4 levels.

(C) The cumulative adjustments from application of both subsections (b)(2) and (b)(13)(B) shall not exceed 8 levels, except as provided in subdivision (D).

(D) If the resulting offense level determined under subdivision (A) or (B) is less than level 24, increase to level 24.

…

(15) If the offense involved—

(A) a violation of securities law and, at the time of the offense, the defendant was (i) an officer or a director of a publicly traded company; (ii) a registered broker or dealer, or a person associated with a broker or dealer; or (iii) an investment adviser, or a person associated with an investment adviser; or

(B) a violation of commodities law and, at the time of the offense, the defendant was (i) an officer or a director of a futures commission merchant or an introducing broker; (ii) a commodities trading advisor; or (iii) a commodity pool operator,

increase by 4 levels.

To determine the number of levels, it is just an addition problem:

Basic Offense 6

Total Loss exceeds $400 million 30

Assume less than 50 “victims” 4

Safety of institutions 4

Violation of securities laws 4

Grand Total 48

With that total of 48 levels, a judge then goes to the “Sentencing Table” to determine the sentence. The full version is here. This is an excerpt.

Offense Level	Months
19	30-37
20	33-41
21	37-46

22	41-51
23	46-57
24	51-63

25	57-71
26	63-78
27	70-87

28	78-97
29	87-108
30	97-121

31	108-135
32	121-151
33	135-168

34	151-188
35	168-210
36	188-235

37	210-262
38	235-293
39	262-327

40	292-365
41	324-405
42	360-life

43	life

The table above starts at 19 for simplicity in addition to which it is inconceivable that with the bloodlust created by the press and fostered by the government a sentence less than level 19 could be imposed. As you can see, the table only goes to a level 43 which mandates a life sentence.

These men are looking at life in prison! And they have not even been accused with causing any loss! In future posts, I will begin dissecting the indictment, not from a legal viewpoint, but from the viewpoint of one who has already gone through the process.

The Indictment

2008-06-24T08:25:00.002-04:00

On June 18, 2008, the government filed an indictment in US District Court for the Eastern District of New York against Ralph Cioffi and Matthew Tannin, the two former hedge fund managers at Bear Stearns. This post is an attempt to put into English what the government is attempting to do.

The defendants are charged with violating:

1. 15 USC Sections 78j(b) and 78ff. The are the sections of the US Code that charge securities fraud.

2. 18 USC Section 371...Conspiracy to commit an offense

3. 18 USC Section 1343...Fraud by wire, radio or television

4. 18 USC Section 2...charging them as principals

5. 18 USC Section 981...forfeiture allegations

6. 18 USC Section 3551...If guilty, imprisonment

7. 21 USC Section 853(p)...if guilty, forfeiture of substitute property

8. 28 USC 2461(c)...the government's power to enforce forfeiture

They are the sections of the US Code that Cioffi and Tannin allegedly violated.

If you are paying attention by this point, you will have noticed that the "violations" of 2 through 8 enumerated above are all predicated upon a crime having been committed. In other words, 2 through 8 require a crime to have been committed in order for them to come into play. The only allegation of a crime is 1, an allegation of securities fraud.

In order for there to be securities fraud, a security must have been offered, purchased or sold at a price that is not market value. There is no ambiguity, no gray area, no innuendo. A security must have been offered, purchased or sold at a fraudulent price.

You can guess what the indictment is missing...that fraudulent price.

Instead, the indictment states that the total losses in the funds exceeded $1 billion. The indictment does not claim that the defendants took the money or that they profited by that amount.

If the government is successful in its prosecution, and considering the blood lust it is creating, it probably will be successful, these two men will spend the rest of their lives in prison. Plus, they and their families will be left destitute.

More later.

They did it

2008-06-19T20:24:00.001-04:00

They actually did it. They indicted and arrested the two hedge fund managers for the Bear Stearns hedge funds, Ralph Cioffi and Matthew Tannin. For those of you interested, a copy of the indictment is available from The New York Times.

I just downloaded a copy and will be posting an analysis in the near future. However, based upon what I read so far, this is not going to be an easy case for the government. That is assuming the defendants will be allowed to defend themselves.

The only comment I will make now is this is a day that most investment advisers had been hoping would not come. What the government is saying by instituting this action is if you lose client funds you can be sent to prison even if you did not profit.

The effect is chilling.

Indict the Bastards!!

2008-06-17T17:01:00.002-04:00

Can you imagine! Someone actually lost money in a hedge fund! And now the cry goes up to indict the money managers, have some sort of trial or better yet a plea bargain, then throw the bastards in jail.

I promised myself when I started this blog that I would not rant about the legal system. But yesterday's Wall Street Journal really got to me.

On the front page was an article about the two Bear Stearns hedge fund managers facing a possible indictment. Why? Because they had the audacity to "paint a rosy" picture of their funds. In case you missed the article, it is available from The Wall Street Journal.

Ralph Cioffi and Matthew Tannin were the managers of "two high-profile bond portfolios." According to the Journal, they could be indicted within the next week.

Having been there and faced the same problems, I have only one piece of advice. Fight this as much as you possibly can. Do not entertain a plea bargain nor be cooperative in any respect. These people are out for a trophy, and you are the target.

Accusations of painting a rosy picture of the fund are hollow at best. I guess they would have you paint a bleak picture of the outlook so the run on the bank could have started sooner with the same results.

Painting a rosy picture of an enterprise is not illegal, if you believe the picture. Unless it can be proven that you offered, purchased or sold a security at non-market prices or that your actions caused a security to be offered, purchased or sold at non-market prices, a fair and impartial judge must dismiss any indictment presented.

Good Luck.

Too little too late

2008-06-09T19:29:00.001-04:00

Last week I was looking over the headlines at Market Watch for interesting articles about changes in municipal finance. What really looked out of place was a piece written by Alistar Barr titled Regulators try to ease selling pressure on muni's.

The fact that this article ran on June 2, 2008 begs the question where has the National Association of Insurance Commissioners been for the last eight months!

On October 13, 2007, Penn State was trouncing Wisconsin 38 to 7. AMBAC's stock price had closed the prior day at 68.96, down from a high of 96. But anyone who was aware of the financial markets knew the monoline insurance companies were in serious trouble. You don't lose a third of your market capitalization without some sort of alarm going off.

The National Association of Insurance Commissioners did nothing.

Fast forward to January 1, 2008. AMBAC's stock price has now fallen to 26, having lost about 75% of its market value in less than a year. And Wisconsin was on the losing end in the game with Tennessee.

By now everyone knows there are major problems with municipal bond insurance companies. The market for municipal bonds is freezing. Liquidity is vanishing.

The National Association of Insurance Commissioners did nothing.

But here on June 2, 2008, we are to believe that the Association is going to save the day by assigning its own credit ratings through its Securities Valuation Office ("SVO").

Just think of how much more credible the action would have been had the Association made its announcement in October. Better yet, how about a decade ago.

I'm sure the market awaits the time when the SVO assigns a rating to a municipal issue higher than the rating given by Moody's or S&P. Maybe it's time for a little long range planning on the part of the Association.

Time to cry UNCLE!!

2008-05-31T11:56:00.001-04:00

After almost 35 years of effort by the federal government, it may be time for the municipal bond market to cry uncle and give up the “benefit” of tax-exempt status on municipal bonds. Since 1974, the federal government has been placing a stronger and more vicious stranglehold on the muni market. It appears that the government’s long quest for the holy grail of no tax-exempt bond issues may be close at hand.

Recently, the United States Supreme Court held that the state of Kentucky could tax the interest paid by another state to a Kentucky resident. According to the Court, such taxation does not run afoul of the “Commerce Clause” of the U.S. Constitution. While this decision may be seen as a victory for Kentucky, it realistically should be viewed as a substantial setback for the proponents of maintaining the tax-exempt interest on municipal bonds.The Opinion is here.

Between the chipping away at the municipal market by the government through the operation of the arbitrage regulations and the self-destruct mode the muni market has been in for the last few years, it really is just a matter of time before all municipalities lose the right to sell tax-exempt bonds.

While this may be greeted with glee from some parties, Joe Mysak, Bloomberg, the halls of Congress and the SEC, we taxpayers will wind up shouldering most of the cost.

At this time, the spread between municipal and corporate rates is about 1%. In percentage terms, municipal rates are about 81% of AAA corporate rates. With approximately $200 billion in municipal debt being issued this year, the increase in borrowing costs will be about $2 billion annually.

But rather than trying to defend and keep the tax-exempt status, the municipal market would be well served to attempt to fashion a plan whereby they give up exempt status in return for other items.

For example, the elimination of the arbitrage regulations could be first on the list to be eliminated. It has been estimated that the costs of compliance with these regulations costs the tax-exempt market approximately $600 million a year.

Next, the federal government should be willing to eliminate its own tax-exempt status on the bonds it sells. Currently, municipalities cannot tax the interest on US government bonds; imposing an effective 5% rate on the interest paid on those bonds could generate almost a billion dollars per year. And that amount is only going up as the growth in federal borrowing exceeds the growth in municipal borrowing.

Lastly, eliminating the tax-exempt status of municipal bonds would open a huge new market of investors. Pension funds, IRA’s, Keogh’s, and other tax-exempt investors would all now be attracted to municipal bonds. The increase of efficiency and tradability in the market would assist municipalities in the issuance of their bonds.

Borrowing Costs

2008-05-22T18:45:00.001-04:00

Recently, a lot of attention has been placed upon the borrowing costs of municipalities. Congressman Barney Frank has held hearings and has threatened the rating agencies, attempting to cajole them into rating municipal bonds on the same plane as corporate bonds.

At the same time, California State Treasurer Bill Lockyer has stated a campaign to have that state start its own insurance program to insure municipal bonds issued by California municipalities. His analysis suggests that municipal borrowing costs could be reduced if the state operated its own insurance program.

It is very easy to fall into the trap of more government oversight and government sponsored enterprises will benefit the taxpayer. But the facts make one question whether these efforts are really sound.

According to data published by the Federal Reserve, from 1977 until 1986, the yield of the Bond Buyer index averaged 76% of the yield of "AAA" Corporate bonds. The range was 64% to 92%.

After the tax reform act of 1986 reduced marginal tax rates, the average from 1987 until June of 1993 was 79% with a high of 90% and a low of 72%.

In June of 1993, the Internal Revenue Service issued its "Final" Arbitrage Regulations. Even that did not materially change the spreads. From June of 1993 until the end of 2003, municipal yields averaged 77% of "AAA" corporate with a maximum of 88% and a minimum of 70%.

Since 2003, the average spread has been 81% with a maximum of 91% and a minimum of 76%. It does seem that the level has risen but not markedly so.

Proposals to "fix" the municipal market have been around for decades. Fortunately, most of them have not been put in place. And I seriously question whether more government programs will materially affect the municipal borrower's cost of funds. The "AAA" corporate and the Bond Buyer yield spreads have been among the most stable and consistent over the last 40 years.

Be careful not to fix something that is not broken.

JP Morgan's Wells Notice

2008-05-19T14:17:00.001-04:00

Recently JP Morgan has received a Wells notice from the Securities Exchange Commission. A Well's notice is official notification that regulatory action is being considered. But what's interesting about this is there is some question whether the SEC actually has jurisdiction for the action it is considering.

The SEC has the responsibility to insure the effective and honest operation of the securities markets. Their primary jurisdiction is contained in the US Code at Title 15 Sections 77q(a) and 78j(b) and Rule 10b-5. It is a well settle point of law that fraudulent activity under these sections must happen in the "offer, purchase or sale" of a security. The problem the SEC has is that the security owned by the municipalities was sold to them at market value pursuant to the government's own regulations.

It is possible for the Commission to claim that if Morgan violated the bidding procedure detailed in the arbitrage regulations (see the following post), that the market value of the derivative in question was misrepresented. But first, the SEC would have to show what the correct market value should have been and how Morgan's alleged misbehavior caused the market value to be misrepresented.

It appears that the jurisdiction for this case may not rest with the SEC. The crux of the government's argument is that Morgan may not have followed bidding procedure, not that the derivative was sold at other than market value. The IRS may have a claim against Morgan, because Morgan's actions may have cost the government some measure of arbitrage profit, but that is a claim not involving the SEC. What should not be forgotten is that the owner of the derivative, the municipality, probably acquired the derivative at fair market value.

Bid Rigging Lawsuits

2008-05-18T16:12:00.000-04:00

On April 24, 2008, the City of Oakland California instituted a class action lawsuit against many of the largest financial firms in the country. The list of those sued reads like a Who’s Who of finance. Bank of America, Wachovia, J.P. Morgan Chase, Bear Stearns, AIG Financial Products Corp., Merrill Lynch, Morgan Stanley, Société Générale and UBS among others were alleged to have conspired to fix the prices of guaranteed investment contracts. A copy of the complaint can be found at: http://www.lieffcabraser.com/pdf/20080400-gic-complaint.pdf

This lawsuit follows right behind another suit against essentially the same parties, but filed by Fairfax County Virginia, City of Chicago, State of Mississippi and others also alleging the financial firms of conspiring to fix the price of derivatives sold to the municipalities.

What appears to be missing from both suits is any allegation that any of the municipalities actually lost money due to the alleged misbehavior of the financial institutions. Sure there are allegations that the institutions conspired to fix the prices of the derivatives, but neither complaint states how this harmed the municipalities. To understand this, you must have an understanding of the IRS arbitrage regulations. The easiest way to understand this is through an example.

Assume that the City of Chicago borrowed funds in the tax exempt market at 1% on $100 million for a year. These suits would have us believe that if the financial institutions had not conspired, the earnings on the investments would have been higher, producing an increase in earnings. In fact, that could not happen.

Assume that the free market yield of the derivatives would have been 3% and that through the conspiracy the actual yield was reduced to 1.5%. Through the operation of the arbitrage regulations, the City of Chicago must pay to the IRS $500,000, the profit it earned by investing for a profit. Now assume the market was not fixed and the City was able to invest at 3%. Now they would get to pay the IRS $1,500,000. In other words, the conspiracy, if it existed, did not harm the municipalities that filed the lawsuits.

One would have to question why file the lawsuit. Is it possible the municipalities are attempting to distance themselves from the financial firms that supported them and rush onto the side of the federal government that has instituted an investigation of the municipal market?