William Selway

Board aims to toughen rules for the municipal bond market and its investors

By William Selway
Bloomberg News / August 3, 2011

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Wall Street banks hired to arrange bond sales for states and cities may be forced to tell public officials about potentially costly risks and conflicts of interest involved in the deals.

The Municipal Securities Rulemaking Board has asked the Securities and Exchange Commission to approve greater disclosure requirements for bond underwriters.

The proposal is among moves to reshape regulation of the $2.9 trillion municipal securities market. Since the 2008 financial crisis, taxpayers have been stuck with billions of dollars in unexpected costs because complex bond deals, pitched as money-savers, backfired.

The proposed 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 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,’’ said Lynnette Kelly Hotchkiss, executive director of the board, known as the MSRB.

Rules to protect municipalities make sense, given that investors are also hurt when financings unravel, said David Lipton, who teaches law at Catholic University of America.

In Jefferson County, Ala., 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 Commodity Futures Trading Commission is drafting rules that would force banks that pitch interest-rate derivative deals to disclose details about the risks, act in the customers’ best interests, and ensure they have the financial wherewithal to handle the potential impacts of wrong-way bets. The MSRB and 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 Dodd-Frank law also empowers the rulemaking board to draft protections for local government officials.

William Selway writes for Bloomberg News.