Bond Advisers: Pay-to-Play, Phantom Bonds, and a Serious Lack of Transparency

An article in yesterday's New York Times points to yet another clever end run around ethics laws involving municipal bonds. Bond underwriters are not allowed to make campaign contributions, to prevent a pay-to-play environment. However, financial advisers, the people who hook local governments up with bond underwriters, are allowed to make campaign contributions. And so they do, in large quantities, it appears, even though they work closely with underwriters as a team.

In fact, it was contributions such as these that led to New Mexico Gov. Richardson's withdrawal from his nomination as Commerce Secretary (the Times article focuses on the financial adviser involved in New Mexico).

Another scheme this article points out is the failure in some cases to use bond proceeds for legitimate government works, which is required by law (such bonds are referred to as "phantom bonds"). Why would the proceeds of government bonds not be used for government works? Because then money managers can invest the proceeds at higher rates and make big money for themselves, as well as money for the local governments. If making money is what local governments are supposed to be doing.

In Gulf Breeze, FL, a local housing authority issued $200 million in bonds, $12 million of which went to pay financial advisers and companies. The rest sat in an account making money. Not one cent was spent on housing. Only a little was spent on housing in a similar deal in Pulaski County, AR.

The most serious problem here is a lack of transparency. Citizens have little idea what bonds are being used for (unless, say, there's a school or stadium built with them) or who's getting paid what in the deals. The article's most frightening paragraph is about transparency:

When challenged by the I.R.S., a local government typically hires lawyers and works out a settlement, sometimes quietly paying restitution. That protects the buyers of the bonds from having to pay tax on their interest. It also keeps the problems quiet since the I.R.S. is generally barred from discussing tax cases.

“If this had been visible to the marketplace, we wouldn’t have had these problems,” said Christopher Taylor, former director of the Municipal Securities Rulemaking Board. The MSRB is now asking Congress for the authority to cover consultants and other advisers in the municipal bond business as well as bankers and brokers. Let's hope it gets this authority.

And let's hope the I.R.S. changes the rules so that local government settlements with it are required to be made public. Governments are not individuals, who have a right to privacy. Governments should have no right to hide any misconduct, or its cost to taxpayers.

See my 2007 blog entry on the federal investigation, and these two related blog entries:  Birmingham gifts, local government fiduciary duties.

For more info on what he calls "black box deals," with a partisan angle, see Robert Verdi's blog.

Robert Wechsler
Director of Research-Retired, City Ethics

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