Oct. 28 (Bloomberg) -- California is the world’s eighth- largest economy. Diamond Offshore Drilling Inc. is the largest U.S.-based deepwater oil driller.

The state known for its wine, Hollywood and earthquakes collected about $80 billion in taxes in the year ended June 30, compared with $3.6 billion in revenue for Houston-based Diamond. The two have similar credit ratings, and the state can rely on its taxing authority to address deficits. Still, the company got a better deal than California when each borrowed money this month.

Even though California has never defaulted on its debt, the state paid 1.5 percentage point more in interest -- a difference that translates into about $785 million in additional cost for taxpayers over the 30-year life of $1.75 billion in Build America Bonds.

California and so many of the 50 states aren’t helping themselves get a better rate, partly because they’re not requiring municipalities to file timely financial information. The disclosure that state and local governments provide to investors is in the “dark ages,” Gary Pollack, of Deutsche Bank AG’s Private Wealth Management unit in New York, said in an interview.

“The municipal bond market is the last bastion of hidden information,” said Timothy Koch, chairman of the finance department at the Moore School of Business at the University of South Carolina in Columbia.

Public officials’ financing in the dark in the $2.8 trillion tax-exempt bond market is costing U.S. taxpayers as much as $6 billion a year, according to data and interviews from more than a dozen states, while the worst recession since the Great Depression forces municipal governments to cut spending or raise taxes.

Exempt From Laws

Federal securities laws that exempt states, cities and school districts from disclosure rules that apply to corporations created an information vacuum that doesn’t help states get the favorable terms they deserve, and boosts yields on public debt issues. A 2008 study found that as many as 25 percent of municipal borrowers go three years or longer without giving investors any information.

“When disclosure is weak or sometimes nonexistent, it allows deals to come at more attractive yields,” said Michael Camarella, portfolio manager on the Rochester, New York-based team that manages about $29 billion in municipal bonds for OppenheimerFunds Inc. “I think it’s a great thing. I wouldn’t want to see it change.”

Kentucky’s Issue

Kentucky taxpayers might. The state sold $209.2 million of Build America Bonds in June at rates of more than 6 percent, and Kenneth Monaghan didn’t order any. Monaghan, who helps manage $35.9 billion as a partner with Rogge Global Partners Inc. in New York, said he avoids state and local government debt because issuers don’t provide enough financial information.

Greater disclosure and information might have saved Kentucky at least $8 million over the 20-year life of the bonds, according to trading records that show interest rates on some bonds dropped more than 30 basis points in less than a month. A basis point is one one-hundredth of a percentage point. The amount would be enough to buy textbooks for 5,400 public high school students each year.

“The interest rates on Build America Bonds should be lower,” said Peter Coffin, president of Boston-based Breckinridge Capital Advisors Inc., which oversees $10 billion of bonds. “Buyers are uncomfortable with the perceived lack of disclosure in the municipal bond market.”

Corporations and Municipalities

Federal law requires publicly held companies to issue quarterly financial statements, details of pending litigation and financial plans. Municipal borrowers must present an annual financial statement and update investors on so-called material events, such as missed payments, instances in which reserve funds are tapped, credit-rating changes or other circumstances that might affect the debt.

California gives investors more information than it has to, said Tom Dresslar, a spokesman for state Treasurer Bill Lockyer.

“The notion that California pays more to borrow because of inadequate disclosure is complete bunk,” he said in an interview. The novelty of Build America Bonds, which have been marketed only since April, may explain why some taxable investors avoided them, he said.

“Issuers may be paying some premium for that newness,” he said.

There’s no penalty for localities that refuse to disclose. Many localities fail to file, according to a 2008 study by DPC Data Inc., a Fort Lee, New Jersey-based company that tracks and supplies municipal disclosure to investors. About a fourth of issuers didn’t provide documentation for three or more years, the company found, led by borrowers with the riskiest credit.

Concentrated Problems

“California, the largest issuing state, has concentrated disclosure problems in the most sectors, particularly economic development, school districts, higher education, local governments, multifamily housing, water utilities and sewer/wastewater treatment,” according to the DPC study.

The study found that 1,771 of a sample of 4,230 California issuers were delinquent on disclosure, almost 42 percent.

While some tax-exempt issuers voluntarily present detailed information about their risk of losing money from interest-rate swaps or other hedging, they’re not required to. Swaps backfired for scores of municipalities during the past two years, costing billions in new debt as they paid banks and insurers to unwind the transactions.

Jefferson County’s Debacle

Jefferson County, Alabama, did several such transactions from 2002 to 2004 as it refinanced more than $3 billion in sewer debt. The financing fell apart as the swaps -- contracts in which officials agreed to exchange payments with banks to hedge against increases in borrowing costs -- backfired and some variable rates more than tripled.

Now the county is on the edge of bankruptcy, and the former president of the county commission, Larry P. Langford, the current mayor of Birmingham, is on trial in federal district court in Tuscaloosa. Langford is charged with accepting Rolex watches, clothing and cash from an investment banker who received $7.1 million from county debt transactions.

As municipal issuers embraced swaps tied to variable-rate debt, they shunned competition in selling their bonds. This year, through September, public officials issued debt without seeking bids for more than 85 percent of the $308.9 billion in new issues, according to data compiled by Bloomberg.

That’s up from 17 percent in 1970 and 68 percent in 1982, according to a 1983 report by the Government Accountability Office.

Pushing Costs

Studies of sale methods, including a 2005 review by the Missouri state auditor, found that, on average and all else equal, negotiated bond sales result in higher borrowing costs than auctions, in which the market determines yields. Most findings have put the difference at 17 to 48 basis points, according to a 2008 article published in the Municipal Finance Journal by Mark D. Robbins and William Simonsen, professors at the University of Connecticut at Storrs.

The no-bid deals and private discussions further limit transparency and present what Christopher “Kit” Taylor, a former top regulator, called “an irresistible invitation to corruption.”

When borrowing, municipalities aren’t obligated by law to provide even such basic financial data as other debts and income that consumer borrowers must disclose.

Regulatory reform that Congress is considering, including an oversight agency for consumer finance, can help bring the market for tax-exempt securities into the open, said Elizabeth Warren, chairwoman of the Congressional Oversight Panel for the Troubled Asset Relief Program.

Demanding Transparency

“We need a worldview change about transparency and that includes municipal finance,” Warren said in an interview this month.

“I believe the single biggest change a consumer finance protection agency would make is to give people financial products they understand, and once that happens they’ll never go back,” she said. “They’ll demand it in other areas, areas such as municipal finance.”

Congress is also considering new financial regulations for public borrowers, including proposals to limit political contributions to local officials from financial advisers and to require credit rating companies to judge municipalities on the same criteria as corporations.

Yet any attempts to improve disclosure standards will encounter opposition from public officials, who say making changes would cost too much, said J. Ben Watkins, director of bond finance for the state of Florida.

High Cost

Providing the same sort of information that corporations do would cost hundreds of millions of dollars nationwide, Watkins said. Most state and local governments already disclose as much information as corporations, or more, he said.

Academic studies suggest that municipalities’ savings could reach billions of dollars. Better disclosure could reduce borrowers’ interest costs as much as by 20 basis points, or 0.2 percentage point, according to Lisa Fairchild, professor and chairwoman of the finance department at Loyola College in Maryland, in Baltimore.

Applied to the entire tax-exempt bond market, that’s $5.6 billion a year -- enough to repave a city street 37,086 miles (59,671 kilometers) long, based on Durham, North Carolina’s average cost of $151,000 per mile. Such a street could circle the earth almost 1 ½ times.

Part of any savings would result from forcing issuers with poor disclosure habits out of the market, improving municipal bonds’ image, Fairchild said.

Rules With Teeth

“If you have disclosure rules with teeth, the riskier issuers may not try to come to market,” she said. “They might get scared away if they knew they had to disclose.”

Build America Bonds, part of President Barack Obama’s economic recovery package, afford a close comparison between municipal issuers and corporate borrowers because interest on them is taxable, as is interest on corporate debt.

Most municipal issues are tax-exempt, a benefit that costs the U.S. Treasury about $36 billion a year and induces investors to accept lower yields for them.

Public borrowers will pay at least $6.1 billion more -- discounted to present value -- over the life of their Build America Bonds than their corporate counterparts will for borrowing, according to an analysis by Bloomberg. Data from Moody’s Investors Service show that corporations are 98 times more likely to default over a 10-year period.

Expected Savings

California was expected to save $350 million using Build America Bonds instead of tax-exempt debt, said Dresslar, the treasurer’s spokesman. Obama’s program provides a 35 percent subsidy for borrowing expenses, essentially transferring that cost to the U.S. Treasury.

And while he doesn’t dispute California’s unfavorable borrowing terms compared with similarly rated companies, he said the gap isn’t because of inadequate disclosure. California provides investors with more than enough information, from required filings to additional financial data on its Web site, Dresslar said.

As the state struggled to close a $26 billion deficit, giving IOUs to creditors in June, investors couldn’t get information they needed, said Richard Ciccarone, chief research officer for Oak Brook, Illinois-based McDonnell Investment Management, which oversees about $11 billion.

“We’d call California and we couldn’t find out how much they had set aside for debt service,” Ciccarone said in an interview. “They always talk like there’s plenty of money. How do we verify this?”

Answered Questions

Dresslar said that on conference calls, state officials answer investors’ questions, including queries about how much cash California has. He also disputed the notion that corporations provide investors with up-to-the-minute details on their cash position.

Municipals investors are becoming more insistent on verifying information, said Taylor, the former head of the Alexandria, Virginia-based Municipal Securities Rulemaking Board, which governs dealers that underwrite and sell bonds in the market.

“The world changed last year,” he said. “You can no longer issue a bazillion dollars of debt and expect investors to take it on blind faith.”

Municipal bond defaults exploded to $7.8 billion in 2008 from $348 million in 2007, according to Miami Lakes, Florida- based Income Securities Advisors Inc., which tracks distressed securities. So far this year, defaults total $4.2 billion. Menasha, Wisconsin, Vallejo, California and 105 community development districts in Florida have defaulted or drawn on reserves since May 2008, although no state has done so since the Great Depression.

Insurers Lose Ratings

Last year marked the first time that seven of the largest AAA-rated insurance companies that guaranteed repayment on nearly half the tax-exempt bonds outstanding lost one or more of their top ratings, forcing investors to rely more on disclosure.

“The rating alone isn’t sufficient to entice investors,” said Paul Rosenstiel, a principal in the San Francisco office of E.J. De La Rosa & Co., an investment banking firm. “There’s concern about disclosure that needs to be addressed.”

The Securities Acts of 1933 and 1934 exempted the municipal bond market from direct federal regulation, said Robert Dean Pope, a public finance attorney with Hunton & Williams in Richmond, Virginia, and author of “Making Good Disclosure.”

State and local debt wasn’t seen as risky at the time because it was composed of general obligation bonds, which are backed directly by taxpayers, Pope said in an interview.

Fraud, Deception, Scandal

“Back in the New Deal, the municipal bond market hadn’t produced fraud, deception and scandal,” Pope said. “As the municipal bond world has changed, the bonds have become more complex and riskier.”

Last year, general obligation bonds made up 28.6 percent of new issues, according to Thomson Reuters data. The rest of the market is composed of bonds tied to specific cash flows for everything from hospitals to convention centers to golf courses.

Under the federal laws, the Securities and Exchange Commission is largely powerless over the municipal bond market. The MSRB writes rules for the market, with SEC oversight, and the Financial Industry Regulatory Authority, which oversees financial professionals who work with municipal issuers, enforces them.

Both self-regulatory organizations, which are overseen by employees of investment banks and securities dealers that operate in the market, attempt to ensure disclosure by requiring bond underwriters to insist on it in their contracts with borrowers -- leaving enforcement to banks that depend on issuers for business.

Regulators Don’t Agree

Investor Lou Fiorentino said he learned that sometimes the two regulators don’t agree on the rules.

Alarmed by increasing writedowns and losses among financial companies, Fiorentino, 62, of Potomac, Maryland, moved $290,000 into Main Street Natural Gas Inc. bonds in April 2008, he said. He thought he was buying a safe security, backed by natural gas and supported by a municipal government in Georgia.

Less than six months later, he learned it was none of the above. He owned a bond guaranteed by Lehman Brothers Holdings Inc., which was by then a bankrupt financial services company.

Since Lehman’s bankruptcy, the bonds have traded for less than 40 cents on the dollar, sometimes as little as 7 cents. Fiorentino said his brokerage, TD Ameritrade, didn’t give him enough information. Kim Hillyer, a spokeswoman for the Omaha, Nebraska-based company, declined to comment for this story.

Official Statement

Later, Fiorentino asked the MSRB and Finra why he wasn’t given an official statement explaining the risks.

The MSRB told him he should have been given one, he said, while Finra said otherwise. In its response, Finra told Fiorentino that he had bought his securities in the secondary market, where there’s no requirement for statements, he said.

That’s not the case, Fiorentino said in an interview. He bought the bonds as a new issue. Finra is “conducting a sweep” looking into the sales and marketing of the Main Street bonds, Herb Perone, a spokesman for the authority, said in an e-mail.

MSRB’s rules require that investors in new issues receive an official statement before the final settlement of their trade, which is within three days of the purchase, Perone said - - not before they buy. Any purchase within 25 days of a bond issue’s closing is considered a new issue.

“Some customers mistakenly believe that they must receive the official statement prior to the purchase trade date,” Perone said.

New Authority

SEC Chairman Mary Schapiro has hinted in public comments that the commission needs new regulatory authority in the municipal market.

Florida’s Watkins said that’s a bad idea. “The SEC has shown its inability to discharge its existing regulatory functions,” he said. John Heine, an SEC spokesman, declined to comment. Most municipalities provide all the information investors need anyway, Watkins said: “We’re an open book, completely transparent.”

Some issuers, including the city of Detroit, only open their books every so often.

In March, Detroit, the largest U.S. city with a below- investment-grade credit rating, presented investors with its annual report for 2007, more than 18 months after the end of the fiscal year. It did so just as it was about to borrow $120 million for its water system.

Patching Disclosure

Issuers often “patch up disclosure problems just before they come to market with a new deal,” said Matt Fabian, managing director and analyst with Westport, Connecticut-based Municipal Market Advisors, a market research firm. “Investors in the new offering don’t know that there is a problem at all.”

Detroit’s budget deficit has widened to $275 million from $155.6 million in 2007, said Elizabeth Foos, an assistant vice president and analyst for Moody’s Investors Service who wrote an August report that accompanied a reduction in the city’s credit rating to Ba3 from Ba2.

The city’s lack of disclosure was one factor in cutting the rating, she said. Lower ratings raise borrowing costs as investors demand higher yields.

“It’s been difficult to get reliable audited financial information from the city in a timely manner,” Foos said in an interview.

Detroit Mayor Dave Bing, who has been in office less than six months, is “committed to fixing the process,” said his spokeswoman, Karen Dumas.

Other approaches to improving disclosure are under way as well.

Information Online

As of July 1, for the first time, investors can find all available disclosure for municipal issuers at the MSRB’s Electronic Municipal Market Access Web site, or EMMA. The site will show how much information each issuer is sharing.

“EMMA will provide evidence for the first time on whether the market rewards strong disclosure practices by municipal issuers,” Lynnette Hotchkiss, the agency’s executive director, said in an interview.

The board has proposed to the SEC that the EMMA Web site note which issuers voluntarily release audited financial statements within 120 days of the end of a fiscal year -- an idea that issuers such as Eric Johansen, debt manager for the city of Portland, Oregon, have criticized as too costly.

“There aren’t enough accounting firms to do that many audits,” Johansen said. Portland would have to hire a dozen employees to prepare the data in time for auditors, he said.

Not Enough Savings

While he agreed that the market would reward issuers’ better transparency with lower yields, he said he doesn’t think the savings would match the increased cost of complying.

Taylor, the former regulator, said that while issuers have resisted for years, improvements in disclosure are inevitable.

“Change is coming to the municipal bond market,” he said. “Whether issuers want it or not, it’s coming.”

To contact the reporter on this story: Darrell Preston in Dallas at dpreston@bloomberg.net.

Last Updated: October 28, 2009 00:01 EDT