Nov. 2 (Bloomberg) -- Vincent “Smiley” Gallegos, who ran a state housing agency out of an office next to a used-car lot in Albuquerque, New Mexico, should have known better when he borrowed $27.7 million, the Internal Revenue Service said.

Gallegos, then the executive director of Region III Housing Authority New Mexico Inc., sold bonds in February 2003 with the help of Los Angeles-based CDR Financial Products Inc. and its founder, David Rubin.

“At the time the authority issued the bonds, there was ample evidence that the program would not be successful,” the IRS wrote in March 2007 after investigating the transaction. “A prudent person would not have taken the same actions.”

Two months later, federal tax authorities revoked the bonds’ tax exemption. The IRS found that one of the agency’s banks, Paris-based Societe Generale SA, would earn as much as $1.5 million on a program for low-income and first-time homebuyers that lent only about $2.6 million. Tax authorities also found that CDR was collecting more than $50,000 a year from Societe Generale in fees not disclosed in public bond documents.

Gallegos, 56, and Rubin, 47, are under criminal indictments as the result of separate investigations unrelated to that debt.

The unraveling of Region III investments shows how municipal financing arranged in the dark costs as much as $6 billion a year through lack of disclosure, officials’ mistakes and public corruption, according to data compiled by Bloomberg. It also reveals how financial professionals may enrich themselves by taking advantage of a tax benefit worth $36 billion a year to state and local governments and non-profit agencies that borrow.

Rubin Indictment

Gallegos, a former five-term Democratic state representative, oversaw two troubled bond issues in 2003. Region III defaulted on the second series of bonds it sold in July of that year to a state investment fund chaired by Governor Bill Richardson, a Democrat. Two grand juries in Albuquerque indicted Gallegos on June 19 on criminal charges of fraud, embezzlement, money laundering and conspiracy related to the operation of Region III.

“No jury is going to find that Smiley violated any law,” said Gallegos’ attorney, Paul Kennedy, a principal of the Kennedy & Han PC law firm in Albuquerque, in an interview.

Rubin, his investment advisory firm and two of its employees were named on Oct. 29 in a federal indictment in U.S. District Court in the Southern District of New York. The nine- count criminal conspiracy case alleges bid rigging and price fixing on investments that CDR brokered from 1998 to 2006. Rubin is contesting the charges.

‘Very Sad Tale’

New Mexico’s State Investment Council, chaired by Richardson, is suing Gallegos, alleging “fraud and deceit” and seeking to recover $5 million it invested in the housing authority.

“It’s a very sad tale and $5 million of our taxpayer money that was meant for housing -- for people who needed it -- didn’t get built,” said Frances Williams, who served on a state housing board in Las Cruces that contracted Region III’s management from 2004 to 2006. “It was squandered and stolen.”

CDR advises schools, towns and utilities on how to invest their tax-exempt debt proceeds. It also packages credit guarantees that make the bonds of small agencies such as Region III salable to institutional investors.

By the time CDR worked with New Mexico authorities, it had helped at least seven housing agencies nationwide on bond sales the IRS would investigate and challenge, public filings show. Only 15 cents of homeowner loans were made for each dollar raised through these offerings, according to the IRS. Its March 2007 letter to New Mexico officials said that 85 percent of the debt proceeds should have gone toward a governmental purpose to maintain the bonds’ tax-exempt status. Region III lent less than 10 cents on the dollar, the IRS said.

Perennial Struggle

Gallegos faced a perennial struggle to promote home ownership without a state appropriation to fund his agency. While the legislature gave Region III bond-issuing authority, lawmakers provided no money for operating costs.

In early 2002, the agency’s bond counsel, Robert Strumor, traveled to Southern California to discuss a lease-to-own financing program CDR previously had packaged in California, Arizona and Georgia, according to Los Angeles investment banker Ken Chilton, who said he hosted Strumor.

“CDR basically owned the process by which the financial feasibility of this structure was made possible,” said Chilton, executive vice president of Chilton & Associates, in an interview. “In other words, you could not do this deal without CDR.” He said he registered his firm in New Mexico that June to help underwrite the issue while Gallegos obtained a loan in November from Capital Concepts Inc., an asset-backed lender, to tide the agency over until the sale.

No Operating Income

“It’s crazy,” said Hank Harenberg, Capital Concepts’ founder and chief executive officer, in an interview. “The state set them up and didn’t fund any operating income.”

Harenberg said he advanced $75,000, taking as collateral Region III bond-issuing fees and a mortgage on the agency’s headquarters. Gallegos had arranged for Region III to purchase the building five months earlier with a one-time legislative appropriation.

Region III sold the $27.7 million bond issue to private investors in a deal managed by RBC Dain Rauscher, a unit of Toronto-based Royal Bank of Canada. Chilton and Associates was paid a $145,670 structuring fee along with $10,000 in reimbursement while Strumor’s firm got $45,000 as bond and tax counsel, according to the bond transcript book.

Undisclosed Fee

Region III received $56,482.33 in administrative fees and Gallegos, as the program’s compliance agent, was to collect $200 for each loan he reviewed, the deal records show. “The program was not successful. There was only 47 lease-to-own contracts,” the IRS said in the March 2007 letter.

Rubin’s firm got $50,000 for structuring the credit guarantee, the bond transcript shows. Undisclosed in the bond documents was the fact that CDR also was receiving a $13,812 quarterly fee from Societe Generale, according to the IRS.

“Societe Generale had an ongoing arrangement with CDR to promote similar abusive arbitrage devices,” the IRS said in its letter to the agency. Societe Generale spokesman Jim Galvin didn’t respond to a request to comment for this story.

Chilton said the administration of Region III was chaotic.

“They were always trying to draw on the bond proceeds in ways that didn’t have to do with the lease-to-purchase program. That was always shot down,” he said. ‘It was shocking because they represented themselves to be capable and knowledgeable.’’

Disciplinary Action

Five months after the CDR-related deal, Gallegos and Strumor managed the separate $5 million sale of housing bonds to the State Investment Council. Under Gallegos, the authority then provided free housing to political allies, including a metropolitan court judge who dismissed a traffic citation against him, according to a disciplinary action at the state Judicial Standards Commission.

Gallegos collected $7 in retirement contributions from his employer for every $1 he chipped in, according to an investigation by the State Investment Council. Region III paid him an average annual salary of $190,000 and lent his real estate company, VSG Inc., $300,000 in January 2005 in a transaction the housing authority board approved a day after the loan was made, the investment council probe found. Gallegos resigned from the housing authority in August 2006, 2 ½ weeks after he repaid that debt.

Region III ran out of money and defaulted on the bonds less than three years after issuing them, according to the civil lawsuit the investment council filed in May 2008 against Gallegos and Strumor in state court in Bernalillo County. The complaint seeks repayment of the $5 million plus interest.

Political Contributions

The state attorney general’s office then filed criminal charges. One of the June 19 indictments against Gallegos also names Strumor, 64, accusing him of fraud, money laundering and conspiracy. The men and two other defendants in the cases pleaded not guilty. No trial date is set. The state brought no action related to CDR’s work.

Gallegos didn’t open the door of his home in Albuquerque when a reporter knocked, nor did he answer his mobile phone. Strumor declined to comment.

While the attorney general’s office was examining Region III, a federal grand jury was looking into whether $120,000 in contributions Rubin made to Richardson’s political causes helped his firm secure $1.5 million in financial advisory work on a $1.1 billion state transportation bond issue.

Richardson cited the probe in January when he withdrew his nomination as President Barack Obama’s choice for Commerce secretary. His office issued a statement asserting vindication after the investigation was dropped.

Process Corrupted

Prosecutors found that “pressure from the governor’s office resulted in the corruption of the procurement process so that CDR would be awarded” advisory work, according to a letter from U.S. Attorney Gregory Fouratt to defense lawyers.

Fouratt didn’t respond to a request for comment and has not said why he dropped the case.

“It is not to be interpreted as an exoneration of any party’s conduct in that matter, nor should it be interpreted to address other conduct that may be under investigation,” he wrote to the prospective defendants.

The federal bid-rigging indictment against Rubin makes one reference to New Mexico. On May 20, 2004, a CDR employee and a representative of a Connecticut-based financial services group identified as “Marketer B-2” spoke by phone between New Mexico and New York, prosecutors alleged. The marketer was checking “to make sure that a bid at the rate suggested by Rubin would be a winning bid and then submitted a bid in accordance with Rubin’s suggestion,” according to the indictment. While that is the date when New Mexico sold the transportation bonds that CDR worked on, federal prosecutors identified this transaction as being for a state housing authority without naming the state.

Abolishing Region III

“The Justice Department is committed to protecting the competitive process and will hold accountable individuals and companies who participate in illegal and anti-competitive conduct,” said Assistant Attorney General Christine Varney in announcing the charges against Rubin and the co-defendants.

Rubin’s attorney, Donald Etra, said in an interview the case against his client has no merit. Rubin declined to comment.

The New Mexico legislature reorganized the state’s non- profit housing authorities in March, repealing their bond- issuing authority and abolishing the Region III agency that had lain dormant since it collapsed. New Mexico’s chief investment officer, Gary Bland, who oversaw the fund that bought the Region III bonds, resigned on Oct. 21 amid an unrelated probe into whether money managers exercise improper influence on public officials.

To contact the reporter on this story: Elliot Smith in Albuquerque, New Mexico at esmith29@bloomberg.net.

Last Updated: November 2, 2009 00:27 EST