Oct. 22 (Bloomberg) -- State, county and municipal entities across the nation enjoy a privileged position in the debt markets -- the interest they pay is often tax-free and their market is lightly regulated. So, how is it possible that local entities frequently pay too much to borrow money?

Consider the example of Build America Bonds. Part of President Obama’s economic stimulus program, the U.S. Treasury subsidizes their repayment, providing issuers with 35 percent of debt service costs. While BABs are taxable rather than tax- exempt, the subsidy gives them a far bigger advantage.

Because of their taxable nature, BABs enable an apples-to- apples comparison with similarly rated corporate bonds. And yet invariably, BABs are priced worse than their corporate equivalents.

For example, the AAA-rated Metropolitan Water Reclamation District of Greater Chicago sold $600 million in BABs in August. Bonds due in 2038 were priced to yield 5.72 percent. During this same period, AAA-rated Johnson & Johnson had similar bonds trading at an implied yield of 5.33 percent. Had Chicago’s authorities borrowed at the same rate as J&J, they would have saved taxpayers $68.6 million over the lifespan of the bonds.

Even so, the treasurer of the district professed himself “really happy” with the net result. It is a common practice for city and state treasurers to put out press releases bragging about how their bond issues have been oversubscribed. That’s like a retailer bragging about how it sold out of merchandise priced at a loss.

Poor Pricing

If there was any doubt as to the wisdom of the Chicago pricing, it was dispelled within a few days, when those bonds -- priced at par when issued -- were trading on the open market at prices as high as 102.58. Investors recognized the yield on the Chicago bonds was too high, and were willing to pay a premium to lock in those rates.

This is unfortunately typical of U.S. municipal markets. But why?      In the interest of public education, allow me to focus on the three main reasons the municipal bond market leaves taxpayers at a disadvantage.

The first is the nature of public entities. Any bond buyer looks at a lender the way a bank does -- how much risk is involved? While political entities have the power to raise revenue at will through taxation, default isn’t off the table.

Repudiating Debt

In fact, because local government officials make decisions based on political expediency rather than fiscal prudence, there are many, including Warren Buffett, who fear municipal issuers might simply make a political decision to repudiate their debts. It doesn’t help that municipal bond issuers frequently fail to disclose material events in their filings, or miss their filings altogether.

Investors don’t necessarily assume all issuers are going to default, but they demand a premium for the elevated risk. And so municipal bond issuers all have to pay a higher yield.

Second, the municipal bond market is complex, and complexity invariably raises costs. Municipal bond buyers must navigate laws and tax treatments that vary from state to state. Municipal bonds use unique features such as calls and sinking fund schedules, both of which allow issuers to retire bonds before their stated maturities. In 2004 the SEC released a report saying that issuers “may be able to raise funds at lower cost by creating simpler bonds.” It is apparent that many municipal offerings are too complicated for their own good -- and taxpayers pay the price.

Uninterested Officials

The third reason municipalities pay too much to borrow money is also the most important: Many elected and appointed officials simply don’t care.

A long time ago, selling bonds was the rather mundane duty of government finance officers who sold their usually simple bond offerings by auction, in a so-called competitive sale. If banks and securities firms wanted to buy a municipality’s bonds and resell them to the public, they had to submit bids. The bid that resulted in the lowest cost to taxpayers won the business.

Naturally, underwriters didn’t like these arrangements. This was far riskier for them since they could end up with unsold bonds on their hands. So during the 1960s, banks and securities firms worked hard to persuade elected officials to choose underwriters first and then worry about the actual terms later.

There was no need for this kind of an arrangement, a so- called negotiated sale, unless you were an issuer with weak credit, no credit, or with huge borrowing needs. But banks pitched negotiated sales hard.

Pay to Play

Why did politicians go along? Because if underwriters competed on everything but price, they would compete in other ways. Campaign contributions, donations to favored charities, sweetheart employment deals for politically connected friends and relatives, and other “pay to play” gimmicks were the new currency of the municipal bond market.

I saw this first-hand: I was once an investment banker trying to establish a small firm in the municipal bond market. Yet nearly every time I approached a community treasurer or finance committee for business, I was told my chances would improve dramatically if I purchased a table or several tables at the local or state political party dinner. Such payments were the price of admission to the marketplace.

While the most egregious forms of influence peddling have been shut down, many continue to persist. And they persist because they work.

In 1978, 54 percent of all municipal bonds were sold through negotiated sales. Today, almost 90 percent are.

Taxpayers should be irate. They are being forced to pay for debts issued at above-market interest rates precisely because their elected leaders will not force underwriters to compete on price.

It would be one thing if the so-called professionals at least protected their clients from risk. But we have seen a series of busted offerings caused by exotic products and techniques that most public officials didn’t understand or even want. The underwriters told public officials to “leave the driving to us.” Instead, taxpayers were all taken for a ride.

(Arthur Levitt, former chairman of the Securities and Exchange Commission, is an adviser to the Carlyle Group and Goldman Sachs Group Inc. and a director of Bloomberg LP, parent of Bloomberg News. The opinions expressed are his own.)

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To contact the writer of this column: Arthur Levitt at alevitt@bloomberg.net

Last Updated: October 21, 2009 21:00 EDT