In April 2000, 12 big municipal bond underwriting firms agreed to pay $140 million to settle federal allegations that they defrauded states and localities in how they reinvested bond proceeds.
A five-year ordeal that had consumed the business was at an end. Or was it?
Yesterday, Bank of America Corp. agreed to pay $137 million to settle accusations it had defrauded states and localities, by cheating them in the reinvestment of bond proceeds business.
The Bank of America settlement is the latest installment of the federal government’s investigation into anticompetitive practices in the municipal-bond industry, including bid-rigging, price-fixing and kickback-paying.
This chapter sounds a little sexier, but it all comes down to a pair of words I’ve come to dread over the last 15 years: yield-burning. Will it never end?
In January, I will have been covering the municipal market for 30 years. Yield-burning has consumed half of it.
The key feature of municipal bonds is their exemption from taxes. When municipalities sell tax-exempt bonds, they are prohibited from reinvesting the cash and earning a profit.
The idea here is that it serves no public purpose for a municipality to go out and borrow at 3 percent, and take the money and invest it in something that pays 5 percent.
And municipalities do have to reinvest. If they are using the proceeds to refinance an older bond, they take the money and put it into something that will pay off the older bonds until they mature or can be called. If the municipality is selling bonds to build a school or a bridge, that construction can take years; the money is drawn down over time.
It’s sort of like Goldilocks and the three bears. The municipality has to reinvest its money into something that is just right. Earn too little, and it loses money. Earn too much, and it has to rebate the excess to the government. If it doesn’t, and the Internal Revenue Service finds out about it, the agency might declare the interest on the bonds taxable.
Bankers for years said that the real money was in the reinvestment business. They would underwrite bonds for free, some said, if they could get the reinvestment business. It was conducted in the dark, by a relatively small group, and usually nobody bothered to check the math.
So what happened? Way back in the early 1990s, some bankers thought it would be clever to raise the prices on those investments, at the time U.S. Treasury securities purchased in the secondary market, to “burn down” the yield to the level the municipalities were allowed to earn.
This was a profitable game, until a banker named Michael Lissack blew the whistle, and incidentally cashed in via a False Claims Act lawsuit, entitling him to up to 25 percent of whatever the federal government recovered. Lissack called the feds in 1993, and in March 1995 was profiled on the front page of the business section of the New York Times.
The government’s take on this yield-burning business is that municipalities can’t make money on tax-exempt bond proceeds, and they can’t give it away, say to bankers and dealers, in the form of unreasonably high prices on reinvestments.
In 2000, after five contentious years, the yield-burning settlement was reached. And then in 2003, IRS officials said they had discovered funny business in some audits. Issuers were paying inflated prices for reinvestment products. The verdict: Yield-burning.
In November 2006, the Justice Department said it was investigating “anticompetitive practices” in the reinvestment of proceeds business, but the probe had begun years before, with those IRS audits. Similarly, in February 2007, Bank of America said it had entered into a leniency agreement with the Justice Department, and that it had been cooperating for some time. According to a November 2009 lawsuit filed by the Sacramento Municipal Utility District against Bank of America and a laundry-list of other firms, the bank has been cooperating since 2004.
Unlike the last time around, this time people may go to jail. Eight former bankers and financial advisers have already pleaded guilty in connection with the investigation, and they face fines and prison terms. Is this the end of yield burning?
I doubt it.
(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)
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