Aug. 3 (Bloomberg) -- Wall Street banks setting up bond sales for U.S. states and cities would be required to tell public officials about potentially costly risks and conflicts of interest in the deals under proposed rules.
The Municipal Securities Rulemaking Board, which writes regulations for banks that work in the tax-exempt debt market, said yesterday that it asked the U.S. Securities and Exchange Commission to approve the proposed rules placing greater disclosure requirements on bond underwriters.
The move is part of an effort to reshape regulation of the $2.9 trillion municipal-securities market after the 2008 financial crisis. Since then, state and local taxpayers have been stuck with billions of dollars in unexpected costs because complex bond deals, pitched as money-savers, backfired.
“A lot of obligations are placed on underwriters that weren’t there,” said David Lipton, a former rulemaking board member who teaches law at Catholic University of America in Washington. “That’s good for the investors, and that’s good for the industry.”
The rules would require banks to disclose all “material risks” of bond financings, including the floating-rate securities coupled with interest-rate swaps that once flourished. Banks also would have to disclose potential conflicts of interest, including incentives they have to recommend such transactions, payments they may get from other parties in the deal and whether banks are betting on derivative contracts that only pay off if the borrower defaults.
The rulemaking board today told financial advisers that they may face the regulations placed on broker-dealers if they arrange private placements of securities sometimes characterized as bank loans, a growing niche in the public-finance market. Standard & Poor’s estimates that as much as 30 percent of municipal borrowing this year may be drawn directly from banks.
The board’s added task to protect municipalities from financial malfeasance was included in the Dodd-Frank financial overhaul law signed last year after the 2008 financial crisis revealed cracks in oversight of the market.
Before Dodd-Frank, regulators provided no supervision of interest-rate swaps that proved costly to state and local governments or the financial advisers who recommended the deals.
“This proposal is a groundbreaking effort in ensuring the interests of state- and local-government bond issuers are further protected in their transactions with underwriters,” Lynnette Kelly Hotchkiss, executive director of the board, known as the MSRB, said in a statement yesterday.
Rules aimed at protecting municipalities make sense, given that investors are also potentially hurt when financings unravel, Lipton said. In Jefferson County, Alabama, officials are considering whether to declare bankruptcy because of bond deals laden with swaps that unraveled.
“If the issuers are torpedoed by an underwriter’s failed scheme, the investors are going to be torpedoed,” Lipton said.
The U.S. Commodity Futures Trading Commission is drafting rules that would force banks that pitch interest-rate derivative deals to also disclose details about the risks, act in the customers’ best interests, and ensure that they have the financial wherewithal to handle the potential impacts of wrong-way bets. The MSRB and the SEC are putting in place regulations for financial advisers.
As many as $300 billion worth of interest-rate swaps were sold to municipalities a year before the financial crisis, according to an estimate from the rulemaking board.
The swaps were paired with floating-rate bonds such as auction-rate securities, whose interest rates climbed when banks began hoarding cash and stopped propping up that market. The swaps often failed to produce the protection from rate changes that they were designed to provide and required penalty fees to break.
The proposal also would make explicit that underwriters must pay a fair and reasonable price for bonds they buy directly from localities. That step would potentially prevent banks from reaping outsized profits or steering quick gains to favored clients by providing them with bonds that were underpriced in the initial offering.
“Dodd-Frank explicitly requires the MSRB to protect municipal entities,” Hotchkiss said. “This gives us the ability to establish detailed requirements for underwriters and make important information more readily available to state and local governments that sell bonds.”
The rulemaking board’s proposal is subject to the SEC’s review and approval.
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