The U.S. Securities and Exchange Commission in August will begin enforcing regulations that require banks to warn state and local governments about the risks and conflicts of interest in bond deals they arrange.
The rules were proposed by the Municipal Securities Rulemaking Board last year and are aimed at preventing Wall Street underwriters from steering public officials toward complicated debt financing without disclosing the risks. They were approved May 4 by the SEC, which will enforce them.
The disclosures are part of the effort to reshape financial regulations to prevent a repeat of the credit-market crisis of 2008, and stem from Congress’s decision to provide added protections for state and local governments. The economic crisis hit taxpayers with billions of dollars in unexpected costs when complex bond deals, once pitched as money savers, backfired as credit markets seized up.
“These new rules are the biggest development in protection of the financial interests of state and local governments since the MSRB was established in 1975,” Alan Polsky, the chairman of the board, said today in a statement.
Under the regulations, banks that underwrite bond deals for public officials will have to disclose risks tied to those transactions. Among them is the possibility that interest costs could soar, as they did for local governments that issued floating-rate bonds tied to derivatives known as interest-rate swaps. Those contracts failed to produce the protection from rate changes that they were designed to provide and forced governments to pay penalties to escape when they backfired.
Banks will also have to disclose incentives they have to recommend such transactions, including payments received from other parties in the deal, such as a bank that provides investments or derivatives in connection with it.
Underwriters will have to disclose whether they trade credit-default swap contracts that provide them money only if their client stops paying its debts. Selling those contracts, a type of insurance for investors, might mean the bank is encouraging others to bet against a government that hired it to work on its behalf. The practice has drawn scrutiny from California Treasurer Bill Lockyer.
The new rules are a response to Wall Street’s once-widespread practice of selling derivative-laden financing to state and local governments on the grounds that it would lower borrowing costs. The derivatives provided banks with higher fees, which were rarely, if ever, disclosed. The contracts were also behind the $4.2 billion bankruptcy of Jefferson County, Alabama, the largest filed by a U.S. municipality.
The rules are intended to protect governments by providing them with information to assess transactions. They also guard against excessive fees and require explicit disclosures by underwriters about the nature of their job, including whether their pay depends on a deal’s going through.
“You want to give state and or local officials all the information they deserve,” MSRB Executive Director Lynnette Kelly said in an interview.
The rules also make explicit that underwriters must pay a fair and reasonable price for bonds they buy from localities and then resell to investors. That may prevent banks from reaping outsized profits or steering quick gains to favored clients by providing them with bonds underpriced in the initial offering.
The new regulations stem from the Dodd-Frank law signed in 2010, which called on the MSRB to write rules to protect municipalities, instead of just those who buy bonds. The U.S. Commodity Futures Trading Commission has also drafted rules to protect local governments that enter into derivative trades.