Fresh Air in the Muni Market
by Gretchen Morgenson
Monday, August 31, 2009
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The municipal bond market may finally be coming out of the Dark Ages.
Three regulatory initiatives put forth this summer are bringing much-needed sunlight to this $2.7 trillion market. And individual investors, who accounted for 64 percent of all transactions last year, will be the prime beneficiaries.
For the first time, investors have been given access to municipal issuers' financial filings and records of trading activity, free of charge. In addition, regulators are putting pressure on issuers of the debt as well as the brokerage firms that sell it, compelling them to expand their financial disclosures and to do so on a timely basis.
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This summer, the Web site known as Electronic Municipal Market Access began providing free, up-to-date financial filings on almost all of the 1.2 million debt issues outstanding. It also publishes detailed information on trades in specific bonds going back to January 2005.
EMMA, as it is called, is overseen by the Municipal Securities Rulemaking Board, the federal regulator of brokerage firms and banks that trade and underwrite debt securities issued by state and local governments. It is an easy-to-use site that allows investors to peruse financial filings and sign up for e-mail alerts on specific debt issues to keep track of significant developments in their holdings.
The library of documents available on EMMA is substantial; it houses original offering statements by issuers going back to 1990. As of July 1, all issuers had to begin filing all current disclosure statements on EMMA.
"There has never been a really legitimate way of understanding whether issuers were honoring their ongoing disclosure commitments," said Lynnette Hotchkiss, executive director of the board. "Now that we have a single repository with EMMA there is no place for issuers to hide."
Greater transparency in the muni market could not be more crucial for investors. Last year, 140 issuers defaulted on $7.6 billion in muni bonds; during 2007, there were only $226 million in defaults.
But it is not just EMMA that is making the muni market more investor-friendly. The Municipal Securities Rulemaking Board is also turning up the heat on brokerage firms that sell these securities to their clients. An advisory last month reminded firms that they must tell clients of recent material changes in an issuer's financial situation when they sell them a bond.
In the past, disclosures by brokers selling municipal securities to their clients were pretty much limited to the bond's price, interest rate and credit rating. Now these buyers must be advised of any material information related to the issuer. This might include the fact that an issuer hasn't filed financial statements for two years, or that it has dipped into the reserve fund to make a recent principal or interest payment. Investors can no longer be kept in the dark.
The Securities and Exchange Commission is also ratcheting up its oversight. Mary L. Schapiro, its head, has said that improving disclosures and practices in the municipal market is one of her top priorities. In mid-July, the S.E.C. proposed a rule ensuring that disclosures of major developments in the financial standing of an issuer are filed promptly on EMMA.
Regulators used to leave it up to issuers to decide whether a development was significant enough to merit disclosure in a filing. But that could soon end. Under the rule proposed by the S.E.C., issuers would be required to disclose any such developments, including changes in the issuer's credit rating, delinquencies in payment of principal or interest, and unscheduled draws on debt service reserves. In addition, the proposal would require these disclosures to be made within 10 business days.
This will curb the problem of delayed filings by some municipal issuers. Consider, for example, the situation at the West Penn Allegheny Health System, the Pennsylvania hospital group that issued almost $760 million in high-yield debt in 2007, the largest junk-bond offering by a nonprofit health care concern.
The S.E.C. began an investigation of West Penn last year after the health system found $73 million in overstated accounts receivable. Its audited financial statements for the 2008 fiscal year were supposed to have been filed by Dec. 31. But it was not until May 22 this year that the results came out; they showed an operating loss of $89 million and a net loss of $57.8 million.
Nevertheless, during the first quarter of 2009, without the benefit of audited financial statements, individual investors bought $1.3 million worth of its bonds, trading data on EMMA shows. The bulk of West Penn's bonds have recently traded at from 62 cents to 65 cents on the dollar.
Finally, the Financial Industry Regulatory Authority, the big Wall Street regulator, has announced that it is scrutinizing sales practices among brokerage firms that deal in municipal securities. Finra is asking firms for detailed data on municipal bond transactions they handled for clients during the first quarter of 2009, including sales and marketing data, pricing and disclosure practices, customer complaints and supervisory procedures.
"Taken together, these three events are momentous in the municipal securities market," said Peter J. Schmitt, chief executive of DPC Data, a provider of financial disclosure documents and data to institutional investors. He said that scrutiny of sales practices by brokerage firms would help curtail the practice of parking bonds -- when a broker dumps securities that institutions sell into the accounts of unsophisticated individual investors.
Of course, these moves don't please everyone. In a recent letter to the S.E.C., the Securities Industry and Financial Markets Association, Wall Street's lobbying group, complained about the Municipal Securities Rulemaking Board's requirement that brokerage firms advise their clients of material information before a trade occurs. "This burden may impinge on the efficiency of the markets and may make dealers less willing to enter into trades with retail customers," wrote Leslie M. Norwood, associate general counsel at the association.
Let's hope that the regulators stand firm on these changes.
"With bond insurance no longer a factor, with so much of the market now unrated by the credit rating agencies, and with defaults and other evidence of broad credit declines appearing across the municipal market, retail investors are probably more vulnerable than ever," Mr. Schmitt said. "This is no time for the regulators to back off the important disclosure developments, regardless of the pushback
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