Muni bond regs need an overhaul

Mounting worries about state and local governments’ growing budget deficits have transformed the municipal bond market from a sleepy safe haven for conservative investors into a rowdy roadhouse for intrepid investors.

Whether real or imagined, fears about budget deficits and underfunded pensions run the risk of bringing the muni bond market to its knees and warrant congressional intervention. If those aren’t reasons enough, inadequate disclosure and the scarcity of bond insurance — which used to protect investors from potential losses — scream for preventive measures.

While the abject fear that ignited a dramatic sell-off in the $3 trillion market late last year seems to have abated, anxiety among retail investors — which account for about two-thirds of the municipal bond market — remains relatively high.

Investors so far this year have yanked more than $27 billion more from muni bond funds than they’ve put in. The popular iShares S&P National Municipal Bond exchange-traded fund Ticker:(MUB), meanwhile, was down about 18% year-to-date as of last Tuesday and down 6% from its 52-week high, established Aug. 25.

The first order of business in restoring faith in the muni bond market is to repeal the so-called Tower amendment. Passed in 1975, the amendment, which was sponsored by the late Sen. John Tower, R-Texas, prohibits the Securities and Exchange Commission and Municipal Securities Rulemaking Board from leaning on muni issuers to file regular disclosure documents.

By comparison, corporate-bond issuers — which aren’t given a free pass on disclosure — are required to make quality financial disclosures on a timely basis. Why should muni issuers be any different?

Make no mistake: Although threats of state and local bankruptcy make for scintillating sound bites and eye-catching headlines, poor disclosure poses a clear and present danger to muni bond investors. Clearly, disclosure rules based on covenant agreements by the issuing municipalities that allow self-reporting to the MSRB aren’t working.

DPC Data Inc. last month released a report showing that bond-issuing municipalities are more or less ignoring their annual financial disclosure obligations.

In a sample analysis of 17,056 muni bond issues, DPC found that 40% did not make the proper financial disclosures in 2009, the most recent fiscal year studied. That was up from 36% in 2008 and 33% during the period from 2005 to 2007.

According to the report, 56% of muni bond issuers studied during the period from 2005 through 2009 were one or more years delinquent, and 19% failed to file any financial statements during any of those years.

“The findings indicated that in any given year, it would be impossible to analyze credit risk or find any warnings of default from officially filed disclosure data on significantly more than half the issues studied,” DPC chief executive Peter Schmitt was quoted as saying in an article on the report that appeared in this publication. “For people attempting to make good investment decisions or protect themselves from potential default, this is not good news.”

The MSRB recently started requiring underwriters of new muni bonds to post publicly how they intend to meet federal disclosure requirements. It is also considering a plan to encourage broker-dealers and issuers to provide more information to investors

But those measures are a clear case of too little, too late.

For that reason, the Tower amendment should be repealed and the SEC given authority to enforce rigorous — and continuous — reporting requirements.

Opponents no doubt will argue that increased disclosure would raise costs associated with issuing muni debt. And they will say those costs inevitably would be passed along to investors.

Although all that is true, those costs likely would be negligible — and a small price to pay for increased investor protection. Also, any increase in costs likely would pale in comparison with the costs associated with a federal bailout should investors stop buying muni debt altogether.

After empowering the SEC to enforce disclosure requirements, Congress must move quickly to reinstate some sort of safety net — like the one investors had with bond insurance. Less than 10% of new muni bonds carry insurance, down from 50% five years ago — thanks in part to ratings downgrades of the major bond insurers amid the financial crisis.

One option being bantered about calls for the creation of a Federal Deposit Insurance Corp.-like federal insurance program for muni bonds. Although it is tempting to use the federal government as a backstop against potential investor losses, one must consider whether such a program might make it too easy for a municipality to default.

Another is to expand the use of letter-of-credit guarantees issued by big banks. But that poses challenges, as banks have become more risk-averse and likely would hike their fees to compensate for the risks that they would be taking.

No matter what, regulation of the muni bond market is in dire need of an overhaul.