Securities and Exchange Commission Historical Society

The Municipal Securities Rulemaking Board Gallery on Municipal Securities Regulation

The Newest Old Market

Less than Level

“For the three years I was on the MSRB there was a climate in D.C. where we were being told as a Board that no one on the Hill would listen to our concerns, because it was the Greenspan era, derivatives were good … It was extraordinarily difficult for the largest firms, for the representatives on the Board, to state publicly that these derivatives had risks that were a concern, because they could lose their jobs, and people did. And those who spoke up, their firms couldn’t tolerate it, and it would be used against them.”

May 19, 2014 Interview with Thomas Doe

Both before and after EMMA, however, there was an issue in the municipal market that was less than level. “Yield burning,” exposed in 1994, was emblematic of the unfair advantages that lurked in the opaque edges of the market. Since the arbitrage rules of the 1986 Tax Reform Act provided that excess earnings from reinvested bond proceeds had to be rebated to the government, dealers found a way to “help” their clients. They reinvested in Treasury notes, and marked up the costs so that issuer profits were low enough to escape the rebate, pocketing profits that otherwise would have gone to the government.

To stem this practice, the SEC applied a 1939 fiduciary duty case to yield burning. The first action was brought in 1998, and in 2000, a collection of major players, including Citibank, Paine Webber, and Merrill Lynch, made a $139 million settlement. This moderated, although not entirely obliterated, the practice.

A controversy involving the rigging of bids on guaranteed investment contracts played out from 2006 to 2011, ending in a global settlement with Bank of America, UBS, JPMorgan Securities, GE Funding, and Wachovia, which returned $744.3 billion to state and federal treasuries. The Wachovia case was notable because it involved a word rapidly gaining negative connotations: derivatives.

The financial crisis of 2008 provided an opportunity for many Americans to take notice of derivatives, securitization and other complex financial transactions which had become commonplace on Wall Street years after their development in the municipal market. Interest rate swaps dated back to the high inflation years of the late 1970s and early 1980s, when they were employed in conjunction with variable rate bond issues. Later, by providing a way to obtain higher short-term interest rates over the long term, these curiously-named “low floaters” enabled investors to boost revenues in a low margin market. Yield burning helped pad profits for a time, but after the practice was tamped down, interest rate swaps proliferated. In increasingly sophisticated mixes, broker-dealers set up swaps that mirrored the risk profile of a debt issue, usually a VRDO, in a “tender option bond program.”

There was sound purpose for derivatives, but by the 2000s, financial institutions were using tender option bond programs as much to obtain returns from the creation and remarketing of the synthetic short term securities as to hedge risk. Another consequence was that, since regional broker-dealers did not have the resources to conduct these transactions, business increasingly came to Wall Street. By 2003, the MSRB recognized that the industry was becoming dangerously over-leveraged, but it had no direct regulatory authority over derivatives.

Through the mid-2000s, interest rate swaps performed beautifully for those who bet on a stable bond market, but they created burdensome liabilities when the market declined and interest rates rose. In February 2008, in the midst of the market drop, the market for another type of variable rate municipal debt -- auction rate securities (ARS) which had their yields periodically reset -- froze entirely when financially-stressed broker-dealers chose not to hold the required auctions. In the aftermath, the SEC pursued two rounds of settlement and the MSRB incorporated both ARS and VRDO disclosure into the pilot version of EMMA.

Christopher Cox, when serving as U.S. Representative (R-California) for Orange County, had become acquainted with interest rate swaps under unpleasant circumstances. Named SEC Chairman in 2005, Cox asked Congress to remove the regulatory exemption for issuers and backed the registration of municipal financial advisors. In 2010, in the wake of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC established four new units within the Division of Enforcement, including a Municipal Securities and Public Pensions unit. That unit created a muni “boot camp” for SEC Enforcement personnel and graduates contributed new tiles to the mosaic defining the boundaries of acceptable municipal market conduct. A case brought against Miami in 2013 confirmed that the SEC could bring action for incomplete disclosure even in the absence of an aggrieved party. Another brought against Harrisburg, Pennsylvania the same year established the SEC’s ability to find fraud in statements other than disclosure documents.


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