“This was really a formative time in the municipal market, because in 1979-1981, the prime rate at one point hit, I think, 18 percent. There were some bonds issued at that time that had astronomical coupons associated with them. This is really a period of the beginning of financial engineering in the debt markets.”
Tax reform and regulatory change created the context for the reshaping of the municipal market, but the participants themselves were among the most innovative, in part because the municipal market has been so lightly regulated. It is also due to the nature of the instruments themselves, which unlike equities, cannot be hedged in traditional ways such as short selling.
In the period of skyrocketing interest rates that followed after the Federal Reserve had put an end to 1970s inflation, long-term obligations became untenably risky. Issuers began searching for more viable instruments. They made early recourse to tax-exempt commercial paper, introduced in 1973. In place of 20- or 40-year notes soon out of sync with prevailing rates, issuers substituted 1-, 30- or 60-day notes, which became resettable long-term debt when rolled over at new interest rates. These gave way to variable rate debt obligations (VRDO), with a periodically recalculated yield and a demand feature to improve liquidity. The VRDO became a market staple along with other innovations, including reset securities, floating rate debt and advanced refundings.
While old-line bond dealers had taken the long view, these innovative instruments were favored by a new generation of mathematically-oriented short-term tacticians. The story behind the bonds was quantitative, computers ran the numbers, and “it wouldn’t matter if the numbers you ran were not going to ever come true” so long as the ratings agencies bought them. 24 By the 1990s, this financial engineering had run to some excess.
Taxpayer fatigue encouraged bond issuers and bond attorneys to innovate. In California, a citizen campaign resulted in the 1978 passage of Proposition 13, which sharply limited state property tax receipts. Orange County, California had great expectations nevertheless when it created an investment pool to raise money for the county, school districts and other entities. County Treasurer Robert Citron employed a variety of the new techniques to leverage limited tax receipts into abundant investment returns. Despite Citron’s later protestations that he did not entirely understand his investment strategies, they succeeded until 1994 when the Federal Reserve raised short term interest rates six times, creating a bad year for bonds and disaster for Orange County.
In December 1994, citing a $1.5 billion loss in its investment pool, Orange County filed for bankruptcy. The SEC could not directly regulate an investment pool run by government officers, but it brought an antifraud enforcement action. Citron insisted that he had been misled by brokers and bond lawyers, but it became clear that he took risks knowingly and tried to cover his mistakes. Citron went to prison and other county officers settled. Orange County underscored the hazards when ratings agencies like Standard & Poor’s, which gave the county its highest score, failed to adequately investigate creditworthiness. It also convinced the public that creative finance had the potential to do great harm. 25
Of less interest to the public, but more distressing to market insiders, was another episode underscoring the potential for exploitation created by information monopolies. When a municipality buys Treasury notes and uses them to service its bonds until they are redeemed at maturity, the debt is called “escrowed to maturity.” Municipalities customarily assured purchasers that they would not call the escrowed bonds before maturity. These investments therefore appeared to offer reliable payments over a defined time period, but sometimes they did not. In 1986, the Kansas City, Kansas Board of Public Utilities sought to redeem escrowed to maturity bonds in advance of maturity, its bond counsel insisting that – despite prevailing assumptions - the call provision remained in place. Wall Street refused to bid on the bonds, Kansas City cancelled, and the escrowed to maturity market froze while lawyers scrutinized fine print. In the end, the Kansas City bonds did turn out to be callable, the public and the broker-dealers having failed to understand just what they were buying and selling.
The MSRB had already put out for comment an amendment to Rule G-15 requiring broker-dealers to provide specific information about call provisions. But issuers and broker-dealers countered that the required recordkeeping would create a logistical nightmare, even if the information was obtainable. 26 In 1987, the MSRB interpreted Rule G-17 on fair dealing to require call provision disclosure. A year later, the SEC was more emphatic, stating that failure to disclose all features of escrowed to maturity bonds constituted fraud.
(24) April 21, 2014 Interview with David Clapp.
(26)Joe Mysack, Encyclopedia of Municipal Bonds (Hoboken, 2012), 57.
Bill McLucas served at the SEC for 21 years, the last 9 as director of the Division of Enforcement. He started as a staff attorney in 1977 and became branch chief under Stanley Sporkin. He then rose through the ranks in the Enforcement Division as assistant director, associate director, and became director of the Division in 1989. In his oral history interview, he discusses what it was like to serve under directors Sporkin and Fedders, and for five SEC Chairmen as division director, and how the SEC’s enforcement program evolved over his time at the SEC, and since his departure from the agency in 1998. Mr. McLucas was a founding trustee of the SEC Historical Society.
