(New York November 27, 2012) The federal government's chosen regulator of the market for state and local government debt is publishing information for investors that is inaccurate, potentially misleading and subject to manipulation.
The Municipal Securities Rulemaking Board (MSRB) disclosure requirements in the troubled market for municipal auction rate securities (ARS) is intended to give investors important information about investing in ARS. It misses the mark, according to Saber Partners, LLC, an independent financial consulting firm for corporate and public sector entities. "The MSRB has made great strides in bringing transparency to an opaque market," said Joseph S. Fichera, Chief Executive Officer of Saber Partners. "Unfortunately, this area has been a continuing problem and representative of larger challenges. Yet it is also one that can be fixed," he added. Fichera has been an auction securities expert for broker-dealers, investors and the SEC.
Municipal ARS are generally long-term (20 year or more) debt securities issued by state and local governments whose interest rates are determined based on the amount of securities offered at periodic public auctions and the interest rates investors bid for them at a price of par. The market for these securities also includes debt issued by not-for-profit institutions like colleges and hospitals. The ability to buy and sell in the auction at par is critical to the investors' risk in owning the security. The fewer bidders, the more risk.
One key problem is that after each security's auction (and there are hundreds of auctions conducted each month for almost $40 billion of different municipal securities) the MSRB publishes an ARS "bid-to-cover" ratio. This supposedly measures the amount of bids received relative to the amount of bonds available for sale and could help investors evaluate demand for the securities.
But, this published ratio fails to accurately inform sellers, buyers or potential buyers of the amount of demand for the securities from independent investors as opposed to broker-dealers bidding for their proprietary accounts. This information is critical to evaluate the risks of participating in the auctions. It was a key issue in the auction market disruption during the 2008 credit crisis.
For more detailed analysis and discussion of the problems with these disclosures, see http://saberpartners.com/press/msrb-action.html
Investor confidence in auction securities was shattered in 2008 when investors discovered how much liquidity (i.e. their ability to sell their bonds at par in the auctions) depended upon the willingness of a single market participant - the broker-dealer -to bid in the auction. Most broker-dealers are not obligated to bid, though before the market breakdown their voluntary purchases made them the largest single category of buyers according to a Federal Reserve study
Saber Partners examined the new MSRB auction disclosures aimed at addressing this problem available on their web site for hundreds of specific securities auctioned currently. It determined that the rules often publish absurd and misleading bid-to-cover ratios, such as 4,000 to 1.
The ratios suggest there is robust independent investor demand for a given auction security in the auction and the investment appears safe and liquid. In this example, the ratio suggests there were $4,000 of bids for every $1 of bonds up for sale. However, the fact is that the ratio is driven largely from a single market maker who can withdraw that support at any time. In some auctions no bid-to-cover ratio is computed at all by the MSRB. Other ratios vary widely.
"What's important is the integrity of the market information given to investors," Fichera added. "The LIBOR scandal, bid rigging for swaps and other controversies in the market for state and local government debt have highlighted the regulators' responsibility to protect the integrity of market information from whatever source. For data published by a market regulator, the bar is particularly high."
The current disclosures are essentially useless to investors since they cannot be meaningfully applied to evaluate ARS risks and bidding in past auctions. Investors need to know how much of the bids came from a broker-dealer. In similarly conducted US Treasury auctions, the "bid-to-cover" information is available and meaningful. Treasury rules limiting the participation of a single bidder assure investors that the market is not rigged. With municipal auctions, there is no such assurance.
In addition to this, other problems with the MSRB ARS data exist. The MSRB does not publish the maximum permitted rate in some auctions allowing them to be designated as "not calculated" despite requirements in the security offering documents. And some MSRB regulations still refer to ARS as similar to "short-term securities" with an "effective maturity" of less than 13 months, which is not an accurate description.
According to Saber, the MSRB was informed of these problems both in 2008 and at the time the data was published in 2011. The MSRB has informally acknowledged errors but has not informed investors of the problem nor made any administrative efforts to correct it public.
The pre-Dodd-Frank MSRB did not act to bring transparency to this market despite a 2004 SEC investigation, comments by the SEC municipal division head in September 2006 and the events leading up to the 2008 crisis. The MSRB in 2011 did create a special web site called the Short-Term Obligation Rate Transparency system ("SHORT") to enhance its web based disclosure system, known as EMMA. This is the only source of free public information for ARS investors and issuers. See Saber proposal from 2008.
About $40 billion of the securities remain outstanding and are offered in hundreds of public auctions each month. Since the 2008 crisis, many ARS investors remain stuck with illiquid securities. Many, though not all, auctions are failing to find enough buyers at the bidding ranges established when the securities were issued. Accurate market information about the auctions remains masked. Those investors who are still bidding must do so with distorted and incomplete information.
"The new Dodd-Frank MSRB has been a strong proponent of an efficient market with full transparency. This also means correcting problems of its existing rules," said Joseph Fichera.
"If the published auction market data is wrong, the MSRB should correct it or take it down. If this information cannot be made useful for investors, the money spent on creating it should be spent elsewhere," he added. "The MSRB should take corrective action and inform the market as to what information it can or cannot rely on so that it can continue its efforts at transparency and efficiency without any distractions or distortions in its current rules. This is a problem that can be fixed."