In the News: Recent Developments

August 11, 2009

Hospitals Hit by Bond Yields Giving Investors Instant Profits

By Michael Quint

Municipal bond underwriters are penalizing taxpayers by setting yields so high that investors are assured quick profits, according to Ziegler Cos., a broker hiring bankers from Wall Street’s biggest firms.

“Investors rush to buy the cheap securities, and many flip them the next day for a quick profit,” said Chicago-based Ziegler, which specializes in tax-exempt issues sold by hospitals and nursing homes, in a letter to clients July 27.

Prices of 28 health-care issues sold in the first half of the year rose enough immediately after underwriters set prices that yields fell on average 0.11 percentage point, the Ziegler letter said. The extra interest would cost a borrower $110,000 of interest annually per $100 million of bonds.

The bankers are warning issuers about unnecessarily high rates as federal and state regulators investigate the municipal bond market following losses from derivatives, auction-rate bonds and other securities that local officials didn’t fully understand.

“Flipping” bonds to generate quick profits is part of “an unhealthy relationship between dealers and institutional investors,” said Christopher “Kit” Taylor, a former director of the Washington-based Municipal Securities Rulemaking Board, the self-regulatory organization that polices underwriters, traders and salesmen in the market for state and local bonds, where $2.72 trillion of securities are outstanding.

Setting prices low enough so investor demand exceeds debt available allows bankers to select buyers who “then dribble it out through the same dealer at higher prices,” Taylor said. Individual investors get the bonds after prices rise again.

Monitor Bank

Ziegler tells issuers that they can reduce interest costs by monitoring bankers more closely and attracting additional investors to their debt. David Johnson, a senior managing director and a former employee at Citigroup Inc. and Merrill Lynch & Co., described the letter as “self-serving,” intended to highlight his firm’s approach. He wrote it with Kerry Rudy, another managing director, who previously worked at Goldman Sachs Group Inc.

Issuers negotiating bond sales need to be aggressive, “otherwise, the million-dollar bonus banker on the other side of the table will likely serve his firm’s interests first,” said Joseph Fichera, the chief executive officer of Saber Partners LLC, which advises corporations and governments and who provides independent analysis for Bloomberg News.

Regulator scrutiny of the municipal market led to payments by banks, including Citigroup, Bank of America Corp. and its Merrill Lynch & Co. unit, Morgan Stanley, JPMorgan Chase & Co. and Goldman Sachs, of $572.5 million in penalties for improperly selling auction-rate bonds to investors. The settlements with 13 states occurred last year after the $330 billion market collapsed when banks stopped buying the bonds, causing borrowers to pay penalty rates as high as 20 percent.

Probing Underwriters

The Financial Industry Regulatory Authority, which oversees 4,900 securities brokers, said in June it was conducting “sweeps” to gather information on firms that underwrite securities tied to derivatives for small municipalities known as interest-rate swaps. Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as interest-rate changes.

The U.S. Justice Department and at least two states are looking into allegations that banks and advisers rigged bids or fixed prices on financial contracts, according to regulatory filings by banks. The probes have focused on contracts to invest bond-sale proceeds, known as guaranteed investment contracts, and interest-rate swaps tied to bonds.

Banking Oligopoly

Five banks — Citigroup, Morgan Stanley, Bank of America, JPMorgan and Goldman Sachs — handled 82 percent of health-care bond sales this year, and have shown “quasi oligopoly-style behavior,” Johnson said. The number of underwriters was reduced by the collapse of Lehman Brothers Holdings Inc. in the world’s biggest bankruptcy in September and the takeovers of Bear Stearns Cos. and Merrill Lynch.

Spokespeople for the banks declined to comment. All are located in New York, except Bank of America, which is based in Charlotte, North Carolina.

The Ziegler letter didn’t identify issuers “because we don’t want to embarrass” potential clients, Johnson said.

Beaumont Hospital in Royal Oak, Michigan, sold $293 million of 8.25 percent bonds due 2039 on Jan. 15 through Morgan Stanley at an initial price of 95.709 cents on the dollar to yield 8.65 percent, according to data compiled by Bloomberg. The next day, they were sold to individual investors at prices of 98.7 cents and 100.28 cents, with trades of $1 million or more between securities firms as high as 98.31 cents to yield 8.4 percent.

Mispriced Issues

Dennis Herrick, Beaumont’s chief financial officer didn’t return calls seeking comment. Jennifer Sala, a spokeswoman for Morgan Stanley, declined to comment.

Hospitals aren’t the only municipal institutions whose issues are mispriced, Johnson said, pointing to Build America Bonds, whose interest cost is 35 percent subsidized by the federal government.

The New York-based Metropolitan Transportation Authority sold Build America Bonds that rose 3 cents on the dollar when trading began April 23, while benchmark Treasury issues were little changed. The MTA debt was among the 25 largest issues of sold, with yields averaging 0.96 percentage point more than similarly rated corporate bonds, Bloomberg data show.

“Taxpayers are taking it on the chin,” said G. Joseph McLiney, president of Kansas City, Missouri-based McLiney & Co., a firm that specializes in selling municipal bonds that qualify for federal tax credits. “There should be no spread.”

Flipping occurs because “capital is tight,” Johnson said. After credit markets froze in 2007 and 2008, “the big firms aren’t willing to use their balance sheets to support issues in the way they had in the past,” he said.

Holding New Bonds

To avoid the risk of holding new bonds beyond the day of issue, banks set yields high enough to sell all the securities to institutions, even though more effort would uncover buyers willing to accept lower yields, he said.

Johnson recommends issuers develop their own relationships with investors by holding regular meetings with bondholders. Borrowers should also include shorter-maturity bonds favored by individuals and other smaller buyers who accept lower yields than the 50 largest institutions.

“Bond placement is not rocket science,” and issuers can get better results from their underwriters and advisers if they are willing “to challenge entrenched behaviors,” Ziegler’s letter said.

Bank trust departments, managers of wrap accounts at brokerage firms and other money managers who buy bonds on behalf of individuals should be eligible to place orders during retail sales periods, Johnson said.

Pay For Performance

Issuers should require underwriter payment according to how many bonds they sell, not the common practice where they agree beforehand how much each firm will collect, regardless of how much debt they sell, Johnson said.

“Creating pay for performance between underwriters creates more competition and lower costs,” Fichera of Saber said.

After bonds are sold, issuers should monitor trading for at least a week, the Ziegler officials said, to evaluate whether any price gains are the result of market conditions or too low a price set by underwriters.

“I never paid any attention to secondary market trading when at Citibank,” Johnson said. “I should have.”

If issuers tell bankers they want a list of all secondary market trading the week after sale, the underwriters “probably will do a little better,” Johnson said. “If they don’t think anybody is watching they won’t feel that pressure to perform.”

For Related News and Information:
Archive of most-read municipal bond stories: TNI MUN READ
News about new bond sales: TNI MUN BONDALERT
News of municipal bonds and securities firms: TNI MUN SCR

–Editors: Margot Slade, Robert Burgess, Michael Weiss

To contact the reporter on this story:
Michael Quint in Albany, New York, at +1-518-426-9921 or

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