Municipal bonds are securities issued by states, cities, counties and other governmental entities to raise money to build roads, schools and a host of other projects. Investors like municipal bonds because they are exempt from federal taxation, and investors like municipal bonds because they are perceived as otherwise conservative investments, backed by the creditworthiness of the governmental issuer.
Municipal bonds, however, can also include bonds issued by a state or governmental entity, but which are not backed by the full faith and credit of the issuing authority, such as tobacco bonds, which in fact “do not constitute a debt, liability or obligation” of government. which may be “under no moral obligation to make payments of principal of or interest on the bonds” but instead are conditioned upon the ability of the tobacco manufacturers to pay the tobacco settlements to the various states, and which could be adversely affected by a number of considerations, including the future solvency of the tobacco manufacturers, and on going litigation, throughout America, some of which actions, if ultimately successful, could result in a determination that the tobacco settlement agreements are void or unenforceable.
As a result, FINRA has issued a series of alerts to remind investors that while municipal bonds have historically been considered relatively conservative investments, they do include risk, including the risk of default, and interest rate risk.
Even where an issuer has purchased bond insurance or some other protection feature, the higher overall credit rating of a bond may be more reflective of that protection than of the financial condition of the issuer. These insurers however also present a credit risk. For example, AMBAC reported approximately $29 billion of exposure in 2007,” resulting from “the global credit market distress, the swift collapse of the subprime mortgage market midway through the year, and the subsequent rating agency downgrades of various mortgage-backed securities, made 2007 the most difficult period in our 37-year history.” Subsequently, AMBAC’s bond insurance unit was put of Rating Watch Negative by Fitch. A review by Fitch of AMBAC’s exposure found that the insurer was roughly $1 billion short of the capital it needs. Similarly, in 2007 Moody’s Investors Services, Standard & Poors, and Fitch downgraded Federal Government Insurance Co.’s rating, and placed FGIC on their respective negative credit watch lists.
As a result the price of municipal bonds guaranteed by these companies plummeted.
High Yield municipal securities often have low or no credit ratings. Municipal bonds are also subject to interest rate risk. If interest rates go up, municipal bond prices will go down, and the price of bonds with longer maturities or durations will go down more than municipal bonds of shorter maturities or durations.
The biggest abuse effecting municipal bond purchasers however is not the non-disclosure of risk. The biggest abuse effecting municipal bond purchasers excessive and undisclosed mark-ups most frequently associated with the sale of otherwise risky or thinly traded bonds. The current market value of a municipal bond may be hard to determine because many municipal bonds trade infrequently. Many of these otherwise risky and infrequently traded bonds may have large spreads between the “bid price,” meaning the price someone is willing to pay to purchase these bonds and the “offer price,” meaning the price someone is willing to pay to sell these same bonds.
For example, a thinly traded, or otherwise risky, tobacco bond may have an inside bid price of $75 and an inside offer price of $100, again meaning that the most any market participant is willing to pay is $75 to purchase the bonds, but the least any market participant is willing to sell these bonds is $100. Accordingly, a broker-dealer may purchase these bonds for into inventory at $75 per bond, and only days later, once risk is established may resell these same bonds for $100 per bond.
Accordingly, in connection with a $100,000 transaction, the broker-dealer may realize profits of $25,000 or 33% of its investment. The best part is that because the broker-dealer is subject to risk after owning these bonds for several days, the “mark-up,” technically over the lowest prevailing offer price is zero.
The applicable rule, with respect to these transactions states: “No broker, dealer or municipal securities dealer shall purchase municipal securities for its own account from a customer or sell municipal securities for its own account to a customer except at an aggregate price (including any mark-down or mark-up) that is fair and reasonable, taking into consideration all relevant factors, including the best judgment of the broker, dealer or municipal securities dealer as to the fair market value of the securities at the time of the transaction and of any securities exchanged or traded in connection with the transaction, the expense involved in effecting the transaction, the fact that the broker, dealer, or municipal securities dealer is entitled to a profit, and the total dollar amount of the transaction.” The “key issue in cases involving allegations of unfair pricing” is the determination of the prevailing market price, which is the basis on which retail mark-ups and mark-downs are computed.
Again, using the above example, based upon prevailing market prices, the mark-up is zero.
The income that can be generated from these transactions make them especially appealing to unscrupulous stockbrokers. The fact that these are “municipal bonds,” often perceived by investors to be safe, and often paying high yields (to compensate for risk) make them an easy sell to unsuspecting investors. Many firms specialize in such practices, and inventory these bonds for the express purpose of reselling these securities to customers with huge spreads and resultant profits. The fact that they are “bonds” and not “penny stocks,” (which are also associated with such mark-up practices), these transactions are less likely to attract regulatory attention.
Because these profits are not required to be disclosed, many customers that are sold these securities, usually as the result of deceptive sales practices, never discover such misconduct until they either sell these securities or receive a month end customer statement showing an instant loss based upon the “market” or bid value of these securities versus the price the customer paid for these same securities.
However, in fact, it has been long held that inter-positioning without disclosure to the customer is a material omission that violates the anti-fraud provisions of the federal securities laws. Brokerage firms and banks that sell municipal bonds are required to have procedures in place to obtain material event notices and other disclosures. Broker dealers and municipal securities dealers must fully understand the bonds they sell in order to meet their disclosure, suitability and pricing obligations under the rules of the Municipal Securities Rule-making Board (MSRB) and federal securities laws.
MSRB Rule G-27 requires firms to supervise their municipal securities business, and to ensure that they have adequate policies and procedures in place for monitoring the effectiveness of their supervisory systems and specifically that firms must supervise the conduct of the municipal securities activities of the firm and associated persons and implement supervisory controls to detect and prevent irregularities and abuses.
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