Of Scandals and Scoundrels

By stupidity or guile, public finance officials--like their corporate peers--can go astray. Fast-buck opportunities are there.
October 2002
John E. Petersen
By John E. Petersen  |  Columnist
John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.

Germans have a name for it: Schadenfreude, the taking of pleasure in the misfortune of others. There is plenty of that these days. From Kenneth Lay to Martha Stewart, a host of high-riding American corporate icons have tumbled along with the value of the corporations they led. Humble toilers in the public sector can take some satisfaction in seeing their corporate betters, so recently held up as the purveyors of all productive virtue, mess up big time with losses in the hundreds of billions of dollars.

Investor losses due to incompetence or skullduggery in the public sector's bond market pale in comparison. The Washington Public Power default in the 1980s, the largest ever on a municipal bond, amounted to about $2 billion--due to irrational exuberance and bad luck rather than personal thievery. This is pretty weak tea compared with the $530 billion wipeout of stockholder value that has occurred among the 23 corporations that are now under investigation by the U.S. Department of Justice.

Really big gains, big losses and big rip-offs seem to be the rightful province of the private sector. Governments, accountable to the public, are supposed to be honest. But, by stupidity or guile, government officials can also go astray. Fast-buck opportunities, albeit modest in comparison to the private sector, are there.

The temptations are especially keen when state budgets are in dreadful shape and local budgets are getting whacked. The heat is on to bolster revenues, and the siren songs of pumping up investment income, borrowing beyond real needs and selling assets for immediate gains become more intense, particularly on the borrowing front.

The attraction for most illicit moneymaking schemes involving municipal bonds stems from the debt's tax-exempt status. It does not take a genius to figure out that if one can borrow at 2 percent and invest at 3 percent, there is money to be made. Federal tax law prohibits muni bond borrowing simply to earn arbitrage profits, and the rules governing this restriction are mind-bendingly complex. They are enforced by IRS audits, and the penalties are very unpleasant. With quick profits available, though, there are always those who will try to capitalize on the situation.

A roundtable of the National Association of Independent Financial Advisors (as reported in the Municipal Finance Journal) provides useful insights into how sharp practices, gullibility and plain corruption can lead to debt transactions that are profitable for some but harmful to all. For example, there is borrowing for "anticipated" cash-flow needs that just never arise. The borrower simply liquidates the invested proceeds, repays the short-term debt and pockets the interest earnings. Another is selling high-coupon, deep-discount, tax- exempt bonds, the proceeds of which are reinvested in long-term, risk- free, taxable securities. The magic of this transformation is such that large piles of cash are immediately generated, which the banker and the issuer (if it is aware of what is going on) can cart away. Then, there is the duplicitous dealer or adviser that rigs the bids on invested funds by marking up their price so that the investment's yield falls within the arbitrage limits. By selling the investments for a lot more than it paid for them, it gets to keep the profits.

These are but a few of the ways to milk the market. And the perpetrator will frequently make it worthwhile for the gullible or corrupt official to play ball.

The IRS has stepped up its municipal bond audit activities. The Securities and Exchange Commission (albeit with a recently much- reduced municipal office staff) and state attorneys general and securities commissions are poking around as well. These activities, unwelcome though they may be to some, are absolutely vital to maintaining the integrity of the market and avoiding its becoming a school for scandal.

So, how does your government avoid ending up in the headlines? Here are a few pointers in checking out the legitimacy of a deal that promises to make an easy buck for your community: --Be suspicious of transactions that essentially represent reinvesting bond proceeds to earn income as opposed to retiring outstanding debt or financing new projects. --If investments are bought with bond proceeds or reserve funds, make sure they are marked to market and that your financial adviser or investment banker is not a party to their purchase. If you are not using an adviser who is completely independent of the deal, you should be. --Hire a bond counsel that reports to you. Do not trust the underwriter to "supply" the legal counsel. If your law firm says the deal smells, you better believe them.

We should take pride in the fact that transparency and honesty in government finance in this country constitute one of its great unsung strengths. But, that happy fact should never be taken for granted-- especially when times are tough.