Study: Rounding May Have Netted Dealers $1B

WASHINGTON - Small investors for years have relied on Ben Franklin's axiom, "a penny saved is a penny earned," to accumulate wealth in small increments. But dealers may have turned that axiom on its head and into more than $1 billion dollars of profits by rounding up the price of municipal bonds charged to retail investors - often by just a few pennies, according to a recent study.

In her doctoral thesis, economist Dan Li, now working for the Federal Reserve's division of research and statistics in Washington, found that in the secondary market more muni bond prices tend to be rounded up to even dollar amounts rather than halves and quarters of dollars. The bond's true market value is a rougher number below the price offered to the investor, according to Li. Her research indicates that by rounding, dealers can charge retail investors as much as 45 cents per $100 par bond, not including the transaction fee.

Li examined the prices dealers reported to the Municipal Securities Rulemaking Board on about 7.35 million of muni bond trades executed between April 2002 and January 2004. Muni bond dealers can generate an extra $1 billion in profits annually from the price round-ups, based on the estimated trade volume, percentage of whole dollar trades, and the cost of those trades to investors, Li, 30, said in an interview. With 2,121 bond dealers registered with theMSRB, the average dealer could make $471, 475.72 a year from rounding.

"It's buyer beware," she said.

Li studied the muni market as a doctoral candidate at Carnegie Mellon University. Her adviser, Rick Green, specialized in munis and coaxed her into studying the market. While observing daily municipal prices, Li said she noticed how they were disproportionately in whole dollars rather than fractions of dollars. The observation became the crux of her thesis.

Since the paper was published in November 2007, Li has presented her work to the Securities Industry and Financial Markets Association, the Federal Reserve Board, and other academics.

Li contends that the muni market naturally discriminates against retail investors, who generally are unsophisticated and buy less than $100,000 in bonds per trade. Two factors inhibit retail investors from achieving the best price, she found.

First, the lack of liquidity in the muni market increases the difficulty of determining a bond's market value. Muni bonds are often held from issuance to maturity and are traded less frequently than stocks. This makes the market price less evident. In addition, munis are traded over the counter, and prices generally were not publicly available prior to April 2003. Now most muni prices must be reported to the MSRB and can be viewed online. Despite the new resources, Li said investors have not taken advantage of what is available.

"It's not the existence of transparency, it's people adoption of the transparency [that will] make the market more efficient," she said.

The second disadvantage for buyers is that they cannot easily bargain with brokers. Since muni bonds are OTC deals, buyers must open an account with each broker they trade with. This is costly and time consuming, she said.

"It is very hard to shop around," Li said. "In my own experience, there are a lot of hurdles for buyers to negotiate a price. The market is not used to [retail] investors negotiating with [dealers]."

Some municipal bond traders on Friday agreed with Li's thesis, but argued that the cost attributed to rounding for entering the muni bond market is less than the "entrance fee" for other investments.

Evan Rourke, vice president and portfolio manager for MD Sass Investor Services Inc. in New York said the mark-up attributed to rounding is "within 3%." Retail investors, by their nature, are less price sensitive than institutional investors because they deal with smaller quantities of bonds, he said, adding that for hedge fund investors, there is usually a 5% entrance fee and a 75 basis point charge on the principal.

Retail investors may make it easier for dealers to round up because they are more comfortable with prices in whole dollars than in fractions, Li suggests. In her study, she found trades rounded to the whole dollar for retail investors occur about 12 percent of the time - a "dramatic" difference from the random distribution of prices one would expect to see.

For institutional trades, whole dollar prices were charged in six percent of the trades. The disparity, Li wrote, occurs because institutional traders have greater access to information about prices and have more resources to help them bargain.

One trader who did not want to be identified said Friday that muni participants are concerned about the yield and tax exemption munis offer, not about the price.

Still, "a buck is a buck," Li said.

The profit potential when bonds are priced in terms of yield is even greater for dealers, Li said. The beauty of interest is that it compounds, and dealers who round yields down can reap the windfall. If a yield price is rounded down by one-tenth, from 4.1% to 4.0, then the difference lost on a $1 million bond is $1,000.

Li claims that this rounding occurs in a "don't-ask-don't tell environment" at brokerage firms. She said she doubts dealers are commanded by their superiors to round up bond prices. It is not an issue of collusion, Li said, but rather a market environment that favors dealers.

"I don't think there's implicit communication that you have to round," she said. But "implicitly they round."

Traders in the equity market found themselves in hot water after a research paper similar to Li's was published in 1994 about rounding on the Nasdaq stock market. Economists William Christie and Paul Schultz found that Nasdaq stocks were almost never quoted in odd eighths rather than even eighths (i.e. one-quarter or one-half dollar). The study led to an investigation by the Justice Department and eventually forced 24 firms, including Merrill Lynch & Co. and Goldman Sachs & Co., to settle in 1996.

The MSRB's Rule G-30 on prices and commissions does not address round-ups of prices and there is no indication that they are illegal. The rule states only that broker-dealers must charge customers "a fair and reasonable amount, taking into consideration all relevant factors, including the availability of the securities involved in the transaction, the expense of executing or filling the customer's order, the value of the services rendered by the broker, dealer or municipal securities dealer, and the amount of any other compensation received or to be received by the [broker-dealer] in connection with the transaction."

Li's research deserves more attention today after the collapse of the auction-rate securities market in February after the credit ratings of the bond insurers that insured these securities were downgraded, said Matt Fabian, managing director of Municipal Market Advisors,who is familiar with her research.

The lack of investor interest in ARS caused auctions to fail, forcing other investors to continue to hold the securities. Investor disinterest overwhelmed the dealers' ability to support the market and that led to a decline in overall liquidity and the widening of bid-ask spreads are being seen into the broader muni market. While prices are more available today and can be easily accessed, determining a muni bond's market value "is one of the principal risks investors face," Fabian said.

Thanks to Li's paper, buyers may be more circumspect about the price they are being offered. Her work has helped uncover a problem people might not have known existed, Fabian said.

"Dan's work has only increased in importance," he said.

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