New Technology Can Help SEC Reform the Muni Market

The Feb. 23 edition of the New York Times reported that new SEC chairwoman Mary Schapiro is looking to the law enforcement and intelligence communities to help identify potential investigations and strengthen enforcement actions. She has retained Mitre Corp. to design a computerized enforcement tip management system. This is smart management.

Bernie Madoff's Ponzi scheme would have been uncovered by the Securities and Exchange Commission years earlier if the multiple clues in its databases could have been pulled together using sophisticated query technology. The right software can find the clues and informant leads in different databases in close to real time. If the SEC enforcement lawyers had the right information technology tools, they would have nailed Madoff years earlier.

Hopefully, Schapiro will take a similar technology approach to the horrific situation in the $2.7 trillion municipal securities market. The financial reports that accompany official statements of new municipal securities can be close to three years old, as are New Mexico's. California's are regularly almost two years old.

Recently, on Jan. 14, 2009, Delaware borrowed $236 million or 14% of its outstanding debt using June 30, 2007, financial statements that were 19 months out of date. Does anyone think that Delaware's financial condition was the same in January 2009 as it was in June 2007?

Not providing timely financials is not only a dereliction of public duty but represents a systemic fraud on the municipal securities market. This is intolerable; it obscures transparency, inhibits effective price discovery, and materially increases borrowing costs for better-rated issuers.

The SEC must find a way to reform the muni bond market. Fortunately, today technology can provide the way.

The commission has direct authority to regulate the underwriters of state and local government municipal bonds, but not the issuers of the debt, which is traded in the over-the-counter market. As a result, the market developed haphazardly and lacks rules and transparency.

To their credit, the Municipal Securities Rulemaking Board is instituting a new state-of-the-art electronic information service, Electronic Municipal Market Access, proposed to begin operations on May 11. It is a transforming event and the MSRB deserves public commendation for developing EMMA. For example, with EMMA the market can know electronically whether an issuer has even filed its continuing disclosure obligations. Late last year, DPC Data issued a report entitled "Estimating Municipal Securities Continuing Disclosure Compliance."

It indicated that "across all bond classes, market sectors, and issuer geographies, more than 50% of bonds outstanding for nine or more years have one or more years of disclosure delinquency, and more than 25% are in chronic delinquency, missing three or more years of disclosures." EMMA will permit electronic tracking and publication of issuers' continuing disclosure compliance to investors.

Unfortunately, the "garbage-in-garbage-out" principal will continue to apply if the MSRB and SEC don't require the underwriters and issuers of muni securities to improve the timeliness of their financials.

For muni bonds, the financials are the comprehensive annual financial report, or CAFR, issued in audited form each year and required to be included with the official statement for a new borrowing.

On Sept. 10, 2008, the National Association of State Auditors, Comptrollers, and Treasurers published its survey for the fiscal years 2003 through 2007. The results of the survey are appalling.

The median average time from closing the books on the fiscal year until the results were published was 181 days or six months. For FY 2007, New Mexico took 398 days. This means that if the state issues municipal bonds with their "latest financials" 365 days after their CAFR is published, it would be over two years old at the time bonds are issued.

Of even more concern, the largest state, California, has over $47 billion of general obligation bonds outstanding, and took 272 days, or nine months, to publish its June 30, 2007, fiscal year financial statements on March 28, 2008.

California in March sold $6.54 billion of new bonds with its accompanying "latest financials" for the fiscal year ending June 30, 2007, 20 months out of date. This means that the state with the nation's lowest credit rating is borrowing more than $6 billion using financials that are over a year and a half old.

No one thinks that California's fiscal shape is the same today as it was at the end of fiscal 2007. This is simply unacceptable in 21st century America. As a citizen, I am outraged that these discrepancies exist.

Traditionally, the view was that the SEC couldn't do anything because it lacked jurisdiction over state and local governments. Those governments in turn have only been able to prepare their CAFRs by hand-merging hundreds of incompatible spread sheets from the executive branch, state higher education, pension fund, and bond authorities' financial systems.

This manual consolidation process plus delay in audits causes the six- or nine-month delay in publishing the fiscal year's results. Fortunately, today commercial software is available that can reduce the CAFR preparation time, shorten the audit process, and reduce preparation cost by 60% to 80% each and every year.

To reform the municipal securities markets, the MSRB can pass a rule stating that EMMA will only accept submissions of official statements and continuing-disclosure requirements filings that have timely financials, e.g., less than 30, 60, or 90 days old. The timeliness of official statements can be published on EMMA.

To improve continuing disclosure filings, EMMA can adopt the same requirement. Those that fail to meet their continuing disclosure filing obligations and provide untimely accompanying financial statements can be publicized and subject to market discipline. Failure or repeated failure to file timely financials could result in an issuer's securities being red-flagged, which could make it more expensive for the issuers to both raise new money and refinance outstanding debt.

Market pricing pressures will result in more complete and timely filings. With EMMA, this comparative performance information will be available on the Internet for the first time.

Broker-dealers will pressure issuers to prepare and file timely financial statements. Market disclosures with red flags for noncompliance will cause the broker-dealers and issuers to act in their own self-interest.

To do this, the issuers will adopt the technology to prepare their CAFRs on a timely basis. The choice is theirs - the SEC isn't making them do anything, capital market pressures are promoting changed behavior. Technology enables that change.

Moving expeditiously, the MSRB could require timely financials from the states and the largest municipalities for all new offerings and continuing disclosure reports submitted to EMMA after Jan. 1, 2010. Smaller issuers could follow a year later. This would be a tremendously positive SEC reform at a time when state and local tax revenues are collapsing while governments' borrowing requirements are ballooning.

Let's hope that chairwoman Schapiro again uses technology for smart management. She told Congress, "It is time for those who buy the municipal securities that are critical to state and local funding initiatives to have access to the same quality and quantity of information as those who buy corporate securities."

Using available and proven technology, she can achieve these objectives by reforming the municipal securities market and introducing corporate-quality disclosure this year.

 

R.T. McNamar is founder and president of E-Certus Inc., a technology and software company. He was Deputy Secretary of the Treasury from 1981 to 1985.

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