Baseline Disclosure May Not Work for Riskier Munis

A disclosure regimen that gives the Securities and Exchange Commission authority to set baseline standards might work for the traditional municipal securities markets, but not its riskier outposts, an independent financial advisor warned in an article last week.

The article, by Robert Doty, president of AGFS in Sacramento, is entitled “The Readily Identifiable Riskiest Municipal Securities: Due Diligence Does Make a Difference,” and appears in the current issue of Municipal Finance Journal.

Doty’s remarks come five months after commissioner Elisse Walter called on Congress to authorize the SEC to set baseline disclosure standards for the muni market.

Earlier this month, at the National Association of Bond Lawyers’ bond attorneys’ workshop, Andrew Kintzinger, a partner at Hunton & Williams LLP in Washington, urged the bond attorneys’ group to do more for “market betterment” by supporting legislative efforts to give the SEC authority to develop a baseline disclosure rule.

But Doty, a former general counsel to the Government Finance Officers Association, a former member of the board of governors of the National Federation of Municipal Analysts, and a former director and vice president of the National Association of Independent Public Finance Advisors, takes a contrarian view.

He cautions that a baseline disclosure regimen tailored to general obligation bonds, on which issuers rarely default, overlooks the need for more careful disclosure and due diligence in non-traditional market segments, where default risks are higher.

“To talk about a single baseline has some attractions,” Doty said in an interview. “But it also could be dangerous.”

In his article, Doty said the muni market consists of two sectors, with different levels of risk.

Significant portions of the muni market — those supported by unlimited-tax general obligation credits or by the revenue credits of well-established traditional government enterprises — are generally sound and safe, with low default rates, even if the issuers experience significant financial distress, he wrote.

But Doty said certain non-traditional municipal securities present far more serious default risks and deserve much more attention, both in disclosure and due diligence.

In particular, he described several categories that have higher rates of muni defaults: industrial development bonds and other conduit financings for private profit-making or nonprofit corporate obligors; housing and health care securities; land-based securities; charter schools and other munis that depend significantly, either directly or indirectly, on the performance of private parties.

In addition, Doty said, start-up or rapidly expanding governmental enterprises also pose increased default risks.

As examples, he cited Harrisburg, Pa., where the city guaranteed about $242 million of bond debt related to an incinerator retrofit — $65 million of which is overdue.

The city, the capital of Pennsylvania, filed a Chapter 9 bankruptcy petition earlier this month.

Doty also pointed to Jefferson County, Ala., which has defaulted on more than $3 billion in sewer warrants and is struggling to avoid filing the largest muni bankruptcy in U.S. history.

In an interview, he identified a third risky market segment: derivatives or other exotic financial instruments, such as interest-rate swaps and collateralized debt obligations.

CDOs are not munis, but were implicated in the SEC’s recent securities fraud cases against Stifel Nicolaus & Co. and one of its former executives, charging they fraudulently misled five Wisconsin school districts by steering them into unsuitably risky and complex investment products linked to the performance of synthetic CDOs.

“People would be hard pressed to find very many defaults that don’t fit into one of these three categories,” Doty said. “They’re all obvious to the people conducting the transaction.”

As for due diligence, he wrote that in the riskier transactions, attention to work performed by experts — such as feasibility studies, financial projections and appraisals — is essential.

In particular, he said, issuers and their independent advisors should scrutinize expert reports, ask questions, seek clarifications and obtain an opinion from the expert that any underlying assumptions are reasonable.

“The basic message is that people should not turn off their brains just because there is an expert study,” Doty said.

For reprint and licensing requests for this article, click here.
Washington
MORE FROM BOND BUYER