WASHINGTON — Institutional investors generally trade at more favorable prices than individual muni investors in the secondary market, the Government Accountability Office said in a report sent Tuesday to key members of Congress.
The congressional watchdog reached that conclusion in a report, entitled Municipal Securities: Overview of Market Structure, Pricing, and Regulation, that was mandated by the Dodd-Frank Act. The report was sent to Sen. Tim Johnson, D-S.D., chairman of the Senate Banking Committee, and Rep. Spencer Bachus, R-Ala., chairman of the House Financial Services, as well as the ranking members of both panels, Sen. Richard Shelby, R-Ala., and Rep. Barney Frank, D-Mass.
“In the secondary market, where these securities are typically bought and sold after issuance, trading largely occurs in over-the-counter markets that are less liquid and less transparent than the exchange-traded equity securities market,” the GAO said.
Individual investors own 75% of the estimated $3.7 trillion muni market, but typically have access to fewer sources of pretrade price information than institutional investors, who can compare thousands of daily offerings from a large network of broker-dealers, the report said.
Broker-dealers interviewed by the GAO said the price differential generally reflects the higher average transaction costs associated with trading smaller blocks of securities to individual, typically retail, investors, according to the report.
They told the GAO it costs less to trade securities in a few large blocks than in a large number of small blocks.
The GAO, which analyzed secondary market trading data from the Municipal Securities Rulemaking Board for the years 2005 through 2010, found: individual muni investors generally paid higher prices when buying munis and received lower prices when selling them; broker-dealers received larger spreads — the difference between the purchase price and sale price of a security based as a percentage of the purchase price — when trading smaller blocks of munis; and the prices individual investors paid tended to vary more than those paid by institutional investors.
In particular, GAO found, as trade size increased, the relative prices investors paid for munis declined steadily while relative prices investors received for selling their securities rose steadily. On average, investors paid 101.9% of a security’s reoffering price and received 99.4% of its reoffering price for $5,000 worth of securities, while they paid 100.1% of a security’s reoffering price and received 100.5% of its reoffering price for $2 million worth of munis, the report found.
The GAO’s report advances several explanations, stemming from academic studies, for the price discrepancies.
One possible factor, according to research cited by the GAO, is the lack of muni market price transparency, which “allows better informed investors to obtain more favorable trade prices.”
Another study cited by the GAO said institutional investors, with their continuous market engagement and frequent broker-dealer interactions, may have more bargaining power than individual investors.
A third study, also cited in the GAO’s report, said muni pricing differences are “not entirely due” to the market’s lack of transparency, but may stem from “interdealer trading,” since munis often “pass through a chain of dealers before being placed with investors.”
Separately, the GAO recommended that the Securities and Exchange Commission collect and analyze information on fixed-income regulatory programs on an ongoing basis to improve its oversight of the self-regulators, the MSRB and the Financial Industry Regulatory Authority, which share jurisdiction over the muni market. FINRA enforces the MSRB’s rules.
The SEC last inspected the SROs’ fixed-income surveillance program, which monitors muni trading, in 2005, the report found. The commission “may not have sufficient sources of information to allow it to effectively assess the risk level” in the SROs’ regulatory programs, the GAO said.
“Without ongoing collection and analysis of information to assess the effectiveness of SROs’ regulatory programs, SEC may be unable to identify and act on regulatory problems in a timely manner,” the report said.
In a letter to the GAO, dated Jan. 6, which is included in the report, Carlo DiFlorio, director of the SEC’s office of compliance, inspections and examinations, or OCIE, said the SEC agreed with the GAO’s recommendations that more frequent oversight of the SROs’ fixed-income regulatory programs would be helpful.
He noted the SEC has moved to a “risk-based approach” to focus its resources on entities and issues that pose the greatest risks to investors.
The OCIE will inspect FINRA’s fixed-income surveillance program later this year, he wrote.
But more frequent review and analysis of the MSRB’s and FINRA’s fixed income regulatory programs would require “additional staff resources,” he said, and the OCIE has been unable to fill “several vacant slots” due to ongoing budgetary constraints.
Even if the vacant slots were filled, the office would still be “understaffed relative to the number and complexity of the entities that it examines” and would need “additional resources” to conduct more frequent inspections of fixed-income programs at FINRA and the MSRB, or do interim monitoring of FINRA’s fixed-income surveillance program, he wrote.
A FINRA spokesperson declined to comment immediately, as did the SEC. An MSRB spokesperson also declined to comment, saying the board is in the process of reviewing the report.
The GAO’s pricing report is the second of three muni-market studies mandated by Dodd-Frank.
The first, which GAO delivered to Congress a year ago, was a review of the role of the Governmental Accounting Standards Board, including its funding.
By July, on Dodd-Frank’s two-year anniversary, the GAO is required to submit a study that compares muni and corporate disclosure requirements and evaluates the costs and benefits to issuers of requiring them to improve disclosure. The GAO must also recommend whether the Tower Amendment, which prohibits the SEC and the MSRB from requiring issuers to file pre-sale disclosure documents, should be repealed.