The many perils of munis

The Securities and Exchange Commission's announcement last week that it was charging Harrisburg, Pa., with securities fraud for making misleading statements about its financial condition not only should serve as a warning to municipalities to watch what they say but to financial advisers who are active in the municipal bond market to watch where they invest. As banking analyst Meredith Whitney reminded attendees at a mutual fund industry conference recently, we're not out of the woods yet when it comes to municipal bond risk. While her much-ballyhooed prediction in December 2010 of imminent and sweeping defaults in the muni bond market never materialized, there have been defaults scattered around the country. And the potential for more defaults, given the sluggish economic recovery, still exists. In fact, Ms. Whitney believes that there will continue to be default hot spots across the country, primarily on the coasts. She singled out the so-called sand states — Arizona, California, Florida and Nevada — as particularly vulnerable because local budgets there have been battered by the collapse of the housing market. Advisers have to worry about more than the potential for defaults. Deteriorating financial conditions often can lead to credit downgrades by ratings agencies, which have a direct influence on the value of municipal bonds.

ALARM BELLS

Ms. Whitney is not the only one sounding the alarm. SEC member Daniel Gallagher also recently warned muni bond investors that they have to pay close attention to the credit quality of their holdings, as well as rising interest rates. For its part, the SEC is putting all municipal officials on notice that they have a responsibility to be honest and forthright about their jurisdictions' finances, not only in official documents but in their speeches and annual State of the City addresses. Harrisburg was cited by the regulator for making misleading statements in official documents and failing to comply with requirements to provide regularly updated financial information to the investors holding hundreds of millions of dollars in bonds issued or guaranteed by the city. It also was cited for attempting to put the best possible face on a bad situation when, in a 2009 address, the then-mayor referred to a troublesome incinerator simply as “an additional challenge” and an “issue that can be resolved.” That trash-to-energy incinerator, which eventually cost $260 million in upgrades and repairs, turned out to be the primary source of the city's fiscal woes, and downplaying its significance was not just a harmless case of putting lipstick on a pig. The SEC called the address misleading for not going into detail about the full impact of the incinerator's debt on the city's finances. It represents the first time the regulator has charged a city for misleading investors outside its securities disclosure documents.

"INFORMATION VACUUM'

“In an information vacuum caused by Harrisburg's failure to provide accurate information about its deteriorating financial condition, municipal investors had to rely on other public statements misrepresenting city finances,” George S. Canellos, co-director of the SEC's Division of Enforcement, said in a statement. “Statements that are reasonably expected to reach the securities markets, even if not prepared for that purpose, cannot be materially misleading.” The incinerator didn't generate enough revenue to pay off the debt taken on for the upgrades, an amount that is five times the city's general-fund budget. Harrisburg had missed $13.9 million in general-obligation-debt service payments as of March, according to the SEC. As a result of its defaults, the city of 48,000, for all intents and purposes, has been shut out of the municipal debt market. Harrisburg is not alone in drawing regulatory action. The SEC this year charged Illinois with failing to disclose the precarious condition of its pension system in bond documents. A similar case was brought against New Jersey in 2010. Another worrisome problem — and one that advisers in particular should be acutely aware of — is that many of the 50,000 issuers of municipal debt do not supply timely financial disclosures after their bonds are issued. If advisers and investors do not have accurate and timely material information, trading decisions are based on stale information. So the lesson for advisers is clear. There is no substitute for continuing due diligence when considering muni bonds. Credit quality should be a top concern as long as economic conditions remain choppy, unemployment remains high and municipalities struggle to generate sufficient tax revenue.