The bond merchants: Wall Street makes millions on municipal bonds, but guess who pays? - underwriting and political campaign funds

Common Cause Magazine, Winter, 1993 by Deborah Lutterbeck

The goal for an underwriter is to land a negotiated deal, typically far more profitable than a deal that is bid on competitively. Negotiated underwriting gives the underwriter far more leeway. Unlike a competitive deal, in which interest rates are set at the time of the bidding, a negotiated offering allows the underwriter some room to adjust the rates and maturity of bond issues to reflect what the market will bear. As a result, negotiated deals are less vulnerable to the periodic interest rate shocks that hit the bond markets. According to one Wall Street underwriter, municipal bond departments throughout the country would shrink dramatically without negotiated deals.

"People lose money on competitive bids," says Chapman, the former Wall Street underwriter and the New Jersey state bond adviser. "No one loses money on a negotiated bid." He adds that Wall Street has a powerful incentive "not [to] kill the goose that lays the golden eggs" - in other words, to do whatever it takes to preserve the negotiated bid.

Negotiated underwriting certainly has been popular. As of the third quarter of this year there have been $180 billion in negotiated bond deals awarded nationwide, and only $41 billion in competitive deals, according to statistics compiled by The Bond Buyer. Public finance specialists are quick to say that the complicated, idiosyncratic nature of many bond issues makes them better candidates for a negotiated deal, which offers more flexibility than a straightforward competitive bidding process.

But negotiated underwriting also gives local politicians considerable discretion in choosing underwriters. And when underwriters contribute to the campaigns of politicians who can award them business, the resulting environment provides "all the ingredients you need for corruption and kickbacks," says Chapman.

According to an informal study by George Friedlander, managing director of fixed-income, or municipal, bonds at the Wall Street firm Smith Barney, the difference in earnings between negotiated underwriting and competitive underwriting is difficult to measure and varies. According to his rough calculations, in the first nine months of this year, underwriters earned $8.39 per $1,000 on negotiated deals compared with $7.55 per $1,000 for competitive deals. On a $200 million bond deal that would mean the difference between earning $1.7 million and $1.5 million. On a $500 million bond issue, that is the difference between $4.2 million and $3.8 million.

With these types of fees at stake, it is not surprising that some underwriters have tried to cut corners.

Other Countries, Other Problems

Orange County isn't the only place where questions have been raised about the business of bonds. * Wall Street titan Merrill Lynch came under federal investigation last spring after questions were raised about the firm's involvement with an obscure New Jersey investment bank called Armacon, which happened to be partly owned by New Jersey Gov. Jim Florio's then-chief of staff. Investigators are examining allegations that Merrill Lynch funneled money to Armacon in exchange for the position of chief underwriter on a $2.8 billion New Jersey Turnpike Authority bond deal. While Merrill Lynch has said an "internal inquiry" to date has uncovered no evidence of criminal conduct by any employee, three of the top executives in the municipal bond department have been suspended pending the investigation's outcome. Meanwhile, the Florio aide resigned. * New York City Comptroller Elizabeth Holtzman's reelection bid collapsed before the September primary when a city investigation reported that she showed "gross negligence" in dealings with the Fleet Bank. She had given Fleet a lead underwriting role on a New York City bond seven months after Fleet loaned $450,000 to her 1992 U.S. Senate campaign. Holtzman, who became a national figure for her forceful questions in the Nixon impeachment hearings, found herself saying she "did not remember" if she knew that Fleet was seeking underwriting business when she met with bank officials about a campaign loan. What she did say was that she wished she "had done things differently." * In Massachusetts, the bond problem was centered on a man named Mark Ferber, who according to Business Week was fired as the independent financial adviser to the Massachusetts Water Resources Authority after some conflict of interest issues were raised. The Boston Globe revealed that Ferber, who works for Lazard Freres, chose Merrill Lynch to underwrite a bond issue that earned the company $4.5 million. Six months later, Merrill Lynch and Lazard Freres entered into a business deal that earned them $6 million, the Globe reported. Nothing in the Merrill Lynch-Lazard Freres contract involved the water authority; nevertheless, the tangled relationships led the authority to dismiss Ferber because of an appearance of a conflict of interest, Business Week said. * In New Orleans, the U.S. attorney has been investigating allegations of impropriety surrounding a $600 million state bond issue in which two of the nation's largest underwriting firms, First Boston and Lazard Freres, made a generous fee-splitting arrangement with Commonwealth Securities Corp. of New Orleans, according to news reports. Commonwealth is owned by a close ally of Gov. Edwin Edwards. According to news reports, the New York-based firms split their bond-underwriting fees with Commonwealth even though Commonwealth sold nowhere near the amount of bonds that would justify its $240,000 commission. * In Kentucky, Frank Collins, husband of ex-governor Martha Collins, was convicted of extorting nearly $1.7 million in political contributions from out-of-state bond-underwriting firms in exchange for state business. Collins could serve up to 25 years for his role in encouraging the firms to invest in his partnerships in thoroughbred horses.