Richard A. Levan & Associates, PC - Wall Street Journal

THURSDAY, FEBRUARY 20, 1997

Jump to Quote

SEC Widens Muni-Bond Scrutiny

'Yield-Burning' Costs Worry Local Officials

By CHARLES GASPARINO and JOHN CONNOR
Staff Reporters of THE WALL STREET JOURNAL

What began two years ago as a routine inquiry into a seemingly obscure practice on Wall Street is now shaking the $1.3 trillion municipal-bond market.

The Securities and Exchange Commission is ratcheting up its scrutiny of municipal-bond "yield burning" abuses. State and local governments are fretting about how much the mess could cost them, and regulators are drawing into their sights some interesting figures, including a former Pennsylvania state treasurer; an old-line brokerage firm, Alex. Brown Inc.; and surprisingly, Michael Lissack, the self-styled whistle-blower who brought on the investigation in the first place, people familiar with the matter say.

Mr. Lissack, after his termination as a top muni-banker at Travelers Group's Smith Barney Inc. in early 1995, first called attention to the alleged yield-burning abuses. His charge: Wall Street had inflated prices of Treasury bonds sold to municipalities by improperly "burning" down the yields on these securities. (A bond's yield moves in the opposite direction of its price.)

Since then, Mr. Lissack has been a key witness in the SEC's probe of muni-market abuses. He has even filed a lawsuit in California superior court under the state's False Claims Act against Lazard Freres & Co., for the firm's work on some Los Angeles County bond deals.

But people close to the probe say the SEC wants to know if Mr. Lissack himself directly participated hi any abuses. Mr. Lissack, for his part, declines to comment; his lawyer, Jeffrey Robinson, also won't comment on the matter.

The SEC also is examining Alex. Brown, parent of Baltimore-based Alex. Brown & Sons, which played a key role in two Pennsylvania refunding deals, which are now under scrutiny. In addition, Prudential Insurance Co. of America's Prudential Securities, the underwriter on a 1993 state-prison bond refunding, has drawn scrutiny from the SEC and the LRS, people familiar with the probe say.

In a statement, Alex. Brown said: "We have responded to SEC inquiries concerning a variety of refundings over the last 18 months. While we cooperate fully with SEC inquiries, we customarily do not comment on them." A Prudential spokesman said the firm received a subpoena for information in May, but that the firm isn't aware of any continuing inquiry.

The whole yield-burning uproar started off rather benignly. In the early 1990s, cash-strapped state and local governments needed to cut their budgets in the face of federal-aid reductions. So Wall Street peddled to the governments an interesting idea: Replace your older, expensive muni bonds with new bonds issued with lower interest costs.

There was just one snag; muni bonds often cannot be replaced immediately. They must be "called," or refunded, on a later date. But that didn't stop Wall Street. To get around the call-date issue, Wall Street firms created special escrow accounts, comprising Treasury securities and other government bonds. The accounts gave state and local governments leeway to wait until their bonds could be called and then replace the old debt with the proceeds from the escrow accounts.

Wall Street's name for the process is "advanced refunding." Between 1990 and 1994, billions of dollars in refunding bonds were sold by municipalities across the country. The deals allowed municipalities to cut their interest costs, but these transactions were also lucrative for bond dealers - maybe even too lucrative, regulators say.

The SEC is investigating as many as two dozen bond deals for possible yield-burning abuses, people with knowledge of the matter say. Many of the largest firms on Wall Street are involved, including Merrill Lynch & Co., Smith Barney and Lazard Freres. They all say they have done nothing wrong. Recently, Lazard Freres issued a report that it said dispels the notion that firms regularly engaged in such abuses, and provided its defense for the government's investigation into the firm's role in Los Angeles County.

Meanwhile, the regulatory swirl continues. The SEC's investigation of yield burning appears at the top of its enforcement agenda for the new year, according to people with knowledge of the probe.

But Wall Street isn't alone in feeling the heat; investors as well as taxpayers could be hurt. In addition to the SEC, the Internal Revenue Service is investigating the matter, focusing on as many as a half-dozen transactions. The LRS doesn't have direct jurisdiction over securities firms, so in a recent ruling the agency said state and local governments that suspect yield burning on their securities should either pay up, or they could face having their tax-free muni bonds declared taxable.

"It's become a burning issue for the nation's" municipalities, says Frank Sha-froth, director of federal relations for the National League of Cities, the nation's biggest municipal-lobby group. "It's a dou-ble-whammy, no-win situation. You get cheated on overcharges on one side and then put at jeopardy by the IRS on the other."

One of the most recent hot spots of the yield-burning controversy has been Pennsylvania, where IRS and SEC officials are investigating three separate refundings the state completed in 1993 and 1994. In response, the state has hired outside counsel, and later this month, former state Treasurer Catherine Baker Knoll, who left office at the end of her second term in January, will meet with SEC officials In Washington, who are probing two of the transactions.

"What I've been given to understand is that this is a matter of formality," Ms. Baker Knoll said. Her lawyer, Richard Levan, said that "to the best of my knowledge, she's not the subject of any investigation."

Treasurys

Treasurys investors confounded conventional wisdom by selling bonds on the bullish news that inflation has slowed.

The benchmark 30-year bond's price fell 14/32, or about $4.40 for a bond with a $1,000 face value, to 100 17/32, its low for the day. Its yield rose to 6.58%.

Analysts said investors - reportedly ranging from large hedge funds to European central banks-moved to take profits after the Labor Department said the consumer-price index rose 0.1% in January.

That was lower than economists' expectations for a 0.3% gain, and normally would spark a rally, but the opposite occurred. Analysts said the market already priced in the bullish news last week, when producer prices were reported to have decelerated for the first time in more than two years.

Bond prices initially rose on the CPI report, but a wave of selling was met by reluctant buyers. Traders and analysts pointed out that investors may be lightening up some positions ahead of next week's monthly two-year and five-year note auction and Federal Reserve Chairman Alan Greenspan's semiannual Humphrey-Haw-kins testimony on Feb. 26-27.

Corporate Bonds

Oracle Corp. made its debut in the corporate-bond arena, marking one of the rare instances in which a software firm has tapped the public debt market.

Otherwise, the market was quiet, with no other straight corporate issues priced and with federal agencies pricing about $700 million.

Meanwhile, market players said the death of Deng Xiaoping has had little immediate effect on China's global and Yankee dollar-denominated bonds, noting that the ailing leader's condition had already been priced into the debt.

Oracle, a computer-software concern, priced $300 million in two parts through lead manager Morgan Stanley & Co.

The first tranche, S150 million of seven-year debt, was priced at par to yield 6.72%, a spread of 0.52 percentage point above Treasurys. The second tranche, S150 million of 10-year debt, was priced at par to yield 6.91%, a spread of 0.62 percentage point above Treasurys. Both parts, which are rated Baa2 by Moody's Investors Service Inc. and triple-B-plus by Standard & Poor's, are noncallable.

-Jeffrey L. Hiday and Craig Karmin contributed to this article.