The SEC’s Race To Restore Municipal Bond Integrity

Creativity has its place. That place is not the financial reports of states and municipalities.

At least it shouldn’t be, although as Wall Street Journal columnist Steve Malanga recently observed, the Securities and Exchange Commission is concerned that tax-exempt bond investors are being sold a collection of fairy tales.

Malanga, of course, is not the first to point out that finances at all levels of government are a mess and that some jurisdictions want to sweep their fiscal dirt under the nearest rug. My colleagues and I have written on this topic for years. But Malanga did a good job of pulling together three discrete, yet related, points: That some governments are hiding the true state of their finances; that the SEC is trying to clean up financial reporting so investors can better protect themselves; and that some bondholders may be in for an unpleasant surprise if they assume that they will be first in line to get paid if a government’s finances go on the rocks.

I think Malanga and the SEC are right to be concerned, though forecasts of municipal default are not popular with politicians or investors. This is why I believe would-be buyers ought to approach all public debt instruments with extreme caution.

The SEC has already has accused Harrisburg, Pa., and South Miami, Fla., of securities fraud. The SEC alleged that Harrisburg officials issued public statements intended to mislead investors and that South Miami created a complex bond deal that risked the securities’ tax-free status while failing to disclose the risk to investors. Both Harrisburg and South Miami agreed to settle. As is common in SEC cases, the settlements do not include admission or denial of wrongdoing.

It seems unlikely that Harrisburg and South Miami are outliers. The SEC accused Illinois earlier this year of misleading investors about the state’s pension fund, and filed similar allegations against New Jersey in the recent past. Anthony Figliola, a vice president with Empire Government Strategies, said that “Harrisburg is the tip of the iceberg.”

The whole idea behind lending money to anyone is that you expect to get it back eventually. That is the difference between a loan and a gift. But as some cities now aggressively push the argument that investors should be the ones to suffer financially when municipal finances run off the rails, the compact between borrower and lender is fundamentally broken. Politicians claim that taxpayers are not at fault and should not be asked to suffer, but conveniently ignore the fact that they and their predecessors are the ones who were entrusted with their jurisdictions’ financial health, not the investors who bought their bonds in good faith.

Despite these signs of trouble ahead, some yield-hungry investors are going to chase what seem like promising returns. All lenders start as savers, and all savers want to earn some return on the capital they saved. Given the rising tax rate environment, you’d probably like that interest to be tax-free. Thanks to the financial repression engineered by the Federal Reserve, which has taken safer alternatives off the table, some investors will gloss over the risks and lend to state and local governments that will eventually prove more loyal to local residents and voters than to their financial backers.

A bond is, after all, supposed to be a bond – a long-term covenant between a government entity that freely decides to borrow and a human being who lends his or her capital to that government. The government pledges its current and future taxpayers to honor that obligation for the many years it is designed to last. The system breaks down when the future becomes the present, and heavily burdened taxpayers renege because they don’t want to bear the costs or suffer the service cuts that good faith demands.

Creative government accounting is a sign that the system is breaking down due to a lack of that good faith. The SEC hopes to restore integrity to the system before it is too late. Let’s hope that threshold has not been crossed; but I believe that, in many cases, it already has.

About Larry M. Elkin 564 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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