Commentary by Joe Mysak
Sept. 2 (Bloomberg) -- Why are the bonds priced that way?
That's an unpromising start to a municipal-market mystery, I'll grant you, but it's how a new whistleblower intends to make his case.
The whistleblower used to work at a big securities company, and asked that I identify neither him nor the firm. Since late last year he has been talking to the Internal Revenue Service, the de facto regulator of the municipal market.
And this is what he is telling them. Take a look at how these bonds are priced, he is saying. Why are there coupons of 6 percent-plus on bonds due in a year?
That's a pretty good question, because bonds due in a year or two usually carry the lowest coupons, of 1 percent or 2 percent. Issuers don't normally pay much attention to such things, because a bond with a 6 percent-plus coupon is priced at 104 or more, bringing the yield down to where it should be.
Now we get to the ``whistleblower'' part, where our man hopes to make his money. How much? Under terms of the law passed in 2006, the IRSpays whistleblowers 15 percent to 30 percent of taxes, penalties and interest that the agency recovers as a result of their information. Our whistleblower puts the amount of fraud here at about $300 million, meaning his payday would be at least $45 million.
Tax-Rule Violation
The tax rule being violated, this whistleblower is telling the IRS, is 171a, which doesn't allow buyers to amortize the premiums paid on tax-exemptbonds. They may amortize the premiums paid on taxable bonds, but many banks' accounting software apparently didn't make the distinction.
This wasn't a big deal in the old days, when most investment banks didn't hold lots of tax-exempt bonds, and when most bonds were priced around par.
``Banks now hold massive proprietary positions of municipal bonds through their treasury, tender-option bond and arbitrage trading desks,'' the whistleblower wrote to the IRS. ``Due to market conditions and investor preference, nearly all tax-exempt bonds are now issued at a premium, sometimes at a significant premium.''
So what did some big banks do? They gamed the system and accelerated the whole process, says the whistleblower. They put 6 percent-plus coupons on big maturities, $20 million or more, due in a year, bought those bonds at premium prices of 104 or 105, and took millions of dollars in deductions to which the banks weren't entitled, he claims.
The thing about whistleblowers is that they speak in a language few people can understand, until you come across someone who knows exactly what they're talking about and says, ``Uh-oh.''
`Yield-Burning'
That much was clear when the modern age's first municipal- market whistleblower, Michael Lissack, told his story to the New York Times.
Lissack appeared on the front page of the newspaper's business section on March 3, 1995, describing ``yield-burning,'' in which underwriting firms routinely overcharged issuers for the securities they used in refinancing bond deals.
It was all pretty heavy going, once you got into the details of the thing, but underwriters eventually paid $205 million to the government to settle the matter. Lissack was entitled to 25 percent of that.
The new whistleblower says that market conditions were perfect from 2001 to 2005, as the Federal Reserve lowered short- term interest rates.
High-Coupon Boomlet
``Certain firms started aggressively bidding on available short-term, high-coupon securities,'' he wrote to the IRS. ``This represented a departure from previous practice, as historically municipal bonds with maturities of one year or less were sold exclusively to money-market funds and individuals.
``This is because short-term municipal yields are in almost all cases lower than bank-funding costs. Without a tax scheme, it is virtually impossible for banks to make money by buying short- term municipal bonds.''
The whistleblower even has a name for the ``tax scheme.'' He calls it ``premium-laundering.''
Of course, nobody wanted to talk about it, when I called my usual sources, although one underwriter did remember being very curious about those big coupons.
The data show a little boomlet of high-coupon multimillion- dollar maturities due in one year and not reoffered to the public in 2003 and 2004, and then they disappeared. The whistleblower says the industry itself put a stop to what it perceived as an abusive practice by a handful of underwriters.
The IRS doesn't comment on its investigations. I did get to what I would call the ``Uh-oh'' guy, a money manager who described the subject as ``sensitive,'' and told me that some people had even been fired for it.
The only question I have about the story the whistleblower is telling the IRS is: Did this really happen? I guess the IRS will find out.
(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Joe Mysak in New York atjmysakjr@bloomberg.net
