The $3 trillion municipal debt market is rife with creative accounting.
It has been a busy few weeks for the Securities and Exchange Commission. In May, the SEC charged two cities—Harrisburg, Pa., and South Miami, Fla.—with securities fraud for allegedly deceiving investors in their municipal bonds.
This follows similar fraud charges against states, New Jersey in 2010 and Illinois in March, after SEC investigators uncovered what they called "material omissions" and "false statements" in bond documents related to those states pension funds.
With Harrisburg, however, the SEC has gone further and charged the city government with "securities fraud for its misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated." The SEC says this is the first time the regulator has "charged a municipality for misleading statements made outside of its securities disclosure documents."
The Harrisburg charges are part of a broader SEC effort to scrutinize state and local government issuers in the nations $3 trillion municipal-bond market. "Anyone who follows municipal finance knows that budgets can sometimes be a work of fiction," says Anthony Figliola, a vice president at Empire Government Strategies, a Long Island-based consulting firm to local governments. "Harrisburg is the tip of the iceberg."
And a mighty iceberg it is. The 2012 State of the States report, released in November by Harvards Institute of Politics, the University of Pennsylvanias Fels Institute of Government and the American Education Foundation, found state and local governments are carrying more than $7 trillion in debt, an amount equal to nearly half the federal debt. Often, the report said, "States do not account to citizens in ways that are transparent, timely or accessible."
Consider the practices of Stockton, Calif., which last June became the nations biggest city to file for bankruptcy. In 2011, Stocktons new financial managers issued a blistering critique of past accounting practices and acknowledged that the citys previous financials had hidden significant costs, including the real cost of employee compensation and retirement obligations. Bob Deis, the new city manager, declared that Stocktons financials bore "eerie similarities to a Ponzi scheme."
If so, the citys bondholders have been taken for a ride. In bankruptcy court earlier this year, a judge ruled that Stockton could suspend payments on its bonds even while continuing to fund its employee retirement system.
Similarly, when another California city, San Bernardino, went bust last year, some city officials alleged that it had been filing inaccurate financial records for nearly 16 years. At best, officials said, the citys bookkeeping had been "unprofessional." The SEC began an investigation last fall. Meanwhile, the city has defaulted on bond payments, leaving investors in the lurch.
One area that has come under special scrutiny is pension-fund accounting, because states have latitude in choosing how to value their retirement debts. The SEC noted that Illinois used accounting that funds a larger percentage of an employees pension costs near the end of his career, a method that increases the risks that the system could go bust. The SEC said Illinois didnt properly reveal the risks posed by this sophisticated accounting wrinkle.
The SEC accused New Jersey of failing to disclose to investors that it wasnt sticking to a plan to adequately fund its pension system. In this, the Garden State isnt alone. Many states underfund their pension systems, even by their own accounting standards.
A June 2012 study by the Pew Center on the States found that 29 states didnt make their annual required contribution for pensions in 2010, the last year for which data were available. It isnt clear how many of the more than 3,000 local government pension systems follow the same practice, although a survey this January by Pew of 61 large cities found nearly half didnt make their full contributions.
In the South Miami case the SEC zeroed in on a complex bond deal that changed over time in a way that threatened the tax-free status of the securities. The SEC essentially warned South Miami that municipalities that employ such schemes need to fully understand the consequences for investors. In this particular case, South Miami paid $260,000 to the Internal Revenue Service to preserve the tax-free status of the bonds for investors.
Municipal investors have often ignored such questionable practices thanks to a generation of low default rates. Many also assume that even when a local government gets into financial trouble, bondholders are always first in line to be paid.
But officials in some troubled cities are pushing back against the notion that investors should get the best deal among creditors. Harrisburg City Council members have balked at a state-proposed bailout plan because they claim it places much of the burden on taxpayers without penalizing investors. Last year, City Councilman Brad Koplinski called the plans 1% increase in the state-imposed income tax on Harrisburg residents "a bad decision for the people of Harrisburg, people who did nothing to get our city into our fiscal crisis."
Investors will hear more of this talk as municipalities face growing budget pressures. Recently, former New York Lt. Gov. Richard Ravitch warned the municipal bond industry that the promises governments have made to repay investors may not take precedent over other obligations. States and cities face "a unique challenge," he said, "in trying to maintain services and meet their retirement commitments to workers," emphasizing that this was "not necessarily a good message" for investors.
Under these circumstances muni-bond investors should be practicing a stronger form of "buyer beware." Yet even that is difficult if governments issue reports designed to disguise their true financial condition. If investors finally catch on to this, it might put an especially deep chill on the market for municipal securities. Less than forthcoming city and state governments will deserve the consequences.
Original Source: http://online.wsj.com/article/SB10001424127887324659404578501241181682894.html