Shady finance deals put cities in regulatory spotlight

Marc Serota | Getty Images

Marc Serota | Getty Images

The financial pain inflicted by the Great Recession has been compounded in some broken cities by ill-advised budget decisions that involved honest mistakes.

Then again, not all of those decisions were honest.

Look no further than Miami-Dade County, Florida, a sprawling patchwork of dozens of suburban governments clustered around the city of Miami—a financial and trade hub to much of South America, a tourist magnet and home to a glittering glass skyline of pricey real estate.

Amid those multiple blessings, South Florida is also a hotbed of shady municipal finance deals that recently brought the region national notoriety in a flurry of fraud and corruption charges.

In September, the board that governs Miami-Dade’s public hospital system settled Securities and Exchange Commission charges that it misled investors about its deteriorating finances when it sold $83 million in bonds in August 2009. The Public Health Trust, which runs the aging public hospital system, didn’t admit or deny the SEC’s findings.

In July, the SEC charged the city of Miami and its former budget manager, Michael Boudreaux, with running a “shell game” with city funds to hide a multimillion-dollar shortfall in vital reserves used to prevent the city budget from running aground. As the Great Recession ate into local revenues, authorities say, Boudreaux transferred funds to hide mounting deficits in advance of three bond offerings totaling $154 million in 2009.

(Boudreaux’s attorney told the Miami Herald his client did nothing wrong and that there isn’t “a scintilla of evidence of bad intent or fraud on his part.” In a statement, the city said the SEC was “trying to transform political and budgetary decisions with which it disagrees unto securities violations.” Last month, the city and Boudreaux asked a federal district court to dismiss the charges.)

(Read more: SEC charges city of Miami with fraud)

The agency also is looking closely at a controversial deal to build a new stadium for the Miami Marlins baseball team—paid for mostly with city and county bonds that left local taxpayers on the hook for over $1 billion for decades. The project was supposed to help attract more tourist traffic, boost the local economy and generate tax receipts. Instead, after three straight seasons in the basement of the National League East, the Marlins played their 2013 home games in a half-empty stadium.

The City of Miami and Miami-Dade County confirmed that they have received subpoenas.

The wider crackdown

The Great Recession inflicted one of the sharpest drops in local revenues on U.S. cities since the Great Depression. That put a historic budget squeeze on city halls nationwide, forcing widespread layoffs and deep service cuts.

That ebbing economic tide also revealed some of the worst municipal finance swindles in decades, according to a series of interviews with academic researchers, independent consultants and federal regulators.

The recent discovery of widespread fraud and corruption in local government finance should come as no surprise, they say. Public finance, long overdue for a regulatory crackdown, has been one of the murkiest corners of the financial services industry.

“For a long time—predating 2008—there’s been a concern at the SEC regarding the opaque nature of this market in terms of disclosure, in terms of pricing, that it is really unregulated,” said Elaine Greenberg, who ran the enforcement division of the SEC’s Municipal Securities and Public Pensions unit.

“And the only way to get a handle on regulating the market is through enforcement,” said Greenberg, who entered private practice in June after more than 25 years with the agency.

The lack of regulation governing disclosures is especially harmful to unsophisticated investors, who are often attracted to the income tax exemption reserved for municipal bonds, say public finance experts.

In response to evidence of a wave of public finance fraud, the SEC set up a task force three years ago to crack down on the most egregious offenders. The effort has begun to pay off in a batch of high-profile cases:

In 2010, New Jersey became the first state ever accused of violating federal securities laws when the SEC alleged it misled investors who bought 79 separate bond offerings totaling $26 billion over six years ending in April 2007. The state falsely claimed it could cover pensions for teachers and state workers without raising taxes or cutting services, according to the government. New Jersey agreed to settle the case, without admitting or denying the findings or paying any penalties.

The trail to Wall Street

The trail of fraud extends to the heart of the securities industry, where the underwriters of taxpayer-supported borrowing have also been digging deep into the $3.7 trillion municipal bond market cookie jar, according to federal regulators.

Two year ago, Wells Fargo paid $148.2 million to settle federal and state charges that it rigged dozens of bidding competitions to win business from cities and counties. The SEC said Wachovia, which Wells Fargo bought in 2008, generated millions of dollars in profits when it fraudulently rigged at least 58 municipal bond transactions in 25 states and Puerto Rico over eight years. That bogus bidding process forced local governments to pay more than they should have for new schools, public hospitals and public transportation projects, the SEC said.

Wells Fargo was not alone in putting its thumb on the municipal finance scale, jacking up local taxpayers’ tab for public project debt for decades, the government said.

In July 2011, a JPMorgan Chase unit agreed to pay $228 million to settle civil fraud charges that it rigged dozens of bidding competitions to win business from cities and counties. UBS agreed in May 2011 to pay $160 million, and Bank of America agreed in December 2010 to pay $137 million.

This July, three former UBS bankers were sentenced to prison. The longest sentence was 27 months, a fraction of what prosecutors had sought.

(Read more: Tax-credit bonds pose potential for fraud: U.S. tax inspector)

The crackdown comes in sharp contrast to the laissez-faire approach that prevailed a decade ago, according to Peter Shapiro, a financial advisor to local public finance officials.

“It’s a very rapid pendulum swing back from one of the most permissive periods to one of the strictest periods in history,” he said. “People are suffering regulatory whiplash. But this is needed right now. The abuses that we saw during the lead-up to the financial crisis were in many cases terrible ones.”

In the extreme, fraud can sink a local government’s finances. In November 2011, Jefferson County, Ala., filed for bankruptcy. It was swamped by $4.2 billion in debt, much of it from corrupt deals to finance a sewer renovation project that resulted in criminal convictions or guilty pleas from 21 officials.

Though municipal bankruptcies and defaults are still rare, cities borrowing money in the $3.7 trillion municipal bond market are supposed to provide enough financial information to let investors fully understand the risks. That job falls to the broker-dealer hired to handle the bond offering.

Investors left in the dark

Or at least it’s supposed to. Earlier this month, the SEC slapped a $300,000 fine on Piper Jaffray, which handled the 2008 sale of $42 million of bonds for the city of Wenatchee, Wash., which was also fined $20,000. The agency said the bank mislead investors about the viability of an ice rink that ultimately fell into default.

Municipal bond investors can also find themselves in the dark after the sale of a bond, many of which don’t mature for decades. Local governments and their underwriters are supposed to provide “continuous disclosure” to let bond holders know of any developments that might put their investment at risk.

But the rules for such disclosures are much more lax than regulations for public companies, which must provide timely financial disclosures of any “material” information—such as earnings problems or a lawsuit—that could sink a stock.

Investors in municipal bonds, on the other hand, must wait more than 10 months after the end of a local government’s fiscal year to get their hands on its audited financial statement, according to a recent survey by the Municipal Securities Rulemaking Board. The agency was set up in 1975, and its authority was expanded in 2009 under the Dodd-Frank reform law.

The board has been working to improve disclosures by centralizing offering documents on a Web clearinghouse, Electronic Municipal Market Access. Retail investors can sift through gigabytes of files detailing thousands of bond offerings on the site, but reportiing much of the information remains voluntary.

At the heart of the problem is a long-forgotten law enacted in 1975—known as the Tower Amendment—that bars securities regulators from requiring municipalities to make the same detailed disclosures that a company like Twitter has to make when it sells shares to the public. State and local governments argued that such regulations were an unwarranted incursion into states rights and that the burden of detailed financial disclosures would add an undue cost to public finance.

But the disclosures of recent abuses related to these inscrutable investments are also costing taxpayers—even those in well-managed cities—in the form of higher borrowing costs.

As recently as the late 1990s, investors were willing to lend money to local governments for at least a full percentage point less than they got from investing in a Treasury bond of the same maturity. Today, local governments pay a borrowing penalty of more a full percentage point compared to the federal government.

In the long run, that may change if local governments and the underwriters they hire take the SEC’s recent enforcement actions to heart. Until then, investors can expect to see more enforcement cases shining more light on a dark corner of the financial markets.

“I think it’s a work in progress,” said former SEC official Greenberg. “While these cases have served to highlight and focus the problems in the industry, I still think that there is more work to be done. And while many market participants appreciate their obligations under federal securities laws, there are many that still don’t.”

—By CNBC’s John W. Schoen. Follow him on Twitter @johnwschoen.

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