Look at all these bond counsel! They can’t all be experts! Who knows what their qualifica- tions are? These pages are cluttered with them!” Carl Trauernicht, a sixtyish-looking lawyer witha squat German butcher’s build, was reaching forThe Red Book—the Martindale & Hubbell of the municipal bond profession—and furiously flip- ping pages. Evidently hundreds of investment banking and law firms have swarmed into the municipal bond business in the last decade, bring- ing “innovations,” and a spirit of competition, that Trauernicht is not at all pleased with. He found the section on St. Louis, his home city, and gave me the book. “Look here, how many firms are listed? Fifteen, maybe, 20, I don’t know! Twenty years ago we were the only firm in the city, in the state almost!”
The municipal bond business, once a sleepy backwater area of the investment world, is grow- ing and changing at a phenomenal rate. In 1971 less than $14 billion in new issues of municipal bonds came to market. In 1983 the total was $85 billion—$122 billion counting short-term debt. Hidden in these swelling numbers is an even more significant change. In 1971, 95 percent of the dollars raised on the municipal bond market financed the building of roads, schools, sewers —the meat and potatoes projects you common- ly associate with municipal bonds. By 1983 these “traditional” projects made up less than half of the total. The other half, about $45 billion, went to finance activities having little or nothing to do with state and local governments: private hospitals, nursing homes, universities and college students, real estate developers and home buyers, and most importantly, corporations.
In all this activity, the small, tightly knit community of bond bankers and lawyers—of which Carl Trauernicht is one of the last representatives—has been overrun. Growing numbers of young turks armed with MBAs and computers and often coming from positions in corporate law and finance are getting into the business and revolutionizing it. Freda Stern Ackerman, exec-utive vice president of Moody’s Investors Service,observes that the once-conservative municipal market, now “flooded with innovative new pro- ducts, is beginning to resemble the corporate debt market”
Carl Trauernicht looks upon this tumult of “creativity” with the bemused indignation of a man who disagrees with a changing world but knows his place in it is secure. His firm, Charles & Trauernicht, has nothing like the dominant position it once enjoyed throughout the South and Midwest when his father, Carl Sr., was run- ning things. Yet, in a growing debt market, business keeps rolling in, largely on the strength of Trauernicht’s reputation for competently han- dling traditional, “plain vanilla” bond issues, where creativity is beside the point.
By avoiding most of the innovative financings, Trauernicht has been able to keep his operation simple. He shows me a “Preliminary Official Statement”—a municipal bond equivalent of a stock prospectus—for an issue being handled by a competing law firm. It is 40 pages of numerical tables and dense legalese. “The literature we send out,” he says, “is two pages, folded in half and stapled .” Does he ever get complaints from bond buyers and bankers? “Occasionally someone will ask for more information; when they don’t get it, they usually buy the bonds anyway.”
In an era in which almost all the old-line bond counsel firms have merged with large corporate firms with sophisticated tax departments, Trauernicht has remained independent. “When I need an answer to a tax question,” says Trauernicht, pointing to a bound set of tax regulations and striking a pose like John Houseman, “I go to the right book and look it up!’
Charles & Trauernicht’s staff is meager: two aging lawyers and two pleasant, matronly secretaries. A conspicuous lack of young, starch- shirted associates suggests the eventual disap- pearance of this way of doing business. Even the offices in downtown St. Louis have that look ofhoary respectability that makes interiordecorators smile in their sleep: grey metal trash cans, conference tables seemingly carved out of tree trunks, doors with windows of opaque, rip- pled glass. There is one acquiescence to the New Era—a word processor.
Retelling the history of his firm, Trauernicht describes the late Benjamin H. Charles, the firm’s founder, without a touch of irony or qualification, as “a good lawyer, a gentleman, a man of honor and principle!’ Of all the changes that have rocked the industry in recent years, the one that truly seems to have wounded Trauernicht’s spirit is the decline of the reputation of his calling—the debauching of the tradition of bond counsel. It’s a tradition unique in the history of the legal profession.
Gentlemen prefer bonds
It all began in the latter part of the 19th century, when a number of southern and midwestern states repudiated their bonded indebtedness on the grounds that the bonds were technically defective and hence not legal and binding. (Southern states, for instance, argued that their bonds had been issued during Reconstruction by carpetbaggers, who were not popularly elected.) After getting burned a few times, bond buyers and bankers began hiring lawyers to read over the bond-issuing documents—called “transcripts” in the trade—to make sure that no undotted “i” or uncrossed “t” could be used to challenge the legitimacy of the bonds. Once the “bond-approving attorney” had examined the transcripts under his loupe, making sure that the tax assessments were done correctly, that notices of bond referendums had been publicly posted, that there were quorums at the local council meetings, and that all the right officials had signed all the right papers on the right day in the right order, the attorney would draft an “opinion of counsel,” affirming the legality of the obligation. This opinion would accompany the bond, or would be printed directly on the security. For the buyer of the bond, it was a form of insurance.
Business naturally gravitated to a few firms that specialized in this arcane realm of the law— first in New York, where most of the big bond counsel firms are still located, then in a few large cities around the country. Bond buyers and “underwriters” (investment bankers who buy bonds from governments and sell them to the public), unwilling to take unnecessary chances with their money, soon got into the habit of pur- chasing only bonds accompanied by an opinion of “recognized bond counsel.” Over a period of decades, this small fraternity of private lawyers came to preside over this obscure corner of government finance.
The instruments of their power were the various and complex state and municipal laws— often the products of 19th-century tax revolts— that were designed to tether the ability of politi- cians to incur public debt. Bond counsel saw themselves as guardians and interpreters of these municipal debt laws and came to regard their opinions almost as those of an ex-officio judge. Though they originally were hired by bankers and then were retained by governments, bond counsel insisted that they represented no one party but all parties or, simply, “the transaction .” It was a heady position, “the closest a lawyer gets to playing God,” remarked an older gentleman who had been a bond counsel in the early fifties.
There was money in it, too. During its long hey-day, from around 1900 to the 1970s, themunicipal bond practice resembled, in the words of an MIT economist, “a classic noncompetitive industry.” Bond counsel customarily took a cut of from .5 percent to 5 percent of the proceeds of a bond sale. Sometimes the percentage sliddownwards as the size of the issue grew,sometimes not. It was no use arguing over the compensation; bond counsel, being gentlemen, wouldn’t hear of it. Bond counsel fees became a fixed cost, paid almost without a second thought.
The real beauty of the job, from the bond counsel’s perspective at least, was that it often involved almost no work. Plowing through bond issuing transcripts and writing opinions was a lot like doing real estate title searches: the first time around, learning all the statutes and procedures was time-consuming and difficult; thereafter, in the words of one Washington bond counsel, “it was pure boiler-plate”; a seasoned attorney could look them over, suggest changes, and write his opinion in a few hours or at most a few days. For this strenuous effort he would receive his customary fee—for a $1 million issue, typically 1 percent, or a cool $10,000.
It was such ridiculously easy work thatmunicipal finance officers, who had been draft- ing all the documents themselves for the bond counsel’s approval, started shifting much of this work to the counsel himself. Even this did not cut too deeply into the attorneys’ nap times: counsel soon developed prefabricated documents they could modify to fit a particular issue and then give to a secretary to work up. (Now you know why a bond counsel’s one concession to modernity might be a word processor.) As late as 1977, the senior partner at Wood Dawson, in New York, the nation’s oldest, most venerable bond counsel firm, could claim that “if you calculate our fees on an hourly basis, you would probably find that [we] are among the highest, if not the highest, of any other area of practice.”
Monopolistic as it was, the old system did have one advantage: it smothered innovation. We areaccustomed to thinking of innovation as the agent of progress and growth; but what do you get when the lawyers start to innovate in the government debt market? Give up? Expanding government debt.
Sheltered from competition and lacking the in- centive to press the advantages of single clients, bond counsel were not in the habit of devising innovative legal strategies for circumventing statutory debt restrictions. A stodgy respect for the intent as well as the letter of the law became the central aspect of a professional culture so clubby that, legend has it, no bond counsel would even consider opining on an issue already rejected by a colleague. But the boom years after World War II, with their mushrooming demands for state and local government services, put this old system under strain. Professionals in the bond business are even more specific. They can tell you the year, the place, and the two men responsible for transforming the municipal bond industry.
Nelson’s manna
Nelson Rockefeller was not a man to take no for an answer. It was 1960, and the governor of New York wanted to be known as a builder of public housing and many other things. To build, he needed a great deal of money. But even for a Rockefeller, that was a problem. New York’s constitution, like those of most states, required voter approval of any bonds secured by the “full faith and credit”—that is, the taxing power—of the state (such bonds are called “general obliga- tions”). By 1960, getting voters to approve hous-ing bonds was no piece of cake: one such referen-dum had been defeated in recent years, and twoothers had barely squeaked by. The voters of NewYork seemed to be telling their elected officials, No.
There was, however, a way to get around the voters: revenue bonds, which are backed not by taxes, but by the revenues generated by the pro- posed project—in this case, rental payments from the housing. New York had pioneered the use of revenue bonds back in the 19th century for the very purpose of avoiding constitutional debt limitations. To issue such bonds, a state general- ly has to set up an independent public authority to keep the project off-budget, among other reasons; accordingly Rockefeller created a Hous- ing Finance Agency.
There was a hitch, however. Millions of dollars of housing revenue bonds had gone into default during the Depression. Investment bankers and bond buyers have long memories, and they, like the voters, were sending Rockefeller an unwelcome message. The projected revenue from the public housing projects was not enough security for them. They wanted the state to put its own credit on the line—or no deal.
To appease the bankers and still circumvent thevoters, the governor needed a new, quick-change bond, one that appeared to commit the state’s taxes but in the fine print really didn’t. He need- ed, in short, a legal innovation.
Almost in desperation, Rockefeller turned to a bond attorney with a venerable New York firm who had made his name in the thirties as an “in- novator” in this very field—housing revenue bonds. The lawyer’s name was John Mitchell, and he brought to the governor’s dilemma the same crafty pragmatism that he would later show as Richard Nixon’s attorney general. In 1960, Mitchell’s sly deed was the invention, for Nelson Rockefeller, of the “moral obligation” bond.
Under the terms of Mitchell’s moral obligation, the governor was to notify the legislature when and if the revenues from the public housing were insufficient to meet the payments on the bonds. The legislature was not obligated in any way to pay the bondholders a dime; it merely had to con-sider doing so. The devious brilliance of Mit- chell’s scheme was that it made everyone think they had what they wanted. Rockefeller didn’t have to seek the approval of the voters, since technically their tax dollars were not on the line. The legislature, assuaged by the governor’s oft- repeated promise that the bonds would “never cost the taxpayers a cent,” genuinely assumed that they would never have to cover any revenue shortfalls.
The bankers, on the other hand, understood that the trump card most probably was theirs. If the state welshed just once on these moral obliga- tion bonds, it would lose its standing in the credit markets for a very long time. No more universi- ty expansion. No more public works. Salesmen for the big investment firms told their customers, with much justification, that “New York will never let these bonds go into default .”
With such assurances, the bonds sold like hot- cakes. Rockefeller was ecstatic. “Old Nelson espoused my theory like it was the salvation of mankind,” bragged Mitchell. “He treated themoney like manna from heaven .” Rockefeller was soon issuing billions of dollars worth of moral obligation bonds to build schools, hospitals, universities, and mental institutions. Investment bankers were getting rich off the burgeoning public debt. And Mitchell himself was making a fortune; as the nation’s authority on moral obligation financing—a technique that would spread to 35 states—Mitchell is reported to have made $2 million a year.
The charade ended in February 1975, only months before the collapse of New York City’s finances. The Urban Development Corporation, another Rockefeller housing authority heavily dependent upon moral obligation financing, defaulted on $100 million in bond anticipation notes. It was a mess for the state, but the bankers did indeed hold the winning hand. The bankers and the the lawyers made money, the bondholders lost nothing, and the people of New York state picked up the $650 million tab.
Profits for parvenus
John Mitchell set an example that would transform the municipal bond profession, but it was the rise of industrial development bonds (IDBs) that gave a new generation of go-go bond lawyers its spurs.
To understand IDBs you need to grasp only one fact: the entire municipal bond market is bas- ed upon a tax exemption. To help states and localities, the federal government has refrained from taxing the interest bondholders get from state and local governments. This in turn enables these governments to sell their bonds at lower in- terest rates than they would have to pay other- wise. In effect, the federal treasury pays part of states’ and municipalities’ interest costs.
Who could object to subsidizing the building of bridges and schools? The problem is that pro- viding this subsidy indirectly, through a tax ex-emption, wastes a great deal of money, as we shallsee. But beyond that, all the federally subsidized capital swirling around in the municipal bond market can attract other interests, such as cor- porations, the way a floodlight attracts bugs. Enter industrial revenue bonds, which were get- ting popular in the early sixties just as John Mit- chell was establishing a beachhead for innovators in the bond counsel world.
In IDB financing, the local government acts as a kind of front man for a private company, borrowing money at low interest rates—thanks to the U.S. Treasury—and using the proceeds to build a factory or a shopping mall for the com- pany in question. The justification for this laun- dry operation is that the resulting employment serves a public purpose. True enough. But when every municipality in sight began issuing these IDBs to attract business, it became a zero sum game. None gained the special advantage they had sought. The only winners were the bond lawyers and the companies themselves.
Back in the 1960s, however, no one thought of that (or if they did, they weren’t talking). Two men who watched the flood of new lawyers break down the old bond clique are William McCarthy, a bond counsel and later a vice president of Moody’s Investors Service and Arthur Hausker, a banker/researcher with Reynolds Securities. (Both are now at Fitch Investors Service, like Moody’s, an investment rating agency.) “The in- dustry grew with industrial revenue bonds,” McCarthy explains, “which brought in corporatelawyers. Wall Street and LaSalle Street and Mont-gomery Street saw that, frankly, there’s money to be made here. That’s the American system .”
These new, corporate-bred lawyers had little sense of the quasi-judicial tradition of bond counsel. “When Bill and I first got into the business,” Hausker recalls, “by and large your bond counsel rendered his opinions based on ex-isting statutes. It wasn’t very long, particularly when IDBs came into the picture, before bond counsel were the ones writing the statutes at the behest of bankers and legislators .”
State and local debt statutes originally were not written with the needs of corporations in mind. “Often obstructions in existing statutes had to be swept aside for the path of progress,” says McCarthy. “If you get the statutes passed, you can probably get the clients a little faster than your competitors .”
“Now, there are some firms that are more known for this . . .” McCarthy pauses, not wishing to name names. I suggest one for him: Kutak, Rock and Huie. “Kutak, Rock is a primeexample,” McCarthy exclaims. “Bob Kutak- that’s how he got going”
Kutak, Rock and Huie—the very name is a kind of generational litmus test for bond lawyers. The parvenus who do mostly IDBs and related work generally refer to its lawyers as “top notch” and “professional.” Attorneys with the older firms have harsher opinions. “I’ve not been very pleased with Kutak, Rock,” one bond counsel with a large New York firm told me. “They’ve not only cut corners on their legal analysis, they’ve lowered the standards for soliciting business .”
“A ll bond counsel are conservative,” counters Haven Pell, a young partner at the Washington, D.C. office of Kutak, Rock and Huie. “Tax- exempt bonds are not like tax shelters. You can’t take outrageous positions and wait for the IRS to rule on them. If your opinion is wrong, the bonds aren’t tax-exempt; and if they aren’t legal, the bondholder gets nothing. Bond counsel getsued.” That said, some bond counsel are more conservative than others: “Different lawyers read things in different ways” Pell reflects on how to illustrate his point. “If the law says L Street is a one-way street, some attorneys will leave it at that. We’ll ask, ‘Can you walk in the other direc- tion if you stay on the sidewalk?’”
Subsidizing K-Mart
Thinking like this has been behind Kutak, Rock’s phenomenal growth from three lawyers to more than 140 in fewer than 14 years—an indica- tion of just how much money there is in private purpose municipals. It started in 1966, on the day Bob Kutak, then a hungry lawyer in Omaha, met Jim Lopp, a 27-year-old bond banker with the investment house of Eastman, Dillon. Together, Kutak and the hard-selling Lopp convinced the city of Omaha to build a multi-million-dollar facility that was supposed to turn the scraps from South Omaha stockyards—which had been foul-ing the Missouri River—into profitable by products. Kutak and Lopp also convinced the city to put its credit on the line (the meatpackers wouldn’t) behind the IDBs sold to finance the dubious venture. The plant failed, of course, and the people of Omaha are still paying off the bonds. But not before Bob Kutak’s firm got $75,000 as bond counsel, $178,000 in the ensuing litigation, and invaluable experience in an exploding new field.
By the time the trouble started, Bob Kutak and Jim Lopp were riding the crest of a wave of private purpose municipal financings. “For four years I just rode the airlines,” Lopp recalled inBusiness W eek. “Other firms would stay with a deal and do it. But I’d bring in [Kutak’s] law firm to do the documents and go and get the next deal .” When it came to lobbying state politicians to get enabling legislation for various IDBs, the team of Kutak and Lopp had few peers. “We’ve been responsible for changing laws in 15 to 20 states,” Lopp bragged in 1972.
In Chicago in 1978, they unveiled perhaps theirmost notorious creation: single family mortgagerevenue bonds. Previously, states had issued hous-ing bonds largely to provide shelter for the poor. Now, local governments would sell these new bonds and pass along the proceeds to savings and loans to lend out as conventional mortgages— not, of course, to the poor, but to middle-incomefamilies.
“Jim Lopp figured there would be just an in- credible demand for these things,” recalls Haven Pell. And indeed there was, in no small part because the program’s definition of middle in- come was so generous that families in the top 10 percent of the income scale qualified for the federally subsidized mortgage money. Almost singlehandedly the team of Kutak and Lopp had created another middle-class government entitle- ment of potentially staggering proportions. Com-peting firms soon were digging through state con-stitutions all over the country to find legal garden plots in which to plant these new moneymakers. Arizona Governor Bruce Babbitt complained that New York underwriters were “flocking into town like vultures trying to drum up business.” Mortgage bond programs multiplied accordingly—$550 million in 1978, a billion dollars more in the first three months of 1979. Mortgage bonds seemed like magic money. State and local politicians could issue millions of dollars of them, gaining commensurate favor from middle-class voters, all without the inconvenience of having to raise state and local taxes. It was like having an American Express card courtesy of the U.S. Treasury.
The IDBs worked the same way. Few municipalities were as naive as Omaha was back in 1966, when it put its own credit on the line behind its IDBs. Local politicians had nothing to lose and everything to gain by issuing these bonds right and left. To keep them from giving away the store—one locality in Oregon, for in- stance, floated a $140 million IDB to build facilities for a Japanese-owned aluminum company—Congress in 1968 imposed caps of $1 million per company per municipality (it later raised the amount to $10 million). But that didn’t keep huge corporations such as McDonalds and K-Mart from accumulating hundreds of millions of federally subsidized IDB dollars simply by garnering many separate small-issue IDBs to finance individual stores and restaurants around the country. Nor did it stop such dubious can-didates for subsidy as Hendersonville, Tennessee’s$1.5 million IDB for an entertainment center in honor of country singer Conway Twitty; or the $5 million IDB Riverhead, New York floated for
a breeder of thoroughbred race horses; or the $400,000 for a building in Philadelphia that hous- ed an adult book store and topless bar. IDBs soared from $1.3 billion in 1975 to $14.2 billion in 1982.
Throughout the seventies and eighties, bankers and lawyers continued to dream up new uses for tax-exempts: student loans, private hospitals, nur- sing homes, universities, and agribusiness. There was even talk of selling tax-exempt bonds to pro-vide low-interest loans for people to buyautomobiles. “You cannot come to a qualified bond counsel,” one such attorney advised me, “who cannot figure out ways to make almost any project tax-exempt .”
In 1982, for the first time, more tax-exempt “municipal” bonds were sold for such private purposes than for the governmental purposes for which these bonds originally were intended. Ten percent of all private borrowing is now done in the tax-exempt market. In 1983, Assistant Secretary of the Treasury for Tax Policy John Chapoton—himself a bond counsel with the Texas firm of Vinson & Elkins—told Congress that “the term municipal bond has become a misnomer?’ These bonds were now an extension of the corporate bond market.
And what’s so bad about that? Don’t these bonds provide jobs and stimulate the economy? Sure, to some extent. But it would cost the tax- payers less just to give the money to corporations and homebuyers. Dispensing the subsidy indirectly, through the bond market, involves all sorts of rake-offs. Part goes to municipal bond buyers, the last people on earth who need a federal hand- out. Seventy-one percent of all municipal bonds are held by the wealthiest 2 percent of American families—those with incomes of $100,000 a year or more. Another big piece for the subsidy winds up in the pockets of you-know-who. Underwriters and bond counsel alone lop off 1 percent to 3 percent before the proceeds of a bond reach their intended beneficiaries. A retinue of middlemen also gets involved. “In some cases, consultants get enormous fees,” explains Fitch’s Hausker. “When you put all the fees together with the capitalized reserve funds, you can sometimes see a third of a bond issue, perhaps even more, go- ing for other than brick and mortar:
A bond counsel with a large corporate law firm, whom I will call my “bond counsel friend,” said, “if government really was saying ‘we want to give you a subsidy to do these kinds of public projects,’ the much more efficient way to do it would be to hand out the money, rather than pass it out to nine gladhanders who just happen to be working on the transactions as they go by.”
Inefficient private-purpose municipals are a drain not only on the federal treasury but on state and local governments as well. The flood of such bonds created a buyer’s market, driving up the interest rates states and localities have to pay for true municipal projects. A 1982 GAO study sug- gests that your state and locality had to pay up- wards of 2.2 percent in excess interest rates in order to build roads, bridges, schools, and court- houses because private businesses were soaking up so much of the available tax-exempt money.
Many state and local officials began to catch on that private purpose bonds were not the sweet deal they had thought. In 1980, over the fierce objections of the municipal bond industry, Congress enacted curbs on mortgage bonds that would phase them out entirely by 1983. But in 1984 House Ways and Means Committee Chair- man Dan Rostenkowski extended the mortgage bond sunset as part of the deal to include modest IDB caps in that year’s Deficit Reduction Act. (Never a man to be left behind at the station, Rostenkowski had already invested $250,000 of his reelection cash hoard in Dow Chemical IDBs.)It was hardly a blow to send the industry reel- ing. The small but influential bond professionals lobby—Kutak, Rock lawyers prominent among them—is, according to one Washington bond lawyer “already busy trying to get the volume caps removed.”
31 Flavors
Perhaps you thought there’d be at least one ad-vantage to the swarm of new lawyers inmunicipals: the competition would bring fees and costs down. If you thought that, you’ve beenreading too many economics texts. Fees and otherbond issuing costs have been going up, up, up: between 1973 and 1979, the costs of doing small revenue bonds doubled.
One reason for this is investors’ demand for greater financial disclosure in the wake of the 1975 New York City crisis—a demand only heightened by the $2.5 billion default (the big- gest in history), in 1983 by the Washington Public Power Supply System. The federal government doesn’t prescribe disclosure standards for municipal bonds the way it does for corporate securities. But the standards that have evolved in reponse to market forces are enough to make any OSHA regulator blush. “Lawyers are writing a lot of the prospectus sections,” says Arthur Hausker. “They tend to go overboard in some areas and you end up with a lot of stuff that is just plain filler.”
Bond lawyers and bankers prefer to call atten- tion to ways the federal government does con- tribute to rising costs. “I’d be willing to bet that one-third of the costs of any state or local bond issue is due to complying with federal regula- tions,” says Arthur Goldburg of the New York investment banking firm of Matthews and Wright. Goldburg is a scrappy, tightly wound fellow who derides uncontrolled federal spending but refers to state and local spending as “mean- ingful attempts to solve social problems.” The regulations he speaks of are the ones defining the bonds that qualify for the tax exemption. “In the mid-sixties, when I came to this business,” Goldburg told me, “if somebody came to me and wanted to produce housing . . . a month, two months, three months tops, we’d be in the marketplace, the deal would be over. Today, the same deal walks in the door, you gotta figure it’s going to take six months or a year, and probably longer.”
It’s easy to understand Goldburg’s resentment. But then, it’s hustling professionals like himself, pushing at the soft borders of existing regulations, who compel the federal government to add even more.
Municipal bonds are getting downright kinky. And the kinkier the lawyers like Goldburg make them, the higher costs and fees seem to go. Take the plethora of new financial products that bond hustlers have invented in recent years in response to volatile interest rates—zero coupon bonds,variable rate notes and bonds, put-optionsecurities, tax-exempt commercial paper. Most of these give bond investors greater liquidity, shift- ing the risk from the investor to the issuing government, in return for lower interest rates. The new “products” are tailor-made for the tax- exempt money-market funds that have an almost insatiable appetite for short-term paper that they can readily convert to cash.
Eager to oblige this new market, bankers and lawyers have been pushing their risky new offerings the way Earl Sheib sells paint jobs. Observers like Phil Dearborn of the Greater Washington Research Center are very worried. “Things like commercial paper are really for the benefit of investors and investment bankers,” says Dearborn, who once was finance director of the city of Cleveland. “Governments shouldn’t be in them .” If interest rates shoot up and investors cash in their bonds, then states and localities suddenly will face much higher debt costs. Even professionals in the business are embarrassed. “I think [bankers and government officials] are playing a very dangerous game,” says Jim Zigler, of the underwriting firm of Dillon, Reed.
Risk is just part of problem. The extra work needed to create and market the new offerings is prodigious, eroding the benefit of the lower in- terest rates. Haven Pell describes the legal bill for Kutak, Rock’s first variable rate demand bond for Tucson Gas and Electric as “pretty stagger- ing .” As bond firms have gained experience, the cost of these financings has come down, but not to the level of simpler bonds. “They’re very com- plicated,” says Pell. “It’s like writing a book. TheFederal Express bills alone are beyonddescription .”
But don’t blame the increasing kinkiness—and costs—entirely on the exotic new offerings. Private purpose bonds, which are almost always revenue bonds, are lawyer-intensive by their very nature. Lacking the safety net of tax receipts, revenue bonds tend to default: almost all post- Depression municipal defaults have been revenue bonds (Washington Public Power Supply System, for instance). To comfort investors into acceptinglower interest rates—and, not incidentally, to helpassure themselves quick sales and easy profits— bankers try to extract all kinds of costly conces- sions from revenue bond issuers: high reserve funds, bank letters of credit, bond insurance,detailed agreements as to which creditors get lienson which revenues. The paperwork for all these concessions helps guarantee a sunny future for the students in the nation’s law schools. “Revenue bonds are field days for lawyers,” a bond counsel told me in his office one day. “You need all those attorneys to certify that the house of cards won’tfall down .”
This particular bond counsel, like so many others, does mostly IDB and mortgage bond work. Lining his office were shelves of what appeared to be fat, hard-covered encyclopedias with gold-embossed letters on their bindings. Each one, it turned out, contained the documents fora single IDB. “A bond transaction is not a simple loan,” he said with great flourish, “it’s a documented moment in history.” To document the moment in history created by a typical $12 million mortgage revenue bond, he said, lawyers have to crank out a set of transcripts six inches thick. He handed me one of the hefty volumes; it was for a simple, $1 million IDB. Many IDBs such as this one, he said, are “privately placed”: a single bank buys all the bonds and treats them as it would an ordinary bank loan. How many pieces of paper would be generated if the company, instead of finagling a low-interest loan through the IDB, had just gone to a bank and borrowed a million dollars, I asked? “About two,”the lawyer laughed. “A note and a deed of trust .”
One way governments could diminish this cost-ly paperwork brigade would be to put up better security, i.e., issue old-fashioned general obliga- tion bonds, backed by the tax base of the issuing government. “For a lot of general obligation financings,” says Phil Dearborn, “you don’t real- ly need a bond counsel.” Bank of America found that governments saved, on average, $100,000 on each $10 million bond issue, and got a 0.3 per-cent better interest rate to boot, when they backedtheir borrowings with their tax base rather than project revenues. If you’ve already guessed that despite this, state and local governments are get- ting more and more of their debt dollars fromrevenue bonds, then you’ve grasped the basic logic of municipal finance. Between 1966 and1979 new issues of state general obligation bonds,as a percentage of total new municipal debt, dropped by more than half, while the revenue bonds of statutory authorities nearly doubled.
Why? Because democracy is a nuisance. Those 19th-century debt ceilings and requirements for voter approval normally apply only to general obligations. Revenue bonds, in their infinite manifestations, are the great loophole. As Nelson Rockefeller realized a quarter-century ago, democracy is no match for a good bond lawyer.
Two barbers, one haircut
Back in the old days, municipalities almost always sold their bonds to underwriters by com- petitive bidding. Today they are more inclined to negotiate their bond sale with a single under- writer; bankers claim that the new varieties of revenue bonds, with their financial bells and whistles, are too complicated to be sold through old-fashioned competitive methods. While bankers still “compete like crazy for the chance to do negotiated bids,” as my bond counsel friend explains, they no longer do so simply on the basis of bid numbers. Underwriters today have to do other things, such as helping innovative lawyers dream up new ways of circumventing debt restrictions, to win the favor of politicians. Also, bankers are learning to stroke politicians where it really counts. “You go through whatever you have to on the political end of it,” says a young banker at E.F. Hutton in New York. “You just have to play the games.”
Games include sending several representatives to $1,000-a-ticket cocktail parties for political candidates such as the one California Treasurer Jesse Unruh threw for underwriters in New York a while back. “It’s become part of the business,” explains a vice president of Morgan Guaranty. “You are dealing in a political environment, where people have to run for office, and it’s become increasingly costly to do so. We certainly see the same thing on the federal level.”
Another trick picked up from the federal level involves political action committees. Bear & Stearns, for example, has been operating the fourth largest corporate P AC in America, through which it lavished state and local politi- cians with more than $400,000 in campaign funds in 1981 and 1982. Bear & Stearns also has gone from a nonentity in municipal finance to a powerful force—in three years. Lessons like this are not lost on the underwriting community. According to the Wall Street Journal, the chief executive of Lehman Brothers sent a memo to his people warning that “other investment banks have larger and more active political action com- mittees” and suggesting that the proper contribution to the firm’s own PAC would be about .5 percent of an employee’s annual salary.
Not that money invested in this manner doesn’t yield a fair return. For instance, in November Michigan Treasurer Robert Bowman chose Smith Barney and several other firms to underwrite $30million of the state’s water bonds. Days earlier these firms had attended a $500-a-ticket cocktail party in New York, hosted by Bowman for the
benefit of Michigan Governor James Blanchard. With the rise of negotiated sales, deals like this are becoming almost routine, but this one had a special twist. The bonds Bowman chose to negotiate were not complicated revenue securities but simple, voter-approved, general obligations. “If ever there was a bond issue that would have brought in a whole slew of low, competitive bids, it was these water bonds,” exclaims an outraged professional in Michigan’s municipal bond com- munity. “But who’s going to know if they sold a point or two higher than they had to?”
Negotiated sales put a premium upon chummy relations between politicians and bankers, greasing the bearings on the revolving door bet-ween the two professions. Take IvanhoeDonaldson, former SNCC organizer, mastermind of Atlanta Mayor Andrew Young’s first race for the House of Representatives and long-time con- fidant of W ashington’s Mayor Marion Barry. When Donaldson left his post in Barry’s ad- ministration in 1983, he became a vice president in E.F. Hutton’s public finance department. (Hut- ton was proposing at the same time an innovative plan whereby the District would float $30 million in mortgage revenue bonds.) Donaldson is follow- ing a path well trod. Maynard Jackson, the previous Atlanta mayor, is now a partner with the Chicago bond counsel firm of Chapman and Cutler. It may not surprise you to learn that A tlanta’s retinue of financial advisors includes both E.F. Hutton and Chapman and Cutler.
Another form of chumminess is requiring a ci- ty’s real bond counsel to split the fees with another firm that has close ties to the mayor. Mayor Barry, for example, practices a form of af- firmative action for lawyers: all bond counsel fees for D.C. industrial and non-profit revenue bonds are split with the “minority co-counsel” firm of Reynolds, Mundy and Gibson. People I talked to who have dealt with the firm on D.C. bond issues couldn’t say what work, if any, the minority co-counsel does. “How do you split the work when you’re giving one opinion?” my bond counsel friend asks. “It’s like two barbers giving you a haircut.”
Such fee-splitting might at least prevent the politically connected firm from making a mess of things. During the late seventies, just as New York City was trying desperately to regain the confidence of the investment community, the city’s comptroller, Harrison Goldin, chose as bond counsel the firm of Rogers & Wells, whose partner, Melvin Schweitzer, is a friend and political ally. Not only did Rogers & Wells over- charge the city by several hundred thousands of dollars; but the firm’s almost total lack of experience rendered New York’s bonds un- marketable. The city then had to hire a second firm, Wilkie, Farr & Gallagher, to issue the opinion, at an additional cost of $750,000.
Bye bye boilerplate
“Maybe I’m a product of a different era,” Carl Trauernicht confided one day. “I just think things ought to be conducted on a higher level” After two decades of competition and innovation, it’s hard to see how anyone’s lot has improved—except for that of a few thousand bankers and lawyers. “The change that is most disturbing to me,” says Arthur Hausker, reminiscing over his years in the business, “is the intrusion into the marketplace of so many players who are mid- dlemen, so to speak, who siphon off large profit without encouraging sound financing on the part of state and local governments.”
Not that the new, souped-up bond bankers and lawyers aren’t working hard. The boilerplate days of the gentleman bond counsel are over. “It’s not the business it was 20 years ago,” my bond counsel friend says. “I don’t know anyone withhis feet on his desk loafing. It’s just toocompetitive.”
I don’t doubt it. Watching a tired and pre- occupied attorney nurse a cup of coffee behind a desk piled high with documents, listening to him describe his 12-hour days as the phone interrupts the interview, I don’t need to be convinced. I feel guilty for taking up his time. The work he does is complicated, tedious, and stressful, and he has to hustle to get it. It is this grueling competition among capable professionals that the proponents of tax-exempt municipal bonds confuse with efficiency and productivity. Better this, they like to claim, than a large bureaucracy to administer an outright sub-sidy. Perhaps. But at least with a bureaucracy youknow that smart and ambitious people will turn to more useful work. “I definitely believe it’s a crime,” says my bond counsel friend, “that all these able minded people spend their time dinking around with this minutiae!”
