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Hedge Funds Win Profit on Chicago Sewer Debt at Public Expense

Date: Tuesday, December 8, 2009
Author: Michael Quint and John McCormick, Bloomberg

The “fair and reasonable” price financial advisers recommended to the Metropolitan Water Reclamation District of Greater Chicago for the biggest borrowing in its history cost taxpayers $8 million in unnecessary interest and resulted in a bonanza for bankers and investors, according to trading data and to documents initially withheld from the public.

Hedge funds bought almost a quarter of the AAA rated debt. Sellers reaped a profit of as much as 2.5 cents on the dollar by immediately trading their share of the $600 million of Build America Bonds because they realized the authority paid higher rates of interest than similarly rated and much less credit- worthy companies. The Texas Transportation Commission, with a credit grade one level below the Chicago agency, sold almost twice as much of the federally subsidized debt the next week at a lower cost to taxpayers.

The Aug. 11 Chicago sewer bond sale, arranged without competitive bidding like 84 percent of the $354.3 billion of municipal debt issued this year, “was a very lucrative deal for underwriters and investors and a very poor deal for the taxpayers of the district,” Daniel Kaplan, president of Kaplan Financial Consulting Inc., said in a letter read at the district’s board meeting Nov. 5.

“I am angry about that, and so we should all be,” wrote Kaplan, of suburban Wilmette, Illinois, who said he has been a municipal-securities adviser since 1981. “Please don’t let bond sales like this ever happen again.”

Shunning Competition

By choosing underwriters without soliciting bids, unlike how it selects vendors to refurbish valves and supply toilet paper, the 120-year-old Chicago agency showed the risks of shunning competitive debt sales. Issuers in such transactions save 0.17 to 0.48 percentage point over negotiated deals on average, with other factors being equal, according to the Winter 2008 issue of Municipal Finance Journal.

The sewer agency’s underwriters, led by Chicago-based Mesirow Financial Inc., and advisers Scott Balice Strategies and A.C. Advisory Inc. were paid $4.9 million to work on the August issue.

“We relied on information from the underwriters as to what they were finding in the marketplace,” said Harold Downs, the district’s treasurer for 27 years. “I’m satisfied with what we got.”

When asked why the agency didn’t seek alternative bids from other underwriters, Downs said, “Mesirow is one that I trust because of what they’ve done for us in the past.”

Texas Debt

While the agency said it saved money by setting the yield on the taxable Build America Bonds 1.25 percentage points higher than Treasuries, the Austin-based Texas Transportation Commission issued $1.15 billion of the securities on Aug. 19 at a so-called spread of 1.2 percentage points.

The highway agency is rated Aa1 by Moody’s Investors Service and AA+ by Standard & Poor’s. Its general-obligation issue is backed by the state of Texas and might have been more appealing to investors than the Chicago bonds, said Jose Hernandez, the Texas commission’s debt management director. The Chicago issue depends on property levies and user charges.

A sewer authority is 90 times less likely to default than a corporate borrower with a similar credit rating. Yet, the Chicago agency wasn’t able to get a yield similar to those obtained for shareholders by Johnson & Johnson or Microsoft Corp., both ranked AAA. Bonds issued by the New Brunswick, New Jersey-based medical-products company traded at 0.39 percentage point less than the water district’s debt at the time of the sale, while the Redmond, Washington-based software maker’s 2039 obligations yielded 5.35 percent, 0.37 percentage point less than the Chicago securities.

Economic Stimulus

The Build America Bond program, part of the $787 billion economic-stimulus approved in February, may be extended past its expiration at the end of 2010, Michael Mundaca, President Barack Obama’s nominee to be assistant secretary for tax policy at the U.S. Treasury Department, said during a Senate Finance Committee hearing on Nov. 4.

With the Treasury paying 35 percent of interest costs, Build America securities provide savings compared with the $2.8 trillion tax-exempt municipal market, according to an Oct. 27 report by the Congressional Budget Office and Joint Committee on Taxation.

The sewer authority, with 5.3 million customers, said it saved $188 million in interest expense on the transaction. The bonds yielded 0.31 percentage point more than a Moody’s index of corporate debt with similar ratings.

First Two Hours

Customers sold more than $73.7 million of the issue, or about 12 percent of the deal, in the first two hours of trading, according to data compiled by Bloomberg.

No investors sold bonds in the first day of a $206.5 million issue of Illinois Municipal Electric Agency securities on July 15. In another instance, Cook County’s $120.2 million Build America transaction on June 18, with Mesirow as the financial adviser, first-day sales by customers totaled $7 million, at slightly higher than the issue price.

Bloomberg filed a Freedom of Information Act request, asking the Metropolitan Water Reclamation District for all documents and correspondence related to its Aug. 11 bond issuance. The agency’s initial response didn’t include evidence that financial advisers provided advice counter to the underwriters.

Asked again to demonstrate how the advisers gave independent counsel, the district provided an undated summary that in part stated: “The advisory team advocated on the District’s behalf suggesting that the underwriters tighten up the spread to the 120 to 130 basis point range with a target of 125.” A basis point equals 0.01 percentage point.

Best Practices

While Downs is a member of the Government Finance Officers Association, he didn’t follow the group’s best-practices recommendations that advisers help select underwriters in negotiated sales and that issuers use software to track investor orders independently of the banks handling the bonds.

“I didn’t see the need for it,” Downs said. “I’m not going to bring anybody back that gives me the short end of a deal.”

Downs recommended hiring Chicago-based Mesirow and the financial advisers in July for a still-pending $300 million bond sale before there was an opportunity to evaluate the team’s performance on the $600 million issue in August.

Less Incentive

The district also stipulated what the 12 underwriters led by Mesirow would be paid, regardless of how much debt they sold, Downs said.

This practice is widespread in the municipal market and reduces bankers’ incentive to find as many buyers as possible, said David Johnson, a former executive at Citigroup Inc. and a senior managing director at Ziegler Cos. The Chicago-based investment firm started as a farm lender in 1902, according to its Web site.

The sewer district’s president, Terrence J. O’Brien, 53, was first elected as a commissioner in 1988 and is now seeking the Democratic nomination for the Cook County Board presidency.

His agency didn’t use bids to hire Mesirow because of the “high degree of professional skill required,” Downs said in a June letter to the board. The firm served as senior managing underwriter on $1.8 billion of municipal-bond sales in the past five years, according to its Web site.

The yield on the Build America Bond sale was enough to attract $1.5 billion of orders, or 2.5 times the debt available, according to bond sale documents.

Money Managers

“Given the time and circumstance, I don’t think they could’ve done better,” said James Tyree, Mesirow’s chief executive officer.

The post-sale report showed that in addition to the 23 percent of the bonds sold to hedge funds, money managers acquired 35 percent; insurance companies 34 percent; pension funds 7 percent and individual investors 1 percent.

Hedge funds aren’t a staple of every Build America Bond deal. Stefanie Devin, Iowa’s deputy treasurer, said her underwriter, Barclays Capital, “didn’t see any hedge fund accounts” listed after reviewing the initial sale of her state’s issue of the debt on July 14.

The authority’s $573 million annual revenue comes primarily from property taxes levied on residents of Chicago and 128 suburbs. Cutting the yield on the Build America Bonds by 0.05 percentage point, to match the spread above Treasuries the Texas Transportation Commission received, would have saved $8 million over their 29-year life, as much as the agency plans to spend to replace electric cables and conduits at a pumping station in suburban Stickney, Illinois.

Public ‘Benefit’

“You really want all of this stuff to be bid out,” said Ralph Martire, executive director of the Center for Tax and Budget Accountability, a public-policy group in Chicago. Instead of “insider deals” with favored bankers “you need to max the benefit to the public, which means lowest cost, especially on something as big as a bond finance deal.”

Scott Balice and A.C. Advisory pushed Mesirow to lower the yield premium over Treasuries to 1.25 from 1.3 percentage points in the week before the Aug. 11 sale after the district and the advisers reviewed pricing and trading in “several comparative” municipal-bond deals, according to the statement issued by Downs’s office.

‘Withdrawn’ Orders

Many potential buyers indicated that if the bonds were priced at a spread less than 125 basis points over Treasuries, “the deal might not get done,” the agency said in a statement. While other underwriters said “their investors had already withdrawn” when the spread narrowed, according to the authority, the bonds’ price rose during the first day of trading. Yields fell to 1.1 percentage points over government bonds.

The financial advisers agreed to work on behalf of the district to ensure the “maturity has been optimally priced,” their engagement letters said. The two firms split a $331,000 fee, according to the district’s expense analysis.

The 5.72 percent yield on the 29-year bonds was the “best rate,” according to a summary from the district treasurer’s office. After the sale, the authority’s advisers certified in a letter to the board that the figure was “fair and reasonable in light of the current conditions in the market.”

The agency’s net interest cost, after the federal subsidy, was the lowest since 1973, according to a Sept. 1 memo from Downs to district commissioners.

Underwriter Payment

The advisers declined personal, e-mailed and telephoned requests to discuss details of their work on the issue. As the leader of the underwriting group, Mesirow got $1.4 million of the $4.6 million in fees, the expense analysis stated.

Mesirow was the district’s financial adviser for sales in 2007 and its underwriter in 2006. The firm’s performance in earlier debt issues made it “natural for us to go with them,” Downs said.

Downs said he didn’t know how many investor orders would have disappeared with a narrower spread. To assure officials have this information, the Government Finance Officers Association recommends issuers and advisers “request access to the underwriters’ electronic order entry system in order to observe and evaluate the flow of orders.”

The sewer agency didn’t do so, Downs said. He said he relied on bankers’ assurances about investor orders because “they would know the best.”

To contact the reporters on this story: Michael Quint in Albany, New York, at mquint@bloomberg.net; John McCormick in Chicago at jmccormick16@bloomberg.net