As appeared in U.S.News and World Report, September 20, 1993 (1369 words)

The Politics of Money

How underwriters of municipal bonds win their business


Rita Kahn knows where the money is. As a fund-raiser for Denver mayoral candidate Wellington Webb, Kahn worked Denver's 17th Street, popping into the offices of bond-underwriting firms in the weeks before Webb's June 1991 election. When they saw Kahn, the underwriters got the message. The city was in the middle of one of the nation's biggest bond deals, the $ 3 billion financing of Denver's new airport. The bonds meant millions in fees for underwriters, who market the bonds to investors. "She would come in and ask for contributions," says one underwriter, "and people would show up at fund-raisers or send in their checks."

Webb won his election, and Kahn's company, Dominion Capital Group, was given a $ 310,000 contract as a consultant to the city. "You're going to work with people you trust and who are not going to screw up the work," Kahn says, explaining her new job. The firm of Denver lawyer Erick Stowe, another Webb fund-raiser, was named the city's special counsel on the airport bond issue; it has earned $ 342,088 from airport work so far. Webb says the notion that politics plays a role in awarding city bond work is "ridiculous. The people are selected based on their qualifications to do the job." Stowe says his support for Webb may have "played a role" in his firm's selection but that his firm competed with others for the bond business.

Though they smack of patronage, arrangements like Kahn's are perfectly legal. In fact, they have become typical in the nation's $ 1.2 trillion, tax-free municipal-bond market. Once the dull cousin among securities, "munis" are now recognized on Wall Street and Main Street for just what they are: immensely profitable, intensely political -- and largely unregulated. The combination is a sure-fire recipe for corruption, securities regulators say.

With the recent boom in municipals -- the volume of new issues financing everything from sewers to stadiums has doubled since 1988 -- the seamier sides of the muni market are starting to come to light. In New Jersey, the top aide to Gov. James Florio is under federal investigation after a fledgling underwriting firm, Armacon Securities, won a piece of a $ 2.9 billion New Jersey Turnpike bond refinancing. It turns out that the aide, Joseph Salema, is an Armacon partner; Salema denies any impropriety. In New York City, Comptroller Elizabeth Holtzman is under investigation after receiving a $ 450,000 campaign loan from Fleet Bank during her failed bid for the U.S. Senate last year. Shortly afterward, Holtzman's staff suggested Fleet as an underwriter for city bonds.

There has also been talk of reform, but so far it is just that. The Securities and Exchange Commission, reacting to the growing concerns, has ordered nearly 70 underwriting firms to turn over records of political contributions made since 1990. On Capitol Hill, Massachusetts Rep. Edward Markey has convened hearings that promise to portray an industry free to do whatever it wants.

"Pay to play." It has been that way for some time. Until 1975, municipal bonds were entirely unregulated. That year, a corruption scandal rocked the industry, leading Congress to mandate that dealers register with the SEC. But it also approved the Tower Amendment, which prohibited reporting or registration of bonds floated by state and local governments. What evolved was a "pay to play" system where underwriters make political contributions in exchange for bond business. There are sound public-policy reasons to sell bonds. Cities need to build bridges, sewers and roads. But taxpayers have to pay the redemption price of those bonds -- usually over 30 years -- through higher taxes or special levies.

How prevalent are underwriters in politics? Since local and state election contributions are generally not stored on computers, it is difficult to tell. But a U.S. News analysis of federal election records shows that the nation's top 10 municipal underwriting firms contributed more than $ 5 million to federal races in 1992. Of those firms, Merrill Lynch and Goldman Sachs & Co., the top two municipal underwriters, respectively, contributed a combined $ 2.2 million.

To understand these relationships better, one need look no further than the White House. Several key Clinton administration aides and cabinet officers have earned sizable fees from municipal bonds. Computer records show that in Arkansas, Clinton's home state, the powerful Stephens Inc. investment-banking firm took part in 554 of the 1,207 bond issues since 1980 -- 45 percent. Bond giant Goldman lent crucial support to Clinton's presidential race. Goldman employees and their spouses kicked in $ 100,000, and the firm paid chief Clinton aide Rahm Emanuel $ 35,000 between 1991 and 1992. Emanuel says the fee was for "national political advice."

Of all the Clinton cabinet members, Transportation Secretary Federico Pena may have the most experience with municipal bonds. As mayor of Denver in the late 1980s, Pena convinced voters that the Denver area needed a new airport. The project's costs have ballooned from initial estimates of $ 1.7 billion to more than $ 3 billion today. The first bonds, $ 700 million of them, were sold in 1990. In keeping with tradition, Pena's staff selected a syndicate of 15 local and national underwriters. That gave more dealers a cut. It also multiplied the number of potential campaign contributors. "This practice of the municipalities selecting all the participants broadens the potential conflict that exists," SEC Chairman Arthur Levitt told Markey's subcommittee last week. On that first airport issue, underwriters earned $ 6.1 million.

Excessive influence? The new Denver mayor, Wellington Webb, named Pryor, McClendon, Counts & Co. as the lead underwriter for a $ 392 million airport bond sale a year after the firm gave Webb's campaign $ 25,000. The firm earned $ 916,000 in fees. Partner Raymond McClendon says, "We are selected because we are good at what we do."

The Municipal Securities Rulemaking Board has a principle prohibiting bond traders from paying bribes in exchange for bond business. It looks good on paper, but campaign contributions can serve the same purpose, winning influence for underwriters with politicians. Now the MSRB wants to stop that practice. It has proposed a restriction preventing campaign contributions "for the purpose of obtaining or retaining municipal securities business." It also wants underwriters to disclose contributions two years before and after the sale. But the rules don't cover financial advisers and consultants. Indeed, there has been little talk of more sweeping reform. "There is no doubt political influence becomes excessive at times," says SEC Commissioner Richard Roberts, a proponent of reform, "and legislation may be necessary." The bond scandals have had little effect on the market. Talk of higher taxes has Americans rushing into tax-free bonds, and low interest rates have spawned hundreds of bond refinancings. In fact, the volume of bonds issued so far this year is up 32 percent over last year. Politicians, not surprisingly, are smiling.

With Ancel Martinez. Copyright 1993, U.S. News & World Report. All rights reserved.

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