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Municipal bond issuance: Institutional investor expectations and underwriter selection in an issuer's market

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Municipal bond issuance: Institutional investor expectations and underwriter selection in an issuer's market

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Content INFORMATION TO USERS This manuscript has been reproduced from the microfilm master. UMI films the text directly from the original or copy submitted. Thus, some thesis and dissertation copies are in typewriter face, while others may be from any type of computer printer. The quality of this reproduction is dependent upon the quality of the copy subm itted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleedthrough, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send UMI a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. Oversize materials (e.g., maps, drawings, charts) are reproduced by sectioning the original, beginning at the upper left-hand comer and continuing from left to right in equal sections with small overlaps. Photographs included in the original manuscript have been reproduced xerographically in this copy. Higher quality 6" x 9" black and white photographic prints are available for any photographs or illustrations appearing in this copy for an additional charge. Contact UMI directly to order. ProQuest Information and Learning 300 North Zeeb Road, Ann Arbor, Ml 48106-1346 USA 800-521-0600 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. MUNICIPAL BOND ISSUANCE: INSTITUTIONAL INVESTOR EXPECTATIONS AND UNDERWRITER SELECTION IN AN ISSUER’S MARKET by Marguerite Russell Creel A Dissertation Presented to the FACULTY OF THE SCHOOL OF POLICY, PLANNING, AND DEVELOPMENT UNIVERSITY OF SOUTHERN CALIFORNIA in Partial Fulfillment of the Requirements for the Degree DOCTOR OF PUBLIC ADMINISTRATION August 2000 Copyright 2000 Marguerite Russell Creel Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 3018069 Copyright 2000 by Creel, Marguerite Russell All rights reserved. UMI UMI Microform 3018069 Copyright 2001 by Bell & Howell Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. Bell & Howell Information and Learning Company 300 North Zeeb Road P.O. Box1346 Ann Arbor, Ml 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UNIVERSITY OF SOUTHERN CALIFORNIA SCHOOL OF POLICY, PLANNING, AND DEVELOPMENT UNIVERSITY PARK LOS ANGELES, CALIFORNIA 90089 This dissertation, written by Marguerite R. Creel under the direction o f h?J..... Dissertation Committee, and approved by all its members, has been presented to and accepted by the Faculty o f the School o f Policy, Planning, and Development, in partial fulfillment o f requirements for the degree o f DOCTOR OF PUBLIC ADMINISTRATION Dean DISSERTATION COMMI' C A j Of c s A, rperson Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ** To Craig who supported me throughout the arduous process of writing and research. Never have I met a more talented, informed and considerate individual. ** Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Acknowledgments I am indebted to Professors Ross Clayton, Chester A. Newland and William Simonsen who gave their suggestions freely. Their professionalism, expertise and insight into the dissertation process made this endeavor easier. In particular, I appreciate the leadership and organizational direction provided by my dissertation chair Professor Clayton; the editing and clarification of the logic of the argument provided by Professor Newland; and the substantive review and excellent resource for both his research and that of others provided by Professor Simonsen. I hope that I have been successful in building upon the solid municipal debt foundation laid by Professor Simonsen. I am grateful for the education, information and resources provided by Guy Hobbs, Kathy Ong, and Lynda Harvey. Much of the argument for a fresh approach to the evaluation of methods of municipal bond sale and underwriter selection may be attributed to them and my employment with Clark County, Nevada. Finally, I wish to thank Robert K. Whelan, who has inspired my academic work in public administration. » * • Dedicated in memory of Dr. Roy Thompson. * * ■ Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table of Contents Dedication .......................................................................................................................... ii Acknowledgments...............................................................................................................iii List of Tables and Figure.....................................................................................................vi Abstract ..............................................................................................................................viii Chapter I. Introduction .........................................................................................................1 A. Overview .........................................................................................................1 B. Debt Obligations...........................................................................................1 1 C. Changing Market Conditions...................................................................... 22 D. The Problem.................................................................................................26 Chapter II. Literature R eview ............................................................................................41 A. Introduction ............................................................................................... 41 B. Conflict in Research versus Practice .........................................................41 C. Efficiency Theory ...................................................................................... 49 D. Management Science...................................................................................53 E. Psychology of Decision-making.................................................................. 55 F. Agency Theory.............................................................................................61 Chapter HI. Methodology.................................................................................................66 A. Introduction ...............................................................................................66 B. Data Instrument ...........................................................................................67 C. Telephone Interviews...................................................................................76 D. Contacts ....................................................................................................... 78 Chapter IV. Analysis.......................................................................................................... 83 A. Introduction ................................................................................................. 83 B. GFOA Recommended Practices for Municipal Bond Issuance................. 83 C. Interpretation ...............................................................................................91 Chapter V. Matrix for Selection of Underwriter..............................................................122 A. Introduction ............................................................................................... 122 B. Criteria for Evaluation............................................................................... 124 C. Bayesian Analysis....................................................................................... 127 D. Weights ........................................................................................................ 134 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table of Contents (continued) Chapter VI. Conclusion.......................................................................................................137 A. Summary ................................................................................................... 137 B. Fiscal Accountability.................................................................................140 C. Implications for Efficiency Theory .......................................................... 144 D. Implications for Management Science...................................................... 144 E. Implications for Psychology of Decision-making ....................................145 F. Implications for Agency Theory.................................................................148 G. Implications for Future Research...............................................................149 H. Practical Implications.................................................................................151 I. Policy Implications..................................................................................... 153 Acronyms...........................................................................................................................156 G lossary.............................................................................................................................157 Bibliography.......................................................................................................................160 Appendix ...........................................................................................................................180 A. U.S. Census Bureau Definitions for Public D ebt...................................... 180 B. Written Responses from Institutional Investor Survey............................... 202 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. List of Tables and Figure Table 1 Texas Bond Issues: Average Costs of Issuance (1996 - 1997)...................... 15 Table 2 Professional Service Fees for Clark County, NV (Public Works Bonds). . . 16 Table 3 Competitive Municipal Bond Sale: Advantages and Disadvantages.............20 Table 4 Negotiated Municipal Bond Sale: Advantages and Disadvantages...............21 Table 5 Holders of Municipal Debt: 1940-1996 (in Billions of D ollars)................... 25 Table 6 Total U.S. States Indebtedness, 1997 .............................................................. 27 Table 7 Individual U.S. States Indebtedness, 1997 ...................................................... 28 Table 8 Excerpts from MSRB Rule G-3 7 (pages 179-181) ........................................ 34 Table 9 Competitive versus Negotiated Sale: Research to D a te ................................43 Table 10 Municipal Bond Sales: Conflicting Interests ................................................ 65 Table 1 1 Surveyed Institutional Investors.......................................................................74 Table 12 Surveyed Financial Advisors........................................................................... 76 Table 13 List of Contacts ................................................................................................79 Table 14 Institutional Investors: Criteria for Municipal Bond Purchase......................92 Table 15 Financial Advisor Ratings for Institutional Investor Criteria ...................... 117 Table 16 Criteria for Municipal Bond Purchase: Investors v. Financial Advisors . . . 118 Table 17 Example: Market Performance of Municipal Bonds (Total Sample) ......... 131 Table 18 Example: Market Performance of Municipal Bonds (Underwriter I) ......... 132 Table 19 Example: Market Performance of Municipal Bonds (Underwriter II)......... 132 Table 20 Example: Market Performance of Municipal Bonds (Underwriter H I) 132 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. List of Tables and Figure (continued) Table 21 Example: Municipal Market Yields (Total Sam ple)......................................133 Table 22 Example: Matrix for Selection of Underwriter.............................................. 135 Figure 1 Municipal Debt Issuance: Key Steps .............................................................. 19 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. viii Abstract This dissertation investigates the following research questions: • What selection criteria do public finance professionals recommend local governments use to determine the method of sale for municipal bonds? • What motivates institutional investors to purchase one municipal bond series over another? • Why do state and local governments predominantly use negotiated sales, despite research which shows competitive sales are more cost effective? Exploration of these questions results in the formulation of a means to evaluate the selection of municipal bond underwriters. The general finding deduced is that relative to investment-grade bonds, local governments should, as a rule, issue their bonds on a competitive basis. This method creates an environment where underwriters are encouraged to bid the lowest interest costs. This proposition adheres, as well, to prior research demonstrating the cost-effectiveness of competitive sales over negotiated ones. Portfolio needs of the institutional investor prove to be the most important determinant of which bond issues are purchased. While institutional investors prefer a negotiated sale, the type of sale is not a key determinant of which bonds they purchase. The millennium financial market is manifestly an issuer’s market, as demand for municipal bonds is relatively high compared to the number of investment-grade issues. To lower the total cost of borrowing, the structure for bond issues should replicate and be Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. aligned with the demands of the institutional and retail market. Local governments should institute a direct relationship with both institutional and retail investors to gauge investor demand and forge a core market for their bonds. To the extent that advanced refundings and complicated structures necessitate the use of a negotiated sale, it is hypothesized that local governments can lower total borrowing costs by selecting an underwriter on the basis of past performance with similar types of issues. The proposed model for evaluation of underwriters is one which can be easily transferred to the recruitment and selection process for other types of consultants. The findings of this dissertation are premised upon data from 24 municipal bond institutional investors and S public financial advisors serving jurisdictions who sell bonds to the queried investors. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 1 Chapter I Introduction A. Overview This dissertation investigates the following three research questions: • What selection criteria do public finance professionals recommend local governments use to determine the method of sale for municipal bonds? • What motivates institutional investors to purchase one municipal bond series over another? • Why do state and local governments predominantly use negotiated sales despite research which shows competitive sales are more cost effective? Exploration of these questions leads to the formulation of a new way to evaluate the selection of municipal bond underwriters that incorporates subjective judgments into the decision making process. This dissertation treats the underwriters as marketing agents and their proposals separately. Selection of an underwriter, it is hypothesized, should be based on the underwriter’s prior experience with similar bonds (e.g., type of bonds, size, rating, region, use of bond proceeds, etc.). While proposals help illuminate novel means for structuring and marketing the bonds, the first step in underwriter selection should properly be premised upon past experience as benchmarked against a market median (e.g., Bond Buyer Index or Delphis Hanover Index). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 2 The overriding objective of this dissertation is to help local governments choose the most cost-effective method for the sale of municipal bonds, given the contextual constraints of a specific issuance. Key decision-making factors in how a municipal bond is issued are investigated. The more fundamental question of why public sector decision-making practices often lead to higher cost alternatives despite reliable information about expected outcomes is explored. What selection criteria should governments use to achieve a bond sale issuance process which embodies economy, integrity, and effectiveness? This dissertation is focused on theory development. First, a theory as to what should be considered in the evaluation process is developed. Results from a survey of institutional investors provides the basis for this theory. Second, a matrix for selection of bond sale method is presented as a template which public financial officials can use to evaluate the performance of specific underwriters vis-a- vis the competitive market. One component of the matrix is derived from a probabilistic model used to predict the future performance of underwriters relative to past sales. The underlying goal of the dissertation is to enhance public sector accountability for a decision-making process that has significant fiscal implications for the future financial affairs of state and local governments. These results potentially impact the public sector far beyond the field of municipal debt management; the choice of method of bond sale simulates the selection process for consultants and private sector vendors so frequently found in federal and local governmental arenas. In an era of increased fiscal stress (e.g., increased demand for public sector services, aging public infrastructure, declining urban tax bases, lack of public support for tax Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 3 increases, and unfunded federal and state mandates) and attention to public sector outcomes, there is pressure on state and local governments to expend their revenues more wisely. The integrity of the bond sale process itself has suffered in recent years, adding to the impetus for its review and evaluation. Bond Marketing Strategies Chapter I commences with a general discussion of alternate municipal bond sale methods local and state governments confront when they need to raise significant amounts of capital.1 The two methods under discussion, negotiated and competitive, are defined for the reader. The former is a form of "private" sale with a preselected underwriter. The latter is a "public" sale, where the highest bidder on the bonds is awarded the bond purchase. Both academic literature and newspapers abound with rationale for the use and preferability of negotiated sales over competitive ones. This predilection toward negotiated sales is primarily attributable to preexisting relationships between underwriters and politicians who ultimately approve the underwriters’ contracts (Simonsen 1998; Homung 1994; Pierog 1994; Stamas 1994; Fitzgibbons 1993; Fitzgibbons and Montsaret 1993; Fuerbringer 1993; Gasparino 1993a; Gasparino 1993b; Kurkjian, 1993). The public’s expense to monitor these incestuous relationships between the investment community and public officials in this respect may not be worth the cost in time to leam 1 The format for this dissertation was borrowed, in part, from Francis Vincent Yanak's dissertation from the University of Southern California The N aw "China Lake" Personnel Management Demonstration Project and Redefining Management Spinoffs (1998T The format for this Executive Summary is derived from Glenn L. Stevens' "Evaluation of Underwriter Proposals for Negotiated Municipal Bond Offerings" (1999). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 4 about the process and to stay current on planned debt issues. Alternatively, this researcher hypothesizes, the public may feel powerless to alter the decision-making process. When an agency problem like this exists (between elected officials and the public), it is due to an imbalance of information between both parties (i.e., asymmetry of information) in addition to a conflict in goals between a principal and its agent (Waterman and Meier 1998: 173). According to Charles Perrow: In its simplest form, agency theory assumes that social life is a series of contracts. Conventionally, one member, the "buyer" of goods or services is designated the "principal," and the other, who provides the goods or services is the "agent" - hence the term "agency theory." The principal-agent relationship is governed by a contract specifying what the agent should do and what the principal must do in return. (1986: 224) With respect to the bond issuance problem, the issuer is the principal, the underwriter is deemed the agent. Their contractual arrangement consists of the gross underwriting spread the issuer principal agrees to pay for the sale of its bonds to borrow capital. From a fiscal standpoint, the issuer's goal is to borrow money at the least possible cost. This aspiration is jeopardized whenever the underwriter endeavors to increase fees and/or other goals at the expense of the issuer. The asymmetry of information in the underwriters’ favor makes it possible for a problem to occur. The counterbalance in underwriter's favor is due to the complexity of the financial instruments used today, the lack of governmental public finance expertise, the investor relationships which accrue to the underwriter as part of the course of conducting business, and the underwriters' sophisticated marketing practices. Government, with its multi-varied goals, lower salaries, and dispersed accountability structures, has a difficult time amassing Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 5 the necessary public finance expertise in-house to match that of an independent financial advisor or underwriter. Another way to view this "principal-agent" theory is to designate the citizens/taxpayers as "principals" and the elected officials as "agents." When elected officials seek to maximize their personal, political goals (e.g., maximization of campaign contributions and votes) at the expense of the citizens (e.g., cost-effective governance), this agency asymmetry discussed above ensues. Despite an on-going debate over preferred method of sale in the academic and professional literature, the trend is toward increased utilization of negotiated sales by local and state governments, with approximately 80 percent of municipal bonds having been sold through negotiation and 20 percent competitively in 1994 (Stevens 1999: 1; Leonard 1996: 43). Confusion for the issuer stems from organizational constraints prohibiting issuers from selling directly to investors. Issuers must use a "go-between" or selected representative of the issuer, by definition an “underwriter” to sell the bonds to the investors in what is deemed the “secondary,” over-the-counter financial market. It is difficult to always reconcile the underwriter’ s profit-making incentive with the issuer’ s goal of borrowing money at the least possible cost. Hence, underwriter selection criteria devolve into a political question. Similarly, this conflict in goals tends to discourage complete and full disclosure of information to the principal by the retained underwriter. Scandals in municipal bond issuance of the early 1990s are discussed in detail, providing the back-drop against which the Municipal Securities Rulemaking Board (MSRB) issued Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 6 its 1994 rule, limiting political contributions of municipal securities brokers and dealers to elected officials for whom they are handling negotiated bond offerings. Secondary to the “pay-to-play” scandals of contributions for contracts are the yield- burning practices of underwriters who artificially inflated bond prices in the early 1990s. The breathtaking scope of these abuses in municipal bond issuance invites discussion of both the importance of injecting integrity back into the process, and the potential for catastrophic loss to taxpayers when cost-effective sales are not pursued. The results of studies evaluating the cost differential between competitive and negotiated sales are presented in Chapter Q following a discussion of how a bond sale method inquiry squares with existing literature on efficiency theory, management science, the psychology of decision-making, and agency theory. On balance, the available professional and academic studies on bond issuance demonstrate that competitive sales are more cost-effective than negotiated sales. This cost differential actually increases in favor of competitive sales as more bids are received in the process. Stevens (1999:2; 1997) contends, like this writer, that all negotiated offerings are not equal as underwriter performance is dependent upon marketing strategies and market variants for each given sale. It is hypothesized that issuers' allegiance to negotiated sales stems from a supposition that a specific underwriter is “market-competitive” if the "right" underwriter is chosen. However, an issuer who chooses a negotiated bond sale must select among numerous underwriters. In developing an effective and practical means for evaluation of underwriters which incorporates often divergent opinions between issuers and financial advisors, a Bayesian Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 7 analysis approach has been chosen. In this approach subjective opinions, coupled with posterior information relative to underwriting performance of underwriters, accommodate the hybrid relative "best" probable underwriting team to a specific issuance. The researcher has queried 41 institutional investors to determine which preponderant criteria are utilized in choosing one bond series over another. In this equation, investors' own preferences for an underwriter are systematically appraised and incorporated into a mathematical matrix. Comparison o f Competitive and Negotiated Offerings The remainder of Chapter I graphically illustrates the cardinal steps in the municipal bond issuance process. Discussion here centers around the similarity between negotiated and competitive sales issuance during the formative stages of preparation. One exception exists: in a competitive sale, the principal redemption schedule and coupon interest rates are predetermined. This "preset" structure is contrasted with the negotiated bond sale where interest rates and underwriter compensation are ascribed through a negotiation process leading right up to the actual sale to investors by either the lead underwriter or syndicate. The underwriter is often selected through a "request for proposals" (RFPs) (Leonard 1994: IS). This paper presumes an issuer would utilize an RFP process as a means for identifying potential underwriters, who consequently illuminate their own convictions in their presale marketing proposals and structure. Advantages and disadvantages of the two types of sales (Simonsen and Robbins 1996: S9; Leonard 1994: 14-15) are summarized in a table fashioned for effortless comparison. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 8 Primary distinctions are highlighted, including the flexibility of a negotiated sale, which affords an issuer with the ability to change timing and bond structure until the final sale; while competitive sales objectively select buyers based on bid costs, but afford limited flexibility relative to timing or structure.2 Those issuers who are not frequent players in the bond sale market often opt for a negotiated sale fearing little demand for their bonds absent a specific, well-established underwriter allotted the task of selling (Stevens 1999: 5). This theory is explored with several large institutional investors in Chapter IV, and with a colloquy concerning the two selling methods from the standpoint of the final retail or institutional investor. One of the principal arguments favoring a negotiated sale is the ability to eliminate the need for a financial advisor, theoretically saving the issuer this additional cost (Stevens 1999: 5). Market know-how an issuer expects to receive from an underwriter can, however, be used selectively to the issuers' detriment. One need only bear witness to the municipal bond scandals in the 1990s and the on-going, daily exchange of negotiated bonds at higher costs than competitive ones. In Chapter V, an argument is made for hiring a financial advisor, irrespective of the type 2 Although flexibility is cited in the literature as one of the predominant advantages of a negotiated sale over a competitive one (Stevens 1999: 5), it may be overrated. With a competitive sale, an issuer may reject all bids if they do not receive what they might consider a fair interest rate and they can cancel and reschedule sales if there are problems with timing and bond structure. The downside to not proceeding with an advertised sale is that the underwriters may not bid a second time and/or a reputation for good financial management may be tarnished. Secondly, presale marketing which is also touted as one of the predominant advantages of a negotiated sale over a competitive one (Stevens 1999: 4; Leonard 1996:40) may be overrated. Utilizing an outside financial advisor and/or in-house expertise, an issuer may be able to market its bonds as well or better than a municipal bond underwriter with its multiple interests. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 9 of municipal bond sale employed. While it is important that a financial advisor be engaged to protect the issuer’s interest, recent enhanced development of in-house financial market expertise and use of post-sale analyses can help the issuer predetermine the market's threshold interest in its own bonds. Maintaining on-going, direct relationships with institutional and retail investors is generally referred to as an "Investor Relations Program." Ultimately, issuers seek the ability to forecast a fair price for their respective bond offerings relative to the market and to secure these rates for their taxpayers. Calculation o f Financing Cost This dissertation recommends the use of a new, improved measure to calculate bond financing costs that builds on the true interest cost (TIC) measure: the internal financing rate (IFR). Developed by Simonsen, Robbins and Jump (2000), IFR is the best measure as it reflects the ability to incorporate the total costs of issuance from the issuer’ s perspective (e.g., litigation, issuance costs, net impact of capitalized interest, debt service reserve funds, and accrued interest). IFR is not without drawbacks, however, as one may be saddled with a discount rate which may not accurately reflect the community’ s rate. The hallmark of this approach lies in its ability to help issuers choose alternatives during the decision-making process (e.g., type of sale, type of bonds, voter approval) on the basis of total costs. As noted by Stevens (1999:6), calculating the overall financing cost of a municipal bond issue is problematic as most municipal bonds are issued with serial maturities. A portion of the total bond principal matures each year over a period of years. The calculation is further Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 10 complicated by the fact that individual serial bonds usually carry different coupon interest rates. In addition, many bonds are sold with discounts or premiums. There are, as described by Stevens (1999:6-8), four popular, commonly used measures of the cost of a municipal bond issue: net interest cost (NIC), net present value (NPV), true interest cost (TIC), and the Bierman technique: "None of the Above" (NOTA). NPV and TIC are valid measures, compared to NIC, as they both take the time value of money into account. The first (NPV) uses expected rates for the compounding periods (e.g., the discount rates for four 6-month periods would be determined from the implied forward rates for current 6-month, 1-year, 18-month, and 2-year borrowings (Stevens 1999: 7; Puelz 1996: 10)), the second measure uses the bond's interest rate as the internal rate of return. NIC does not discount its costs over time. NOTA compares total costs for set proposals from different underwriters. In other words, it looks at the total offered cash value for evaluating competitively bid bond issues. As reflected in Chapter II, most of the analyses of competitive versus negotiated sales of bonds use TIC as the measure of choice. Unlike prior research, which primarily suggests underwriter selection be made on the basis of evaluation of costs for proposals, this dissertation focuses on the major role subjective judgments play in the underwriter selection process. While the IFR may be used to ultimately select the best structure of a bond and measure the cost-effectiveness of a sale compared to other sales, it cannot stand alone in the underwriter determination. As measures of actual or proposed costs of issuance, IFR, NIC, TIC, NPV, and NOTA are not designed to incorporate the likelihood that a proposed, negotiated sale will perform according to plan. While IFR gives early insight into the expected costs in evaluating competing proposals, Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 11 additional information must be generated to forecast the likelihood of achieving an underwriter’s proposal. Process for Evaluation o f Negotiated Bond Purchase Proposal Chapter III presents the methodology used to query a group of institutional investors as to their criteria for municipal bond purchases. Analysis of this survey is presented in Chapter IV. A process for evaluation of underwriters assimilating both preferences of institutional investors and past experiences of underwriters culminates in a matrix in Chapter V. This matrix, parenthetically, can be altered to meet the needs of issuers. Chapter VI summarizes literature review findings and the institutional investor survey. The implications of these findings for practice and future research in the realm of municipal bond sales is reexamined. Detailed explanation of the municipal bond sale process and potential areas for conflict in the selection of method for sale follow. Of concern are both the size of the market and the potential for abuse when cost of sale stands unmonitored. B. Debt Obligations Municipal bonds are debt obligations issued by governmental entities to raise money to fund large public projects (An Investor’s Guide to Municipal Bonds: 2000). State or local governments contract to pay a specified sum of money, the principal or face value, at a specified future date plus interest, with a maturity that usually exceeds one year (Mikesell 1991:478). In essence, the sale of long-term debt represents a decision to trade the use of Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 12 expected future resources for the ability to use those resources today. The purchase planned for today is considered to be a higher priority than that which could be purchased later with the accumulated interest payments. State and local governments may only issue debt in the primary municipal securities market. Once municipal bonds have been sold by the issuer to an underwriting syndicate through a negotiated or competitive sale, they are traded in the secondary municipal market, otherwise known as the “over-the-counter market” (Johnson 1996: 349). More than 2,000 banks and securities dealers are registered to buy and sell municipal securities C A n Investor's Guide to Municipal Bonds 2000). Issuance Process/Costs When governments decide to issue municipal bonds, they follow several key steps regardless of whether they use a competitive or negotiated sale. First, beginning with origination activities, they decide on a dollar value of the sale, when they will need the money, what revenue sources or assets they will use to secure the bonds, the type of bonds that they will issue, the structure of the issue (e.g., maturity schedule, call features, credit enhancements), and how they will market the bonds. The type of sale, be it negotiated or competitive, will determine the sequence of these steps. In both types, payments are made to the underwriter to sell the bonds in the secondary market to investors. Investors themselves will expect a certain return based on risk factors, including not only their respective portfolios, but their degree of comfort that the bonds will be repaid at the agreed upon price. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 13 Generally speaking, governments look at the true interest cost (i.e., total interest cost discounted for the value of time) they will pay on an issue as an indicator of how much it will cost to borrow money from investors. The interest cost makes up the vast majority of the cost to issue a bond, although other "issuance costs" include the gross underwriter spread, the time of finance managers and public officials, and any fees associated with the retention of a financial advisor and bond counsel (Texas Bond Review Board Annual Report 1997V Control over the underwriting spread is the primary concern of this dissertation. Likewise, this control serves as the dependent variable of the research. The underwriter’ s "spread" takes up the largest portion of issuance costs. It represents the income earned by the dealer or underwriting syndicate that underwrites the issue. The gross underwriting spread is paid to the underwriter as compensation for the risk of holding the bonds and marketing them (Texas Bond Review Board Annual Report): it is the difference between the price the underwriter pays for a new offering of bonds and the price the public pays for the bonds. By comparison, ways to reduce spread are the independent variables. This dissertation investigates, through the institutional investor survey, means to reduce this spread. The development of better selection criteria by which to rank qualified underwriters allows the issuer to better match institutional demand. Bayesian analysis (i.e., probability equations) and other issues identified such as timing, marketing, investor relations programs, etc. would all be considered independent variables affecting the control over the underwriting spread. In sum, the gross underwriting spread has four components: the management fee, the underwriting fee, expenses, and the average takedown (commission) the underwriter achieves Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 14 through its sale (King 1993). Expenses generally include travel, underwriters' counsel, printing and mailing, and closing costs, of which the fee for underwriters' counsel is generally the most significant (GFOA 1996). The largest component of the gross underwriting spread is the average takedown. Table 1 below illustrates average issuance cost for Texas bond issues as reported by the Texas Bond Review Board, Office of the Executive Director, for 1996 and 1997. The reported $6.27 in underwriting spread per $1,000 in bonds is lower than the national average as cited by the Texas Bond Review Board.3 (Texas Bond Review Board Annual Report 1997) Table 2 illustrates Clark County, Nevada, costs of issuance for financial advisory and bond counsel services for 1998 transportation issues. The transportation bonds require approximately .25% of the amount of the bond issue for fee expenditures in these two areas, contrasted to .75% spent for same services for Special Improvement District Bonds (SIDs). Underwriting, bond counsel and financial advisory services become more cost-efficient as the value of the bond issue increases. Origination tasks include structuring the issue; preparing the official statement to disclose the details of the issuing entity’s financial condition; preparing the bond documents to specify the terms of repayment; considering whether to purchase bond insurance to reduce the risk of the investment in the event of a default; obtaining a rating from one or more investor services (e.g., Standard & Poor’s Corporation, Fitch Investors Service, Inc.,and 3 The average issuance costs for Texas are presented rather than those of the nation simply because they were readily available and illustrative of the fees and general costs local and state issuers incur when they issue bonds. According to their own report, the Texas Bond Review Board places their costs below national averages. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 15 Moody’s Investors Service) (An Investor's Guide to Municipal Bondsl. and scheduling the date of the sale. Table 1 Texas Bond Issues: Average Costs of Issuance (1996- 199' Underwriter's Spread $451,936 $330,791 $5.68 $6.27 Bond Counsel 52,165 1.25 Financial Advisor 33,592 .93 Rating Agencies 37,532 1.23 Printing 10,036 .33 Other 77,344 1.17 Total $541,460 $11.18 Table Notes: (1) Average issue size in 1996 was S84.0S million compared to $54.5 million in 1997. Much of the increase in"Avg Cost per $1,000 in Bonds Insured" for 1997 can be attributed to the smaller issue size as there are economies of scale in bond issuance costs. (2) Bond Insurance premiums are not included in the average cost calculations. (3) Figures are simple averages of the dollar costs and costs per $1,000 associated with Texas state bond issues, exclusive o f conduit issues. Source: http://www.brb.state.tx.us/brbpages/arfy97/Chap4/chap4.html; page 2 o f 7. In a competitive sale, origination activities are managed by the issuer. The issuer either opts to rely upon its internal resources or an independent financial advisor for the threshold work of bringing a bond to market. In recent years, bonds have been increasingly issued with the aid of a financial advisor. The number of issues with financial advisors increased 95.6 percent from 1986 to 1992. In 1986, advisors were used on 2,652 debt issues as compared to 3,470 in 1988. The dollar volume of debt sold via financial advisors increased steadily over the same period to $125 billion in 1992. (Johnson 1994) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced w ith permission o f th e copyright owner. Further reproduction prohibited without permission. 16 Table 2 Professional Service Fees for Clark County, NV (Public Works Bonds; March - December 1998) y:;!7".y'4hJ A . • T y p e o f B o n d s Strip H '-- ,;f!y: » • . 1 D a te o f ' A P p p n t - f : B o n # ; Gonnae|." rr. 1 1 . . ----- FA 1 • F A 2 ’ •'! .'iiiu-v:.-- I f * * f m i l i i Transportation Bonds Transportation Refunding 1998 ABC 3/1/98 $ 1 1 8 ,0 6 0 $68,000 $86,028 $86,028 $172,056 .06 .15 .20 RTC M edium Term 1998 6/15/98 $11,200 $17,500 $37,400 0 $37,400 .16 .33 .49 Flood C ontrol 1998 9/15/98 $150,000 $55,240 $97,500 0 $97,500 .04 .07 .10 Transportation 1998 AB 12/1/98 $100,000 $55,000 $140,000 0 $140,000 .06 .14 .20 Subtotal $379,260 $195,740 $360,928 $86,028 $446,956 .05 .12 .17 SID Bonds SID (4) 1998 3/1/98 $3,779 $17,500 0 $15,000 $15,000 .46 .40 .86 SID (2) (R efunding) 1998 AB 9/1/98 $9,310 $21,865 $22,155 $22,155 $44,310 .23 .48 .71 Subtotal $13,089 $39365 $22,155 $37,155 $59310 .30 .45 .75 Total $392349 $235,105 $383,083 $123,183 $506366 .06 .13 .19 Source: C lark County, N evada, D epartm ent o f Finance N ote: FA = Financial Advisor; SID = Special Im provem ent D istrict 17 For both competitive and negotiated sales, government’s goal is to pay the investor the least amount of interest to borrow money. The differences between the two types of sales lie in how the price of the bonds is determined. In a competitive sale, both the gross underwriter spread and the planned reoffer yields are buried in the underwriting syndicate’s sealed interest bid (Leonard 1994: 14). Because the fees, "commission," and yield of the bonds are rolled into one sealed interest bid, it is difficult for the issuer to know how much an underwriter plans to make off of the bond sale. Once the terms of sale are established, the issuer advertises through a “notice of sale,” usually run in the daily Bond Buver. On the sale date, sealed bids are opened simultaneously, and the bond is officially awarded to the underwriting syndicate that bid the lowest interest cost. For a negotiated sale, the reoffer yields are established by the underwriting syndicate, who resells the securities to investors. The governmental agency selects an underwriter to manage the sale of its issue. This selection can be either highly politicized or involve a rational decision-making process based on specified criteria. Generally, underwriters are evaluated on the basis of their prior experience, financial resources and past commitment or involvement with the agency. The underwriter which serves as the senior manager of the issue often selects a team of underwriters to help structure, underwrite and distribute the bonds. The terms of the offering, including the underwriter spread and planned reoffer yields, are established in a negotiation process between the underwriter selected to manage the issue and the agency itself prior to the actual sale (Leonard 1994: IS). Figure 1 provides an overview of the issuance process and Tables 3 and 4 highlight some of the advantages and disadvantages associated with competitive and negotiated sales. The Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 18 biggest difference between the two methods is the amount of control exercised by the underwriter in the sale process. Competitive sales offer an objective selection of the underwriter and incentive for lowest cost bid, while negotiated sales offer a high level of service from the underwriter and flexibility to match the specific needs of the market and issuer. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 19 / Origination / Activities ( Terms \ Scheduling \ Marketing Award Bonds Competitive: Lowest Bidder Negotiated: Resells + ------ ^ Funds Received Debt Repaid 1: Municipal Debt Issuance: Key Steps Decision: Is a capital project needed? What is the shortfall between expected revenues and expenditures? When is the project needed?___________________ Decision: Is a capital project needed? Does the public want to fund the project? Does the authorizing board want to fund the project? Decision: How should the municipal bonds be sold? Use an underwriter or the competitive market? Which underwriter should be selected? Preparation: Prepare official statement and bond documents. Purchase insurance. Obtain credit rating. Schedule sale. Advertise sale._________________________________________ Process: Competitive • Sealed bids are opened: lowest bidder wins. Negotiated - Spread and reoffer yields established upfront; investors buy. Serials sold to institutional investors, pension funds, mutual funds, individual investors, insurance companies and banks. Interest rate good or bad relative to market yields for similar issues. Completion: Issuing agency receives funds to purchase/build/operate new project Paving off interest begins.________________________________ FoIIow-ud: Principal plus interest is fully paid to complete terms of bond obligations.______________________________________ Source: Original Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 20 Table 3 Competitive Municipal Bond Method of Sale: Advantages and Disadvantages Advantages Disadvantages Incentive for underwriters to submit best bid. Discounts associations with issuing agency. Gross underwriter spreads are typically lower than with negotiated sales. Low level of service provided by underwriter. Objective criteria for selection of underwriter. Limited flexibility to change structure of issue. Encourages broad market participation. Makes it difficult to give preference to DBE and local/regional firms. Helps clarify the payment schedule for specific services in the process. Disfavors complicated debt structures. Minimizes the need for market information to evaluate the costs of bids. Lack of control over selection of underwriter. Discounts associations with issuing agency. Low level of pre-sale market research. More difficult to overpay relative to the market. Limited flexibility to change timing of the sale. May need independent financial advisor services. Little ability to effectively communicate a “story’ (e.g., law suit, capacity issues). Risk premium for market uncertainty may be embedded in underwriters’ bid. Source: Leonard: 14-15; Simonsen and Robbins 1996: 59; writer. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 21 Table 4 Negotiated Municipal Bond Method of Sale: Advantages and Disadvantages Advantages Favors underwriter with issuing agency association. Little incentive for underwriters to submit best bid. High level of service provided by underwriter. Gross underwriter spreads are typically higher than with competitive sales. Flexibility to change the structure of the issue. Subjective criteria for selection of underwriter. Can direct business to DBE and local/regional firms. Discourages broad market participation. Facilitates complicated debt structures. Difficult to determine whether the gross spread is fair for the range of services provided. Self-selection of underwriter. Information about market conditions is necessary to gauge the fairness of reoffer yields. High level of presale market research. Favors underwriter with issuing agency association. Flexibility to change timing of the sale. Easier to overpay relative to the market. Can omit independent financial advisor services. Easier to communicate a “story’ (e.g., law suit, capacity issues). Can negotiate the reoffer yield down to match investor demand. Source: Leonard: 14-15; Simonsen and Robbins 1996: 59; writer. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 22 C. Changing Market Conditions The municipal bond market has undergone significant changes over the past 35 years. Sweeping reform dominates how municipal bonds are now sold (e.g., negotiated vs. competitive), structured (e.g., swaps, hedges and variable rates v. fixed rate G.O.s), and marketed (e.g., institutional v. retail markets and commercial banks v. individual investors). As one former Denton, Texas, city councilman and professor of public administration wrote: . . . when I was involved in bonds a tiny bit as a city council member 35 years ago, much smaller debt limits were the rule, total size of the municipal bond market was relatively small compared to its gargantuan size today, and competitive sales were ostensibly the practice (Newland 2000: 2). Today, negotiated sales dominate the municipal bond market, and have actually grown as a percentage of the total (Simonsen and Robbins 1996: 59). In 1970, 83 percent of municipal bonds were sold competitively, compared to 17 percent sold through negotiated sales. By 1993, this pattern had reversed, with 80 percent of municipal bonds sold on a negotiated basis, and 20 percent sold competitively (Public Securities Association 1994). According to Fuerbeinger (1993), some municipalities issue bonds solely on a negotiated basis. Johnson attributes much of the increase in negotiated offerings to the increased use of sophisticated financial instruments (1996: 348). Conventional wisdom dictates that bonds exhibiting complicated rate structures cannot be easily absorbed into the market, thus requiring more pre-marketing and personal “selling” in order to ensure good placement (Simonsen 2000). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 23 The combination of three factors: (1) issuers dictating the terms of sales (2) increased awareness among issuers about markets and (3) a general dissemination of information about markets to the public evolved into better informed issuers, who are now more actively managing their borrowing needs to achieve cost savings. The use of various hedging techniques, the swap market, and other sophisticated, synthetic transactions are now not only used with more regularity, but were actually “invented” in the mid-1990s.4 Generally speaking, the larger states have increased their financial investment sophistication, which has led to an increased ability to capitalize on the bond market. (Darcy 1999) Issuers' ability to use more complicated rate structures is a complicating predicate for their “power” in the modem market. In the early 1990s, demand for investment packaged products in mutual funds grew, leading to declining rates. The results? The market for municipal bonds grew, which heretofore had been far outweighed by the municipal bond offerings. Investment companies reaped financial benefits from investors on the promise (for example) that a $10 investment would reap a return of "X" percent. (Darcy) Subscriptions to municipal bond funds were heavy to the extent demand began to outpace the number of available municipal bond offerings. This demand artificially stimulated a decline in interest rates. For example, an institutional investor may have thought a bond was worth 3.5 percent but the issuer only wanted to pay 5.23 percent. In a 4 To a large extent this increased sophistication of borrowers can be attributed to the use of these new instruments. But only the large, sophisticated issuers will use or be able to take advantage of these financial products. The ability of the issuer to enter the complexity of the swap markets is based on a broader range of familiarity with being in the market. An issuer who wishes to participate needs to remain a "player" in the market and must be very liquid. (Darcy) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 24 market where the respective bargaining positions are balanced between issuer and the investor lender, no transaction could be finalized, as the parties would take issue with the actual value of the bond. But when the demand exceeded the availability of paper, the institutional investor would be happy to pay the demanded cost and take the terms as specified by the governmental agency. (Darcy) Prior to the early 1990s, demand on the part of issuers exceeded the needs of the market. Consequently, the market itself had a free hand in setting the terms. Once the issuers gained a secure footing, they gained the ability to dictate more self-indulgent terms for securities and designation prices. Another example of issuer control in this area was the designation of "minority qualified" firms (i.e., D/M/WBE firms) as members of underwriting syndicates. Then, came devolution, the sprinkling of the federal debt on the backs of local governments as unfunded mandates and federal requirements forced local governments to pick up more of the share of public service provision. Budgetary pressure created from these forces led to fiascos such as that in Orange County, where public officials become receptive to riskier financial schemes designed by financial brokers to enhance the return on local financial investments. However, with more money and increased risk also comes more consequences. (Darcy) Commensurate with more sophisticated financing tools, market discernment of the average public investor improved. The number of people involved in both the stock and bond markets greatly expanded, in effect, to include more “little people.” Newland referred to the increased participation as the “democratization of investment” (2000: 1). Traditionally, the main purchaser of municipal bonds had been large commercial banks (Lee Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 25 and Johnson: 378). Market dynamics completely reversed themselves in the 1990s, which resulted in households taking the first spot as the primary holders of municipal bonds (See Table 5 below). Table 5 Holders of Municipal Debt: 1940-1996 (in Billions of Dollars Commercial Banks 3.6 7.4 16.8 61.2 152.4 231.7 117.4 92.7 Households NA NA NA NA 129.1 348.2 572.1 441.5 Source: Lee and Johnson: 379. Note: NA = Not available Centering upon the municipal bond market specifically, the extension of private activity bonds into the non-traditional governmental arenas of public utility companies (e.g., power generating plants) and private sector investment (e.g., housing developments) helped broaden the number of available tax-exempt instruments. Another phenomena affecting market dynamics is mergers and acquisitions of large corporations and financial institutions commonly investing huge sums in municipal bonds (Newland 2000). Previously, local banks had cornered the market on regional issues (due to state tax exemption laws and familiarity with and desire to invest in respective communities) so “locality,” as a general rule, is no longer a paramount concern with the globalization of the market. The increased number of tax-exempt offerings, complexity of instruments, and number of investors bred an increased market for financial advisors, underwriters, bankers, portfolio managers, credit analysts and brokers. Future implications for the globalization of the municipal bond market suggest there may be a greater dependency and willingness to rely Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 26 on third parties as Newland suggests (2000:1). The tangled web of future investments may be so large, that to penetrate the market with any one particular issue may be very difficult. On the other hand, as good economic times almost uniformly result in increased demand for investments, frequent, investment-grade issuers may find themselves driven to sell their issues competitively. In this fashion, they can employ the demand of the market to drive underwriting fees and interest payments down. The survey of institutional investors reported on below will help clarify the importance of specific criteria in the decision-making processes for large purchasers of bonds. Only in this way can the need for a negotiated type of sale versus a competitive one be best understood. D. The Problem It can be argued that state and local governments are heavily dependent on the municipal bond market to raise capital. According to the United States Federal Reserve, outstanding state and local debt totaled approximately $1.5 trillion at the end of the first quarter of 1999 (An Investor's Guide to Municipal Bonds 1999). New debt equaled 23 percent of general annual revenues for state and local governments issuing new debt in 1991 (Johnson 1996: 370). As further illustration, municipal bond sales totaled $174 billion in 1991, $235 billion in 1992, $291 billion in 1993, $164 billion in 1994, and $280 billion in 1998 (Stone 1994; Doran 1994; Schuchner 1995; Simonsen et al. 1999:1). This prodigious reliance of U.S. local governments on the municipal bond market necessarily engenders tremendous borrowing costs. In 1997, for example, states were saddled with over $27 billion in interest on debt, the equivalent of 3 percent of total Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 27 expenditures for the year (State Government Finances: 1997 1999) (See Tables 6 and 7). Substantial public outlays are at stake in municipal bond sale issuance costs, depending on which method of sale (i.e., negotiated or competitive) is employed. Table 6 Total U.S. States Indebtedness, 1997 Population (0001 267.107 1 Total Revenue $1,039,440,392 $3,891.48 Total Exuenditure $893,392,972 $3,344.70 Interest on Debt $27,024,821 3.02 $101.18 Interest on General Debt $26,310,095 2.94 $98.50 D e b t a t e n d of fiscal y ear $ 4 5 5 ,6 9 7 ,3 5 9 $ 1 ,7 0 6 .0 5 Source: State Government Finances: 1997 Note: See Appendix A for clarification o f definitions for public debt. The need to increase the efficiency and effectiveness of government operations has filtered down through public agencies in the form of restructuring and quality efforts.5 The professionalization of the field of governmental administration has led to a further emphasis on measurable outcomes and outputs. In this vein, the total cost of municipal borrowing represents a sizeable expenditure that merits review. According to Lee and Johnson (1998:395), municipal bonds issued by local authorities and special districts (e.g., water, sewer, school) accounted for 55 percent of the total issues 5 Lee and Johnson (1998) note that the preoccupation with efficiency and effectiveness is the third major fiscal reform to envelop the nation - derived from a renewed emphasis on overall financial management, financial condition and program planning. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. T a b to 7 Individual U .S. Stataa Indabtadnasa, 1997 % R"s s = s ssa ; ; s sss ss 8 8 ' ' ' s s a SSS ftfts s s s rv 28 8 ? | | f t S 2 3 g g ? 2 2 g 2*5 22* g g ? 3 3 5 SSS S S S S S S SSS 2 j o S 2 1 * * • * * •* * « — ' W w • » w ^ SS 53 « * • ^ ss 4 0 A BB 88 8 8 4 0 4 0 SS N N §§5. §S( Sis SSI III IIS III III SSI SSI SSI i l l i i i s.* 5 111 i l l I I I 111 IM. i l l i l l H i H i §?"?' | f s s s i s s s s a s a s a a a a a s i f l i h u i t u h i i u i r _ i i i i a i l i . i l i i i l i . i i l i l l i i ! i i ! i i ! i U i U . i l ! i i ! i i ! i ii] ill lilliiliiijjilliiliii! ii! lilliiiiii! 8 8 8 8 8 8 3 8 8 SSS SSS 5 5 8 8 8 8 8 8 8 5 5 3 8 8 5 S 8 R J ! i 3 3 8 « § I l l h i P I IS! I s l n s 111 H i s s i n s ss? u s » < * “ 5 S » 5 5 S S 5 88 88 33 * » — -- nn 8 8 88 SSS 1(1 ( ( ( ( ( ( ss? (S8 II? SIS 335 25s 115 81? IIS IK |g( ssi |s i | | i sss | | 5 iss § I s' s's’| m i n gs( s a s “ “ a uus s a g -"a s a g 3 8 a 8 d 3 - 3 8 8 s I T i i 11 n n 1 1 u n 11 i i 11 S S! SS] Si] S g| SSS S58 5 ..................................sas sss s s ; sas sss ass aas sss 888 n | l l | H I H I H ! is? i i i II! I l l H I ss§ ss§ • » « < • a s x a a aa aa ss n n n n n h 88 88 §3s Sia rSI 555 US I?5 H I la? -a * u * » S a S SSg 5 3 a i i i i i i ii i i i i i i il i l i l i l i l il | |1 111 111 SS1 8sls«SSl s Ssi 5 sl , 5 *11 S s| 8 s|a g g| 1 si I I “ IJ ssa 888 SSS SSS 835 SSS 883 833 883 888 SSS 55§ g§( 22§ 22| 55? s3§ gg = I P *?§ sag gg? 1 7 3 1 7 3 88 « O — e n n 88 r « n ri N i 2 2 0 2 1 7 88 « « ♦ ♦ 4 0 « 5 5 m ri 4 0 4 0 K ► - as 4 0 4 0 i i ? n m o N • SaK . a ii* 3 8 8 3 i l l « • * ' 9 — « O * • ^ h * ““a 55? • s N N f » ^ « " “a ??i 25? a as 11? a a a 33 | §§? i i | W i i ? I P a i i i I l f m §?§ w a £ V » 8 8 = ssa 223 11 a * « i t 1 1 1 i i ill ill ill ill ill ill ill ill ill ill ill h Iff ssi gg? gg?. ggg. gg? gg? 3 gg?_gg? gg* ssi sss *1 ,1 1 5 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 29 in 199S, compared to 30 percent for municipalities and townships, and IS percent for counties. When local municipal debt is combined with the states' debt, the annual interest spent on debt as a percent of total expenditures rises to approximately 5 percent. Interest payments on outstanding municipal bonds have remained fairly constant around 5 percent. (Lee and Johnson 1998: 392) Usually, one hopes that increased expenditures result in some positive benefit. However, in the case of a municipal bond sale, increased borrowing costs may not result in increased bond proceeds. The intended outcome of the municipal bond sale is to expend the lowest possible amount for a given sum of borrowed money.6 Because additional cost of issuance does not necessarily have a positive impact on the intended outcome, it is wasteful and inefficient to overpay on the takedown. Once established, the yield of the bond and its maturity schedule do not fluctuate regardless of the fees paid to an underwriting team or syndicate who sell the bond in the secondary financial market. Increased issuance costs do guarantee that the total outlay to borrow money will increase.7 6 Principal plus interest plus issuance cost equals total outlay. The issuer's goal is to minimize issuance costs and pay the lowest interest cost relative to a set borrowed sum of money. 7 As noted by Simonsen (March 16,2000), this argument only holds true with respect to the issuance costs associated with the underwriter after the bond has been structured. Clearly, more dollars can often buy better advice. An excellent financial advisor, for example, may be able to negotiate a better structure and/or rate. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 30 Bond Issuance Scandals Scandals broke out in the early 1990s which heightened public awareness of potential overpayment in issuance costs (Leonard 1994: 12). For example, in 1993, there were allegations of malfeasance in a New Jersey Turnpike refunding issue. This 2.8 billion dollar "negotiated" sale involved a major underwriter, who allegedly funneled money to a small New Jersey firm in exchange for the position of chief underwriter. This small firm was ultimately revealed to be owned by the Governor's chief of staff and a close political ally (Fitzgibbons and Montsarret 1993). Similarly, a scandal arose in Massachusetts in 1993. Here, state investigators questioned an arrangement wherein a financial advisor with a major investment firm allegedly received a $1 million annual retainer from a major underwriter for recommending the underwriter for interest rate swaps with the Massachusetts Water Resources Authority and other clients (Kurkjian 1993). The Massachusetts Inspector General suggested that the relationship between the financial advisor and the underwriting firm virtually assured that the underwriter would be chosen as the chief underwriter in large bond deals (Fitzgibbons 1993). This matter culminated in the filing of a 63 count criminal indictment, including violation of bribery statutes and attempted extortion. The investment banking firm and underwriter were eventually compelled to pay more than $20 million to settle suits brought by both the U.S. attorney for Massachusetts and the Securities and Exchange Commission (Wayne, 1995). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 31 In Chicago, The Bond Buver (Gasparino 1993a; Pierog 1994) reported that the Mayor’s brother was allegedly paid $15,000 a month by a major underwriter for assistance in securing the position of lead underwriter in some of the city’ s largest bond deals. In New York, the city’ s Comptroller, Elizabeth Holtzman, was found to have shown gross negligence in selecting a bond underwriter affiliated with a bank that gave her a $450,000 loan (Allen 1993). In three separate speeches given over four years (1994; 1995; 1997), U.S. Securities and Exchange Commission Chairman Arthur Levitt acknowledged the widespread use of political influence to award contracts relating to municipal bonds (i.e., "pay-to-play") in lieu of consideration of merit. Rule G-37 Political Contributions and Prohibitions on Municipal Securities Business These highly publicized cases of “pay-to-play” resulted in the Municipal Securities Rulemaking Board (MSRB) promulgation of rule G-37 on April 7,1994, which specifically limited political contributions from municipal finance professionals. The MSRB Rule Book (1999) defines a municipal finance professional as an “associated person” of a dealer (other than a bank dealer) under Section 3(a)(18) of the Securities Exchange Act of 1934 (Act), or an associated person of a bank dealer under Section 3(a)(32) of the Act. In summary, the associated person must fit within several categories listed in the Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 32 definition of municipal finance professional under rule G-37: • Any partner, officer, director, or branch manager (or any person occupying a similar status or performing similar functions); • Any person directly or indirectly controlling, controlled by, or under common control with the dealer; • Any employee of such broker or dealer, except those whose functions are solely clerical or ministerial; • Any person directly engaged in the management, direction, supervision, or performance of any of the municipal securities dealer’s activities with respect to municipal securities; • Any person directly or indirectly controlling such activities or controlled by the municipal securities dealer in connection with such activities. (MSRB 1999: 191) Specifically, under rule G-37(g)(iv), a municipal finance professional is defined as: 1. Any associated person primarily engaged in municipal representative activities pursuant to rule G-3(aXI) (such activities include underwriting, trading, sales, financial advisory and consultant services, research or investment advice on municipal securities, or any other activities which involve communication, directly or indirectly, with public investors relating to the activities listed in this paragraph); 2. Any associated person who solicits “municipal securities business” as defined in rule G-37 (which includes negotiated underwriting activities, private placement activities, negotiated remarketing services, financial advisory and consultant services); 3. Direct supervisors of the associated persons described above, including: (1) for dealers that are not bank dealers, the CEO or similarly situated official; and (2) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 33 for bank dealers, the officer or officers designated by the bank’s board of directors as responsible for the day-to-day conduct of the bank’s dealer activities. 4. For dealers other than bank dealers: any member of the executive or management committee, or similarly situated officials, if any. For bank dealers: any member of the executive or management committee of the separately identifiable department or division of the bank, as defined in rule G-l, if any. Each person listed by the dealer as a municipal finance professional is deemed to be such for purposes of rule G-37. (MSRB 1999: 191-192) The purpose of rule G-37, “Political Contributions and Prohibitions on Municipal Securities Business,” is to ensure that the high standards and integrity of the municipal securities industry are maintained, to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to perfect a free and open market and to protect investors and the public interest by: (I) prohibiting brokers, dealers and municipal securities dealers from engaging in municipal securities business with issuers if certain political contributions have been made to officials of such issuers; and (ii) requiring brokers, dealers and municipal securities dealers to disclose certain political contributions, as well as other information, to allow public scrutiny of political contributions and the municipal securities business of a broker, dealer or municipal securities dealer. (MSRB 1999: 179) Table 8 highlights excerpts from rule G-37 intended to curb the practice of “pay-to-play” and help insure the integrity the municipal bond market Today rule G-37 bars underwriters from participating in a negotiated underwriting with an issuer within two years of making political contributions to officials who “could” influence the award of bond business (Stamas 1994). The prohibition on business applies to contributions made within the previous two years, beginning with contributions made on April 25,1994 (MSRB 1999:192). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 8 Excerpts from MSRB Rule G-37 (pages 179-181) 34 (a) Purpose... .to ensure that the high standards and integrity of the municipal securities industry are maintained... (b) N o broker, dealer or municipal securities dealer shall engage in m unicipal securities business with an issuer within two years after any contribution to an official o f such issuer . . . (c) N o broker, dealer or municipal securities dealer or any m unicipal finance professional o f the broker, dealer or municipal securities dealer shall solicit any person or any political action committee to make any contribution, or shall coordinate any contributions, to an official o f an issuer with which the broker, dealer or m unicipal securities dealer is engaging or is seeking to engage in municipal securities business. (d) N o broker, dealer or m unicipal securities dealer or any municipal finance professional shall, directly or indirectly, through or by any other person or means, do any act which w ould result in a violation o f sections (b) or (c) o f this rule. (e) (I) Each broker, dealer or m unicipal securities dealer shall send to the Board by certified or registered mail, or some other equally prom pt m eans that provides a record o f sending, and the Board shall make public, reports on contributions to officials o f issuers and on payments to political parties o f states and political subdivisions that are required to be recorded pursuant to rule G -8(aX xvi).. . . (ii) Two copies o f the reports referred to in paragraph (I) o f this section (e) m ust be sent to the Board on Form G-37/G -38 by the last day o f the month following the end o f each calendar q u a rte r. . . (0 T he Board will accept additional information related to contributions m ade to officials o f issuers and payments to political parties o f states and political subdivisions voluntarily subm itted by brokers, dealers or municipal securities dealers or others provided such inform ation is submitted in accordance with section (e) o f this rule. (g) Definitions. (I)... “contribution” means any gift, subscription, loan, advance, or deposit of money or anything of value made . .. for the purpose of influencing any election . .. or... inaugural expenses... (ii)... “issuer” means the governmental issuer... (h) T he prohibition on engaging in municipal securities business, as described in section (b) o f this rule, arises only from contributions m ade on or after April 25, 1994. (i) A registered securities association. . . or the appropriate regulatory ag e n c y . . . m ay exem pt, conditionally or unconditionally, a broker, dealer o r m unicipal securities dealer w ho is prohibited from engaging in municipal securities b u siness. . . Source: MSRB Rule Book 1999 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 35 Both the legality and constitutionality of rule G-37 were tested by William Blount, Alabama’s Chairman of the Alabama Democratic Party and registered broker and dealer in municipal securities. In a far reaching decision, issued by the District of Columbia of the U.S. District Court (August 4, 1995; petition for writ of certiorari denied by the U.S. Supreme Court April 1,1996), the Court determined that there was no abridgement of either First or Tenth Amendment principles as a result of the mandatory proscriptions of MSRB rule G-37. The Court of Appeals, Stephen Williams, Circuit Judge, held that regulation restricting ability of municipal securities professionals to contribute to and solicit contributions for political campaigns of state officials from whom they solicit or obtain business, satisfied strict scrutiny test for restrictions on freedom of speech... (61 F.3d 938,314 U.S.App.D.C. 52). “Government regulation of expressive activity is content neutral so long as it is ‘ justified without reference to the content of the regulated speech”’ (61 F.3d *942, 314 U.S.App.D.C. 52, **56). Rules in former cases, noted the Court, were intended to safeguard the political process as a whole whereas here the petitioner’s effort is “to safeguard a commercial marketplace:” But is the object of extirpating corruption-in the particular form of implicit exchanges between political contributions and politically allocated benefits— is content-based when the focus is on politics, we are uncertain why the object would be content-neutral when the focus is on the allocation of commercial benefits. In every case where a quid in the electoral process is being exchanged for a quo in a particular market where the government deals, the corruption in the market is simply the flipside of the electoral corruption. (61 F.3d 938,314 U.S.App.D.C. 52, **57) Further, “attacking corruption in securities market was compelling government purpose.” The SEC’s approval of rule G-37 was predicated, the Court found, on the desire to “prevent Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 36 fraudulent and manipulative acts and practices, as well as the appearance of fraud and manipulation” (SEC Approval Order at 26). The restrictions on political campaign donations “furthered that interest (despite claim of under inclusiveness), and regulation narrowly tailored to achieve objective (despite claim that results could be achieved through simple record-keeping and disclosure requirements).” (61 F.3d 938,314 U.S.App.D.C. 52) If the Commission’s goals were only to protect the investing public, wrote the Court, “disclosure and record-keeping requirements might do the job . . . however, it is not at all clear that investors are harmed or even perceive themselves to be harmed when underwriters obtain business through shady practices” (61 F.3d 938, *947 314 U.S.App.D.C. 52, **61). Even though it was claimed that the regulation was an attempt to usurp state power to control elections; the “rule neither compelled states to regulate private parties nor regulated states directly,” and thus it did not violate the Tenth Amendment. (61 F.3d 938, 314 U.S.App.D.C. 52) Rule G-37 constrains relations “only between the two potential parties to a quid pro quo: the underwriters and their municipal finance employees on the one hand, and officials who might influence the award of negotiated bond underwriting contracts on the other. Even then, the rule restricts a narrow range of their activities for a relatively short period of time” (61 F.3d 938, *948 314 U.S.App.D.C. 52, **61). Together, sections (b) and (c) (See Table 8) restrict the ability of municipal securities professionals to contribute and to solicit contributions to the political campaigns of state Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 37 officials from whom they do business.8 Section (d), the Court found, served as a “loophole- closer, prohibiting indirect violations of the restrictions in (b) or (c)” (61 F.3d 938, *940, 314 U.S.App.D.C. 52, **53). Issuer Reactions to Underwriter Abuses The fusion of rule G-37 with the subsequent banning of political contributions from underwriters in some jurisdictions, and the approval of debt management policies which dictate those instances when competitive sales will be used, has limited some local governments’ discretion in the determination of the method of sale for municipal bonds.9 8 The Court found the rule did not apply to competitive underwriting business which is awarded according to “best bid according to stipulated criteria set forth in the notice of sale” (61 F.3d 938, *948, 314 U.S.App.D.C. 52, **62). 9 In May 1993, for example, the New Jersey Governor Jim Florio, through executive order, required that most state and authority bond issues be sold through competitive bidding and encouraged the New Jersey State Assembly to take similar actions for all issuing localities (Gasparino, 1993b; Pryde 1993). In 1996, members of the New Jersey Assembly proposed a series of measures that would require the state, its counties, and large cities to competitively bid their bond issues (Reynolds 1996). In 1993, New York City Council President Andrew Stein called on the city to ban negotiated underwritings for bond sales (Pryde 1993). In 1994, staff members under New York City Comptroller Alan Hevesi completed a debt management policy which directed when the city should issue its general obligation bonds, on a competitive basis (Gasparino 1994). As a former New York State Assemblyman from Queens, Hevesi introduced legislation in the summer of 1993 that would have forced New York City to issue bonds through competitive bids unless officials could prove that the selling process would increase costs and produce a "substantial loss" for the city. The bill passed the State Assembly but failed in the Senate. (Gasparino 1993) In 1994, a Chicago City Alderman proposed revisions in local laws to require competitive bids on all debt issues (Homung, 1994). In 1995, the Los Angeles County Metropolitan Transportation Authority considered a ban on negotiated transactions (Altman 1995). In Florida, state officials led by Governor Lawton Chiles have pushed for competitive offerings for years (McEntee 1997). Alabama Governor Fob James Jr. has set a state policy since 1994 for all Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 38 Notwithstanding rule G-37 enactment and increased scrutiny relative to alleged bond sales abuses, investigative forays and reproval continues. By 1998, the federal government had completed a three-year investigation into “yield-burning” improprieties encompassing 102 municipal bond refinancings by 83 municipalities. Yield-burning may be defined as a fraudulent marking up of bond prices. (Shafroth 1998:1) In short, Wall Street firms were perpetrating schemes by which underwriters consciously inflated the prices of bonds sold to municipalities to complete advance refundings.1 0 By marking up the bonds sold to local and state entities, underwriters, in effect, “burned down” yields, with a concomitant loss in revenue to not only the Internal Revenue Service, but state and local governments. Federal regulators and attorneys inquiring into these practices postulated that as many as 3,000 cities and towns which issued debt in the early 1990s were adversely affected. IRS estimates indicated cities and other municipal bond issuers could be liable for as much as $1 billion as a result of these compromising practices. A multi-jurisdictional settlement ultimately was reached, in which the Core States Financial Corporation agreed to pay $3.7 million to settle allegation its brokerage firm grossly overcharged local and federal governments in a succession of early 1990s negotiated, state issuers to sell bonds on a competitive basis (Strickland and Molis 1999). The State of Nevada (NRS Chapter 350) requires local governments, with few exceptions, to issue straightforward general obligation bonds, backed by the "full faith and credit" of its governments, on a competitive basis. Only airport revenue and "dirt" (unrated special improvement districts backed solely by the value of the land) are sold on a negotiated basis in Clark County, Nevada (Swenseid 2000). 1 0 Advance refundings are complex municipal bond deals which allow local governments to gain substantial savings in interest expenses by replacing older, higher interest rate municipal bonds with newer, lower cost bonds (Shafroth 1998:1). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 39 municipal bond financing deals. (Shafroth 1998: 1; Connor 1997; Gasparino and Connor 1997; Mysak; Stevens 1999:3) Likewise, negotiated, brokerage deals engendered by such notable underwriters as Goldman Sachs, Lazard Freres, New Jersey’s First Fidelity Bank and Prudential Securities have been the focus of separate investigative probes for "pay-to-play" and "yield-burning" transgressions. (Puelz and Lee 1989:153; Stevens 1999: 3). The more than $1 trillion municipal bond market and its procedures has piqued the regulatory interest of both the Internal Revenue Service and the Securities and Exchange Commission (Pare 1995; Beckett 1997; Stevens 1999: 3). Needless to say, these financial transactions actions involve negotiated proceedings. From the public executive’s perspective (e.g., county commissioner, city manager, finance director), they owe it to themselves and the organizations they lead to be historically informed. Specifically, so that indefensible and fiscally inappropriate past practices do not persist, with a view toward making decisions which are in the best interest of the communities they serve. In the interest of the prevailing majority (i.e., non-special interest groups such as the public investment community represented through bond counsel, underwriters, and financial advisors), economy optimization of the issuance process is critical. Should underwriters base their spread merely upon what the retail and institutional investors will pay in the secondary market, then local governments have a corresponding obligation to scrutinize both the pricing threshold and what investors seek. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 40 In Chapter II: Literature Review, the dissertation explores the relationship of the question of method of municipal bond sale to the pertinent literature available on efficiency theory, management science, psychology of decision-making, and agency theory. First, however, the chapter leads with a summary of the findings of existing research which specifically analyzes the cost differential between negotiated and competitive municipal bond sales. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 41 Chapter II Literature Review A. Introduction Why is there a debate over method of sale? What is the basis for disagreement? What can be learned from efficiency and decision-making theories when they are juxtaposed with each sale technique? This chapter explores the research findings on the performance of competitive and negotiated sales, while summarizing the theoretical bases underlying the controversy over the selection of method of sale. The decision-making process will be comparatively analyzed with topical emphasis upon: • the insular nature of the issuance process; • the competing interests in the issuance process; and • the background of research findings against which current practices play out. What does it mean to theorize in the social sciences about human action? Are there practical limits for this type of theorizing? Reasoning will be geared toward a rational approach to the decision-making process, grounded in common sense and conducive to a sustainable integrity of the debt issuance process. B. Conflict in Research versus Practice Municipal bond cost studies indicate that competitive sales are less expensive than negotiated sales. Further, the difference in underwriting spread actually increases as the Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 42 number of bids in a competitive sale increases. In any event, negotiated sales continue to dominate the bond market. From a cost-effectiveness standpoint the reality of how municipal bonds are sold runs directly counter to pro-competitive research findings. Almost all the available research relative to “competitive versus negotiated sale” centers upon the evaluation of bond issuance samples. The cost components analyzed generally include gross underwriting spreads, reoffer yields and total borrowing costs- as measured by net interest cost (NIC) or true interest cost (TIC). A summary of the key findings from studies published from 1965 to 2000 is found in Table 9. In 1979, Peterson first determined that negotiated bond sales are higher cost than competitive ones. Kidwell (1979) and others also found that both revenue and general obligation bonds (GOBs) are sold more cheaply through competitive sale. Comparing NICs from a sample of bonds, Rogowski (1983) confirmed the higher price paid for negotiated issues. Dewitt (1983) found as much as an 18 percent basis points lower cost in NIC on competitive sales- resulting in an average $265,000 difference for his sample of bonds. Other work in the 1970s, conducted separately by Maese and Joehnk, reaffirmed the finding that increased bids resulted in lower reoffering yields, gross underwriting spreads and TICs. Additional studies disclosed that as dispersion in bids decreased, the cheaper the cost relative to a negotiated sale. In 1990, the Public Resources Advisory Group found that negotiated and competitively sold municipal bonds produced comparable costs for government. The Government Finance Resource Center (1991) found that competitively sold bonds were substantively cheaper, that TIC for six competitive bonds in the sample were under the Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 43 Table 9 Competitive versus Negotiated Sale: Research to Date West 1965, 1966, 1967 When only one bid is received in a competitive GOB sale, the underwriter spreads and NIC are much higher as compared to sales where there are multiple bids. Kessel 1971 Reoffer yields decline as number o f competitive bids increases (sample o f 9,420 issues sold between 1959 and 1967). Logue and Jarrow 1976 For public utility common stock, a sample of 122 offerings between 1963 and 1974, the average underwriting commissions are 1.2 percent higher for negotiated offerings than competitive bid. Ederington For public utility and industrial bond offerings, a sample of 1,081 issues between 1964 and 1971, offering yields on negotiated issues are approximately 7 to 8 basis points higher than yields on equivalent competitive bid issues offered at the same time. Dyl and Joehnk For public utility new debt issues, a sample o f 383 issues between 1972 and 1974, the average underwriter’s commission as a fraction of proceeds is higher b y . 13 percent and the yield on the debt is higher by 36 basis points for negotiated than for competitive bid offers; differences are evident across bond rating classes; and results occur despite average negotiated offer being S10 million larger than a competitive offer. Benson 1979 Lower TICs are associated with a greater number o f bidders and less bid dispersion (sample o f 340 issues sold June • August 1973). Forbes and Petersen GOBs sold by negotiation have higher NICs, reoffer yields and spreads than comparable issues sold by competitive bid (sample o f 886 bonds sold by 10 northeastern states between 1976 and 1978). Joehnk and Kidweil NICs, reoffer yields, and spreads are, on average, higher for negotiated general obligation bonds and revenue issues (samples o f404 matched pairs o f GO issues and 330 matched pairs o f revenue bonds sold between 1970 and 1976). Sorensen Increased numbers o f bids in competitive sales contribute to a narrowing o f the cost differential for NICs between negotiated and competitive sales and a 38 basis point difference; negotiated becomes least costly when bonds are rated Baa-1 and below or only one bid is received (sample o f 504 revenue bonds sold between 1971 and 1976). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 44 Braswell, Nosari, DeWitt Kidwell and Rogowski 1983 TICs are lower on issues sold competitively. Negotiated sales result in higher NICs than comparable competitive bid sales for individual bond issues. Joehnk and Kidwell 1984 Negotiated issues have lower spreads during unstable markets and when issues receive only one bid. Competitive sales are more favorable than negotiated sales for regional issues. Maese 1985 Reoffer yields and NICs, on average, are lower for revenue issues when three or more competitive bids are received relative to negotiated issues. Bhagat and Frost 1986 For public utility common stock, a sample o f 552 offerings between 1973 and 1980, total issue costs are higher for firms which use negotiated offerings by 1.2 percent of proceeds; each component o f costs (commissions, issuer- borne expenses, and underpricing) are higher in negotiated offerings. Public Resources Advisory Group 1990 Yield indices and spreads are comparable for issues sold on a negotiated and competitive bid basis. Government Finance Research Center GFOA 1993 Competitive sales produce lower yields than negotiated sales. Small study on 37 City o f Pittsburgh bond issues found Pittsburgh could have saved $2.2 million on six negotiated deals worth S464 million if the issues had been competitively bid. Simonsen and Robbins Leonard 1996 Competitive sales result in lower costs (29 basis points) to issuers compared to negotiated sales and this difference increases with the number of bids received. There is no evidence to suggest that financing costs as measured by reoffer yields on negotiated bonds are different from the costs on competitive sales (sample of 2,333 municipal bonds sold in 1992). Stevens and Wood 1997 Bond marketing strategy does not systematically influence overall financing costs (sample o f school district bond sales in Pennsylvania in 1993). Simonsen, Robbins, Helgerson 2000 Competitive sales result in lower interest rates (17 basis points) compared to negotiated issues. 1 to 3 bids did not result in a significant difference, however 3 to 5 bids resulted in a 21 basis points savings and 6 or more bids resulted in a 24 basis points savings. Table 7 Competitive versus Negotiated Sale: Research to Date, continued Source: Leonard 1994:17-24; Simonsen and Robbins; Pryde 1993; Smith 1986:16-17; Stevens 1999:2; Writer Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 45 average cost, on same day for similar size and type of issue, versus 16 of 31 negotiated sales that provoked a higher than market average price. In 1993, King reported in The Bond Buyer that there is a significant savings in average gross underwriter spread for $1,000 par value bonds for competitive issues versus negotiated ones: $9.31 for all tax-exempts, $8.98 for refundings, $9.28 for negotiated sales and $8.98 for competitive ones. This report was based on data provided by Securities Data Corporation.1 1 In addition to straightforward TIC and NIC analysis of costs, some of the municipal bond research has looked at the impact of the number of bids on the cost of issuance. West, a pioneer in this research, found in three separate studies conducted over thirty years ago (1965, 1966 and 1967) that in large, bid sales, the gross underwriter spreads were significantly higher than for those issues where there were two or more bids. He even went so far as to hint that underwriters could be colluding to force high yields in large public offerings; potential bidders were thus compelled to either join the syndicate or refrain from bidding. (Leonard 1994: 17) Sorensen, by way of regression analyses and in-depth study, has contributed the best research in this area. In 1979, he, with other researchers, found that GOBs rated baa-1 or lower were cheaper to issue through negotiated sale. Further, that for competitively bid 1 1 Private placements, short-term notes maturing in 12 months or less, municipal forward issues, and remarketings of variable-rate securities were excluded from the spread calculations. This information was based on calculations of data supplied voluntarily by investment bankers who may not have included complete data for each category. (King 1993: 1) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 46 general obligation bonds, there was no cost differential when only two bids were received. Negotiated was cheaper when only one bid was received, and competitive bids were significantly more cost efficient when three or more bids were received on a competitive issue. Another significant piece of research in this debate over negotiated versus competitive sale cost differentials was conducted by Roden and Bassler (1996), who looked at the effect, if any, of any underwriter "prestige" on the interest cost of municipal bond offerings. The sample consisted of 123 underwriters, acting as leads in 490 municipal offerings, between 1977 and 1982. Their findings, predicated upon the basis of multiple regression analysis, were that issuers received no significant positive benefits from using underwriters with good reputations. One of the commonly heard arguments in favor of negotiated sale over competitive is that the selection of a good underwriter (i.e., one with regional, marketing or sector expertise) can save an issuer interest cost. Roden and Bassler go on to speculate: “Why should monopolistic issuers use prestigious investment-banking firms which seem not to affect interest cost?” (1996: 651) In 1996, Simonsen revisited the debate over preferred method of sale in Public Administration Review (“Does It Make Any Difference Anymore? Competitive versus Negotiated Municipal Bond Issuance”). This was an important piece of research, given the heightened awareness of the benefits of competitively sold GOBs. At the center of this maelstrom were the relatively new mandates for debt management policies around the country - which prescribed set criteria to determine method Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 47 of sale, a new MSRB rule prohibiting campaign contributions by underwriters for set periods of time (see scandals in Chapter 1, pp. 30-31, 38-39). In addition, many underwriters’ subsequently required corporate bans on political campaign donations reinforced the merits of competitive sales. Simonsen’s Oregon research serves to tip the scales against the conclusions of Leonard (1996) and Stevens and Woods (1997). Primarily, Simonsen lends a contrary, coherent and viable assessment that marketing strategy (i.e., negotiated or competitive) does systematically influence overall issuance costs (Stevens 1999: 3). Simonsen’s work is likewise significant as it reaffirmed the relative financial benefit of issuing bonds competitively instead of through a negotiated sale. Of further interest, he found that differences between the two types of sales became greater as the number of bids increased -- a finding replicated in 2000. It may now be maintained with some certainty today “that increased competition is the enemy of high prices” (Simonsen, Robbins, Helgerson 2000). While studies exist which show no relative benefit to a competitive issuance, the only true findings in support of negotiated over competitive are in those rare instances when only one bid is received, or where credit quality is very poor (e.g., baa-1 or below) (Sorenson 1979). What can be surmised from the research, overall, is that it is more likely that a competitive issuance that is attractive to many bidders will yield lower true interest costs than a negotiated issue. These findings become even more likely in cases where multiple bids are received. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 48 Why is it then that, on average, local governments have not switched to a competitive sale - given substantial, empirical evidence that governments are likely to save taxpayers money when they opt for this method? The case could be made there are too many variances between types of issues and issuers to state a generalizable rule for the issuance of municipal debt. Perhaps issuers think they are the exception or their issue is too “complicated,” “tricky,” and “market intensive” to sell well through a competitive bidding process. It seems existing ties between underwriters and government entities are too strong. Many finance professionals lack the confidence to try alternative methods of sale. In any event, it is clear they continue to either ignore or are not cognizant of the research findings. An alternative explanation to this perplexing rejection of bona fide research is that issuers may simply not know how to evaluate alternative methods of sale. Take, as an example of public financial incompetence, the continued prevalent use of NIC as a measure by which issuers compare the costs of their bond issues. It has been well established in the literature that NIC is an inferior measure of interest cost for an issue, as compared to TIC'2 , because it does not take the time value of money into account (Simonsen, Robbins, and Jump 2000; Stevens 1999; Hopewell and Kaufman 1974; Benson 1999; and Bierman 1985). Yet, as reported by Simonsen, Robbins, and Jump (2000: 2), in 1998, of the 6,229 issues that reported either TIC or NIC to Securities Data Corporation, 68 percent reported NIC. According to a paper of Robbins and Dungan (1999), cited by Simonsen, Robbins, and Jump 1 2 True Interest Cost (TIC) is the interest rate that sets the present value of interest and principal payments on the bond equal to the proceeds from the issue (Simonsen et al. 2000: 1). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 49 (2000:2), the states of Georgia, Kentucky, Louisiana, North Carolina and Ohio continue to award municipal bonds on the basis of NIC. Stevens (1999: 6), McLoughlin (1996: 553), and Clarke (1997: 80) also have found that NIC is used widely to present the cost of a municipal bond issue. If governments have trouble with discount rates, why would it not be assumed that they would have trouble evaluating financial services? Issuers should, as a rule, use competitive sales, as recommended in the literature when they feel confident they can gamer at least three or more bids on their issue or when they receive otherwise conflicting information from their investors. A means by which issuers may evaluate competing underwriters when they can justify a negotiated sale is developed on the basis of past performance of the underwriters with similar types of issues and issuers. The actual proposal for structure and sale of the bond would be secondary to the selection of the underwriter while incorporating the expert advice of the issuer’s respective financial advisor. C. Efficiency Theory When the public sector ponders the question of how to issue municipal bonds, efficiency may, in general terms, be equated to effectiveness. Rarely does a question in public administration result in a scenario where the desired ends are also the most cost- effective alternative to achieve. When deciding how to borrow money, the overriding goal, of course, is to pay the least amount possible - in both interest and fees. Webster's (1995: 360) lists "high-performance," "productive," and "proficient," as synonyms for efficient. Efficiency theory takes root from classical scientific management Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 50 theory. Scientific management theory, in turn, emerged from the systematic observation of production. Meticulous research into shop operations resulted in mathematical representations of factory production efficiency. (Whicker, 1990; 133) Given this mathematical prototype, competent managers were needed to efficiently engineer these operations. Frederick Winslow Taylor, widely acknowledged as the inventor of "scientific management," shifted a heretofore myopic view of management from negative, controlling coercion over labor to a controlling orientation incorporating the entire factory process. Woodrow Wilson (1887:1) was at the forefront in the systematic application of the new concept of efficient production as it dealt with the administrative work of public employees: It is the object of administrative study to discover, first, what government can properly and successfully do, and, secondly, how it can do these proper things with the utmost possible efficiency and at the least possible cost either of money or of energy. Consequently, the most effective process, from the standpoint of "most" important goal, is one which requires the lowest amount of inputs in exchange for the greatest amount of output (i.e., efficiency). Efficiency remains a highly valued goal in public administration. The notion that government can “do more with less” is sprinkled throughout modem administrative theory. By definition, efficient resource allocation and expenditure enable government to maximize its ability to solve social, political and economic problems with an established level of available resources. Put another way, "efficiency is a ratio of valued resources used to valued outputs produced. The smaller that ratio the more efficient the production" (Wilson 1989: Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 51 317). Drucker fosters a more simplified efficiency philosophy: "doing better what is already being done" (1989:45). The efficiency principle, as directed toward discussion of municipal bonds issuance, seems straightforward. However, as with most government processes, there are compelling and competing goals. Unnatural emphasis on only financial goals often distorts the theoretically "efficient" process, and its model. An economic definition of efficiency assumes only one valued output (Wilson 1989: 317). Here, the singularly defined goal would be lowest issuance cost. However, debt issuance processes often generate multiple and conflicting aspirations. For example, government values many other outputs, such as integrity, confidence of the people, and support of important interest groups (Wilson 1989:317). Allison (1977), contrasting private and public organizations, propounded two preeminent governmental designs -- efficiency and equity. A bond process whose financial rewards are primarily bestowed upon certain political cronies may be decried by the citizenry and the media, especially when at the expense of local participation or minorities. With this manifestation of its concern with civic accountability, the public exhibits its desire for what Wilson termed contextual constraints (1989: 317). Perception of government does play a role in the bond process. Government can, on occasion, concern itself with issues of integrity, inclusiveness and open accountability. In this regard, a bond sale mechanism emphasizing candid accountability proves problematic. When these factors arise as vanguard issues in the bond sale process, "efficiency" takes on new meaning. Why? Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 52 Such a goal cannot easily coexist or be reconciled with one which is elementally concerned with only financial imperatives. Efficiency endures as a primary goal of regulation. Reflecting upon the administration of public debt, Johnson notes, "the efficiency principle refers directly to the design of debt policies that help minimize borrowing costs" (1994: 351). Debt policies, he adds, should promote low-cost, high-quality contracting for services from financial professionals. An efficient debt policy stands on a shaky precipice between risky administrative maneuvers and its monitoring while competing with other factors which might unnecessarily constrain an agency's ability to promote the least expensive borrowing alternative. These selection constraints (e.g., requirements that all general obligation bonds be competitively bid, quotas for female and minority owned firms on the underwriting teams and disclosure mandates) are actually protectionist islands in the contextual waters of integrity, often at the expense of fiscal goals. Organizational debates frequently surround the relative importance of different goals, though conclusive resolutions can be paradoxical. There is little agreement on the value to be accorded different goals, much less an underlying system devised for measuring their attainment (Wilson 1989: 318). In Allison’s paradigmatic treatment of an organizational process model, he notes that conflicting, ambiguous operational goals are the norm within organizations (1971:76). For the purposes of this dissertation, lacking such an objective measure for deciding how much time and money should be devoted to maintaining an open and objective process Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 53 for the selection of underwriters, whichever sale method uses the fewest dollars, including the time cost, will be considered the most "efficient" process. Drucker (1989: 45), advocates a position where the financial manager has a responsibility to redirect resources from areas of low or diminishing results to areas of high or increasing results. The administrative job of the manager is to optimize the yield from resources. Interest costs on bond sales are simply a cost of buying money today. Absent explicit correlation between increased interest costs and the total amount of money purchased, responsible public managers and officials alike should reevaluate the additional expense.1 3 Whether this compounded expense is to satisfy the appearance of process propriety, integrity or to gamer political influence, an honest look at the motivating goals behind the processes will help decision makers better evaluate the method for sale chosen in the future. D. Management Science Management Science, an inversion of the original scientific management movement, deals with quantitative models which serve to extricate managers from recurring efficiency 1 3 Issuer’s habitual use of negotiated sales with a familiar underwriter could be labeled a “programmed” decision as Simon defines it: “Decisions are programmed to the extent that they are repetitive and routine, to the extent that a definite procedure has been worked out for handling them so that they don’t have to be treated de novo each time they occur” (Simon 1965: 58-59). It is argued here that the selection of bond sale requires a “nonprogrammed” decision to the extent the decision is “novel, unstructured, and consequential” (Simon 1965:59) to the demands of the market and individual issuers at any given time. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 54 problems (e.g., queuing, simulation, linear programming, transportation demand, forecasting and decision theory models). According to Stevenson, "management science uses a logical approach to problem solving. The problem is viewed as the focal point of analysis, and quantitative models are the vehicles by which solutions are obtained.” (1992: 2) Statistical analysis is at the heart of today's management science. Where is the "science" in Management Science? Some surmise it abides in the general rules of applicability used in the process of looking at many case studies for confirmation through simulation and quantitative study. Though Management Science cannot be classified as a mode of "scientific" method, similarities abound. The major distinguishing feature stems from the virtual impossibility, in public enterprise, of fashioning a thoroughly controlled environment. Resultant assumptions must be made, many of which go far beyond the normal perception of what might be termed the "strict" scientific method. Management Science is concerned with the formulation of general rules of nature. Strict natural science frameworks dictate set rules under set conditions. Management Science can be understood better in terms of what it truly can be. At its core is an overriding and systematic way of thinking. Managers learn to look at problems and situations objectively by examining the available facts and considering a variety of alternatives as possible solutions. As explained by C. Kenneth Meyer (1983: 7), managers recommend a proposed course of action for a particular difficulty on the basis of objective analysis. A logical rationale is applied to a problem in a quantitative way, yielding practical solutions for problems which, at the outset, may appear abstract in nature. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 55 E. Psychology of Decision-making Man's quest to become rational, coupled with organizational, behavioral forays into rationality, are ongoing dialectics in both business and public administration. The classical administrative approach to decision-making theory has largely been prescriptive and rational. Individuals are seen as capable of making decisions in a logical way (i.e., a person considers all available information, identifies all possible alternatives, is fully aware of the consequences of each possible choice, and selects the best alternative). Herbert Simon's 1947 groundbreaking work expanded the classical administrative approach to decision-making theory. He poured out a conceptual foundation for inquiry into how organizations make decisions. Simon suggested that the concept of the classical “Economic Man” was inadequate. In its stead, he presented a model of the “Administrative Man,” one who does not have complete knowledge, is limited in what he can comprehend and subject to the dictates of available resources (Simon 1957: 39). The decision maker, Simon suggested, aspires to rationality. Unfortunately, he ultimately engages in some form of "satisficing" due to his inability to gather and process the available data. In this concept of "bounded rationality," Simon spoke to man's inherent humanity, which resulted in a restricted parameter of rationality. It follows, then, that man’s ventures into rationality and subsequent conclusions must necessarily lack an altogether coherent and logical structure. Primarily due to Simon's decision-making contributions, models moved away from individual study to a methodology which prompted an organizational level of analysis. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 56 By 1958, March and Simon had amplified these organizational analyses into a series of propositions about behaviors. They asserted the nucleus of most human decision-making dealt not with the discovery of optimal solutions, but instead with a concern and selection of satisfactory ones -- "satisficing" ones: Most human decision-making, whether individual or organizational, is concerned with the discovery and selection o f satisfactory alternatives; only in exceptional cases is it concerned with the discovery and selection o f optimal alternatives (March and Simon 1958: 162).1 4 Optimization requires much more work than "satisficing." In making choices that meet satisfactory standards, the standards become part of the definition of the situation (March and Simon 1958: 162) Following in the footsteps of James March and Herbert Simon, Graham Allison championed new frames of reference, arguing, as well, that prior, classical decision-making theories were grossly inadequate for purposes of explaining the complexities of modem organizational decision-making. Specifically, he posited three alternative conceptual frameworks to analyze the Cuban Missile crisis. Allison first chose a "rational" approach, or an "average American" perspective of the Cuban affair (1971: Chapter 1). Two optional approaches were chosen: (1) an organizational process model, where organizations function according to standard patterns of behavior (Chapter 3) and (2) a bureaucratic politics model, centering around a political perspective, where government role players take part in various bargaining games (Chapter 5). 1 3 This concept was latter applied to the behavior in private firms by Cyert and March (1963). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 57 At the core of the organizational choice model are four concepts that relate variables affecting goals, expectations and choice: quasi-resolution of conflict, uncertainty avoidance, problemistic search, and organizational learning. In this model, internal consensus does not develop among organizational subunits. Conflicts among ever present operational goals are, thus, resolved sequentially rather than comprehensively, within the changing dynamics of the organization. There is never complete conflict resolution (i.e., quasi-resolution of conflict). (Allison 1971: 76-77) Secondarily, rather than anticipating future actions emanating from the external environment, organizations seek to avoid uncertainty by imposing plans, standard operating procedures, industry traditions, and uncertainty absorbing contracts. The organization devotes its immediate attention to pressing problems at the expense of developing long-run strategies. (Allison 1971: 76-77) Organizational search as identified by March and Simon (1958: 58) becomes a "problemistic search" for Allison. Organizations search for the first alternative to any given problem which satisfies their acceptable goals. Thus the training, experiences, hopes, expectations and communications of the organization, its subunits, and individuals bias the outcome of the search process. Simple-minded rules first direct the searcher to problem symptoms and then to the current alternative. Organizations do learn, however, over time. As they are dynamic institutions, their experiences are incorporated in changes to goals, attention rules, and search procedures. (Allison 1971: 77) From the governmental politics model, as applied to the Cuban Missile Crisis, this dissertation benefits from the singular attention given to the concept of the "struggle for Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 58 power" (Allison 1971:182) Allison notes that when key dominant players view themselves as partners facing similar pressures, the most promising prospect for crisis resolution is the arrangement of private communication between the conflicting parties (Allison 1971: 184). Unlike the natural sciences, as Allison demonstrates well with his three decision making models elaborated to address one problem,1 5 no hard and fast rules exist for the ways in which human beings behave. Different outcomes may emanate from similar “calculations” without nullifying any type of hypothesis or behavioral theory. As Winch notes in The Idea of a Social Science and its Relation to Philosophy, it is not possible to predict, to any accurate degree, how human beings will act given certain circumstances, “. .. the whole point about a decision is that a given set o f‘calculations’ may lead to any one of a set of different outcomes” (1990: 91). The best success for predicting, Winch continues, lies in an understanding of the decision itself. This understanding necessarily involves a conceptualization of a problem, and a comprehensive grasp of the various alternatives. It is important to fathom the decision maker's perspective of the dilemma, his/her character, and his/her concept of the available options (i.e., voluntary behavior is behavior to which there is an alternative). (Winch 1990: 91) 1 5 Allison notes that even his three paradigms (i.e, rational actor, organizational process, and governmental politics) neglect or underplay a number of aspects of governmental behavior: “Additional paradigms focusing, for example, on individual cognitive processes, or the psychology of central players, or the role of external groups, must be considered" (Allison 1971: 277). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 59 Allison adds that predictions are important, inevitable elements in the structure of opinions about policy issues, policy analysis and recommendation: These predictions are most often implicit. Most analysts formulate predictions in an intuitive fashion, without much explicit thought. But in making predictions, analysts are forced to relate and weight hundreds of factors known to be relevant to the outcome. Would making explicit predictions about outcomes, and assessing other analysts' implicit predictions, be a useful way of clarifying thought about policy problems and improving analysis and advice? Specifically, should we accept the precept: a good, simple-minded test o f someone's expertise in a particular area is whether he can win money (on average) in a series o f bets with other reasonable men about outcomes in that area? (Allison 1971: 270-271) For the current question under review, the answer would have to be "yes." The ability to choose an underwriter that outperforms the market stands as the ultimate test of bond sale expertise which lends itself to this type of comparison between financial managers. For the public finance manager, the decision of method of sale is a straightforward choice between two alternatives.1 6 The research compels the conclusion that most modem managers opt for a negotiated sale. This is in spite of dissimilar educational backgrounds, which one might think, would lead to different means of framing their conceptualization of the sale alternatives.1 7 Taken as either a "rational" or the more limited "satisficing" 1 6 Note that two successful sales of municipal bonds have occurred over the Internet in 2000: City of Pittsburgh (competitive) and Puerto Rico (negotiated). There is no indication, however, that Internet sales, either through MuniAuction or other developed products, will immediately replace the role of the underwriter in the secondary financial market as most issuers benefit from a designated “sales force,” at least with respect to negotiated sales. However, as government financial expertise is enhanced, the overall securities trading procedures evolve to accommodate automation, and the sophistication of investors increases, the role of the Internet will play a much larger role. 1 7 Simonsen and Hill found that many government finance managers do not even have a college degree (1999: Appendix). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 60 manager, a rationale for this repeated opting for the negotiated process can be established. The predominant opinion regarding the rationale for selection of negotiated sale is that public finance managers feel compelled to rely on the outside expertise of an underwriter who has direct access to the markets, investors, companies, bond counsel and the issuer. Simonsen and Hill (1999) found, through a nationwide survey, that lower interest rates, as a rating criteria, were significantly less important for issuers selecting negotiated sales than for issuers using competitive sales. A simplified decision-making process and development of a matrix, incorporating the subjective judgments of the issuers, once illuminated, can be used to help reorient his/her decision-making processes towards a more efficient [i.e., competitive] one. Allison's work was novel in the field of organizational decision-making for its suggestion that complex organizational forces were what influenced individual decisions. He went somewhat farther, premising his discussions upon the need to employ various frames of reference before contemplating any decision-making processes; particularly when dealing with complex issues. As already noted, myriad reasons circumscribe the continued dominance of negotiated sales. These include the lack of expertise on the part of financial managers and public officials; government’s desire to shift accountability to a consultant for either a fear of making a mistake or for a lack of time or resources to research the problem; previous friendships or alliances; and personal interest to be gained— campaign contributions, support for new governmental positions, valuable information, kickbacks, contracts etc. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 61 Another theory that explains how the latter proposal could influence the choice for a negotiated sale is agency theory. F. Agency Theory “Accountability relationships are the mechanisms by which public employees are held to answer for their performance” (Romzek 1996:97). Whether through supervisors, the courts, professional standards, clientele, elected officials, or the general public (Dubnick and Romzek 1991: Chapter 3), there are legal, structural, cultural and organizational means by which public employees may be held in check. Management Science, as discussed above, is one means to acquire better information to directly enhance production and efficiency. It is also used to indirectly improve accountability. When there is a lack of information or asymmetry of information between different parties, it is much easier for accountability relationships to weaken. To address such problems, we turn to what is now called "Agency Theory." This approach was first developed as an economic theory, but was later expanded to describe examples of accountability relationships (particularly ones involving contractual agreements) prevalent in business, law, sociology, and government. Agency theory was first proposed by Jensen and Meckling (1976) in “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure” as a way to explain the way in which agents, linked by contractual arrangements with a firm, influence its behavior. These arrangements may include organizational and capital structure, remuneration policies, accounting techniques and attitudes toward risk-taking. Remuneration policies include any Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 62 policies relative to how to pay “for goods provided, service rendered or losses incurred” (Webster’s 1995: 938). Agency costs are those costs considered when looking at the total expense to administer and enforce these arrangements (Bothamley 1993: 15). Anderlini and Felli (1998: 39-40) aptly describe the general quandary with the principal-agent relationship. To wit, a principal hires an agent to perform a job which the principal either lacks the time or the ability to undertake himself. Even at this early juncture, the principal and agent despair of the “local conflict of interests,” in the sense that the distribution of the outcomes or action most preferred by the principal does not (in fact, cannot) coincide with the one most preferred by the agent. With municipal bond sales, a licensed firm must sell the bonds in the secondary financial market. Underwriting for the capitalization of the bonds is also dictated by a large investment firm, in a manner which will to make the issue attractive to investors. The simple problem here? Underwriters (understandably) are motivated by a profit incentive. Governments are motivated by a cost savings incentive. Taking a look at such agency problems in the field of municipal bond sales, one can view the elected official as the “agent” and the taxpayers/citizens as “principals.” Obviously, agency theory can present a problem, particularly when the cost of monitoring officials ends up overtaking the benefits in terms of lower issuance costs.'8 1 8 Principal-agent models have been the basis for extensive studies relating bureaucracy to elected officials. Such studies cited by Waterman and Meier (1998: 173) include Mitnick (1980; 1975; 1973); Moe (1985; 1984; 1982); Wood (1988); Wood and Waterman (1994; 1993; 1991); Scholz and Wei (1986); Downs and Rocke (1994); and Songer, Segal and Cameron (1994). Such studies relate the principal-agent model to presidents’ decisions to use force, the relationship of the Supreme Court to the lower courts, and the role of regulatory agencies relative to their constituencies and the legislative branch, for example. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 63 In “Negotiated Versus Competitive Bond Sales: A Review of the Literature,” Leonard (1994) explores the possibility of goal incongruence between the electorate and the politicians in his discussion of agency theory. Here, the interests of the public officials, “the agents,” differ from those of the electorate. As stated above, public officials may not always act in the best interest of the electorate. This proves especially valid when political campaign contributions are at stake. In order to test this hypothesis, Leonard reexamined whether negotiated offerings are inherently more costly than competitive offerings. If negotiated offerings do not have higher capital costs, he argued, an agency problem could not exist (1994: 13). Leonard concluded, on the basis of what proves to be a conclusory review of the literature, that one method of sale is not superior to the other in terms of lowering capital costs. His result was that the lowest cost method of sale hinged upon the characteristics of a particular issue, the issue itself, and existing market conditions at time of sale. He submitted that this phenomenon may have more to do with the existence of “imperfect knowledge.” Lacking full knowledge, public finance professionals rely on trusted brokers.1 9 Aside from his emphasis on the peculiarity of the issue in question, Leonard summarized his belief that a dearth in current studies on the issue of types of sale precluded 1 9 The reliance on “trusted brokers” that Leonard references signals an “escalating commitment to principle-agent relationships” as described by Kirby and Davis (1998:206). The dependency on an underwriter based on prior commitment and comfort can lead to the escalation of an agency problem when the principle basically hides its prior mistakes by never opting for another underwriter or type of method of sale against which the performance of the current agent could be judged. The lack of incentive for performance or, as is in the case with underwriters, the desire to maximize profits at the expense of the principle is further escalated when the agent feels no threat to its existing contractual agreement. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 64 any practical resolution for the preferred method of sale. He suggested the appropriate tack for governments to take is to develop a flexible debt management policy which allows governments to take advantage of the benefits of both competitive and negotiated sales, as they see fit, until the controversy can be settled. (Leonard 1994: 13) Unlike Leonard, this researcher believes that an agency problem would exist even were exhaustive research to conclude higher capital costs are generally associated with negotiated offerings. An on-going relationship with one underwriter at the expense of other underwriters could be the basis for such a problem, versus a general proclivity towards negotiated sales at the expense of competitive ones. Parenthetically, the great weight of recent research indicates competitive sales are in fact less expensive than negotiated ones as addressed in the subsequent section (Kessel 1971; Joehnk and Kidwell 1979; Leonard 1983; Braswell, Nosari, and Sumners 1983; Kidwell and Rogowski 1983; Benson 1979; Forbes and Peterson 1979; Government Finance Research Center 1993; Simonsen and Robbins 1996; Simonsen 2000). Table 10 serves to illustrate the conflicting interests among the different parties as to what is considered a “good” sale relative to interest rates and total bond price. A natural conflict exists between the underwriter - who is first accountable to its shareholders to make a profit -- and the issuer, who is first accountable to the taxpayers to obtain lowest total issuance costs.2 0 2 0 Another conflict in the municipal bond issuance process highlighted in the literature is that of the financial advisor turned underwriter. Clarke (1997), on the basis of a review of nearly 1,000 municipal debt issues sold competitively in Texas from 1991 to 1995, found that unrated issues are much more likely to be bid on and won by the advisor, indicating that issuers should be wary of a financial advisor's advice to take their issue unrated to market. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 65 Table 10 Municipal Bond Sales: Conflicting Interests High Sales Price Underwriter Goal (for Investor) Underwriter Goal (for Issuer) Low Sales Price Investor Goal Issuer Goal Source: Original So long as a broker or middleman is required to bring the sale o f the bonds to the secondary market, there will be underwriting spreads which the underwriter needs for compensation. This added cost is not one which the issuer can easily manage, but one which ultimately affects the authentic marketability o f its bonds. The institutional investor survey which follows, detailing their position on competitive versus negotiated issues, provides even more insight for the continued support and attraction of negotiated sales. Issuers may take the stratagems discussed in this survey and use them for their own purposes. Specifically, governments could use these responses to devise a valuable and strategic method for evaluating different methods of sale for their particular needs. In the next chapter, the methodology for this research is discussed, including the written questionnaire sent to institutional investors and the questions used in the telephone interviews of the same group of investors. Then, the rationale for the recommendation to use Bayesian analysis, in a manner which will help evaluate underwriter performance, is set forth along with a “set of standards’1 by which a bond sale process could be evaluated. The chapter closes with a complete list of all persons contacted during the writing of this dissertation. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter III Methodology 66 A. Introduction John Keynes distinguishes between three methodologies in his description of the scope and method of political economy: positive science, normative or regulative science, and art. Positive science is “a body of systemized knowledge concerning what is .. . normative science is “a body of systemized knowledge discussing criteria of what ought to be . . and art is “a system of rules for the attainment of a given end.” (1891: 34-35,46) Contained within this dissertation are aspects of all three. Equal attention is given to positive science and art with less attention to a normative methodology. In a positive fashion, this dissertation seeks, first, to explain what motivates institutional investors to buy one municipal issue over another and how, if at all, the type of sale influences their purchase. Both scholarly and "real-world" reviews will be used to suggest how public decision makers can “artfully” be induced to make more cost-effective future decisions. This dissertation considers various institutional investor purchasing criteria, derived from practical experience and the opinions of public finance professionals. Of primary concern is the ranking of these underlying criteria, so that issuers may adjust their marketing strategies accordingly. Given the current competitive nature of financial markets, the goal of issuers is to make their offering the most attractive when compared to other tax- exempt investments. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 67 To help demystify the process, a matrix for the selection of method of sale is presented in Chapter VI. The final part of this research questions the current decision making processes employed to determine method of sale and reflects on government’s ability, generally, to make decisions which are in the best interest of the public from efficiency and effectiveness perspectives. In a normative fashion, a conceptualization of an efficient, legal, and economical bond issuance process is delineated with a “set of standards” for municipal bond issuance. B. Data Instrument A one-page questionnaire (consisting of three questions and one rating scale) was either faxed or e-mailed between November 1999 and April 2000 to 41 finance professionals with institutional investment firms that currently hold or have held Clark County, Nevada, and Las Vegas Valley Water District municipal bonds. The format and questions for the institutional investor survey follow: Questions for Institutional Investors Name_______________________________ (FAX Response to Marguerite Creel (702) 455-2294) 1) Please comment on the following: “Is the price local governments pay to borrow money actually within their control? It is true the market economy establishes the general rates for which willing investors lend money. As with any financial investment, the higher the perceived risk of an investment, the higher Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 68 the yield necessary to attract willing investors. Although interest payment schedules cannot be changed, market prices of securities also change as market conditions change. As interest rates decline in the market, municipal bond prices increase. Conversely, when interest rates rise, bond prices decline. Interest rates fluctuate in response to underwriters' confidence the bonds will be repaid in full as promised. The attractiveness of a bond issue to an investor is primarily a function of the offering relative to other offerings in the market and the risk of the investment. Secondarily, what an investor is willing to pay is associated with his/her respective portfolio. Theoretically, the interest rate paid to the investor includes a cost differential for the level of risk.” (Source: Author) 2) Should issuers determine their selection of method of sale and/or which underwriter to use for a new municipal bond issue on the basis of the past performance of underwriters? Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 69 3) What are the primary criteria that factor into your decision to purchase a bond series? 4) Please rate the importance of the following criteria (with “I" being most important; factors may be rated the same number to show equal importance) for your decision to purchase a bond series: Anticipated Future Interest Rates Bond Rating Current Bond Market Prices Current Stock Market Prices Debt Ratios for Issuer Familiarity with the Issue Familiarity with the Issuer Familiarity with the Underwriter Portfolio Needs Purpose of Bonds (e.g., General v. Airport v. Sewer) Rate Structure (Variable or Fixed) Size of the Issue or Series Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 70 Structure of the Issue (e.g., maturity schedule, call features, credit enhancements) Type of Sale (Negotiated or Competitive) A similar one-page questionnaire seeking institutional investor municipal bond preferences was faxed to 5 persons working for financial advisory firms that service Clark County, Nevada and surrounding jurisdictions. The survey was virtually identical to the one sent to the institutional investors with the exception of inserting “institutional investor” where “your” decisions are implied in questions 3 and 4. The format and questions for the financial advisor survey follow: Questions for Financial Advisors Name_________________________________ (FAX Response to Marguerite Creel (702) 455-2294) 1) Please comment on the following: “Is the price local governments pay to borrow money actually within their control? It is true the market economy establishes the general rates for which willing investors lend money. As with any financial investment, the higher the perceived risk of an investment, the higher the yield necessary to attract willing investors. Although interest payment schedules cannot be changed, market prices of securities also change as market conditions change. As interest rates decline in the market, municipal bond prices increase. Conversely, when interest rates rise, bond prices decline. Interest rates fluctuate in response to underwriters' confidence the bonds will be repaid in full as promised. The attractiveness of a bond issue to an investor Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 71 is primarily a function of the offering relative to other offerings in the market and the risk of the investment Secondarily, what an investor is willing to pay is associated with his/her respective portfolio. Theoretically, the interest rate paid to the investor includes a cost differential for the level of risk.” (Source: Author) 2) Should issuers determine their selection of method of sale and/or which underwriter to use for a new municipal bond issue on the basis of the past performance of underwriters? 3) What are the primary criteria that factor into institutional investors’ decision to purchase bonds? Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 72 4) Please rate the importance of the following criteria (with “I" being most important; factors may be rated the same number to show equal importance) for institutional investors to buy a bond series: Anticipated Future Interest Rates Bond Rating Current Bond Market Prices Current Stock Market Prices Debt Ratios for Issuer Familiarity with the Issue Familiarity with the Issuer Familiarity’ with the Underwriter Portfolio Needs Purpose of Bonds (e.g., General v. Airport v. Sewer) Rate Structure (Variable or Fixed) Size of the Issue or Series Structure of the Issue (e.g., maturity schedule, call features, credit enhancements) Type of Sale (Negotiated or Competitive) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 73 Although an enlarged font and double-spacing have been used here to clearly present the survey questions to the reader, each of the two questionnaires was limited to one page. These questions were wholly devised by the writer. Usable replies to the written questionnaire were received from 39 percent of contacted investors (16 of 41), a predictable response rate given the guarded nature of investment firms. Respondents included rating/credit analysts (3), investment officers (3), senior management (3), and portfolio managers (7) currently working with the tax-exempt investment and trading departments of their respective companies. The names, titles and companies of contacted investors are listed in Table 11. All responding participants were articulate and definitive. With respect to the financial advisors, 4 of the 5 contacted advisory professionals (80 percent) provided written responses to the questionnaire. This response rate is high given the proprietary nature of information shared by financial advisors. All of the participant advisors have significant experience (more than 10 years) working with public finance in the western region of the United States. The names, titles and companies of contacted advisors appear in Table 12. The instrument carefully examines three topics: what local governments can do to lower their municipal borrowing costs; the importance of selecting type of sale and or underwriter on the basis of past performance of underwriters; and purchase criteria habitually used by institutional investors. The latter subject matter was solicited both in an open-ended Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. AIG Geoff Cornell Portfolio Manager ✓ ✓ AIG Richard Thompson Managing Director X ✓ Alliance Capital Mgt. Susan P. Keenan Sr. VP, Head of Muni. Bonds X X Alliance Capital Mgt. Terry Holts Portfolio Manager X X Allstate Insurance Russ Augsburg Sr. Mgr, Banking and Cash X ✓ Allstate Insurance Karen Szerszen Credit Analyst ✓ / American Century Dave MacEwen Sr. V.P., Portfolio Mgr. X X American Century Ken Salinger Portfolio Manager ✓ X American Century Brad Bode Sr. Municipal Analyst ✓ ✓ BankBoston David Thompson Director of Funds Manager X / Blackrock Financial Mgt. Susan C. Heide NA (Credit Research) X / Calvert Group Reno Martini Chief Investment Officer X X Chubb Corporation Fred Gaertner Portfolio Manager ✓ ✓ Conning Asset Mgt. Frank Campbell Portfolio Manager ✓ ✓ Country Mutual Insurance Mary Guinane Investment Officer ✓ X Dean Witter Jim Willison NA (Senior Management) X ✓ Dreyfus Joe Darcy Portfolio Manager X ✓ Dreyfus Monica Wieboldt Portfolio Manager X X Eaton Vance Robert Macintosh V.P., Portfolio Mgr. ✓ X Employers Reinsurance Brad Postema Portfolio Manager / X Erie Insurance Group Mark S. Borowy Municipal Bond Analyst / X Federated Investors Pat Heagy Trader X X Fidelity Investment Corp. John Vetter Fund Analyst X X First Union National Bank Rick Marone Sr. V.P., Sr. Portfolio Mgr. X ✓ G. E. Investments Susan Courtney Portfolio Manager ✓ X Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 75 G. E. Capital Service Rick Filipelli Chief Financial Officer X X Houghton Mifflin JoeDodi Treasury Manager ✓ X Lyons Street Asset Mgt. Michael Martin Dir. Tax-Free Fixed Income X / Merrill Lynch Asset Mgt. William Bock V.P., Portfolio Manager X X Merrill Lynch Asset Mgt. Fred Stuvy Trader X X MS Valley Advisors Peter Merzian NA (Principal) X X Ohio Casualty Group David Land Portfolio Manager / ✓ Scudder Kemper Bob Peck NA X X Sentry Investment Mgt. Jay Cook Portfolio Manager X X State Auto Mutual Group Jim Duemey Chief Investment Officer ✓ X State Farm Insurance Julian R. Bucher V.P. Municipal Securities ✓ X Van Kampen Investment Richard Ciccarone Co-Head of Municipals / X Vanguard Ian A. McKinnon Head of Municipals X X Vanguard Mark Stockwell Credit Analyst X X Vanguard Peter Cordary Trader X X Vanguard Chris Ryan Portfolio Manager X X Table 11 Surveyed Institutional Investors, continued Note: W = Response by Written Survey, V = Response by Telephone / = Usable Information, X = No Response NA = Not Available Abbreviations: Corp. = Corporation, Dir. = Director, G.E. = General Electric, MS = Mississippi, Mgr. = Manager, Mgt. = Management, Muni. = Municipal, Sr. = Senior, V.P. = Vice President Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Paul Howarth & Associates Lynda Harvey Vice President ✓ ✓ Paul Howarth & Associates Paul Howarth Principal X / Hobbs, Ong & Associates Guy Hobbs Principal / ✓ Hobbs, Ong & Associates Kathy Ong Principal ✓ / Public Financial Management John Bonow Vice President ✓ ✓ question and by way of rating scale. The implications of the data, and the role that local governments eventually might play in lowering borrowing costs are examined in the next chapter.2 1 The one-page, open-ended questionnaire was designed to elicit individual investor insight into what factors most impact the final determination of issuer borrowing costs. The question relative to decision-making criteria was asked alternatively two different ways -- one with mathematical emphasis and another as a requisite list -- to identify any answering inconsistencies possibly attributable to the framing of questions. By limiting their response to four questions and one page, respondents were compelled to put down either what is most important or “top-of-mind.” C. Telephone Interviews For those willing to discuss the survey questions directly over the phone, or alternatively unwilling to respond in writing, one or more of the following additional 2 1 The methodology section was derived, in part, from James S. Bowman’s article “Ethics in Government: A National Survey of Public Administrators,” PAR (1990: 345-346). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 77 questions were asked: • Could government lower its borrowing costs by selling when other issuers are not? • Do underwriters influence which bonds are to be purchased? • Do you prefer a negotiated or competitive sale? • Do you recommend issuers use swaps and hedge on the market? • Does an issuer need a financial advisor? • How much control does the issuer have over additional spread demanded? • Is any size too big for a competitive issue? • Should issuers attempt to develop direct relationships with institutional investors? • What effect does the marketplace have on the price of borrowing? Of the 41 contacted investor representatives, 14 (34.1 percent) were willing to be interviewed over the phone. (See Table 11 for a list of these individuals.) Between the written and verbal feedback, 24 investors (S8.5 percent) were responsive to the request for information on their decision criteria, disposition toward investor relations programs, and description of how markets impact issuer borrowing costs. One hundred percent of the financial advisors were agreeable to being interviewed, either over the telephone and/or in person. (See Table 12 for a list of these individuals.) Set o f Standards To ensure a predictable, reliable decision-making process for (1) the determination of method of sale and (2) the selection of underwriter, an established set of criteria by which Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 78 both processes and selection will be judged must be in place. Definitions against which “legal,” “efficient,” and “economical” decision-making processes will be judged: Legal A legal municipal bond process is one which follows applicable local, state and federal rules and regulations for disclosure, public notice, and sale of municipal bonds. Efficient An efficient municipal bond process is one which maximizes net revenue from the sale of municipal bonds (e.g., Net Bond Revenue = Principal - Interest - Issuance Cost). Economical An economical municipal bond process is one which is not wasteful of public resources which is the net result of diligent review of available alternatives for both method of sale and selection of underwriter. The criteria above have been prioritized. By far, the most important predicate basis for issuance is that the process be legal. Assuming it may be more efficient to follow an illegal practice, the governmental administrator must opt for a more inefficient, legal process. The overall most efficient process may not be seen as the most economical in certain aspects of the issuance process. Where true, governmental administrators must take steps to improve the economy of any such uneconomical aspects. In sum, much more is at stake than which issuance process is the most efficient. D. Contacts In the course of conducting specific research as outlined in this chapter, numerous public finance professionals, governmental administrators and public administration Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 79 professors were contacted to help clarify the logic and validity of the presented findings, the articulated arguments, the preferences of institutional investors, and the general process of municipal bond issuance. Where specific points are attributable to a person, the reference is appropriately made. However, credit for the writer’s hypothesis development and education must also be extended to some of these persons who freely shared their opinions and expertise. Any possible inaccuracies, misrepresentations or printed mistakes remain the sole responsibility of the writer. Table 13 below presents a list of these persons. Table 13 List of Contacts 1 John Swendseid Swendseid & Stem Bond Counsel Lynda Harvey Paul Howarth & Associates Financial Advisor Paul Howarth Paul Howarth & Associates Financial Advisor Guy Hobbs Hobbs, Ong & Associates Financial Advisor Kathy Ong Hobbs, Ong & Associates Financial Advisor John Bonow Public Financial Management Financial Advisor George White Fiscal Services & Foley & Jadell Financial Advisor Geoff Cornell AIG Investor Richard Thompson AIG Investor Susan P. Keenan Alliance Capital Mgt. Investor Terry Holts Alliance Capital Mgt. Investor Russ Augsburg Allstate Insurance Investor Karen Szerszen Allstate Insurance Investor Dave MacEwen American Century Investor Ken Salinger American Century Investor Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 80 Brad Bode American Century Investor David Thompson BankBoston Investor Susan C. Heide Blackrock Financial Mgt. Investor Reno Martini Calvert Group Investor Fred Gaertner Chubb Corporation Investor Frank Campbell Conning Asset Mgt. Investor Mary Guinane Country Mutual Insurance Investor Jim Willison Dean Witter Investor Joe Darcy Dreyfus Investor Monica Wieboldt Dreyfus Investor Robert Macintosh Eaton Vance Investor Brad Postema Employers Reinsurance Investor Mark S. Borowy Erie Insurance Group Investor Pat Heagy Federated Investors Investor John Vetter Fidelity Investment Corp. Investor Rick Marone First Union National Bank Investor Susan Courtney G. E. Investments Investor Rick Filipelli G. E. Capital Service Investor Joe Dodi Houghton Mifflin Investor Michael Martin Lyons Street Asset Mgt. Investor William Bock Merrill Lynch Asset Mgt. Investor Fred Stuvy Merrill Lynch Asset Mgt. Investor Peter Merzian MS Valley Advisors Investor David Land Ohio Casualty Group Investor Table 13 List of Contacts, continued Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 81 *tcu;?rja*irrf'»-r'fvc xvzsjtx**-. t* Bob Peck Scudder Kemper Investor Jay Cook Sentry Investment Mgt. Investor Jim Duemey State Auto Mutual Group Investor Julian R. Bucher State Farm Insurance Investor Richard Ciccarone Van Kampen Investment Investor Ian A. McKinnon Vanguard Investor Mark Stockwell Vanguard Investor Peter Cordary Vanguard Investor Chris Ryan Vanguard Investor Jeff Chapman University of Southern California Professor Chester Newland University of Southern California Professor Ross Clayton University of Southern California Professor Alex McEachem University of Southern California Professor Dr. Ciccarrelli University of Southern California Professor Detlof von Winterfeldt University of Southern California Professor William Simonsen University of Oregon Professor George Stevens Clark County, Nevada Public Manager Margaret Barton Clark County, Nevada Public Manager Joe Grippaldi Clark County, Nevada Public Manager Table 13 List of Contacts, continued In the next chapter, the institutional investor and financial advisor survey results are contrasted with research (specifically Government Finance Officer Association recommendations) for consideration of what should constitute the key decision factors for determining method of sale. No significant, discerning objective test among the competing Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 82 factors exists. However, an explanation, based on the results of the telephone interviews and research survey, is provided for what is the likely significance of individual criteria. Subjective and intuitive discussion provides the basis upon which the writer predicts how decision-makers can be induced to make more cost-effective decisions in the future. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter IV Analysis 83 A. Introduction This portion of the dissertation begins with analysis of the recommendations of the Government Finance Officers Association (GFOA), the preeminent professional organization for public finance officials, where discussion centers upon various bond sale methods and underwriting fee epistemology. What follows are the “GFOA Recommended Practices for Municipal Bond Issuance” and an interpretation of these practices as it relates to the survey results. An “Institutional Investor Criteria for Purchase of Bonds” section then summarizes the key purchasing criteria as communicated in the institutional investor survey and interviews. B. GFOA Recommended Practices for Municipal Bond Issuance GFOA is a professional association of over 14,000 state, provincial and local finance officers in the United States and Canada. Established in 1906, the GFOA initializes the standards for the management of public finances, sponsors awards for program and seminars on performance improvement, and prepares publications on "recommended practices" in fiscal administration. (GFOA 2000) GFOA provides somewhat extensive analysis for public debt issuance and management in the following publications, summaries of which appear hereafter: Maintaining an Investor Relations Program (1996) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 84 Payment of the Expense Component of Underwriters' Discount (T9961 Pricing Bonds in a Negotiated Sale (1996) Development of a Debt Policy (199S) Selecting and Managing the Method of Sale of State and Local Government Bonds (1994) GFOA is a robust supporter of having effective financial policies, so it comes as no surprise that the association advocates parameters for issuing debt and managing the debt portfolio while offering practical guidance for decision makers. The stimulus for governments doing so are enumerated in Development of a Debt Policy (1995). Auxiliary goals cited are the facilitation of sound debt positions, protection of credit quality, and shoring up of the quality of the decision-making process from the inception of the process. (GFOA 1995: 3) GFOA catalogues other, secondary debt policy factors which a debt policy should address: when debt may be issued; legal debt limitations; limitations established by policy, including limitations on the pledge of the issuer's general credit; use of moral obligation pledges; types of debt permitted to be issued; criteria for issuance of short-term, long-term, general obligation, revenue, fixed rate, variable rate, lease-backed, special obligation (such as assessment district), conduit issues, and taxable debt (GFOA 1995: 3-4). More complex structural features find their way into the GFOA recommendations for debt policies. These include debt maturity, setting maturity equal to or less than the useful life of the project, zero coupon bonds, capital appreciation bonds, deep discount bonds, Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 85 premium bonds, debt service structure, redemption provisions, credit enhancement, senior and junior lien obligations, and the use of derivative products. (GFOA 1995: 4) GFOA then elaborates upon credit objectives, like maintaining credit ratings and adhering to benchmark debt ratios and other affordability targets. Authorized methods of sale (competitive, negotiated and private placement); nomination of outside finance professionals; policy on refunding of debt; primary and secondary market disclosure practices; compliance with federal tax law provisions, such as arbitrage requirements; integration of capital-planning and debt-financing activities; and investment of bond proceeds otherwise not covered by explicit written law or written investment policy are also factors recommended for inclusion (GFOA 1995:4). The selection and management of the method of sale were addressed in a GFOA publication issued a year earlier (Selecting and Managing the Method of Sale of State and Local Government Bonds 1994). While GFOA notes “a divergence of views as to the relative merits of the competitive and negotiated methods of sale due to the lack of comprehensive, empirical evidence that would favor one method over the other,” the association adds, “. . . in negotiated sales, there is concern about the fairness of the selection process and the possibility of higher borrowing costs because of the potential for underwriter selection on the basis of political favoritism rather than merit and cost” (1994: 14) GFOA recognizes that conflicts of interest may stem from agreements between outside financial professionals and public managers participating in negotiated transactions. To help ensure “the most appropriate method of sale is selected in light of financial, market, and transaction-specific and issuer-related conditions,” the association offers the Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 86 following conditions “favoring a competitive sale” (abbreviated; enumeration is the writer’s): 1. The market is familiar with the issuer; 2. The issuer is a stable and regular borrower in the public market; 3. There is an active secondary market with a broad investor base for the issuer's bonds; 4. The issue has either an enhanced or unenhanced credit rating of A or above; 5. The debt structure is backed by the issuer's full faith and credit or a strong revenue stream; 6. The issue is not too large to be easily absorbed by the market; 7. The issue is not too small to attract investors without a concerted sales effort; 8. The issue does not have complex or innovative features; 9. The issue does not require an explanation as to the bonds' soundness; and 10. Interest rates are stable and market demand is strong (GFOA 1994: 14). While issuers often use negotiated sales to address public policy issues such as the desire to attract disadvantaged business enterprises (DBE) and regional firms for participation in the syndicate and as recipients of bond allocations, GFOA notes these goals may be met by specifying these requirements upfront in the notice of sale (1994: 14). If conditions do not allow for a competitively bid bond sale, GFOA recommends the following practices (abbreviated): 1. Use a competitive underwriter selection process; 2. Remain actively involved in each step of the negotiation and sale processes; 3. Ensure a qualified employee or outside professional other than the issue underwriter Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 87 is available to assist in structuring the issue, pricing, and monitoring of sales activities; 4. Avoid using a firm to serve as both the financial advisor and underwriter of an issue; 5. Require that financial professionals disclose the name(s) of any person or firm compensated to promote the selection of the underwriter; any existing or planned arrangements between outside professionals to share tasks, responsibilities and fees; the name(s) of any person or firm with whom sharing is proposed; and the method used to calculate the fees to be earned; and 6. Review the "Agreement Among Underwriters" and ensure that it governs all transactions during the underwriting period (GFOA 1994: 14-15). GFOA further advises issuers to steer the following course in an effort to procure the lowest overall cost of financing in a negotiated sale (i.e., striking a balance between the maturity yield and the takedown) (abbreviated): 1. Communicate specific goals to the underwriting team at the outset (e.g., expectations of roles each member will play in finalizing the price and choreographing issuer and independent financial advisor actions to actualize a comprehensive pricing process) and identify the issuer representative who can both make key decisions and remain easily accessible throughout the pricing process; 2. Include a provision in the request for proposal, prior to final pricing, requiring respondents to indicate the range of costs for each component of compensation, with an expected maximum for each, capping management fees and expenses, reviewing the amount of underwriters' compensation paid by the issuer for previous sales, and Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 88 requesting information on each component of underwriters' compensation for other recent similar sales; 3. Develop an understanding of prevailing market conditions, evaluate key economic and financial indicators (e.g., supply and expected demand for municipal bonds; key economic indicators; anticipated actions by regulatory or political bodies; other factors that might affect the capital markets; interest rates and current market yields of recently priced and outstanding bonds with similar characteristics; interest rates for bonds with similar characteristics provided by independent services that track pricing performance), and conclude how these indicators will likely affect the outcome of the pricing; 4. Work with the underwriter to gauge and build investor interest; 5. Request that the senior managing underwriter propose a consensus pricing scale on the day prior to the pricing; 6. Evaluate carefully whether structural features that reduce TIC, but limit future flexibility in managing the debt portfolio, will result in greater overall borrowing costs; 7. Give clear directions to underwriters on how bonds should be allocated, including reviewing the “Agreement Among Underwriters” prior to the sale to ensure that it incorporates the issuer's goals; 8. Approve all information that will be sent out by the underwriter on the preliminary pricing wire, including the allocation of bonds and the takedown; 9. Be present on the trading floor of the lead manager when the bonds are sold; Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 89 10. Examine the bond sale after completion to assess the level of up-front costs of issuance, including whether the underwriters' compensation was fair given the level of effort and market conditions; the pricing of the bonds, both in terms of the overall TIC and on a maturity-by-maturity basis; and distribution of bonds and sales credits; and 11. Develop a database with information on each issue sold with regard to pricing performance (e.g., types of bonds sold, credit rating, maturities, yield and takedown by maturity, and the TIC) (GFOA 1996a: 10-11). GFOA recommends further that state and local government issuers clearly communicate to the senior managing underwriter the expenses they view as legitimate. “Unless issuers take specific actions, they may pay for unreasonable expenses by the senior managing underwriter. . . ” (GFOA 1996b: 9). To ensure the expense component represents charges for items that are necessary to complete the financing, GFOA recommends the issuer adhere to the following steps (abbreviated, enumeration is the writer's): 1. Require firms proposing to serve as senior managing underwriter to propose an itemized list of expenses they expect to incur; 2. Convey clearly to the firm selected as senior managing underwriter the expenses that the issuer regards as legitimate (e.g., compensation for underwriters' counsel; travel to and from the issuer's offices; Dalcomp/Dalnet fees for transmitting information on interest rates, takedowns, and priority of orders; interest/day loan costs; charges for communication, including the rating agency presentation, mailing, printing, and telephone expenses; documented clearing charges; and closing costs) and those that Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 90 the issuer does not view as reasonable (e.g., cost of taxi rides to and from work by the underwriters' staff, the Public Securities Association's underwriting assessments, entertainment expenses, computer-run charges, and undocumented clearing charges); 3. Set a cap on fees paid to underwriters' counsel; 4. Require the senior managing underwriter to explicitly document all expenses incurred on behalf of the issuer in a negotiated sale; and 5. Require explanation from the senior managing underwriter for expenses not included in the original proposal (GFOA 1996b: 9). GFOA advocates “investor relations programs,” which entail issuer disclosure of annual financial and operating data, material events, changes in financial or operating position, and changes in government policies to all of the holders of an entity’s bonds. Documents that GFOA considers as possible sources of such information are annual budgets, financial plans, comprehensive annual financial reports, materials sent to governing bodies, and copies of ordinances or resolutions adopted by a governing body. Secondly, GFOA advocates active marketing of any planned sales to existing investors, including early release of official statements, the preparation of special reports, the scheduling of investor meetings or conference telephone calls and tours of facilities. (GFOA 1996c: 7) Although GFOA recommends issuers identify ways to stay abreast of issues likely to be of concern to investors, such as the development of policies and practices pertaining to investments, they offer no specific guidelines for doing so. Further, GFOA is noticeably silent in its “recommended practices” on selection of method of sale, despite more recent Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 91 research which confirms the cost effectiveness of competitive sales (notably Simonsen’s work, 1996,1998,2000). The institutional investor survey results presented in the next section help identify the purchase criteria of particular investors and reflect on the validity of the above “conventional wisdom” of municipal debt management as laid out in GFOA publications. The survey is a purposive one, designed to address concerns of investors who hold bonds in the western region of the United States. While GFOA’s recommendations are “blanket” ones tooled to assist all issuers of municipal bonds across the United States, the interviews help provide guidance to issuers similar to Clark County, Nevada, as to the merit of these recommendations. C. Interpretation For the purposes of this section, the feedback from institutional investors, both verbal and written, will be summarized together as responses were, with few exceptions, consistent across type of response, company and job title. The verbatim written responses of the investors are compiled in Appendix B. Table 14 presents the results from the answer to question 4 of the survey (“Please rate the importance of the following criteria (with “1" being most important; factors may be rated the same number to show equal importance) for your decision to purchase a bond series:...)). Following a report on the institutional survey, this research turns to a discussion of the financial advisors’ opinions. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission o f th e copyright owner. Further reproduction prohibited without permission. Table 14 Institutional Investors: Criteria for Municipal Bond Purchssa Queried Companies: AIQ, Allstate, American Century, Chubb, Conning Asset Management, Country Mutual Insurance Co., Eaton Vance Mutual Funds, Em ploy era Reinaura nee, Erie Insurance, GE Investments, Houghton A M ifflin, Ohio Casualty Group, State Auto Mutual Group, State Farm Insurance Companies, Van Kampsn Investment Advisory Question: Please rate the importance of the following criteria ( with "1” being moet important; factors may be rated the same number to show equal importance) for your decision to purchase a bond series: Title Date o f Receipt o f Response Number ___ Anticipated Future Interest Rates Current Bond Market Prices Current Stock Market Prices Debt Ratioe for Issuer Familiarity with the Issue Familiarity with the Issuer Familiarity with the Underwriter ■ to iiik M A Purpose of Bonds Rale Structure Size of the Isa ue or Series Structure at the issue Type of Sale 2 1 1 2 2 3 2 2 2 2 2 3 3 3 1 2 M O 12/02/99 12/07/99 12/15/99 12/16/99 12/17/99 12/17/99 12/21/99 12/27/99 12/27/99 12/28/99 12/29/99 01/04/00 01/05/00 04/06/00 04/07/00 Simple ._±_ _____ 2 _____ 3 ___________8 _____ JL ______ 7 ___________ ! 9 10 11 12 13 14 18 16 Avg- 3 N A 5 . 13 2 13 3 4 3 1 4 2 7.7 1 3 3 3 4 4 3 1 1 1 8 1 1 2 S S £ • N A 1 8 2 1 12 14 3 2 7 3 8 8 7.8 N A 1 14 4 14 14 9 5 10 3 9 9 10.1 3 2 4 4 3 2 10 4 7 3 4 1 10 1 1 6.0 4 5 2 10 4 5 6 2 9 5 4 1 2 2 13 4 4.9 5 6 2 6 3 5 2 8 2 4 3 9 2 1 1 13 6.9 7 7 6 7 3 4 3 7 5 6 2 1 1 5 12 12 6.9 6 1 1 1 1 7 1 1 5 1 1 1 s 1 1 " 1' ‘ ■ U 10 4 2 1 1 4 1 1 1 3 8 2 12 4 5 14 7.4 N /A 2 4 5 2 1 S 2 1 1 5 1 7 ? S' U B 2 5 12 1 2 3 4 2 2 1 13 2 3 7 6.1 2 2 3 2 1 3 2 1 3 2 2 2 6 1 * 3 2.3 g 8 6 9 2 6 7 2 6 6 6 14 6 14 10 7.8 Notes Anticipated Future Interest Rates 2 - These are all taken Into consideration when assessing portfolio needs' Bond Rating 1 - 'Bond Rating' was crossed out. “ Our opinion of the bond rating through credit analysis’ Current Bond Market Prices 2 - These are all taken kilo consideration when assessing portfolio needs * Currant Stock Market Prices 2 - These ere all taken into consideration when assessing portfolio needs* Debt Ratios for Issuer 1 • Too lim ited a question much more goes into analysis* Rate Structure (Variable or Fixed) 1 - “ we only buy fixed* 5 - "Fixed* was circled 6 - * - important upfront" BUS 1 • M unicipal Bond/Rating Analyst 2 * Portfolio MiniQtf 3 • Senior Management (i.e., Chief Investment Officer, Co-Head of M unicipals. Senior Vice President, Treasury Manager) * * Averages were calculated by using *14* where left blank or noted as * N A * by the respondent. The only exception is * 1 * used for "Rato Structure" for respondents 1,5, and 6 based on their written comments. SO to 93 Institutional Investor Findings General findings of the institutional investor instrument can be condensed into 13 points: • The municipal bond investment community is guarded, insular, and unamenable to the open sharing of noteworthy information. • Price versus the price of comparably rated bonds, credit quality of the issuer (bond rating), maturity schedules (structure of the issue), rate structure (variable v. fixed), and liquidity in the secondary market are the most important influences upon institutional investor choice (see Table 14 for a compilation of written rankings). • The price of borrowing is determined largely by the marketplace. • Issuers have a certain level of control over additional spread when sound fiscal management is a linchpin in the process. • Selling bonds at a time when other major sellers are not can result in lower borrowing costs. • Institutional Investors rely heavily on underwriters for information. • Issuers should consider the past performance of underwriters as one important criteria to determine method of sale or selection of underwriter. • Issuers should develop direct relationships with institutional investors. • Given the option, institutional investors uniformly prefer negotiated sales over a competitive one. • Lower cost of issue, however, trumps the desire for a negotiated sale. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 94 • Lower quality issues or issues that need intense financial work (such as advance refundings) can benefit from a negotiated sale through a certain underwriter with a proven track record. • Prognosticating of public bond value is truly subjective. • In desirable economic times, issuers have already "squeezed" the spread out of the municipal market. It can said that responses received from these employees were substantively indicative of the policies of their respective companies. Several attempts to contact co- workers or supervisors of those who had already participated resulted in affirmations that their co-worker’s response reflected overall company policy. In some instances, several co employees completed the written questionnaire together. For consistency, the name and title of the person with whom the writer had direct contact was noted. A noted, major caveat is that the responses may be markedly influenced by the current markets. While no respondent indicated their decision criteria were contingent on prevailing market conditions, there is no way to guarantee such attitudes would not shift under different market conditions. As no major upsets or dramatic shifts are anticipated in the market, information gleaned from institutional investors should prove useful to an issuing agency wishing to target the demands of the market to reduce its total borrowing costs. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 95 The following responses can be taken to reflect the opinions of several institutional investors (expressed both verbally and in writing) in a generally favorable climate for municipal bonds: (1) The municipal bond investment community is guarded, insular, and unamenable to the open sharing of noteworthy information. More than 41 percent of the contacted representatives of 41 companies (see Table 11) were adverse to supplying any information whatsoever. Although some of these representatives indicated a willingness to complete the faxed questionnaire, sometimes even on multiple efforts, the surveys were not returned. The vast majority of those eventually sharing some information retained a core reluctance, presumably due to their time constraints. All contacted institutional investing firms either hold or have held Clark County or Las Vegas Valley Water District bonds. These reservations to discuss purchasing practices occurred despite introduction by the writer as a Clark County, Nevada, employee. Three representatives (Alliance Capital Management, Dean Witter and Vanguard) professed a standing corporate policy not to share decision making strategy with any outside persons/media. Vanguard is one of the largest holders of Clark County municipal bonds. An executive from Dean Witter Sears-Intercapital even went so far as to state a company preference to only talk with lead underwriters, “We do funds here and municipal funds; and if you have negotiated deals, we talk to lead underwriters, and if you have competitive deals, we get the OSs and decide if we are going to bid pre-sale or wait to see who buys it if we Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 96 care about the issue.” Another company, Mississippi Advisors, would not give out their fax number. Given the homogenized, closed and somewhat secretive nature of institutional investors, can local and state governments actually market their bonds as well or better than an underwriter as originally hypothesized? How many inroads can an entity's “Institutional Investors Relations Program” make if a coercive “insiders’ network” exists? If an underwriter is needed to sell the municipal bond to a buyer, would not a local government want to work with the representatives from the underwriting firms which have the best relationships with the intended buyers? Not only would an agency want to amass the best underwriting syndicate, but perhaps, more importantly, they would want to take extra care to select the right people from these large underwriting firms to handle their issue. In what amounts to a sophisticated sales and marketing force, issuers are dependent on underwriters in a negotiated sale for their networking abilities. Put simply, which specific underwriting professionals are personal friends or close associates of the chief investment officers and senior portfolio managers of the targeted funds?2 2 These concerns of inclusiveness are tempered by the wealth of information shared by some representatives and the general consistency of responses across respondents. In the words of one representative, “ it (investor relations programs) certainly can’t hurt and it may help.” The performance of a recent direct sale of Pittsburgh, Pennsylvania, bonds to 2 2 Similarly, if an underwriter has excellent contacts in the retail market, an issuer may do very well on interest cost by either circumventing or bolstering the demand of the institutional investor market with direct private placement (Bonow 1999). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 97 investors through the Internet gives further support to the idea that many institutional investors may, in fact, be open to future direct sales and relationships with government financial administrators.2 3 The findings, however, forcefully compel a conclusion that on the whole, institutional investors, large and small, feel most comfortable working with underwriters directly for the general purchase of bonds. Investors express a desire to work directly with local government officials only when it is on their terms (e.g., the investor needs to discover/confirm a specific piece of information that is either lacking in the OS or troubling in terms of a negative finding). (2) Price versus the price of comparably rated bonds, credit quality of the issuer (bond rating), maturity schedules (structure of the issue), rate structure (variable v. fixed), and liquidity in the secondary market are the most important influences upon institutional investor choice, 2 3 In the November 1999 sale, the City of Pittsburgh used the Internet, through MuniAuction, Incorporated, to allow institutional investors to compete alongside underwriters. Last January, the underwriting firm Goldman Sachs & Company ran the books for a World Bank loan which generated $1.7 billion of on-line orders. This offering was the precursor for Goldman's on-line negotiated sale of a $475 million Puerto Rico general obligation bond issue in March 2000 through a proprietary system. This event marked the first time institutional investors were able to place orders electronically in an automated book. (Sherman 2000: 1, 36) Since the Pittsburgh and Puerto Rico deals, there has been heated discussion on the future role underwriters will play as intermediaries in the municipal bond market. Brevard County, Florida, is contemplating a "direct-to-investor" sale through the Internet as a result of Pittsburgh's experience. One of the salient arguments against Internet sales is the need to maintain the liquidity of the market provided by the underwriters. Proponents of minimized underwriter interaction in the future believe that the investors may be able to provide their own liquidity through enhanced communications. (Whalen 2000: 1-2) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 98 The 16 respondents who ranked criteria found “structure of the issue” (2.3), “portfolio needs” (2.4), “rate structure” (2.8), and “bond rating” (2.8) to be the four most important criteria influencing their decision to purchase one municipal bond series over another (on a scale of I to 14 with 1 being most important). In the interviews, in lieu of citing “structure of the issue,” participants used the language “maturity schedules” to voice their preoccupation with bond structures. “Portfolio needs” was one of the top reasons listed on the open-ended question as a decision factor influencing purchase, although “overall price” and “liquidity” in the market were most often cited over the phone. “Structure of the issue” and “portfolio needs” are interrelated as they both pertain to the needs of the investor, irrespective of what else is going on in the market. Investors are looking for set amounts, at set credit levels, to mature at set times: “Once the chief investment officer has determined that municipals represent value, we analyze our current portfolio to determine which maturity(s) of the new bond is appropriate. Analysis of particular issues includes the strength of the entity (GO, Revenue Bond are looked at differently); the quality of management; financial status; feasibility of any projections; and comparative value vs. other comparably rated bonds.” (Respondent 3) The preeminence of portfolio needs is the single most important finding of the research because it underscores the requirement for issuers to closely match the demand of the market if they wish to receive multiple bids in a competitive sale. Coupled with the finding above that investors prefer to work with underwriters versus issuers, it may become important for the issuer to have in-house personnel with former ties to the market or to retain an expert financial advisor who is closely attuned to the market to structure the issue. More often than not, according to several investors, issuers structure their Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 99 bonds to meet the government’s demand for cashflow. If issuers had more flexibility in their need for cash, they could save interest cost by appealing to investors who would pay a small premium to match their portfolio needs. “Price” pertains to the yield of the issue as compared to other municipal bonds. Yield, as explained by another investor, is also dependent upon available supply (both primary and secondary). The value (or yield) of a given bond is a function of the maturity, coupon, original issue, yield, call features, credit rating, sector, credit enhancement, state, and region. (Respondent 4) Another investor added that the price needs to also be evaluated against taxable securities as well for the investment to occur. (Respondent 8) What the investors are looking for is a “good deal” or value for their money. “Liquidity” is often provided by the underwriter who brings the deal to the market (Respondent 1). Liquidity alone can serve as one single justification for selecting an underwriter with market staying power. That is, the experience and assets of the company provide insurance to the issuer that the underwriter will have investors willing to buy from them. After the top four ranking criteria (average score ranging from 2 to 3) there is a jump to “familiarity with the issue” (4.9) and “size of the issue or series” (5.1). These factors are clearly secondary to the aforementioned criteria. Due to this gap in importance, it can be said that issuers should focus their efforts on devising the maturity schedule, deciding how much insurance to buy to make their bond credit-worthy, and deciding on a fixed versus a variable rate structure. Only after careful consideration of these investor determinants would the Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 100 issuer embark on a formidable sales effort. Research, it is demonstrated, is well worth an issuer’s efforts. The least important criteria that factor into the institutional investor’s decision to purchase a bond are current stock market prices (10.1), current bond market prices (7.8), type of sale (negotiated or competitive) (7.8), anticipated future interest rates (7.7), the purpose of bonds (e.g., General v. Airport v. Sewer) (7.4), familiarity with the underwriter (6.9), debt ratios for issuer (6.0), and familiarity with the issuer (5.9). Of these factors, the most surprising is the rating for debt ratios which rating agencies and financial advisors would have issuers believe are very important. Perhaps because debt ratios are taken into account in the overall credit rating, the end purchaser views this factor as just one of many which does not deserve overriding attention at the expense of their respective portfolio needs for set maturities. (3i The price of borrowing is determined largely bv the marketplace. Overwhelmingly, the written responses to the questionnaire noted that costs of municipal borrowing are predominantly determined by the market: “To the extent that local governments can manage their finances responsibly, they can ‘control’ a portion of the price at which they borrow. The choice of selling bonds competitively vs. negotiated (i.e. choosing a particular underwriter) mav lower costs. Beyond these factors, though, the price of borrowing is determined largely by the marketplace. . . ” (Respondent 3) Another investor wrote succinctly, “ACTUALLY, THE ONLY CONTROL THEY (issuers) HAVE IS WHETHER TO BORROW OR NOT. The market dictates their (issuers’) cost of borrowing.” (Respondent 14) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 101 In the municipal market, new issue prices are very dependent on supply. Supply is a key driver of price. Interest rates fluctuate more in response to inflationary fear than to credit concerns. (Respondent 9) Issue price is primarily a function of the offering relative to other offerings in the market. Governments’ cost of borrowing is set at the time bonds are initially sold to the market Issuer’s cost is not impacted by secondary trading of bonds, contends Respondent 2. Actual rates may, however, vary depending on specific state or federal tax matters indicating state tax exemption, such as an allowance for banks to buy eligible small issues and still deduct the carrying cost. (Respondent 2) As an investor in both tax exempt and taxable investments, Respondent 8 acknowledged that his company’s buying needs are determined, more than ever, by the spreads between markets and by changes in the tax code that impact ownership of “tax advantaged” bonds by property and casualty companies. “Having the ability to “control” what you (the issuer) pay(s) to borrow money is never total. By borrowing you give up certain forms of control,” notes Respondent 8. The more times an issuer goes to market to borrow, the more the lender (investor) allows the issuer to “control” rates by averaging costs. However, the more the issuer goes to market, the greater the indication that the issuer needs outside help. (Respondent 8) The response to question 1, summarized above, puts the issuance cost in perspective from the investors’ point of view. Although institutional investors acknowledge nominal savings to be achieved in issuance cost, the investors tend to emphasize the relative strength and momentum of rates set in the financial markets. After all, there are limits to the cost savings any given issuer can expect to achieve over their total interest cost The financial Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 102 condition of the governmental entity, the socioeconomic condition of its jurisdiction, and the overall economy are certainly not within the purview of the public finance manager. Many of the companies surveyed hold billions of dollars of municipal debt in par value. They simply may not see the achievement of a $ 100,000 cost savings as significant. This might also provide insight into why cost differentials between type of sales and different underwriters in their takedowns are not viewed as critical problems within the public finance community. On the other hand, to an issuer entrusted with its taxpayer’s money, a savings of $50,000 to $150,000 off of issuance cost could prove quite significant in opportunity costs or tax savings. (4) Issuers have a certain level of control over additional spread when sound fiscal management is a linchpin in the process. While the general level of interest rates is set in the market and out of the control of government, at the margins, governments can reduce their borrowing costs through good financial management: The price local governments pay to borrow money is within their control to the extent that by being fiscally responsible and keeping their finances (and ultimately ratings) in check, they can reduce the spread investors will demand. They cannot control base rates, but they do have a certain level of control over additional spread demanded. (Respondent 1) Relative value is certainly very important to investors. An issuer does have control over its financial & debt management practices. These practices & other factors will impact an issuer’s credit quality & their borrowing costs. (Respondent 11) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 103 A local govt, can make sure that there finances are in good shape - so that they can receive a good rating for their bonds. Many investors are high quality buyers and will sacrifice yield for good quality. (Respondent 12) To a certain extent, the interest cost to borrowers is within their control. If an issuer takes steps to improve their rating they will be rewarded by lowering borrowing costs. When an issue is priced in the primary market, it is priced most often in line with other issues of similar credit quality. If an issuer improves its rating to A from BBB, there will be significantly lower borrowing costs to the issuer. (Respondent 15) Yes, it is within their control to some extent. While it’s true the market will set the target rate issuers pay, how fiscally responsible they are will determine their rating and thus the spread the market will demand. (Respondent 16) Of all the ways to improve issuance cost, the surveyed investors believed the most important issue was for the issuer to manage its own finances well which would translate into a favorable credit rating. This recommendation held true for those investors who participated through telephone interview as well. Every representative mentioned some type of fiscal management policy or practice that issuers could implement to improve their borrowing costs. Some of the strategies advocated for this purpose by representatives of institutional investing firms are: • Increasing the security of a bond issue (e.g., insurance, more collateral); • Increasing communications post sale; • Providing investor tours; • Maintaining public financial expertise in-house by paying higher salaries; Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 104 • Keeping attuned to market trends and maintaining flexibility to act on opportunities that may arise in the market; • Participating in bond banks or revolving bond funds, for smaller or infrequent issuers; • Taking advantage of the swap markets and utilizing sophisticated financial products to hedge the market whenever possible; • Selecting underwriters with experience pricing and selling the issuer’s type of security; • Using underwriters who historically sell “cheap”; • Identifying legislative restrictions and effecting legislative change where necessary to achieve issuer flexibility; • Evaluating long-term versus variable rate short-term funds to identify the greatest demand for changing periods; • Maintaining good financials in order to achieve a high bond rating; • Offering the maturity schedules that the institutional buyers prefer; • Eliminating preferential DBE designations for spread allocations; and • Posting quarterly financials and OSs on the Internet. The retention of an independent financial advisor was never mentioned. The use of an expert underwriter was noted several times. However, the predominant means for achieving cost savings in the issuance process was through use of good operating financial practices in order to improve the entity’s credit rating. Clearly, investors do not see a “quick fix” or trick for how issuers can lower issuance costs in an immediate sense. Rather, they Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 105 view governmental cost issuance savings as evolving over time in tandem with the maturation of an entity’s financial prowess. (5^ Selling bonds at a time when other maior sellers are not can result in lower borrowing costs. “Within the market, timing is also key. Selling bonds at a time when other sellers are not could result in lower borrowing costs,” wrote Respondent 3. Although he added, “Municipalities may not have the luxury to wait for a more favorable market.” Several other institutional investors, when asked, agreed that the timing of sale affected costs. One portfolio manager explained the difficulty of achieving this ideal: it is extremely difficult for governmental agencies “mired in red tape and bureaucracy”2 4 to be able to control when they issue. The State of Florida, he noted was an exception as it “always has a deal on deck.” New York was touted as an example for how the process for bond issuance approval takes so long that the issuer will “generally just do it” when they get the approval. Issuers “push a lot of these projects so long through the political side,” that by the time they are approved, they need the money. Further, it was acknowledged, if issuers waited out the market, there is a possibility they could miss out on some favorable rates as it is difficult to gauge supply. Another New York portfolio manager, however, thought issuers could do a much better job watching the markets and issuing under more favorable conditions. 3 4 Note that whenever quoted language is not attributed to a particular “respondent,” this is because the quotes were obtained in telephone interviews, where anonymity, as it pertained to direct attribution, was guaranteed. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 106 One credit analyst recommended January as a good month to issue. Many redemptions and bankers are conducting their “year-ends;” supply tends to be low. This past January, however, was an exception to this generally good advice. There appears to have been low cash-flow this past year in the mutual funds. The same sentiments about January being a good month to issue, with the exception of this year due to “Y2K” scare, was stated by an executive in municipal funds management. He added that revenue bond supply tends to be particularly high in August, September, October, while general obligation bond supply tends to be high in March, April, May, typically after jurisdictions have their sales approved by governing boards. Any times outside of this peak periods, for bringing a bond to market, would be worthy of further investigation. (61 Institutional Investors relv heavily on underwriters for information. For some institutional investors, reputation of an underwriter in the market has a direct influence on their decision to purchase a specific issue. One research manager said she would buy anything from one underwriter, so long as the issue is “good,” meaning a stable, investment grade credit. This inclination was based solely on the company’s history of distribution concerns, and concomitant low rates. “1 always buy them and they are always cheap.” While most investors did not say their decision to purchase one bond series over another directly correlated with who the lead underwriter was (in fact, as a criteria, “familiarity with the underwriter” ranked relatively low (6.9)), they acknowledged that the underwriter was their primary source of information. As further evidence, one need only Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 107 look at the difficulty this writer, an issuer representative, had accessing the municipal fund decision-makers. Although a number of respondents note the typical usefulness of underwriters as a source of information, at least two representatives were quick to observe they do not rely solely on underwriters, as they do not generally keep investor concerns at the forefront of their agendas. Perhaps local governments, where warranted, could step up to the plate and fill this void? The Internet was transmitted as a useful tool for obtaining OSs directly. (71 Issuers should consider the past performance of underwriters as one important criteria to determine method of sale or selection of underwriter. Most representatives strongly counseled evaluation of past underwriter performance: “Absolutely... ” (Respondent 1). “Yes - some underwriters do a better job selling certain types of bonds” (Respondent 4). “Yes. Underwriters need to price the asset at a level that will assure a good reception by the market. If they have been successful in the past it is fair to assume they can do it again.” (Respondent 12) “The ability of an underwriter to successfully price & place a deal should be considered when an issuer is selecting an underwriter” (Respondent 11). “Yes. Different underwriters have different strengths & weaknesses when it comes to selling bonds. Finding the best fit can save money.” (Respondent 16) One portfolio manager recommended study of the entire series of bonds, instead of a cursory examination of past performance. It is not sufficient to only evaluate the deals that the underwriter brings forth. The results of similar types of bonds sold during the same time Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 108 period, through other underwriters, must be weighed to develop an understanding of an entire bond series. “While not the only indicator of what method of sale or underwriter to choose past experience should be an important consideration,” wrote Respondent 8. Other factors, including size, complexity, and risk of issue; underwriter specialization; and the current personnel experience of underwriters were listed as companion factors to consider along with past performance in the selection of the underwriter. (Respondents 6 and 13) To the contrary, one representative suggested governmental entities should continue with their underwriter if the entity had prospered with an existing underwriter relationship. He would only consider reevaluation if a new issue were outside the scope of the underwriter’s previous pricing or selling experience. (Respondent 2) Similarly, another portfolio manager finds comfort level between the underwriter and the issuing agency the predominant feature. He said there are about 6 or 7 good underwriting firms which any institutional investor should feel comfortable working with. As long as an issuer aligns itself with one of the reputable underwriting firms, the issuer’s level of satisfaction is most important. The obvious follow-up question? If there are only 6 or 7 acceptable underwriters, who are they? This list from a fund manager would be helpful for the issuing agency who wanted to target a particular municipal fund. Is this list based on volume of sales? Regional expertise? Total assets? Placement and distribution? This type of question should be proposed to potential investors. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 109 (8) Issuers should develop direct relationships with institutional investors. Institutional investors respond favorably to the notion that issuers should design some type of “investor relations” program. That said, as previously discussed, portfolio managers and investment officers were notoriously close-mouthed in putting on the table factors which they deemed to be important. As one California portfolio manager stated, there is no harm trying to develop a direct relationship; it may turn out to be extremely beneficial. One credit analyst noted the increasing desire for secondary disclosure on behalf of the issuers. Quarterly financials, at a minimum, would be very useful to the institutional investor. This type of information could make its way directly to the investor, circumventing both bond counsel and financial advisors. In the long-run, Respondent 1 notes, these efforts could prove very beneficial when the bond holders overlook a temporary downturn in a local economy or an unfavorable legal settlement. Disclosure helps the issuer develop an image as a “good citizen.” The positive image could “certainly translate into lower interest costs,” as the investor becomes familiar with the issuer. Conversely, issuers slow to respond to requests for information could be penalized in interest costs for a poor image. One area recommended for increased direct communication is public hospitals. A New York portfolio manager noted that the states of Florida and California regularly contact their desk to discuss what they are proposing and to find out what the company thought about where the market was going. Larger public institutions, who are regularly in the market, it was recommended, should maintain an on going dialogue with the investors who hold the majority of their existing bonds. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 110 O f all GFOA’s prolific lists of tips for municipal bond issuance and policy generation, the recommendations concerning investor relations programs and secondary disclosure are best borne out by this research. Interim financial and operational data distributed between issuances and mid-fiscal year would find a home with receptive investors. (9) Given the option, institutional investors uniformly prefer a negotiated sale over a competitive one. From the investor’s perspective, negotiated issues may be cheaper than competitive issues. All but one institutional investor questioned on preference of type of sale stated a preference for negotiated sales. Further, many stated a very high preference through the tonality and detail of their explanations. According to one financial advisor serving the states of California and Nevada, investors will not say this on the record, but they will tell you there is a marked difference in total interest cost to the issuer between a competitive and negotiated issue, in favor of competitive ones. Despite this, he asserts, investors prefer a negotiated issue because they can get exactly what they want. The argument is that investors communicate regularly with the underwriters who take their pre-sale bids and preferences into account when structuring the issue. One portfolio manager for a large company likewise preferred negotiated sales, but with a dissimilar motivation. Ironically, he felt negotiated deals were more specifically 4 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Ill structured to meet the issuers’ needs, as opposed to the investor’s, and that a competitive sale was more of the standard, “vanilla” type they would buy. The preference for the negotiated sale stemmed in part from the simplified purchasing scheme. For example, one could have lunch with one’s regular underwriter and emerge with three separate purchases. Alternatively, he felt a competitive sale required additional company time and energy, coupled with the uncertainty that the final bid itself was hypothetical in nature. Another portfolio manager noted as a negative that they could get “burned” on a competitive issue. For instance, a buyer could put in a bid with Goldman Sachs, but then turn around and place a higher bid with Smith Barney after the issue was sold. This representative had suffered from this type of experience, and bemoaned the real possibility of being “stabbed in the back” on a competitive issue. While recognizing the legality of this practice, he acknowledged such competitive shortcomings merely served to make negotiated issues more attractive. The preference for negotiated sales holds true in both the primary and secondary markets for these larger issuers. One larger company representative stated their minimum buy was $5 million. Inclining toward revenue bonds versus “plain vanilla, nothing complex” general obligation bonds, it was rare for them to bid in the primary market on a competitive issue. From the issuer perspective, a negotiated sale gives you the benefit of being able to better time the market, said one analyst As an example, the resulting 3-day volatility of the market after a speech given by Federal Reserve Chairman Alan Greenspan could simply be Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 112 avoided by rescheduling a sale. There are, however, on-going discussions which would also enable competitive sales to be timed to the market, with sale dates scheduled and bids rejected if the issuer is not satisfied with the performance. Written comments from respondents did acknowledge that from the issuer’s perspective, competitive sales may often be more cost-effective for the issuer: “... issuers may be better served by pursuing the sale of bonds in a competitive bid fashion” (Respondent 3). “Looking solely from the issuer perspective, I believe competitive sales result in lower overall interest cost to the issuer.” (Respondent 9). The sentiments of which were echoed in the telephone interviews. (10) Lower cost of issue, however, trumps the desire for a negotiated sale. As stated by one research analyst, “all we really care about is price.” This strong preference for negotiated issues can be trumped if she is offered an issue which is competitively cheap. All of the companies contacted hold some competitive paper - evidence that there exists no major stumbling block to these being purchased by investors - large and small. As one financial advisor serving the states of California and Nevada stated, “if competitive issues were all they got, they would buy them.” If negotiated issues were cheaper, noted several institutional investors, it could be because the buyers bid up the price in a competitive deal in order to “win.” The analyst from a company that primarily purchases revenue bonds stated that she recommends the purchase of all bonds, essentially, on the basis of price. In the secondary market the type of sale (i.e., negotiated or competitive) should make no difference in yield Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 113 (indeed as a purchase criteria, “type of sale” was ranked low by the investors (7.8)). A general obligation bond issued by the City of Pittsburgh, for example, should trade the same in the secondary market whether it was issued on a negotiated basis or competitively in the primary market (a factor disputed by other interviewed investors). Therefore, suggestions remain that price, relative to the market, is the most important consideration. Another way to look at this is to see if an underwriter typically lowers its spread knowing certain investors will buy. Knowledge of how the underwriters price is helpful to portfolio managers who purchase these bonds, but price remains the most compelling feature to the investor, outweighing choice of underwriting alone. Investors who were interviewed on this question agreed they sought to enhance underwriter competition, seeking the most fiscally beneficial climate for their respective organizations. (11) Lower quality issues or issues that need intense financial work (such as advance refundings! can benefit from a negotiated sale through a certain underwriter with a proven track record. According to one financial advisor serving Nevada, one good reason for a negotiated issue is to tell a “story” about a bond that needs extra marketing. This intuition appears to be reinforced by responses from representatives of institutional investors, albeit many also conceded that certain issues, particularly general obligation bonds from investment grade credits, benefit from competitive sales. The expertise of the underwriter to structure and sell a particular series was cited as the number one reason why issuers elect a negotiated process Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. over a competitive one, according to surveyed investors. 114 121 Prognosticating of public bond value is truly subjective. There are nuances and subjectivity to the determination of a public bond issue’s value. A portfolio manager provides an example, comparing how a corporate bond trades to a public one. A corporate bond for a company, rated AA, located in Maine, would trade the same, garnering a set “spread,” as a AA rated bond issued by a company in Mexico. Two AA government issues, however, issued in Maine and Mexico, for example, would not trade the same, because of the “guile of the market.” One bias such as climate or an impression about a locale could cause investors to value similarly rated bonds differently, thereby garnering different spreads for the same bond rating, all else being equal. This finding would give further support to the argument that issuers can influence investors through institutional investor relations programs. Building on this theory, Respondent 15 writes, “From an analyst standpoint, we try to find bonds that may be undervalued from a rating standpoint, i.e., bonds may be upgraded within the next several years. We also look for bonds with a stable rating outlook. Our ratings and outlooks often differ from the rating agencies.” The overall credit rating of an issuer may not be worth as much as in prior years. “There is a cost differential for the level of risk but bond issuance has impacted this. With the good economic times the cost differential between lower and higher rated credits has been lowered,” writes Respondent 9. To ensure issuance funds are well spent, an issuer needs to get a feel for how its paper trades compared to similarly rated issues in its region. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 115 A concerted institutional investor relations program with emphasis on the credit expectations of the investors should help keep the issuer from overinsuring its bonds. 13) In desirable economic times, issuers have already “squeezed” the spread out of the municipal market. Whereas competitive issues used to sell for $4 to $5 a bond compared to a negotiated issue’s $12 to $15 a bond, according to one portfolio manager, a negotiated bond is selling today for $3 compared to a competitive sale at $2.75 (per $1,000 par value). He offers a number of reasons for this occurrence. First, he makes an overall finding that the investing public has become more sophisticated. The number of people involved in the markets has greatly expanded, which has increased demand for municipal bonds. Today’s combination of three factors: (1) issuers dictating the terms; (2) increased awareness among issuers about markets; and (3) a general dissemination of information about markets to the public, has evolved into a generation of more informed, “hands-on” borrowers. Numerous investors cited lower underwriting spreads, begging the question of the significance of cost savings to be generated from a switch from negotiated to competitive municipal bond sales. Secondarily, but perhaps more importantly, if underwriters feel under compensated then their allegiance to any given entity or issuance may wane if an issuer does not have promising future revenue as a carrot incentive. Reduction in underwriting spreads makes it even more critical that issuers carefully select among underwriters, the key personnel who can effectively market their bonds. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 116 Institutional Investor Findings The results of a survey of five institutional investors serving Clark County, Nevada, and surrounding jurisdictions is that they do have a good idea as to what is important to institutional investors: “portfolio needs,” “structure of the issue,” and “rate structure,” although “bond rating” was decidedly undervalued. Table 15 presents the results from their answers to question 4 of the survey (“Please rate the importance of the following criteria (with “1" being most important; factors may be rated the same number to show equal importance) for institutional investors’ decisions to purchase a bond series:...) ) . Table 16 compares the average rankings across institutional investors and financial advisors. Although five financial advisors were independently interviewed, together they represent two companies serving the same market. One of the companies is a working partnership between a national firm and a local one. Both locally based companies have long-standing ties to the public financial institutions in Southern Nevada. One can be categorized as more pro-competitive than the other. The one advocating negotiated sales argues for “competitive” negotiated sales which means injecting competition into the selection process for lead underwriter. This admittedly limited discussion with financial advisors (6, including the lead financial advisor serving the State of Louisiana and its local jurisdictions), compels a finding that the trend toward increased use of negotiated deals may be a factor of the increased usage of financial advisors. If independent financial advisors, hired to provide governments with issuance advice, recommend negotiated sales, presumably the local governments who are Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission o f th e copyright owner. Further reproduction prohibited without permission. Table 15 Financial Advisor Ratings for Institutional Investor Criteria Surveyed Companies: Paul Howarth & Associates; Public Financial Management; __________ ____________ ____ Hobbs, Ong & Associates_____________________________ Date o f Receipt o f Response 12/20/99 12/23/00 03/22/00 03/22/00 14 point Number__________ _______________ 1 2 3 4 Scale Avg. Weighted Avg. Anticipated Future Interest Rates 13 6 9 9 9.3 7.8 Bond Rating 5 2 9 5 5.3 4.2 Current Bond Market Prices 11 3 7 6 6.8 5.5 Current Stock Market Prices 14 4 12 10 10.0 8.0 Debt Ratios for Issuer 12 5 10 7 8.5 7.1 Familiarity with the Issue 5 5 6 12 7.0 6.0 Familiarity with the Issuer 5 5 5 11 6.5 5.6 Familiarity with the Underwriter 8 4 10 14 9.0 7.3 PortfolioNeeds 1 1 1 1 1.0 0 9 Purpose of Bonds 8 6 11 8 8.3 7.1 1 4 2 3 2.5 : 3,5 Size of the Issue or Series 1 4 4 4 3.3 3,1 Structure of the Issue 1 2 2 2 1,8 10 Type of Sale 8 7 13 13 10.3 8.8 118 Table 16 Criteria for Municipal Bond Purchase: Investors v. Financial Advisors Weighted Average Simple Average Weighted Average Simple Average Structure of the Issue 2.7 2.3 1.6 1.8 Portfolio Needs 2.7 2.4 .9 1.0 Rate Structure 2.6 2.8 2.5 2.5 Bond Rating 3.5 2.8 4.2 5.3 Familiarity with the Issue 5.4 4.9 5.6 7.0 Size of the Issue or Series 5.1 5.1 3.1 3.3 Familiarity with the Issuer 6.0 5.9 5.6 6.5 Debt Ratios for Issuer 5.9 6.0 7.1 8.5 Familiarity with the Underwriter 7.3 6.9 7.3 9.0 Purpose of Bonds 7.0 7.4 7.1 8.3 Anticipated Future Interest Rates 6.8 7.7 7.8 9.3 Current Bond Market Prices 6.5 7.8 5.5 6.8 Type of Sale 8.1 7.8 8.8 10.3 Current Stock Market Prices 8.8 10.1 8.0 10.0 Note: Participants were asked to rate the importance of the above, listed criteria for institutional investors to buy a bond series (with “ 1" being most important; factors may have been rated the same number to show equal importance). Weighted and simple averages were calculated for the two classes o f respondents. The weighted average corresponds with each individual’s highest reported number. The simple average corresponds to a 14 point rating scale. paying for the advice will use it Do financial advisors make more money off of a negotiated sale? Do they generate business leads as a result of recommending lead underwriters? Conventional wisdom has been that financial advisors recommend competitive sales because financial advisors can be completely cut out of a negotiated deal. Underwriters often argue that a cost savings is derived in a negotiated sale because the services traditionally Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 119 provided by the financial advisor (i.e, structuring the maturity schedule, developing the OS, advertising the bond sale, etc.) can either be eliminated or performed by the underwriter. However, if financial advisors are retained for negotiated deals, as this writer would recommend they should be to provide another source of expert advice, local governments must guard against the potential for collusion between financial advisors and underwriters. All of the interviewed financial advisors are very bright and knowledgeable about the bond market. On the issue of trust, one financial advisor noted that underwriters are well paid in addition to a premium for the level of risk they are assuming. In fact, if not watched, underwriters charge “as much as they think they can get away with” on the underwriting spread. The cost of issuance is as much a factor of the risk of investment an issuer’s bonds presents as the profit issues which an underwriter is facing at any given time within their own companies. Underscoring the theme of this dissertation, the financial advisors are in agreement that it is the specific people and the actual team of underwriting players that makes a difference in how well a negotiated deal sells. It is not enough to focus on underwriter selection. Issuers must pay attention to the actual personnel who will be managing their deal. Summary On the basis of institutional investor response to verbal and written questions on method of sale, there is no apparent reason to advise issuers to steer clear of competitive sales. In fact, the message appeared to be one of strong support for competitive sales, Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 120 assuming the issuer’s goal is to lower the total cost of borrowing. This, of course, would seem to fly in the face of institutional investors’ overriding preference for a negotiated sale. To make the sale attractive to potential retail and institutional investors, it seems wise, based on the high rating of “structure of the issue” and “portfolio needs” as criteria for purchase, that issuers spend more preliminary effort investigating investors’ portfolio needs. Why not target the funds intended to purchase municipal bonds in advance? Whether competitive or negotiated, advance marketing and knowledge of the intended buyer will help denote timing and structure of the issue. These are all activities the financial advisor can correlate with the issuing entity; or, better yet, as many portfolio managers advocate, develop proactive in-house managing expertise. Portfolio managers and investment officers appear to share an affinity for certain times of day (and year) when information would be given. For some, it meant only afternoon contact, others were to be exclusively contacted by e-mail, yet others only during “non reporting” cycles. Catching an issuer’s investors at the right time, while “in the mood” to share information, is critical in ascertaining their personal agendas in investment instruments. Along with good economic times come lower cost differentials between disparate credit ratings. Many issuers, however, would be willing to sacrifice yield for a higher quality issue. In a market where demand is heavy, an institutional investor contemplated the importance of comparing yields for many investment products, not just against comparable municipal bonds — but versus comparable taxable products as well. Despite “conventional wisdom” submitted by GFOA, large issues often are easily absorbed by the market; it was found that institutional investors, and perhaps retail investors Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 121 as well, do not shy away from large competitive purchases. A preference for the issuance of a negotiated bond would exist if the issue were particularly small, thus deriving a benefit from private or negotiated placement. Investors’ bottom lines are driven by price. In the next chapter, the findings from the institutional investor and financial advisor surveys are taken into account in the development of a matrix for selection of underwriters. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 122 Chapter V Matrix for Selection of Underwriter A. Introduction After having discussed the results of the institutional investor and financial advisor surveys in detail, this final section pulls together the recommendations found in the literature with the survey results, devising a matrix to accompany a decision-making process for the selection of method of municipal bond sale. One heavily weighted score for the matrix represents the probability that a particular underwriter will outperform the market. Probability theory offers government officials an alternative means of looking at the question of negotiated versus competitive sale. Rather than trying to isolate issuance costs globally for each method of sale, probability theory allows the decision maker(s) to focus on the merits of each type of sale for their particular agency. Probability theory recognizes the inherent uncertainties in picking one method over another and one underwriter over another. By looking at the track record of individual underwriters and past experience with competitive sales, governments can ascertain the probability that they will receive a higher or lower cost of capital for each different method. The use of probability equations to evaluate this issue is different from former approaches because (1) it allows for differences in performance by individual underwriters and (2) it can be easily used by analysts to evaluate costs. Bayesian analysis allows governments to evaluate the cost-benefit of a specific underwriter. Underwriters are treated Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 123 as consultants for purposes of evaluating the net cost. Probability statistics evaluate the risk associated with different options. Bayesian analysis, a type of probability equation, is proposed as the evaluation method because it incorporates the subjective opinion of the decision-maker who can score one underwriter better than another based on his/her judgment about the abilities of contending underwriters. The institutional investors do have preferences regarding underwriters, and they do recommend the selection of firms which are both compatible with an issuing agency and competent in the areas in which they are requested to sell municipal bonds. Rather than “pretend” the selection process is a purely objective one based on the evaluation of sale proposals, why not systematically incorporate decision-makers' preferences?2 5 The unit of analysis for the Bayesian evaluation is the interest yield for each issuance for a sample of bonds as compared to a “median” rate for the day as represented by the Delphis Hanover Corporation index reported in the daily Bond Buver. Using these statistics, the probability for achieving yields below or above the Delphis would be calculated for specific underwriters and the competitive market. Sample tests and definitions that would be used to evaluate negotiated and competitive performance are presented. 2 5 This type of weighting is similar to an evaluation scheme used to score candidates for employment in an interview process. Although candidates for a position may receive a score for each response to a set list of questions, another subjective criteria can be weighted into the total score to account for an interviewer’s opinion about how well the candidate will fit into the organization/job (e.g., personality, attractiveness, congeniality, communication skills, presentation, disposition, background not covered in the established questions, indications of unusual creativity or intelligence, etc.). To retain the overall objectivity of the process, however, the subjective criteria should not be so heavily weighted that this factor alone would be a decisive factor in determining the final selection. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 124 B. Criteria for Evaluation Barring any problems associated with a competitive sale such as a low credit rating or infrequency in the market, issuers should first structure their issues to sell through a competitive process. When it is necessary to use a negotiated sale, an RFP (Request for Proposal) is recommended for the selection of the underwriter or underwriting team. As part of the RFP, underwriters need to be screened for minimum requirements. Prior activity in the market (e.g., at least “X” number of sales over a set period of time with a minimum volume of “$X”), prior experience in the region, and prior experience with the type of anticipated bonds to be sold are worth consideration in addition to a company’s assets and requirements that types of prior illegal activity would automatically disqualify a firm. Utilizing the feedback from institutional investors and the recommendations of GFOA, four criteria for rating underwriter proposals are recommended for inclusion in an evaluation matrix for the selection of underwriter: 1) Rating for Institutional/Retail Investor Perception; 2) Rating for Liquidity in Secondary Market; 3) Rating for Past Performance; 4) Rating for Prior Bids on Issuer’s Bonds. In their applications, underwriters would be requested to present a proposal for the sale including the structure of the bonds and plan for marketing and selling them. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 125 Criteria 1 and 2 Ratings for criteria 1 and 2 can be garnered through a survey of existing investors — both retail and institutional customers currently holding an issuer’s bonds. The issuer simply needs to ask which underwriters their companies prefer to work with and which provide the most liquidity in the market. Scales can be generated from this data for specific underwriters. Thus, ratings for both “Institutional/Retail Investor Perception” and “Liquidity in Secondary Market” would be driven by the end customer. This information could be updated semi-annually so that assumptions only need to be rechecked in the event of an offering. Tracking data over time may also provide some insight into changes in the market. Criterion 3 “Rating for Past Performance,” can be generated a number of ways. Regression analyses which evaluate TIC or IVR for a sample of bonds are common means for comparing the performance of past bids for negotiated versus competitive issues. This same type of analysis could be run, operationalizing individual underwriters as “dummy variables” to calculate the variance associated with TIC (IVR alternatively) for individual underwriters. Another means is to look at recent, past performance of bids for underwriters which score well on the “Institutional/Retail Investor Perception” and “Liquidity in Secondary Market” scales and compare then across underwriters. Another evaluation methodology as outlined below is to use Bayesian Analysis to incorporate posterior information on bond sales as new issues are sold by underwriters to improve the issuer’s ability to gauge the probability that an underwriter will “outperform” Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 126 either the market or other underwriters. While this method does not provide a significance rating of how well or poorly an underwriter performs against a benchmark, it establishes a minimum threshold against which an underwriter can be judged. Combined with a receptivity rating of investors (criterion 1), liquidity in the market (criterion 2), and underwriter commitment (criterion 4), it provides a level of confidence that, on average, an underwriter can “beat” the market. Once selected, the issuer can then focus on designing the best structure for its bond with the aid of the underwriter. The Bayesian Analysis outlined below compares an underwriter’s performance to the Delphis Hanover Index as reported by The Bond Buver: but there are other indices issuers could track against. What is important is to gauge the frequency and significance of an underwriter’s ability to “outperform” the market. As noted below, one measure for good performance would be garnering TIC for a particular issue below the average for the day for issues of similar size and rating. Criterion 4 “Rating for Prior Bids on Issuer’s Bonds” is recommended in response to the research on method of sale that shows the cost differential between negotiated and competitive sales increases as the number of bids increase. Former Clark County Director of Finance, Guy Hobbs regularly used this criterion in his rating of underwriters for negotiated sales as a means to both increase the number of bids on Clark County’s paper and provide an indicator of the commitment of an underwriting firm to the County. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 127 Criterion 4 reflects a score for how often and how well an underwriter bid in prior issuer sales. It may be a requirement that any underwriter who had not bid on at least one of the past three competitive sales for the issuer, for example, would not be considered at all for the position of lead underwriter. Another way of using this criterion is to require a minimum bid of at least once in the past five years. Another means for scoring underwriters would be on how close the underwriter came to the “winning” bid or some such composite o f frequency and value of the bids. The idea is to get underwriters accustomed to bidding on issuer paper to (1) encourage better performing competitive sales and (2) to gauge the commitment of the underwriter to the issuing agency. C. Bayesian Analysis Below is an outline of a sample Bayesian Analysis designed to calculate the probability that a negotiated sale will yield interest rates below the Delphis Hanover Corporation index for the daily bond market yield. This score would serve as the rating for criterion 3. The test is envisioned to be calculated first for a sample of bond issues across the United States, or a region of the United States, which is representative of the type of issue that the governmental entity would like to sell (e.g., dollar amount, rating, maturity schedule). Once the days for evaluation are selected, the top three (arbitrary number which would actually be determined by frequency in the market as lead underwriter) underwriters’ yields will be used to generate the probability that a negotiated sale issued by a particular underwriter will be below the Delphis index. Where it intuitively makes sense, types of Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 128 bond issues (e.g., airport, transportation, water infrastructure, education) would be looked at separately for the purpose of calculating probabilities. Below are the definitions that would be used in the calculations: (A) Event: “A municipal bond is issued through a negotiated sale.” (a) The denial of (A): “A municipal bond is not issued through a negotiated sale (i.e., the bond is sold competitively).” P(A) The probability that (A) will be true (i.e., the probability that “a municipal bond will be issued through a negotiated sale”). B Event: “The cost of issuance of a municipal bond is lower than the Delphis index.” (b) The denial of (B): “The cost of issuance of a municipal bond is not lower than the Delphis index.” P(B) The probability that (B) will be true (i.e., the probability that the cost of issuance of a municipal bond will be lower than the Delphis index). P(A + B) The probability that either (A) will occur, or (B) will occur, or both. P(AB) The probability that both (A) and (B) will occur. P(A/B) The probability that (A) will occur, given that (B) occurs. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 129 Below are the rules that would drive the calculations: 1. The probability that (A) is true plus the probability that (A) is not true equals one (i.e., certainty as to how the bond will be issued). P(A) + P(a)= 1.00 Conversely, P(A) = 1 - P(a) and P(a) = 1 - P(A) 2. The probability of (A) given (B) times the probability of (B) plus the probability of (A) given not (B) times the probability of not (B) equals the probability of (A). {P(A\B) x P(B)} + (P)A/b) x P(b)} = P(A) 3. The probability of both (A) and (B) equals the probability of (A) given (B) times the probability of (B). P(AB) = P(A\B) x P(B) Conversely, P(BA) = P(B\A) x P(A) and P(A\B) x P(B) = P(B\A) x P(A) 4. The probability of (A) or (B) or both equals the probability of (A) plus the probability of (B) minus the probability of both (A) and (B). P(A + B) = P(A) + P(B) - P(AB) For example, (A) stands for a municipal bond issued on a negotiated basis; P(A) equals .60; / (B) stands for an issuance cost below the Delphis index; Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 130 P(B) equals .30; (AB) stands for a municipal bond that is issued both on a negotiated basis and reaps a cost of issuance below the Delphis index; P(AB) equals .20; then, P(A + B) = .60 + .30 - .20 = .70; that is , the probability that a municipal bond will be issued on a negotiated basis or a municipal bond is sold at a rate below the Delphis index, or a municipal bond is both issued on a negotiated basis and gamers an issuance cost below the Delphis index, equals .70 or 70 percent. 5. Bayes’ Theorem: The probability of (A) given (B) equals the probability of (B) given (A) times the probability of (A) divided by the probability of (B) P(B\A) x P(A) P(A\B) = P(B) Alternatively, P(A.\BUE(B) P(B\A) = P(A) Or, by rule 2, above, Pf A\B) x PfBl P(B\A) = (P(A\B) x P(B)} + {P(A\b) x P(b)} For example, (A) stands for a municipal bond issued on a negotiated basis; P(A) equals .75; Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 131 (B) stands for an issuance cost below the median market rate; P(B) equals .55; (AB) stands for a municipal bond that is issued both on a negotiated basis and reaps a cost of issuance below the Delphis index; P(A\B) equals .95; then, ,95 X ,55 P(B\A) = .75 = .70 That is, the probability is .70, or there is a 70 percent chance, that a bond will be issued at a cost lower than the Delphis index when it is issued on a negotiated basis. Sample tables to analyze the data sets are listed below. “Competitive Bonds” for the sample are listed for sake of comparison. An understanding of underwriter performance versus competitive bid performance for a sample helps illuminate the significance of the performance of the underwriter. Table 17 Example: Market Performance of Municipal Bonds (Total Sample) Negotiated Bonds (N) 41 47 88 Competitive Bonds (n) 153 111 264 Total 194 158 352 Number of Days: 25 Number of Bond Issues: 352 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 132 Table 18 Example: Market Performance of Municipal Bonds (Underwriter I) Negotiated Bonds (N) 9 16 25 Competitive Bonds (n) 50 5 55 Total 59 21 80 Number of Days: 25 Number of Bond Issues: 80 Table 19 Example: Market Performance of Municipal Bonds (Underwriter II) Negotiated Bonds (N) 14 16 30 Competitive Bonds (n) 50 8 58 Total 64 24 88 Number of Days: 30 Number of Bond Issues: 88 Table 20 Example: Market Performance of Municipal Bonds (Underwriter III) Negotiated Bonds (N) 18 15 33 Competitive Bonds (n) 53 10 63 Total 71 25 96 Number of Days: 33 Number of Bond Issues: 96 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission o f th e copyright owner. Further reproduction prohibited without permission. Table 21 Example: Municipal Market Yields (Total Sample) ii-riM ;. ; i |; ~Ui'l'rrc',, 2000 2004 ______________________________________________ 2009 ______________________________________________ 2014 ____________________________________ 2 0 1 9 ______________________________________________ 2024_____________________1 1 1 1 1 _________ D = Delphis Hanover Corporation Municipal Market Yield Index C = Composite of Competitive Sales U1 - RFP Negotiated Sale Underwriter Applicant I U2= RFP Negotiated Sale Underwriter Applicant II U3 - RFP Negotiated Sale Underwriter Applicant III U> U> 134 D. Weights The evaluation matrix depicted in Table 21 illustrates suggested weights for each criterion. The combined weight for criteria 1 and 2 would equate to a M l half of the rating for an underwriter being driven directly by the customer of the bond product. This type of rating differs from RFP processes which look at financial statistics and proposals for past and current deals in that it is driven by the expert advice of the end purchaser. Different investors’ scores could be weighted as well. Another way to use these two suggested criteria is to develop a “short list” from investor participation after which a more systematic evaluation of the proposed deal (e.g., consensus pricing scale) and past performance could occur. The other half of the weighting criteria would be derived on the basis of the interests of the ultimate customer, the public, whose goal is to minimize issuance costs. Of course, indirectly, the idea behind pleasing the investor by matching their demands is to lower issuance costs for the public as well. In summary, the following general steps would be followed in the implementation of the suggested evaluation matrix: 1) Develop list of investors. 2) Survey investors for preferences. 3) Invite RFP participation. 4) Verify prior agency activity. 5) Collect market data for specified sale dates. 6) Calculate probability for “beating the market' Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 22 Example: Matrix for Selection of Underwriter 135 I M S i m § Past Performance .40 10 4 (perfect score) Underwriter I 9 3.6 Underwriter II 8 3.2 Underwriter in 9 3.6 Institutional/Retail Investor Perception .40 10 4 (perfect score) Underwriter I 5 2.0 Underwriter II 4 1.6 Underwriter III 4 1.6 Liquidity in Secondary Market .10 10 1 (perfect score) Underwriter I 8 .8 Underwriter II 7 .7 Underwriter m 6 .6 Past Bids .10 10 1 (perfect score) Underwriter I 5 .5 Underwriter II 8 .8 Underwriter in 9 .9 All Criteria 1.00 10 (perfect score) Underwriter I 27 6.9 Underwriter II 27 6.3 Underwriter HI 28 6.7 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 136 7) Rule out competitive sale. 8) Score for “liquidity,” “perception,” and “commitment.” 9) “Weight selection criteria.” 10) Develop subjective calculations for Bayesian analysis. 11) Calculate high scoring underwriter. 12) Select lead or comanaging underwriters. In the following, concluding chapter, the research findings of this dissertation are summarized. Implications are drawn both for real world application and theory development. The contribution made to the current base of municipal bond knowledge is explicated. Further areas of research suggested by this work are delineated. The reader is left with an argument for restoration of integrity to public financial management through the education of public finance managers and the institutionalization of analysis for the sake of selecting municipal bond method of sale or underwriter. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 137 Chapter VI Conclusion A. Summary Today, negotiated sales dominate the municipal bond market despite research findings that competitive sales are more efficient. This incongruence between the academic and the practical has fueled a debate over preferred method of sale (Simonsen et al. 1999; Simonsen and Hill 1999; Simonsen and Kittredge 1998; Simonsen and Robbins 1996: Stevens and Wood 1998; Braswell et al. 1983; Benson 1979; Forbes and Petersen 1979). This modem dominance of negotiated sales is a function of reliance on more complicated debt structures. Institutional investors and financial advisors interviewed in this research hypothesize that the dominance of negotiated sales may be attributed to a lack of issuer confidence in competitive sales, stemming from (1) issuers’ lack of knowledge regarding sophisticated debt instruments and (2) issuers’ perceptions that an underwriter is required to successfully market (i.e., presell) specialized debt maturity schedules. Other reasons for this dominance, cited in both the reviewed academic and news articles, is that an agency problem exists, causing local governments to choose the alternative which best meets the needs of a few (e.g., the elected officials, underwriters or public finance professionals) at the expense of choosing the lowest cost issuance alternative which most benefits the public. Much of the research reviewed in Chapter 2: Literature Review, with the exception of the work completed by Simonsen et al. and state bond commissions, is rather dated. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 138 Nonetheless, the finding that competitive sales are more cost-effective than negotiated ones is clear. Further, the cost disparity between the two methods increases in favor of competitive sales as the number of bids increase. (See Table 9, pages 43-44.) The only time research has proven negotiated sales are less expensive is when two or fewer bids are received or below investment grade bonds (Baa-1 or below) are issued (Maese 1985; Joehnk and Kidwell 1984; Sorenson 1979). Most of the prior research conducted on method of sale focused on an evaluation of true interest cost (TIC) with reports on interview data from public finance administrators. This dissertation sought the opinions of 41 institutional investing professionals who have input into which municipal bonds are purchased by their companies. The participants were asked to expound on how much control an issuer has over interest costs. Secondarily, they were asked what motivates them to buy one issue over another. As it turned out, for the 26 who responded, type of sale is not very important to the investor, as originally hypothesized. This finding dispels the conventional wisdom that there is an added sale or placement advantage to selling on a negotiated basis, simply derived from the investors’ general preference for negotiated sales. In addition, the investors, as well as 4 of 5 interviewed financial advisors, generally agreed that competitive sales are more cost- effective for the issuer, barring any unusual requirements in the debt structure. This revelation would appear to render issuers free to pursue the one best type of sale that is right for their timing and issuance. At a minimum, it should provide investment grade issuers some confidence that competitive sales are not financially inferior. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 139 The decision for local governments to use negotiated versus competitive sales, for any given sale, cannot, however, be based on the findings of general research which evaluate true interest cost (TIC) for all or a sample of sales. Variance in underwriter performance and types of issues is too great. Competitive sales may, overall upon evaluation, be more cost- effective, but individual governments need to evaluate the performance of specific underwriters to see what value they bring to the sale for their particular issuance. Probability statistics, using a Bayesian analysis, has been suggested in this dissertation as one means to provide a decent indication of the probable or likely outcome that a government might expect from an underwriter and the competitive market based on regional diversities, size of issuance, rating of issuance, and size of local government. One significant advantage an underwriter brings to the sale is its marketing expertise, perhaps second in importance only to the capitalization needed to underwrite the issue. An underwriters’ marketing expertise is the result of a special skill set. Of primary importance is the willingness of the underwriter to use these skills for the benefit of the client in relation to a specific issuance. This individual dedication of a particular underwriter is therefore a proper consideration in the ultimate bond process selection as laid out in this dissertation. A cost-effective bond sale process, which seeks to obtain the lowest possible borrowing cost, is obviously critical to the fiscal welfare of both state and local governments. This dissertation does not result in one recommendation for best method of sale, but it does provide some guidelines for meeting current needs of institutional investors based on a survey of what they deem important. Further, some general rules about what is cost-effective in municipal bond issuance are laid out for future research. The transferability of this Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 140 decision-model to selection of other outside “professional consultants” for public sector services is high. B. Fiscal Accountability In the grand scheme of public management, the issue of having a cost-effective bond sale process is an important question. It is empirically obvious that governments accomplish more with their respective resources if they use them wisely. When governments spend less to accomplish a goal, they may purchase more services or products with their savings. However, is the price local governments pay to borrow money a matter actually within their purview? It can be argued that the market economy establishes general rates for which willing investors lend money. As with any financial investment, the higher the perceived risk, the higher the yield necessary to attract willing investors. The conclusion reached in this dissertation is that governments do, on the margins, have control over total interest costs -- one factor being the method of sale used to issue bonds. Method of sale is a key determinant of how well a municipal bond sells, as borne out in the research referenced above and the reports in the Bond Buyer, the daily municipal bond trade newspaper on underwriting spreads for negotiated versus competitive sales. Municipal bond sales hinge on the selection of an underwriting syndicate, or dealer, who resells the bonds in the secondary financial market. Depending on the number and value of bids received for a competitive sale — or the selection of an aggressive and fair underwriter for a negotiated process, an issuer may expect lower interest rates, relative to the market Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 141 On a macro level, interest rates fluctuate in response to underwriters' confidence that bonds will be repaid in full as promised. The attractiveness of a bond issue to an investor is primarily a function of the offering relative to other offerings in the market and the risk of the investment. Secondarily, what an investor is willing to pay is associated with his/her respective portfolio. Theoretically, the interest rate paid to the investor includes a cost differential for the level of risk. On a micro level, the cost of municipal bond sales is influenced by the size of the issue, the credit quality of the issuer, the investors’ familiarity with the issue and issuer, the complexity of the issue, and market conditions, as both general research and the results of this survey report. For example, issue size influences the level of investor demand. Issues that are too small may not attract a lot of competitive bids. An investor grade rating is generally preferred by bidders in competitive sales. Frequent issuers require less marketing activity because the investors are already familiar with their economic and financial outlooks. Bond issues with complex structures (e.g., put options, variable rates, interest rate swaps) may require more marketing to investors. Governments involved in complicated lawsuits may feel compelled to choose an underwriter to tell their “story” to investors. Many of these listed factors have import relative to the level of interest paid on a specific issue, but are indirectly or completely out of the control of the public finance manager. For example, the credit rating of the issuer, local and state debt capacity and outstanding litigation all have marked impacts on the perceived risk an issuer's bonds present, but they are difficult for the issuing agency to control, much less address in the short-term. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 142 Other components affecting interest rates for bond offerings are a direct result of decisions made by the issuer at the time of sale: the dollar amount of the issuance; the structure of the issue (e.g., maturity schedule, call features); the timing of the sale; the use, type and amount of insurance; and the type of sale (e.g., negotiated or competitive). These latter factors, where active decision-making is required on the part of the issuing agency, provide the greatest impetus for controlled, adept bond market forays. Traditionally, public debt issuers had overwhelmingly used competitive sales to issue “plain vanilla” bonds, a trend that began to reverse itself in the 1980s, until 1993 when a full 80 percent of the municipal bonds were being issued on a negotiated basis (Public Securities Association 1994).2 6 This practice of competitive sales relegated the discussion of the nuances of factors affecting municipal bond sales to a small group of academics and public finance professionals. Indeed, even use of an independent financial advisor was a novelty until the 1980s (Johnson 1984). It was not until the heightened awareness of abuses associated with the issuance of negotiated debt, throughout the 1990s, that the interest of many concerned with fiscal accountability peaked. The prior scandals and future potential for ones involving political contributions for the award of underwriting bond sales (i.e., “pay-to-play”) made the bond sale issuance environment a hotly contested one. The dollar amounts and on-going scandals, referenced in Chapter 1: Introduction, speak for themselves as to the financial and cultural impact on the well-being of a local or state government’ s operations. 2 6 The expansion of the municipal bond market and enhanced sophistication of individual, retail investors, throughout the 1980s, spurred competition which led to the development of new financing tools and creative maturity schedules (Darcy 2000). Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 143 Short of a scandal, governments are slow to assess on-going practices. The negotiated bond scandals of the 1990s rightfully brought the factors affecting the cost of municipal bond sales to the forefront. This lack of self-awareness in the public sector relates to the most fundamental question in public administration of the proper relationship of politics to administration. The question of method of municipal bond sales pits the normative, political decisions of elected officials against the expert, technical advice of public managers. A tool for evaluation has been provided to help disclose results of comparative analysis between methods of sale, and to close the circle of asymmetric information between the municipal bond players, public finance mangers, citizens at large and elected officials. In a more depoliticized environment, it has been hypothesized that governmental officials will be more receptive to exploring the benefits of each type of debt issuance with the purpose of securing the lowest cost alternative. This theoretical discussion should help practitioners in the field of municipal finance gain a broader understanding of the motivations of buyers in the municipal bond market, and, ultimately, lead to cost savings for taxpayers. Fiscal accountability is particularly difficult given the political weight of different groups and the barriers to building consensus among often extremely disparate parties. More investors and more issues have fueled the need for more investment brokers, advisors, bankers and funds. Nonetheless, it is the public financial executive’s primary duty to establish the criteria and priorities of responsibility to which s/he and his/her subordinates will be responsible. There will often be conflicts between what one personally believes and Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 144 what the law, common sense and intuition seem to dictate. This dissertation provides one means for selecting municipal bond method of sale based on the preferences of the end consumers while adhering to the standards of efficiency, legality, and economy. C. Implications for Efficiency Theory The heated, continued debate over preferred method of sale and the dominance of negotiated sales, in the face of compelling evidence in support of competitive sales, suggests issuers are either in the dark as to many bond sale intricacies, or need a better means to identify the most efficient sale method for their particular issuance. With respect to municipal debt issuance, a case has been made that the most efficient process, the one which expends the least amount of money to borrow a set sum, is also the most effective and preferable choice for local governments. A means for evaluating type of sale and individual underwriter performance utilizing Bayesian analysis has been provided. The criteria for selection, the issuer’s minimum expectation for performance of sale, and the weighting scheme can be easily altered to reflect the goals and preferences of an issuer. D. Implications for Management Science The question of negotiated versus competitive sale of municipal bonds pivots around determination of the value which an underwriter brings to the table versus the nature of the competitive bond market at any given time. The evaluation of competing alternatives with quantitatively measurable outcomes lends itself to the employ of Management Science. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 145 Chapter 5 presents a matrix which lays out criteria for decision-making. This framework helps financial officials organize their respective decision-making processes and steer them away from decisions predominantly based on intuition, trust, prior experience, existing relationships and/or comfort levels with specific underwriters. The idea is to provide some “science” or rigor of method to the selection process; a rigor which could predict future performance with a high degree of significance. Herbert Simon's (1969) conceptualization of decision makers as artificial systems was quite insightful. With the advancement of the technological age, additional information will be available to assist individuals and organizations in making rational decisions. It is from this vantage point that this dissertation has argued the usefulness of an evaluation matrix. However, in the ongoing quest by decision makers to be rational, future trends outlined by Ferris and Tang (1993) such as costly information, uncertainty and questions of equity, justice and fairness, are not amenable to representation in matrix form and will continue to present challenges. E. Implications for Psychology of Decision-making The concept of bounded rationality and the characterization that decision-making in organizations should be value free has been the cornerstone of debates on the topic of decision-making for the past half century. Herbert Simon sought to develop a pure science of administration that was value free. Ironically, the investment community, hiding behind the intricacies of bond “deals,” have been able to gamer lucrative fees at the expense of the public through the maintenance of an argument for necessary expertise. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 146 Morstein Marx (1948) and Frederickson (1980) have both challenged the belief that public administration should strive to become a pure science and value-free. Harmon (1989) asserted that the push toward a value free orientation in public administration and an uncritical acceptance of Simon's characterization of decision-makers as morally neutral has led, among other things, to an abandonment of the public interest. The selection of method of municipal bond sale seems to be the perfect decision question to which Simon would have assigned a value-free solution. However, local governments have not always been able to choose the most rational method of sale (i.e., least expensive) - perhaps due to a genuine lack of expertise on their part. The public may view the process of debt management as a technical function best implemented by public administrators, displaying their abandonment of interest in “value-neutral” problems as Harmon portended. The result of a seemingly “value-free” question coupled with an either ignorant or unethical governmental administration and the hands-off nature of the public is an abuse of public funds. In 1996, Lynn, explaining the development of public management, argued that public management grew out of the bifurcated field of public administration, one which focused on politics separate from administration. In 1991, Ronald Moe asserted that the politics/administration dichotomy had not disappeared following the Golden Age of public administration with Herbert Simon and his fact/value distinction but had actually become institutionalized. For clarity, one can view public administration as dealing with decision-making processes as its primary focus with its primary question being how to improve the decision Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 147 making process to result in better solutions (i.e., ones that encourage agreed upon outcomes such as creativity, diversity, education, economy, efficiency, equity, effectiveness, etc.). For public management, the focus is on implementation of governmental affairs, an easier task than improving decision-making processes, but important and challenging, nonetheless. The question as to “what constitutes good debt management” falls squarely in the public management field as an administrative question that could be solved quite successfully outside of the political arena. Lowest cost is not a goal over which there is much debate. Nonetheless, many issuers have had difficulty with the fact/value distinction with even a question whose outcome is seemingly dictated by expertise such as type of method of sale. For this reason, it has been an excellent question to theorize about how both decision-making processes can be improved generally and how measures can be developed, as tools of objective analysis, to arrive at better outcomes. The central issues constraining local governments’ ability to address public sector questions today, (1) the American electoral system, which promotes aggrandizement of power through payoffs, opportunities for political contributions and special interest policies and (2) poor education which portends ignorance and loss of freedom, constrain the decision making process for municipal debt issuance as well. The two factors weaken professionalism in public administration and the quality of decision-making. How do governments balance political considerations with professional ones? This dissertation answers this question with the establishment of decision criteria which finance professionals can use to objectively evaluate alternatives on the basis of past performance. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 148 Lack of education is addressed by urging the hiring of public administrators with more financial expertise and through the education of the public about municipal debt issues. Today, the primary public sector implementation question is one of motivation. The question of motivation as it specifically relates to quality decision-making in debt issuance is answered with a means to objectively evaluate performance of competing processes and types of sale. Access to education on municipal debt processes, coupled with tools for evaluation, should provide the motivation for administrators to make better decisions and to help illuminate those decisions when they are poor. The ultimate motivation upon which this theory rests is on disclosure. F. Implications for Agency Theory When a long-term alliance persists between underwriter and government agency, there is enough lack of concern for cost efficiency, in favor of relationships, to convincingly indicate that an agency problem does exist. So long as great variance exists between type of issuers, issues and the status of the market at any given time, repeated and almost absolute failures to look at alternative underwriters or groups of underwriters strongly suggests an agency problem. There is evidence that agency problems exist in other aspects of public administration (e.g., agenda setting, the selection of consultants for performance audits and software development, and the award of defense and construction contracts). The development of a means to evaluate different underwriters’ performance could lead to a Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 149 means for sorting solutions based on political interests from those based on administrative expertise for a myriad of governmental problems. An exploration of the selection process for type of sale has helped explain why government often does not choose the most effective (which also equates to the most efficient for the bond issuance problem) alternative: the weight of any given relationship is stronger than the desire for reevaluation. G. Implications for Future Research The complexity of the financial instruments used today signals a need to reevaluate the debate over preferred method of sale, or at least reaffirm the predominant finding that competitive sales result in lower TICs compared to negotiated sales, and that this disparity increases in favor of competitive sales as the number of bids increases. This type of analysis, however, utilizing standard multiple regression can be easily performed by issuing agencies for their most recent sales and those of their respective state, region, or benchmarked governments. It is within this area that further research needs to occur on a continuing basis, as the economy and market structure will inevitably shift in this new "information age." A stronger recommendation in support of identified investor preferences could be made if this study were replicated and included (1) a greater number of institutional investors and (2) retail investors. Replication of the research during a different time of year or under different economic conditions would also strengthen the findings if they were similar to the ones obtained here. The findings could be tested for reliability through a blind, random sample mailing to institutional investors. For validity, the findings, particularly marketing Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 150 strategies outlined in Chapter 4, could be tested in actual sales or simulated ones. This first interview provides a benchmark for future studies. In summary, implications of this dissertation indicate the need for the following future research: • Replicate institutional investor survey. • Conduct follow-up survey to the same representatives of institutional investors during the next major recession. • Survey additional institutional investors. • Replicate Simonsen's survey of public finance managers (1998) on criteria for selection of method of sale to further investigate agency problems. • Analyze the role the private sector plays in the lending of large sums of money to state and local governments. • Investigate inequity in bond issuance costs by region, type and wealth of agency. • Investigate funding block mechanisms for the financial needs of low investment grade issuers. • Research Bond Banks to help poor grade issues. • Conduct hypothesis building for issuer response to an investor's market. • Predict and define a mature, more standardized municipal market that will emerge in the new information age. • Test financial advisors’ ability to replicate the findings of the institutional investor survey. • Test the decision criteria and suggested weights through post-sale analyses. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 151 • Test the Bayesian theory on large samples of bonds. • Use multiple regression to uncover variance in TIC among underwriters. • Study the applicability of the Internet and alternative means of placement that could circumvent the underwriter (e.g., direct placement, "MuniAuction"). Like Simonsen and Hill’s work on principal-agent theory (1998), the base of the research for this dissertation relies on self-reported surveys. Conclusions drawn from institutional investor responses must be balanced with objective analysis of tangible results from post analysis of actual sales and triangulated with opinions from parties representing different interests. H. Practical Implications Investors are the primary source of capital for state and local governments. When a governmental entity sells bonds, it enters into a long-term contract to make timely debt service payments with investors who purchase the bonds initially, as well as to future investors who will hold the bonds. An effective investor relations program that responds to investor needs and concerns can lower borrowing costs for issuers. The merit of this GFOA recommendation has been confirmed through the institutional investor survey. In response to the preferences stated by the surveyed representatives of institutional investors, there are a range of things that issuers can do to make their sales more attractive to investors. Identifying what investors need for their portfolios is the first step. This “nfceds assessment” function, generally performed by an underwriter or public financial advisor, should become the priority of the public finance professional him/herself based on the Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 152 feedback from investors. Targeted sales become even more important when the sale is a competitive one. Encouraging underwriters to bid in the issuer’s competitive sales, through minimum bid requirements for future lead underwriting contracts, places pressure on underwriters to “bid well and bid often.” Where a negotiated sale is warranted, local governments should evaluate the past performance of underwriters to determine the probable future performance of underwriters for an issuer’s respective sale. This dissertation developed criteria which finance managers can use to make better decisions when selecting method of sale for municipal bonds. So long as an agency problem exists where the goals of public officials may differ from those of the electorate, public finance managers can use probability statistics to check assumptions regarding decisions on method of sale. These statistical equations can be used in conjunction with other post-analyses of sales to evaluate the competence of specific underwriters. There is a practical application to public administration, policy and management research. Indeed, it was found, very useful information can be gained from directly questioning institutional investors as to what their preferences are for rate structure, timing and size of issue. In order for the findings of the issuers’ institutional investor survey to be used as an effective management tool, investors’ preferences should be incorporated into an informal debt policy which is compatible with a jurisdiction's goals pertaining to its capital program and budget, financial plan, and operating budget. GFOA recommends that a debt policy should strike an appropriate balance between establishing limits on the debt program and providing sufficient flexibility to respond to Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 153 unforeseen circumstances and new opportunities (1995). Finally, debt programs should be continuously monitored to ensure that it is in compliance with the debt policy and achieving the intended results. I. Policy Implications Government plays a significant role in creating feelings of mutual obligation and respect in society. People must have confidence that it will protect the public interest, since representative democracy rests on officials and the trust they engender (Bowman 1990: 345). Decision-makers must always be cognizant of the social and political implications of their decisions, whether they are working with an arguably “value-free” question or a problem of a highly subjective nature. When the public or political side of inquiry is downplayed, as asserted by Ronald Moe (1995), there is a blurring of the lines of accountability to citizens and public interest. With huge sums of money at stake, given underwriting spreads and the powerful relationships that can naturally grow out of the underwriter selection process, the question of negotiated versus competitive sale is relevant to all actors in the municipal bond issuance process (e.g., governmental officials, underwriters, and taxpayers). In the end, good people, the right people, with competence, morals and vision could solve many of the governmental problems which surface today. If public management and administration focus on the structures, processes, and enticements to encourage recruitment and retention of "the cream of society," civic trust in public institutions would be restored. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 154 With respect to public finance, several representatives of institutional investors noted a lack of issuer expertise with respect to debt issuance. Clearly, better educated public administrators with knowledge of the wiles of the market will have the savvy to negotiate better gross spreads with underwriters and structure their issues to match market demand. This technical expertise, however, will not address the potential agency problems that exist between public goals and those of elected officials or finance professionals. As Carl Friedreich pointed out, responsibility is more elicited than enforced in public management. How does society ensure governments stay the proper course? By educating all citizens, letting the media report on processes, providing full disclosure of events, valuing diverse opinions, and conducting audits with follow-up to help ensure public executives and their areas of action are held responsible to the public's interest. Accountability is a concept that is crucial to executive behavior. It is the crux upon which effective, quality management and public administration reside. Accountability provides an ordering of criteria, goals and values to which the executive must be held responsible. With regard to public financial executives, the range of duty and accountability is far-reaching touching on legal, ethical, moral, fiscal and professional standards, norms, rules, and laws. The excellent public financial executive realizes that he/she must be flexible and open to alternatives in decision-making and policy formulation, while maintaining a strict adherence to legal requirements and the tenets of democratic governance. To whom public executives should be held most accountable becomes blurred when the preferences of elected officials conflict with the executive’s definition of the “public good.” Falling back on Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 155 responsibility to law will help provide the guiding, defining line for public executives when questions of process integrity and openness are explored in municipal finance. An informed shift in focus to analysis will provide guidance for approximating lowest cost issuance. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. DBE Acronyms Disadvantaged Business Enterprise 156 FA Financial Advisor GFOA Government Finance Officers’ Association of the United States and Canada GOB General Obligation Bond IFR Internal Financing Rate MSRB Municipal Securities Rulemaking Board NIC Net Interest Cost NOTA None of the Above NPV Net Present Value OS Official Statement PA Public Administration TIC True Interest Cost Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 157 Glossary bid: the price at which a buyer will purchase a security (An Investor’ s Quid? to Municipal Bonds)- credit ratings: benchmarks which reflect a professional assessment of an issuer's ability to repay a bond's face-value at maturity. They do not, however, take market trends into account. Generally, bonds rated BBB or Baa, or better, by Standard & Poor’s and Fitch, or Moody’s, respectively, are considered suitable for preservation of capital (i.e., “Investment Grade”). Credit Ratings Credit Risk Moodv’s Standard. & Poor’s Fitch Prime Aaa AAA AAA Excellent Aa AA AA Upper Medium A A A Lower Medium Baa BBB BBB Speculative Ba BB BB Very Speculative B, Caa B, CCC, CC B, CCC, CC,C Default CA, C D DDD, DD, D (An Investor's Guide to Municipal Bonds') current yield: the ratio of interest to the actual market price of the bond stated as a percentage. For example, a $ 1,000 bond that pays $80 per year in interest would have a current yield of 8% (An Investor’s Guide to Municipal Bonds'). general obligation bonds: bond instrument secured by a pledge of the issuer's full faith and credit (Mikesell 1991: 489). These bonds are usually supported by either the issuer’s unlimited or limited taxing power and are voter-approved (An Investor’ s Guide to Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 158 gross underwriting spread: interest: issuer: marketability: maturity: municipal bond: offering price: official statement (OS): income earned by the dealer or syndicate who underwrites the issue. It is the difference between the price the underwriter pays an issuer for a new offering of bonds and the price the public pays for the bonds. It is generally comprised of four components: the management fee, the underwriting fee, expenses, and the average takedown, the takedown being the largest component. (King) compensation paid or to be paid for the use of money. Interest is generally expressed as an annual percentage rate and is also known as the “coupon rate.” Bond interest is usually paid semiannually. (An Investor's Guide to Municipal Bonds) a state, political subdivision, agency or authority which borrows money through the sale of bonds or notes (An Investor's Guide to Municipal Bonds). a measure of the ease with which a security can be sold in the secondary market (An Investor’ s Guide to Municipal Bonds). the date when the principal amount of a security becomes due and payable (An Investor’ s Guide to Municipal Bondsl. state or local government contract to pay a specified sum of money, the principal or face value, at a specified future date plus interest paid at an agreed percentage of the principal; maturity is usually longer than one year; notes have shorter maturities and are issued with less formality (Mikesell: 478). The two basic types of municipal securities are general obligation bonds and revenue bonds I An Investor's Guide to Munifiip.aLBi?Dds)- the price at which members of an underwriting syndicate for a new issue will offer securities to investors (An Investor's Guide to Municipal Bonds!. document prepared by or for the issuer that gives detail security and financial information about the issue (An Investor’ s Guide to Municipal Bonds!. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 159 principal: revenue bonds: true interest cost (TIC): underwriter: the face amount of a bond, exclusive of accrued interest and payable at maturity (An Investor's Guide to Municipal Bonds)- principal and interest are secured by revenues derived from tolls, charges or rents paid by users of the facility built with the proceeds of the bond issue; ofren issued by special authorities created for the purpose (e.g., airports, water and sewage treatment) (An Investor’ s Guide to Municipal Bondsl. the internal rate of return that will be paid by the issuer of bonds to investors; the interest rate discounts the debt service payable for a bond issue to its present value, or net proceeds (i.e., takes into account the time value of money) (Johnson 1996: 359). investment firm that buys an entire bond issue from an issuing government with the intention of reselling the bonds to the public in the secondary financial market (Mikesell: 501). 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"Wall Street and Politicians: Breaking Up the Unholy Marriage." Governing (Dec. 1993): 40-44. Lenna, Robert 0 . Letter. “Municipal Market’s Reaction to Scandal Resembles Hysteria in a Chicken House." The Bond Buyer 304.29163 1 June 1993. Leonard, Paul A. “An Empirical Analysis of Competitive Bid and Negotiated Offerings of Municipal Bonds.” Municipal Finance Journal 17 (Spring 1996): 37-67. —. “Negotiated Versus Competitive Bond Sales: A Review of the Literature.” Municipal Finance Journal 15 (Summer 1994): 12-36. —. "Some Factors Determining Municipal Revenue Bond Cost." Journal of Economics and Business 35 (1983): 71-82. Levitt Jr., Arthur. "Legal Ethics Shouldn't Be an Oxymoron." The Wall Street Journal. 155 5 Aug. 1997, A18(W), A18(E), col. 3. Lim, Yong. “Issuance Volume Up 32% From Same Period in 1997.” The Bond Buver 326.30512 2 Nov. 1998. —. “Yield Indexes Mostly show Decreases; Web Hosts Negotiated Puerto Rico Deal.” The Bond Buver 17 March 2000: 7. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 170 Lindblom Charles E. "The Science of'Muddling Through1 ." Classics of Public Administration. 1959. Ed. Jay M. Shafritz and Albert C. Hyde. Oak Park, IL: Moore Publishing Company, Inc., 1978,202-213. —. "The Science of Muddling Through'." Public Administration Review 19 (Spring 1959): 79-88. Maco, Paul S. and George L. Shepard. "Let There Be Light: The SEC's New Regulations for the Municipal Securities Market" Public Budgeting & Finance 16.2 (Summer 1996): 133-140. Maese. "Competitive Versus Negotiated Municipal Revenue Bond Issues: An Investigation of Underpricing." Financial Management (Spring 1985): 26-32. Managerial Economics and Operations Research: A Nonmathematical Introduction. Revised and Expanded Edition. Ed. Edwin Mansfield. New York: W. W. Norton & Company, Inc., 1970. March, James G. and Herbert A. Simon. Organizations. Second Edition. 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McKenna, Jon. “Florida Conference’s Panelists Join in Freewheeling Talk.” The Bond Buyer 318.30025 15 Nov. 1996. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 171 —. “Fong Enters California Race for U.S. Senate.” The Bond Buyer 323.30321 30 Jan. 1998. McLoughlin, Tom. "Bid Evaluation of Competitive Bond Sales: NIC vs. TIC." Handbook of Debt Management. Ed. Gerald J. Miller. New York: Marcel-Dekker, Inc., 553- 556. Meckling, W. H. and M. C. Jensen. "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure." Journal of Financial Economics (1976) 305-360. Meier, Kenneth J. Regulation: Politics. Bureaucracy, and Economics. New York: St. Martin’s Press, 1985. Meier, Kenneth J. and Jeffrey L. Brudney. Applied Statistics for Public Administration. 3rd ed. Belmont, CA: Wadsworth Publishing Company, 1993. 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Moore, Mary. “Bill Seeks GO Oversight; Some Question Necessity.” California Public Finance 4.26 4 July 1994. “Mountain View on Track with July Debt Issue." California Public Finance 6.8 26 Feb. 1996. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 172 Mysak, Joe. “Smith Barney’s Friedlander Enters the Fray, Says Some New Issues Cry Out for Negotiation.” The Bond Buver 306.29285 22 Nov. 1995. —. “Watching the New Jersey Bond Scandal Unfold is a lot like Waiting for the Hindenburg to Land.” Bond Buyer 304.29158 24 May 1993. National Federation of Municipal Analysts. Disclosure Handbook for Municipal Securities, ed. 1992. Nauss, Robert M. "True Interest Cost in Municipal Bond Bidding: An Integer Programming Approach." Management Science. 32 (July 1986): 870-877. “Negotiated Sales Need Comptroller Approval." The Bond Buyer 5.41 11 Nov. 1991. Newland, Chester A. 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"Municipal Bond Issue Structuring." Handbook of Debt Management. Ed. Gerald J. Miller. New York: Marcel-Drekker, Inc., 1996,401-432. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 174 Puelz, Amy V. and Sang M. Lee. "Structuring Tax-Exempt Serial Revenue Bonds: A Multiple-Objective Decision Support System Framework." Municipal Finance Journal 10.2 (1989V. 153-171. Rainey, Hal G. Understanding & Managing Public Organizations. Second Edition. San Francisco, CA: Jossey-Bass Publishers, 1997. “Rally Loses Steam but Renews Hope.” California Public Finance 6.16 22 April 1996. Rannazzisi, Julie. “Blazing Treasuries Eclipse Municipals as Both Enjoy Notable Gains.” The Bond Buver 320.30157 2 June 1997. Resnick, Amy B. “Government Finance Officers Association Annual Conference Panel Reviews Risks, Benefits of Bonds as a Tool for Pension Fund Liabilities.” The Bond B uver 320.30158 3 June 1997. 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Sanders, Lisa and Daniel Kruger. Column. California Public Finance. 9.41 26 Oct. 1996. Schuchner, Michael. "Munibond Insurers Optimistic for 1995." Business Insurance 13 Mar. 1995: 3. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 175 "SEC Stresses Importance of Municipal Bond Integrity." Journal of Accountancy 180.2:12. “SEC’s Chief sets Priorities for Municipal Market Reform.” The Bond Buver 8.4 31 Jan. 1994. "Securities Board Asks Muni Dealers to Reveal Consultants' Donations." The Wall Street Journal 156 6 Aug 1997: C17(W), C18(E), col 4. Selznick, Philip. Leadership in Administration: A Sociological Interpretation. Berkeley, CA: University of California Press, 1957. Shafroth, Frank. 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Public Administration Review 6 (Winter 1946) 53- 67. ~ . The Shape of Automation for Men and Management. New York: Harper & Row, Publishers, 1965. Simonsen, William. “Municipal Bonds, Basics.” International Encyclopedia of Public Policy and Administration. Boulder, CO: Westview Press, 1998. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 176 “Municipal Bonds, Policy and Strategy.” International Encyclopedia of Public Policy and Administration. Boulder, CO: Westview Press, 1998, —. “Oregon’s Local Government Debt Management: The Aftermath of the Property Tax Limiting Ballot Measure #5.” Municipal Finance Journal 13.2 (Summer 1992): 30- 41. —. Telephone interview. January 2000. Simonsen, William and Bill Kittredge. “Competitive Vs. Negotiated Municipal Bond Sales: Why Issuers Choose One Method Over The Other.” Municipal Finance Ifiumal 19.2(1998). 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"Investment Banking and the Capital Acquisition Process." Journal of Financial Economics 15 (1986): 3-29. Sorensen. "Negotiated Municipal Bond Underwritings: Implications for Efficiency." Journal of Money. Credit and Banking (Aug. 1979): 366-370. Spiro, Leah Nathans and Geoffrey Smith. "Lazard Gets Clobbered By Its Own Clout; The Firm Tried to Sell Munis Using Political Connections - And Is Paying a Steep Price." Business Week 3451 20 Nov. 1995,142-147. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 177 Stamas, Vicky. "MSRB Bans Gifts by Dealers, Firms to Go into Effect Monday, April 25." The Bond Buver 14 April 1994: 1. —. “SEC vows to Speed the Swan Song of Negotiated Bond Offerings.” The Bond Buyer 7.41 1 Nov. 1994. State Government Finances: 1997. 1999. U.S. Bureau of the Census. Sept. 1999 <http://www.census.gov/govs/www/st97.html>. Steiss, Alan Walter. "New Financing Instruments for State and Local Capital Facilities." 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New York Times 27 October 1995: 2., col 5. Weber, Max. "Bureaucracy." Classics of Public Administration. 1946. Ed. Jay M. Shafritz and Albert C. Hyde. Oak Park, IL: Moore Publishing Company, Inc., 1978,23-28. Webster's 1 1 New College Dictionary. Boston: Houghton Mifflin Company, 1995. West. “Determinants of Underwriters’ Spreads on Tax-Exempt Bond Issues.” Journal of Financial and Quantitative Analysis (Sept 1967): 211-263. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 179 —. “More on the Effects of Municipal Bond Monopsony.” Journal of Business (April 1966): 305-308. —.“New Issue Concessions on Municipal Bonds: A Case of Monopsony Pricing.” Journal 9f Business (April 1965): 135-148. Whalen, Robert. “MuniAuction Pulls Off a Second Sale With Nary a Crash in Sight.” U s Bond Buver 16 March 2000: 1,7. Whicker, Marcia Lynn and Todd W. Areson. Public Sector Management New York: Praeger Publishers, 1990. “Whisman Chooses Paine Webber.” California Public Finance 6.10 11 Mar. 1996. Wilson, James Q. Bureaucracy: What Government Agencies Do and Whv They Do U. Basic Books, Inc., 1989. Wilson, Woodrow. "The Study of Administration." Classics of Public Administration. 1887. Ed. Jay M. Shafritz and Albert C. Hyde. Oak Park, IL: Moore Publishing Company, Inc., 1978,3-17. —. “The Study of Administration.” Political Science Quarterly n, I (June 1887). Winch, Peter. The Idea of a Social Science and its Relation to Philosophy. 2nd ed. Atlantic Highlands, NJ: Humanities Press International, Inc., 1990. Winterfeldt, Detlof von and Ward Edwards. Decision Analysis and Behavioral Research. Cambridge, England: Cambridge University Press, 1986. Wong, P. C. Role of Private Financial Institutions in the Development of Local Infrastructure in Thailand. U. S. Agency for International Development, 1995. Workman, Wayne L. and Jeffrey C. Apfel. "Negotiated verses Competitive Issuance: The Need for New Offering Types." Municipal Finance Journal 16.3 (1995): 1-10. Yanak, Francis Vincent. The N aw "China Lake" Personnel Management Demonstration Project and Redefining Management Spinoffs. Diss. U. of Southern California, May 1998. Zinn, Robert W. "Applying the Bierman Technique: Municipal Bond Valuation." Handbook of Debt M anagem ent. Ed. Gerald J. Miller. New York: Marcel-Drekker, Inc., 1996, 561-567. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 180 Appendix A U.S. Census Bureau Definitions for Public Debt The following verbatim definitions and edited text (pages 114 - 138) for the classification of “public debt” were taken directly from the Internet page for the Government Finance and Employment Classification Manual (June 1992, http://www.census.gov/govs/manual/ch9.txt). These definitions and classifications should be used to understand the classifications for “interest on debt,” “interest on general debt,” and “debt at end of fiscal year” as used in Tables 1 and 2 in Chapter 1 of this dissertation. Preface Governments are diverse and complex organizations. To describe their financial and employment activities, both across time and among governments, requires a set of standardized concepts and definitions. The purpose of the U.S. Census Bureau classification manual on government finances and employment is to provide such guidance. This edition of the Census Bureau classification manual became effective with fiscal year 1987-88 finance data and October 1988 employment data. It represents the first major revision since the 1982 version. It contains the most substantial changes to this classification system since 19S2. It also introduces a significant redesign of the manual's format. The Census Bureau has been gathering state and local government statistics since the 1840 Decennial Census. The classification system largely dates to the early 1950s when it Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 181 received an overhaul in preparation for the Bureau's expanded responsibilities. The basic features of the system remain intact today despite periodic revisions. As with prior editions, the realities of data availability and collection methods impose limitations on the use of the coding system. For example, mail survey questionnaires for small governments often collected less detail, requiring data to be summarized or classified into "all other" categories. Final data assembled for these small governments may not, therefore, reflect the full detail possible within the coding framework. Both data compilers and users should be aware of limitations regarding the data produced by this classification. This manual, in its entirety, is produced in limited volume. It is intended for administrative use by the Bureau of the Census. Copies are available upon request. Requests should be addressed to: Governments Division U.S. Bureau of the Census Washington, DC 20233 Telephone: (301) 457-2584 Indebtedness Relevant excerpts from “Chapter 9: Indebtedness” follow. The full chapter includes contents under the following headings: “Contents and Abstract;” “Debt Definition;” “Liabilities Outside Census Bureau Definition;” “Major Classification Changes with Fiscal Year 1987-88 Data;” “Four-Way Classification of Public Debt;” “Public Debt for Private Purposes;” “Related Revenue, Expenditure, and Cash and Security Issues;” “Refunding of Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 182 Long-Term Debt;” “Regular Refunding;” “Advance Refunding;” “Derived Debt Statistics;” “Borrowing and Redemption;” “Change in Debt;” “Net Long-Term Debt Outstanding;” “Other Debt Topics;” “Zero Coupon and Other Deep Discount Bonds;” “Bond Banks and Pooled Debt;” “Leases and Lease-Purchase Agreements;” and, “Taxable Public Debt.” Debt Description Sheets Perhaps more than any other area of public finances, government debt has grown in complexity since the Census Bureau's classification system was created. The effect of these changes on the classification system has been so pronounced that major changes were made to it beginning with the fiscal year 1987-88 finance survey. Debt Definition Public debt comprises all interest-bearing short-term credit obligations and all long-term credit obligations incurred in the name of the government and all its dependent agencies, whether backed by the government's full faith and credit or nonguaranteed. It includes tax-exempt as well as taxable public debt. The Census Bureau concept of public debt is an inclusive one, covering judgments, mortgages, "revenue" and "earning" bonds, and special assessment obligations as well as the more traditional general obligation bonds, notes, and interest-bearing short-term warrants. It includes not only public debt for public improvements (roads, sewers, airports, etc.) but also public debt issued for the direct benefit of the private sector (industrial development, mortgage revenue, pollution control abatement, etc.). Indeed, the latter category has grown to become the largest type of government debt today. (See Section 9.3 for a more detailed discussion of this topic.) This definition covers obligations of all agencies, boards, commissions, or other organizations categorized as dependent on the government concerned (see Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 183 Chapter 3). For instance, government business-type activities, particularly utilities, have debt that is payable exclusively from earnings of the facilities which the debt financed. Many special assessment obligations are paid completely from levies on the property benefitting from such improvements, without recourse to the general credit of the government. State authorities, educational institutions, and other agencies frequently have debt secured only by their own revenues, other dedicated receipts, or agency properties. These types of obligations are issued widely by dependent agencies of a government, such as special improvement districts of city corporations, state dormitory authorities, or housing finance agencies. Often, the parent government does not even maintain central accounts on such debt. Nonetheless, all these examples are types of credit obligations reported in Census Bureau statistics on public debt. The Bureau assigns public debt, as defined above, to the government in whose name it is incurred, regardless of the location of responsibility for debt service. In the case of public debt for private purposes, this generally represents the government whose tax-exempt status was used to issued such debt. State obligations for which interest and principal payments are financed by local government payments to the state are treated as state debt. Similarly, debt of an agency classified as dependent on a local government is treated as local government debt. Liabilities Outside Census Bureau Definition This concept of public debt, however, is not so broad that it covers every liability listed on the balance sheets or elsewhere in government finance reports. The following types of liabilities are excluded from Census Bureau statistics: Noninterest-bearing short-term obligations, such as accounts payable, noninterest-bearing warrants, and the like. Note, however, that noninterest-bearing long-term obligations having a formal debt instrument (such as a fixed repayment schedule) are classified as government debt. Interfund advances, loans, or other obligations between accounting funds of the same government (see Section 6.6 for a discussion of intragovemmental transactions). As a practical matter, these debt statistics do include formal debt instruments of a government that are held as investments by its own agencies or fund. Amounts held (and owned) by a government in a trust or agency capacity on behalf of others (see Section 6.5). Contingent loans and advances from other governments, which are classed as intergovernmental transactions (see Section 6.4). Rights of individuals to benefits from retirement funds or other social insurance trust systems. Unfunded liabilities of retirement systems, unpaid annual or sick leave, or other obligations without a formal debt instrument specifying terms, length, interest rate, etc. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 184 Leases, including both capital and operating leases (see Section 9.63). Loan guarantees and nonguaranteed obligations of the Federal Government. Chart 9-A provides a sample of the most common types of government liabilities that are included and excluded from this definition of public debt. Major Classification Changes with Fiscal Year 1987-88 Data Due to the growing complexity of government debt financing and the difficulty in collecting statistics regarding it, the Census Bureau instituted major classification changes to this area, effective with fiscal year 1987-88 data. The major effects of the changes were to simplify the classification scheme and to more completely identify public debt for private purposes. The classification changes are summarized as follows: 1) The functional detail on long-term debt issued, retired, and outstanding was reduced from 19 to 8 categories, half of which are for utilities. 2) Two functional categories previously used to classify state government full-faith and credit long-term debt, “General Obligation Bonds” and “Debt Initially Payable from Specified Nontax Revenue,” were eliminated. Four-Way Classification o f Public Debt The Census Bureau classifies public debt into four categories using a three-digit coding scheme. Except for the first category, the three remaining categories apply solely to long-term debt These categories are defined in detail in the description sheets at the end of Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 185 Chapter 9. Below is a summary of the categories: 1) Length of Term Debt is classified as either short-term or long-term. For short-term debt, only the amounts outstanding at the beginning and end of the fiscal year are reported. Unlike long-term debt data, no effort is made to collect the entire amount of short-term debt sold and paid off during the fiscal year or to categorize short-term debt by function. 2) Type of Long-term Debt Long-term debt is classified by one of three types: issued during the year, retired during the year, or outstanding at the end of the fiscal year. The first two classifications record debt activity over a period of time while the last one measures debt at a specific point. Also, “end of the fiscal year” refers to the government's fiscal year, not the Census Bureau reporting period. 3) Character of Long-term Debt Long-term debt is classified as backed by the full-faith and credit of the government or as nonguaranteed. For smaller local governments, long-term debt issued and Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 186 retired is not classified in either category but is categorized as "unspecified in character." 4) Purpose of Long-term Debt Long-term debt is classified according to the purpose, or function, to be financed from its proceeds. There are eight functional categories for debt: a) Utility Debt 1: 1. Water Supply Systems, 2. Electric Power Systems, 3. Natural Gas Supply Systems, 4. Public Mass Transit Systems b) General Debt: 5. Elementary and Secondary Education, 6. Higher and Other Education, 7. Public Debt for Private Purposes, 8. All Other Debt. Public Debt for Private Purposes This functional debt category was first used in the fiscal year 1987-88 survey. It represents a consolidation of two former categories plus certain debt from others. It is now the largest type of state and local government debt. Public debt for private purposes comprises a government’s credit obligations or that of any of its dependent agencies for the purpose of funding private sector activities. This includes debt that is backed solely by the Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 187 private organization(s) involved. Such debt is assigned to the government whose bond- issuing authority was used to secure its tax-exempt status or was used for its issuance, as in the case of taxable debt Examples of funded private sector activities include industrial and commercial development, pollution control, housing and mortgage loans, private hospital facilities, student loans, and such private ventures as sports stadiums, convention centers, and shopping malls. This type of debt poses certain data collection problems. First it is not always listed always in the issuing government’s financial statements. Often, the debt is discovered in secondary sources, such as credit agencies. Second, even if its issuance is identifiable, its retirement schedule, interest payments, and amount outstanding may be unavailable. Where these amounts are unavailable, the Census Bureau estimates them. Third, the governments' themselves often do not construe such debt to be their own and object to its being included in statistics about their finances. Finally, this debt can distort the presentation of data, such as its effect on per capita debt when a small government (as measured by population) issues a large amount of public debt for private purposes. Related Revenue, Expenditure, and Cash and Security Issues Public debt for private purpose generates special treatment regarding its related revenue, expenditure, and cash and security holdings. This treatment was revised for the fiscal year 1987-88 survey to cover all such types of debt. Previously, it was limited to mortgage revenue debt. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 188 Revenue Classified as Interest Earnings is an amount equal to the interest expenditure on all public debt for private purposes. Expenditure Unlike all other forms of issued debt, no expenditures from the proceeds of public debt for private purposes are reported. Classified as Interest on General Debt is the actual or estimated interest payments on such debt. Cash and Security Holdings Classified as an Offset to Debt is an amount equal to the public debt for private purposes outstanding at the end of the fiscal year. This figure is annually revised to account for amounts retired or issued. Refunding o f Long-Term Debt Another growing feature of public debt finances is the refunding of long-term debt. Governments often retire debt before it matures by issuing more debt, generally at a lower interest rate (e.g., like refinancing a mortgage). A more peculiar version is advance Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 189 refunding where a government issues new debt but sets aside the proceeds rather than actually paying off the debt. The old debt, is "defeased" and removed from the government's accounting statement How the Census Bureau reports such statistics is described in the next two sections. Regular Refunding Regular or direct refunding refers to the issuance of long-term obligations in exchange for, or to finance the retirement of, existing long-term debt typically on or after the first call date of the debt to be refunded. This straightforward transaction is classified for Census Bureau statistics as described below: Refunding Debt Issued The par value of debt issued during the fiscal year is reported twice: (1) under regular debt issue categories and (2) under the refunding debt issued category. Any amounts authorized but not actually issued are excluded. Debt Retired bv Refunding The par value of debt retired by refunding during the fiscal year is reported twice: (1) under regular debt retired categories and (2) under the debt retired by refunding category. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 190 Rsfimdine DfibLfitttstandins The par value of debt outstanding that was issued for refunding purposes is reported under regular debt outstanding categories. The debt that has been retired by the refunding bonds is excluded. Advance Refunding A more complex situation exists when a government issues refunding debt but cannot legally retire the old debt under the terms of the original debt issuance, typically 10 years after its issuance. The original debt's "first call" date has not yet been reached. Usually, this occurs during times when interest rates are dramatically falling. In these cases, the government places the proceeds of the refunding bonds in escrow. This includes enough monies to cover the debt service (i.e., principal and interest) until the original debt's first call date is reached. The escrowed funds are used to retire the original debt's remaining balance. The government generally has two choices on treating the refunded debt: (1) If the refunding debt issued is sufficient to pay the remaining principal and all future interest on the original debt, then the government can remove the original debt from its balance sheet (i.e., defeasance). For Census Bureau purposes, a debt is defeased whether or not the government is released from its legal obligation for the debt (i.e., legal defeasance) or remains the primary obligor (i.e., in-substance defeasance). (2) The government may use the escrow funds to pay the interest and principle due on the refunding debt, not the original debt, until Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 191 a certain date is reached, at which time the escrowed money is used to retire the original debt, which is then defeased (i.e., "crossover" refunding). The example below illustrates a typical advance refunding: City X has $10 million in water utility nonguaranteed debt outstanding at 13% interest whose first call date is not for four more years. It issues $12 million in advance refunding bonds (at 6%) to cover principal and interest to maturity. The proceeds are used to purchase Federal securities which are placed in escrow and used for debt service on the original issue. The original debt is "defeased" and removed from the books of the government, that there is no other principal paid on either the original or refunding debt. For Census Bureau statistics, the above advance refunding scenario in the following manner: Advance Refunding Debt Issued The par value of the entire refunding debt issue (i.e., the $12 million cited in the example) is reported under regular debt issued categories. The par value of the refunding debt issue used to refund the old debt principal (i.e., the $10 million in the example) is reported under Refunding Debt Issued. Assume advance would be treated Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 192 Debt Retired bv Advance Refunding The treatment of the original debt's retirement and its outstanding amount depends on when the government no longer considers the debt to be on its books, regardless of whether or not the debt still exists (i.e., is still in possession of its bond holders). Once the government considers the original debt defeased and removes it from its official accounting records, the par value of the original debt issue is reported twice: (1) under regular debt retired categories and (2) under Debt Retired by Refunding. The retirement of the refunding debt itself is treated the same as any other debt retirement. Advance Refunding Debt Outstanding The refunding debt is reported in the same manner as any other long-term debt outstanding. The treatment of the original debt to be refunded in advance depends on whether or not it is still on the government's books. If the original debt is still shown on the government's official accounting records, then it is reported as debt outstanding (along with the advance refunding debt outstanding). This is not uncommon for the first year the advance refunding debt is issued. Nor is it uncommon in cases of crossover advance refunding. Using the example above, this would be a total of $22 million in debt outstanding. If the original debt has been defeased and no longer shown in the government's official accounting records, then it is not reported as debt outstanding. In the above example, debt outstanding would be limited to the $12 million in advance refunding debt. This treatment was adopted first with fiscal year 1978-79 data. The Census Bureau made a one Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 193 time adjustment of about $5.6 billion to state and local government long-term debt outstanding for that year to accomplish this revision. Derived Debt Statistics From the debt data that is collected from state and local governments, the Census Bureau also computes derived statistics on indebtedness. Some of these also use data gathered on cash and security holdings. Borrowing and Redemption Borrowing is an estimate of the net amount of new money a government has borrowed during the fiscal year, including short- and long-term debt. It consists of the par value of long-term debt issued during the year, other than for refunding purposes, plus any net increase in short-term debt between the beginning and end of the fiscal year. It does not reflect the total amount of short-term debt sold during the year. Redemption is an estimate of the net amount of debt that a government has paid off during the fiscal year. Redemption includes short-term and long-term debt It consists of the par value of long-term debt retired during the year, other than debt retired by refunding, minus any net decrease in short-term debt between the beginning and end of the fiscal year. It does not reflect the total amount of short-term debt paid off during the year. Debt redemption includes debt redeemed not only from current revenue or prior year fund balances but also from the sale of assets accumulated Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 194 in debt service funds (i.e., sinking funds). The transfer of current revenue to such funds for future debt service is considered an intragovemmental transaction and is not included in either revenue or expenditure statistics. The amounts held, however, are recorded as cash and securities. Change in Debt Change in debt is an estimate of the net change in a government's indebtedness during the fiscal year, combining features of both debt borrowing and redemption. It consists of the par value of long-term debt issued during the fiscal year less the par value of long-term debt retired during the year plus or minus the change in short-term debt between the beginning and end of the fiscal year. It does not reflect the total amount of short-term debt sold or paid off during the year. Net Long-Term Debt Outstanding Net long-term debt outstanding is the amount of long-term debt held by a government for which no funds have been set aside for repayment. It consists of total long-term debt outstanding less total offsets to debt (i.e., cash and security holdings in debt service or sinking funds). For state governments and the largest city and county governments whose data are compiled by the Census Bureau, net long-term debt is divided further between full- faith and credit and nonguaranteed. The category of Net Long-Term Full-Faith and Credit Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 195 Debt consists of the par value of total full-faith and credit long-term debt less offsets to full- faith and credit long-term debt. Net Long-Term Nonguaranteed Debt consists of the par value of total nonguaranteed long-term debt less offsets to nonguaranteed long-term debt. Other Debt Topics This section primarily covers new and more complex debt instruments that governments have employed in recent years. Zero Coupon and Other Deep Discount Bonds Deep discount bonds and their equivalents (e.g., zero-coupon bonds, compound interest bonds, etc.) are debt instruments sold at a price much below their face value. The interest they earn is added to the value of the bond rather than paid out serially. This is similar to how U. S. savings bonds work. Interest is reinvested, compounded at the original rate that applied to principal, and paid at maturity. Deep discount debt transactions are reported as follows: Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 196 Debt Issued Only the actual proceeds from the sale of bonds are reported as long-term debt issued (i.e., not the higher face value amount). Debt Retired When the bonds are paid off, only the original sale price is reported as long-term debt retired (i.e., not the higher face value which includes accumulated interest). The amount retired is equal to the amount originally reported as issued. The proceeds from the original sale of the bonds are reported as long-term debt outstanding (i.e., the outstanding amount is not incremented by the interest earned and added to its face value). The amount outstanding remains constant during the life of the bond. Interest Expenditure Interest Expenditure is the amount of interest earned by the bond (even if it does not involve actual cash disbursements) added to its face value. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 197 Bond Banks and Pooled Debt Governments sometimes issue debt jointly rather than individually to reduce the cost of issuing debt and achieve a lower interest rate. For instance, a state government may create a "bond bank." The state’s bond bank issues debt in the state's name that is used to purchase securities from local governments. Local governments may also create their own bond banks or enter into "pooled debt" arrangements where one member issues debt and the others borrow from the proceeds. The Census Bureau reports such arrangements as follows: Debt Issued. Retired, and Outstanding The government in whose name the bond bank or pooled debt was issued is recorded with the amount issued, retired, and outstanding. Loaning of Proceeds to Other Governments The distribution of the bond bank or pooled debt proceeds is not reported as an intergovernmental transaction. Instead, for the government issuing such debt, the purchase of other government's securities or the borrowing of debt proceeds by other governments is reported as investment under Offsets to Debt For the governments whose securities are sold or which borrow the proceeds, it is treated as long-term debt issued. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 198 Repayment of Proceeds When the member government repays part or all of the loan from the issuing government, it is reported as long-term debt retired by the former government. The amount repaid each year reduces the security holding for offsets to debt for the issuing government. Interest on Debt The interest paid on the debt is reported under the appropriate interest expenditure category for the issuing government. For the member governments, it is treated as an intergovernmental expenditure, and, for the issuing government as intergovernmental revenue. In some cases, the original debt is issued by a nongovernmental entity such as a league of cities. In these joint arrangements, the debt and its related transactions are assigned to the member governments and reported as regular long-term debt. Leases and Lease-Purchase Agreements For the Census Bureau, leases, lease-purchase arrangements, lease-rental agreements, and the like are not considered public debt. Instead, payments on them are reported as capital outlay. A government may enter into a leasing arrangement with a private firm in lieu of issuing debt and building its own facilities. The private firm obtains the funding for the project, builds it, and leases the facility or equipment back to the government For Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 199 governments, leases offer the advantages of not requiring voter approval and are not counted toward its debt limitation ceiling. Census Bureau debt categories do, however, include lease- rental bonds issued by a dependent agency of a government which builds a facility that it leases back to the parent government. Lease payments would not be reported since they represent intragovemmental transfers. Taxable Public Debt Taxable public debt is reported in the same manner as tax exempt public debt. Most government debt is tax exempt (i.e., the interest it pays to bondholders is exempt from federal income taxes). In some cases, however, governments will issue debt that does not receive exemption from federal taxes (e.g., to get around debt limitations). General Notes (4) 1) Utility Debt Utility Debt only applies to debt amounts that can be readily identified as being for particular utility purposes. Such obligations are included without reference to the conditions determining payment of interest and principal, that is whether or not utility or general revenues are used. Likewise, general obligation bonds or other "tax supported" obligations Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 200 issued specifically to fund utility operations or facilities are classed as utility debt, and the interest on them as utility interest expenditure. 2) Private Activity and Housing This statistical category is broader than the "private activity bonds" that are regulated by such federal laws as the Tax Reform Act of 1984, which excludes such debt as private multi-family rental housing and mortgage subsidy bonds. 3) Defeased Debt For purposes of determining whether or not the original debt has been removed from the government's books, the Census Bureau considers the “official record” to be the balance sheet from the government's annual financial report. Thus, defeased debt only carried in notes to the financial statements or in a debt compilation sheet would not be considered outstanding debt of the government. 4) Leases Leases are not classified as debt for various reasons. Unlike bonded debt, leases rarely generate cash flow. With no available proceeds, there are no funds to expend on capital outlays or to turn over to the private sector in return for an investment security. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 201 Moreover, leases are rarely negotiable instruments. They do not require voter approval or apply to debt ceiling limits; are funded by annual appropriations rather than dedicated taxes or other revenue sources, in effect making them renewable one-year contracts; can be canceled in some cases; and, often have an “interest” component that is simply an imputed amount. Thus, leases are closer to the "pay-as-you-go" way of financing capital improvements than to debt. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 202 Appendix B Written Responses from Institutional Investor Survey The number of written responses to the questionnaire faxed or e-mailed to institutional investors between December 1999 and April 2000 are 16. Following a reiteration of questions 1 through 3, the verbatim responses of the participants follow. The respondent number corresponds to the respondent number used in Table 14 in Chapter 4. Question 1: Please comment on the following: “Is the price local governments pay to borrow money actually within their control? It is true the market economy establishes the general rates for which willing investors lend money. As with anv financial investment, the higher the perceived risk of an investment, the higher the yield necessary to attract willing investors. Although interest payment schedules cannot be chanced. market prices of securities also change as market conditions change. As interest rates decline in the market, municipal bond prices increase. Conversely, when interest rates rise, bond prices decline. Interest rates fluctuate in response to underwriters' confidence the bonds will be repaid in full as promised. The attractiveness of a bond issue to an investor is primarily a function of the offering relative to other offerings in the market and the risk of the investment. Secondarily, what an investor is willing to pav is associated with his/her respective portfolio. Theoretically, the interest rate paid to the investor includes a cost differential for the level of risk.” (Source; Author! “The price local governments pay to borrow money is within their control to the extent that by being fiscally responsible and keeping their finances (and ultimately ratings) in check, they can reduce the spread investors will demand. They cannot control base rates, but they do have a certain level of control over additional spread demanded.” (Respondent 1) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 203 “Governments’ cost of borrowing is set at time bonds are initially sold to the market and it is not impacted by secondary trading of bonds. While general level of interest rates are set in the market and out of the control of government, at the margin they can reduce their borrowing costs by increasing security of a bond issue (DSRF, more collateral, etc.) and increasing communications afterwards.” (Respondent 2) “To the extent that local governments can manage their finances responsibly, they can ‘control’ a portion of the price at which they borrow. The choice of selling bonds competitively vs. negotiated (i.e. choosing a particular underwriter) mav lower costs. Beyond these factors, though, the price of borrowing is determined largely by the marketplace. Within the market, timing is also key. Selling bonds at a time when other sellers are not could result in lower borrowing costs. Municipalities may not have the luxury to wait for a more favorable market.” (Respondent 3) “This statement is generally true. But yield is also dependent upon available supply (both primary and secondary). The value (or yield) of a given bond is a function of the maturity, coupon, original issue, yield, call features, credit rating, sector, credit enhancement, state, and region.” (Respondent 4) No written response. (Respondent 5) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 204 “This statement appears accurate to me. Actual rates may also vary depending on specific state or federal tax matters, indicating state tax exemption, an allowance for banks to buy eligible small issue and still deduct the carrying cost, etc.” (Respondent 6) No written response. (Respondent 7) “Having the ability to “control” what you pay to borrow money is never total. By borrowing you give up certain forms of control. The more times you come to market to borrower allows you to ‘control’ rates by averaging costs but the more you come to market also indicates you need outside help more. There is a cost differential for the level of risk but bond issuance has impacted this. With the good economic times the cost differential between lower and higher rated credits has been lowered. As an investor in both tax exempt and taxable investments our buying needs are determined, more than ever, by the spreads between markets and by changes in the tax code that impact ownership of ‘tax advantaged’ bonds by property and casualty companies.” (Respondent 8) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 205 "In the municipal market, price on new issue is very dependent on supply. Supply is a key driver. Also interest rates fluctuate more in response to inflationary fear than credit concerns." (Respondent 9) No written response. (Respondent 10) The following text was underlined: “primarily a function of the offering relative to other offerings in the market.” “Relative value is certainly very important to investors. An issuer does have control over its financial & debt management practices. These practices & other factors will impact an issuer’s credit quality & their borrowing costs.” (Respondent 11) “A local govt, can make sure that there finances are in good shape - so that they can receive a good rating for their bonds. Many investors are high quality buyers and will sacrifice yield for good quality.” (Respondent 12) “I agree with every item in the above statement” (Respondent 13) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 206 “ACTUALLY, THE ONLY CONTROL THEY HAVE IS WHETHER TO BORROW OR NOT. The market dictates their cost of borrowing. I agree with the statement.” (Respondent 14) The first sentence of the paragraph was underlined: “Is the price local governments pay to borrow money actually within their control? “To a certain extent, the interest cost to borrowers is within their control. If an issuer takes steps to improve their rating they will be rewarded by lowering borrowing costs. When an issue is priced in the primary market, it is priced most often in line with other issues of similar credit quality. If an issuer improves its rating to A from BBB, there will be significantly lower borrowing costs to the issuer.” (Respondent 15) “Yes, it is within their control to some extent. While it’s true the market will set the target rate issuers pay, how fiscally responsible they are will determine their rating and thus the spread the market will demand.” (Respondent 16) Question 2: Should issuers determine their selection of method of sale and/or which underwriter to use for a new municipal bond issue on the basis of the past performance of underwriters? Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 207 “Absolutely. Certain high grade issues benefit from competitive sales while other lower quality issues or issues that need intense financial work (advance refundings) can benefit from a negotiated sale through a certain dealer (underwriter) with a proven track record.” (Respondent 1) “If a governmental entity had good success with an existing underwriter relationship, they should continue with that underwriter unless the new bond issue is of the security type for which the underwriter has no experience pricing or selling.” (Respondent 2) “Past performance should be one consideration. As I mentioned above, issuers may be better served by pursuing the sale of bonds in a competitive bid fashion.” (Respondent 3) “Yes - some underwriters do a better job selling certain types of bonds.” (Respondent 4) No written response. (Respondent 5) “As well as other factors, including size & complexity/risk of issue, specialization and current personnel experience of underwriters.” (Respondent 6) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 208 No written response. (Respondent 7) “While not the only indicator of what method of sale or underwriter to choose past experience should be an important consideration.” (Respondent 8) "Looking solely from the issuer perspective, I believe competitive sales result in lower overall interest cost to the issuer. This presumes that it is a 'clean' transaction." (Respondent 9) No written response. (Respondent 10) “The ability of an underwriter to successfully price & place a deal should be considered when an issuer is selecting an underwriter.” (Respondent 11) “Yes. Underwriters need to price the asset at a level that will assure a good reception by the market. If they have been successful in the past it is fair to assume they can do it again.” (Respondent 12) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 209 “Yes. the underwriting business has become specialized, therefore it maybe difficult to have a firm that specializes in equity underwriting to issue Muni’s” (Respondent 13) “Yes. They should go to the underwriter with the lowest cost.” (Respondent 14) “Issuers should choose the method that gets the deal sold at the lowest borrowing cost but may have to use a negotiated deal due to the complexity of the deal being sold. That’s why G.O. bonds and school bond issues are often sold competitively, due to their “plain vanilla” features.” (Respondent 15) “Yes. Different underwriters have different strengths & weaknesses when it comes to selling bonds. Finding the best fit can save money.” (Respondent 16) Question 3: “What are the primary criteria that factor into vour decision to purchase a band series? Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 210 “Credit Quality of the issuer (financially, economically, etc.) and liquidity in the secondary market. This liquidity is often provided by the street or the underwriter that brought the deal.” (Respondent 1) “If we can ‘live’ with the credit risk, whether or not we are adequately being compensated for the risk we are assuming.” (Respondent 2) “Once the chief investment officer has determined that municipals represent value, we analyze our current portfolio to determine which maturity(s) of the new bond is appropriate. Analysis of particular issues includes the strength of the entity (GO, Revenue Bond are looked at differently); the quality of management; financial status; feasibility of any projections; and comparative value vs. other comparably rated bonds.” (Respondent 3) “maturity, coupon, original issue yield, call features, credit rating, credit enhancement, sector, state, and region” (Respondent 4) No written response. (Respondent 5) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. 211 “Yield, bond structure (coupon maturity, call) and credit quality. Also state tax exemption factor.” (Respondent 6) No written response. (Respondent 7) “Comparison of yield, against comparable taxable product, maturity structure, credit quality.” (Respondent 8) "(1) Price (2) structure (3) size of blocks (4) state that is issuing debt" (Respondent 9) No written reponse. (Respondent 10) “a) available cash/portfolio contributions b) structure of bond issue c) deal pricing” (Respondent 11) “The most important criteria is quality. We only buy high quality (AA or better) municipals.” (Respondent 12) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. “Because of the tax savings. (We only buy Muni’s)” (Respondent 13) 212 “Anticipated int rates, debt ratios for issuers, portfolio needs, structure of the issues.” (Respondent 14) “From an analyst standpoint, we try to find bonds that may be undervalued from a rating standpoint, i.e., bonds may be upgraded within the next several years. We also look for bonds with a stable rating outlook. Our ratings and outlooks often differ from the rating agencies.” (Respondent 15) “credit quality, yield level, portfolio needs” (Respondent 16) Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

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Creator Creel, Marguerite Russell (author)

Core Title Municipal bond issuance: Institutional investor expectations and underwriter selection in an issuer's market

Degree Doctor of Public Administration

Degree Program Public Administration

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag business administration, management,Economics, Finance,OAI-PMH Harvest,Political Science, public administration

Language English

Contributor Digitized by ProQuest (provenance)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-75175

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Legacy Identifier 3018069.pdf

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Document Type Dissertation

Rights Creel, Marguerite Russell

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