There is a novel, called "The Financier," that I'd recommend to anyone working in the municipal bond business today. It bears a lesson for those industry regulators who hope to clamp down on the selection of negotiated underwriters in the wake of the recent scandals in New Jersey and Massachusetts.
The story concerns a banker, Frank Cowperwood, an ambitious up-and-comer whose growing list of clients includes the elected treasurer of a large municipality with significant public funds to invest. Cowperwood is not dishonest, but he is prone to overextending himself: in his ambition to compete with the larger players in the market, he sets complex schemes in motion.
The treasurer agrees to back a series of highly speculative investments that, under normal market conditions, would offer handsome rewards. However, a financial panic forces Cowperwood to cover his options, the extent of which he had not fully disclosed to the treasurer. He asks for additional funds to invest, primarily to save the funds already invested. The treasurer balks, out of ignorance of the complexities and out of fear of scandal.
Cowperwood, in desperation, transfers certain available municipal funds to his own account, which he fully expects to repay when the panic subsides. Political cronies become aware of the situation and, fearing any scandal that could bring down the party in the upcoming elections, sacrifice Cowperwood, notwithstanding the treasurer's role in the affair.
These party hacks enlist some of Cowperwood's rivals, who are quite willing to assist in his demise. Jealous of his acumen and connections, they hope to profit from a desperation sale of his assets. They feed all the appropriate information to an overzealous district attorney who is looking to make headlines. In the end. Cowperwood, who by now has restored all the borrowed funds, is found guilty on a range of technical charges. He is publicly disgraced and sentenced to jail. The treasurer receives a mild rebuke, and the political party weathers the election unscathed.
"The Financier" is not a modern page-turner you'd pick up at the airport bookshop. In fact, the novel was published in 1912. Its author, Theodore Dreiser, who also wrote "Sister Carrie" and "An American Tragedy," based the novel on the life of Charles T. Yerkes, who was active in municipal bonds just after the Civil War (the above-mentioned financial panic is a result of the Great Chicago Fire in 187 1). Yet the characters portrayed by Dreiser could step onto a modern trading floor and fit right in.
The municipal market is characteristically one in which individuals play a large role. It is a market of strong personalities, both client and banker alike, who are defiant in exercising their right to associate and conduct business with others based on a sense of personal trust and lovalty.
Unlike corporate finance, where relationships between firms tend to dominate those between individuals, the public finance business is greatly influenced by "who you know." In corporate finance, the banker "is assigned to work an account." In municipal finance, one is more likely to hear that the banker "is close to the client." Hence, one routinely sees municipal clients follow their banker from one firm to another. Likewise, when clients change jobs, the existing banking relationship goes along too.
There have been many explanations for this phenomenon. I've heard it suggested that financial officers in the public sector are politicians first and financial officers second. How they appear to the voting public is more important than how they execute their jobs. And most good politicians would have little patience for the municipal market: It is rife with arcane rules and prohibitions based on seemingly unintelligible tax laws. It is also a quickly moving market, where opportunities appear in an instant and innovations are dreamed up to address them. The banker must be part soothsayer, part savant, and part shaman. Is it any wonder that at the core of most banking relationships in the municipal market is personal trust?
Critics of the negotiated underwriting process, where a single underwriter is designated upfront to manage the bond deal, are always suspicious that such designations are won not through personal trust based on good advice, but rather through political contributions, fundraising, or personal favors.
In New Jersey, for example, the opportunity for quid pro quo is certainly evident, as it is in many states: The governor has the right to appoint members of key issuing authorities, who in turn have the opportunity to carefully observe which bankers are active in the state. In cases where this opportunity is abused, bagmen are never far from the designation of the underwriter, sometimes "suggesting" a timely political contribution or an allocation of bonds to another securities firm more politically connected. In New Jersey, rumors abound that such influence peddling went as far up as a trusted aide in the governor's office.
In Massachusetts, Mark Ferber, an ambitious banker and financial adviser engaged by several prominent municipal issuers, has never been formally accused of steering business. But he failed to disclose to his clients that he had been accepting fees for advising the very same banking firms with whom the issuers had extensive and lucrative relationships. To the press, the politicians, and his rivals, this had all the appearances that he set himself up as a gatekeeper.
In both situations, the bankers were sacrificed: In New Jersey, a former banker who served as a prominent aide to the governor resigned over as-yet unsubstantiated allegations of influence peddling; in Massachusetts, the firm for which Ferber served as co-chairman. First Albany, fired him when it was released as adviser to one prominent issuer and excluded from underwriting bonds for two other large clients.
In both cases, it is interesting to note that the clients and the banker's firms defended their men to the end. The personal ties built up over years reinforced the banker-client relationship against attacks by press and competitors until the potential damage was overwhelming.
Things have changed now in both states. In New Jersey, in this election year, the governor's knee-jerk reaction has been to require that virtually all bond deals issued by state authorities and agencies must be awarded through competitive sale. This sweeping order includes many deals for which market practice has always favored negotiated offerings, such as lower-rated health-care issues and intricate advance refundings.
In Massachusetts, requests for proposals to serve as underwriter or adviser to the large issuers have appeared with elaborate disclosure requirements on any fee-splitting or shared underwriting arrangements with other firms. Industrywide, we are seeing a cry for wider use of competitive sales.
And the Municipal Securities Rulemaking Board has released for comment a series of rules that prohibit bankers from making political contributions with the intent of purchasing access to the deal.
Such precautions do not address the many reasons why some bankers always seem to get the business: They're smarter, they're more aggressive, they come from the client's old neighborhood, they know everyone in the party. The attempt to force wider use of competitive sales furthers the efforts to reduce the municipal bond market to a commodity business, devoid of personality and ruled by price alone. It will also slow the introduction of valuable innovations and render obsolete much of the personal trust that built the business.
Such precautions, while well intentioned, will never address what truly drives the client-banker relationship. Nor, unfortunately, will they thwart those who would use the system for their personal gain. For example, the MSRB guidelines, which rely on proving the banker's intent, are widely held to be virtually unenforceable. If applied to Frank Cowperwood in "The Financier," it would have been a tough call: His intentions were deemed to be honorable, but his methods were not.
Nor will these precautions keep the truly ambitious among us from rising again. It is worth noting that Dreiser's subsequent novel, the second of the Yerkes/Cowperwood trilogy, follows the banker after he emerges from prison. It is entitled "The Titan," and it chronicles how Yerkes amassed a great fortune in the municipal bond business, the same one that tried in vain to crush him.