Thursday, December 07, 2006

Not your daddy's bond daddy...

Consolidation on Wall Street has pushed out a lot of smaller brokerage firms. Right here in Baltimore, we used to have multiple prominent regional brokerage firms such as Legg Mason and Alex Brown. Both are gone. Today it is difficult to compete with the cost advantages that firms like Merrill Lynch or Morgan Stanley enjoy.

But there remains one area where regional firms have the advantage over the big shops: municipal bonds. Not necessarily the big billion dollar state deals, which do exist in the muni market, but in the smaller deals which make up the majority of the market.

A firm like Merrill Lynch isn't set up to do a $20 million muni deal. There isn't enough in it to make a difference in the bottom line. Enter the smaller dealers, for whom $10-$50 million deals are just the right size.

Of course, municipal deals and corporate deals are very different. In a corporate deal, the corporate executives have a personal financial incentive to minimize interest cost. In a municipal deal, the municipality's finance people may be morally obligated to seek the best deal, but they have no personal incentive. Which opens the door for unscrupulous bond dealers to use political donations, entertainment, and outright bribes to influence how business is awarded.

There used to be a cadre of smaller dealers in the south referred to as "bond daddies," which were known for operating in a "mutual back scratching" fashion. For me the term conjured images of muni investment bankers and local politicians sitting around smoking giant cigars and sipping mint juleps. At some point the banker offers a generous campaign contribution to the politician and says "Now, don't you think this road needs repaving? I'm sure we could float a bond issue to cover the costs..."

If you talk to anyone at Stephens or Morgan Keegan, they will probably laugh at your quaint story about the old "bond daddy" days. But I hear tell stuff like that still goes on in the muni market. Yes, according to the Wall Street Journal and federal regulators, some bond dealers are still willing to spend money to make money, even if the spending money part involves bribery. And it may be that firms north of the Mason-Dixon line have learned a thing or two about garnering new business the old fashioned way.

Federal regulators are not well equipped to deal with this problem for the same reasons that Merrill isn't well equipped to sell $10 million bond issues. The Feds like going after big targets, but the big boys don't make enough money in the muni business to bother with underhanded dealings. Its the small firm with 10 offices scattered across one state that are more likely to be doing something untoward to win deals. Does the IRS or SEC want to sent investigators out to the 1,000 firms like that to find the 2 or 3 that are guilty? If you are a Federal prosecutor, you don't make your career by going after corporate criminals no one has ever heard of and are guilty of a crime no one cares about.

Here is the bottom line. The muni market is a dank and sometimes seedy place. More retail customers get ripped off when buying munis than any other single product. The fact that each bond is so unique and trades occur in small sizes means that the market is far less efficient than other areas of the bond market. In terms of the whole bribery thing, its a classic example of what happens when you give someone power but no financial incentives. This occurs in all sorts of governmental posts all over the world.

4 comments:

Anonymous said...

OT Tom, As a long time momentum ranker you piqued my interest with your rankings over at roger's blog. I used to just look at a performance chart when I had less choices with 401k plan. Now, I'm at Fidelity; a ton of etf choices. I'm using their software and doing a little programming. It calls for assigning points to 5 different ROCs(10,30,55,100, and 150)Points are ascribed if the Roc beats the comparable Roc for a benchmark like a total mkt etf/VTI(easily changed). The middle three Rocs get two points. The roc(10) is underweighted with one point and the roc(150) is overweighted (less sure about this choice) with three points. Any suggestions or commentary welcome . p.s.still curious if you have heard of the asset manager mentioned to you. Thanks, Bill

Tom G. said...

Bill

I think you have me confused with someone else. I don't do anything with momentum investing.

Anonymous said...

tom k an tom g...shure do have you guys confused..I think that I picked up on both of you guys from random roger's blog..but was it you that I emailed about an asset manager in Bethesda...just looking for word of mouth opinion, particularly if positive, thanks, bill

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