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.