Corruption in the US Municipal Bond market

American Municipal Bonds (Munis) market, through which local governments raise money for public infrastructure projects, has been the envy of the world. It offered an excellent window for raising the huge resources required to fund these projects. Now it is emerging that the Munis market may have been afflicted by serious corruption and nepotism.

Federal investigators in the US appear to have uncovered possible bid-rigging, tax evasion and other wrongdoing throughout the $2.6 trillion tax-exempt municipal bond business, that may have had the effect of imposing layers of excess cost on local governments who may have paid more than what was required for raising the resources.

It is now emerging that banks and other companies that have helped state and local governments take approximately $400 billion worth of municipal notes and bonds to market each year did not engage in open competition for this lucrative business, but secretly divided it among themselves, violating the federal rules for tax-exempt bonds and making questionable payments and campaign contributions to local officials who could steer them business. The use of financial derivatives in combination with municipal bonds have made the market even more opaque.

The Munis market has suffered by way of credit rating agencies assigning lower ratings than similarly placed corporate debt issues, thereby raising the cost of capital besides forcing the issuers to take insurance policies that safeguard their bonds in the unlikely event that they fail to pay the debt. The rating agencies benefitted by evaluating both the original and the insured bonds and insurance agencies receieved handsome bond insurance premiums. A vicious cycle gets generated - credit rating agencies give cities lower ratings, necessitating insurance at higher premiums, thereby increasing the cost of capital and straining municipal finances, and ultimately lowering their credit worthiness.

The use of derivatives in connection with municipal bonds has grown rapidly in the last five years. The packages are presented as money-savers to the municipalities, which may want to protect themselves against interest rate changes. Interest rate swaps, linked with the bonds, were used extensively to hedge for risks. But over the last year, as turmoil spread through the credit markets, some of the derivatives have blown up, leaving local governments stuck with unexpected costs. One of the issuing agencies, Jefferson County is now at risk of declaring what would be the biggest governmental bankruptcy in United States history.

For long, the Munis were seen as one of the safest and most attractive investments options for fund managers, including hedge funds and foreign investors, much to the surprise of everybody. Now, with all the aforementioned issues coming into the open, it is clear that Munis were exposed to the same fraudulent practices as the other parts of the financial markets.

Update 1
Since households own a third of all the Munis, the Municipal Securities Rulemaking Board, which regulates the issuance and trading of Munis has called for more powers to effectively regulate the Munis market.