To assess current market practices, Finra demanded on June 30 that firms provide detailed information about derivatives transactions they have underwritten or issued involving municipals, including the issuer name, the type of instrument, its value and the role the firm in question played in the transaction. Moreover, firms will have to reveal whether they recommended the use of the instrument, the due diligence they performed on the instrument and the compensation they earned from the deal.
At the same time, Finra launched two separate investigations into other areas of the municipal bond market. First, the regulator is examining municipal bond sales practices to retail investors by requesting firms provide details of retail transactions from the first quarter of 2009, including the documents and memoranda customers would have been presented with when entering into the deal.
Second, Finra has asked firms for information regarding the sale during 2008 to retail investors of municipal gas bonds that were underwritten and guaranteed by Lehman Brothers. One series of the Main Street Georgian gas bonds defaulted and came under scrutiny after Lehman collapsed in September 2008; however, other similar bonds are still being traded.
On the same day, Finra issued a regulatory notice to securities firms and brokers, as well as a set of guidelines to municipal bond investors, in an attempt to encourage best practices in the market. The warning to sell-side firms underlined the need to disclose all material information to investors, as well as ensuring the suitability of a product for retail clients. The advice to investors illustrated the potential risks of municipal bonds and provided guidance for those looking to invest in the market.
"Finra is taking concerted action to ensure investors are aware both of the risks and the benefits that might be associated with muni-bond investment. Firms should also be aware of their responsibilities," said Finra chief executive Richard Ketchum in a written statement.
The problems around municipals' use of derivatives have been well publicised over the past 18 months. In the Obama administration's Financial Regulatory Reform report released on June 17, the US Treasury wrote: "The securities laws should be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities."
Towards the end of 2008, some US municipals were forced to pay hefty termination fees to end rate swaps they had undertaken. However, these losses were small compared with those of Jefferson County, Alabama in mid-2008. The municipal had issued $3.2 billion in floating-rate debt, predominantly in auction-rate security (ARS) paper, overlaid with interest rate swaps worth $5.4 billion. But these swaps did little to protect Jefferson County from the collapse of the ARS market in the first half of 2008: it was landed with losses of hundreds of millions of dollars.
Elsewhere, the US Treasury has taken steps to protect consumers by creating its own Consumer Financial Protection Agency (CFPA), which was first mooted in the Regulatory Reform Report. On June 30, the legislation for creating the agency was delivered to Capitol Hill.
"The agency will be dedicated to looking out for American families when they take out loans or use other financial products or services. For the first time, a single agency will have authority to examine and enforce compliance against any institution, bank or non-bank, that provides consumer financial products or services," stated the US Treasury.
"By consolidating accountability in one place, we will reduce gaps in federal supervision and enforcement, drive greater clarity in the information consumers receive around products they are sold, set higher standards for those who sell those products and promote consistent regulation across the system," said US Treasury secretary Timothy Geithner in a written statement on June 29.