According to a recent NY Times article has not only devastated thousands of individual investors with their once high flying RMK Funds but entire towns as well. A cut and paste of the article regarding Morgan Keegan’s investment banking practices appears below.
LEWISBURG, Tenn. — Five years ago, this small factory town was struggling to pay the interest on a bond for new sewers. Bob Phillips, Lewisburg’s part-time mayor and full-time pharmacist, was urged by the town’s financial adviser, an investment bank named Morgan Keegan & Company, to engage in a complex financial transaction to lower interest rates.
When a Lewisburg official attended a state-sponsored seminar intended to lay out the transaction’s benefits and risks, he was taught by investment bankers from Morgan Keegan.
And when Lewisburg decided to go ahead with the transaction, who was there to make the deal? Morgan Keegan.
In January, local officials were shocked to discover that annual interest payments on the bond had quadrupled to $1 million. Morgan Keegan, they said, did not serve them well in any of its roles.
“We’re little,” Mr. Phillips said, “and we depend on people wiser than us in financial ways to keep us informed, tell us what things mean, and I really didn’t think we got that.”
Lewisburg is one of hundreds of small cities and counties across America reeling from their reliance in recent years on risky municipal bond derivatives that went bad. Municipalities that bought the derivatives were like homeowners with fixed-rate mortgages who refinanced by taking out lower-interest, variable-rate mortgages. But some local officials say they were not told, or did not understand, that interest rates could go much higher if economic conditions worsened — which, of course, they did.
The municipal bond marketplace was so lightly regulated that in Tennessee Morgan Keegan was able to dominate almost every phase of the business. The firm, which is based in Memphis, sold $2 billion worth of municipal bond derivatives to 38 cities and counties since 2001, according to data compiled by the state comptroller’s office.
After The New York Times made inquiries, the Tennessee comptroller, Justin P. Wilson, ordered a statewide freeze on bond derivatives and a review of the seminar taught by Morgan Keegan and others.
Representatives of Morgan Keegan pointed out that they saved cities and counties money for years by delivering lower interest rates, and that the economic decline that created the turmoil in the bond market was beyond their control. Moody’s credit rating agency on Tuesday issued a negative outlook for the fiscal health of municipal governments.
In Washington, federal regulators are now considering ways to restrict the use of municipal bond derivatives. Regulators and some in the industry are challenging whether it is appropriate for large investment banks to engage small cities and counties in transactions that lower interest rates but carry higher risks.
“When these sophisticated things were created, most people didn’t think they’d ever be used by the smallest issuers, who had the least amount of resources and knowledge and experience to understand the risks,” said Thomas G. Doe, the chief executive of Municipal Market Advisors, a bond strategy company in Concord, Mass.
In Lewisburg, the fallout from the bad bonds confronted the city of 11,000 people at an inopportune moment. Unemployment just nudged past 10 percent, businesses like Penny’s Home Cooking are shuttered, and a sprawling new corporate park sits mostly empty. A nearby employer, Sanford Pencil, the maker of Sharpie pens, is preparing to move to Mexico.
Unlike most states, Tennessee was one of the few where the legislature passed a law intended to regulate the sale of these complicated municipal bond derivatives to local governments. But the profusion of those deals and the various roles of Morgan Keegan have left leaders of those cities and counties furious at both the firm and the state.
In Claiborne County, north of Knoxville, officials said they were recently told by Morgan Keegan bankers that extracting themselves from a municipal bond derivative would cost $3 million, a sum the poor county cannot afford.
“I told the Morgan Keegan man here in my office, ‘It seems to me, you are all trying to slip paperwork by us like a small, shady loan company,’ ” said Joe Duncan, the mayor of Claiborne County.
An Unpleasant Surprise
In Mount Juliet, a suburb east of Nashville, city leaders were surprised to discover that the payments on its bonds had increased by 500 percent to $478,000. Morgan Keegan offered to refinance the bonds, but the city hired a new financial adviser and another investment bank.
“We decided we needed advice from someone who was not trying to sell us something,” Mayor Linda Elam said.
Mr. Wilson, the state comptroller, told a State Senate finance committee two weeks ago that his office was examining the guidelines on municipal bond derivatives, including the “swap school” taught by Morgan Keegan and the Nashville law firm of Bass, Berry & Sims, which often served as the bond counsel.
An investment bank makes more in fees and annual income from derivatives than from fixed-rate bonds. Morgan Keegan has made millions of dollars in fees in Tennessee since 2001, but the precise number is not public.
“I think the multiple roles of a single firm is something we should look at, and there well may be limitations or prohibitions,” Mr. Wilson, who became comptroller in January, said in an interview. In hindsight, he said, it “may not have been the best idea.”
Municipal bond experts say they know of no other state where a firm was allowed to wear three hats; several states prohibit a single firm from acting as both adviser and underwriter. In Pennsylvania, which has such a prohibition, federal prosecutors are investigating accusations that investment banks and financial advisers conspired to sell bonds with inflated fees to school districts.
“It’s like the lion being hired to protect the gazelle,” Robert E. Brooks, a municipal bonds expert and a professor of financial management at the University of Alabama, said of the situation in Tennessee. “Who was looking after these little towns?”
Morgan Keegan said local officials were unfairly blaming them for the economic downturn. “People are upset; we’re upset, too,” said Joseph K. Ayres, the firm’s managing director. “We’ve been very successful helping a lot of communities try to weather this storm. Obviously, there are going to be a few disappointments. People are going to look to find a scapegoat. We’re big boys and girls. We understand that.”
Mr. Ayres denied that the firm had a conflict in advising municipalities and underwriting bond derivatives. He said that Morgan Keegan had taught the seminar at the request of the state and that they had offered unbiased descriptions of municipal bond options. He added that the firm had not marketed products during the sessions.
“I don’t think the course was skewed at all,” Mr. Ayres said. “It was designed to deal equally with risk and reward. The course was approved by the state comptroller’s office.”
Karen S. Neal, a lawyer at Bass, Berry & Sims, said the comptroller’s office had strictly monitored the seminars. “There was certainly no intent that they be biased one way or the other,” Ms. Neal said. “The intent was purely to educate people on the process, the mechanics, the legal requirements, the risks and the benefits.”
For decades, the tax-exempt municipal bond was considered as safe a way to raise money as it was to invest money. If a city wanted to build a bridge, a hospital or a school, it raised the money by issuing a bond and repaid investors over decades. Bonds were considered conservative and dependable.
Beginning in the late 1970s, big states like California began to use variable rate bonds as a way to save money. By the late 1990s, some rural counties and small towns jumped on board as a way to avoid raising taxes.
Not long afterward, interest rate swaps were introduced.
A swap allowed a municipality to keep a portion of its debt at a fixed interest rate and a portion at a variable rate. The municipality was, in effect, betting that interest rates would move in its favor. Investors protected themselves by taking out insurance that guaranteed they would be paid. But as the nationwide credit market collapsed, most of the bond insurers’ credit ratings were downgraded, including the Ambac Financial Group, the primary insurer of Tennessee bonds. That allowed the investors to accelerate the retirement of the debt, usually from 20 years to 7, leading to a steep increase in the interest rate.
Although such a provision was in the swap contract, several local officials said that possibility had not been explained to them.
The risks of the transactions were, in fact, on the minds of members of the Tennessee legislature in 1999, when they passed a law requiring a municipality to follow several procedures before receiving authorization from the comptroller to enter a swap agreement.
Even with those regulations, the comptroller approved all 215 swap applications submitted in the state since 2001. “Tennessee was an unwitting conspirator in this whole mess,” said Emily Evans, a Nashville City Council member and former bond trader who was a critic of her city’s swap deal on the bond for the Tennessee Titans’ stadium.
One of the most important provisions of Tennessee’s law was education. In 2000, the state comptroller at the time, John G. Morgan, appointed nine government and industry representatives to establish guidelines for derivatives and devise a curriculum for the swap school. The panel included two lawyers from Bass, Berry & Sims and a Morgan Keegan banker.
Mr. Morgan said he had asked business professors to teach the course, but they had declined. “So the job was left for the people who know the most about these intricate transactions — the people in the business,” he said. “I didn’t think there was a problem.”
State records show that the comptroller’s office approved course material submitted by Morgan Keegan and Bass, Berry & Sims. In 2007, the comptroller approved a 300-page course book in two days, the records show.
In a 177-page book used in 2003 and reviewed by several bond experts for The Times, there was far more about rewards than risks. On a page titled “Interest Rate Swap Risks” for example, there is no mention of the consequences of a downgrade in the bond insurer’s rating. Ms. Evans said the daylong seminars, held in Memphis, Nashville and Knoxville, amounted to “nothing more than an infomercial.”
The first page of a manual used at a 2007 seminar quotes the former Fed chairman Alan Greenspan extolling the virtues of derivatives in 1999.
Peter Shapiro, the managing director of Swap Financial Group of South Orange, N.J., said the material “certainly doesn’t have what we would consider the requisite amount of detail going through the risks, how they materialize and how you might attempt to mitigate them.”
Sheila Luckett, the city recorder in Mount Juliet, attended the swap school twice. “It was way over my head,” she said. “I’m not a bonds person. People with Morgan Keegan told me, ‘Don’t worry if you don’t understand it.’ ”
A ‘Good Thing’ Goes Bad
In many corners of Tennessee, the first anyone heard of interest-rate swaps was from C. L. Overman, a vice president of Morgan Keegan who assured officials that the deals carried little risk, city and county officials said.
“He told us it would be a good thing and there wasn’t much downside,” said Mayor Duncan of Claiborne County. He then laughed, adding, “When everything went belly up, of course, they told us it wasn’t their fault.”
Earlier this year, Claiborne County officials were told by Mr. Overman that they had only a few weeks to refinance an $18 million bond or pay a quadrupled quarterly payment of $700,000. Mr. Overman declined to comment for this article.
In Lewisburg, after Mr. Overman pitched the swap idea for the sewer project, Kenneth E. Carr, a city official, attended the class. “The seminar was dull and boring,” said Mr. Carr, who still has a copy of the book, stamped with the state seal of Tennessee on every page. “I thought, ‘Well, this is approved by the state because they put their seal of approval on it. This must be something they think is good for us.’ ”
Mr. Carr said he had not known the course would be taught by the bank and the law firm involved in Lewisburg’s deal. “It would have been better if someone neutral had taught the course,” he said. Even so, he said the officials making the decision never asked his opinion after the session.
Connie W. Edde, Lewisburg’s finance director, said she had assumed the city would reject the proposal because “it was a big risk.” But hours before the City Council was to meet on the plan, Ms. Edde said, she saw the city’s superintendent for water and sewage return from lunch with Mr. Overman. The superintendent “announced that he decided this was now a good idea.” That evening, the plan passed.
Mr. Ayres, the Morgan Keegan managing director, pointed out that Lewisburg had benefited from a relatively low interest rate of 2.5 percent, a rate that did not include the firm’s fees.
This year, with residents facing a 33 percent increase in water and sewer rates, the city decided to refinance the bond, dropping Morgan Keegan and hiring another financial adviser. Mayor Phillips said the city would use fixed rate debt on its new bonds. “Nothing that says derivative, nothing that says swap,” he said. “We learned our lesson.”
The attorneys at Colling Gilbert Wright & Carter are currently investigation and filing claims against Morgan Keegan alleging misrepresentation and unsuitability in the solicitation and sale of several investment products including the Regions Morgan Keegan (RMK) family of bond and income funds. If you have lost money related to investment advice from a Morgan Keegan representative, please contact our office for a free case evaluation.