BusinessTN

Some time soon, one of the most powerful boards in Tennessee government will adopt a series of new guidelines for overseeing the state municipal bond market.The guidelines were drawn up by the office of state comptroller Justin P. Wilson in response to a market situation that, though it stopped short of an all-out meltdown, still found its way into the pages of The New York Times.

"State official revises guidelines to prevent future financial mishap" might seem all too common a headline in these days of burst real estate bubbles, stock market upheaval and Ponzi schemes, but in this case, the devil, and especially the drama, lies in the details. If Wilson has his way, the revised guidelines will discourage conflict-of-interest-prone behavior from financial entities while protecting municipal officials from their own ignorance.

Davids and Derivatives
In its Apr. 8, 2009, edition, The New York Times published a story taking to task Memphis-based investment bank Morgan Keegan, a subsidiary of Regions Financial Corp., for its role in marketing risky municipal bond derivatives to small cities and counties across the state. The piece spotlighted tiny Lewisburg, which had entered into variable rate bond deals, with third-party swap agreements put in place to protect against rising interest rates. When times were good and interest rates were low, Lewisburg and other small governments were saving money on re-payments.

But when the worldwide financial markets were stuffed inside a blender and set to puree in 2008, that all changed. As a result, Lewisburg officials were now facing quadrupled annual interest payments on the bond coming in at $1 million. At first glance, as bad as the town's gamble had turned out, it would seem just that--a gamble.

But in this case, Lewisburg officials did not feel they had been fully informed--or at the very least conscientiously advised--by their financial advisor. Morgan Keegan had not only recommended the deal as a golden opportunity, it had then played three separate roles in ensuring the municipality entered into the agreements.

Morgan Keegan taught the state-approved seminar attended by Lewisburg's full-time pharmacist and part-time mayor. Morgan Keegan served as the contracted-out financial advisor to the city of Lewisburg. And, to top it off, Morgan Keegan was the underwriter for the issuance of the variable rate bonds.

A Rate of No Return
Lewisburg was not the only municipality for whom Morgan Keegan served multiple roles. Nor was it the only one that found itself in a bond-related dilemma. Three days before a city commission meeting in February, officials of the Nashville suburb of Mt. Juliet received a draft of a resolution prepared by bond counsel at the law firm Bass, Berry and Sims. The resolution, prepared at the behest of Mt. Juliet's financial adviser, Morgan Keegan, offered a course of action to fix $6.6 million in adjustable rate municipal bonds that had been called by financial giant J.P. Morgan. The quarterly principal payment on the bonds, which became bank bonds after they were called by J.P. Morgan, would be about $150,000, and city officials had until March 1 to act. For a city with an operating budget of about $11 million, such payments would be crippling.

Recognizing they lacked the financial expertise to determine the best path forward, Mt. Juliet commissioners and city officials initially looked to their financial advisor for options. A Morgan Keegan representative suggested a similar version of the variable rate deal that had put Mt. Juliet behind the eight-ball in the first place.

In a February meeting, Morgan Keegan provided the commission with a 45-minute presentation explaining the predicament and offering possible solutions. When someone suggested switching to a fixed-rate loan, a company representative scoffed at the option.

For Mt. Juliet city attorney Jason Holleman and finance director John Rossmaier, the reaction, and the solutions offered, didn't sit well. At the same time, though, neither knew the best course to fix the problem. Finally, the city decided to look elsewhere for expert advice, hiring Little Rock, Ark.-based The Stevens Group as its new financial adviser.

The city's new adviser recommended the very thing Morgan Keegan had dismissed--that Mt. Juliet opt out of its bond deal and switch to fixed-rate debt. The end result appears to have saved Mt. Juliet significant money. According to Rossmaier, Morgan Keegan quoted to the city a $642,000 price tag to terminate the swap agreement. The city ended up paying "just" $202,000 and entering into fixed-rate debt with an interest rate of about 3.7%. (It bears mentioning that in addition to serving as Mt. JulietÕs financial adviser, Morgan Keegan was the city's bond underwriter, as well.)

"They were our financial adviser, but then they were also the underwriter," Holleman says. "Their advice was basically for us to keep using them."

Mt. Juliet has a new city policy to separate its financial adviser from its underwriter.

For their part, Morgan Keegan officials insisted that such variable rate agreements had yielded substantial savings for numerous other counties and cities throughout the state and that only an unprecedented plummet in the global bond market had led to the situation in which municipalities like Lewisburg, Mt. Juliet and others found themselves. In a one-page response to the Times article, the financial giant attacked what it considered to be multiple factual errors and exaggerations in the story. These ranged from the efficacy of the Morgan Keegan-led seminar, the relative stringency of Tennessee's regulatory environment and the effectiveness of such swaps in general.

Conspicuously absent was the recognition or denial that wearing three hats--those of educator, underwriter and advisor--creates an inherent conflict of interest between the firm and its clients. The response also seems to overlook that the role of educator carries with it more than just the transmission of information--there's also an obligation to gauge how well a lesson is being understood.

Three to Tango
Still, it would be unfair to put the blame solely in the laps of firms like Morgan Keegan. In the end, they are built to aggressively pursue business. Nor would it be fair to blame municipal leaders--the majority of whom are part-time government officials with "day jobs" that have little or nothing to do with finance.

Morgan Keegan and municipal leaders were not the only players in the bond derivative collapse. As the Times article pointed out, the comptroller's office approved all 215 swap applications submitted in the state from 2001 to 2008. That's either an astounding streak of solid applications or else evidence that the stamp of approval wielded by the comptroller's office was decidedly rubbery.

"It goes from one end of the state to another. . .with the Comptroller's office taking a very passive look the other way," says Emily Evans, a Council representative for Metro Nashville and a former bond underwriter. In the April Times article Evans added, "Tennessee was an unwitting conspirator in this whole mess."

No, when it came to assigning fault for Tennessee's municipal bond crisis, there was ample blame to go around.

The Man in the Muddle
To use a phrase like "perfect storm" to describe the straits entities like Lewisburg, Mt. Juliet and other local governments found themselves in would be as imprecise as it is cliché. Just as with the global financial meltdown, the municipal bond market crisis in Tennessee was less about an unforeseeable collision as it was about what happens when uninformed decisions are encouraged in an inert regulatory environment.

Nonetheless, it was this climate, and this mess, that new state comptroller Justin P. Wilson inherited upon assuming the office. Wilson's arrival in January 2009 was noteworthy in and of itself. The appointment of the former Sundquist administration deputy governor who had most recently served as partner at the Nashville law firm of Waller Lansden Dortch & Davis was only made possible after the historic 2008 election that gave Republicans control of the Tennessee General Assembly for the first time since Reconstruction. Once Wilson placed his name into the ring for the position of state comptroller, no other Republican in the state even ventured to apply for the job.

In addition to the freezing of new bond derivative agreements, Wilson immediately set about revising the state's existing guidelines regarding them.

The existing guidelines "reflect the world of 2002," Wilson was quoted saying in an April 10 story in The Commercial Appeal. "The world has changed since 2002."

Though the derivative agreements themselves might be complex, Wilson's approach to the guidelines concerning them isn't. They require that government employees be able to demonstrate financial proficiency--to prove they understand the bond deals recommended to them by outside advisers. They require a separate swap adviser for some deals, as well. And in what should be termed the "common sense provision," the guidelines require a separation of roles, along the same lines as instituted by Mt. Juliet. A firm will not be allowed to act as both adviser and underwriter.

The guidance and oversight provided by Wilson's office is welcomed news to many across the state, including Blount County Commissioner Wendy Pitts Reeves. In February, Reeves' county joined the "burned by derivatives" club when it transitioned $53 million in bonds from long-term, variable-rate debt to short-term, fixed-rate debt.

Though Reeves had questions about the fees the county would pay over the life of the loan, along with the risks associated, she felt like her concerns were cast aside by county leaders nervous about being perceived as ignorant about the government's financial operations.

"There is a lot of pressure on county commissioners and probably on city council people to not look stupid, to act like they understand when they don't," Reeves says. "You have people who come in and throw a lot of information and language at you, and you just want to go, 'I understand.'"

Wilson's recommended guidelines would not only provide local officials with help processing the deals, they would also provide the public with avenues to hold elected leaders accountable. Even in Mt. Juliet's case, the best-case scenario cost taxpayers over $200,000. When Blount County refinanced its debt, it cost $368,000.

"The guidelines we propose will have conflict-of-interest provisions and require a demonstration of competence either by internal staff or knowledge of outside advisers," Wilson says. "It will require a certain level of expertise in order to enter into these deals."

A Moment of Silence
If Wilson's ascendancy to the post of comptroller required an almost unprecedented upheaval in the status quo, his behavior since has been marked by a restraint almost as rare in these times of partisan vitriol. After all, any examination of the state's derivatives market of the last few years provides ample opportunities for finger-pointing.

Wilson certainly would not be the first public figure to seize upon the public's heightened distrust of financial giants to advance his personal profile. Nor would anyone consider it unusual were Wilson to tear into his Democrat-appointed predecessor--a ripe target--for party gain. Yet, thus far, Wilson is having none of that.

"I'm interested in studying what went on before in the sense of finding out what needs to be changed," Wilson says. "But I'm not interested in playing the blame game. I'm a future guy."

It's easy to appreciate the significance of things that happen. A volcano erupts. A bridge collapses. But there are moments just as remarkable for what does not happen, particularly when that inaction allows for action. Wilson's focus on learning from the past instead of profiting from it may be exactly what Tennessee municipalities need to ensure they have a brighter fiscal future.