MSRB Rule G-15 and FINRA Rule 2232 require broker-dealers to disclose markups on bonds.
This guest post was written by William R. Gurtin, CEO, CIO, Managing Partner
at Gurtin Municipal Bond Management
Hallelujah! The municipal bond market is finally inching its way into the 21st Century! It has been a long time coming.
The Great Con
I began my financial services career in 1985 as a naïve 25-year old with no investment experience; this was a time I often refer to ingloriously as “the wild, wild west” in the brokerage industry. Many of the aberrant acts by brokers from this period — from insider trading to egregious markups on over-the counter stocks — have been well documented, adjudicated, and properly regulated. There is, however, one perfectly legal remnant of this time, housed shamelessly in the “sleepy” municipal market, which to this day has gone completely untouched — I call it “The Great Con.”
Allow me to paint the picture for you. Back in 1985, brokers were most often found on the phone with a retail mark, brazenly peddling financial products and promoting pronouncements such as the benefits of buying municipal, corporate, or even Government bonds through their firm’s trading desks. “This is one of those things that really is too good to be true,” brokers would profess confidently and unequivocally. A pause generally followed, and then came the killer line, “Trust me; we sell the bond to you at the same price the institutions pay; it’s like going directly to the wholesaler.”
Sadly, what I describe above was not a one-off con. I personally observed brokers delivering this same message with equal aplomb at firms throughout the industry. And mind you, it was completely legal; though, in my opinion, the assertion was not presented in an entirely ethical manner.
As we all know, anything that seems too good to be true generally is, and this was no exception. In fact, brokers were buying bonds directly from their firm’s inventory and then “marking up” that bond to a higher price for sale to their retail client. The trade was reported as a “net” trade, with no corresponding commission reported on the client’s confirmation statement. The spoils of the markup were a handsome commission pocketed by the broker with zero transparency and zero accountability. The “Great Con,” so ridiculously easy to pull off in 1985, was complete. Remarkably, these deceptive practices have been mostly left unchecked — at least until May 14th when MSRB Rule G-15 kicks in.
FINRA Rule 5.3 set the maximum allowable markup on bonds at 5%, with no obligation for transparency. Thus, for a $100,000 bond, it was completely legal to pocket an undisclosed markup of up to $5,000!
While not 5%, our research suggests that, today, the average markup on retail trades of municipal bonds is more than 1% (markups of thousands of dollars are commonplace), as outlined in our March 2016 white paper on municipal bond dealer markups. Those numbers, when added up over years and years, is a far cry from a free lunch. Brokers executed all these trades, through all these years, with no duty of disclosure to the retail client. They mercilessly exploited the “Great Con,” which regulators knowingly enabled.
What will be the likely impact of the new regulations?
On May 14, 2018, MSRB Rule G-15 and FINRA Rule 2232 will require bond markups to be reported on client statements and confirms analogous to the manner in which commissions are reported on stock trades. When bond commissions — similar to stock commissions — magically begin to appear on trade confirms, financial advisors at banks and brokerage firms, who had previously not been disclosing markups or commissions on past retail trades to clients, will likely start to ponder two options. Unfortunately, neither of the two following options will be particularly easy to “sell” to a client who has been brainwashed on the benefits of buying from their firm’s inventory:
1. Buy a bond for a client and pray he doesn’t notice the commission.
2. Suddenly espouse the benefits of municipal bond mutual funds and SMA Managers (either internal or on their firm’s retail platform).
In either case, the advisor will still be compensated, as long as the funds remain within their purview, albeit likely with a fraction of the compensation they had been receiving in the past.
My best guess is option No. 1 will prove to be unpalatable, and monies will ultimately flow to SMA Managers and mutual funds. Due to direct retail trade flows evaporating, I believe we will likely see a cascading impact on the municipal market, involving the following:
1. Banks’ drastic reduction of their municipal bond inventory and of their resources dedicated to municipal bond trading (this will ultimately include not only traders, but also strategists and research analysts)
2. Impaired liquidity for those investors who are unequipped for the future and who lack access to the vast trading network and technology necessary to effectively facilitate trades in this new era
3. Unimpaired liquidity for dedicated municipal managers who have invested in the future through technology linked to vast trading networks
If you need evidence for these assertions — we are being flooded with resumes from municipal professionals employed by banks and brokerage firms looking to move to the buy side.
The Opportunities and Risks
Opportunities for Wealth Managers (and, Directly or Indirectly, for Individual Investors)
MSRB Rule G-15 represents a rare opportunity for registered investment advisors, or independent wealth managers, who avoid the retail brokers’ (aka financial advisors at a bank) inherent conflicts of interest, by being compensated with a fee for either time spent or as a percentage of assets under management. The new regulation regarding markups opens the door for wealth managers to reengage with potential clients that made the naïve assumption that they were “getting a great deal” by buying bonds through their broker as well as current clients that left their bond portfolio with their long-time broker out of a sense of loyalty or inertia.
In the Gurtin spirit of “show me — don’t tell me,” we can help you show these existing and potential clients the markups paid. We have designed technology that provides our research opinion on each individual obligor, and we can also determine the markups a broker has charged on each individual purchase. All we need is a list of the bond holdings’ purchase date, original price or cost, identifier (CUSIP number), and position size. Please explore the sample client-ready analysis we can provide on demand.
Having traveled around the country for years meeting with independent wealth managers, I know we all share a common passion for bringing professionalism and transparency to the investment experience for individual investors. By making certain that individual investors are made aware of the markups now made visible by MSRB Rule G-15, I believe together we can bring clarity to a previously opaque and shadowy culture that regulators enabled and that banks and brokerage firms exploited for decades! A way to repair investors’ fractured trust, while also capitalizing on a great business opportunity? It just doesn’t get better than this.
Risks Specific to Independent Wealth Managers
The risks that MSRB Rule G-15 presents to independent wealth managers are limited to those who have historically purchased bonds from bank inventories as a service on behalf of their clients and who do not have the size, scope, resources, and technology that will be necessary for the new municipal landscape that lies ahead. For wealth managers sourcing bonds through relationships with banks and brokers, one risk is simply not being able to benefit from MSRB Rule G-15; notably, MSRB Rule G-15 does not require direct transparency on markups for trades to independent wealth managers. Another, perhaps greater risk, is potentially significantly deteriorated access to coverage, limited future bank inventories of municipal bonds, and impaired liquidity. In my opinion, it is logical to conclude that:
1. Fewer bonds will be available to build client portfolios, due to banks seeing reduced retail flows and thus holding less inventory.
2. Banks will be less willing to buy bonds back from you, as they will not want to add the bonds to their own inventory.
3. Institutional municipal salesmen, with little monetary incentive, will be less willing to work with independent wealth managers buying smaller lots, because brokers’ margins will be razor-thin without their extensive internal inventory.
My expectation is that banks and brokers will begin to carry less bond inventory, likely serving almost exclusively as an intermediary and facilitating trades through bids-wanted and offerings over the vast network, in which sophisticated municipal money managers traffic.
Risk for All Investors
Finally, in my opinion, reduced liquidity is a risk that all investors in bonds of credit-stressed obligors will bear. There will no longer be a vast, unsophisticated network of retail “marks” on which to pawn off the high-yield bonds of obligors in the midst of a material decline in credit quality. (Puerto Rico is a great example.) From firsthand observation, these sorts of bonds were commonly marketed heavily to retail investors — in no small part due to their having far juicier markups for the broker than the average, plain-vanilla, high-grade municipal bond.
Unfortunately, investors holding these bonds, which will now be forced to trade purely on fundamentals, will no longer benefit from the liquidity safety net, enabled by an unsophisticated retail network, which bank inventories previously provided. This will only amplify the necessity of having access to extensive, forward-looking independent research and ongoing surveillance capabilities.
This Is a Time to Celebrate!
This is a time to rejoice, as is each time that transparency and professionalism are brought back to the financial industry. It is continued validation of our shared mission: empowerment for the individual investor as well as access to the same quality, protection, and respect for the individual investor, as is afforded the institutional investor. To the regulators, thank you — but what took you so long?!
William R. Gurtin
CEO, CIO, Managing Partner
Gurtin Municipal Bond Management
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