Voice from the Past
Chapter 16

One day in 1960 or thereabouts I got a call from Dave Lawrence, then head of the municipal bond department of Boettcher and Company in Denver, who wanted to talk about some proposed financing. He really wanted to talk with my senior partner, Joe Matter, who was out of the country; yet he was willing to discuss his plan with me. I agreed to see him, and none of our lives has been the same since.

We discussed the situation in the City of Phoenix, which had issued two series of water revenue bonds, first and second lien, with no provision for additional parity bonds. These issues were not yet callable for redemption, and the City needed to finance more water system facilities. Mr. Lawrence had heard of a practice in Alabama in which an issuer delivered refunding bonds several years before the refunded bonds could be redeemed, invested the proceeds in government bonds, and was able to sell junior lien refunding bonds as if they were first lien bonds by convincing investors that the revenues of the system would not be needed to pay the prior lien bonds. The interest on the government bonds would more than cover the interest on the refunded bonds, so the issuer would not have to pay interest on both issues at the same time. He wondered if this could be done in Phoenix.

I had learned not to say no to a client unnecessarily, so I took the easy way out by saying that the proposed financing could be done with authority from the State Legislature. He said, to my surprise, that obtaining legislation would not be a problem. I couldn't think of any constitutional objection, and so my advance refunding career was born.

Although it was known that the government bonds, bearing taxable interest, would bear a slightly higher rate than the tax exempt refunding bonds, most of the people involved in the transaction did not, at that time, realize that the difference could, in a carefully structured transaction, be wonderfully magnified by the magic of compound interest. When this information got out, it was mostly used in the West for a few years. The number of advance refundings was limited by the availability of underwriters and bond lawyers who knew how to do them. Whether or not a given refunding made sense otherwise, the arbitrage was enough to make it profitable for all concerned.

The original dealers were sensitive enough about public opinion and their view of their rightful place in society so that they didn't engage in many transactions that the local newspapers considered abuses. I suspect that the staffs of the local newspapers didn't pay much attention to the arcane aspects of the Federal-State relationship involved, and that the public, if it thought at all about the matter, would have approved of making money at the expense of the Federal Government. In time, of course, people in other parts of the country found out about the practice and imitated it. Someone had the lack of judgment to ask the Internal Revenue Service for a ruling on a particularly abusive transaction.

On August 11, 1966, the Internal Revenue Service whelped a Technical Information Release -- TIR 840. This was really just a press release, but it said that pending a study, the IRS would not grant any rulings on the tax exemption of municipal bonds in situations:
"1.Where all or a substantial part of the proceeds of the issue (other than normal contingency reserves such as debt service reserves) are only to be invested in taxable obligations which are, in turn, to be held as security for the retirement of the obligations of the governmental unit.

"2. Where the proceeds of the issue are to be used to refund outstanding obligations which are first callable more than five years in the future, and in the interim, are to be invested in taxable obligations held as security for the satisfaction of either the current issue or the issue to be refunded."
Neither a regulation nor a ruling, TIR 840 had no force under the tax laws, but probably would have caused securities law problems for anyone who sold bonds of the sort covered without disclosing the implied threat. I don't know of anyone who tried.

The Tax Reform Act of 1969 first defined "arbitrage bonds" and declared the interest on them taxable. Exceptions from a prohibition against investing tax exempt bond proceeds in higher yield taxable obligations were established for "materially higher" and amounts less than a "major portion." Precise definitions of these terms were left up to Treasury - IRS regulations.

A group of bond lawyers headed by Danny Goldberg of New York met several times with people from Treasury and the IRS to discuss what ought to go into such regulations. Joe Johnson, Jim Perkins, Don Hodgman and I were in the group. Later, I testified at public hearings on a succession of proposed arbitrage regulations.

I recall telling one Treasury-IRS panel that its proposed regulations would stimulate refunding issues by requiring them to be very profitable to underwriters. It was the underwriters who induced issuers to undertake such refundings; cities seldom regarded bond issues (which they had to pay back with interest) as a way to make money. By requiring issuers to invest at a yield below market, the law would open a flood of opportunity to underwriters. They would provide government bonds at prices well above their market value to reduce the yield on investments of the major portion of a refunding issue, and let the issuers earn whatever they could from investing the minor portion.

The panel members may or may not have believed me, but the proposed regulations were not changed much. For years thereafter, many refunding issues that had no beneficial municipal purpose but saving very modest amounts of money came to market. Many underwriters and lawyers (including me) profitably devoted substantial parts of their careers to such issues.

Manly W. Mumford