My Latest Forbes Magazine Article: “The Madoff of Munis”

I’ve written my third Forbes magazine article, “The Madoff of Munis” and it’s online now. The print magazine, Forbes’ Investment Guide, should also be on newsstands now with a date of June 24, 2013. (A sidebar, How To Protect Yourself  When Buying Municipal Bonds, gives further tips.)

I’ve wanted to write about Rita Crundwell, the thief of Dixon, IL , for a while. Rita Crundwell stole $53 million dollars over twenty years from the City of Dixon with a very simple plan: Create a fake bank account; pay fake State of Illinois invoices from the city’s account; put those funds in the fake bank account. How was all this possible? No one was watching.

Another municipality featured in the article is Jefferson County, AL, a combination of fraud and mismanagement that was the largest municipal bankruptcy ever in November of 2011. In a stroke of luck, just as out story was going up online, Jefferson County announced a deal to emerge from bankruptcy by shortchanging bondholders as much as 35%. From The New York Times DealBook story which buried this bombshell at the bottom.

If the refinancing goes forward, the county’s public creditors on the sewer debt will be offered a choice: either 80 cents for every dollar of sewer debt they now hold, if they relinquish all other claims, or 65 cents on the dollar with the right to pursue their own claims, either against the county or its bond insurers.

Those sewer bonds were insured and creditors will still get shorted.

The story is about much more than Crundwell who is used as “color”, as they say in the magazine industry, to draw you in for a lesson on municipal fraud, municipal bonds and the sorry state of public finance.

What did I learn from digging into the story? The municipal bond market is ripe for fraud, abuse and manipulation. Reliable, objective data is hard to find and most state and municipal finances are in a shambles because of economic conditions. The tide has gone out and the problems will be more apparent than ever. From my story:

Crundwell’s crime was extraordinary, but Dixon’s failure to heed its most famous resident’s dictum to “Trust, but verify” is all too common among municipal governments. While auditing in corporate America is far from perfect, the standards public companies must adhere to are stringent compared with what’s required of local governments, whose sometimes shoddy accounting practices enable not only rogue embezzlers but also corrupt elected officials and those who would cook the books to hide fiscal mismanagement.

And we always ask on re: The Auditors, what about the auditors?

Dixon’s external auditor, CliftonLarsonAllen, was a licensed accounting firm, as Illinois law requires, but hardly independent. That’s because it was paid to do Dixon’s bookkeeping while it audited the town’s financial statements. Incredibly, the same partner who oversaw work for Dixon also prepared Crundwell’s personal tax returns, which showed large sums inexplicably flowing in. (The partner has so far faced no public sanctions.)

In 2005–at a point when Crundwell’s thievery was ramping up–Dixon became subject to the federal requirement for an independent audit, and CLA decided it could no longer perform the town’s audit. So it recruited Janis Card Associates, a tiny two-person CPA firm, to sign Dixon’s audits, according to a negligence lawsuit filed by Dixon against the two accounting firms. After that, the suit alleges, CLA continued to do most of the audit work, performing what it called a “full disclosure compilation.” Janis Card owner Samuel S. Card signed off on the audits, but his firm was paid only $7,000 for the 2011 audit, compared with the $34,750 CLA billed Dixon for its “audit” work.

How is it the firms never caught Crundwell’s scheme? According to the city’s lawsuit, they never asked for documentation to support even one of her amateurishly prepared State of Illinois invoices, which looked very different from real state bills–no logo, no contact information, nonexistent dates. Attorneys for the city say CLA, which advertised its expertise in government audit, should have noticed the difference between Crundwell’s fakes and legitimate state paperwork. Both accounting firms have denied liability in the suits but declined to talk to FORBES.

A city or town feels the financial impact of a fraud that continues over several years less than the pain from a quick hit, even if the total theft is significant. Year after year Crundwell pilfered and Dixon got used to living with less, borrowing and constantly cutting staff and capital expenditures to fix deficits. I spoke to David Hoffman, the City of Chicago’s first independent Inspector General in 2005 and now a partner at Chicago’s Sidley & Austin specializing in public corruption and corporate investigations. (Unfortunately David Hoffman’s comments didn’t make it to the final version of the magazine article.)

Chronic corruption creates a “pariah effect” says Hoffman. Higher quality vendors and bond underwriters won’t do business with local governments that cost them more for compliance, reputational risks, and legal penalties and vendors won’t submit a bid or will submit higher quotes to compensate for the additional risk.

Dixon’s auditors seem to have never questioned the city’s deteriorating cash position and Dixon’s residents paid the price. The City of Dixon’s problem was complacency. Dixon officials, the city auditors and residents allowed Rita Crundwell to run the city’s finances on her own and were immensely grateful to her for doing so. The external auditor, CliftonLarsonAllan, was not independent after 2005 because of several other services it performed such as bookkeeping and IT. To solve that problem, CLA selected a “straw man” firm, according to a lawsuit filed by the city against both audit firms, to sign the audits after 2005 that were still prepared by CLA. According to the city’s lawsuit the “straw man” audit firm had neither the staff nor the qualifications to audit a city of Dixon’s sixe and complexity.

An annual audit by a state-licensed public accounting firm is required for municipalities in most states, including Illinois. Very few states, however, do much more than file the reports and wait for something bad to happen before investigating. In Illinois, the state comptroller has no legal authority, or funding, to perform its own audits. As long as the financial statements and audit report are filed on time, there’s no follow-up.

“An audit firm must be independent and competent. There should be sufficient oversight to make sure both conditions are true,” says David Hoffman. Illinois performed no oversight of Dixon’s finances or its auditors.

Illinois is on the fiscal precipice with another downgrade from Moody’s last week. But it’s the combination of fiscal mismanagement, economic stress and rampant corruption that makes our problems so intractable. We need more than just a refinancing in Illinois.

Harriette Walters stole $48 million in property tax refunds in Washington D.C. over almost twenty years but that amount was still not material to the district’s multi-billion dollar annual budget. Six people, including the external auditor, went to jail in 2005 for stealing $11 million over nine years from the Roslyn, Long Island New York school district. (Read this great article by Professor Ron Huefner at State University of New York about the Roslyn case.)

Borrowing costs have not gone up in Dixon, DC or Roslyn but that may not last. According to a paper published in 2009, “Corruption, Political Connections, and Municipal Finance”, chronic fraud and public corruption raises borrowing costs for municipal issuers. A “corruption penalty” eventually kicks in which can range from 6.6 to 10.4 basis points; nearly the same effect of a credit rating two notches lower. Higher yields mean higher tax-free income for investors. But the higher yields compensate for higher risks that are difficult to separate from tangible concerns about overall credit quality. Retail investors chasing higher yields may be the same taxpayers footing the bill for it.

Here’s another working paper that applies the theory of institutional corruption to the world of private-activity bonds, which offer private entities access to tax-exempt borrowing, which generally provides lower interest rates. The paper’s author, Zachary Fox at Harvard University’s Safra Center for Ethics says “there is a long history of corruption in the bond market, the latest development being a 2011 Department of Justice investigation that exposed rampant bid-rigging by Bank of America, J.P. Morgan Chase and others. This paper will focus on bonds used for affordable housing, and explore whether the theory of institutional corruption might apply to either housing bonds or tax-exempt bonds writ large.”

In a difficult economic environment poorly secured bonds issued for non-essential projects like sports stadiums are an accident waiting to happen. In April, Bronx Parking Development Corp. missed a $6.9 million interest payment to bondholders. In 2007 it issued debt with a face value of $237.6 million through New York City’s Industrial Development Agency to build three garages and renovate two others. Revenue is not meeting projections and Bronx Parking has hired bankruptcy counsel. The IRS publication, Avoiding Troubled Tax-Advantaged Transactions, has more examples.

Read, “The Madoff of Munis” and sidebar, “How To Protect Yourself  When Buying Municipal Bonds“, and please let me know what you think.

Main page photo was found here which also has a transcript of the Rita Crundwell story that aired on NBC’s Rock Center.