Wednesday, October 04, 2006

black box deals / more "enronstyle"


Banks' $7 Billion Tax-Exempt Bond Ruse Yields Nothing for Needy


Pastor Willie Williams frowns as he approaches a 10-foot-high concrete wall that's topped by spirals of barbed wire. On a steamy August morning in Pensacola, Florida, he's entering the Oakwood Terrace apartments for low-income residents. Williams, 62, shakes his head as he passes an unmanned security station.

``It looks like a concentration camp,'' he says.

The 300-apartment complex was on a list of developments that were eligible to benefit from $220 million in bonds issued by a public agency in 1999 to promote affordable housing in Florida.

None of the money went to Oakwood Terrace. Not a penny of the $220 million bond issue -- which was underwritten by JPMorgan Chase & Co., the third-largest bank in the U.S., and insured by a unit of American International Group Inc., the world's largest insurance company -- was ever spent on low- income residences.

During the past decade, local governments across the U.S. have issued more than 70 of these phantom bonds -- at least $7 billion of them. That's enough money to pay the salaries of 150,000 teachers in the U.S. for one year, based on an average pay of $46,597. Proceeds from the tax-exempt bond sales are supposed to be used to improve homes for the poor or upgrade health care for the elderly or supply computers to inner-city schools.

Taxpayers never get most of those benefits; the winners are the banks, insurance companies and financial advisers that get paid millions of dollars for crafting these transactions and then profit by using bond proceeds for their own investment gains.

Black Box Deals

The arrangements -- often called black box deals, because they're complicated and mysterious -- sometimes contain secret agreements that promise to pay the financial middlemen higher fees if none of the money from the bond offerings is used to help the public. The agencies that issue the bonds buy them back from investors. The money goes untapped, and the advisers keep their fees.

``You have people who are deliberately trying to find a way around the law, and that's not good for anyone,'' Most of the black box deals consist of so-called blind pools, meaning the money is put in an account that's supposed to be used to finance a basket of projects. Local authorities give their advisers the power to decide how the money in the pool is dispersed -- or whether it's to be dispersed at all.

The Fees

In the Florida deal, a little-known government body called the Capital Trust Agency turned the work over to its advisers: Anchor National Life Insurance Co., a subsidiary of AIG; CDR Financial Products Inc., a Beverly Hills, California-based financial advisory firm; and underwriter JPMorgan. These companies and other middlemen extracted $12 million in fees from the bond issue; the rest of the money went unused.

The less money that was used to acquire and renovate apartments, the more money CDR stood to make, and the less risk AIG's affiliate faced as an insurer since all of the money stayed in a safe account.

Black box bond deals do more than deprive local taxpayers of promised spending on homes, schools and hospitals: They also rob the U.S. Treasury of about $100 million a year in revenue, Anderson, 55, says.

The IRS has found that at least 70 of these deals, including the one in Florida, violated U.S. tax laws. The agency has demanded more than $200 million in back taxes and penalties from banks, insurance companies and issuers since 2000. In the Florida case, AIG reached an undisclosed settlement with the IRS, and Capital Trust paid $920,000, agency records show.

`Sense of Fairness'

Bond lawyers and advisers who've collected fees from pooled deals blame the IRS for stopping programs that could have helped the public.

Ron Tym, a former attorney in Kansas City, Missouri-based law firm Stinson Morrison Hecker LLP, who was the lawyer behind three black box deals in the Midwest, says housing would have been purchased had the IRS not started an audit. Robert Kolek, a lawyer representing an Illinois authority, says an IRS probe made interest rates soar and stifled a program to provide computers to schools and libraries.( they have really nerves....)

IRS `Shakedown'

Many of the black box deals in Florida and across the U.S. are sold by invisible public authorities. The Capital Trust Agency, which issued the $220 million in housing debt in Florida, consists of three people working out of a ranch house that's situated behind the police station in the city of Gulf Breeze.

These agencies, the book says, make up a ``shadow government'' with control over $1 trillion in roads, sewers and buildings. They do so through such means as levying tolls or issuing debt.

No Voter Approval

Legislatures and local governments create the authorities to get around restrictions such as the need to get voter approval for projects, the book says. In many cases, their finances aren't included in city and state budgets. (enron style / off balance sheet)

Banks woo shadow agencies by offering them an alluring pitch: We'll underwrite your bonds for you, and it won't cost you a cent. We'll guarantee your authority an upfront fee for the privilege of doing business with you. Fees to the authorities come from the bond proceeds, and the agencies use the money to fund their budgets, while giving some of it to local communities to build parks, hire police officers or buy fire trucks, local records show.

Too Good

The Community Development Authority, a public agency in Manitowoc, Wisconsin, a city of 33,917 on the shore of Lake Michigan, issued $150 million in bonds in 2002 to improve low- income housing. Bergen Capital Inc. of Hasbrouck Heights, New Jersey, underwrote the bond, and Tym was bond counsel. None of the money was spent; the agency bought back the entire issue, and its advisers collected $1.3 million in fees.

Life's Work

There's nothing illegal about collecting fees for bonds that are issued and then bought back as long as there is legitimate intent to use the money for the stated purpose, the IRS's Anderson says. Where local governments and their advisers run afoul of the law is when they invest the proceeds of tax- exempt bonds and take profits that exceed what the IRS allows.

The penalties can be severe. The IRS may order local governments to forfeit all of these so-called arbitrage gains and hand them over to the U.S. Treasury. The IRS can also revoke the tax-exempt status of municipal bonds if local governments don't spend at least 95 percent of the proceeds within three years --one reason many of the black box bonds are bought back by the authorities that issued them.

Taxpayers Stung

The IRS is seeking a penalty of $73 million in one unidentified black box deal, Anderson says.
Taxpayers are stung three times by these bond schemes, Anderson says.

The public doesn't get the housing or health care the bond was intended for.
The U.S. Treasury is being cheated. So many pooled bonds have been issued that the market has become saturated, driving up interest rates for all municipal debt.
``The public suffers,'' Anderson says. ``Every citizen gets hurt. At some point, there has to be due diligence. The public has to wonder what their politicians are doing.''

Banks and bond advisers have found new ways to circumvent IRS regulations,

Dual Role

Anderson says the IRS investigation is finding that financial firms are increasingly hiding arbitrage profits in bond insurance fees. He says banks sometimes play the dual role of insuring and investing the proceeds of a bond.

Black box deals have something else in common with each other. They're sold without competitive bidding -- part of a growing national trend in municipal finance. Eight out of 10 times, the banks that underwrite bonds for schools, roads and hospitals clinch those assignments in private discussions with local authorities.

No Competition
That's a complete reversal in 30 years
. In 1974, banks competed at public auction for bond sales 75 percent of the time,

There was no competition for the $220 million housing bond issue in Florida.

Need for Housing

The housing bond deal LeCroy pitched was crafted by financial adviser CDR, according to documents prepared by Capital Trust's attorneys. CDR has negotiated more than $158 billion in transactions since it was founded in 1986, according to its Web site, which says CDR ``creates and markets leading edge financial products.''

Gulf Breeze

All told, JPMorgan Chase got $4.3 million in underwriting fees, and AIG made an estimated $15 million by guaranteeing to pay bondholders in case of a default,

In those two years, the tiny city of Gulf Breeze and Capital Trust sold $650 million in bonds -- $350 million for housing and $300 million for assisted-living facilities. Just $130.7 million, or 20 percent, of that $650 million was ever used.

`Many a Phone Call'

The bond issue's offering statement said that a Boston- based nonprofit organization called Community Builders Inc. would use the money to finance or refinance the ``costs of acquiring, erecting, extending, improving, equipping or repairing'' multifamily rental housing for low-income residents.

Gray, 54, says he constantly called Community Builders to ask why no work was being done with the $220 million. ``I made many a phone call to them, saying, 'Why aren't we being successful? Why aren't you originating? Why aren't you doing what we intended?''' he says. ``Their response was either a political problem wherever they might have found something, or they were critical of underwriting guidelines' being too stringent.''

The standards for loan approval were written by Anchor National. Patrick Clancy, executive director of Community Builders, declined to comment specifically on why his organization was unable to acquire properties. He attributed the failed program to his group's inexperience in Florida. ``It was a very frustrating experience,'' Clancy says.

Secret Agreement

In May 2002, Gray wrote to Anchor National asking that the bonds be called because he was concerned the money wasn't being used, agency records show. The AIG unit insisted that the money stay in the investment account, Gray says. Anchor Vice President J. Franklin Grey didn't return phone calls seeking comment.
Gray says he was stunned to learn from the IRS three years ago that Anchor National had a secret agreement with CDR that gave both companies an incentive to deny all of Community Builders' spending proposals. Under the covert pact, CDR was paid 0.25 percent per year of the bond proceeds that weren't used, according to the Nov. 18, 1999, letter from Rubin to Grey.

If none of the money was used for housing, CDR would get about $550,000 a year in fees, according to an analysis of expenses over the life of the bonds. Agreements in the three Gulf Breeze deals between CDR and Anchor National violated the U.S. tax code and thus jeopardized the tax-exempt status of Capital Trust's debt, the IRS said in three letters to the agency in June 2003.

`Smoking Gun'
``There was a side agreement that only those two parties knew about,'' Gray says. ``That little side deal was a smoking gun.'' ''

AIG and Capital Trust reached a settlement with the IRS. It paid the IRS. The bottom line on the $220 million housing bond: $12 million in fees to banks, insurers and advisers; $920,000 to the U.S. Treasury; and zero spent on housing.

`Get Angry
``You get angry about the money that was available,'' Williams says. ``Who would dangle it and then not give it to you?''

Shewaun Boyd, a convenience store cashier, lives with her seven children in a three-bedroom apartment at Oakwood Terrace. A sheet provides the only covering for a living room window that faces a weedy courtyard. Boyd, 32, says banks and other finance firms won, while needy residents lost.

In April 1999, the city sold $300 million in bonds to develop centers that would improve care for Alzheimer's patients.

Dreaded Disease

Gulf Breeze put Heritage Healthcare of America, a Los Angeles-based operator of assisted-living facilities, in charge of spending the money. The city bought back the bonds between 2001 and 2003 as less than 10 percent of the $300 million was spent.

Thomas Conklin, a Sarasota, Florida-based lawyer who is board chairman of the nonprofit Johnnie B. Byrd Sr. Alzheimer's Center & Research Institute in Tampa, says it's shocking that most of the bond money was never used to help Florida's 450,000 Alzheimer's disease sufferers.

14 Percent Loaned
JPMorgan Chase, using credit guarantees from AIG affiliates, underwrote similar black box housing deals in Georgia, Oklahoma and Tennessee. The bank sold $425 million in housing bonds in the three states in 2001 and 2002. Just $60.5 million, or 14 percent, was used for housing; the rest of the bonds were bought back by local governments.

Deal Falls Through
Bob Boyd, a former executive for Maitland, Florida-based real estate firm NAI Realvest, sought to find properties for the Fulton County authority to buy. Boyd negotiated an agreement for the authority to pay $31.6 million for four complexes with a total of 816 apartments, Fulton County authority records show. CDR wrote a memorandum on July 8, 2002, saying it would allow a loan of $18.4 million from the bond proceeds for that purchase.

Since that amount wasn't enough to buy the properties, the deal fell through, and Boyd's group didn't buy any housing.

``We thought we had found properties that fit all the criteria, but we could never get them approved,

no disclosure

As taxpayers in Florida and Georgia scorn the misuse of bonds meant to improve housing and health care, citizens in Illinois wonder what happened to $150 million in bonds the Illinois Finance Authority, a state agency that funds public projects, sold in 1999 to pay for computers in schools and libraries.

``We've struggled,'' says Barbara Clark, the principal of Skinner Elementary School in Chicago. Skinner has fewer computers than the state average

The 1999 variable-rate bonds, which initially sold at an annual interest rate of 3.3 percent, were supposed to make more computers available to kids. The Illinois Finance Authority, which is based in the state capital of Springfield, paid $1.4 million in fees to the underwriter, Kansas City, Missouri-based investment bank George K. Baum & Co., and an additional $1.8 million to advisers and promoters.

The schools got almost nothing
. Of the $150 million from bond proceeds, a total of $833,000, or less than 1 percent, was used for technology. The Illinois authority ended the program in 2002 and bought back the bonds to avoid having the IRS declare them as taxable.

Financial Advisor's Role
Daniel Denys, president of Austin Meade Financial, the Illinois authority's financial adviser, says his firm developed the program with honest intentions. Denys was also a principal stockholder in Skokie, Illinois-based National Technology Network Inc., which helped promote the bonds and was in charge of handing out loans, according to bond documents.
He says Chicago public schools expressed interest in borrowing all of the money and then backed out. Rising interest rates also stifled borrowing, he says.
``It was a failure to realize a noble cause,'' he says. ``We stand by the work we did.''
The IRS began investigating the program in 2002 and says in records provided by the authority that the program exploited schools, while allowing financial firms to profit.
``In this case, the farce has been shown because there were only two loan originations totaling $833,000 out of a bond issue of $150 million,'' the IRS wrote.

Fees Too High

The IRS said the authority, as issuer of the bonds, owed almost $2.3 million in taxes and interest because George K. Baum's fees diverted too much money from the loan pool, violating IRS arbitrage rules.

After a year of negotiations starting in 2004, the authority reached a settlement with the IRS on May 11, 2005. The authority paid $804,716 in penalties and legal costs.

Midwestern Housing Bonds

Tym, 52, then an attorney in the Stinson firm, designed programs that led two cities and a state agency to sell a total of $450 million in bonds with the promise that the money would be spent to provide housing for low-wage workers, according to local records. ``

No money went to housing, and eventually the issuers used the money to buy back the bonds. Banks, advisers, issuers and others collected at least $5 million in fees.

Large Fee Volume

As Tym pitched the housing bonds to local authorities, he underscored that authorities themselves would make money.

``This program generates a large volume of fees for the issuer of the bonds,'' Tym said in a sales pitch to officials in Lee's Summit, Missouri, according to a transcript of a Sept. 20, 2000, city meeting. ``

Officials involved with each of the transactions say Tym brought in the banks that would underwrite the bonds. Stinson, Tym's law firm, also signed the legal opinion vouching for the bonds' tax-exempt status even as Tym was the one who promoted them to the issuers, records show.

The Winner

Gold Banc, based in Leawood, Kansas, stood to be a winner in the bond sales -- with the kind of return that would have dazzled a hedge fund manager. Gold Banc bought $14.2 million of the $450 million in bond sales that Tym arranged. Under the terms of the purchase, gains on those bonds paid Gold Banc 30 percent annually on its investment, or about $4.3 million a year. Those payments came from investment gains of the entire bond pool, which was kept in an investment account.

IRS to Blame

In October 2005, Gold Banc paid about $3.5 million to settle with the IRS, which said the bank didn't have the right to avoid income tax on the debt payments. Stinson agreed to pay $3.25 million to Gold Banc to settle the bank's claims against it.

`A Nightmare'

Manitowoc, like towns and cities across the U.S., sold bonds that never helped the public. Florida Auditor General William Monroe examined the unused bonds in that state and published his findings in a May 2003 report.

``The effect of issuing these bonds has been to generate significant fees for financial advisers, underwriters, insurers, attorneys, consultants and other bond professionals with minimal demonstrated benefit to local citizenry,'' Monroe wrote. He suggested tightening oversight.

Nothing But Anger

Public officials in Florida, Georgia and three states in the Midwest say they were deceived by bankers or lawyers and now are left where they started, minus payments to the IRS.

In Pensacola, Pastor Williams looks over his shoulder at the Danger sign on the barbed-wired wall ringing the housing project. ``You hope that something would change, that something would actually come true,'' he says. ``But it doesn't, and it leaves you with nothing but anger. Now we're right back in a cesspool.''



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