Bankers Trust New York
may get more than it bargained for when it buys
later this year.
Securities and Exchange Commission
is examining Baltimore-based Alex. Brown's part in several financial transactions called advanced refundings. The probe is part of a growing examination of an obscure practice called yield-burning -- essentially overcharging municipalities for Treasury securities.
It's unclear what impact, if any, the probe could have on the merger between Alex. Brown and Bankers Trust. But the potential for a good-sized problem certainly exists. A story in
Grant's Municipal Bond Observer
said the yield-burning problem could amount to as much as $1 billion industrywide. As for Alex. Brown's possible exposure? The firm is a significant underwriter of muni bonds, having been the lead manager on about $2.1 billion in advanced refundings since 1990, according to
There is a precedent for an acquirer offering to make good on potential yield-burning instances.
said in February that it may reimburse clients of
, which it acquired in late 1995, if the SEC finds they were overcharged, according to
The Bond Buyer
. No figure has emerged so far about how much CoreStates could have to cough up.
A Bankers Trust spokesman declined to comment on the issue, but said, "Alex. Brown is not part of Bankers Trust." Yet Bankers Trust has told analysts that it has completed its due diligence review of Alex. Brown's finances.
For its part, Alex. Brown said, "Published reports have indicated that the Securities and Exchange Commission is conducting an industry-wide review of the municipal-bond refunding process. As part of this review, we have responded to SEC inquiries concerning a variety of refundings over the past 20 months. While we cooperate fully with SEC studies, we customarily do not comment on them."
Despite recent publicity, yield-burning remains a little-known issue beyond the municipal bond market. In fact, analysts who follow Bankers Trust knew little about the issue.
"Is this something that could derail the deal? The straightforward answer is no," says Lawrence Vitale, an analyst at
, which hasn't participated in any recent Bankers Trust underwriting projects. "Could it affect the economics of the deal? I don't know enough to comment."
Yield-burning first came to light in 1995. While some major publications have delved into the issue, for the most part it has remained in the realm of more specialized newsletters such as
Grant's Municipal Bond Observer
Here's how yield-burning works. A municipality wants to cut its interest expense, but it can't call a bond offering carrying a high interest rate until a date in the future. So instead, it sells another issue with a lower interest rate and uses the proceeds to set up an escrow account made up of Treasury securities. It will use proceeds from the escrow account to fund the high-interest-rate bond offering. That is the advanced refundings piece of the equation.
The tax code says the yield of the escrow account must match the yield of the high-interest bonds so the municipality doesn't make money off the transaction. An investment bank puts together the Treasury portfolio. Here's the opportunity for yield-burning. To get the yield of the Treasury portfolio to match the yield of the high-interest portfolio, the investment bank marks up the Treasuries' prices, pushing down the yield.
While the debate over yield-burning has attracted an intense following on the
, regulators have been slow to reach a conclusion in their probe. Some muni bond experts believe the yield-burning issue could take an unexpected bite out of securities firms like Alex. Brown.