Whistleblower Offers Tips on Bond-Premium Laundering: Joe Mysak

Commentary by Joe Mysak

Sept. 9 (Bloomberg) -- Laundered premiums aren't what you pick up at the dry cleaner.

Instead, they are something that may have created hundreds of millions in fictitious profits for securities firms, says a whistleblower who has been telling the Internal Revenue Service all about it.

If the IRS finds that what the whistleblower says is true, he can collect 15 percent to 30 percent of whatever fines and penalties it imposes on the firms, one of which he worked for.

I wrote about the whistleblower last week, and this time I asked him to walk me through a transaction.

I didn't get a lot of e-mail about the whistleblower's claim that some dealers seem to have been improperly deducting the amortization of premiums on tax-exempt bonds during the early years of this century, when the Federal Reserve was keeping the federal funds rate at less than 2 percent.

So here, let's spell it out and see if anyone recognizes themselves or their firms.

Here's a big deal, and it shows a $50 million tax-exempt bond maturing in almost a year with a 6 percent coupon. The price is 104.91, bringing the yield down to 0.92 percent. A similar bond, with a 2 percent coupon, was priced at about 101, yielding 0.941 percent.

Why would someone accept the lower yield in exchange for the higher coupon? The 6 percent bond doesn't trade; the underwriter bought it.

How It Works

Here are the economics of the transaction. The dealer pays $52,455,000 for the bonds. He also pays $481,666 to finance the position (this is assuming the bank borrows money at the 1 percent federal funds rate).

Here is what happens at maturity. The dealer gets back the $50 million, plus $2,833,333 in tax-exempt interest. Since it cost him $52,936,666, the dealer lost $103,333.

``The proper tax treatment is that the IRS should never see any of this on the tax-return,'' the whistleblower tells me. ``The gain portion is tax-exempt (the coupons are the only gain), and the two loss pieces (the $2,455,000 capital loss is non- deductible since it relates only to premium amortization, and the $481,666 loss is non-deductible since it is related to the financing of a muni position).''

`Decent Bonus'

Now let's say that the dealer's accounting software doesn't take into consideration that the premium amortization on the tax- exempt bonds isn't deductible. The dealer's tax return shows that he purchased the bonds at $52,455,000 and received $50 million at maturity, a mark-to-market loss of $2,455,000.

The coupon income, $2,833,333, is tax-exempt. The financing cost of $481,666 is non-deductible. The dealer reports a $2,455,000 loss.

``This allows them to offset $2,455,000 of real gains'' -- remember, this occurred back in the early 2000s, when securities firms were still raking in lots of profit -- says the whistleblower, avoiding $859,000 in taxes at the 35 percent rate. ``The trader gets credit for that, and is not worried that the position actually lost $103,333, because the system credits him for $859,000 in tax savings, for net p&l of $755,667.''

Or, as the whistleblower said, with some glee: ``Magic! No real market risk, no real credit risk, just use of $50 million in balance sheet for a year, for a $750,000 gain! Stack 10 or 20 deals like this together and a trader might be able to cobble together a decent bonus!''

Not an Option

I asked how I would explain this to grandma. He obliged: ``When you buy a muni bond, the tax-exempt interest you are entitled to is the yield, not the coupon. Buying a 6 percent coupon bond at a yield of 0.92 percent, on your tax return you can avoid paying tax on the 0.92 percent, not on the 6 percent.''

Bond accounting systems were designed for taxable bonds, and accrue interest daily at the 6 percent rate on the bond, according to the whistleblower. The market value of the bonds drops daily due to the premium amortization. An above-market coupon is accrued while the deductible amortization losses flow through to the mark-to-market line. That's fine on taxable bonds.

If the bond is tax-exempt, the dealer has two choices: split the daily 6 percent accrual into tax-exempt (0.92 percent) and taxable (5.08 percent) pieces, or let the 6 percent go entirely into the tax-exempt interest line and adjust the tax basis of the bond downward each day.

``Either choice is correct,'' said the whistleblower. What is not correct is doing nothing and looking the other way.

And so I ask again: Did this really happen?

(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Joe Mysak in New York at jmysakjr@bloomberg.net