Ian Mathias

The United States experienced another interesting first on Wednesday. For the first time in the history of our union, the Securities and Exchange Commission brought charges against a State. The powers that be in New Jersey had been deceiving and misleading investors in regards to the fiscal well-being of the Garden State, and the SEC busted ’em. Bravo.

That’s where the good news ends.

But first, the Cliff’s Notes to this mess, according to the SEC’s allegations:

In 2001, New Jersey increased pension benefits for state employees without having the funds to cover new benefit expenses. For the next six years, at least, the state continued to underfund the pension system – but hid that information from municipal bond investors. On 79 separate occasions the state sold a total of $26 billion in bonds while “withholding and misrepresenting pertinent information about its financial situation,” said SEC director of enforcement Robert Khuzami.

In other words, they lied so that the bonds they were selling would appear more attractive. It’s classic balance sheet fraud, committed by senior state officials working for both democrat and republican governors. And the state’s bond underwriters – JP Morgan, Citi, Morgan Stanley, Bank of America, Barclays, Merrill and (of course) Goldman Sachs – all probably lied too. At the very least, they all failed to conduct due diligence before vouching for the quality of the state bonds.

What’s the penalty for this outright fraud? Nothing.

The State of New Jersey will pay the SEC precisely zero dollars. Not one state employee will pay a fine either, or go to jail…not even lose his job. In fact, the State didn’t even have to admit wrongdoing. “New Jersey agreed to settle the case without admitting or denying the SEC’s findings,” calmly explains the SEC press release. Come again? Essentially, the only provision of the settlement is Jersey’s promise that it won’t do this in the future. That’s it.

And Goldman Sachs, JP Morgan and all those other mega-banks? C’mon… They weren’t even mentioned in the SEC’s statement.

It’s worth repeating: We’re talking $26 billion in bonds sold under purposely false pretenses. This isn’t some small-time phony IPO. Pretend a company like McDonald’s, which has a market cap of roughly $77 billion (that’s about the same value of New Jersey’s pension fund system) sold $26 billion in bonds under similar guise. Heads would freaking roll. They’d be lucky to not go bankrupt.

Yet, here we are. New Jersey officials were so unfazed by the SEC settlement – the status quo was so unchanged – that they proceeded with a $2.2 billion bond sale on August 19, 2010. That’s less than 24 hours after the SEC announced the results of their investigation. SEC investigators did a fine job forging into uncharted territory and exposing State fraud, but they offered literally the most toothless settlement possible.

That’s not to say no lessons have been learned. The smart investor should already be leery of municipal bonds, with so many states struggling to close budget gaps while honoring swollen pension agreements. Now you have all but absolute proof that State administrators are not only unable to balance their books, but they’re willing to cook ’em too. Plus, there is really no incentive for States to change their ways, aside from a gentle tap on the wrist from the SEC.

And this whole mess ought to (though it likely won’t) highlight fundamental unfairness in the way we regulate the $3 trillion municipal bond market. Having the SEC patrol state funds is a hot mess of conflict of interest and political gamesmanship. At the end of the day, this is government policing government…an operation likely to be as inefficient as it is ineffective.

Of course municipalities need a regulator, as they have proven unable to regulate themselves. But once the SEC discovers such a fraud, why not – at the least – order the state to hire a team of private sector auditors that will report their findings to the government every year for the next five…or as long as it takes for the State to get its act together.

How’s that for a stimulus plan? Auditing state pension programs would employ thousands of accountants for years. And those are real jobs, with a real purpose… Bean-counters could get back to work and bureaucrats would have to be just as responsible and forthright as the rest of us. While they’re at it, those auditors can figure out exactly how long those struggling pension funds will last before running out of money. Wouldn’t that be nice to know?

We’ll be on the lookout for an e-mail from Mr. Obama, asking for more details on our stimulus plan. In the meantime, know what you’re getting into when you buy muni-bonds. Only one state has ever defaulted on its bonds – Arkansas back in 1934. So the odds are still in your favor. But reason is not. Now ethics aren’t, either.

Ian Mathias
For The Daily Reckoning

Ian Mathias

Ian Mathias is the managing editor of Agora Financial's Income Franchise, where he writes and researches about retirement, dividend and fixed income investing. Much of his work is featured in The Daily Reckoning and Lifetime Income Report, Agora Financial's flagship income investing advisory.  

Previously, Ian managed The 5 Min. Forecast, a fun, fast-paced daily look into the future of global markets and macroeconomics. He's also worked in public relations, where media outlets like Forbes, AP, Yahoo! and MSN Money have syndicated his writing. If he's not at work, you'll probably find Ian on a bicycle, racing up and down the "mountains" of Baltimore County. Ian has a BA from Loyola University in Maryland. 

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