Contracting for Underwriters: Are All Underwriters Equal?

INTRODUCTION The sale of municipal bonds to finance state and local government capital improvements requires investors to ultimately buy those bonds. In the majority of cases, the intermediary function is provided by an underwriter that buys the bonds from issuers and subsequently resells them to investors. We are interested in whether underwriting is effectively a commodity service from the perspective of the government manager. If so, managers can select firms and expect similar outcomes. If not, and there are differences between underwriters that produce different interest rates for bond issuers, then they should consider selection processes likely to assure the outcomes about which they care. We set the stage by examining the contracting and privatization literature. The normative literature suggests that governments should encourage competition and focus on outcomes and evaluation. The literature testing the efficacy of underwriters suggests that certification, reputation, and relationships with issuers and investors might influence interest rates. If we measure and control for these factors, are there still differences between particular underwriters? To our knowledge, we are the first to look at the influence of individual underwriters on interest costs. We find that underwriters are not commodities and governments receive substantially different pricing when selecting one firm versus another. This has implications for public managers and argues for the application of contract management techniques, such as requests for proposals, the use of competitive sales, and evaluation of results. This paper proceeds as follows. We first present the relevant literature. Next, we discuss our data and our methods. Then, we describe the findings of our research. Lastly, we discuss the imphcations of our findings. RELEVANT LITERATURE Privatization/Contracting for Services Governments contract with the underwriter to provide market access to investors. Figure 1 below shows the role of the underwriter in the bond sale process. The underwriter acts as an intermediary between the municipal bond issuer and the investor. The underwriter buys the bonds from the issuer (the issuer gets the cash) and then sells them to the investor (the underwriter gets cash from the investor). The underwriter steps out of the process after the transactions are complete and the issuer pays principal and interest to the investor, typically through a paying agent. Governments choose whether or not to use underwriters to find the investors. In 2013, $21.9 billion of municipal bonds, or 6.5%, were sold to investors without underwriters, called private placements (SIFMA, 2014). The use of private placements is a small but growing portion of the municipal bond market. Riverside, California, for example, placed a $25 million private placement with National Bank in Los Angeles for expansion of its performing arts center rather than sell a traditional bond through an underwriter (Dugan, 2011). Banks, such as J.P. Morgan Chase & Co., are actively courting public borrowers to sell directly without the use of an underwriter (Dugan, 2011). These developments raise the question of the value of intermediation, whether there are distinctions in that value across firms, whether bond issuers could do without underwriting services altogether, and the cost effects of such choices. A bond sale directly to investors is not only possible, it might sometimes be advantageous to issuers. Using an underwriter to access investors is a policy choice to privatize a government activity that could be done in-house. Specifically, the issuer uses the underwriter to provide a service: to act as the go-between with investors. This financial intermediary service includes searching for investors and some risk taking that is described later in the section on underwriter compensation. A focus on outcomes has been central to management and finance reforms over the past several decades. …