The Streets Were Paved with Gold (17 page)

Since UDC Bonds were backed only by the state’s “moral obligation,” investors were naturally nervous. After a series of frantic meetings and touch-and-go negotiations with the banks, on February 26 Governor Carey shaped a bipartisan plan to provide the UDC with continuous financing and stave off its collapse. There was statesmanship on all sides, and the plan was duly saluted. Largely overlooked, however, was the fact that the UDC defaulted on the repayment of $104.5 million of notes due on February 25 when the state legislature refused to appropriate the monies. Governor
Carey double-talked: since these were short-term notes, he said, they “do not carry the moral obligation of the state.”

Four weeks later, the state made good on the money. But the psychological damage was done. The UDC became the first major government agency to default since the Depression. The message communicated to investors was clear: state “moral obligations” were not legal obligations—the state could unilaterally break a contract. “People did business with the UDC—small businessmen, architects, civil rights organizations—thinking they were doing business with the state of New York,” explained Richard Ravitch, the man Carey installed as the dollar-a-year UDC chairman after replacing the discredited Logue. “The fact that they technically were not doesn’t matter now.”

The consequences were swift. Out-of-town investors, the key to the banks’ underwriting function, got cold feet about all New York securities. “Why should I buy the moral obligations of immoral politicians?” screamed one Wall Street bond trader. That same day,
The Wall Street Journal
reported, “Public authority bonds fell an average of $15 for each 1,000 face amount.” Michigan’s Housing Department Authority couldn’t sell some of its bonds. The New Jersey Housing Finance Agency complained of paying almost 2 percent more in interest than they should have and blamed the UDC default. Within days, New York City was compelled to accept a then-astronomical 8.69 percent interest rate on $537 million of bond-anticipation notes—up from 7 percent two weeks before.

The financial community was experiencing its own problems, and the UDC default hardened resistance to government securities. “The Nation was just recovering from the most severe recession of the post-war period,” Lynn E. Browne and Richard F. Syron observed in a 1977 issue of
The New England Economic Review.

Memories of double-digit inflation were still fresh and the performance of the wholesale price index over the summer and fall was not reassuring. Bank loan losses were at record levels and the collapse of real estate investment trusts had affected the profits of many financial institutions. Prophets of doom abounded. A natural result of these developments was a significant increase in investors’ caution.

Coincident with this overall increase in caution was a major decrease in the demand for municipals by traditional purchasers. Commercial banks have traditionally been the single most important purchaser of municipal bonds and as late as 1972 bought 50 percent of all new issues. The tax-exempt feature of municipals has made them an attractive
vehicle for sheltering commercial banks’ income. In the last several years, however, banks have developed alternative ways of sheltering income. Also, loan losses of banks in 1975 placed many of them in a position where they had little income to shelter and thus no real need for tax exemptions. As a result, commercial bank acquisitions of state and local obligations fell by 70 percent from 1974 to 1975. Property and casualty insurance companies, the second largest group of institutional buyers, also had a poor profit year in 1975 and reduced their purchases of municipals by 30 percent from 1974.

The spillover from the UDC default hit New York City in another way. For the first time, a bank bond counsel refused to automatically sign off on the issuance of city notes without confirming to its satisfaction that there were sufficient revenues to support repayment. This happened when lawyers for White & Case, who represented a Bankers Trust syndicate of underwriters, told Comptroller Goldin in a February 27, 1975, meeting that they wished to inspect the city’s tax receipts. “The Comptroller and the City Corporation Counsel stated that this request for more current information by White & Case was unprecedented,” the SEC staff report would later recall. “In response, concern was expressed that, in view of the recent default of the Urban Development Corporation (‘UDC’) on its debt securities, underwriters should be reviewing new and different types of information than had been previously requested.” The meeting in the Comptroller’s office dragged on into the wee hours, with the city finally consenting to permit the inspection of its tax receipts.

After studying these receipts on the morning of February 28, White & Case firmly decided not to issue an opinion approving the sale. In response, Comptroller Goldin issued a dissembling press release: “Contrary to inaccurate reports which have been circulated, there is no question concerning the sufficiency of City tax revenues to meet all obligations including the February 19th offering. The certainty of repayment is in no way an issue in the deliberations now taking place.” A joint statement from the Mayor and Comptroller chimed: “The recent default by the state Urban Development Corporation” has created an “unwarranted climate of suspicion in the marketplace.” New York City taxpayers, they said, should not be forced to pay for the mistakes of “another jurisdiction.”

The state Housing and Finance agency was forced to postpone a scheduled note sale. Construction on more than $1 billion in nursing
homes, hospitals, facilities for the handicapped and other projects was halted for lack of investors. New York City’s market would have collapsed without a UDC default or the repeal of the Port Authority bond covenant. But these two psychological blows accelerated the crisis, prompted the investment community to take a closer look at the city’s books. When they did, in the winter and spring of 1975, the game was up.

I
N
M
ARCH AND
A
PRIL
1975, the market slammed shut to New York City securities. To save New York from bankruptcy, the state advanced the oity $800 million: As default—the inability of the city to pay its creditors, including its workers, on time—again loomed, in June Governor Carey shepherded the creation of the Municipal Assistance Corporation (MAC) to monitor city finances and to create “investor confidence in the soundness of the obligations of the City.” In August, all agreed the city’s cumulative deficit was over $3 billion. MAC was authorized to borrow $3 billion for the city, pledging specific revenues as security, and it was assumed that by September the city would be back on its feet and in the bond market.

It didn’t work that way. Investors remained wary. So, in September 1975, the state created the Emergency Financial Control Board, consisting of four elected officials—the governor, mayor, city and state comptrollers—and three nonelected business executives. The Board was granted tougher “emergency” powers to police the city’s budget, to approve or reject city contracts, and to order the preparation of a three-year city fiscal plan. Still, the Control Board did not succeed in restoring investor confidence.

Regular cash deadlines neared, and nerve-ending dramas were played out as all the participants marched to the brink of bankruptcy—each time pulling back at the point of no return. Usually, employee pension fund trustees would relent at the last minute and agree to invest more of their members’ money. Sometimes the banks agreed to roll over due dates on securities. With notes coming due in November, the state legislature, at the instigation of city officials, declared a moratorium on the repayment of $2.4 billion of outstanding city notes. Next, the federal government came to the rescue, narrowly approving a $2.3 billion annual seasonal loan to the city (to be repaid with interest) after assurances that this loan would put New York back on its feet. Without it, MAC Chairman
Rohatyn warned, the Western world’s economy might collapse. Without it, warned former Under Secretary of State George Ball, communism would achieve a great victory.

For the next three years, the city limped along, again barely escaping bankruptcy when the New York State Court of Appeals declared the Moratorium Act unconstitutional in November 1976. By the winter of 1978, the city once again admitted a huge deficit, once again returned to the Congress, once again issued dire warnings that without new federal loans New York—perhaps the country, perhaps the world—would go bust.

T
HE
F
RANKLIN
N
ATIONAL
B
ANK
retains the distinction of being the largest bankruptcy case in American banking history. In October 1974, the bank went broke. And in August 1975, eight Franklin National officers were indicted by a federal grand jury. The indictments charged them with trading in foreign currency without adequate collateral; filing fraudulent financial statements claiming profits of $79,000 at a time when losses were totaling $30 million; defrauding investors and creditors by issuing false financial statements to obtain a $35 million credit extension from Manufacturers Hanover Trust Company. Several laws were broken, including: Title 18, U.S. Code, Sections 1001 and 1014; and Section 32 and Rule 10b-5 of the Securities and Exchange Act of 1934. Most of the defendants received stiff fines and prison sentences.

The City of New York has the distinction of being the largest potential municipal bankruptcy in American history. In August 1977, the Securities and Exchange Commission issued an 800-page staff report accusing past and present officials of fraud. “The city,” they concluded, “employed budgetary, accounting and financial practices which it knew distorted its true financial condition.” As in the Franklin National Bank case, city officials were judged guilty of defrauding investors, of claiming nonexistent revenues and filing false and misleading financial statements in order to obtain more credit. Unlike the Franklin case, no one who participated in the city’s swindle has been indicted or gone to jail.

And yet some of the same laws could apply to past city financial practices:

(1) Federal laws pertaining to fraud—the filing of false statements and failing to make full disclosure. The Securities Exchange Act of 1934, particularly Rule 10b-5, makes it a potential crime—fraud—to fail to “disclose any material fact” in the sale of notes or bonds. Section 1001 of the U.S. Code, Title 18, makes it a crime to file false statements where the federal government is directly or indirectly involved, as they are in the sale of all securities; Section 1014 makes it a crime to file a false document with a bank insured by the federal government.

(2) The New York State penal laws pertaining to fraud. Sections 175.30 and 175.45 define the differing degrees of crime committed when a person files “a false instrument … with intent to defraud.”

(3) The New York State Blue Sky Law, Chapter 20, Section 352. This law permits the state attorney general to investigate any fraudulent “advertisement [or] investment advice” in connection with the sale or transfer of any securities.

(4) The New York State larceny laws. According to Article 155, it is a crime to “deprive” someone of his property. Section 155.40 says it is a crime for someone to “use or abuse his position as a public servant by engaging in conduct within or related to his official duties, or by failing or refusing to perform an official duty in such manner as to affect some person adversely.”

Violations of these laws entail severe penalties. Sentences range from one to ten years; fines, from $500 to $10,000. For federal and state felonies, the statute of limitations expires after five years; for a state misdemeanor, after two years. The statute of limitations for violations of state law by public officials, however, is extended to “within five years after the termination of such service.” Thus for a state felony the statute of limitations extends up to ten years; for a misdemeanor, up to seven.

Fraud laws can be pretty stern. In a 1925 case involving the city of Long Beach, New York (
People
v.
Reynolds
), a state court convicted municipal officials of fraud for making false entries in the city’s books, even though they did not personally benefit from their acts. In the 1967
Walston
case, underwriters of municipal bonds were found guilty for failing “to make diligent inquiry” to ensure that “all material facts” presented to investors were correct. In the 1974
Ferguson
case, a bond counsel was judged guilty and censured because “he should have known” that a securities prospectus
omitted important facts. And one does not have to commit a “willful” or knowing act to become vulnerable to prosecution. “If you are so negligent, at some point you become criminally liable,” explains a prominent attorney who advises MAC and is an expert on securities laws. “It’s like an engineer on a train who falls asleep and the train crashes and kills fifty. He did not intend to kill those people, but he is criminally liable.”

If these laws and precedents were applied to persons involved in “balancing” and financing city budgets during the last twenty years, a stadium would be needed to house the defendants. The roll call of those implicated would read like a
Who’s Who
of government and banking: Wagner, Lindsay, Beame, Nelson and David Rockefeller, former Treasury Secretary William Simon (in the late sixties and early seventies, he was the chief municipal bond dealer for the Wall Street banking firm of Salomon Bros, and served on the City Comptroller’s Technical Debt Advisory Committee), Harrison Goldin, former Deputy Mayors James Cavanagh and Edward Hamilton, former Budget Directors Melvin Lechner and David Grossman, former speakers of the state assembly, majority leaders of the state senate, City Council and Board of Estimate members, partners in the bluechip Wall Street law firms, prominent bankers and underwriters—to name a few.

They were Democrats and Republicans, Liberals and Conservatives. They had different personal viewpoints and political backgrounds, supported opposing candidates, feigned outrage in public debate and whispered disdain for each other in private. But they shared a community of interest, the same life preserver. When in a jam, public officials had a friend at Chase Manhattan and other banks. Everyone benefited. The public avoided unpleasant service cuts. Taxes were frozen—in election years. City officials could continue to expand services to their constituents. State officials could hold down state aid payments to the city. The financial community continued to reap handsome profits on tax-free municipals. Bond counselors collected huge fees. Unions received new pay and fringe benefits. The public got the promise of more services. There was little danger of exposure since there was little opposition. Most politicians went along. The press—usually more interested in politics than in government—would briefly note the tricks for a day, then forget them. Besides, these shenanigans were so complicated, the public wouldn’t understand—if they cared.