Underwriting, Brokerage, and Risk in Municipal Bond Sales

Municipal finance practitioners and scholars have given considerable attention to the evaluation of municipal bond issuance. Much of this work has focused on the cost implications of various choices made by government borrowers when preparing to issue debt. An important component of borrowing costs is the compensation that accrues to firms underwriting the bonds. These firms are presumably compensated for their time and effort in arranging the purchase of bonds from the issuer and then the resale of bonds to customers and for the risk that they are assuming by carrying the bonds on their books until the bonds are resold to customers. The financial value accruing to the underwriting firm as a result of participating in such a sale comes from the underwriter’s discount and from the capital gain (or loss) experienced when reselling the bonds to customers. This article seeks to better understand and describe differences in the manner in which firms purchase and resell bonds in order to more precisely classify firm behavior. In order to make a distinction between underwriting and brokerage, the authors look at the resale risk that firms actually experience. This article presents several examples of actual transactions and post-sale trading where the risk exposure is substantially different and offers definitions of underwriting versus brokerage that use this distinction.