The Impending Municipal Bond Debt Crisis
Municipal bonds are a key financial instrument in the growth and development of local governments, but they may also be those same governments’ downfall. Whereas business bankruptcies harm investors and debt-holders, municipal bankruptcy can result in heightened taxes, budget cuts, public worker layoffs, and default. For too long, several cities have delayed their debt responsibilities, and cities’ recent (and likely continued) drop in tax revenues has greatly damaged their abilities to continue operating as expected. This article explores the fundamental flaws in municipal debt, how some cities have taken on too much debt, and what we can expect of these cities.
Historic Problems
Municipal bonds gained in popularity in 1945 after the US Supreme Court approved the tax exemption of interest on municipal bonds (Virtue, 1949). There were originally some provisions to protect investors, such as revenue bonds, in which municipalities would pay bond debt with utility revenues rather than tax collections. However, municipal bonds were difficult to accurately analyze, and many municipalities evaded debt limitations (Virtue, 1949). Beyond that, corrupt or even self-serving politicians may support the issuance of debt for a specific public purpose, while in reality using that debt for undisclosed purposes by the end of a business cycle. Municipal bond debt is also unique in that the generation who enjoys the greater public services financed by such debt is often different from the generation of taxpayers who pay off that debt (Virtue, 1949).
There have long been complaints about information asymmetry in the municipal bond market (Virtue, 1949), which largely stems from the fact that issuers are often first-time issuers, and buyers are often individual investors (Peng & Brucato, 2004). In fact, as of 2018, 83% of municipal securities are held by individuals as individual investors or in mutual and money market funds. Certain mechanisms, such as underwriter certifications and underlying credit ratings, have reduced such information asymmetry, as demonstrated by significant reductions in borrowing costs to issuers in the form of lower risk premiums demanded by investors (Peng & Brucato, 2004). Despite this, issuer disclosure of pertinent information is often delayed or inadequate, and progressive litigations, while effective, are relatively rare (Gellis, 1996). Additionally, such mechanisms are not adequate, as they do not address the underlying issue – the lack of initial disclosure by municipalities. The 1975 Tower Amendment to the Securities and Exchange Act of 1934 affirms cities and states are not subject to disclose information before issuing bonds unless such information is generally available from other sources, meaning obligations to disclose further information are often imposed indirectly through other provisions and regulations (Gellis, 1996). This is a known issue and has been criticized by public figures, such as former commissioner Luis A. Aguilar of the U.S. Securities and Exchange Commission.
Further, municipal bond’s tax-exempt status, which allows local governments to offer lower interest rates to investors and, thus, acts as a subsidy to local governments, has major fundamental flaws. Critics say such a status leads to greater yield volatility, widening inequalities, and economic inefficiencies (Fortune, 1992). They are also financially inefficient in that the cost to federal taxpayers equals the interest savings of local governments plus the extra returns awarded to municipal bond investors. In 1990, it was estimated that only 74% - 77% of muni-exempt federal taxes were received by local governments in the form of reduced interest payments on municipal bonds while the remainder was earned by investors (Fortune, 1992). Further, this subsidization of local governments strengthens the public sector while relatively putting the private sector at a disadvantage – resulting in an estimated $3.4 billion drop in annual aggregate output in the nonfarm, non-federal government sector between 1980 and 1985 (Fortune, 1992).
Current Problems
In addition to such asymmetric investment information and market inefficiencies, local governments have abused municipal bond debt at the cost of local taxpayers. Many have also hidden debt in the form of pension debt, which can be greatly skewed based on the return-on-investment rates a municipality uses in discounting future payments. By navigating around borrowing limits, many municipalities have stretched out repayment times and taken on additional debt. There are several mechanisms by which this has been occurring. One is cities’ growing pension obligation bond schemes in which they deposit bond money into pension funds hoping that they will grow in value faster than the interest on their debt. Another mechanism to create more debt is the creation of public agencies that are capable of issuing debt to finance projects that are funded by local property taxes and yet are not subject to voter approval. This has led to reckless and large failures, such as the construction of a baseball stadium for the Fresno Grizzlies. Not only is the city’s taxpayers now covering the $3.4 million in annual bond payments, but the city is paying the Grizzlies to stay. Similarly, the Massachusetts Bay Transportation Authority, which became financially independent in 2000, has excessively borrowed and now owes $500 million in annual debt payments – some of which had to be covered by taxpayers.
Amidst the pandemic, local governments are facing unexpectedly low tax revenues and large budgeting issues. For many cities, COVID-19 may be the nail in the coffin. The 2020 worst cities by debt per capita are New Orleans, Philadelphia, Honolulu, Chicago, and New York City – many of which are suffering due to underfunded retirement obligations. Debt per capita reflects a city’s ability to collect tax revenue to offset its debt, but a city’s total debt reflects the federal government’s ability to help that city. Using 2020 census population data, we can convert these cities’ debts per capita to total debts of $7.3, $40.6, $9.1, $99.1, and $544.1 billion, respectively. A large portion of this debt is in the form of pension fund shortages in which previous promises of pensions to public workers may be too large for current governments to actually pay. These cities are also now relying on the stock market not crashing again, as a majority of state pension assets are invested in stocks and alternative investments.
Mitch McConnell has suggested states should go bankrupt rather than relying on the federal government to plug holes in their budgets – to which Democrats are opposed on grounds of disrupting the municipal bond market and causing long term borrowing issues for local governments. In late April, however, the Fed announced its new Municipal Liquidity Facility, which will purchase up to $500,000 billion of short term notes from eligible states and counties. The facility was criticized for widening racial inequalities, as it will not cover smaller cities like Atlanta, Baltimore, or Detroit, nor will it cover Native American and overseas territories. Further, because only new debt issued with maturity dates under two years is eligible, critics believe the facility is too short-sighted and may cause additional problems towards maturity. Lastly, analysts are concerned that such a move can crowd out traditional municipal bonds and lead to the federalization of local debt financing - similar to complaints against the Fed’s intervention in the repo market in late 2019.
Local governments’ other options, of course, include hiking taxes or drastically cutting their budgets (whether in the form of fewer public services or workers). The Fed’s response may prevent defaults, but it provides no long-term solution for an arguably broken market. Unfortunately, whether now or later, it will most likely be the local taxpayers and public workers who will suffer due to elected officials’ short-term ambitions.
Works Cited
Fortune, P. (1992). The municipal bond market, part II: problems and policies. New England Economic Review, (May), 47-64.
Gellis, A. J. (1996). Municipal Securities Market: Same Problems--No Solutions. Del. J. Corp. L., 21, 427.
Peng, J., & Brucato, P. F. (2004). An empirical analysis of market and institutional mechanisms for alleviating information asymmetry in the municipal bond market. Journal of Economics and Finance, 28(2), 226-238.
Virtue, M. (1949). The Public Use of Private Capital: A discussion of problems related to municipal bond financing. Virginia Law Review, 285-315.
