Muni Abuses Weigh Down States, Cities
Speaking to the Wall Street Journal last week, the comptroller of Harrisburg, Pa., sounded downright glum as he explained his city's diminishing prospects of meeting a big upcoming bond payment. Harrisburg has just $1.2 million cash on hand and faces payroll costs alone of about $3 million a month. Even worse, it has about $17 million in debt payments coming due, a result of a series of "dizzying debt deals" according to a local newspaper. "We can't raise taxes; they're already very high," the comptroller explained. "If we did, people would just leave."
At least Harrisburg can take comfort in that it is not alone. A decade of exuberant, oftentimes unnecessary and occasionally barely legal borrowing by states and municipalities on top of rising employee costs have prompted increasing talk of a wave of defaults on municipal debt unlike anything since the Great Depression. So heated has the talk become, in fact, that the California legislature is considering a bill that would make it harder for its municipalities to declare bankruptcy because of worries that many will want to do just that (this is the same legislature whose own state government had to issue IOUs last year to pay its bills).
Increasingly, public officials have blamed their debt woes on the sharp drop in tax revenues from the recession, and so a clamor for bailouts has been growing. But as the debt crisis intensifies we should look more closely at its causes. Although in theory a market where governments can issue tax-free debt to fund long-term projects seems like a good idea, in practice the municipal bond market is increasingly abused by politicians who use the debt to finance ill-advised projects that taxpayers don't want, or employ borrowing to evade tax and spending limitations in state constitutions or local laws, or who simply see debt as the source as another pot of money for political patronage.
The long-term trends are stark. In the last 15 years, total state and local debt outstanding increased to about $2 trillion, a gain of about 125 percent, or nearly twice the rate of inflation plus population growth. This debt has also grown faster than the nation's personal income.
Much of the gain was driven by recent debt-binging. In this decade governments floated an average of $376 billion of new debt every year, compared to just $180 billion annually in the previous period. Issuing so much new debt is especially a big problem if you are not paying off your old debts. On average since 1990, in fact, state and local governments have been issuing about 50 percent more debt every year than they are retiring.
Governments have used municipal bonds in the U.S. since at least the early 1800s, often to finance construction of roads, canals, railroads and other important infrastructure as the country grew. In 1913 the new federal income tax ensured that most of these offerings would be tax-free to local residents, which is what makes them a deal for governments, who can pay interest rates below what private issuers are paying and still attract investors.
But over time governments have shifted more and more of their borrowing away from long-term infrastructure projects and toward other, "special" uses that have done little to provide essential services or secure an area's economic viability. Over the course of this decade, for instance, governments have floated just $24 billion a year on average for transportation projects and $14 billion a year for utilities investments, but $70 billion a year on "other" types of bonds, a catch-all class that includes various sorts of abuses.
Take New York State, for instance. Every year state legislators divvy up hundreds of millions of dollars that they dish out in earmarks from money raised through bond offerings, which the Institute for Competitive State Government calls "capital pork." Once upon a time this pork was financed with cash out of the budget, which is bad enough. But for more than a decade the state has simply floated bonds and hidden where the cash has gone until the Manhattan Institute filed a Freedom of Information Act which forced the state to disclose its grant recipients, including local little leagues, senior citizen centers, and community nonprofits. Grantees also included the Brunswick Sportsman's Club, a private club associated with one legislator, and a Western New York organization known as Christian Airmen organized to "evangelize in the aviation community." Not surprisingly, New York is the nation's second most indebted state.
Muni bonds have helped build a generation of government-funded projects that the marketplace would never risk investing in on its own because these projects are so ill-advised and uncompetitive. One good example: starting in the early 1990s local governments went on a convention center building spree, using bonds to help construct meeting facilities that the private sector wouldn't build. The result is about 40 percent more convention space than the country needs, empty facilities that are running in the red and deeply discounted hotel rooms. Meanwhile, taxpayers are stuck with the bill.
Perhaps most disgracefully, more and more of the muni debt that's piling up is not approved by voters but issued by politicians who find ways to circumvent laws that require taxpayers to sanction new debt. To evade these requirements, states and cities have formed independent authorities and other mechanisms that courts somehow judge to be free from debt restrictions.
And so, for instance, when New Jersey wanted to raise money for a gigantic $8 billion school building program that seemed loaded with unnecessary spending, the state simply formed a construction authority and authorized it to raise the money without consulting voters. In just a few years the new authority burned through all of its money while completing just half the work, a remarkable amount of waste even in a state as corrupt as New Jersey. And although voters didn't get to approve, they got stuck with the bill.
Still, even these authorities that float debt without voter approval aren't the biggest outrage. As states and cities have increasingly shirked their growing pension obligations in recent years, they have been issuing something called "pension obligation bonds" to fund their rich employee benefits. These POBs are potentially toxic because they are a risky form of arbitrage in which government raises money from a bond offering, invests it in the stock market and then bets that stocks will provide a higher return than the interest rate that government is paying to bondholders. But if the market tanks, as it has for most of this decade, an underfunded pension system's liabilities could go from bad to worse. A mistimed POB in the late 1990s in New Jersey, for instance, has plagued the state's budget for years. Illinois, meanwhile, has placed some big bets with POBs in an attempt to bolster its pension system.
Looking out over this rubble, the muni environment increasingly resembles the savings and loan industry during the worst years of the 1980s in one important way: It's a market served by sophisticated Wall Street advisors counseling unsophisticated politicians who often have a big stake in believing this debt is all safe and affordable, and who know that even if it isn't, someone else will pay the price for failure, namely the taxpayer.
When New York City defaulted on its debt in the mid-1970s the subsequent rescue by the state and federal governments came with a series of fiscal constraints that ended the city's most egregious borrowing practices. Will the bailouts and workouts that accompany a new round of defaults also come with conditions and restrictions that bring some common sense back to the current municipal market?