It's Become Too Easy to Blame Wall Street

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In the summer of 2003 the Oregon legislature decided overwhelmingly to ask voters for the right to issue billions of dollars in pension bonds to help fund public employee retirements. The ballot measure had the support of virtually all state officials and was endorsed by Oregon's major newspapers. The Statesman-Journal called the initiative "a no-brainer" while the Oregonian claimed that the measure "is exactly what taxpayers say they want: State government acting prudently, like a business." The newspaper dismissed the only organized opposition to the measure, Oregon's Libertarian Party, as a group "desperate to get someone, anyone, to notice them."

Pension bonds are, in reality, hardly a no-brainer. They involve a risky form of arbitrage in which governments invest the proceeds of bonds in the stock market and bet the money can outperform the interest they must pay back to investors. Way back in September of 2003 Sage Investment Advisory Services noted that pension bonds were not, as proponents in places like Oregon were claiming at the time, simple ‘refinancings' but were potential debt ‘bombs" that would go off if the stock market tanked. As the Center for State and Local Government Excellence recently noted, most pension bonds have in fact been "a net drain on government," including apparently in Oregon.

Newspapers there are now up in arms about huge unfunded state and local pension liabilities and the fact that pension bonds have state and local governments looking at potential fiscal disaster, given the plunge in the stock market. And Wall Street gets a big part of the blame, apparently. A November front-page story in the Statesman-Journal entitled, "How a pension play paid off... for the dealers," noted in great detail that the biggest Wall Street firms contributed money to the campaign to pass the state initiative in 2003 and then actually profited when voters approved the measure. The story is remarkable in the degree that it outlines all of the risks associated with pension bonds that never made it into any of those editorials endorsing the ballot initiative in 2003. And nowhere in the piece did the newspaper note that its own editorial page had called the plans to issue pension bonds a "no-brainer,' and that Wall Street's money almost certainly didn't make the difference on a landslide vote in which the only significant opposition came from those "desperate" libertarians.

This is more than just an isolated case of journalistic negligence, however. It's part of the next wave, really. You see, even though the recession appears to have ended and the recovery begun, there is more pain to come, and the next wave may well come in the arena of municipal finance. And someone easy to blame, like Wall Street, must be put forward.

States and municipalities have loaded up with trillions of dollars in debt through unwise bond offerings and unsustainable pension promises to government employees. They've done so in a market that is rife with abuses by politicians and government officials. Once thought of as the place where local governments go to raise funds to build our essential infrastructure, muni debt is now the vehicle that politicians use to finance their own unwise schemes, from government supported stadiums and arenas to risky and impractical redevelopment projects that the private sector wouldn't touch by itself. Local officials have used debt increasingly to escape from making the tough political decisions like cutting spending or raising taxes, and to garner support from public workers by bribing them up with untenable future commitments.

Many observers of the muni market now expect a meltdown of one sort or another, especially since tax revenues are recovering very slowly. Rick Bookstaber, a senior policy advisor to the Securities and Exchange Commission, recently shook things up when he observed on his blog that the market has all the characteristics in place for a wipeout. "Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened," he wrote.

When the defaults come, so will the cries for bailouts, because when municipalities are awash in debt they inevitably wind up having to make steep cuts in services. Bailouts are much easier to arrange, however, when the people asking for them are not the perpetrators of the mess. It will be so much easier if we can just blame Wall Street.

The stage is being set to do just that. For instance, the Service Employees International Union, which represents government workers around the country, has now embarked on a "stop the swaps" campaign which focuses on the deals local governments made with Wall Street firms linked to another round of unwise municipal debt. States and municipalities began using interest-rate swaps liberally earlier in the decade as hedges against variable-rate bonds they were issuing. Governments wrote the contracts to lock in low rates and protect themselves against having to pay bond investors more if interest rates rose, as expected. But as part of this protection, governments also agreed to pay Wall Street firms if interest rates declined. Of course, rates haven't just declined, they've plunged in recent years, and governments are now on the wrong end of these costly bets they made with Wall Street firms.

And so it's time to blame Wall Street for the thousands of swaps contracts out there burdening budgets, as SEIU head Andy Stern did recently: "We're not going to allow the same Wall Street bankers who burnt our economy to the ground to come and loot what's left," Stern said at one of SEIU's stop-the-swaps rallies. Stern made no mention of the fact that politicians endorsed many of these contracts against risky variable rate bonds that they chose to issue so that they could camouflage their true debt and make their budgets appear to be in better shape than they actually were. Instead, the emerging story-line is that Wall Street buffaloed a lot of simple-minded but well-meaning politicians into investments they didn't understand.

But Wall Street is not the cause of the coming municipal debt shakeout. It is merely an enabler of politicians, who use borrowing as a means to extend their reach far beyond the power that tax revenues give them. Yes, a Wall Street firm will happily underwrite business a politician brings to it without asking whether voters really want this debt. And before the SEC disallowed pay-to-play, firms were happy to pony up millions in political contributions to get in on the underwriting action.

Although Wall Street firms are hardly managed by choir boys, they wouldn't have a business here if politicians didn't do their best to evade limits on constitutional borrowing, create an array of special government entities to hide true debt levels from voters, and violate many of the basic principals of good government by using debt to make promises that saddle taxpayers with big future bills.

Wall Street didn't create the emerging state and local debt bubble. Governments did.

Steven Malanga is an editor for RealClearMarkets and a senior fellow at the Manhattan Institute

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