Muni Investors Beware: If You Get Burned, You Deserve It
Detroit's bankruptcy has provoked a considerable amount of debate about how the municipal bond market is changing. The city's emergency financial manager, Kevyn Orr, has even declared that he would treat a chunk of Detroit's general obligation bonds, traditionally considered the safest local debt, as unsecured borrowing.
I don't know if Orr's view of municipal debt will prevail. But as American cities and states grapple with mountains of debt amid rising taxes and shrinking services, it seems likely that some new set of priorities about repaying the trillions of dollars that local governments owe (and in some cases can't easily pay) is going to emerge. One class of debt that might prove vulnerable, especially if taxpayers figure out how they've been conned over the years, is debt that's masquerading as something else.
Here's what I mean. The vast majority of state constitutions include limitations on how much a government can borrow, and restrictions on when it can borrow. Just as predictably, politicians in many states and cities have spent decades evading these restrictions and piling up borrowing that falls outside constitutional restrictions.
In a 2003 scholarly article, Columbia Law School Professor Richard Briffault estimated that nearly three-quarters of state debt and two-thirds of local borrowing has taken place outside the legislative limitations on debt that taxpayers think offer them protection from borrowing-happy politicians. States and cities have accumulated this borrowing, Briffault argues, by calling it something other than debt, what he terms ‘non-debt debt.' To evade constitutional limits, local governments often float this debt by claiming it's not actually the responsibility of taxpayers to pay back.
Maybe sometime soon if a burgeoning debt revolt gathers steam, taxpayers and reform politicians will in fact start declining to repay some of this non-debt.
There are a bunch of linguistic maneuvers that politicians and the bond underwriters they employ use to create borrowing loopholes. One technique is to call these borrowings ‘subject to appropriation' bonds, where investment documents say that repayment is not the obligation of taxpayers. Instead, bond holders will be repaid ‘subject to appropriations' by the state legislature (or the city council, or the local school board, depending on who is doing the borrowing.) The fiction that these documents create is that somehow the legislature has its own funds separate from those supplied it by taxpayers, as if maybe your state representatives intend to pass the hat among themselves to repay these bonds.
In other cases, local governments have created independent authorities and done the borrowing through them, dedicating revenues supplied by taxpayers to the authorities for repayment of the debt, even though the taxpayers had no hand in approving it.
Sometimes this hidden debt is in the form of complex lease-financing deals which are little more than borrowing masquerading as rent. Perhaps the most infamous recent case of this was when Arizona sold government buildings to itself in 2009 then leased back the buildings for state government's continued use. No one took title to the buildings. Instead, the state floated tax-exempt certificates of participation, then took ‘rent' payments from itself, deposited them in a trust and used the money to pay bond holders what it called rental payments.
No one is fooled by these maneuvers, least of all the courts that routinely approve them. As New York's Court of Appeals observed in one challenge to a state debt offering, "modern ingenuity, even gimmickry" have "stretched the words of the [New York] Constitution beyond the point of prudence." Still, thanks to the court's unwillingness to rein in these evasions, 95 percent of all New York state debt has never been approved by taxpayers, according to a recent study by the state's comptroller, even though the New York constitution requires that taxpayers vote on all new debt.
Similarly, California's supreme court acknowledged in one case involving such debt that the court was, "not naive about the character of this transaction," yet the judges declined to stop the offering.
Professor Briffault speculates that courts in some states have routinely ignored what their own constitutions say on debt because judges, "appear to share with state governors and legislators a belief in the legitimacy of the modern activist state."
Over the years investors have scooped up this non-debt debt, often demanding only a slight premium over municipal borrowing that actually calls itself ‘debt' and that is directly backed by taxpayer commitments. Investors have assumed that elected officials wouldn't dare fail to repay the non-debt even though it's not technically guaranteed.
But as states and cities face an ever-growing heap of liabilities, including obligations like pensions which are protected by contract law and legislative safeguards, something has got to change about the way we prioritize and rank debt for repayment.
Detroit's bankruptcy has begun the process of upsetting the old rankings. Emergency financial manager Orr even rebuked bondholders who balked at the meager repayment terms he offered them by observing that Detroit was going bankrupt, "as openly and notoriously as possible since 2000," yet they continued buying its debt.
Today, I hear a lot of anger from taxpayers about unaffordable pensions, because those are in the news. They're a tempting, but also difficult, target.
But as the budget crunch hits more and more places and taxes rise while services decline, the mountains of never-approved debt issued under unusual contract terms, sometimes with claims this is not debt at all, will be a tempting target, and an easier one to forgo than some other state and city obligations.
Investors who get burned will deserve it.