The Muni-Bond Debt Bomb
. . . and how to dismantle it.
By STEVEN MALANGA
Wall Street Journal
In the early 1970s, New Jersey officials decided to build a sports facility in the Meadowlands, the state's wetlands just outside New York City. To help pay for it, they formed the New Jersey Sports and Exposition Authority (NJSEA), a quasi-governmental agency with the power to issue debt.
The authority floated $302 million in bonds, used the proceeds from the bond sale to construct Giants Stadium and a Meadowlands racetrack, and planned to pay off the debt in 25 years, largely with proceeds from the track but also with some help from the stadium. Horse racing proved a big hit, and the plan seemed bound for success.
But the pols couldn't resist soaking
the Meadowlands. They siphoned track proceeds into the state budget; repeatedly refinanced the NJSEA's bonds, pushing repayment dates far into the future; and relied on the authority's good credit rating to launch other building schemes
, including a costly but unsuccessful aquarium in Camden. Today, 35 years after its first bonds, the NJSEA is $830 million in hock.
Worse, it can't repay that debt because business has cratered at the racetrack, still the Meadowlands' principal revenue source. As for Giants Stadium, it was demolished this year, and its replacement won't be contributing much to the debt repayments. The state, facing its own cavernous budget deficits, has had to assume the authority's interest payments—about $100 million this year on bonds that now stretch out to nearly 2030. "The sports authority is paying the consequences for politicians using it for their pet projects," observes Steve Lonegan, former mayor of Bogota, New Jersey.Stories like that have become frustratingly common around the country. State and local borrowing, once thought of as a way to finance essential infrastructure, has mutated into a source of constant abuse. Like homeowners before the housing bubble burst, states and cities have gorged on debt, extended repayment times, and used devious means to avoid limits on borrowing—all in order to finance risky projects and kick fiscal problems down the road.
Though the country's economic troubles have helped expose some of these unwise practices, the downturn has brought not reform but yet more abuse. Even as Tea Party protesters and taxpayer groups revolt against excessive government spending and taxes, they are paying too little attention to the gigantic state and local debt bomb.
If it can't be defused, we're all at risk.
Government debt helped finance the expansion of the American republic. The first municipal bond on record in the United States was an 1812 New York City offering to pay for digging a canal. Six years later, New York State began issuing bonds to finance the $7 million construction of the Erie Canal, whose beneficial impact on the state's economy led other states and cities to rush out bond offerings to pay for new roads, bridges, and waterworks. Total state and local debt outstanding hit $200 million by 1840 and about $1 billion by 1880 ($22 billion in today's dollars).Though the early muni-bond market helped the young country grow, the borrowing could be risky. Some of the toll roads, railroads, and other endeavors were highly speculative and failed to generate enough income to pay back investors.
The five-year downturn that followed the 1837 bank panic left eight states, including Pennsylvania, unable to pay off their bonds, prompting William Wordsworth to pen "To the Pennsylvanians," an ode that castigated those in the state who had "ruthlessly betrayed" the legacy of prudent founder William Penn. Realizing that the defaults would interfere with their ability to borrow in the future, some states imposed debt restrictions on themselves, and eventually inserted requirements into their constitutions that voters approve future bond offerings.
Those moves made the market more secure, but they didn't protect investors from occasional bouts of irrational exuberance. After a flurry of municipal offerings in the 1920s, for instance, total outstanding municipal debt in America reached some $16 billion ($250 billion in today's dollars). Then the Great Depression arrived, drying up tax revenues and leaving governments unable to meet their debts. The 1930s would see 4,500 defaults by state and local governments. It wasn't until the 1950s that the muni market bounced back and debt outstanding surpassed pre-Depression levels.
Though the immediate postwar years proved tranquil, they also saw some troubling changes in the market. States and cities began to expand the scope of what bonds financed to include everything from subsidized housing to private hospitals to urban redevelopment to private industrial development, and they found new ways to skirt state constitutional limits on borrowing. The borrowing craze led to a series of spectacular fiscal crises in the 1970s.
Beginning in the previous decade, New York City, under Mayor John Lindsay, had rapidly increased spending on an ambitious menu of social welfare programs, borrowing hefty sums to paper over the resulting deficits. By 1975, New York was borrowing $500 million a month just to pay its everyday bills. Eventually, the banks that managed the debt offerings refused to underwrite further borrowing, fearing that in the increasingly likely event of a default by the city, they might be held liable. New York State and the federal government were forced to bail Gotham out.
Three years after New York's crisis, Cleveland actually did default on $14 million in bonds, in the first major municipal bankruptcy since the Depression. Like New York's, Cleveland's budget had swollen rapidly, expanding by 42 percent between 1972 and 1977, even as the city's population and tax revenues were falling. Cleveland funneled millions of dollars borrowed for capital expenditures into day-to-day operations until the banks refused additional credit and the city's money ran out. Cleveland spent two years unable to borrow and had to make big spending cuts before returning to solvency.
These debt crises woke politicians up. By the late 1970s, borrowing had fallen significantly, and state and local debt as a percentage of the country's gross domestic product had shrunk. Over the next 20 years, the country's fiscal picture improved: debt rose only slightly as states used good times to pay their debts.But such salutary responsibility went by the wayside at the start of the twenty-first century. As memories of the earlier crises faded, politicians, eyeing splashy new development projects
and confronted by powerful constituencies like public unions that agitated for plush benefits, began loading up on debt again. Over the last decade, through good times and bad, total state and local debt has soared from $1.5 trillion in 2000 to $2.4 trillion (in current dollars). When that debt is added to other growing obligations that governments are racking up, using techniques like not paying their bills on time, state and local liabilities have increased from 15 percent of GDP in 2000 to an estimated 22 percent this year. In 1980, they were 12 percent.Even more disconcerting than the crushing debt is what it has paid for: giant development projects, for starters, including many in which the private sector has wisely shown little interest, except when government subsidizes them.
These projects trace their origin to the urban-renewal movement of the 1950s, when states and the federal government cleared tracts of supposedly blighted urban slums and replaced them with large, centrally planned housing projects. Over time, such efforts became so widespread that even thriving communities were declaring themselves blighted to justify construction. The nature of the projects changed, too, as politicians increasingly issued bonds to make bets on private ventures whose economic benefits were uncertain, at best.
California's redevelopment regime is an egregious case. Starting in the 1950s, the state gave localities the right to create public agencies, funded by increases in property taxes, which could issue debt to finance redevelopment in blighted areas. A whopping 380 such entities now exist in California. They collect 10 percent of all property taxes—nearly $6 billion annually—and have borrowed $29 billion to pay for projects ranging from sports facilities to concert venues to subsidized shopping malls. Originally designed to expire after they have improved an area, the agencies go on forever by claiming that blight never disappears. Consider San Jose's redevelopment agency, one of the state's biggest, which filed an application last year to increase its allocation of property taxes. Blight was getting worse in the city, the agency argued—52 years after it was created to eliminate it.
The California agencies' failures have sometimes been spectacular. In 1999, Fresno conceived plans to revive its downtown area with various projects, including a baseball stadium for the minor-league Grizzlies, whom it had lured from Phoenix. The city's redevelopment agency floated some $46 million in bonds to build the stadium, commissioning the world-famous architectural firm HOK, whose résumé includes Camden Yards in Baltimore, to design it. The plan was to repay the debt with help from the rent that the Grizzlies would pay. But the Grizzlies fizzled in their new home, and under financial strain, they have demanded a break in their rent and threatened to skip town if they don't get one—sticking taxpayers with the entire $3.4 million annual bond payment on the facility. Meanwhile, the Fresno Metropolitan Museum has gone bust, defaulting on $15 million in debt that the city had guaranteed for it—which the city is repaying with money from still more borrowing, to the tune of $750,000 a year. As for that downtown blight: "In 1999, experts called [downtown] dirty, outdated, underutilized and disconnected," the Fresno Bee recently observed. "By 2009, many of the same complaints persist, despite the stadium and other additions to downtown."
In fact, California's government-financed stadiums and sports arenas, like others around the country, have frequently failed to produce the economic bounce that politicians promised. In 2008, two reporters for the Press-Enterprise in Riverside surveyed the record of California sports venues built with public subsidies. In Lake Elsinore, a baseball stadium constructed in 1994 with $24.3 million in bonded debt couldn't meet its obligations for six years, forcing the city to dip into its general fund to make up the difference. A San Bernardino stadium that opened in 1996 with $17 million in public funds is paying off its debt, but it has spurred no new development. "There's a huge consensus among economists that there is no economic development benefit to these stadiums," notes economist J. C. Bradbury.
Nor do other projects that seek Californians' entertainment dollars pay much better. A San Bernardino amphitheater that opened in 1993 with financing from a $22 million bond offering hosts only a handful of concerts every year and can't make enough money to meet its debt payments, the Press-Enterprise found. "If there's a need for it, the market will supply it. We don't need government subsidizing it," says state assemblyman Chris Norby.Cities that use municipal debt to subsidize expensive private projects often get into fierce competitions for the privilege of subsidizing them.
Atlanta and Charlotte, for example, recently unleashed a bidding war for NASCAR's Hall of Fame—a private enterprise. Atlanta assembled a $90 million package that included $32 million in subsidies, largely from economic-development debt issued by Georgia. But Charlotte pols—desperate, according to the Charlotte Observer, to "secure a one-of-a-kind attraction that finally answers the question: What's Charlotte got that makes it different from any other city?"—trumped Atlanta with a $154 million bid, promising to build the museum by issuing bonds and to service the bonds with funds from a new hotel tax, despite an economic-development study's conclusion that increased annual tourism from the venture wouldn't equal what a single NASCAR race generates.
The price tag for the Hall of Fame quickly rose to nearly $200 million, and Charlotte was on the hook for all of it. Further, back in 2006, when Charlotte had made its bid, the city was on a roll, with budget surpluses and plenty of ability to issue debt and pay for it; but after the worldwide financial-sector meltdown, Charlotte, a regional banking center, watched unemployment skyrocket from under 5 percent to 12.8 percent, laying waste to tax collections. The city has already had to dip into a reserve fund to pay the debt service on the just-opened Hall of Fame. As the head of the Charlotte Chamber of Commerce observed, "It is a new decade and Charlotte is not the same. Unemployment is stubbornly high. The real estate market is anemic. Public revenues are challenged." Yet he also argued that there was room for optimism. Why? Because of expensive new projects like the NASCAR Hall of Fame!
Charlotte isn't alone. Across America, states and cities have heaped on the debt to build facilities aimed at luring tourists and conventioneers away from other states and cities. For instance, cities have been waging a two-decade-long "arms race," as University of Texas public policy professor Heywood Sanders puts it, to expand convention centers, and have been funding them through billions of dollars in municipal debt. The result: a market with perhaps 40 percent more space than demand warrants, underperforming facilities, operating deficits, and little economic payoff. Washington, D.C., spent $850 million to triple the size of its convention center; its business has since eroded. Indianapolis is in the middle of a $275 million expansion of its convention facility; the center is struggling even to hold on to its current business. Chicago has shelled out $1.5 billion to expand McCormick Place; business there has fallen by a third since 2000, from 3 million visitors a year to 2.1 million. The Orange County Convention Center in Orlando, Florida, which officials expanded at a cost of $748 million in 2003, suffered a record $18 million operating deficit last year.Recall that many states sensibly require all bond offerings to be approved by voters—who have often defeated new borrowing aimed at financing grand, politically inspired projects. But the requirement has led to a rise in maneuvering by officials, who have created quasi-governmental authorities that can issue debt without voter approval. Such backdoor borrowing has become the most common kind of state debt.
In New York, which has 230 of these independent entities, voters have approved only $3 billion of the state's $60 billion of bonded debt outstanding. California's army of redevelopment agencies can likewise borrow without the approval of the voters whose taxes they ingest.When government can create a shadow world of independent agencies able to borrow without consulting voters, abuses become inevitable.
In 2001, after the New Jersey Supreme Court ordered Trenton to embark on a construction and renovation program for schools in poor districts, the state legislature extended the initiative to districts across New Jersey, inflating a $2 billion program to $8.6 billion. Knowing that voters would never swallow the cost, the legislature set up an independent construction authority and sanctioned a massive debt offering without voter approval. Largely unaccountable, the authority became a patronage pit ridden with waste and corruption; investigations by newspapers and the state eventually revealed that it could accomplish only half the job with its huge pot of money. Despite the scandal, the court signed off on a second, $3.9 billion bond offering in 2008 so that the authority could finish the work it had bungled.Another unaccountable independent agency is the Massachusetts Bay Transportation Authority (MBTA), which runs Boston-area mass transit
. In 2000, Massachusetts moved to make the MBTA financially independent. As part of the plan, the authority was supposed to reduce costs and gradually pay down some $5.6 billion in debt; instead, it continued to spend liberally, deferred the debt payments, and borrowed even more money—again, without voter approval. Today, the authority owes $8.5 billion and is paying a staggering $500 million yearly in debt service, which has forced it to neglect maintenance, shelve expansion plans, and cut service. It also needed a $160 million bailout from taxpayers to close a budget deficit last year.Politicians increasingly use municipal debt to create the false appearance that they are balancing the budget. One feature of muni debt that helps the pols is the sheer complexity of governments' relationship with the independent authorities.
Back in 1990, New York State faced a deep budget crisis, but Governor Mario Cuomo didn't want to borrow money to fund day-to-day spending—a fiscal no-no. Instead, he sold Attica Prison to an authority, the New York State Urban Development Corporation, for $200 million—which the authority raised through a bond issue—with the understanding that the state would continue to use the prison over the next 30 years by making yearly payments to the authority. This fiscal trick amounted to the state's borrowing the money itself, of course, but it didn't look as improvident. Then, piling irresponsibility atop chicanery, the authority frequently refinanced the debt, so that it still owes $300 million on the original offering, even after paying bondholders $242 million.The other way that muni debt camouflages politicians' fiscal extravagance is with repayments on bonds that stretch far into the future. Politicians tend to consider debt more palatable than tax increases or spending cuts.
New York's current lieutenant governor, Richard Ravitch, has proposed $2 billion in borrowing this year to close the state's budget gap, even though financing day-to-day operations this way brought New York City to its knees 35 years ago. (Ravitch, ironically, helped engineer the bailout of Gotham back then.) Closing the state's budget gap with spending cuts would be "totally disconnected from reality," Ravitch claimed, in justifying the new debt: voters aren't ready to accept service reductions. He apparently thinks that New Yorkers are okay with adding more debt, even though they've voted down numerous bond offerings when given the chance.States and cities have also used muni debt to play dangerous games in the stock and bond markets. A particularly potent weapon in the politicians' debt arsenal is the so-called pension-obligation bond, the municipal equivalent of borrowing money on your credit card to make contributions to your IRA.
Oakland issued the first pension-obligation bonds, which were tax-free, in 1985, and invested the proceeds in taxable securities, which paid the city a higher interest rate than it had to pay on the bonds. Oakland then banked the difference in its pension fund for city workers. The move proved too slick for Washington, however, which eliminated pension-obligation bonds' tax-free status in the Tax Reform Act of 1986.
But that didn't end their use. During the early 1990s, governments started playing a risky arbitrage game in which they issued bonds and then invested the money in the stock market, hoping that the market would outperform the bonds.
For a while, the strategy worked: the market was rebounding from the 1989–90 recession, and returns were good. But over the long term, it proved impossible for the stock market to keep up with the returns that the pension bonds were offering. As the Center for State and Local Government Excellence noted in a report earlier this year, most pension bonds issued since 1992 have been money losers for states and cities.
Take New Jersey, whose fall into fiscal chaos has been accelerated by pension bonds. During the mid-1990s, the pension system for state and local employees needed shoring up because the previous governor had overvalued the system's assets. Governor Christine Todd Whitman took the easy way out, deciding to finance the state's payments into the system by taking the proceeds from a pension-bond sale and investing them in the stock market. The market was near its peak; since then, of course, it has endured a decade of essentially zero growth. So Jersey's returns were dismal: the state now has so little cash that it has been skipping its payments into the pension system. Now, to add insult to injury, it must start paying back the bonds that it issued. Some actuaries say that the state's pension system will either go bankrupt in the next several years—testing the limits of guaranteed public-employee pensions—or need a federal bailout. "These pension funds are often run for a political rate of return to keep the pension benefits high and put off the costs," says Rick Dreyfuss, an actuary and a fellow at the Commonwealth Foundation in Harrisburg, Pennsylvania. "It's a recipe for disaster."
Or look at Oregon. Seven years ago, officials there began to push for a change in the state's constitution to let its pension funds issue bonds, saying that it would save millions of dollars. The Statesman Journal in Salem called the idea "a no-brainer," while the Oregonian claimed that it constituted "state government acting prudently, like a business." The measure passed, and Oregon municipalities loaded up with billions in pension debt, which they invested in the market—often using risky investment strategies in an attempt to beat what the bonds paid out in interest. That approach proved ruinous during the financial crisis. In 2008, Oregon pension funds lost 27 percent of their value, the largest decline in the state's history. Oregon taxpayers are now staring at a $1.2 billion hike in the state's contributions to the pension system. "That could force school districts, cities and counties to lay off workers or cut services as they struggle to pay higher pension contributions," the Oregonian noted, conveniently omitting its earlier support for the bonds.All these debt-enabled abuses—extravagant spending, concealments of budgetary problems, and risky investment strategies—came to a head in the second half of 2008, when spooked investors withdrew from the muni-bond market in droves.
A downturn in tax revenues had revealed how little breathing room some local governments had left themselves to pay their debts; also, several insurers that typically backed muni bonds had exited the market, leaving buyers unprotected against defaults. The investors' flight should have signaled to cities and states that it was past time to reform their debt practices.Instead, the federal government reopened the muni-bond business by stepping in with a new kind of municipal offering, the Build America Bond, which is taxable but can offer an attractively high interest rate because it's partly subsidized by Washington.
Municipalities enthusiastically embraced the new bonds, racking up another $58 billion in debt in 2009. It's no surprise that the states in the worst fiscal shape, thanks partly to previous borrowing, made the biggest use of the bonds; California led the pack.
Build America Bonds have worsened what economists describe as a misallocation of resources that results from municipal debt's favored status. Muni bonds are usually tax-free, and numerous studies have estimated that of the enormous tax revenues forgone by the government, 20 to 33 percent goes to the bond buyers, who tend to be high-income individuals. That's a huge incentive not to invest in the private sector by buying, say, corporate bonds or equities. Economist Peter Fortune estimated in the early nineties that the misallocation reduced private-sector output by billions of dollars a year; the amount is obviously far larger now. The introduction of Build America Bonds, attracting a whole new class of investor with subsidized interest rates, will make the misallocation even greater.
The current crisis in state and local budgets may be the best opportunity in ages to bring reform to the muni market. Critics have argued in the past that the government should abolish the federal-tax-exempt status of municipal bonds. Those arguments have gone nowhere because the market has powerful defenders: the Wall Street firms that earn underwriting fees selling bonds; the investors benefiting from subsidies; and state and local politicians making liberal use of the debt.Still, Congress has narrowed muni debt's tax-free status in the past to eliminate egregious abuses, and it's time to do so again. One place to start is municipal debt used to finance for-profit businesses, a job that governments are ill equipped to perform capably.
Take the city of El Monte, California, which subsidized the opening of a handful of local car dealerships and watched three of them go bust. When cities take the process a step further and get into bidding wars with one another for things like the NASCAR Hall of Fame, they drive up the price of the attractions, ultimately at a heavy taxpayer cost. Congress should revoke the tax exemption for bonds in all these cases.
Another key reform is to restrain or eliminate the independent authorities. New Jersey has already moved in this direction with a 2008 referendum, approved by voters, constraining the authorities' ability to issue debt without voter approval. Meantime, in California, critics of local redevelopment authorities are intensifying their efforts to rein in or eliminate these bodies. Taxpayer groups point to studies showing that regions of the state that have created the authorities don't do much better than regions that lack them. If that's true, much of the real-estate tax money that they collect winds up wasted, including money that could help fund basic services like schools. "Redevelopment is an ever-growing blight on education finance" because of the tax dollars it siphons away, argued Doug McNea, president of the Silicon Valley Taxpayers Association, in the San Jose Mercury News recently.Finally, states and cities need to limit debt-related fiscal maneuvers. They could begin with sophisticated investment vehicles like swaps, which few politicians understand. In recent years, some municipalities tried to insure their bonds against rising interest rates (and, consequently, rising payouts to bondholders) by purchasing swaps contracts with Wall Street firms: if rates rose, the firms would pay the governments; if rates fell, the governments would pay the firms. The arrangement would have worked if rates had risen or fallen modestly. But what has happened since 2008, of course, is that interest rates have plummeted, leaving some governments on the hook for huge payouts.
According to Pennsylvania's auditor general, 107 of the state's 500 school districts entered into swaps, some approved even though local school board members didn't understand the deals. One district, Bethlehem, had to pay a $12.3 million fee on a deal gone bad. The state has since proposed banning school districts from buying swaps.
Taxpayers are slowly realizing that their states and municipalities face growing costs—above all, debt and pension obligations—that will be hard to reduce. The squeeze is already forcing cities and states to cut basic services, since they can't risk defaulting on their debt. But these politically unpalatable moves are troubling more and more observers of the muni market. Nicole Gelinas has warned in these pages that "once state and local governments have borrowed too much, they may well find a way not to pay their lenders back" (see "Beware the Muni-Bond Bubble," Spring 2010). Similarly, Rick Bookstaber, a senior policy advisor to the Securities and Exchange Commission, shook the market recently by observing that it has all the characteristics in place for a crisis that might unfold like the home-foreclosure mess: a few municipalities could declare bankruptcy, decline to honor their debts, and unleash "a widespread cascade in defaults." If that painful scenario emerges, it will be because we have too long ignored how politicians have become addicted to debt.Mr. Malanga is the senior editor of City Journal and a senior fellow at the Manhattan Institute. He is the author of the forthcoming Shakedown: The Continuing Conspiracy Against the American Taxpayer.
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