Overspending or Overpowered? Part I – The Financialization of State and Local Debt

By Amanda Page-Hoongrajook


Part I of of a two part series. Here’s Part II.

Over the past decade and a half, the US has experienced a slew of municipal bankruptcies and defaults[1]. Most notably, the City of Detroit filed for bankruptcy in 2013 and even more recently Puerto Rico defaulted on its debt for a second time. Even non-defaulting municipalities’ finances are being scrutinized – Illinois has been singled out for its underfunded public pension funds.  Why are state and local budgets all of a sudden so fragile and does the financial crisis have anything to do with it?

One narrative claims that states and municipalities have simply spent more than their means, particularly on overly generous pensions for public employees[2]. If governments engaged in fiscally irresponsible behavior, imposing an austerity agenda that cut expenditures – such as public school budget allocation and benefits to pension beneficiaries – might be more justifiable.

The approach taken by Roosevelt Institute’s Refund America Project involves a thorough look at municipal income statements, inspecting both the revenue and expenditure side.  They conclude the story isn’t about municipalities overspending; it is about big banks leveraging their power over state and local governments to extract money through financial deals.    

In a series of reports, Saqib Bhatti, Carrie Sloan, and others describe the two channels through which big banks contributed and continue to contribute to municipal shortfalls[3].  First, big banks helped cause the financial crisis and the resulting recession which depressed the revenue side of municipal income statements via lower property and income taxes.  Second, the big banks leveraged their power and in some cases engaged in potentially illegal behavior to transfer, to themselves, flows of income that would normally go to things like school budgets, social services, and transportation.

Big Banks Cause Financial Crisis, Get Bailed Out: Revenue Side

The effects of depressed revenues on the municipal budgets can best be seen in the context of Detroit.  Although it had experienced de-population and unemployment problems before the crisis, the bursting of the housing bubble, according to a report by Demos, contributed to a 20% decrease in the city’s revenue via property and income taxes since 2008.  Detroit’s operating expenses have actually also decreased by 38%, meaning the city made cuts, however its financial expenses have increased, leading to persistent budget gaps. While banks received bailouts for creating the financial crisis, state and local budgets have received no such bailout and some, as a result, have imposed draconian cuts.

Big Banks Use Power to Extract Income Flows from Public Budgets: Expenditure Side

Municipalities wishing to engage in a public investment project must first come up with the money. Their main option is to purchase the services of an investment bank like JP Morgan or Goldman Sachs who will sell the bonds that the municipalities issue.  Besides extracting fees for this service which can total 3 to 4 billion dollars annually, there are several instruments banks use to write financial deals that overly benefit them at the expense of state and local governments.[4]

When municipalities raise money for projects, they usually issue general obligation (GO) bonds which are backed by the municipality’s ability to tax.[5]  They can issue fixed rate bonds in which the interest rate paid to bondholders is fixed or variable rate bonds in which the interest payments fluctuate with major interest rates such as the LIBOR.[6]   Municipalities that issue variable rate bonds take on the risk of volatile interest rates. In order to protect or “hedge” themselves from the interest rate fluctuations, they make deals with the banks known as interest rate swaps.  Municipalities pay banks a fixed interest rate, banks pay the municipality a variable rate, and the municipality pays the bondholders a variable rate – which in theory should be equal to the variable rate received by the bank. This exchange is outlined in Figure 1.

Figure 1. Payment Flows Between Banks, Municipalities, and Bondholders

Figure 1

Source: Bhatti & Sloan, 2016

If the variable rate is above the fixed rate for about half of the time, the municipality and the bank would benefit equally.  However, the fixed rates that were locked in before the recession ranged from about 3 to 4%.  In response to the financial crisis major interest rates dropped dramatically to near zero, increasing the “spread” or difference between the fixed rates that municipalities pay and the variable rate that banks pay.  Figure 2 demonstrates the losses the City of Chicago incurred from the increase in the interest rate spread.

Figure 2. Municipal and Bank Interest Payments

Figure 2

Source: Bhatti & Sloan, 2016

Chicago is not a stand-alone example. In 2012, the City of Oakland was receiving 0.15% rate from Goldman Sachs while paying the bank a fixed rate of 5.68%. As of March 2015, the State of Wisconsin was receiving 0.18% rate from three banks and paying a rate of 5.47%. A study on the City of Philadelphia’s budget shows the city would have saved millions of dollars if the swaps with several banks had not occurred.  New York City has paid out nearly $250 million per year on swap deals.

If municipalities are losing so badly on these contracts, why wouldn’t they cancel them? Municipalities in theory could cancel the swap deals but only at a high cost. The termination fee is equal to the net present value of the stream of income (interest) payments, which has the following implication here – the lower the interest rate is, the higher the termination fees.  Effectively meaning the bank was able to contract a “tails I win, heads you lose” type of exchange. Furthermore, decreases in municipal bond credit ratings can force terminations of the swaps, meaning municipalities would need to find millions if not billions of dollars immediately.

Finding money immediately is not likely to be a pleasant experience for municipal officials and they go to great lengths to ensure their bonds are credit-worthy.  However, it should be noted here that municipal bonds have a reputation in the investor community as one of the safest investments around.  Excluding the last decade or so, municipal defaults and bankruptcies are extremely rare.  The ability of municipalities to tax their citizens is another reason bond buyers are comfortable holding municipal bonds.  Yet state and local governments bought products to strengthen investor confidence.

One way to strengthen credit ratings is to buy insurance on the bonds from a third party in the form of credit enhancements. For example, a letter of credit is basically a guarantee from the bank that the bonds will be paid by the bank if the municipality is unable to do so.  In addition to municipalities not needing this insurance, one of the few times bondholders relied on it, the insurance companies themselves were in financial trouble, rendering their insurance worthless(Chicago). Municipalities buy unnecessary insurance that does work and get charged increasing fees for it every few years since there is a term-mismatch in the contracts.  Variable rate bonds and their corresponding swap contracts usually last for two or three decades whereas the letters of credit are only for three to four years.  This effectively allows banks to increase fees every time a letter of credit is renewed or simply reject renewals.

Swaps and letters of credit are not the only deals in which banks ended up on top. Municipalities have incurred losses on several other types of bonds; pension obligation bonds (POBs), capital appreciation bonds (CABs), and auction rate securities (ARS). The idea of a POB is that the money from the sale of POBs is invested in the public pension fund with hopes that the return on investment from the pension fund will be larger than the interest payment on the bonds. Unfortunately, like several cities, Oakland lost millions of dollars from this deal. CABs allow the issuer to postpone both principal and interest payments for a period of time, which for Milwaukee Public Schools resulted in a 600% interest rate over 37 years. ARS are “variable rate bonds whose interest rates reset every week or several weeks and bondholders who want to sell action them to investors who bid the lowest interest rates they are willing to accept for the bond” (Sloan & Bhatti, 2016). If there are no bidders, state and local governments can face double-digit interest rates in penalty.

In sum, municipalities are locked in to deals, sustaining heavy losses (fees and interest payments) and paying for credit enhancements that don’t matter.

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[1] Municipal meaning government of a city or town

[2] Kristof, K. (2012). Cities Under Siege.

[3] “Big banks” used loosely here to describe investment banks like JP Morgan, Goldman Sachs, and Wells Fargo

[4] An important and perhaps unanswered question is why state and local government engaged in these deals in the first place.  A more cynical view of government is that the municipal budget managers are either stupid or corrupt.  A more cynical view of the big banks is that they at some point engaged in illegal practices which misled municipal managers or that banks have the power by virtue of monopolizing the channel of municipal finance.

[5] The other option is a revenue bond which guarantees interest payments to bondholders based on the revenue generated by the investment project for which the state is issuing bonds.

[6] The LIBOR stands for the London Interbank Offered Rate.  It is basically a measure of the interest rate charged by banks to lend to each other.