Municipal Finance and Asymmetric Risk

Abstract

In 2016, both major presidential candidates supported a big increase in federal spending for infrastructure improvements. This is a good thing in light of the state of America’s infrastructure. Given that much of the nation’s infrastructure is owned and maintained by local governments, such proposals require local governments to access the capital markets even more than they currently do. And, as it is, the municipal market is extremely large. In 2015 alone, there were 6,530 “new money” municipal bond issues, totaling nearly $153.86 billion.

Looking forward, there is therefore good reason to pause and think about how local governments might access the capital markets more efficiently. Looking backward, however, the Great Recession also provides another reason to think about local governments and the capital markets, as it revealed that local governments had not been issuing debt wisely.

For example, in the years leading up to the financial crisis of 2008, numerous public entities borrowed for infrastructure projects using a borrowing structure known as auction rate securities (“ARS”). By February 2008, the total dollar amount of ARS outstanding was estimated to be about $267 billion. To give a bit more context, the total municipal market had $3.653 trillion outstanding in 2008. Thus, ARS represented a substantial part of the market. In many ways, using ARS is analogous to borrowing for a house using an adjustable rate mortgage (“ARM”). The interest rates on ARS were lower than the rates for conventional borrowings and, thus, public entities saved billions of dollars.

Then the crisis of 2008 hit and the entities that used ARS, much like the many individuals who used ARMs, found themselves in trouble, costing governments millions — possibly billions — of dollars. These losses came from governments (1) having to pay higher interest rates than expected within these transactions, (2) having to pay to get out of these (or related) transactions, and (3) having to pay to re-finance the debt using a more conventional structure at a less than opportune time. Since 2008, no ARS have been issued and only a tiny amount of ARS, approximately twenty billion dollars, remain outstanding.

So, the once flourishing ARS market is no more. What should policymakers conclude about this?

One plausible, if Panglossian, analysis is that there is little to learn. Government is obligated to uphold the public trust, and lowering borrowing costs is consistent with this duty. This government duty justifies using ARS. Whether the ARS market had design flaws that always doomed it or only a crisis as severe as the Great Recession could have destroyed it, local governments are supposed to be laboratories of innovation, and sometimes experiments fail.

We think the dominant analysis is more circumspect. The financial crisis of 2008 made clear that government officials did not always understand the implications of the financial instruments that they used. There will be other fiscal shocks, especially throughout the long terms over which much borrowing occurs. Accordingly, government officials’ current level of knowledge is inadequate and should be corrected, especially as to more complex financial instruments. Indeed, in the aftermath of the Great Recession, federal law has changed, largely through the Dodd-Frank Act, to compel financial intermediaries to provide more information to government issuers and to take the best interests of the government issuers into account.

In this Article, we will argue for yet a third analysis. Not every problem is amenable to resolution through additional education or disclosure. We will explain why the ARS debacle illustrates that there are certain kinds of borrowing structures that should be categorically prohibited.

Keywords: Municipal Finance, Auction Rate Securities (ARS)