Municipal Borrowing Costs and State Policies for Distressed Municipalities

Abstract

Policies on financially distressed municipalities differ across U.S. states, with some allowing unconditional access to Chapter 9 bankruptcy (“Chapter 9 states”) and others having proactive policies to assist distressed municipalities (“Proactive states”). These differences significantly affect borrowing costs. In Chapter 9 states, local municipal bond yields are higher, more cyclical, and more sensitive to default events than Proactive states. Default events have a contagion effect in Chapter 9 states, but not Proactive states. Lower local borrowing costs in Proactive states come at the expense of the state via higher intergovernmental revenue transfers in times of weak economic conditions.

Keywords: Default Risk, Municipal Bonds, Government Policy, Risk Sharing

JEL Classification: G12, G18, H74