Municipal Finance and Asymmetric Risk
Belmont Law Review, Forthcoming
20 Pages Posted: 2 Feb 2017 Last revised: 8 May 2017
Date Written: January 27, 2017
In this paper we develop and resolve a tension amidst several widely held – and sensible – general propositions concerning municipal public finance. On the one hand, local governments are supposed to be scrupulous protectors of public dollars. And yet there is also widespread agreement that it was not appropriate for many – even all – local governments to have issued debt using more exotic financial products, such as auction rate securities. Yet these securities did promise – and sometimes delivered – lower costs to the public fisc. Without doubt, one big reason for the consensus against these instruments is that, despite the savings, most local government officials did not understand the risks they entailed. We are not satisfied with this reason. We do not think that these instruments generally would have been appropriate even if a well‐informed local official decided to take on the risk so that her jurisdiction could get ahead of its neighbors. We demonstrate that auction rate securities were not just an ordinary cost saving device. Rather, these securities posed asymmetric risk to local government issuers; that is, they threatened calamitous losses for little reward. We argue that, by design, local governments are not the appropriate bearers of asymmetric risk. Among other reasons, this is because local governments are (properly) subject to hard budget constraints, which means that they will not be able to borrow in order to provide basic services should a debt instrument catastrophically fail. We conclude by arguing that there should be a state‐level institution responsible for protecting localities from taking on asymmetric risk.
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