Originally Posted: March 14, 2017
American cities collectively hold about $3.7 trillion in bonds, which have historically been used to fund capital expenditures. In recent years, however, bond issuers have been strategically leveraging municipalities’ debts via derivatives, which have introduced systemic risk into the municipal finance system. L. Owen Kirkpatrick writes that the Trump administration’s stated desire to dismantle the Dodd-Frank Act may speed up the current cycle of financial instability, and lead to more financial pain and misery for US cities.
On February 3, 2017, President Donald Trump signed an executive order directing the US Treasury to begin dismantling the financial regulations established by the 2008 Dodd-Frank Act. On the surface, the order may seem to have little to do with the affairs of US cities. But cities are now deeply reliant on finance markets to pay for the things that they need. In 2011, the US municipal bond market encompassed over one million bonds worth $3.7 trillion, issued by almost 50,000 different municipal entities. Being so closely tethered to capital markets means that cities are now profoundly impacted by changes in the financial sector.
Local officials, of course, have always needed access to long-term debt for the upfront capital expenditures required for large-scale municipal systems. In the mid-twentieth century, the municipal debt market was a rather staid and sedate place, made up of low-risk, long-term debt instruments. This debt took two basic forms: (1) low-risk “general obligation bonds” backed by the taxing power (“full faith and credit”) of the issuing municipality, and (2) “revenue bonds” that are backed by dedicated revenue streams (such as toll receipts), which do not require electoral approval nor count against local debt limits.
In the 1970s and 1980s, municipal finance began changing as arcane, high-risk products and practices gained popularity. These profitable but unstable instruments flourished in an under-regulated environment. While the federal government sets the parameters of municipal securities via tax law, they are otherwise only lightly monitored. As the Securities and Exchange Commission (SEC) reports, “[d]espite its size and importance, the municipal securities market has not been subject to the same level of regulation as other sectors of the US capital markets.” The passage of the Tax Reform Act of 1986 changed the structure of the market, but not the level of regulation or oversight. After its passage, new practices emerged which ultimately encouraged municipal issuers to strategically leverage their bond proceeds.
The strategic leveraging of municipal debt takes the form of financial derivatives: interest-rate swaps, variable-rate demand obligations, floaters/inverse floaters, auction-rate instruments, and the like. If there was any doubt as to the regulatory status of municipal derivatives, the Commodity Futures Modernization Act (2000) ruled that they were exempted from federal rules governing securities, an exemption that would also preempt the field of state regulations. Municipal derivatives had three key things in common. First, they promised more profits for Wall Street firms than long-term, fixed-rate bond issues. Second, due to the lack of oversight, they could be aggressively pitched to local officials. And, lastly, they promised impressive returns for municipal issuers by capturing the spread between long- and short-term interest rates.
Derivatives also introduced systemic risk into the municipal finance system. As more US cities made the bet that interest rates would remain low, vulnerability spread, and when interest rates rose, it triggered a crisis from which some cities are still recovering. Diminished revenues and a rash of speculative municipal debt that “went bad” in the aftermath of the crisis tightened the fiscal noose. When Detroit filed for bankruptcy in 2013 it became the twenty-eighth US city to do so since the onset of the crisis. Numerous quasi-public agencies (local and regional authorities, public corporations, and special districts) face similar pressures. For better or worse, urban fortunes are now tied to finance markets. READ MORE