The imminent securitization of the municipal bond market can be used to efficiently finance a much needed increase in our national investment in infrastructure, reducing congestion and pollution costs, improving our productivity and competitiveness, and creating jobs and economic growth for all Americans.
The United States is underinvesting in infrastructure - the highways, bridges, transit systems, airports, and wastewater, drinking water, and solid-waste disposal facilities that are the foundation of our economy and the very quality of our lives.
While international comparisons can be slippery, our global competitors clearly invest more heavily in infrastructure than we do. The Organization for Economic Cooperation and Development, as cited by the Rebuild America Coalition, reports that "the United States is investing less than 0.3% of its Gross Domestic Product annually on infrastructure, lagging way behind other industrial nations such as Japan (5.7%), Italy (4.8%), Germany (3.7%), France (2.7%), Britain (2.0%), and Canada (1.8%)."
And infrastructure demands continue to grow.
The Federal Highway Administration, for example, estimates that government will need to invest $82.1 billion per year over the next 20 years to maintain and improve our highways, bridges, and transit systems. In 1991, by comparison, total federal, state, and local capital investment in surface transportation was $40.2 billion - a funding gap of over $40 billion. The U.S. Environmental Protection Agency estimates that by the year 2000 our annual shortfall in public and private investment in environmental infrastructure will reach $85 billion, with much of this funding burden falling on hard-pressed local governments.
The nation's dilemma is that we must fund a significant increase in infrastructure investment with no new taxes. The 4.3-cent increase in the Federal gas tax recently enacted with such pain was dedicated to deficit reduction, not surface transportation. There are no new federal revenues or loan guarantees to pay for the additional infrastructure investment. State and local government budgets and tax and debt capacities are also highly constrained.
Structured municipal bonds can help fund the infrastructure investment gap. They will securitize state and local bonds into bond-backed securities. They will also use anticipated federal grants as credit enhancement, accelerating the availability of federal funding and leveraging best-rate debt capital into the widest range of state and local infrastructure projects.
Securitization is a financial process for pooling loans into securities. In a typical securitization, loan repayments are sold to a trust that finances the purchase by selling securities to investors. Borrowers' principal and interest payments are passed through the trust to the investors. The flow of funds may be structured (or sliced and diced) and credit enhanced at the trust level. The extent to which securitized cash flows may be sliced and diced to meet issuer needs and investor requirements is largely a function of federal tax and securities law.
Securitization was pioneered for the housing industry by the federal government. Ginnie Mae completed the first securitization in September 1970. Ginnie Mae and the government-sponsored enterprises Fannie Mae and Freddie Mac were established by the federal government to help create a secondary market that would make residential mortgages more available and less expensive. Today, the market for "mortgage-backed securities" exceeds $1.24 trillion. Freddie Mac's studies indicate that securitization may have resulted in up to a 50-basis-point savings in mortgage interest costs for home owners.
Through the 1970s and early 1980s, the growth of the market for mortgage-backed securities was hampered by federal and state laws written long before the invention of securitization. Congress clarified certain federal and state securities law and legal investment issues for investment-grade mortgage-backed securities with the adoption of the Secondary Mortgage Market Efficiency Act of 1984. By creating real estate mortgage investment conduits in the Tax Reform Act of 1986, Congress eliminated the risk of double taxation when mortgage repayments sold to a trust are restructured to better meet issuer and investor needs. Of the current market for mortgage-backed securities, $628 billion are Remics.
With the growth of the market for mortgage-backed securities, the technology of securitization came to be applied to an ever more diverse array of financial assets; for example, auto loans, credit card and lease receivables, home equity loans, and commercial mortgages. These "asset-backed securities" do not have government guarantees or sponsorship. Their market has nevertheless grown from $500 million in 1980 to $180 billion in new offerings in 1990. McKinsey & Co. predicts that by the year 2000, 80% of all new loans are likely to be securitized.
Since the mid-1980s, securitization also has been used by the federal government to increase investment in small businesses (through SBA Section 7[a] Certificates), farms (through Farmers Home and Farmer Mac), and students (through Sallie Mae). To reduce the deficit, the federal government securitized and sold $7.3 billion in loans, for $4.6 billion, in 1987 and 1988. The Resolution Trust Corp. is currently selling asset-backed securities to reduce its inventory of failed savings and loan assets. These securities carry an RTC guarantee of certain documentary representations and warranties, but are not federally guaranteed against default and delinquency.
The municipal bond market is being securitized. Members of the Public Securities Association have drafted federal legislation to authorize tax-exempt municipal investment conduits. Wall Street firms are seeking SEC approval to pool already issued tax-exempt bonds into inverse floaters and other derivative securities.
Properly designed federal legislation, modeled after both SMMEA and the Remics measure, must be sensitive to the imperatives of the issues of municipal bond tax exemption and disclosure, reporting, and suitability currently being addressed by securities regulators and congressional committees.
To bring the full benefits of securitization to state and local infrastructure users and taxpayers, new federal laws should empower state and local officials to effectively negotiate with securities underwriters to pool, slice, and dice their loan repayments, and thus incur lower interest costs for their infrastructure capital. The new legislation should also permit private developers to use securitization to gain access to best-rate taxable capital for their infrastructure investments.
Federal laws should not only facilitate the pooling of outstanding municipal bonds. They should also enable municipal borrowers to structure their debt service payments in terms of risk, maturity, and flow of funds priorities, giving borrowers the opportunity to create offerings that better meet their needs as well as investor requirements.
The federal government may also use its future grants to provide credit enhancement for state and local infrastructure investment. Credit enhancement is an additional assurance to investors against repayment default and delinquency. In a structured municipal bond, assurance of timely repayment will begin with the diversity of the pooled loans and the structuring of repayment cash flows into multi-class securities.
The "capitalization grants" authorized by the Clean Water Act of 1987, and funded with current appropriations, have been used by states as credit enhancement for their waste-water bonds. Securitization creates the opportunity to use future authorized federal grants as credit enhancement. Grant-backed credit enhancement will accelerate the availability of federal dollars for infrastructure investment. No new revenues, expenditures, or contingent liabilities will be required. State grants have been used to enhance local infrastructure financing, Recommendation D0T05 of the National Performance Review calls for the U.S. Department of Transportation to use its grants as credit enhancement.
Structured municipal bonds will capture the efficiencies of municipal bond securitization - increased market liquidity, interest rates on bond-backed securities that lower municipal financing costs, and a significant increase in government's capacity to leverage current revenues into new bond financings. They will help the United States increase its investment in vital infrastructure by providing the widest range of communities and projects with best-rate infrastructure investment capital.
Scott M. Reznick is the president of Commonwealth Development Associates. For the past three years, he has been involved in the development of structured municipal bonds.
