Municipal finance is at a crossroad. If the national economy does not rebound quickly enough to refill the coffers of government, municipal finance may be headed for a rather significant restructuring, which could involve a modern-day version of the urban reform movement. The economic quagmire currently facing the nation has already had a negative impact on nearly all categories of tax-exempt bonds. Without a radical and immediate national political solution, the prospect of further downside at least through the mid-1990s seems assured given slow economic growth, the federal deficit, and the public's resistance to tax and fee increases.
While the trend-line for municipal credit quality is negative, defaults, at least among governmental issues, are rare. The future incidence of defaults remains difficult to predict due in no small part to the uncertain influence of politics. Nevertheless, a look back at the 1980s challenges the long-held view that tax-exempt bonds rarely default. It is noteworthy that Bond Investors Association default statistics indicate that there have been over $16 billion in actual or technical defaults among all municipal bonds issued since 1980. While these statistics are heavily concentrated in issues secured by private activity entities, the days of considering municipals risk-free are surely gone in the minds of most municipal market observers.
As we enter the 21st century, new and progressive solutions will be needed to reinvigorate traditional municipal credit quality. In the interim, selective investing in tax-exempts is more critical than ever.
of Municipal Finance
In our research, we have focused on two inter-related factors which appear to directly affect municipal bond credit quality. One is the sensitivity of state and local credits to regional economic cycles; the other is the interwoven fiscal structure involving a wide variety of municipals. The regional cycle factor can have widespread influence on both tax-supported and revenue bonds; however, its impact is by nature temporary. In the latter case, the changing face of federalism has an ongoing long-term impact on state and local budgets and debt burden. In the most recent decades of this century, the withdrawal of federal aid has forced state and local units to depend more on local tax generation to fund operations as well as capital projects. The shift away from federal revenues has intensified both the vulnerability of municipal entities to regional economic changes and their dependence on local revenue support. Reduced federal grant programs have had implications for non-tax-supported municipal bonds as well, including hospitals, water and sewer, transportation, higher education, student loans, and housing and economic development.
The 1990s are tougher times for municipals because the national economy is not expected to keep up with the growth rates of the 1980s. As a result, the states won't be able to cover growing spending demands coming from health care, education and the cities. Diminished federal aid won't be much help either. While national defense spending cuts could provide the basis for some reallocation to municipal entities, the size of the federal deficit weakens the prospect of immediate relief. In addition, increasing levels of local tax support will be even harder in the foreseeable future as the outlook for real estate development and appreciation falls short of the levels seen in the last decade.
Conditions for Non-Governmental Munis
For other types of municipal bonds, which do not have access to local tax revenues, there are other problems that are likely to last past this recession.
The airport sector with few serious problems to date, has been undergoing a major building program despite there being few healthy airlines. Colleges and universities are worried as much about rising tuition costs as they are about the potential drop-off in enrollment.
Hospitals are facing new stringencies motivated by the competitive pressures of managed care and the unpredictable impact of new political agendas. Long-term health care providers will be needed more than ever in the next century to handle the greying of America. However, their ability to finance new facilities in the tax-exempt market will be hampered by a relatively poor track record to date for start-up projects.
Perhaps the most positive municipal credit sectors for this decade are the public power and state housing agencies. Municipal electric bonds, considered to be relatively recession-resistant, have lowered their debt loads because of reduced construction programs and refinancings. For most, the main risk is an unexpected economic boom that would leave them with insufficient capacity toward the end of the decade. State housing agencies appear to have sufficient cushions left over from their most prosperous arbitrage days to fight off the current decline in real estate.
The Time Is Ripe for Major Structural
Changes in Municipal Finance
Barring a comprehensive reversal in federal support, which is not assured given the huge federal deficit, the conditions are present for major changes in municipal finance that will help offset the negative trends facing municipal-bonds.
One approach - which is dismissed by some as merely a buzzword of the period - is privatization. While privatization may not be the solution for all municipal problems, it remains a worthy alternative to raising taxes, downsizing/consolidating and, in the most acute situations, bankruptcy. It may just be the pill that hard-pressed municipal credits take to avoid potential defaults.
Privatization as a Modern-Day
Urban Reform Strategy
Privatization, today, is a modem-day extension of the urban reform movement that began about 100 years ago. This time around it is being driven not by outsiders looking in as it was in the 1870s to 1920s but, instead, by insiders looking to survive the complex fiscal, social and economic problems challenging municipal finance.
The urban reform movement at the end of the nineteenth century drew its support from the principle that good government incorporated business-style efficiency. In the twentieth century, privatization reflects the complete embrace of the alleged ideal that business can deliver services better and more cheaply.
One hundred years ago, the reformers' objective was to clean up the city government by limiting the power of the city leaders (bosses) and the patronage system and eliminating honest graft. It was political corruption, waste and the expanding scope of government activities that served as a rallying cry. The citizens at that time were convinced that city governments had become inefficient because irresponsible officials were squandering public treasuries and burdening taxpayers with huge debts - a concern that proved valid when depression came later and cities were left with huge commitments and insufficient resources to pay off their debts.
The campaign for reform took place gradually through the 1920s with innovations such as centralized, bureaucratic controls, including the civil service; competitive bidding; city manager and commission style governments; and municipal ownership of utilities.
Ironically, today's advocates for privatization are often the mayors and elected officials whose predecessors were once the objects of the reformers. Moreover, some of the privatization ideas being promoted today are the antithesis of what was advocated back in the 1890s. Today, instead of talking about municipalization of the utilities and transportation centers, mayors are talking about selling or contracting out municipal enterprises to the private sector - using the same efficiency argument.
Means to Address Growth
in Public Payroll
Some of the municipal problems that we have today are due in part to the success of past urban reforms left unbridled, particularly in the area of municipal employees. Bloated payrolls are partially the result of the protection built into the civil service system to prevent bosses from hiring and firing employees merely on the basis of their political leanings. At the same time, patronage has not gone away entirely - political appointees and consultants still make up a significant part of state and local budgets. Compounding the burden of public payrolls is the growth of state and local unions, which have flourished over much of the last 30 years. More recently, although the total number of all union members fell by 4% from 1983 to 1989, membership amongst state and local governments grew by 12%. While all union workers received weekly earnings growth of 29%, government unions received a 40% increase in the same period (1983 to 1989). Payroll and benefit costs remain a major reason for the substantial rise in taxes.
Today's municipal leaders are coming to support privatization because they feel frustrated in their ability to control the increasing cost of bureaucracy. In most cases, bankruptcy has not been seen as a reasonable alternative. As a result, privatization seems to be the preferred choice.
Privatization implementation has already been taking root gradually and without fanfare, as a variety of services previously provided by governments have been contracted out to private enterprise. The most comprehensive plans, however, are often sought out by leaders out of desperation, when cash is gone and tax levels are already burdensome. For example, Philadelphia and Detroit are two cities that have spent considerable time examining major privatization proposals.
A complete sell-off of municipal assets remains a difficult choice, politically and economically. Often the most attractive assets, such as the water system, are also cash cows for local governments. They frequently subsidize less efficient operations of government. If these types of assets are sold, analysts should demand that the proceeds be invested into other long-term assets, such as infrastructure, education or neighborhood rejuvenation.
There are numerous obstacles to privatization, including concerns about rate control and equal access to services, little experience with valuation of municipal assets, resistance from the unions, and the assumption of legal liabilities such as in environmental services or public safety. These problems, however, can be overcome, if competitive bidding and ongoing competition or effective regulation are re-quired at all time,s better capital stock ac-counting and experience with privatization valuation are put into place,-labor is involved in the solution (e.g., employee equity interest in new companies) and current litigation trends are bridled.
Prospect for Implementation
Privatization, as a solution to today's municipal finance problems, will be implemented gradually and selectively but not comprehensively. Just as the last urban reform movement spanned five decades, urban reform this time around might last for years ahead. Public/private partnerships are already a part of municipal finance (e.g., tax increment districts, Section 8 housing, airline owned/leased terminals at airports). Attempts at privatization will not all be successful nor should they be expected to be since we are for the most part treading new ground. More than likely, elements of privatization will be increasingly interwoven into public administration as a means to control the growth of government, encourage efficiency and raise cash in more dramatic situations.
The call for business-style reform in response to complaints about waste, inefficiency and, less frequently, corruption is already making its mark on credits throughout the municipal market. Hospitals have already experienced a taste of the modem-day reform movement forced on them by the changes in federal reimbursement. So far, the damage to hospital bonds has been apparent but not catastrophic. Privatization of not-for-profit hospitals may be more widespread if additional third party reimbursement changes take place.
Risk/Reward Yield Spreads
In times like these, one would expect, wider quality yield spreads between higher rated and lower rated credits. However, we continue to find almost all investment grade credits selling at relatively modest yield differences. The rise of bond insurance provides some explanation for the prolonged period of narrow quality spreads. This compression in yield levels suggest that buyers are willing to accept the notion that credit quality risk is relatively evenly distributed among investment grade bonds justifying the slight rewards for investing in the lower rated issues.
Perhaps, the narrow yield spreads among different rated bonds as well as different types of municipals can be explained by the interwoven variables affecting most all municipal bonds. State credits, which have long been regarded as the safest of all natural municipal, have repeatedly fallen from the top notch rating spot and appear to be more vulnerable to credit price swings than ever before.
Non-rated municipal bonds, particularly those which would probably not receive an investment grade if they were rated, have experienced far higher default rates in a non-depression environment than the market ever thought possible for a municipal bond a decade ago. Two-thirds of all BIA actual and technical defaults involved non-rated bonds. Although non-rated bond investors often receive more than twice the spread between AAA and BBB bonds, the reward is not nearly the level being earned in the corporate sector due in part to the strong demand for the limited supply of higher yielding municipal bonds.
Summary and Outlook
The 1990s won't be an easy time for rebuilding municipal credit quality unless economic and political circumstances change significantly. Those municipal credits in all sectors that will face the least difficult road will be those that avoided huge debt loads and personnel burdens and have been efficient in their ongoing operation. From the rest, sooner or later you'll be hearing a lot more about privatization crossing a variety of municipal credit sectors.