State and Local Governments Feeling Pinch of Debt Limit

To prevent default, the Treasury Department stopped issuing a security that's key to municipal bond issuers.
by | May 25, 2011
 

Earlier this year, as federal lawmakers bickered over the budget, FedWatch wrote about the impact a potential federal shutdown might have on state and local governments. (Short version: The impact would have been small, and the shutdown, of course, never happened.)

Lawmakers are now debating whether to increase the federal debt limit, which was reached earlier last week.
 
This time, though, the congressional inaction a is having a real impact on states and cities. 
 
Now that the federal government has hit its $14.3 trillion debt limit, the Treasury Department has taken steps to try to give the country some breathing room, such as borrowing funding from federal pensions. As a result, official default of the government's debt would be delayed until Aug. 2, according to Treasury Secretary Timothy Geithner.
 
But one step Geithner took that garnered much less press was his announcement that Treasury would stop issuing a type of security that  state and local governments use in conjunction with bond revenue.
 
When state and local governments issue bonds, there is a delay between when they receive the money, and when it must be paid to contractors or vendors. In that interim, they invest their money into Treasury-issued State and Local Government Series Securities (known as SLGS or slugs). The vehicles help states and municipalities earn interest on those funds while conforming to tax rules restricting them from putting the proceeds of tax-exempt bonds into higher-yielding investments.
 
Slugs count against the debt limit, which prompted their suspension. Treasury has sold $47.4 billion of slugs this fiscal year to municipal bond issuers, according to Reuters. The move "is not without costs," Geithner wrote in a letter to House Speaker John Boehner earlier this month. "It will deprive state and local governments of an important tool to manage their outstanding debt expenses."
 
Slugs have been suspended six times over the last 20 years. 
 
Negotiations on the debt limit are set to resume tomorrow, when congressional and administration leaders will meet. A likely prospect would be a vote to increase the debt ceiling in exchange for a reduction in federal spending. Slugs won't be reinstated until an agreement is reached, and in the absence of slugs, those funds will be sitting in savings accounts, earning virtually no interest. 
 
"It's very important to them," Larry Jones, assistant executive director of the U.S. Conference of Mayors tells Governing. He wrote about the issue for the association's weekly newspaper. "When they receive this money, it helps them pay the bondholders what they owe them."
 
In its guidance to municipal bond issuers, the Treasury Department said the suspension would impose "some added cost and inconvenience on state and local governments."
 
"The added negative effects of closing the SLGS window are unfortunate and only compound the difficult situation faced by state and local governments," Treasury wrote on TreasuryDirect, the website it uses to sell securities. "[A]s state and local governments are struggling with extraordinary challenges due to the recent recession, any added cost or inconvenience is unwanted and only make their challenges more difficult."

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