Stimulus II: Guaranteeing Muni Bonds
Let's triple the infrastructure stimulus -- and put municipalities back to work.
The House stimulus bill contains many of the items I suggested in my December column. These municipal bond provisions will help provide financing so that more infrastructure projects can be feasible for state and local governments to undertake on their own, without direct federal aid. Unfortunately, they are not sufficient in themselves to get the nation rolling again, so more congressional action is needed. In a companion column, I have addressed the issue of the Taxable Bond Option, which could provide incentives to jump-start more local infrastructure projects. I would now like to discuss the single most important remaining measure that Congress can enact to triple the amount of stimulus that public-sector infrastructure projects can provide in 2009-10: Make muni bonds bullet-proof in the credit markets. Then state and local officials can take advantage of the lowest government-bond interest rates in three generations.
A new friend in Congress. Fortunately for the state and local governments across America, the country has a new champion for local self-governance in the U.S. Congress. Freshman Rep. Gerry Connolly, a Democrat representing Northern Virginia, is a former county official who really "gets it" when it comes to the world of state and municipal finance. I had the pleasure of hearing him speak knowledgeably before leaders of the Government Finance Officers Association at their recent winter meeting. I was quite impressed by his sincerity, his political connections, his intelligence and his style. He's staking out an important role for himself as a "go-to guy" for municipal finance. This is a member to watch, and to work with, in the new Congress.
Although Connolly declares himself "agnostic" with respect to the best way to rebuild the municipal bond market, he touched on several options that he's willing to entertain and perhaps even advance in the House when the opportunity presents itself. The two that interest me the most are (a) an immediate backstop federal guarantee for new-issue municipal infrastructure bonds and (b) for the longer term, some kind of a consortium or enduring facility to provide reliable and affordable municipal bond insurance in an open market. Several other proposals, including ideas to create a federal borrowing facility for state and local governments, strike me as dead on arrival, at least in the Senate. They smack of a creeping Big Brother role that conservatives and Jeffersonian federalists will distrust. All of these ideas need to be considered against the background tapestry of that famous cartoon character who says, "I'm from the federal government and I'm here to help you."
A federal backstop credit guarantee. The first idea goes like this, and was first unveiled in my December column on the muni credit markets: Congress should provide for a temporary 18-month federal backstop (secondary) guarantee of insured or qualified general obligation municipal bonds sold in 2009-10 for infrastructure projects. (These guarantees would apply only to new securities, not outstanding bonds.)
Right now, even the highest-grade municipal bonds are trading with interest rates way above tax-equivalent Treasury bond yields. That's because investors are scared that municipalities could someday default on their obligations, which now seems more likely with Vallejo California declaring bankruptcy and the State of California declaring a $42 billion deficit. So Uncle Sam must step up and provide the same credit guarantees to states and localities that the Congressional TARP extended to the rotten bankers, brokers and insurance companies along with FDIC-TLGP bank guarantees.
How a federal guarantee could work. As a genuine partner with the states, Congress could agree to guarantee any state general obligation bonds sold for qualifying infrastructure, regardless of ratings -- with a provision to recapture any money it ever loses from bond defaults by withholding future federal aid. I for one consider that credit default risk to the taxpayers to be pretty negligible. For state authorities that sell revenue bonds for turnpikes, toll roads, public hospitals, and other revenue-based infrastructure projects, the federal guarantee should extend only to those issues which receive the highest two ratings (AAA or AA) by two nationally recognized securities rating organizations. The same credit requirement should extend to all municipalities including school districts and local authorities that issue general obligation bonds. The risk to the federal government that such bonds will ever default is very minor. And for issuers whose credit is too weak on their own to make this grade, they can purchase pre-qualified municipal bond insurance in the private markets to bring their ratings up to standards for the federal backstop guarantee.
The availability of the federal backstop guarantee at the AA level would be a boon to the flagging municipal bond insurance industry, where firms are suffering downgrades of their credit enhancements. Getting new business would help them immensely as they work to dig themselves out of the financial mess they got themselves into with squirrely deals they did in other markets in the past decade. Putting new business on the books at competitive price levels would help put that industry back on its feet. Obviously those with ratings below AAA would have to meet certain Treasury Department capital tests to qualify for the federal backstop guarantee, to preclude a race to the bottom in creditworthiness.
With a federal guarantee of their municipal bonds, states and local governments could once again finance infrastructure projects with borrowing costs in the 3 to 4 percent range, which will make many more deals feasible, and I would not be surprised if the total of such locally financed projects would be double or triple the $100 billion amount authorized under the House stimulus bill. This is a great way to leverage the federal balance sheet with no immediate cost to U.S. taxpayers. In fact, it would reduce tax expenditures in the future because the tax-exempt bonds sold to finance these projects will carry lower interest rates and therefore cost the Treasury less than under current law. (Municipal tax exemption costs the U.S. Treasury in revenues as explained in my companion column on the taxable bond option.)
The Credit Enhancement Cooperative/Consortium concept. A second initiative has been undertaken by a working group of public-sector associations including the National League of Cities (NLC) and the National Association of Counties (NACo). They have recently released a Blue Ribbon Commission report on Municipal Credit Enhancement that outlines an idea that is still formulating and gaining interest in the public finance community. Their concept is to create an intergovernmental authority or a captive mutual insurance company (or something similar) that would operate very much like a private-sector municipal bond insurance company, but more as a cooperative or a "captive company" than a for-profit business. State municipal leagues and county associations have been doing this sort of thing for years in the workers compensation and liability insurance when the private industry walked away from their risks. In a similar vein, I once served on the board of a captive insurance company for the mutual fund industry, which was created for the same reasons -- unreliability and access to private insurance for certain industry-specific risks like D&O insurance.
A key concept in the consortium idea is that municipal bond issuers could establish reserve funds, which many now establish already for revenue bonds. These reserves are generally exempt from federal arbitrage regulations which otherwise discourage profits from investing tax-exempt bond proceeds. Issuers could then use those moneys as collateral or participations in the cooperative. Municipalities would have an incentive to improve their financial position over time, as the percentage of their pledged reserves that they would receive as refunds or dividends when their bonds are repaid would be higher for those who upgrade their balance sheets and their creditworthiness. There are dozens of tax issues that would need to be addressed, but the idea is certainly worth exploring in today's frozen municipal bond insurance marketplace.
Federal sponsorship or enabling legislation? Whether Congress should play a direct role in fostering a voluntary inter-municipal credit consortium is debatable of course. It would be hard to object, however, to federal tax law provisions allowing such an entity to operate tax-free as long as there is no private inurement. The muni bond arbitrage rules might require a minor tweak for these reserve funds, which the bond lawyers' association (NABL) should investigate. I would even go so far as to allow risk-based rewards to capital provided by public pension funds, and the participating bond issuers, in the form of co-op dividends. (That's my farm-boy roots coming out in me). If all the investors are tax-exempt entities at the outset, this organization deserves to have pass-through tax treatment as an instrumentality of government.
Some of the plan's proponents would like to see a federal cash infusion and/or Federal Reserve Bank liquidity facility, perhaps as much as $50 billion, to provide initial launch capitalization for this new organization -- with the understanding that moneys would be returned to the federal government as soon as possible as the reserves are received from participating bond issuers. Such an exit strategy could be an important feature to gain popular support among socialism-averse Republicans and Blue Dog Democrats, and it makes far more sense to me than the dubious repayment strings attached to loans to U.S. automakers.
Competing private-sector bond insurers may not like the idea of government-sponsored competition. But if the net result is a significant reduction of state and local government borrowing costs, and a permanent improvement in municipal market credit quality, this could certainly be a win-win for the taxpayers. And if the private bond insurance companies were to benefit from the federal re-guarantee of their deals as outlined in my first proposal above, there should be something for everybody in this two-part legislation.
A call to action. As Representative Connolly says, there are a number of good ideas floating around out there, and others may have superior solutions to the two mentioned above. But the important thing now is to get a proposal moving through this Congress -- either as part of Stimulus I legislation, or perhaps as part of a forthcoming Stimulus II package that will likely be presented soon to deal with the housing and mortgage industry and other economic sectors whose rebirth is essential if the recession is to end in the foreseeable future. Cost-conscious state and local leaders should work with and through their various associations to promote these proposals.
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