BOND TURMOIL + REVENUE CAPS = ???
According to a March 4, 2008, article in the Houston Chronicle, Houston I.S.D. officials recently postponed a planned bond issuance at the last minute because rising interest rates were unfavorable for taxpayers. The story is significant for two reasons. First, it highlights the seriousness of the current turmoil in the local government bond market. Second, it raises an interesting point about the wisdom of artificial revenue caps during a time of financial upheaval.
Bond Market in Turmoil
Officials with the Houston school district, according to the newspaper article, decided to postpone the issuance of a bond package because interest rates had increased dramatically since voter approval of the issue in November 2007. The increases included a half-point jump just in the final week before the planned issue. According to data from the Bond Buyer Index, interest rates that local governments pay for general obligation bonds rose by 20 percent between March 2007 and March 2008.
Such turmoil in the municipal bond market is widespread. If it’s not higher interest rates that governments—that means taxpayers—must pay on traditional general obligation bonds, then it’s the collapse of any market whatsoever for other types of fluctuating, or auction-rate, debt. These types of debt are often considered superior to general obligation bonds because of their low rates, but they depend on a liquid market where they can be bought and resold at fluctuating interest rates. A March 6 story from the Bloomberg News cites an increase in certain auction debt interest rates from 3.63 percent in January to 6.52 percent in February, an 80-percent increase in just one month. Worse, in some areas there simply isn’t a market for these securities at any rate, resulting in many issues “defaulting” to a predetermined penalty interest rate of six, eight, or in some cases in excess of ten percent.
Switching from auction rate debt to more traditional bonds or notes is possible, but expensive. The Bloomberg story reports that Nassau County, New York, may have to spend $3.75 million in underwriting costs to switch from their auction-rate bonds to more stable revenue anticipation notes. Borrowers nationwide may have to pay at least $1 billion in transaction fees to “unwind” these transactions and escape the collapsing auction rate market.
What is causing these increases in the cost of municipal borrowing and the collapse of viable markets for such debt? According to the various articles, the root cause is fallout from the subprime mortgage debacle. Another contributing factor is worsening financial conditions for bond insurers, a problem also linked to the mortgage crisis. In neither case are local governments the culprits, but they (along with their taxpayers) are among the victims.
Time for Risky Caps?
How would mandatory, state-imposed caps on municipal revenue fit into this mix? There’s an interesting point to note by returning to the Houston Chronicle story above: the local government officials who postponed the bonds had already received voter approval for the new bonds (and the tax increase that would have accompanied them). Nevertheless, solely out of concern for the added burden that higher interest rates would place on taxpayers, the local government officials took it upon themselves to postpone the new revenue the bonds would have provided. Put another way, the voters had said “go ahead,” but when conditions changed, the local officials said “not so fast.”
This forbearance isn’t very surprising to local government officials, but it would most certainly surprise proponents of revenue caps who call for restraints on local government officials who are supposedly “tone deaf” about high property taxes and “want to spend all the money they can get…” (Please see the February 21 edition of the TML Legislative Update.)
What’s wrong, one might ask, with additional, state-imposed restraints on local revenue? The truth is that artificial tax and expenditure caps, while never a good idea for a variety of reasons, will be particularly dangerous during a time of financial crisis. Here's why:
- Revenue and expenditure limits that only apply to the maintenance and operations side of the ledger sheet, as most of the recent proposals do, would give local governments an incentive to move more of their taxing and spending to the debt side of the ledger. When bond markets are in a crisis, however, that may be the last place local governments ought to do business. Most local governments would likely do their best to resist that pressure—witness the school board officials above—but some may not be able to
- Artificial revenue and expenditure limits, by pushing taxes to the debt side of the ledger, discourage pay-as-you go financing, which can be much less expensive than debt. Consider, for example, a city that needs to build a $1 million facility in order to comply with an EPA mandate. If the city issues a 30-year bond at five-percent interest, the city will ultimately pay over $1,900,000 in taxpayer dollars after accounting for interest. On the other hand, if the city could set aside $100,000 per year in maintenance and operations taxes for ten years, it would pay only the $1 million that the facility costs. (Actually, it would pay even less if its money earned interest while being held to pay for the facility). Tax caps may thus have the ironic effect of “protecting” the taxpayer from more affordable, common sense approaches to financing needed infrastructure.
- Tax caps that trigger mandatory elections create additional taxpayer costs. This point has been made numerous times in this publication. Why go to the expense of an additional election when the collective wisdom of various elected officials of different backgrounds and philosophies already exerts the kind of careful oversight that occurred in the Houston area bond issuance?
- Tax caps could harm bond ratings. (Please see the following report by Standard and Poors about the effect of tax caps on local governments in Texas, including potential negative effects on their debt ratings: http://www.tml.org/legal_pdf/2008propertyTaxCaps.pdf). Lower bond ratings mean even higher interest rates, exacerbating the problem rather than fixing it.
Texas cities will survive the current upheaval in the bond market. They will do so, as has always been the case, with little to no financial help from state government. Burdensome revenue caps would make that much more difficult.