Municipal Finance and Depression

Ken Houghton

I’ve been trying not to talk in these terms, but I’m sick, and Walter Jon links to an article in the Chronicle of Higher Education that puts it out in the open, so let us compare:

The problems had emerged around 1870, starting in Europe. In the Austro-Hungarian Empire, formed in 1867, in the states unified by Prussia into the German empire, and in France, the emperors supported a flowering of new lending institutions that issued mortgages for municipal and residential construction, especially in the capitals of Vienna, Berlin, and Paris. Mortgages were easier to obtain than before, and a building boom commenced. Land values seemed to climb and climb; borrowers ravenously assumed more and more credit, using unbuilt or half-built houses as collateral. The most marvelous spots for sightseers in the three cities today are the magisterial buildings erected in the so-called founder period.

But the economic fundamentals were shaky….The crash came in Central Europe in May 1873, as it became clear that the region’s assumptions about continual economic growth were too optimistic. Europeans faced what they came to call the American Commercial Invasion. A new industrial superpower had arrived, one whose low costs threatened European trade and a European way of life.

with this:

The sudden loss of credit, one of the ripple effects of the current financial turmoil, is affecting local governments in all parts of the country, rich and poor alike. In New York, a real estate boom has suddenly gone bust. Washington has shelved a planned bond offering to pay for terminal expansion and parking garages already under construction at Dulles and Reagan National Airports…. [other examples omitted]

The only alternative would be what New York City did on Monday: Go into the locked-up markets and whip up demand by offering to pay investors a very high return.

Analysts said the dysfunction in the municipal bond markets appeared to signal the end of an era of relatively cheap money for governments and, probably, the start of an era of tough choices for communities. When the market starts moving again, they said, it will look a lot like the municipal bond market of 10 years ago, before the arrival of financial wizardry in the form of structured-finance products, which lowered borrowing costs but added big new risks. Instead, governments will probably be issuing plain-vanilla bonds with fixed rates of interest, higher than they are accustomed to.

The thing is, innovations such as auction-rate securities are, conceptually, a great idea. One of the things that got overlooked in all of the fooforah about how people couldn’t sell them is what the result was:

If you couldn’t sell an auction-rate security, you got an above-market coupon instead.

Which is the way it was supposed to work. If the securities can’t be sold, they are riskier. If they are riskier, they compensate investors and try again the next period.

It is, therefore, in the interest of everyone to make certain that such securities sell the next time.* And it reduces overall municipal financing costs, enabling tax burdens to be kept more reasonable.

But it appears we may lose that. And therefore infrastructure projects will become more difficult to finance, and, as with the early 1870s, the question may well have become who will be the new industrial superpower—and whether we will react more skillfully than the Europeans and Americans of the time did.

Read the whole thing.

*There are some exceptions to this. A municipality may have swapped itself into a lower fixed-rate, agreeing to receive the coupon of the auction-rate security to offset that cost. But in such a scenario, the originating investment bank GLB-entity really wants to sell the securities the second time around.