In the middle of 2009, the State of California Government ran out of money during the last financial crisis (timeline). As an emergency measure, the State issued registered warrants (or “IOUs”) to pay its obligations starting on July 2nd. The registered warrants were issued to yield 3.75% annual interest and mature on October 2nd of the same year.
Several interesting things happened. A few days after the program started, the four largest commercial banks (about 55% of the market at the time) stated that they would not honor the IOUs (as reported on July 9th). Although the worst of the Global Financial Crisis had passed at this point, banks were still obsessed with shrinking balance sheets and risk exposures. At the time, the secondary market was wide open to a few intrepid firms (Second Market made a fair amount of noise), credit unions and warnings of scam artists on Craigslist. Although it is hard to get a read on actual secondary prices, the Guardian at the time quoted a market participant who saw trading between 80% and 95% of face value. Interest rates were higher then, but not that high!
When the program was halted, almost a month early on Sept 4th, the State Controller reckoned it had issued 450,000 in IOUs worth $2.6bn.
Given the intense legislative battles, the furloughs of government employees and agencies, the general economic environment and debt downgrades, it is not a stretch to call this a very rough patch for California. The decision to issue IOUs caught many businesses flatfooted in the middle of a deep recession and without a proper secondary market, the liquidity squeeze was painful.
What does the history of the crisis and the aftermath tell us?
The first thing it tells us is that municipal governments can “spend” before they “borrow”. I put “spending” and “borrowing” in quotes because as officials warned during the crisis, only registered broker dealers were permitted to make a secondary market in the IOU’s. Therefore, the IOUs were, in fact, municipal securities, combining the spending and borrowing elements. What was non-traditional is that they were issued directly to vendors and creditors. The usual process is to first issue a bond through underwriters on “Wall Street” and use the resulting proceeds to satisfy the State’s obligation. In mid-2009, the State was compelled to access the market directly.
The second thing it tells us is that IOUs are considered “bad” largely because the situation was bad. California’s tax base (which swings dramatically with capital gains taxes) was crippled. The State Government was in turmoil. The Agency ratings were downgrading towards junk. There was no preparation for secondary trading and the usual sources of liquidity, the big banks, walked away.
With a decade of recovery and prosperity between us and this crisis, most people would prefer to forget the whole thing ever happened.
But, what would happen if municipalities chose this direct issue “spend before borrowing” route today under existing bonding authority with a predictable secondary market in place?
To answer the question, one needs to look at each of the three components: Bonding Authority, Structure and Secondary Markets.
Bonding Authority, especially for General Obligations (ie. dependent upon regular taxes), is granted by the citizens in regular ballots. For well-run municipalities, the process of proposing, gaining approval and monitoring the progress of the process is fairly straightforward. Between rating agencies, the Offering Statements and Continuous Disclosure through the EMMA website, investors and voters have access to all the relevant information regarding the process.
The structure of the issue is different but hardly new. Currently, almost all bonds are issued via an underwriter into the Depository Trust Corporation’s system with a unique CUSIP number for each separate bond. But that is not the only option available. A city or a state could issue municipal bonds directly to the public and keep track of things internally. That is how bonds were issued in the olden days. Just as startups and mutual funds hire transfer agents to keep their books and records in order, it is more likely that a city or a state would save the hassle of keeping track of ownership and payments by hiring a transfer agent. A transfer agent could handle all the administrative details for the life of the bond. A transfer agent could also maintain a relationship with DTC for those investors who wished to hold their bonds in a brokerage account in the DTC system.
Secondary markets are actually a weakness in the municipal bond market today. As a general rule of thumb, about 200 issues trade actively through their issued lives on the market. For the rest, it is common to see some trading in the first two months as the underwriting group distributes the new bonds to smaller funds and retail investors. After that period, trading tends to fall off dramatically. So, even though there are 50,000 issuers and about 1m unique municipal bonds out there (Munifacts), ensuring adequate liquidity is an important element to consider.
One source of steady demand for directly issued municipal securities would be the money market funds that buy up almost all of the short paper (one year or less) in the market in order to offer tax-free funds to investors. If the securities were properly structured (through the transfer agent) and priced, the city could take advantage of the rates and liquidity available in the “short end” of the market.
Why would a city, county or state consider a direct issue?
As we can see from above, the technical difficulties of issuing municipal securities directly to vendors and creditors are not terribly difficult to overcome. But just because one can do something does not necessarily mean one should.
There are two reasons to do a direct issue and they are not mutually exclusive. The first is to save fees and markups paid to “Wall Street”. The second is to use municipal securities to foster greater domestic economic activity.
The resistance to “Wall Street” is not unique to the municipal bond space. As noted in a previous article about AB-857 (which has since been signed by the Governor), there is a mood shift amongst the large cities in California to localize financing activity. Already a number of cities are planning to join forces or, in the case of LA and San Francisco, apply on their own for one of 10 state licenses to open a municipally funded and operated bank. For big municipalities considering a plunge into fractional reserve banking and maturity transformation (borrow short, lend long), the idea of directly issuing municipal securities is actually a relatively conservative one.
The second factor relates to technology. As we move from physical cash to electronic forms of payment, the ability to directly issue, trade and even spend a municipal security is no longer a wild idea. Almost all of us bank and shop electronically now and we use tap & pay cards to get on public transport and buy most things when we venture onto the streets. Cities are starting to think about how they can squeeze more local economic benefits out of a fairly mundane process (issuing municipal debt instruments). The activity will likely be concentrated mostly amongst the largest players in the local economies but eventually, we could see citizens turning municipal securities into a local currency, backed by the municipality’s ability to raise funds in US dollars. With the application of blockchain technology, one could even transform these debt instruments into a well backed stable coin, meaning that the local economy isn’t the only thing municipalities should be looking at.