How state and local governments use financial engineering to game their debt burdens — the new “affordability products”
In my recent proposal for changing the tax exemption for municipal bonds, I mentioned the rampant use of “affordability products” by state and local governments in the municipal market as a significant and mostly unexposed risk. These include non-economic “scoop-and-toss” refundings, capital appreciation bonds, capitalized interest, some derivatives, and pension obligation bonds. Many readers asked me to elaborate on how these borrowing structures work and why I believe the municipal bond market is observing an analog to the subprime mortgage crisis in the making. The use of financial engineering for budget purposes is something all recent municipal insolvencies have in common.
In what follows, I am going to explain how these affordability products work and how the risks they pose to investors are largely ignored by credit analysts and the rating agencies, much as they were during the subprime mortgage crisis. I am also going to explain how hedge funds and other event-driven investors will likely be burned through their bets that legal protections will outweigh credit fundamentals.
Moreover, due to the nature of these transactions and the fact that they are frequently associated with fraud and major disclosure issues, I believe the enforceability of these bond issues can be plausibly challenged by other stakeholders (taxpayer advocates and labor organizations, for example). It would not be surprising if such legal challenges become more common and devastating to institutional investors (and the bond insurers) as these products become increasingly associated with fiscal distress.
Bondholders’ biggest mistake in dealing with distressed municipal borrowers is that they do not take other stakeholders’ claims seriously. Many regard their legal claims as discrete contractual matters and assume a sympathetic court system. This has not and likely will not be the case going forward.
Why are affordability products used?
During the subprime mortgage crisis, banks pitched products aimed at allowing home buyers to assume more debt than they could under traditional borrowing structures and underwriting procedures. Examples include adjustable rate loans or stacked loans that reduce or eliminate the need for a down-payment.
The banks were able to do this because they were passing the risks associated with these loans on to investors in the capital markets. The loans also included embedded terms that theoretically would protect lenders, but instead aggravated home buyers’ finances to the point of them abandoning their investment altogether.
Two things are important to understand from the home buyer’s perspective: (1) the home buyer was not left with affordable debt, rather its un-affordability was delayed; and (2) the home buyer’s ultimate incentive was to walk away from the financial commitment rather than fulfill it. Something analogous is unfolding in the municipal market right now.
For over a decade now, a network of dozens of investment banks, financial advisors, and bond counsels in the municipal market have been ushering state and local governments into non-traditional borrowing structures.
These borrowing structures are used for four purposes:
(1) To skirt statutory or constitutional restrictions on government borrowing, which are typically worded as a percentage of revenue or tax assessments;
(2) To delay making debt service payments on outstanding debt, in order to provide budget relief in the current fiscal year by deferring costs to later years;
(3) To finance operating expenses and defer raising taxes, in order to fund political priorities without the current administration having to locate a revenue source; and
(4) To fund government operations or other financial commitments (like pensions) through market speculation.
Many people ask me why these products are not illegal, and the above is the answer. Politicians love them.
Perversely, the rating agencies (who are compensated for rating these deals and do not get paid if the deals are not done) lump these products together as “non-recurring resources” in the analysis they circulate to investors and rarely ascribe a motive to their use. So undertaking a scoop-and-toss refunding is more or less equivalent from a rating perspective as drawing down cash reserves. Except it isn’t equivalent in reality — although drawing down reserves may limit future flexibility, it doesn’t create additional costs in the future as these products do. Some of these products can also instigate liquidity crises when they fail to work as planned (products that involve termination triggers or acceleration clauses, for example).
What affordability products exist in the municipal market?
Many of these products simply co-opt traditional borrowing structures for purposes they were not intended.
Traditionally, “refunding” municipal bonds is akin to refinancing the mortgage on your house when interest rates decline. However, because municipal bonds typically come due in serial maturities, a refunding can be used as an opportunity to push debt that is coming due out into future fiscal years. This means that the government has less debt service immediately due, but more coming due in future years.
Even in an ultra-low interest rate environment, this can produce significant additional costs to taxpayers. This is because the debt is outstanding longer than it would be otherwise. It does, however, free up funding for pet projects or operating costs right now.
Capitalized interest refers to when a government borrows more money from investors than is required to pay for the direct costs of a construction project in order to pay the interest due on the bonds for a period. Traditionally, capitalized interest is used in circumstances where the bonds are financing a project that will eventually be producing revenue (for example, a sports facility or convention center) and the bonds are secured by the revenues the facility will be generating. The capitalized interest is used to cover the interest cost on the bonds during the period where the project is under construction or being being renovated, and is not otherwise producing revenue. After that period, the capitalized interest ends and normal payments begin.
Some governments (including the City of Chicago, Chicago Public Schools, and Puerto Rico) have been using capitalized interest simply to avoid having to balance their budgets. As serial users of this structure, they avoid making debt payments year after year after year, piling the actual cost of the borrowings (and general government for the current year) into future years.
Why are the political leaders doing this? When the bill comes due, the cost isn’t their problem. New people will be in office to deal with yet another manufactured crisis.
Capital appreciation bonds (and similar structures)
CABs have been a highly controversial debt instrument in the municipal bond market. Several state governments — including California and Texas, which are among the largest issuers in the market — have now enacted legislation to restrict their use by local governments, as policymakers have come to regard the structure as abusive.
CABs are a type of municipal bond where the return on the principal amount is reinvested at a stipulated rate until the debt matures. When the debt matures, bondholders receive a single payment that includes the principal amount plus the cumulative investment return. The bonds are sold at deep discounts, but unlike traditional zero coupon bonds can be used strategically to evade statutory debt limits. This is because the investment return is regarded as compounded interest rather than accreted original issue discount. However, issuers can end up paying many times the amount they originally borrowed. For some California school districts, up to 15 times as much. Substantially all of the bonds issued by Puerto Rico’s largest debt-issuing authority are structured this way.
Yes, this is reckless. But when you are a politician with a short time horizon and you want to borrow a lot right now, it seems like an attractive option. Because the cost falls out in future years, it is also a way to circumvent debt statutory or constituional debt limits (which was its explicit purpose in Puerto Rico and for school borrowings nationally).
Derivatives that serve a borrowing function
Derivatives are a type of contract where its value is derived from the value of another investment. Governments sometimes use derivatives like swaps, swaptions, caps, and collars to manage the interest rate risk associated with their bond issues. However, some governments have used swaps and options that involve up-front payments to plug budget gaps, with the knowledge that they would involve future expenses. This is akin to a getting a bank loan. They have also switched back and forth between interest rate exposures — not for the purpose of managing interest rate risk, but to collect payments from the transitions and treat them as another budget resource (Chicago and Harrisburg are excellent examples). Risk is an afterthought, again to be addressed by future political leaders.
Pension obligation bonds
Pension obligation bonds involve issuing bonds to capitalize a state or local government’s pension system. This is an arbitrage strategy (and the reason why pension bonds are usually issued on a taxable, not tax-exempt, basis): the government hopes the pension’s earnings on its investments will be higher than the interest the government is obligated to pay to investors for the privilege of using their money.
This debt structure is typically used by governments that are behind in funding their pension commitments and are looking for an alternative to playing catch-up with available funds. Despite the Government Finance Officers Association recommending governments do not use this product under any circumstance, governments still do.
Why do investors pile into these deals?
The lack of fiscal discipline on display here is matched in force by a lack of market discipline. It takes years of this behavior before a government borrower is denied market access. Usually the government is insolvent or well on its way to getting there when that occurs.
Most institutional investors should be able to identify abusive structures like the ones I have described above. So why do they not avoid investing in government debt that involves a clear affordability component?
One reason is the current investment environment. Not a whole lot of government borrowers are going to market, so there is captive interest in whatever paper is sold. Also, persistently low interest rates encourage excessive risk-taking and misallocation of capital.
Another reason is that the investors flocking to these borrowers to pick up some yield seem to value their perceived legal protections over credit fundamentals. This is especially evident with Chicago and Puerto Rico, which have been among the most aggressive users of affordability products in the marketplace.
Many municipal investors continue to talk about bankruptcy the way analysts did in the 1990s:
“Chapter 9 is not a panacea. There are better alternatives.”
“Municipalities do not want the stigma of filing for bankruptcy.”
The very purpose of a government using these products is that the political actors want to avoid making hard decisions and locating new sources of revenue. To a politician, these products are convenient substitutes for raising taxes. To expect the same culture to “do the right thing” in an emergency state involves two problematic assumptions: (1) that the politicians involved will experience a profound intellectual conversion, and (2) that a community in fiscal distress can levy significant additional taxes without prompting its tax base to leave (which is to say, even if they want to, it is legitimately a better economic decision to walk away from their debt).
The municipal market no longer reflects that world. This is the first wave of municipal insolvencies where pensions and other post-employment benefits play a major role. In previous insolvencies, bondholders had the luxury of control. There are now other stakeholders that have significant financial and political backing, that are more organized and — unlike the capital markets creditors — have mostly sympathetic press coverage.
Beyond that, precedents are being made that do nothing but harm to bondholders. There is increasingly institutionalized priority for pensions and essential government services. Bondholders are making critical mistakes in waiting until a government is in an emergency state to introduce discipline. The amount of money that needs to be raised after years of this behavior is so large that it would hurt the population. Courts are rarely sympathetic with bondholders when ruling in their favor means the government cannot function as a government as a result. And even if politicians share culpability here, the courts can distinguish between them and the people they are supposed to serve.