What If Ireland Defaults? (24 page)

Most bonds issued by the state government in Albany were backed by the full faith and credit of New York State and were subject to constitutional limits. The UDC's commitment to repay its lenders was more creative and less binding. It depended on the state's ‘moral obligation' to repay, a concept originated by a Rockefeller adviser, John Mitchell, before he became the Nixon administration's attorney general. ‘This was one of the original “structured investment vehicles”', Weisman would write, ‘like the ones that brought down several Wall Street houses in 2007–08 by establishing the principle of off-the-books debt'.

By January 1975, with revenues from its housing projects failing to keep pace with the expense of aggressive construction, the big banks informed Carey that they would no longer lend the UDC money or to underwrite its bonds. A month later, the UDC defaulted on a loan and on $100 million in bond anticipation notes. Carey recruited a prominent New York builder, Richard Ravitch, to bail out the agency out, meet its contractual obligations and restructure its debt by creating the Project Finance Agency to sell long-term bonds. That agency became the model for the Municipal Assistance Corporation (MAC) created later that year to save the city.

‘We can't assume, as we did in the past', Ravitch said, who might just as well have been referring to New York City as to the state agency, ‘that because a program is socially desirable it is credit-worthy'. New York, for the first time in a generation, was forced to acknowledge its limitations.

That May, Ravitch was again summoned to a meeting with the governor. Reeling from the UDC's default, the bankers were back. After months of warnings and after dumping their own holdings, they dropped a bombshell: they would no longer underwrite city bonds or short-term notes, which were being marketed at a rate of $600 million a month. The market was shut for what had been its biggest supplier. The bankers' decision triggered what became known as The Fiscal Crisis and immediately prompted the Beame administration to fire 20,000 workers, close eight fire houses and impose wage freezes and deferrals. Carey recruited the financier Felix G. Rohatyn who, inspired by Ravitch's Project Finance Agency, conceived the Municipal Assistance Corporation – Big Mac, it was soon dubbed – to lay legal claim to city tax revenues and restructure city debt. But by the summer, even the MAC was being shunned by the bond market. Washington spurned entreaties to help. Furtive hints were dropped about declaring bankruptcy and removing the mayor. Neither developed traction.

‘The fiscal crisis was misnamed', Rohatyn would say later. ‘It was a bankruptcy crisis', but without bankruptcy, because of the near-unanimity that the precedents for a government bankruptcy were so rare that the prospects made it the most alarming alternative. Nobody knew for sure what it would entail, but Rohatyn memorably likened it to ‘stepping into a tepid bath and slashing your wrists: You might not feel yourself dying, but that's what would happen.'

Carey imposed an Emergency Financial Control Board, with himself as its chairman – ‘my sign to Washington that the state was taking over', he would say – and accompanied his coup with higher taxes, an agreement with the banks to convert notes and bonds to lower interest rates and with municipal employee unions to purchase MAC securities and established a moratorium on repaying the principal on short-term debt.

By 3 p.m. on 17 October, the city had to pay off $449 million to bondholders and a state loan, but Albert Shanker, the teachers' union president, was balking at investing the pivotal $149 million in union pension funds in MAC bonds. (Shanker had been immortalised a few years earlier in the Woody Allen film
Sleeper
when the protagonist travels to the future only to learn that the world was destroyed after ‘a man named Albert Shanker got hold of a nuclear warhead'.)

The draft press release, which pointedly invoked the city comptroller, Harrison J. Goldin, a sometime Beame adversary, as the bearer of the bad news, went on to say that the city had applied for and obtained a court order to preserve its assets from creditors. It said that ‘rational and humane' priorities had been approved to make payments in this order: police, fire, sanitation and public health services; food and shelter for people dependent on the city; hospital and emergency medical care for those with no other resources; bills from vendors of essential goods and services; school maintenance; interest on city debt; and payments due to the retired and aged, beyond those from pension funds. But Shanker finally relented (Beame would later reveal that another union leader was waiting in the wings just in case). A formal default was averted, but the city still had not resolved all of its $6 billion or so in short-term debt. After demanding more concessions, President Gerald Ford and recalcitrant members of Congress finally – if warily – went along with a programme to guarantee a $1.7 billion union pension fund investment in MAC bonds (at 7 per cent interest) after having been warned by, among others, Chancellor Helmut Schmidt of Germany and President Valéry Giscard d'Estaing of France that the bankruptcy by New York – jeopardising the investment of banks around the world that the city was indebted to – would trigger a global financial crisis.

‘Bankruptcy was averted in stages over the following six months, finally with President Gerald Ford and Congress agreeing to participate with a package of short-term “seasonal” loans', Weisman wrote. Carey brought:

… unions, banks, and political figures together to accept a package of shared sacrifices. … Could these steps have been taken in the absence of a crisis? That is highly doubtful. But the austerity and decline in city services (and quality of life) ushered in by the actions under Governor Carey probably contributed to the tarnishing of Lindsay's image in the eyes of New Yorkers, who also generally became disenchanted with his form of liberalism in later years.

The Consequences

The fiscal crisis cost tens of thousands of city workers their jobs, including Abe Beame, who in 1977 became the first elected mayor in half a century to be defeated for a second term. New Yorkers were also instrumental in the defeat of President Ford, whose onerous conditions for federal aid prompted the tabloid
Daily News
to famously proclaim: ‘Ford to City: Drop Dead!' Other fallout from the fiscal crisis would be less dramatic, perhaps even invisible for a time, although there was ample physical evidence, too, that something had gone terribly wrong in city government. Construction abruptly stopped on thirteen schools. Enrolment at the City University of New York plunged by 70,000 to 180,000. Layoffs of police officers inflicted deep psychological damage on a force that considered itself immune from dismissals. The Narcotics Division would be decimated. From July 1975 to November 1979, no new police officers would be hired. The ratio of students to teachers in public schools soared by 5 to 25. The Fire Department scrapped a fleet of vans that ferried fire-fighters when shifts changed, forcing them to hire dial-a-cabs to race to fires. The police force shrank from 32,000 to 22,000. Crime went up, manpower went down, parks were transformed into dust bowls, maintenance was deferred ….

‘If there are life-and-death services the city of New York provides – and there are – then you have to sort of assume a fire wasn't responded to as quickly as if you had 20 percent more fire coverage', Raymond D. Horton, a Columbia University business professor and research director for the Citizens Budget Commission, a business-financed research organisation, would say with a decade's worth of hindsight. ‘You have to assume at some point in time a police officer couldn't get to a crime as quickly because he was answering another call, or you have to assume that a nurse didn't get to a patient on time because her patient load increased.'

Under Beame's successor, Edward I. Koch, the city adopted generally accepted accounting principles in 1980, a year earlier than required, and balanced its budget in 1981, also a year earlier than required. That same year, the private credit market reopened its spigot; the city sold $100 million in short-term notes backed only by anticipated tax revenue. The federally guaranteed loans were repaid eight years early. ‘In the 60s, in the early 70s, there was a breakdown of any system of checks and balances', a Koch administration official, Robert F. Wagner Jr., a son of the former mayor, recalled. ‘Nobody was able to say no. Institutionally built back into the system is not only the ability to say no, but the legal requirement to say no.'

By 1985, Comer S. Coppie, executive director of the State Financial Control Board (‘Emergency' had been dropped from its title), would render this verdict: ‘New York's is perhaps the most comprehensive and substantial recovery in the history of American cities and perhaps for any jurisdiction at the state or local level.' The continued loss of factory jobs was more than made up by the growth in finance, real estate and other white collar services (the strength of the dollar didn't hurt either). ‘This is the city's best recovery record in the post-World War II years', said Samuel M. Ehrenhalt, regional director of the Bureau of Labor Statistics. ‘The good old days really have been these days.'

But the payoff came with a stiff price, the result of a Darwinian accommodation to fiscal realities. Within a decade, the poverty rate rose from 15 per cent in 1975 to 23.4 per cent ten years later. Layoffs and attrition eliminated one in five municipal workers; the real earnings of those who survived were reduced by inflation, which also eroded welfare grants, frozen at pre-fiscal crisis levels, by one-third. Professors Horton and Charles Brecher of New York University, who would succeed him at the Citizens Budget Commission, would conclude that the Koch administration's forced austerity ‘yielded a balanced budget, but at what cost? And to whom? The greatest burden was borne by the city's poor, whose standard of living was reduced.'

And by the late 1980s, with crack cocaine fuelling a crime epidemic and costs again outpacing tax revenues, the city was facing another crisis. A series of
New York Times
editorials branded New York as ‘New Calcutta'. In 1991, the murder toll reached a record 2,245. The trailer for a film titled
King of New York
declared: ‘Not everyone who runs a city is elected.' It wasn't about a banker. It was about a drug dealer. And this time there were fewer options. ‘Last time, part of the solution was an unbalanced budget for a couple of years, but a mechanism to work your way out of the hole', said Philip R. Michael, the city's budget director. ‘This time, there are no options to having a balanced budget.' But David N. Dinkins, who succeeded Koch and served as the city's first black mayor, cautioned: ‘We know from our experience in the 1970's that the budget cuts of today lead to higher social costs a decade from now.' Felix Rohatyn would put it another way years later when the city again faced looming deficits. Were there some things the city could no longer afford to do, he was asked. ‘It may not be able to afford to do them', Rohatyn replied, ‘but if you stop doing them you may lose more than you gain'.

‘Because of the fiscal crisis, there won't be another fiscal crisis', Dick Netzer, a New York University professor, concluded. ‘Indeed', said John E. Zuccotti, who was recruited as deputy mayor to save Abe Beame from his complacency, ‘maybe the things that had to be done could only be done by creating a crisis.' Still others expressed regret that despite the strict fiscal framework that was imposed on the city, more fundamental changes in productivity, privatisation and governance – and public expectations – had not been effected. ‘We didn't change the way we provide public services', Professor Horton said. ‘We simply shrunk the system.'

In his book
Political Crisis, Fiscal Crisis: The Collapse and Revival of New York City
, Martin Shefter, a political scientist at Cornell University, argued that the events of 1975 were merely the latest manifestation of a recurring dynamic between two sets of goals of government officials: getting elected and preserving civil harmony, on the one hand; and nurturing the local economy and maintaining the city's ability to pay its bills, on the other. In other words, there would be other crises, but they would manifest themselves in different forms. As Steve Weisman, now the editorial director and public policy fellow at the Peterson Institute for International Economics, wrote in 2011: ‘It is amazing, in retrospect, how so much of that crisis foreshadowed the debt and deficit crisis in the United States and Europe today.' That year, several figures who were instrumental in resolving the crisis – Richard Ravitch, Felix Rohatyn and Paul Volcker, who was president of the New York Federal Reserve Bank in the mid-1970s – banded together to apply the lessons of The Fiscal Crisis to struggling state and local governments overwhelmed by public pension commitments. ‘New York in 1975, is kind of a microcosm for what's going on in the U.S. generally now,' Volcker told the
Financial Times
. ‘We borrow and borrow and continually spend and, so long as people are willing to lend, there is not sufficient pressure to do something about it in a timely way.'

11

When Cities Default …

Marc Tomljanovich

Marc is associate professor of Finance at Drew University, New Jersey.

The sovereign debt crises in Greece, Ireland and Italy are in the gun sights of policy makers and news agencies alike. Their concern is well warranted. The effects of any developed country, even the smallest, being unable to fully repay its debts in a timely manner would likely have extreme impacts on many economies in Europe and across the globe, as well as on global financial markets. However, another debt crisis is looming, one that threatens to have more severe effects on individual households and local communities who only know about the travails of Irish banks through the late night news or online
Wall Street Journal
. This crisis involves municipal bonds, and is a tremendous example of trickle-down public spending gone wretchedly wrong. Though only a few US communities declared bankruptcy in 2011, these defaults may represent the dead canary in the coal mine. The next few years have the very real potential of bringing with them a cascade of new municipal defaults, and the combination of local and state tax hikes, alongside reductions or suspensions of local services, will make life much more difficult for these local areas for years to come. Nor is the crisis in locally-issued bonds limited to the United States. Whether the number of municipal defaults explodes across the United States and other countries depends on the extent to which national and regional governments are willing to step in and bail out struggling local governments facing challenging economic conditions and failing capital projects.

First, a very brief background on municipal bonds is in order. In the United States, municipal bonds are debt instruments issued by local governments, such as counties, towns and cities. It is an IOU – by purchasing one a municipal bond holder is entitled to the face value of the bond, which is paid back when the bond matures, as well as semi-annual coupon payments. Local governments issue these bonds for various capital projects designed to either repair deteriorating infrastructures, such as bridges and roads, or to create new infrastructures, such as a sewage treatment plant or new sports stadium. Municipal bonds fall into two main categories. The first type is general obligation bonds. With these bonds, the local government can raise taxes if needed to repay bondholders. These bonds are predominantly rated at investment grade status, since the municipality can almost always raise property taxes to repay the bonds. The second type is revenue bonds; for these bonds, only the revenue stream gained from the completed investment project can be used to repay bondholders. A good example of a revenue bond is a bond used to build a tolled highway – the government repays bondholders using the taxes it collects from drivers who pay exit tolls. Notice that there is one important feature of municipal bonds – they are not issued to cover operational costs. So, as tempting as it might be to try, a city cannot simply issue bonds and use the proceeds to pay workers their monthly salaries! The funding is to be used for capital projects only.

Why do investors like municipal bonds? There are two main advantages. The first is that, historically, municipal bonds confer a steady return to investors, unlike equities. Second, many municipal bonds also have a unique tax advantage in the United States. Interest received from municipal bonds is exempt from federal income taxes; this is not true for corporate or US Treasury bonds. And many states also allow interest payments to be exempt from state income taxes as well, provided the bondholder also lives in the state. What this means is that the returns gained from holding a municipal bond are in all cases exempt from federal taxes, and in some cases exempt from any US taxes at all. This tax advantage, combined with an overall stable performance, helps to explain why individual investors hold two-thirds of the $3 trillion of outstanding US municipal debt.

Historically, municipal bond markets have been wonderfully tranquil creatures. Secondary market trading is thin, since once investors purchase municipal bonds they tend to hold onto them until maturity due to their tax benefits. In addition, Lawrence Harris and Michael Piwowar found in a 2006
Journal of Finance
article that municipal bonds are more expensive for retail investors to trade, so that, combined with the lack of price transparency, many investors take a ‘buy and hold' attitude. However, municipal bonds certainly are not completely riskless assets. Bond holders may be exposed to multiple types of risk, including the risk that price levels may rise (inflation risk), the risk that market interest rates may rise (interest risk), the risk that municipalities may call their bonds early (call risk) and the risk that a municipality may declare bankruptcy prior to the bond's maturity (credit risk). The failures and near-failures are notable in part because they are so rare. The most widely cited municipal defaults in the United States include Orange County, California in 1994, the city of Cleveland in 1978, Washington Public Power Supply System in 1983 and the state of Arkansas in 1933 in the height of the Great Depression. And despite its eventual resolution, the near bankruptcy of New York City in 1975 serves as the highest profile cautionary tale of the short-term and long-term impacts a default can have on a local region.

Like many US cities in the post-World War II era, New York City experienced economic and social decay as both households and businesses began a flight to the suburbs in the 1950s and 1960s. Tax revenues dropped while crime rates soared, spurring on budget deficits by as early as 1961. By 1975 the city was on the brink of disaster, being unable to pay its daily operating expenses. It faced a $750 million budget deficit, and also had $14 billion in bonds outstanding, with almost $6 billion being short-term. By this time, the city also found itself shut out of credit markets, so new bond issuances were impossible. New York City avoided a full-scale default through a $2.3 billion three-year loan by the US federal government. New York City's services were reduced in noticeable and permanent ways. Many construction plans were halted, and the city's libraries, schools, parks and hospitals became more crowded and more poorly maintained. Programmes helping unemployed workers, such as weekly benefits and job retraining, were slashed. The city's free universities and open admission policy became a casualty of the new austerity plan, as restrictions were placed on who could get into the colleges and tuition was imposed for the first time. City teachers were forced to use $150 million of pensions to purchase city debt. Higher city taxes, including a 25 per cent increase in NYC's income tax, hastened residents' migration to the suburbs of New Jersey, New York and Connecticut, eroding the city's tax base. Of course, New York City's debt had been heavily downgraded by rating agencies, and the city was unable to re-enter the municipal bond market in any significant capacity until the end of the decade. Other related governments were also impacted by the de facto default. By also loaning New York City essential funding, New York State also suffered; being unable to raise money through new debt issuance for other needed projects. In a 1977
Financial Analysts Journal
study, David Hoffland found that the New York City default resulted in credit spreads rising from 7 basis points (0.07 per cent) to 50–70 basis points (0.50–0.70 per cent) for a group of eastern cities including Pittsburgh, Boston and Philadelphia, raising borrowing costs for those cities and putting new external pressures on their budgets.

New York City's situation, though, appeared to be an exception to the norm. Moody's Investment Services discovered only 54 municipal bond defaults out of 18,400 rated issuances between 1970 and 2009. And Fitch ratings found that the cumulative default rate on municipal bonds issued between 1987 and 1994 was only 0.63 per cent. Furthermore, financial losses incurred by bondholders are rare, with Moody's reporting an average recovery rate of 67 per cent on defaulted municipal debt. In almost all of the cases listed above, bondholders were fully repaid at some point after the initial suspension of interest payments. The exception that perhaps proves the rule is Washington Public Power System Supply (WPPSS). Created in 1957 to bring affordable power to the northwest United States, WPPSS ambitiously issued $2.25 billion in bonds to finance the creation of five nuclear power plants, the proceeds of which would be used to repay bondholders. Environmental concerns and design changes led to massive cost overruns which forced the early cancellation of the project, and bondholders eventually received less than 25 cents on the dollar. Investors and the media quickly began pronouncing the municipal corporation's acronym as ‘whoops'. One can thus see the allure of municipal bonds: credit risk is low, and even if default occurs, there is a high probability an investor will get back almost the entire principal. But the occasional defaults are also notable because they remind investors that if one municipality declares bankruptcy, it is entirely possible that any other municipality could do so. There may be key structural differences between the economies of Topeka, Kansas and Fargo, North Dakota, but they are likely lost on the average municipal bondholder who bought the related general obligation bonds based on after-tax rates of return. However, a municipal default that hits the news headlines can get investors looking at local communities with a more discerning eye, a requisite trait for successful long-term bondholders in coming years.

The financial crisis in autumn 2008 brought plenty of discerning eyes to every type of financial instrument. The implosion of the credit-default swap and structured products markets, in tandem with the heart-wrenching plunges in US, European and emerging equities markets, and topped off by spectacular bank collapses in multiple nations, meant that no asset class was completely safe. And it turns out that municipal bonds have many warts as well.

Municipalities in the United States have faced a perfect storm of financial horrors over the past three years. First, US property values began to fall by late autumn 2006, reversing a long-term trend and lowering local tax revenues. The meteoric rise in housing prices throughout the 2000s had led local governments to increase the depth and variety of their services, not to mention public salaries, and many were not equipped to quickly adjust to the new financial landscape. The presence of teacher, fire and police unions also tied the hands of many municipalities, which, due to long-term contracts, were forced to increase wages for public workers despite the deterioration in the economy. Second, in many states such as Florida, the fast pace of housing development required new infrastructures and new municipal bonds were issued to raise funds to build them. The assumptions of continued robust growth of new homes, and the associated revenue streams for the local governments, were decimated by the crisis. Third, as national consumer demand for goods and services slowed down in late 2008 into early 2009, millions of Americans were thrown out of work, eroding state finances as unemployment claims rose and income tax receipts fell. Fourth, beset by their own financial troubles, states reduced the amount of aid bestowed to local communities. The governors of Nebraska, Ohio, Wisconsin, Michigan, Massachusetts and New York are proposing deep aid cuts to their cities in 2012. Fifth, the rising number of foreclosures, with over 600,000 US foreclosure filings in the third quarter of 2011 alone, crimps both tax receipts and depresses home prices further. Foreclosures are an especially pressing issue for many high-growth areas, such as Nevada, that had to quickly construct new services like schools, roads and parks to accommodate the influx of families. These municipalities paid for these services through new bond issuances, expecting that tax revenues would continue to rise with the population and home values. Nevada now has the highest foreclosure rate in the country: as of the second quarter of 2011, an estimated 63 per cent of all homes in the state were ‘underwater', and one out of every 75 residences was in foreclosure proceedings.

The time of reckoning has come for some municipalities in 2011. One well-publicised example involves Harrisburg, Pennsylvania, a city of 50,000 that is also the state's capital. The city has been in financial distress for decades with both low population growth and low per capita household incomes, including a 30 per cent poverty rate in 2009 according to the US Census Bureau. Adding fuel to the fire, the city guaranteed much of the $310 million in debt tied to a trash incinerator project that was envisioned to be self-sustaining but quickly turned into a financial morass. Members of the city council rejected demands from state officials that city assets be leased or sold. The city filed for bankruptcy protection in October 2011 claiming $450 million was owed to creditors, but just days later the state's governor signed legislation that would turn over the city's finances to state officials. The December holiday parade in the state's capital was one of the first items to be cancelled.

Sewage is causing mounds of problems down south. Jefferson County, Alabama began construction of a $3.2 billion sewage treatment plant designed to address population increases as well as environmental concerns. The project went awry as cost overruns and corruption issues mounted, and the county's decision to engage in interest rate swaps in 2002 designed to lower interest rate payments spectacularly backfired. Jefferson County defaulted on a $3.5 billion bond issuance in 2008, making it the largest municipal default thus far in US history. The county also tried imposing an occupancy tax to help pay for the project, which was ruled unconstitutional by the state's Supreme Court in mid-2011 and sent the county to the edge of disaster. In mid-September, following three years of tense negotiations with creditors, the county narrowly avoided filing for bankruptcy. One of the biggest holders of Jefferson County's bonds was J.P. Morgan Chase. The biggest impact of the bill is the effect on sewer rates in the county: 8.2 per cent annual increases have been proposed over each of the next three years, followed by 3.25 per cent annual increases until the debt is paid off.