New Municipal Tricks

Through much of the past decade I wrote and posted about municipal (Chapter 9) bankruptcy. Here, here, and here for some examples. Anticipating a good question--why aren't there more municipal bankruptcies--I have argued that the current super-low interest rates are permitting cities to borrow from Peter (folks seeking any decent yield on fixed-income securities) to pay Paul (municipal retirees). (For what it's worth, I don't think the uptick in rates over the past week or so portends a radical increase in the costs of municipal borrowing, at least not as long as the leadership of the Federal Reserve and the current administration in Washington remain in place.)

But what if the current low rate environment isn't enough? What if some municipalities want to take on more debt--without voter approval--than state law allows? And what if investors seeking yields are stupid? Well, as you might expect, there's an app for that. The market is as adept at developing flim-flam as useful products.

You can read about the latest flim-flam in municipal finance here. (I posted about an earlier version of this sort of scheme here.) Quoting from the article with some interpolations added for clarity,

A city creates a dummy corporation to hold [municipal] assets, [transfers the assets to the corporation], and then rents [the assets back]. The corporation then issues bonds [borrows money] [secured by the rental payments due from the city] and [transfers] the [loan] proceeds back to the city, which sends the cash to its pension fund to cover its shortfall. These bonds attract investors — who are desperate for yield in a world of near-zero interest rates — by offering a rate of return that’s slightly higher than similar financial assets.

In other words, arbitrage. 

But why? Two reasons: first, as the article notes, the state pension fund in California (CalPERS) charges 7% interest on unpaid municipal pension contributions. Borrowing by any means at, say, 3%, means the municipality "profits" by the difference. Of course, someday the bonds will come due, but a different set of elected city officials will have to deal with that eventuality.

Second, in some states general revenue bonds must be approved by voters. In other words, voters can veto what amounts to an unsecured loan to their city. But some of those states make an exception for bonds secured by specific assets and some states allow their cities to do the two-step end-around of using a corporation to shield their indirect borrowing from voter approval.

But wait, isn’t the borrower a corporation, not the municipality? Why should the city care if the corporate borrower defaults? The article doesn’t explain this but there are two reasons why a municipality might care. First, it may have guaranteed the payment of corporate debt (the bonds). Alternatively, the corporate debt is secured by some apparently municipal assets. What will the city do if its corporation defaults and the bondholders attempt to repossess the collateral (say, a golf course, art collection, city hall, etc.)? Detroit managed to wheedle out of surrendering its municipal parking lots to bondholders, but future bankruptcy judges might not be so forgiving.

Of course, if a municipality can keep its cake—its transferred assets—and not repay the money its corporation borrowed, the bondholders will be left holding the bag. Which goes to prove the truth of the adage that there’s a sucker born every minute.