Attention Federal Reserve: Start Planning Now to 1) Extend Longer Term Loans to States and Localities, 2) Pick and Choose in the Secondary Municipal Finance Market and 3) Intervene in the Primary Municipal Finance Market
There is an updated (And shorter) post on how the Fed should lend to states here. An updated post on the municipal market will be ready soon.
[Author’s Note: What follows are some initial thoughts on an unprecedented situation. I intend to revise this post in light of new information and further thinking. Please e-mail me your thoughts.]
Update: On April 9th, the Federal Reserve acted, but only to alleviate the cash flow problem detailed below. However, the Fed noted that it “will continue to closely monitor conditions in the primary and secondary markets for municipal securities and will evaluate whether additional measures are needed to support the flow of credit and liquidity to state and local governments.” This post is about what those measures might look like.
Further update: Thomas Cochran has made a similar argument here.
The current pandemic is a giant catastrophe, the only question is how giant. In the American system of federalism, states and localities are at the forefront of providing basic government services, but without the financial power of the central government. In ordinary times, this has worked well enough and in most national emergencies the federal government has taken the lead. This is a national emergency with states and localities in the lead; they need the financial support of the federal government. It turns out that Section 4003(b)(4) of the CARES Act is a means by which the federal government can play this vital role. I will also argue that the Federal Reserve has more power than it might think to play this role even without the CARES Act. Let me explain.
A further somewhat idiosyncratic feature of American federalism is that a vast percentage of our infrastructure is financed by state and local governments. The basic tool for such financing is known as a municipal bond. At the moment, the $3.8 trillion municipal bond market is in trouble and looking for help from the Federal Reserve and the US Treasury. Indeed, it is expecting help and the recently passed CARES Act provides up to $454 billion in help (See Section 4003(b)(4), at bottom of post). On the one hand, the uses to which this money can be put are pretty broad (see section (b)(4) and the discretion given to the Treasury Secretary in subsection (C )(1)(A), also below). On the other hand, this pot of money is also available for loans to private businesses, which places states and localities in competition with private businesses. Accordingly, Senator Elizabeth Warren has written to Secretary Mnuchin and Chairman Powell emphasizing the need to prioritize help for state and local governments. As you can tell from the first paragraph of this post, I strongly agree with the argument made in this letter.
Furthermore, the National Association of State Treasurers, Government Finance Officers Association and National Association of State Auditors, Comptrollers and Treasurers have written a letter outlining how, specifically, the feds can help the municipal bond market (NAST letter).
The NAST letter asks for two kinds of extremely sensible support. First, state and local governments are about to suffer a liquidity crunch. Consider income taxes. States typically receive a lot of their revenue from income taxes in April; this year, much of this money will be delayed (at best). It is therefore important that an easy to use credit facility be established for state and local governments.
The second issue has to do with the secondary market for municipal bonds, which has been in trouble. If buyers of new bonds fear that they cannot sell their bonds, then the primary market will freeze up too. Accordingly, the NAST letter proposes that the Federal Reserve purchase a wide variety of municipal securities. This proposal also makes good sense and can clearly be implemented, as the European Central Bank had a similar program, a program that is being expanded for the current emergency.
These are low-hanging fruit, policy-wise and politics-wise. There are, however, three more fraught expedients that should be considered and now: 1) Making longer term loans to states and localities (this is the most important), 2) Picking and choosing in the secondary market and 3) Intervening in the primary markets.
1. Longer term loans. The revenue drops the states will experience as a result of this crisis will be very large. Suppose the Federal Reserve extends a short-term loan to cover a state’s expenses through the end of June, what happens then? States and localities almost uniformly operate under balanced budget rules; do we want them to cut desperately needed services and increase unemployment during a recession in order to balance their budgets?
I hope that Congress will do more — much more — for states and localities, but, whatever is to come, Section 4003(b)(4) CARES Act gives the Treasury and the Federal Reserve authority to extend longer term loans to states and localities and they should do so. This is not the place to sort out exactly what these loans will look like, but a very low-interest loan extended over a long-time period with no prepayment penalty seems appropriate.
There is a question as to whether states can borrow from the Federal Reserve, as this would seem to violate their balanced budget rules. This is another place where further details need to be hashed out, but the upshot is that this problem is solvable. Typically, states can borrow (without a vote) if the borrowing fits under one of several exceptions. For example, a borrowing secured by a special fund is generally exempt from the balanced budget rule. Though there are broad commonalities between states, states do differ in the details. In some cases, the states might need to pass new laws. In other cases, it might make sense for the legality of the borrowing to be tested by a validation action.
This is why the planning should start now. Another reason to start thinking about this now is that states can borrow with voter approval. It is perhaps not too late for states to get measures on their November ballots if the federal government were to signal that low interest financing will be available. I think that a majority of voters in many states would be interested in approving taking such loans.
A more aggressive approach. It could be objected that the Treasury Department is not going to approve long-term loans to states for political reasons, and, if it did act, it would be too little too late. Even if all $454 bn in Section 4003(b)(4) were lent to the states, it might not be enough. It turns out that, under Section 14(b) of the Federal Reserve Act, the Federal Reserve can purchase “bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States…” This provision dates to the original 1913 Act.
The good news about this section is that this is independent authority for the Federal Reserve to extend short-term credit to the States and localities. No need for the zero sum game of the CARES Act or negotiating with the Treasury Department. Also good news is that there is a short-term borrowing exception from balanced budget rules and so states and localities can act quickly.
But the bad news is that the debt that is purchased can only have a six-month maturity. But how bad is that news? Could the Fed not commit to permit states to roll over their debt during the crisis and for a fixed, but significant, period after that (say 20 years)? Once the crisis was over, the states could be told they could only roll over a declining amount of principal. The Fed could even have upfront rules as to the amount of debt they are willing to purchase from a state or locality based on the size of the projected deficits compared to a recent historical baseline. In ordinary times, short-term municipal financings often require a similar calculation. No doubt this would be an aggressive expedient, but that appears to be what the crisis warrants.
2. Picking and choosing in the secondary market. Consider bonds secured by sales tax revenue or toll receipts or airport fees. At least most of these bonds will have reserve funds, but these funds typically provide about one year of debt service. Depending on the length of the crisis and whether a return to normal will ever occur for certain revenue streams, certain bonds will be in trouble. Yet for many of these issues, the trouble will not likely be terminal. Even if toll receipts never fully recover, investors could be made whole — or nearly so — if the term of the bonds were extended. The problem is that changing the essential terms of the debt obligation will require consent of the debt holders, which might be quite difficult and time consuming. It would seem odd for the Federal Reserve to purchase lots of municipal debt on the secondary market that is unlikely to default, while only owning small amounts here and there of debt that could really benefit from a workout. This is not to say that the Federal Reserve should not begin to buy a wide range of securities per the recommendations of the NAST Letter, only that it should start thinking about how it might formulate neutral guidelines as to which types of bonds it might purchase more systematically. For example, airlines are getting special solicitude under Sections 4003(b)(1) and (b)(2) of the CARES Act, and so it would seem that there is a good case to look after airports under Section 4003(b)(4).
3. Intervene in the Primary Market. If a state or municipality has a borrowing/project that is ready to go, then it should proceed for the benefit of those communities and the wider economy. But it is possible that the primary market will freeze up despite the help provided to the secondary market. If this happens, then the Federal Reserve should intervene.
However, the Federal Reserve cannot purchase all such securities indefinitely, and thus it makes sense for the Federal Reserve to be wary of intervening. As was well put in a recent NYT article, quoting Vikram Rai of Citigroup: “If New York issues debt in April, when the Fed is buying, it will be able to price its bonds better. If New Jersey issues in September, when the Fed isn’t, it could find itself at a disadvantage.”
This political problem is solvable, if imperfectly, so long as neutral rules and timelines are proposed in advance, which is one of the reasons I am writing this post.
What might the plan look like? Let’s go back to toll roads or airports. I am assuming that there are good projects that were scheduled to go to market this spring, summer and fall. This country still has intense infrastructure needs after all. But perhaps purchasing an airport bond when no one is using airports will seem daft. For a pre-existing list of the kinds of infrastructure projects Congress has looked kindly on, see the definition of “Exempt Facility Bond” in IRC Section 142(a). To be clear, I am not suggesting that this is the right list, but I am suggesting that starting from such a list as a planning exercise would be a good idea.
Indeed, I would propose going a step further. Consider a regional transportation initiative: one set of bonds for a bridge, another set for a parallel mass transit line. If the Fed only enables the bridge financing, then the bridge is going to be much more crowded than anticipated. It would therefore make sense for the Fed to take a broader look at which programs are complementary, as well as a higher priority. It turns out that the federal bureaucracy already contains many experts considering just such questions in connection with federal transportation grants. This expertise should be utilized so that the Federal Reserve gets the maximum bang for its buck. Indeed, many of these grant programs require a state/local match and so federal support of the municipal finance component might be essential just so state and local governments can even access federal grant funding.
If there are more good projects than CARES funding, the Fed could again use the expedient of rolling over short-term financing, with the understanding that the issuer would need to complete a traditional municipal financing once the crisis is over.
Statutory Appendix from the CARES Act
Section 4003(b)(4)
Not more than the sum of $454,000,000,000 and any amounts available under paragraphs (1), (2), and (3) that are not used as provided under those paragraphs shall be available to make loans and loan guarantees to, and other investments in, programs or facilities established by the Board of Governors of the Federal Reserve System for the purpose of providing liquidity to the financial system that supports lending to eligible businesses, States, or municipalities by —
(A) purchasing obligations or other interests directly from issuers of such obligations or other interests;
(B) purchasing obligations or other interests in secondary markets or otherwise; or
(C making loans, including loans or other advances secured by collateral.
Section 4003(c)(1)(A)
A loan, loan guarantee, or other investment by the Secretary shall be made under this section in such form and on such terms and conditions and contain such covenants, representations, warranties, and requirements (including requirements for audits) as the Secretary determines appropriate. Any loans made by the Secretary under this section shall be at a rate determined by the Secretary based on the risk and the current average yield on outstanding marketable obligations of the United States of comparable maturity.
