Posts Tagged ‘direct democracy’

As this article from the Tax Foundation states, you can’t make this stuff up…

See highlighted article about the struggle among a group promoting an initiative to curb costs: covering pensions for new employees’, raising the new employee retirement age and capping the pension formula. The initiative also would prevent the city council from passing retroactive increases (which is what Detroit did in the middle of its fiscal mess).  Looks like the local legislators are letting the taxpayer groups fight the fight with the unions; how convenient.

We have two opposing camps in the muni-market at the moment: those who say it is the next systemic shoe to drop and the rating agencies that are systemically raising ratings.

Which is right?

We have moved from a market that has had heavy intermediation from the bond insurance companies to one where investors are on their own. Bond insurers historically performed heavy analysis and monitoring of the credits they insure and actively affect the legal protections embedded in a security. Bank credit enhancers have done the same, although in some cases their agreements allow them out of the risk under certain circumstances. Rating agencies assign their rating on sale and their business model has never been designed to provide robust monitoring of issuers in the secondary market. The Moodys and other agency default studies covered this time period – a relatively prosperous period from 1970 – 2007 when pending defaults on the investment grade level were mostly managed by bond insurers. Further, the default studies did not include insured bonds.

Municipal bonds do default and have throughout this period –not at all in large numbers by any comparison to the corporate world. Knowledgeable high yield investors are aware the risks in hospital, senior care, land development, and corporate-style tax exempts such as industrial revenue bonds. Project finance, such as the Harrisburg incinerator, Las Vegas monorail and Connector 2000 also carry high risk. (I should add WPPSS and other nuclear power projects to this list.)  These should not be lumped together with the other 30,000 or so municipal bond issuers. Like the stock market, there are many, many nuances among borrowers. Only now the investor is left to grapple with his own resources – and the loss of granularity among this diverse and deep market from ratings “re-calibration”.

(Concerning re-calibration of ratings:  As I have said before, lowering corporate ratings to their appropriate probability of default relative to municipals – would achieve the same effect, and be truer to their own research. Instead, the agencies are compressing ratings into fewer categories and eliminating much granularity for investors. But of course the other approach would have been business suicide and harmed many corporate portfolios.)

Within this, market prophets are now generalizing greatly, mostly those who have not spent their careers in this non-standard, messy, sometimes corrupt and poorly understood state and local financial world.

This brings me to some comments on Rick Bookstaber’s recent post. Many of his points are strong and need to be actively debated, but others generalize to the detriment of this very varied marketplace.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Agreed. The Tower Amendment should be abolished and municipalities that want to participate in public capital markets and be rated like corporates should be held to the same reporting standard. Period. Would you buy a corporate bond whose disclosure was two years old?

The argument that it’s too expensive and too burdensome for smaller municipalities to achieve transparency can and must be resolved. Technology and know-how exist to achieve this in a cost effective manner. Those municipalities that cannot produce timely and accurate reporting – should borrow locally and not expect to participate in national markets. Or they should not be given (potentially misleading) ratings. Borrowing locally will likely end up costing more than paying the auditor to get the report done in a timely manner.  Hiding behind the “municipals don’t default, so what difference does it make?” argument is so yesterday.

The rating agencies still do not fully incorporate pension and other benefits into the debt statement that produces their debt ratios and medians. Taxpayers certainly do consider these factors. All obligations that are paid from the public purse should be clearly disclosed. Understandably, rating agencies argue that they serve investors not taxpayers. But political risk – unwillingness to pay – clearly reaches back into the investor’s pocket.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

This is a big market, but is not uniformly systemic like housing.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

In some cases. Given our federal system, each state has its own set of rules for local municipal finance. For example financing infrastructure for housing and economic development is vastly different in structure and credit quality in California (Mello Roos for example) vs. Florida (community development districts) vs. Texas (municipal utility districts).

Bookstaber’s point does apply to the municipal market in several ways. Investment portfolios and cash management are prey to marketers of the security “du jour”. As one of his commenters suggests, Fannies and Freddies could put municipal investments systemically at risk of a federal policy change — affecting many municipal government investors at one time. I would add to this list: securities lending practices among pension plans and other large public funds  (which some practice but others do not).

Ratings triggers on counterparties that create terminations, unwinds and a change in interest rates, basically legal provisions that automatically change the terms of the deal — also create across the board risk for those borrowers involved. Examples include variable rate securities, swap transactions, LOCs and GICs. These structures effectively embed corporate and market risk into municipal credit.

At the traditional fixed income municipal debt level however, there is significant diversification among security types and legal structures – given the 10th amendment and individual state peculiarities.

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky — the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Agreed. Analysts and investors should incorporate a haircut for unfunded pension and benefit liabilities that use overly ambitious earnings as a discount rate. The debate about “risk free” vs. a historical earnings rates is an important one. Stated another way, this debate points to the fact that public pensions (defined benefit) are irrevocable, guaranteed and must be paid.  How would you invest funds when you could not afford to lose a penny vs. money you are willing to take on more risk? Since pension obligations are long-lived, the counter-argument that earnings over time should be used has some merit as well.   But the inequities between public retirees and the rest have piqued the taxpayer whose 401K and life savings have been subject to market losses.  Also, the “defined benefit” retirees are facing off against the “defined contribution” beneficiaries.  Fairness is an important public good, as difficult as this debate may be.   

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the underfunded portion of the portfolio.

Absolutely. Maybe they don’t have to do a site visit on each review, but they should disclose the date of their latest full review for each rating, no question. How many of the re-calibrated ratings have been freshly reviewed?

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Disagree. See my comments above and other blog posts on this site. Municipalities do not behave the same as homeowners. Clearly there are scoundrels and irresponsible politicians who just want out of obligations they did not understand or were misled from the get-go.

Even with debt repudiation talk in the air, it is difficult to file bankruptcy in most states, and default is not a good option for a municipality that needs capital markets access. Plus, as covered elsewhere, given the 10th amendment, bankruptcy does not give the federal courts the same kinds of control over a municipality as a corporate entity.

Keep in mind that the majority of municipal borrowers (like the majority of homeowners) want to do the right thing.

Neither are taxpayers irrational. Protests are explainable. There are only certain states where initiatives and referenda are permissible (and this too has historical roots). There are correlations between rapid growth in taxable assets, public spending increases and taxpayer protest. (I have written about this on my blog and elsewhere.) 

Taxpayers are right to be angry at politicians who are spending their money mainly to buy votes and for poor policy reasons. We need to look at the spending patterns in government and have this debate. How many say, “It’s a pre-election year, of course nothing will get done.” In the private sector, someone with that approach would be fired.

Two important worries Bookstaber hasn’t addressed directly:

Liquidity: There are major liquidity issues at some of the states, quickly filtering down to the local level. At least three states have held back making payments to localities and vendors – California, New York and New Jersey. At some point liquidity markets may stop lending – or the cost will become prohibitive — which will have immediate impact on the economy in those states. Where enough taxes roll in the next month to cover payments, these states will limp along until they are able to cure their structural imbalance or they will hit the wall. While some look for a federal bailout in this situation, a failure to tackle the cure for structural deficits is bad policy. As we learned in recent banking crisis, institutions that require regular market funding for survival will fail in a liquidity freeze.

State solvency: tied to the first point, there is no mechanism in our society to address state insolvency. States, as sovereign entities, do not go bankrupt. There simply does not exist any legal or political institution with the authority to facilitate an orderly reorganization of state obligations. We need to think up objective, non-political structures that put the brakes on spending increases when times are good and that facilitate reorganization when times are bad.

Midterm congressional elections will be lively this year.   Conditions are ripe for tax and spending initiatives and numerous recall elections are also on the popular agenda.  Budget deficits, rising taxation and runaway spending are factors leading to tax and spending limitations.  Anger at the federal government sometimes gets played out at the state and local level where people can air their views in the local media and have greater influence on budgets, tax levies and spending. 

The combination of denied credit, deeper debt, harsh taxation…led the discontented to suspect a conspiracy by the moneyed interests of the country to enslave them in a web of economic servitude.

(From David Schmidt, on the rise of the initiative and referendum movement in the 1880’s. Citizen Lawmakers: The Ballot Initiative Revolution, Temple University Press, 1991)

The same characteristics that showed up in the 1970’s and today were present in the original initiative movement.  Indebted farmers and frontiersmen who had moved out west felt that they were subject to the special interests of industrialist bankers, railroad barons and land speculators.  The boom and bust cycles of westward development left a rift between the farmers and frontiersmen and the groups that they saw as the exploiters.  It was the farmer’s belief that these greedy influences had corrupted the legislatures and that they were being taxed to help those special interests. 

In the late 1880’s the number of farm foreclosures exploded and a vast number of farms were taken over by the loan companies.  Out of this era came the Farmer’s Alliance which later developed into the Populist Party.    The right of citizens to directly create laws through the initiative movement – “direct democracy” — stems back to this time and later with the Progressive Party.  These groups were strongest in Texas, the Dakotas, Kansas, Oklahoma, Alabama, California, Colorado and elsewhere in the South and West.  Ballotpedia, a “wiki”, or open electronic encyclopedia, (like “wikipedia”) shows the following map of states that permit initiatives, referenda and constitutional amendment.

Click twice to enlarge

Click twice to enlarge

In the 1970’s rapidly rising real estate values accompanied by a tax structure that captured an increasing proportion of homeowner’s income in property taxes again led to significant voter unrest.  That time period gave us California’s Proposition 13 in 1978, passed by two-thirds of the state’s voters and reducing property taxes 57%.  In the 1960’s and 1970’s California had experienced an extraordinary growth in property values and in tax bills, largely due to inflation and dramatic increases in population.  In Massachusetts, prior to passage of Proposition 2 ½, state and local taxes grew from 103% of the national average to 124% of the national average.  Idaho, which passed Petition No 1 in 1978, had seen residential taxes nearly double between 1969 and 1978.  Later, Colorado voters passed the “taxpayer bill of rights” or TABOR which sought to significantly limit government (1992).  (TABOR has subsequently been loosened but a movement is afoot to roll back the liberalization of the original law.)

The presence of a committed and zealous individual or group is another key ingredient.  Although some dismiss these individuals or groups as “cranks”, they will persist in introducing ballot measures year after year, until something passes.  Howard Jarvis in California and Bill Sizemore in Oregon are two well-known names.  Today’s Tea Party groups are spawning new leaders in this effort. 

Demographics play a part in initiative and referenda movements as well – states with lots of retirees like Florida, Arizona and California – have ready workers with time on their hands to get petitions signed and talk with the neighbors.  In addition, the continuous migration of people from place to place has intensified demographic differences. 

The “pick-up-and-go” mindset in the U.S. has led people to sort themselves into like-minded communities – reinforcing particular political viewpoints.  “Over the past thirty years, the United States has been sorting itself, sifting at the most microscopic levels of society, as people have packed children, CDs, and the family hound and moved…When they look for a place to live, they run through a checklist of amenities: Is there the right kind of church nearby? The right kind of coffee shop? …When people move, they also make choices about who their neighbors will be and who will share their new lives. Those are now political decisions, and they are having a profound effect on the nation’s public life…In 1976, less than a quarter of Americans lived in places where the presidential election was a landslide.  By 2004, nearly half of all voters lived in landslide counties.”  (Bill Bishop, The Big Sort, Houghton Mifflin, 2008)  Another of Bishop’s key points is that interacting primarily with like-minded people tends to make a group’s political viewpoint and perspective more extreme.  Electronic social media also plays this role.  The use of the Internet, blogs, Twitter and YouTube for grass roots campaigns has made it easier to create, inform and activate like-minded communities.

The sorting, polarizing and intensifying of political views has created gridlock in many state and the federal legislatures. Maintaining the primacy of one’s political party and political viewpoints often win out over collaborating to create effective policy. “California’s primary system and gerrymandered Assembly and Senate districts, both parts of the Constitution, consistently produce candidates from the ideological extremes.  In such an atmosphere, party orthodoxy rules all, and crossing the line to compromise is political suicide.  For this reason, real, desperately needed change is blocked at every turn, and only bills like regulating tanning booths actually escape alive.”  This is from Jim Wunderman in the San Francisco Chronicle last summer.     Examples are easy to find in the state legislatures, notably California and the embarrassing New York State Legislature where Democrats physically locked out the Republicans last summer.  At the Federal level too, Republicans’ refusal to vote on any proposals from the Democrats or collaborate on sensible solutions is a further example of this polarization.

Finally, funding for initiatives and referenda has become big business for some proponents.  In California and elsewhere, gathering petitions and paying for advertising campaigns has spawned a well-funded cottage industry.  The recent Supreme Court decision permitting corporations and unions unrestricted campaign funding will inevitably reinforce the trend. 

Grassroots groups are reacting.  The Tea Party is an example of the tension between the grassroots and organized parties.  The Tea Party is a loose and in some areas unaffiliated collection of organizations.  Tea Party Nation, Tea Party Express and Tea Party Patriots are among the few national organizations.  Tea Party Patriots has accused Tea Party Nation of co-opting the name from the grassroots movement and receiving support from the GOP.  Teapartynation.org is sponsoring the first national convention on February 4-6 in Nashville, Tennessee and Sarah Palin is the featured speaker.  Complaints about the hefty registration and GOP support are common.  A lawsuit erupted in Florida over the registration of the name as a political party.  The defendants argue that the name stands for “taxed enough already”.  The blog site “TPM Muckraker” has some interesting coverage of these various party disputes.

Whatever your affiliation, ballot initiatives will likely affect state and local government finance as well as governance in the next year.  It is worth following these trends.  Along with Ballotpedia, we recommend the Initiative and Referenda Institute at the University of Southern California as a good resource, as well as the National Conference of State Legislatures.