City And State Budgets May Drag Down Muni Market And Put New Pressure On The Fed

Failing to pass another Covid stimulus package because of Senate Republican resistance is increasing the budget squeeze on cities and states and raising cautions in the municipal bond market.  Although Joe Biden and the Democrats want significant new spending aid, post-election gridlock could hurt cities, states, and the public finance market and also damage the economic recovery. That in turn will increase calls for aggressive new Federal Reserve powers and actions that could dramatically affect the muni market.

State and city revenues remain under water, and the sputtering economic recovery isn’t likely to bail them out.  According the Center on Budget and Policy Priorities, “state tax collections for March through July 2020 were 7.5% less than in the same months of 2019.”  And in September, Moody’s
 said its improved baseline economic forecast would still mean that “the fiscal consequences…for states and local governments would be the worst since the Great Depression.”

Chicago illustrates the problem.  With revenues pummeled by the ongoing recession and no relief from a troubled state or a gridlocked federal government, the city plans “to borrow an additional $1.7 billion to refinance existing city debt,” which will generate short-term savings while adding to long-term debt.  

This financing technique is sardonically known as “scoop and toss”—scoop up your current debts and toss the payments into the future.  Although Chicago has used it for years, it is increasingly attractive in the face of the Covid revenue squeeze.  Connecticut cities Hartford and New Haven, the states of Ohio and Virginia, and many other jurisdictions are pursuing or considering similar steps, especially as interest rates stay very low.

By itself, there’s nothing wrong with refinancing debt with low interest rates to spread out payments, especially with the dramatic revenue crunches now facing many governments. The danger comes when debt keeps piling up without adequate future revenues to cover it.

For example, New York City is seeking state authorization for short-term borrowing to buffer its Covid-related budget woes, but business observers fear that will lead to permanent borrowing to cover operating expenses.  So the business community wants the city to cut spending.  And if borrowing is allowed, the Citizens Budget Commission and other business-oriented groups want the city’s budget to be controlled by the state Financial Control Board, first established in the city’s 1970s fiscal crisis.

What about borrowing from the Federal Reserve’s Municipal Liquidity Facility (MLF) set up to backstop liquidity in the private muni market?  The Fed never wanted the MLF to be a regular borrowing or funding mechanism for cities and states, and set higher interest rates accordingly.  As a result, only two loans have been made—to the state of Illinois and the New York Metropolitan Transit Authority (MTA).

Many Democrats and progressives want the Fed more involved in municipal financing.  The Fed thus far has refused, basing its limited actions through the MLF on its emergency powers to keep the private market liquid.  But early in the crisis, economist Nathan Tankus called for the Fed to use its regular authority under section 14.2(b) of the Federal Reserve Act and act aggressively in the muni market (not just using emergency powers), becoming a more regular direct lender to cities and states.

The House is moving forcefully in this direction.  In the House’s over 2000-page October Covid legislation, Title VIII of Division O authorizes MLF lending for up to ten years (not the current three year cap) at the federal funds rate, the same rate charged to commercial banks for overnight lending.  Governments would not have to show an inability to borrow elsewhere to access this lending.

Conservative commentator Marc Joffe says this provision “might destroy the municipal bond market.”  Although it can’t pass the current Republican Senate or the Trump Administration, a Democratic sweep of the presidency, House, and Senate might well mean something like this in a major Covid stimulus package.

Of course, providing more direct financial aid to states and cities is better than adding to their debt, even at lower interest rates.  After all, the federal government can get the lowest interest rates out there and use the proceeds to support states and cities.  But Senate Republicans still resist fiscal aid to states and cities. In the event of a Democratic sweep they might decide to block all legislative relief in a lame duck Congress, leaving Biden and the Democrats a big mess.  

That would leave major aid for states and cities until February 2021 at the earliest, seven months into most of their current fiscal years.  And with no economic aid, depressed government revenues from the ongoing recession will carry over into FY 2022, which in turn will mean longer subpar macroeconomic performance.  In that scenario, pressure will grow not just for spending, but for mandating a new Federal Reserve role or other dramatic measures to help states and cities.

That in turn will have unknowable consequences for the muni market and investors.  But those are the risks we run when the obvious economic solution—greater spending aid to states and cities—remains blocked by Senate Republicans.

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