1. Governance
September 29, 2014

US cities turn could turn to “community mini bonds” to fund infrastructure projects

By Drew Reed

Earlier this month, the US Federal Reserve and the FDIC revised their liquidity standards for 100 of the country’s biggest financial institutions. The revision appeared in the form of a hefty 400 page document which, at first glance, appeared to be little more than a cure for insomnia.

But buried in the changes was a shocker for state and local governments across the country: the measure would make it much harder for them to issue bonds.

For those not familiar with how “muni” bonds work, here’s what you need to know. They are essentially payment guarantees issued by a city, asking investors for a certain amount of money in exchange for that money back over a set period of time (known as the bond’s “maturity”), plus some interest. Cities generally use bonds to pay off one-time capital costs, often in the form of large infrastructure projects.

Once issued, these bonds are frequently traded by investors. They’re not so popular with average citizens (individual bonds usually go for $10,000 or more apiece). But they’re a favourite of investment firms looking for stable assets: when compared to stocks, they generally hold their value and garner reliable returns.

Or, at least, they did. Before the financial crisis, real estate values soared, and municipalities banked on increasing tax revenue to pay back their bonds. When the bubble burst in 2008, some cities were unable to make payments. To make matters worse, many of the firms who’d insured those bonds swiftly ran into trouble, undermining the market’s confidence that these were the safest of safest bonds. So traders began frantically trying to dump their muni bonds.

If cities don’t pay, [Wall Street] can go after city-owned assets, such as pensions and utilities.

The current regulations purport to head off future credit crises by requiring big banks to keep a set amount of “high quality liquid collateral assets” on hand. And, to the dismay of municipal bean-counters across the country, state and muni bonds were eliminated from this list of assets: big banks will now be required to dump these bonds in favour of more supposedly liquid assets.

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Among the first to sound the alarm about this was Ellen Brown, a financial whiz turned barnstorming populist politician (she recently ran a spirited, though unsuccessful, campaign for California state treasurer). Writing at Truthout, she explained why this was so harmful to city and state governments:

“Muni bonds fund the nation’s critical infrastructure, and they are subject to the whims of the market: as demand goes down, interest rates must be raised to attract buyers. State and local governments could find themselves in the position of cash-strapped Eurozone states, subject to crippling interest rates.”

Appropriately enough, this sentiment was shared by the man whose job Brown was trying to take. According to a Bloomberg report, a spokesman for California treasurer Bill Lockyer stated that the change in regulations “will increase their borrowing costs because it will reduce demand for municipal bonds”.

The biggest casualties of this decision appear to be new infrastructure projects. Since bonds are typically issued to pay capital costs, higher interest rates mean that cities will have to pay more for vital upgrades to their transportation, power, and water networks.

But this change threatens more than future infrastructure. As Brown points out, higher interest rates give more power to the financiers who hold the bonds: if cities don’t pay, they can go after city-owned assets, such as pensions and utilities.

There have already been a number of ugly examples of this. In bankrupt Detroit, water service has been cut to roughly 15,000 of the city’s residents (described as a human rights violation by the UN) in a bid to get users to pay up.  After Stockton, California, went bankrupt, bondholders forced the city to cut pensions to city employees. In classically tactless Wall Street fashion, one of the pensioners whose insurance they cut was a former policeman dependant on medical care due to a brain tumour.

Cities do still have a number of options for obtaining necessary the capital funds. One solution frequently advocated by Brown is the creation of city and state-owned banks: that would give them fundraising options currently only available to their private sector equivalents. In 2013, Brown reported on an initiative to create a municipal bank in San Francisco, which made significant progress when a judge struck down a prohibition on city-issued credit. Nonetheless, opponents balk at the idea of issuing taxpayer money as loans, even if it is for community investment.

Cities can also turn to the federal government for assistance; or they can try to pass local tax initiatives to fund specific projects. However, in a climate where Republicans in congress threaten necessary federal transportation funding and the tax-averse Tea Party is growing its influence in local government, these efforts might not be enough to meet cities’ needs.

Denver mayor Michael B. Hancock meets an admirer of his community bond plan. Image: Getty.

In the midst of these shaky options, a new type of muni bond has appeared with the potential to avoid the issues conventional bonds now face. In August, Denver announced the sale of $12 million worth of “mini-bonds”; these, unlike regular bonds, were sold at $500 apiece as opposed to the usual $10,000 or more.

According to the program’s official website, their sale was limited to Colorado residents, and though the bonds could be “transferred” to other owners, they could not be resold. These measures were to ensure that the bonds, instead of going to bankers on Wall Street, would be purchased by members of the community.

The project was a success: the mini-bonds were so popular that they sold out within an hour of being offered. This measure is more expensive than regular bond offerings normally have been (though an increase in the national interest rate might change this); but it does avoid the risk of giving Wall Street excessive influence, by keeping bonds within the community.

It’s a model with potential for other cities in the US, too. “It seems like a compelling idea. If this could be scaled, the transaction costs could be brought down,“ says Marc Joffe, founder of Public Sector Credit Solutions, and an expert in public sector securities. “Since the mainstream muni market is quite inefficient, a market for mini bonds may be a win-win for cities and small savers who are getting near zero interest from banks these days.”

Time will tell if these community-based bonds prove effective. But, in the face of unfavourable Fed regulations, they may be the best option for cities eager to take power back into their own hands.

This article is from the CityMetric archive: some formatting and images may not be present.
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