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Out of Control Policy Blog Archives: 7.14.13–7.20.13

Don't Cry for Detroit's Bondholders

For all practical purposes, Detroit has been bankrupt for years. Yesterday, the city's state appointed emergency manager Kevyn Orr took the first step in making the Motor City's insolvency official, filing for bankruptcy protection from roughly 100,000 creditors.

If Detroit is allowed to move forward with its bankruptcy filing, bondholders will be fighting each other tooth and nail for the meager resources the city has to offer.  For now, though, bondholders are unified with a single message: bankruptcy would be unfair to those who have lent Detroit around $2 billion.

But no one should be crying for bondholders. Lending to munis may have always involved little risk, but there was still risk. Call it the black swan of municipal lending risk or whatever you want, but the bond investors should be held just as liable as Detroit's leaders for letting the city's debt spin out of hand.

Not only should Detroit's bankruptcy be allowed to proceed, but this largest municipal bankruptcy filing in U.S. history should serve as a reminder to bond investors that due diligence in managing credit risk is still an important aspect of finance.

On Thursday, the Securities Industry and Financial Markets Association (SIFMA) sent a letter to Michigan Gov. Snyder, arguing that bondholders are entitled to full repayment under state law, and that a Detroit bankruptcy "could have potentially significant, negative municipal securities market implications."

SIFMA and other critics of Orr's bankruptcy move have warned that the filing could cause municipal borrowing rates to rise across the state. Bondholders may think twice about lending to cities and counties for public works projects, payroll, and pension obligations.

To that we should all respond, "Great!"

General-obligation bonds have long been considered one of the safest forms of investing in the United States because local governments guarantee their repayment with tax dollars as necessary. Rhode Island recently faced a related situation, after guaranteeing loans to a now-defunct videogame company called 38 Studios. The private firm failed, leaving the state on the hook for around $75 million plus interest. Some individuals in the Ocean State said the government shouldn't pay out such a large sum, especially with a strapped pension system and a $30 million budget gap this year. The Governor decided Rhode Island had a moral obligation to make good on the loan, though, and the state is making cuts to services as necessary to repay the lenders.

Rhode Island also passed a law a few years ago guaranteeing municipal bondholders first rights to tax dollars in the event its cities declared bankruptcy. This has been important for the state, as there are half dozen cities on the cusp of bankruptcy this year, but lenders are still funneling money into state municipalities.

Municipalities in Michigan are concerned that Detroit forcing its creditors to take haircuts will raise borrowing costs across the Wolverine State. And they might be right. The question is whether this is a problem in the long run.

Muni-debt is often important for helping cities and counties meet payroll as tax receipts typically flow into government coffers at uneven intervals. But muni-debt is also used to fund often dubious economic development projects, unnecessary infrastructure projects, and as a stop-gap measure so that municipalities can kick the can down the road on properly funding their pensions.

Higher borrowing costs will force cities to be more thoughtful with their bond issuance, will force more fiscal responsibility, and may also force some local leaders to address budget problems today instead of continuing to stiff arm responsibility. Detroit is not alone in letting its pension liabilities get out of control -- although its $16 to $18 billion in unfunded pension liabilities are vying for some Olympic medal in mismanagement.

Bankruptcy in Detroit will allow the city better leverage to work with creditors on refinancing obligations. Ideally it will also force the city to divest itself of property it doesn't need to own, and to outsource many of the city services that it has proven incapable of efficiently managing-both as cost saving measures and to ensure bondholders get the maximum return available.

There are interests that have to be held in balance in this situation. Bondholders deserve the most repayment available; the city must do everything it can to pay back money that it owes. And to the degree that the state constitution guarantees payment, the law must be honored.

At the same time, the city should use whatever legal room it can to force bondholders to carry some of the risk of their lending. Once the money has run out they need to recognize they were taking risks with their lending and have to be held responsible too.

The city is maxed out on its tax dollars and raising rates will just bleed more taxpayers out of the system. Detroit's property taxes are already so high -- some of the highest in the country -- that nearly half of the city's resident's just don't pay them. (See this scary map about tax lien foreclosure risk in Detroit.) Its time to refinance the debt, get the bankruptcy proceeding in the rear view mirror, and let the Motor City start to build itself again as a city of the future.

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North Carolina’s Rural Economic Development Center Operates in a Crony Capitalist Manner

A recent report from North Carolina's Civitas Institute has brought to light the culture of waste and crony capitalism plaguing the states nonprofits in charge of rural redevelopment. 

In an effort to spur economic growth, back in the 1980s the North Carolina General Assembly established a number of Special Purpose Nonprofits, some fully supported by millions in taxpayer money. There purpose is to create jobs, but what actually ends up happening is a perverse distortion of the capitalist system. The state government collects tax dollars and then forces rural entrepreneurs to go through the nonprofits to get a portion of that money back if they want to start a small business, and then to complete the cycle the state government collects taxes on the newly established small businesses.

Civitas highlights the case of The Rural Economic Development Center, one of the most egregiously crony redevelopment nonprofits in North Carolina. The Rural Center, which receives $6 million in taxpayer money annually, not only gets away with paying its president a salary of $214,000 per year (more than four times the median household income in North Carolina), but it also discriminates on the basis of race and gender. It engages in lending practices that favor certain groups over others in a way that no private lender would ever be able to get away with. 

It gets worse.

In 2012, The Rural Center had seven members on its Board of Directors either directly or indirectly received funding for projects for their own departments, businesses, colleagues, or organizations. A total of $1.2 million was allocated to these questionable projects.

As the Civitas reports points out, while it is not illegal for a government official to coax the government into giving tax dollars to a private firm, then sit on its Board of Directors and receive money from it, it is certainly a conflict of interest at the very least and a definite form of crony capitalism.

North Carolina though isn't the only state susceptible to this exact form of crony capitalism. In a recent Reason Foundation report the case of Enterprise Florida, a redevelopment nonprofit in Florida, was highlighted and bears a great resemblance to the case in North Carolina. Enterprise Florida has been accused of failing to meet its job creation objectives, having the appearance of a pay-to-play scheme, having conflicts of interests, and displaying clear favoritism toward certain companies and industries. Like The Rural Center, Enterprise Florida has provided contracts to corporations with ties to its Board of Directors and even corporations listed in its paperwork as "anonymous".

Creating nonprofits and then funding them with taxpayer money is not a great way at spurring development. In the cases of North Carolina, Florida, and many other places, what the state is doing is essentially diverting money away from local communities and into the hands of these nonprofits which, after skimming a nice chunk of change off the top for administrative costs, only end up giving a small portion of the money taken back to local communities.  The cases in North Carolina and Florida have proven that having a group of unelected and unaccountable bureaucrats in charge of millions in taxpayer funds is not a good way to bring about community development, and often leads to cases of waste, fraud, and abuse because of the crony capitalism inherent in the system. These sorts of crony capitalist government programs must end.

For more on community development cronyism see our Policy Brief, Crony Capitalism and Community Development Subsidies here

Also see our piece for the Heartland Institute here.

 

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Massachusetts Governor Vetoes Transportation Bill Because Tax Hike is "Too Small"

Last week, Massachusetts Governor Deval Patrick vetoed $240 million in transportation funding from the $34 billion state budget. While MBTA and state transit agencies continue to be plagued by overspending and inefficiency, this move was meant to pressure legislators to approve even larger tax increases asked for by government officials.

The governor’s office had originally requested $1.9 billion in tax hikes. Governor Patrick believes despite the legislature’s rebuff that an additional 3-5 cent increase in the gas tax is needed if tolls on the Massachusetts turnpike are removed on schedule in 2017. Although the legislature seems poised to override the veto without further amendments, the current bill already includes half a billion dollars in new taxes, from a 6.25% tax on “software services” to a 3-cent increase in the gas tax and a $1 increase in cigarette taxes.

While Governor Patrick is correct to call attention to the expiring toll authority on the turnpike, replacing it with new taxes would compound the mistakes of the present bill. Tolls are a more fair and efficient way to fund state roads than general taxes which everyone pays. Pricing on roads also helps manage traffic and control congestion which has reached near crisis levels around Boston—for instance, Sunday’s 25-mile, 8-hour traffic jam out of Cape Cod. Removing tolls is likely to make a difficult situation worse.

There is no compelling reason to replace existing tolls with taxes. Legislators have already signaled a willingness to continue the current system by reinstating tolls that were removed in 1996 on the western end of the turnpike. Moreover, the emphasis on raising revenue to solve the state’s transportation needs is misplaced. In reality, the state’s highway system is marked by overspending and huge administrative costs. According to Reason Foundation’s Annual Highway Report, the state ranks 3rd in transportation spending per mile—nearly 4.5 times the national average—but 43rd in overall performance and efficiency.

The argument over the details of this bill may be a sign that a larger conflict is brewing over transportation funding and priorities. Earlier this year, the governor’s office called for a massive ten-year, $13-billion capital expansion to improve transportation infrastructure throughout the state. The proposal would devote the bulk of this spending to a variety of expensive commuter rail projects that have been postponed or tabled since the Big Dig fiasco. However, it is unlikely that the state could afford these projects without a raft of major tax increases, given the poor condition of its current finances.

Both MassDOT and MBTA are projected to continue running large structural deficits over the next decade, and these shortfalls have frequently been covered with borrowed funds. While this is a short-sighted and increasingly costly practice, the solution is more efficient and cost-effective service, not more taxation. Handing bureaucrats a blank check is merely an invitation to continue business as usual, and taxpayers should demand better performance before rewarding them with new sources of revenue.

A number of options are available to improve transportation in the Bay State, without raising taxes or exacerbating the deficit. Modest improvements in efficiency and reductions in overhead would go a long way towards closing budget shortfalls. Adding high-occupancy toll lanes to highways around the state is an effective way to reduce congestion, as well as generate revenue. This strategy would also allow the state to replace its stalled rail projects with less costly bus transit. Express Bus lines, for instance, operate on HOT lanes and provide service comparable to commuter rail at a fraction of the cost. Public-private partnerships can bring in new sources of capital for these projects, while protecting taxpayers from cost overruns. Policymakers should look at each of these before imposing still more taxes on a weak economy.

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Reason vs. Streetsblog on annual state highway performance rankings

Reason recently published the 20th Annual Report on the Performance of State Highway Systems. Over at Streetsblog, Angie Schmitt took exception to the report, claiming it "works against urban areas."  I'm responding to her criticisms.

The opening salvo: "Reason Foundation — has a funny way of judging these things. But media outlets all over the United States are reporting its findings as if they’re gospel."  Well, what this report does is very simple.  It takes annual data reported by the state departments of transportation to the Federal Highway Administration and reports it with useful graphs and tables, and creates a ranking of the 50 states based on the 14 metrics they track.*  Nothing 'funny' I can see about using the only existing, reliable, and comparable sources of data on state highway system performance and presenting that data to the public. And the massive media coverage shows that public is hungry for such information and that the states do not provide it.

Next, Streetsblog Reason took exception to ranking higher those states who spend less per mile for building and  maintaining roads. " Here rural, southern, lower-cost regions perform better: South Carolina and West Virginia spend the least per mile, receiving the highest rankings. Places with higher costs of living score badly. The “worst performers” in this category are New Jersey, Florida, and California."  I have a hard time understanding why states that have relatively good highway conditions while spending less should not be ranked  higher.  Is Streesblog suggesting the opposite? That we should rank higher the states that spend more, regardless of what is accomplished with that money?

Streetsblog goes on to say “The more urban you are, the harder it is to just pour tarmac and open roads, the more expensive it is.”  True, but some states with large urban areas do well-- Missouri (8th), Texas (11th) and Georgia (12th). Indeed, Texas has the most major urban areas of the 50 states.  Again, it makes sense to rank higher those states that get more bang for their buck.

Our report uses available and comparable federal data on all states highway systems. Yet Streetsblog complains that " A more fundamental problem is that Reason’s report ignores non-motorized transportation." Transit is not run by the states, but by local governments, and similar data is not collected by the federal government.  There are many things our report does not do because it has a specific scope and purpose. That is hardly a criticism. 

Streetsblog has two bottom line comments.

"One, states that are doing a decent job of managing their transportation systems might actually be rated very poorly by this report." No, actually. If a state is spending more and the condition of the state highway system is not getting better, you are not managing your system well. For example California has for years been in the top five in spending, but the bottom five in highway conditions. If they were managing use of those dollars well, conditions would improve with all that spending.

Every state has unique circumstances that it will gladly point to as excuses for its poor performance. This study is about holding states accountable for their spending. Are they fixing potholes, repairing bridges, reducing congestion? Are they paying attention to administrative costs? Reason believes transportation money should be spent effectively and that taxpayers benefit when state transportation departments are held accountable.

Second, Streetsblog wraps up with "media outlets should be much more skeptical about transportation reports from groups that deny climate science." Really? Read that link yourself and see if you think it "denies" any science.  Moreover, Reason's position on climate change is "For the record, it is still my judgment that the balance of scientific evidence indicates that man-made global warming is real and is a problem. The question remains: Is What Governments Are Likely to Do About It Worse than Global Warming?"

Just as distasteful is the reliance on Ad Hominem (remember that college freshman logical fallacy?) arguing that if you disagree with us on any one topic you can disregard anything we say on any other topic.  And it is particularly absurd regarding a report that does not include opinions or judgments, but is simply a reporting of publicly available government data.

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* The federal data sources used are: The Highway Performance Monitoring System; National Bridge Inventory; and the Fatal Accident Reporting System. For congestion data, we use the Texas Transportation Institute's Urban Mobility Report

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Sallie Mae Using a Federal Line of Credit for Private Gain

Sallie Mae appears to once again be reaping the benefits of crony capitalism. This time it's in the form of an $8.5 billion low interest line of credit from the Federal Home Loan Bank (FHLB) in Des Moines, IA.

The interest rate on this exclusive line of credit available to Sallie Mae charges only 0.23% to 0.34% in interest. Meanwhile Sallie Mae is apparently using the line of credit to initiate new student loans at interest rates up to 20 times higher than the rate the FHLB charges Sallie Mae. So far, Sallie Mae has tapped the line of credit for $2.1 billion and it is secured by $2.7 billion in loans. 

Sallie Mae is one of America's top crony capitalist organizations, as is shown in a recent Reason Foundation policy brief, and in this loan we have a prime example why.

First, Sallie Mae is receiving a low interest line of credit from a government sponsored bank that is not available to their competitors - this gives Sallie Mae a financial advantage and the profits reaped depend on this government assistance. 

Second, the reason why Sallie Mae is getting this low interest line is because of their history as a former government-sponsored enterprise. Using its political connections and strong lobbying presence, Sallie Mae worked the system to become the largest originator and holder of federally backed student loans-originating more than 4 times the amount of federally backed student loans than its competition in the last year of the Federal Family Education Loan Program's (FFELP) existence. Sallie Mae is still viewed by many as tacitly backstopped by the federal government, much in the same way Fannie Mae and Freddie Mac were from the 1980s to 2008 when they were bailed out by taxpayers.

Third, the profits Sallie Mae is collecting on this government subsidized line of credit -- earning profits on the interest rate spread between the FHLB loan and issuing new private loans -- is going into its own pockets, not being passed on to students. The recent jump in student loan interest rates testifies to this. 

Sallie Mae is leveraging its politically favored status to gain a competitive advantage and earn a profit in a system that looks capitalist but only survives in the status quo due to cronyism.. Private banks that are trying to compete with Sallie Mae in the student loan market will find it difficult to do so if Sallie Mae can continue to take advantage of such cheap capital. This is the definition of crony capitalism.

A spokesperson for the FHLB says the line of credit is meant to only support the lingering federally backed loans on Sallie Mae's portfolio. This statement was refuted by Senator Elizabeth Warren (D-MA), who recently argued that any claim that this line of credit is specifically devoted to a dwindling amount of government backed student loans contradicts Sallie Mae's own corporate filings. Sen. Warren argues that the company's 10-K disclosure acknowledges that the FHLB line of credit would be used to help fund the origination of new private student loans.

Unfortunately Sen. Warren's proposed solution is to have the government lower the interest rates on student loans even further. While this will erode Sallie Mae's profits it does nothing to solve the bigger problem of government induced distortion of student loan interest rates in higher education finance and the rampant crony capitalism between the government and Sallie Mae that accompanies it, despite the elimination of the FFELP program in 2010.

 The real solution is to eliminate federally subsidized student loans and government mandated interest rates and let private institutions decide the appropriate rates for student loans through market mechanisms. Accurate price signals are necessary in order to get the efficient amount of capital into the student loan market. Any solution that involves more government meddling will only distort the market further and likely lead to more crony capitalism down the road since Sallie Mae will retain its politically influential position with no real competition.

 For more of Reason's work on student loans click here

Also see our Policy Brief, Sallie Mae and Uncle Sam: Cronyism in Higher Education Finance here

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A Red Line That Shouldn't Be Crossed

When the Maryland Transit Administration first proposed a new light rail system for Baltimore, the plan was to add 66 miles of track on six lines at a cost of $12 billion. More than ten years later, as a result of skyrocketing costs and collapsing revenues, that plan has dwindled to one east-west line. Chronically underfunded and over budget, this project has been ill-fated from the beginning.

The Red Line, the lone survivor of the original plan, has been cut down from 21 miles to 14, from 27 stations to 19, and has had its start date pushed back from 2013 to 2016. It’s not expected to open until 2021, if not later. Unfortunately, even after numerous modifications, the city still can’t afford it.

In 2009, the line was expected to cost $1.6 billion. By 2011, mounting costs and persistent delays had pushed the total over $2.2 billion. Undeterred by its $2.3 billion revenue constraint, the Baltimore Regional Transportation Board called for spending 93% of the area’s entire revenue between 2016 and 2021 on this single corridor. As a result only 7% of the funding is available for all the other highway and transit needs.

That was two years ago. As of last month, the governor’s office reported the line will cost $2.6 billion—over $185 million per mile. There is not yet a clear explanation of where all this money will come from, nor what other projects will get axed to make way for light rail, but proponents of the plan remain hopeful that federal grants will cover an unspecified portion of the construction costs.

Boundless optimism is no match for fiscal realities, however. Over the next ten years the city government is facing a $745 million deficit which grows to $2 billion when infrastructure needs and pension liabilities are included. With already exorbitantly high property and income tax burdens, raising taxes is simply not politically feasible. Baltimore must find a realistic and fiscally responsible way to meet its transit needs; the Red Line is not it.

A Better Way

Fortunately Baltimore has options. Bus Rapid Transit, an innovative bus system that provides rail-like service at a fraction of the cost, is an increasingly popular option with cities looking to expand transit without breaking their budgets. Traveling on dedicated lanes with queue jumps and traffic signal priority, BRT uses larger vehicles than regular local buses, combining frequent service with frequent stops. Because the lines are built on existing infrastructure, BRT is both faster to implement and less expensive than light rail.

In 2008, before settling on the $1.6 billion plan for the Red Line, MTA did a comparative analysis of various BRT and rail alternatives. Simply by replacing light rail with BRT, the cost of the project fell by a third to $1.1 billion. Skipping the hugely expensive tunnel portions of the line and building on the surface would bring the total down to $545 million—only around $40 million per mile.

Best of all, if the city implements a “Managed Arterials” strategy, the capital costs of building BRT on the Red Line can be subsidized by drivers who pay a toll to use the excess capacity of the busway. By varying the toll rate based on demand, the city can keep the lanes flowing freely, even during rush hour, to guarantee fast and reliable transit service, as well as reduce traffic congestion along the corridor.

Baltimore doesn’t have to wait another decade for expanded transit, nor pay through the nose for an expensive light rail line. Bus Rapid Transit offers a cost-effective solution that can be implemented today to meet the region’s needs and not worsen the government’s financial situation. It’s hard to stop a train in motion, but the city shouldn’t let inertia carry it towards bankruptcy.

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