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Financial Crisis Bodes Ill for Muni Bonds & Budgets (and PPPs to the Rescue)

Leonard Gilroy
September 30, 2008, 6:55pm

From the NYTimes today,
Cities, states and other local governments have been effectively shut out of the bond markets for the last two weeks, raising the cost of day-to-day operations, threatening longer-term projects and dampening a broad source of jobs and stability at a time when other parts of the economy are weakening. The sudden loss of credit, one of the ripple effects of the current financial turmoil, is affecting local governments in all parts of the country, rich and poor alike. In New York, a real estate boom has suddenly gone bust. Washington has shelved a planned bond offering to pay for terminal expansion and parking garages already under construction at Dulles and Reagan National Airports. Billings, Mont., is struggling to come up with $70 million more for a new emergency room. And Maine has been unable to raise $50 million for highway repairs. "We really are in terra incognita here," said Robert O. Lenna, executive director of the Maine Municipal Bond Bank, which helps that state's towns and school districts raise money. He said he had worked in public finance for 34 years and had never seen credit evaporate so completely. Maine had already begun some of its road work when the bond markets stopped functioning, so now it is scrambling for bank loans to keep the dump trucks rolling. If money does not start flowing soon, Mr. Lenna said, Maine will have to cancel some of its road and bridge projects. The only alternative would be what New York City did on Monday: Go into the locked-up markets and whip up demand by offering to pay investors a very high return. Analysts said the dysfunction in the municipal bond markets appeared to signal the end of an era of relatively cheap money for governments and, probably, the start of an era of tough choices for communities. When the market starts moving again, they said, it will look a lot like the municipal bond market of 10 years ago, before the arrival of financial wizardry in the form of structured-finance products, which lowered borrowing costs but added big new risks. Instead, governments will probably be issuing plain-vanilla bonds with fixed rates of interest, higher than they are accustomed to. And higher rates suggest some degree of belt-tightening, especially difficult in places where tax revenues are being squeezed because of falling real estate values and the slowing economy. Municipalities will probably be able to function, but may not expand services, said John V. Miller, chief investment officer at Nuveen Asset Management, a municipal bond investment firm. "For some, the level of service they provide will decline." Some governments, already straining to balance their budgets, will have to cut payrolls, he said, and others may decide to raise taxes.
One of the key issues related to privately financed infrastructure (through public private partnerships, or PPPs) that is relevant to revisit here is the issue of the relative costs of capital between the public and private sectors. Among the most frequently voiced arguments against PPPs is that the public sector, with its access to tax-exempt financing, can always borrow money at lower interest rates than private sector entities. Hence, the thinking goes, the private sector will always face higher costs of capital than public sector entities that can issue tax-exempt bonds, so we should avoid privatization and continue our reliance on public-sector financing of infrastructure projects. Not so fast, argues my colleague Bob Poole here (read the whole thing)...
My point is that today's financing opportunities for private-sector toll roads enable them to come very close to the weighted average cost of capital that is available to long-established public-sector toll agencies. Positing a major difference in cost of capital between the two options should no longer be taken seriously as an argument. What should be considered instead are the trade-offs involved.
And by me here:
However, real-world evidence shows that this analysis is faulty and that borrowing costs can actually be quite competitive between public and private sector. In fact, TollRoadsNews.com reported last week that in the recent financial close on the I-495 Capitol Beltway High-Occupancy Toll (HOT) lanes concession, the concessionaires were able to achieve lower costs of borrowed capital than the Pennsylvania Turnpike Commission did in its most recent tax-exempt bond issuance. How did they do this? Private sector infrastructure developers have the ability to tap into Federal tax-exempt vehicles like Private Activity Bonds (tax-exempt bonds available for private sector infrastructure investment) and TIFIA loans (low-interest Federal loans), which can drive down borrowing costs significantly. In fact, the intent behind these financial tools is precisely to encourage more private sector infrastructure financing by leveling the public-private playing field. [. . .] So, in the end, real world experience shows that the cost of capital issue is a red herring. Because private investor-operators can tap into both federal tax-exempt financing vehicles and robust global capital markets, they can structure sophisticated financial arrangements at highly competitive rates that can neutralize the public financing's supposed advantages. Even though private financing could potentially incur a slightly higher cost of capital overall (once you factor in both debt and higher returns on equity invested), it's important to remember what value proposition the private sector is really offering – a new source of capital to supplement public funds increasingly stretched thin. When you then add in other benefits of P3 deals -- such as upfront payments to the public partner (or a share of ongoing revenues); corporate taxes paid by concessionaires; superior cost efficiency and private-sector operational expertise; requirements for capital expenditures by the concessionaire; and rigorous performance standards with financial penalties for underperformance –- the added value the private sector brings to the table in delivering infrastructure becomes quite clear.
These pieces were written before the financial crunch, but I sense that they're just as applicable today as ever, if not more so. And as I wrote yesterday in regard to the announced Midway Airport privatization, anyone who thinks PPPs are off the table in the current financial crisis would be wrong:
And the fact that [Mayor Daley] announces a multi-billion dollar bid in the thick of the financial crisis says something extremely relevant–despite the financial turmoil on Wall Street, PPP mega-deals are still getting done in this climate. Having just attended a major PPP investor conference where the current market conditions were a central focus, there was a virtual unanimity that infrastructure PPPs are one of those attractive, go-to options in the "flight to quality" we're seeing in the markets more generally (investments flowing to solid, safe, and tangible investments with steady returns and lower risk profiles, relatively speaking). That's not to say that they're entirely unaffected–nothing is in this market–but even if bids aren't as high as they might have been or the tightening of the capital markets may make it more difficult, infrastructure PPPs are as attractive as before the crunch, if not even more so now.
Putting all of this together, (1) muni budgets are going to be squeezed for the foreseeable future, (2) muni bonds are going to look less attractive (with higher costs of capital) than they have in the recent past, (3) the global capital markets may be in turmoil, but they still find PPPs an attractive investment and are even trying to raise another $100 billion next year in infrastructure investment funds. Hence, it seems to me that muni governments are facing some major challenges ahead, and PPPs offer far better solutions to keep projects moving and give an appealing "third way" when compared to taxes and bonding, the usual muni go-to funding/financing solutions. And with the higher costs of capital associated with tax-exempt muni bonds that we're likely to see moving forward, the supposed advantage of public sector financing over private sector financing is going to be a far more difficult argument to make. While the private sector costs of capital could conceivably rise in tandem, I'd suspect that they'll still have a great deal of flexibility in structuring deals on the global capital markets to keep rates attractive overall. And simultaneously, governments are facing far less flexibility in tapping the muni bond market, so the tables may have just turned significantly. At the most basic level, with tax revenues declining in many areas and having just gone on a multi-year government expansion bender, there's just going to be more and more pressure on bond issues and proceeds and less willingness to use them as a default first option. Those days are over, IMO. And so too are the days of PPPs as an almost-last-resort, exotic procurement option, I suspect. » Reason's Annual Privatization Report 2008 » Reason's Transportation Research and Commentary

Leonard Gilroy is Director of Government Reform


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