|Table of Contents|
Letter of transmittal
Table of Contents
Chapter 1. Recent developments
Chapter 2. New and controversial types and uses of tax-exempt debt
Chapter 3. A changing fiscal environment
Chapter 4. The impact of changing monetary conditions
Chapter 5. Changing patterns in the demand for municipal bonds
Chapter 6. Growing concerns over credit quality and information
Chapter 7. Future demand for capital funds
Chapter 8. Policy options to improve the municipal bond market
Chapter 9. Conclusion and postscript
r, ?, 0 3,
94th Congress TOINT COMMITTEE PRINT
2d Session J
CHANGING CONDITIONS IN THE MARKET
FOR STATE AND LOCAL GOVERNMENT
PREPARED FOR THE USE Or THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
APRIL 16, 1976 .
Printed for the use of the Joint Economic Committee
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 1976
For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington, D.C. 20402 Price $1.15
JOINT ECONOMIC COMMITTEE
(Created pursuant to see. 5(a) of Public Law 304, 7Sth Cong.)
HUBERT H. HUMPHREY, Minnesota, Chairman
RICHARD BOLLING, Missouri, Vice Chairman
JOHN SPARKMAN, Alabama
WILLIA-M PROXMIRE, Wisconsin
ABRAHIAM \ RIBICOFF, Connecticut
LLOYD M. BENTSEN, JR., Texas
EDWARD M. KENNEDY, Massachusetts
JACOB K. JAVITS, New York
CIIARLES H. PERCY, Illinois
ROBERT TAFT, JR., Ohio
PAUL J. FANNIN, Arizona
JERRY J. JASINOWSKI
LOUGHLIN F. MCHUGH
HOUSE OF REPRESENTATIVES
HENRY S. REUSS, Wisconsin
WILLIAM S. MOORHEAD, Pennsylvania
LEE H. HAMILTON, Indiana
GILLIS W. LONG, Louisiana
OTIS G. PIKE, New York
CLARENCE J. BROWN, Ohio
GARRY BROWN, Michigan
MARGARET M. HECKLER, Massachusetts
JOHN H. ROUSSELOT, California
JOivN R. STARK, Executive Director
SENIOR STAFF ECONOMISTS
WILLIAM A. CoX
JOHN R. KARLIK
COURTENAY M. SLATER
RICHARD F. KAUFMAN, General Counsel
WILLIAM R. BUiCHNEIt
ROBERT D. IIAMRIN
RALPH L. SCHLOSSTEIN
GEORGE R. TYLER
LUCY A. FALCONE
L. DOUGLAS LEE
CHARLES H. BRADFORD (Senior Economist)
GOa;r D. KBUMBHIAAR, Jr. (Counsel)
M. CATHERINE MILLER (Economist)
LETTERS OF TRANSMITTAL
APRI 13, 1976.
To the Members of the Joint Economic Committee:
Transmitted herewith is a study entitled "Changing Conditions in
the Market for State and Local Government Debt." This study was
prepared for the Joint Economic Committee as part of the committee's
observance of the 30th anniversary of the Employment Act of 1946.
It is one of a number of studies being undertaken by the committee to
examine State and local government fiscal conditions and their re-
lationship to the Employment Act goals of "maximum employment,
production and purchasing power".
This study describes the changing conditions in the municipal bond
market and their effect on the availability and cost of State and local
government debt. It describes recent changes in the supply of and de-
mand for tax-exempt securities. I believe Members of the Joint Eco-
nomic Committee will find this study most helpful and informative.
The views expressed in this study are those of the author and do not
necessarily represent the views of the Members of the Joint Economic
Committee or of the committee staff.
HuiuuRT H. Humpiimry,
Chairman, Joint Economic Committee.
APrIL 8, 1976.
Hon. HuBFaRT H. HUxPHEY,
Chairman, Joint Economic Committee,
U.S. Congress, Washington, D.C.
DEAR MR. CIAmmAN: Transmitted herewith is a study prepared by
Dr. John Petersen, entitled "Changing Conditions in the Market for
State and Local Government Debt." This study is the first in a series
of papers being prepared for the Joint Economic Committee dealing
with the fiscal condition of State and local governments. These studies
are part of the Joint Economic Committee's 30th anniversary study
Dr. Petersen's paper describes in great detail the recent changes
that have occurred in the municipal bond market. He concludes that
the increased supply of and reduced demand for tax-exempt securities
has increased the borrowing costs of State and local governments. He
also discusses several proposals to broaden the market for State and
local government debt, thus reducing borrowing costs.
The views expressed in this study are those of the author and do not
necessarily represent the views of the Members of the Joint Economic
Committee or of the committee staff.
JOHn- R. STARK,
Executive Director, Joint Economic Committee.
Digitized by the Internet Archive
Letters of transmittal ----------------------------------------------- i
CHANGING CONDITIONS IN THE MARKET FOR
STATE AND LOCAL GOVERNMENT DEBT
I. Recent developments ------------------------------------------- 1
Recent trends in State and local borrowing --------------------4
II. New and controversial types and uses of tax-exempt debt ----------- 9
Short-term borrowing ----------------------------------
Moral obligation bonds -------------------------------------10
Housing and mortgage finance borrowing ---- 12
Hospital and health care facility financing -------------------14
Tax increment bonds -------------------------------------- 15
Advanced refunding bonds ------------------------------6
The pollution control bond ----------------------------------17
III. A changing fiscal environment ----------------------------------23
The large city borrowers ------------------------------------23
City financial management ----------------------------------27
IV. The impact of changing monetary conditions --------------------- 29
V. Changing patterns in the demand for municipal bonds ---------------.3
Patterns of investment in municipal bonds ---------------- 3
Commercial banks ------------------------------------------
Fire and casualty insurance companies --------------------
VI. Growing concerns over credit quality and information -------------41
Demand for more information ------------------------------43
Municipal bond market regulation and disclosure --------------44
VII. Future demand for capital funds --------------------------------47
Public construction in the years ahead ----------------------- 48
VIII. Policy options to improve the municipal bond market -------------52
Broadening the market for State and local securities -----------52
Efficiency of the subsidy mechanism ---------------------
The tax equity effects of tax exemption -------------------
Improving marketability and creditworthiness ----------------60
Recent proposals for Federal credit assistance to State and
local governments ---------------------------------------61
Reducing the supply of tax-exempt bonds --------------------64
IX. Conclusion and postscript ----------------------------------
CHANGING CONDITIONS IN THE MARKET FOR
STATE AND LOCAL GOVERNMENT DEBT
By John Peterson"
Chapter I. RECENT DEVELOPMENTS
To pick a certain date as marking the beginning of a new era in any
field is always difficult and usually arbitrary, especially when changes
are evolutionary and complex with implications that continue to
emerge. Nonetheless, the year 1969 can be identified as a watershed for
the municipal bond miarlket. It was in that year that tax exemption was
actively debated in the Congress and defenders of the tax-free market
were victorious in preserving the almost exclusive reliance upon the
tax-exempt bond as the capital-raising vehicle for State and local
But while the political defense of the tax-exempt bond was success-
ful. other forces unfolding at the same time would lead to new chal-
lenges for the State and local borrower and investor in the 1970's.
These changes have benefitted certain borrowers and investors, but
their overall impact has been to shrink the demand for the conven-
tional debt of most governments and to make debt-financing more
The more important changes in the municipal bond market and the
environment in which it now must operate are:
(1) The national economy in the late 1960's passed into a prolonged
period of inflation and recurring tight money conditions that have
exacerbated the problems in all debt markets-and the municipal bond
market in some special ways.
(2) The demand for municipal bonds has changed significantly. The
major purchasers of tax exempts in the 1960's were the commercial
banks, which bought municipal securities for tax shelter. By the early
1970's it became increasingly evident that banks could no longer be
counted upon to maintain their previous level of demand for municipal
bonds. In the absence of other large institutional support. the house-
hold sector-consisting largely of individual investors--must be relied
upon to support the credit needs of State and local governments.
(3) Municipal bonds since the late 1960's have been used increasingly
for other than the traditional purposes of financing school. highway.
water and sewer projects. Public-purpose activities began to include
Washin ton director and economist of the Municipal Finance Officers Association.
The views expressed herein are solely those of the author, and do not represent the
position of his employer.
'Tax-exempt securities are generally defined as those debt securities issued or gumrantee I
by states or territories, their political subdivisions, agencies or instrumentalities, and
any security issued by a government that is an industrial revenue bond, the interest of
which is exempt from Federal income taxation, as described by Spetion 103 of the Internal
Revenue Code of 1954. The definition of "exempted" security in Federal securities laws
parallels that used for tax exemption purposes in the tax code.
the tax exempt debt-financing of projects that were owned or operated
essentially by private entities, and, ultimately, were linked to a private,
prlontmakIi.r enterpise. Although the Tax Reform Act of 1969 re-
tricted the blossoming practice of using tax exempt bonds to finance
industrial development, it also left large exceptions to this prohibi-
tion. These exceptions have since led to the use of tax exempt bonds for
pollution control equipment, housing market support, hospital filane-
Jng, stadiums, and an assortment of publicly financed but private op-
(4) A complex array of new financing devices has appeared in re-
sponse to the use of tax exemption for varying purposes. Novel finai-
cial arrangements have been designed to accommodate the legal and
practical implications of new forms of public activity and, not infre-
quently, to bypass certain legal constraints that otherwise would limit
or preclude borrowing for such purposes. Perhaps the most noteworthy
of the new financing vehicles was the moral obligation bond. But other
arrangements such as advanced refunding and tax-increment financ-
ing-have led to a swelling in the supply of special purpose bonds
that are nontraditional both in their use and structure.
(5) Short-term loans have become increasingly important to State
and local borrowers as a result of spiralling interest rates in the late
1960's early 1970's. In 1969, a sudden surge in short-term borrowing
occurred as the vohune of note sales doubled. There were several rea-
sons for this trend. The most prevalent seemed to be that governments
felt released from old prohibitions against short-term indebtedness
'Ald saw temporary financing as a means to borrow more cheaply and
to time long-term bond sales more advantageously. As the same time,
the seeds of uncertainty and cash crises were sowed for States and
localities which became too immersed in short-term liabilities and
midit be too dependent upon their future ability to sell bonds. These
concerns over credit quality and information were crystallized by the
New York City and State crisis of early 1975 and now pervade the
entire municipal bond market.
(0') More attention now is being given to the fiscal condition of State
and local borrowers and how information on this condition is reported
:iMid analyzed by nvestors. Until recently, this was a lingering, but
seldoti Presso,,, uneasiness in the market. In part. the concern about
(Te it qualityy has been reflected in intermittent criticism of the heavy
reliance placed bv the m1iiicip'l 1)ond market uon the options and
rel)ort ing doculnents of the two national bond rating agencies, Moody's
fl)(1 Standard & Poor. More recently, the redliced growth and o!i)viouS
iscal presslires in the State and local sector have focused attention On
timely and accu1ra1te reporting to the market by the governments them-
1 el\,e(, (pecilly in the disclosure of material information at the time
of bond sale. That concern has been reinforced l)y an emerging recog-
nition of legal liabilities on the l)art of undeliritsers and issuers under
tl antifraul provisions of the Federal securities laws.
(1"anfes in the municipal bond market in the late 196)0's and early
197Ws have occurred against the background of older and continuing
(Il etions .raised about the market. These questions concern the effi-
clency ,nh1 eqidty of the vast uncontrollable Federal tax subsidy in-
vol ied in granting an exemption from Federal income taxes to income
from State and local securities. That uniq e feature of municipal
Londs has lowered interest costs to State and local borrowers through
the years. It has also meant that part of the subsidy must be shared
with investors in the bonds. Furthermore, the tax-exempt feature of
municipal bonds-combined with the financial structure of major in-
vesting institutions and their tax liabilities-has made the market
highly susceptible to changing market conditions and has produced
wide swhgs in investor group participation and the cost of borrowing.
Another persisting concern in the municipal market has been posed
by certain problem borrowers. Generally, these are defined as the very
small and unsophisticated governmental borrower and the large, im-
providelt urban area. Both types of borrower may encounter difficul-
ties when they enter the bond market to borrow from private investors.
A wide variety of measures have been taken through the years to assist
such borrowers, but the long-term problems of a highly diffused and
variegated market remain.
The final item of concern now faced by the market for State and
local debt is linked to the national worry about capital adequacy in the
future. The question here is whether the municipal bond market, as
presently constituted, can compete succesfully and efficiently for what
appears to be an increasingly limited supply of investible capital. The
issue, of course, transcends the essentially mechanical concerns of ef-
ficiency and equity in the municipal bond market. This lifts the discus-
sion to a consideration of how much capital will be available for-long-
term investment by all sectors of the economy; how much of that
should be claimed by the public sector; and what is the appropriate
role to be played by the municipal market in allocating limited capital
to State and local governments.
Although this study does not purport to answer such cosmic ques-
tions, it will review future demands for capital facilities and borrowed
funds by State and local governments. This can give insights into the
relative magnitude of potential demands and the ability of the pres-
ent-or a modified-municipal bond market to meet those demands
at a reasonable cost.
The following chapters review first the changing supply of munici-
pal securities both in terms of the volume of debt instruments by type
and maturity, and the uses for which the borrowing takes place. A
discussion will follow on the questions of credit quality and informa-
tion, particularly as these are reflected in the recent appearance of
wide differentials in the cost of capital by region, use of proceeds, and
type of instrument. At this point too the paper will discuss the current
problems of special classes of borrowers, ranging from the fiscal hard-
ships now being visited upon our largest, oldest, and particularly East-
ern cities to the continuing difficulties of the smallest borrowers whose
market is usually confined to local and regional markets. Next, recent
developments in the compositions and strength of demand for munici-
pal bonds will be surveyed. Special attention will be given to the recent
evolution in commercial bank investment policies and its ramifications
for the tax-exempt market. As a corollary, the support of other
sectors-notably, the household sector-will be examined. At this
point the response of State and local government borrowing to mone-
tary and fiscal policy will be discussed, for the State and local
sector has exhibited a peculiar sensitivity to changes in the availability
and cost of money.
While, the current performance and structure of the market present
numerous problems that suggest various changes in policy, the market
and the needs it meets are dynamic. Therefore, it is equally important
to judge the future capability of the market to provide capital for new
and growing public purposes. This involves forecasting not only the
desired level of borrowing by the State and local sector but also project-
ing the economic and financial environment in which these units will
contest for funds from private investors.
The final section of this paper reviews an array of current and poten-
tial problems and discusses a broad selection of solutions that have
l)een recommended. The discussion will consider the variety of ob-
jectives to be met by reforms and will compare specific suggestions for
reforni with their objectives. Of course, radical changes in the level
and distribution of public services may alter, in turn, the size and
nature of borrowing. Nevertheless, the policy options discussed are
oriented towawrd borrowing and are predicated on the thesis that
State and local governments will continue to rely heavily on borrow-
ing for both long-term improvements and seasonal or occasional short-
RECENT TRENDS IN STATE AND LOCAL BORROWING
The volume of State and local government borrowing has increased
dramatically since 1960, and the composition of the deb-t has changed
greatly during the same period. The total of State and local bonds and
notes sold rose from an annual level of $11.5 billion in 1960 to $55
billion by 1974. As a result, total outstanding indebtedness of govern-
ments grew from $71 billion at the end of 1960 to $207 billion by the
end of 1974. Despite the difficulties experienced in the municipal bond
market in 1975, it appears that total bond and note sales for that year
will exceed $60 billion, a record amount.
These large dollar volumes and strong trends in the aggregate cloak
an amazing degree of diversity within the State and local bond
market. All types of government borrow in the credit markets, so the
markets consist of issues of all sizes and kinds, ranging from very
short-term notes to bonds with a maturity of 40 years or more. Chart
I sketches some of the more significant trends in the municipal bond
market. As may he noted, there seems to be a long-term reduction in
the percentage of general obligation bonds sold to the total and a cor-
responding increase in use of the revenue bond.2 Even more pro-
nounced is the rapid increase in short-term notes The ratio of short-
term debt compared to total bond sales reached 100 percent in 1969
and has reilaine(l at or above that level ever since.
Tlle lower panel of chart I shows that, the growth in municipal bonds
has not been a smooth, u)ward climb but rather has been sensitive to
changing financial conditions and has demonstrated a changing mix
l tyl)es of debt instruments. A review of the last 15 years Indicates
that there was a relatively simiootlh gr'owthi in bond sales through 1968
at which point the itiarket reacted negatively to the credit crunch of
1!!. fin 1970 aid 1971 the market appeared to regain its growth and
ton make up sonie of the sales delayed by the earlier tight-money period.
Subsequenitly, in 1972, 1973, and 1974, the market showed essentially
no growth ill bonid sales and a continuing reliance on short-tern bor-
rowiMg. In 1975, the market evidently moved to a record level of sales
despite high rates of interest.
2 The convention of the municipal bond market is to divide debt obligations Into two
broai categories: (1) general obligations, secured by the full faiith and credit and taxing
power of a government; and (2) revenue or special fund obligations, secured on the
revenues or receipts of a project or special fund and not backed by full taxing power
of a borrower.
8 Short-term obligations are generally those of 1 year or less In original maturity.
STATE AND LOCAL GOVERNMENT BORROWING
Notes, Bonds and Type of Bond 1960-1975 (est)
1 2 0. -" ... i .. . . "
... .. .. I..
Panel 1: composition Of BorrowLng .
100 I r.e.ntages)- "- -. ____ ". .
Ra Uo of Ilotes t
0 ... .._. .
4 0 .... . . ..... ...
.. .. .t -- -'- K Revenue Porcern
Panel 2:, Dollar Volume of Annual al Ies
3 (billions of dollars) IN 'a t."' I., ,
---- ,__ -" _,.-..-- 7o7
____ __ -_ ..,
Source The B
60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75t
Also, of significance in the 1970's has been the growth of revenue
bonds in comparison to general obligation securities, demonstrating
an increasing reliance upon user charges and rental fees to secure debt
instead of securing debt directly by taxes.
Table 1 gives a more detailed breakdown of State and local govern-
ment borrowing by type of security. As may be seen, over the last 15
years there has been significant growth in the total amount of revenue
bonds and also interesting changes in their composition. The rental
revenue bond, which is secured on lease arrangements between the
issunig authority and the actual operator of the facility, has grown
from a miniscule portion of total revenue bonds sold to more than half
of current sales. Many of these bonds represent debt issues sold on
behalf of housing, pollution control facilities, industrial development,
and various arrangements entered into by general units of govern-
ment to finance public facilities outside of their own debt limitations.
Therefore. it is the revenue security-and a particular class of revenue
security-that is the major growth area in the municipal bond market
TABLE I.-STATE AND LOCAL BORROWING BY TYPE OF ISSUE, SELECTED YEARS 1960 TO 1975 (ESTIMATE)
[in billions of dollars]
1960 1970 1972 1974 (estimate)
General obligation ------------------------------ 4.36 11.85 13.33 13. 57 16. 60
Revenue -------------------------------------- 2.07 6.10 9.40 10.21 14.50
Utility ----------------------------------- 1.79 4.59 6.99 6.53 4.80
Special tax -------------------------------- .08 .34 .25 .46 3.80
Rental ------------------------------------ 19 1.17 2.17 3.22 5.90
New housing authority -------------------------- 40 .13 .96 .46 ------------
Total long-term -------------------------------- 6.81 18. 19 23.75 24. 32 31.10
Total short-term ------------------------------- 4. 01 17. 81 25. 27 29. 54 30.00
Note: Details may not add up to totals because of rounding.
Source: Investment Bankers Association, "Statistical Bulletin"; Securities Industry Association, "Municipal Market
Developments" (various issues). Estimates are the authors on the basis of sales recorded through October 1975.
Another vantage point from which State and local debt may be
viewed is by the level and type of government. As table 2 illustrates,
debt issuances by general units of government have diminished in im-
potance. Here again, classes of special district debt changed in relative
itnportance. School district debt, which represented more than 20 per-
cent of bonds sold in 1960, dropped to less than 9 percent in 1974.
Other local district debt also decreased in importance. The strongest
growth element was found in statutory authority, which occurs at
1)oth tihe State and local levels.
TABLE 2.-LONG-TERM DEBT SOLD BY TYPE OF ISSUER, 1960 TO 1975 (ESTIMATE)
[Billions of dollars)
1960 1970 1972 1974 estimate
State ..---------------------------------------- 1.00 4.17 4.99 4.79 7.60
Local general government ------------------------ 2.54 6. 21 7.25 8. 66 9. 50
School district --------------------------------- 1.35 2. 13 1.92 2.16 2.20
Special district ------------------------------.66 1. 16 1.51 1.27 1.60
Statutory authority ---------------------------- 1.30 4. 39 8. 01 7.37 10. 20
Total ----------------------------------- 6. 85 18.08 23. 69 24.24 31.10
Source: Securities Industry Association and author's estimates.
Although the definitions used are not completely consistent, the
growth in special district and authority debt on the local level is re-
flected in the debt outstanding figures published by the U.S. Bureau
of the Census.4 The debt of local special districts (including local au-
thorities) has grown more rapidly than that of school districts or
general units of government. Likewise, State level borrowing-both
general unit and authority-has grown more rapidly than that of local
general government units.
The growth in authority and special district debt and the increas-
ing reliance on lease-rental revenue obligations are clearly inter-
twined. Before World War II, most state and local debt was sold in
general obligations. However, growing out of the Depression, there
came an increasing reliance on "special fund" obligations, which are
secured on a special revenue source-usually a user charge. The move
toward revenue bonds was stimulated by the public housing assistance
programs in the 1930's and the availability of Reconstruction Finance
After World War II, several factors led to the increasing use of
revenue obligations and, frequently, to the creation of special districts
and authorities. These were:
(1) The widening scope of the definition of public purpose. which
increased the activities for which bonds could be sold by public en-
tities and, hence, on a tax-exempt basis (in many cases this could only
be accomplished by enabling legislation creating the special-purpose
district, the debt of which was payable solely from project revenue);
(2) The desire to circumvent legal limitations on general obligation
indebtedness or, sometimes, the requirement for voter approval; and
(3) The desire by officials to apportion costs for improvement on a
quid pro quo or user charge basis rather than on taxation.5
Investors have typically viewed limited obligation bonds as being
riskier than those backed by the full taxing power of governments and
have commanded a higher yield for purchasing such bonds.6 As in-
vestor familiarity with the revenue bond grew, the interest rate differ-
entials between it and general obligation bonds waned. Concurrently,
State legislatures continued to authorize and courts approved as
public purposes a great variety of facilities and undertakings, in-
cluding airports, redevelopment districts, housing, stadiums, and tran-
The growing variety of uses of State and local borrowing are de-
picted in table 3, again using bond sales data collected by the Securi-
ties Industry Association and its predecessor, the Investment Bankers
Association. Loans for education and transportation grew rapidly
through the 1960's-and then leveled off dramatically. Two other
areas, social welfare and utilities and conservation, exhibited strong
growth throughout the period. There has been a pronounced change
in the composition of borrowing. In 1960 education, transportation,
4 The Securities Industry Association data on special districts includes both State and
local authorities, whereas the Bureau of the Census includes statewide authorities in the
State debt figures. Unfortunately, the Census does not report the authority (as opposed
to other revenue-secured debt) separately.
5 See Lennox Moak, Administration of Local Government Debt, Municipal Finance
Officers Association (1970), pp. 17-18.
6 For most varieties of revenue bonds, the reoffering yields have been 15 to 20 basis point
(one-hundredths of a percentage point) higher than general obligation bonds of similar
credit rating. See George Hempel, The Postwar Quality of State and Local Debt (1971),
7 See Frank Curley, State and Local Public Facility Needs and Financing, Vol. 2, Joint
Economic Committee (1966), pp. 156-172.
and water and sewer bond sales amounted to $4.6 billion or 65 percent
of total bond sales; by 1974 their combined share had slipped to 35
percent of total sales.
TABLE 3.-STATE AND LOCAL GOVERNMENT BONDS SOLD BY USE OF PROCEEDS
[Billions of dollars]
Purpose 1960 1970 1972 1974 estimate
Education ------------------------------------- 2.28 5.03 4.98 4.73 5.00
Transportation -----.--------------------------- 1.31 3. 17 2.99 1. 71 2. 20
Utilities and conservation ------------------------ 1.30 3.47 4.68 b.64 7.30
Water and sewer --------------------------- 1.02 2.40 2.45 1.99 2. 70
Pollution control (ind.) ---------------------------------------------- *%.60 1. 71 2.20
Other utility and cons ------------------------ .28 1.07 1.64 1.94 2.40
Social welfare ------------------------------- .60 1.47 3.82 4.45 4.60
Public housing ----------------------------- .43 .13 1.92 1.69 .70
Hospitals ---------------------------------- N A NA .50 .78 2.10
Other -------------------------------------- .17 1.30 1.41 1.98 1.80
Industrial aid ------------------------------- .04 .11 .33 .50 .50
Others (general purpose) ------------------------ 1.53 4.20 5.30 6.50 10.50
New capital ----------------------------------- 7.06 18.00 22. 12 23.51 30.10
Refunding ------------------------------------- .05 .11 1.57 .73 1.00
Total --------------------------------- 7.11 18.11 23.69 24.24 31.10
Source: Securities Industry Association and author's estimates.
Various aids to private business have had a major impact since
1960. Industrial development bonds-sold to build facilities for lease
or resale to prl ate conipaniies-flourished in the early and mid-1960's
alId then were cut back to a trickle after changes n the allowable uses
of tax exemption under section 103 of the Federal Internal Revenue
(ode, which took effect in 19G9. However, the same legislation gave
birth. to a new instrument, the pollution control bond. These are is-
sled om belhlf of corporations for purposes of installing pollution
'abatcn lellt facilities.
Although the inability to disaggregate by purpose a substantial
portion of the (debt sales (oltier uses) somewhat fuzzes the trend in
volume by function. it is abundantly clear that the "traditional" uses
of (de1t llave been supplemented by an array of new purposes. Many
(f these iew uises are financed by special authorities with the aid of
coIl)le\ iilacial arralugemnets and the revenue bond.
To smnmarize recent trends, it is (eair that State and local debt
dvana1,1tic shifts ]i the directions of increased short-term
blorrowing, a greater use of s-ecial authority financing, and growing
ll(e of the revenue bond. Both the general l obligation and general pur-
)ose goveIm1nental borrower, whlle still of great importance, have
eu thwi relat ie positions recede with the advent of new definitions
of the public purpose and a galaxy of new borrowing instrumentali-
ies a( d(ebt instruments to accommodate those purposes. The next
ehaI)ter examines more important and, frequently controversial, new
I1)ur (o S for tax-exempt borrowing and new financing vehicles.
Chapter II. NEW AND CONTROVERSIAL TYPES AND USES
OF TAX-EXEMPT DEBT
One of the most noticeable phenomena of the 1970's has been the
meteoric rise in short-term borrowing by State and local governments.
Commencing in the tight money period of 1969, note sales began a
steep ascent, eventually trebling by 1974, when they totaled nearly $30
billion. In that period, short-term debt outstanding grew from $11
to $18 billion.1
Several reasons may be cited for the jump in note sales. Clearly,
many long-term borrowers, faced with the steep rise in long-term rates,
were waiting for better market conditions and, therefore, sought to
postpone definitive financing. Leading users of notes for interim fi-
nancing have been the state housing authorities, which had $2.4 bil-
lion in short term debt outstanding in 1974.2 Also, the pace of growth
of note offerings was quickened by the sales of U.S. Government-
backed public housing and urban renewal notes, which grew from
$,4.9 billion in sales in 1968 to $10.5 billion by 1974. A third factor
was that, as the 1970's progressed, some units were finding short-term
borrowing against current deficits a convenient, if misguided, way
to forestall increased taxes or reductions in expenditures. New York
City, which alone accounted for one quarter (or $7 billion) of short-
term note sales in 1974, was no doubt the leading, if not the sole,
practitioner of this use of short-term c7dit.
A fourth kind of demand was crr-ed by governmental units that
preferred not to pay off their short-term indebtedness with available
assets but rather to keep the latter invested in taxable obligations at
higher rates of return than they needed to pay out on their own debt.
Although Federal arbitrage regulations have cast a pall over this
practice, it is undoubtedly the case that governmental debators, even
when faced with relatively high short-term tax-exempt rates, may
find it worthwhile to stay in debt and to use other funds to earn a
profit on the differential between tax-exempt and taxable yields.
Although the high levels of short-term borrowing are worrisome
to some observers, the fact is that the use of short-term debt in the
State and local sector continues to be mild in comparison to other
sectors. Short-term market debt comprises only 9 percent of all the
sector's outstanding debt in comparison to nearly 50 percent for the
nonfinancial corporate sector.
The traditional use of short-term borrowing in anticipation of lo-
cally levied taxes that may legitimately be expected to be collected
within the revenue cycle always has been used and is widely accepted.
IFederal Reserve Board of Governors, Flow of Funds.
2 "State Housing Finance Programs," Moody's Bond Survey (Jan. 6, 1975), p. 1795.
However, the early 1970's saw the introduction of a new type of short-
term borrowing-borro-in done in anticipation of assistance pay-
ments due from another level of Government and, therefore, depend-
ent upon the appropriation process of that unit.
Finally, another traditional means of interim financing, the bond
anticipation note, also has ben used more and more. With the recent
turbulence in the financial markets this poses new problems, because
paying off the short-term debt is often dependent solely upon the fu-
ture ability of the borrower to convert his short term liability into
This adds a new element of risk-the inability to borrow long term
because of future problems-of which investors are increasingly con-
scious in the wake of the New York Urban Development Corporation
default of February 1975. Such moneys were rampant by the end of
1975 when the municipal note market was in serious disarray in the
Eastern United States, primarily in reaction to the protracted crises in
New York State and surrounding areas. Recent estimates are that the
cost of short term borrowing has leaped by 2 to 5 percentage points for
borrowers in New York State because of credit concerns.-3
Mo RL OBLIGATION BO-NDS
The moral obligation bond, which has greatly widened the scope of
tax-exempt financing, is now under heavy fire--both in the markets
and by public critics. Use of the financing device began in 1960 with
the creation of the New York State Housing and Finance Agency and
has since blossomed to more than $8 billion in outstanding bonds. The
distinguishing feature of the moral obligation bond is its backing by a
unit of government which agrees to meet any deficiency in a reserve
fund established to back up the debt.
The unique attribute is that although the government is morally obli-
gated and authorized in the future to make such deficiency payments,
the unit is not legally liable for the debt, and it does not constitute part
of the debt of the unit.4
Needless to say, the ability to finance certain projects by this back
door or contingent guarantee has proved most attractive, especially
in view of the fact that revenue-supported projects need not be ap-
proved by -public referendum. (because their debt is not that of the
sponsoring and morally obligated unit).
Typically, a public corporation or agency is formed for the purpose
of selling-and ultimately retiringw-the tax-exempt bonds. As in other
areas of debt finance, New York State gave the initial impetus to
SS ee Ronald Forho- and Tohn Petersen, "Cots of Credit Frolon In the Munieil fond
Mr:rket," Municipal Finance 4Jtcers Association (revised Dee. 1975). p. 17, A, ). Sthan
('hilton et a., "Trends in Short Term Borrowing Costs for New York State Localities,"
St; tc UniversitY of New York at Albany (Dec. 1975).
"The rmec'hanies of tIi 'moral obligation' generally involve the following ;tep4 (1) A
capitl ri-serve fund IS created and funded ; (2) any deficiency by reaon of withdrawal
or otherwise is certified by the chief officer of the agency to the top offieisq of the state.
,I) the certiflerd deficiency funds are paid over to the capital reserve fund by the state.
The third recent ik generally- hedged, however, nnd the statement Iq nuallv i'n bold tyro,
to there cIn be no misunderstanding (a) all moneys paid by the State are subject to prtor
npJr(pration by the legislature (,) the legislature is not obligated to appropriate thl,
niojieN s. and the Ist is not obligated to pay them ; (e) but should a future legislation elect
to apprprite sIch moneys, it may legally do so, 'in the opinion of bond counsel.' The
divorce of the St:te's leI-l responsibility is completed by statements, again in bold type,
theft the State shall not be liable on the bonds and that the bonds shall not be debt of the
State." (1oody' Bond ;urvc1, Sept. 17, 197,3, p. 568.)
this. type, of financing; however as table 4 depicts, 15 other States
and Puerto Rico have followed suit in using the device. As table 4
also illustrates, most moral obligations have been sold by State-
created instrumentalities to finance housing construction or to sup-
port the residential mortgage market. Funds for the payment of inter-
est and principal are derived from mortgage payments, lease rentals,
and governmental subsidies of one form or another (often, Federal
housing subsidies). Other uses have been found for the moral obliga-
tion, including the repackaging of local government bond issues in
bond banks (Vermont, Maine, and Puerto Rico have been active thus
While the use of the moral obligation has flourished, it has pre-
sented special analytical problems for the bond analyst and the rating
agencies. There are analytically three forms of risk to evaluate:
(1) The risk that the project itself will not be self-sustaining; (2) the risk
that the State will not "back up" the "moral obligation"; and (3) the risk that
the State, if it does honor its contingent liability, will jeopardize the credit
standing of its own obligation."
TABLE 4.-Moral obligation bonds, outstanding as of February 1975
Connecticut --------------------------------------- $180
Illinois ----------------------------- -----------------------196
Kentucky --------------------------------------------- 52
Maine ---------------------- ------ -------------------------
Massachusetts --------------------- ---------------------- -- 119
Minnesota ------- 84
New Jersey ------------------------------------------------ 472
New York -------------------------------------------6,336
North Carolina ----------------------------------------------17
Rhode Island ------------------------- ------------------- 4
South Dakota -----------------------------------------------27
Tennessee -------------------------------------------------- 33
Vermont --------------------------------------------------- 90
Virginia --------------------------------------------------- 113
Wisconsin .....--__----....-------------- --- ------- 38
Puerto Rico ------------------------------------------------55
Total -------------- ---------------- ----------------8,204
Source: Moody's Bond Survey (Apr. 7,1975), p. 1429.
Moody's rating agency (expressing uncertainty about the strength
of the commitment and looking first to the self-sufficiency of the
projects themselves) has evidently discounted the moral obligation
as a binding pledge.8 As a rule of thumb, rating agencies have tended
to rate the bonds a notch below the rating assigned the morally
The question of the security of the moral obligation catapulted into
the headlines 'with the temporary default of the Urban Development
Corporation on $100 million in short-term notes in March 1975. Al-
though the State of New York ultimately stood behind the note issue,
it initially maintained that the short-term borrowings of the corpora-
tion were not covered by the moral obligation that backed the bonds,
5Ronald Forbes et al., "Evaluating Credit Assistance Programs" In Planning for
Research on Improving Municipal Credit Information and Credit Quality, Municipal
Finance Officers Association (1974), Appendix, p. 17.
e Moody's Bond Survey (Sept. 17, 1973), pp. 568-69.
68-626-76 3 ..-3
a legal point that did not reassure investors in the sincerity of the
State's pledge to back up the agency's financing. Soon thereafter, the
general loss of confidence in New York securities and the moral obliga-
tions in particular displayed itself in an inability of New York City
and various State agencies to refinance billions of dollars in short-term
loans, either by rollovers of the notes or their funding into long debt.
This has led several of the New York agencies to thebrink of default
and has raised questions about both the willingness and ability of the
State of New York to stand behind either the notes or debt service on
the outstanding bonds.8
Bond anticipation notes sold by agencies backed by moral obliga-
tions have suffered especially from the lack of investor confidence.
The Commonwealth of Massachusetts, in order to avoid default by
that State's morally obligated Massachusetts Housing Agency, was
forced to convert the agency's maturing notes into general obligations
of the Commonwealth.9
The immediate future for moral obligation financing is bleak. The
difficulties experienced by the various New York State agencies has
put a crimp in confidence that will be hard to straighten out. One
consequence of the problem is that the high cost of borrowing will
probably forestall many activities of the State housing agencies unless
and until they can devise more acceptable methods of borrowing.10
Furthermore, interrupted financing will lead to slippages in partially
completed projects. This will reduce these projects' ability to pay for
themselves and perhaps make it necessary to invoke the moral obliga-
tion of the sponsoring State government in some cases.
HOUSING AND MORTGAGE FINANCE BORROWING
A rapidly growing use of the tax-exempt security has been to finance
housing construction either directly or by purchases of mortgages
originated by private lenders. Such programs are now in effect in 32
States, and reportedly have financed more than 270,000 new housing
units since 1968, with a total of nearly $6.3 billion in debt outstanding
as of mid-1974.11
The structure of such progretms varies greatly though, as has been
discussed, the use of moral obligation securities has been heavy. Four
types of programs have been used by the State housing agencies: (1)
The direct development approach, where the agency actually engages
in the construction and ultimate operation or sale of multifamily hous-
ings projects; (2) mortage loans, where the agency makes direct loans
to purchasers of housing; (3) mortgage purchases, where mortgages
may be purchased from ortfolio or originators of new mortgages; and
(4) the newest approach, loans-to-lenders, where loans are made di-
rectly to private lenders who are required to make new loans and to
collaterahze their loans from the State agency.'2
Alan Bautzer, "New York Agency's Insolvency Shakes Markets," Mone Manager
(M~ar. 3, 1975), p. 1.
( Reacting to the financial difficulties and dismal prospects for the army of New York
State financial authorities, Governor Carey of New York created a special study group, the
Moreland Commission, to Investigate the downfall of the Urban Development Corporation
and to recommend measures to avert future disasters.
0 "Municipal Market." The Da4ly Bond Buyer (Oct. 14, 1975), p. 6.
10 "State Housing Finance Agencies," Hou8ing and Development Reporter (Nov. 17,
1975), p. 49.
'L Ibid., p. 43.
12MoodV8' Bond Survet (Jan. 6, 1975), p. 1795.
From the outset, State housing agencies have depended upon the
availability of housing subsidies from the Federal Government. The
availability under the 1968 Urban Development Act of sections 235
and 236 money, part of it allocated directly to the State agency, led
to the initial formation of many State housing agencies in the late
1960's and early 1970's. With the impoundment of housing assistance
programs early in 1973, the Agencies switched to use of section 23
leased housing programs. Collaterally, they developed indirect assist-
ance programs to support the mortgage market. Typically, these per-
mitted original lenders to liquidate their existing holdings by selling
them to State mortgage finance agencies which, in turn, sold tax-ex-
empt bonds in the capital markets. The fact that many of the mort-
gages were guaranteed by FHA or VA enhanced the security of the
borrowings. Although, technically, many housing agency activities fall
in the category of industrial development bonds, they were spared for
the tax-exempt market by virtue of the exclusions written into section
103 in the 1969 Tax Reform Act.
They have also been given special dispensation under the arbitrage
bond regulations to allow them a higher markup between their bor-
rowing and lending rates.'3
The Housing and Community Development Act of 1974 provided a
role for the agencies by replacing section 23 with section 8, which is
basically a leasing program that shifts financial risk to the developer
and owner. UUD has encouraged the activities of the State agencies
by making bulk set asides of section 8 subsidies. Devising a workable
financing scheme has presented problems for the agencies, but these
problems have not deterred them fom continuing support of the hous-
Faced with dire conditions in both the housing and bond markets in
1974, the agencies borrowed long term about $1.5 billion and sold $2.2,
billion in notes. Thus, State borrowing to support housing has repre-
sented about 6 percent of recent State and local bond sales and 8 per-
cent of short-term borrowing. As of the end of 1974, total long- and
short-term housing debt came to $4.7 billion and $2.4 billion respec-
tively. In view of the high level of outstanding short-term debt and
the continued demand for low and moderate-income housing support,
it was widely anticipated that housing agencies would be heavy bor-
rowers in the market in 1975. However, the combination of high in-
terest rates, the concern over the frequently-used moral obligation
security form, and the difficulties in developing section 8 arrangements
acceptable to the market have held down such financing in 1975. Bonds
sold have tended to carry considerably higher rates of interest than
similarly rated general obligation bonds, and during the chaotic
months of fall 1975 several issues were canceled or reduced in size.'4
Although the housing construction industry is demonstrably a hard-
hit sector and public involvement in housing support is a longstanding
tradition, the use of tax-exempt bonds for such purposes has been
criticized. First, it is obvious that the heavy volume of borrowing has
brought increased pressures to the bond and note market. Bonds sold
IHousing and Development Reporter (Nov. 17, 1975), p. 50.
e4 William J. White in Debt Financing Probie of state and Local Government, Hearings
before the Subcommittee on Economic Stabilization, House Committtee on Banking,
Currency and Housing, Part 2 (Oct. 27, 1975), pp. 1364-1368.
for housing tend to have long-term maturities-as doother large reve-
nue bond issues-and, therefore, along with pollution control borrow-
ing have an especially heavy impact on the relatively shallow long
end of the tax-exempt market. Second, it may be argued that the bonds
constitute a misuse of public funds, especially when proceeds are chan-
neled directly to private mortgage activities and to the refinancing
of conventional mortgages or-as sometimes has been the case-com-
mercial mortgages. Certainly, in cases where the agency merely acts
as a conduit to private, profitmaking lenders, bonds maintain their
Federal tax exemption only by virtue of the exception granted hous-
ing section 103(c).
On efficiency grounds, the use of tax-exempt housing bonds can be
attacked because as long as some savings are possible by borrowing
in the tax-exempt market, benefitted parties will continue to push
bond issuances to the point where tax-exempt rates become very close
to those on taxable mortgages. (With yields on some new issue tax-
exempt housing bonds approaching 10 percent in fall 1975, this argu-
ment is not without foundation.) Accordingly, the impact on other
tax-exempt yields lessens the value of the exemption for all State and
local government borrowers.
HOSPITAL AND HEALTH CARE FACILITY FINANCING
The construction of hospitals and health-care facilities is another
rapidly growing, and controversial area of tax-exempt financing. Al-
though the owning and operating of hospitals has long been an ac-
knowledged public purpose, the use of revenue bonds to finance
construction or acquisition for not-for-profit entities is a development
of the 1970's. In 1974, $1.3 billion in hospital and health care facility
bonds were sold, and it appears there was an even greater volume of
sales in 1975-perhaps $2 billion.
The typical arrangement is that the bond-issuing entity, a special
authority or unit of local government, enters into a lease agreement
under which the hospital makes payments toward debt service of the
bonds. Such agreements are usually secured as a first claim on gross
revenues, which frequently consist of medicare and medicaid pay-
ments that, in turn, give the bonds the aura of a partial Federal
Because of their newness and the novelty of both the purpose and
form of security, hospital bonds have been accepted by investors only
if they carry relatively high rates of interest. In addition, they present
analysts with new problems in assessing credit quality. A special con-
cern in new construction is whether future net income will be sufficient
to cover future debt service payments. These estimates and levels of
payment depend on the feasibility studies of consultants hired to make
projections. Since hospitals compete with one another and other health
care facilities, it is also important that plans for future hospital con-
strmtion in the patient customer area be known.
As in the case of housing, hospital financing by tax-exempts is at-
tractive so long as there is some savings over a taxable bond or mort-
gage rate. This means rates on these bonds can be much higher than
those normally paid on tax-free bonds and still make projects feasible.
15 f3oody's Bond Rurvey (Jan. 6, 1975), p. 1797.
Reportedly, tax-free hospital bonds with interest costs up to 91/
percent can still be the lowest-cost financing vehicle for construction.'6
The tax-exempt hospital bond market was shaken by the notorious
Covington Hospital case involving fraud on the part of the under-
writer and financial adviser.'7 Subsequently, there has been greater
circumspection and selectivity in the market for these bonds and wide
interest cost differentials between higher and lower credit quality
bonds. Hospital bonds appear to be supported primarily by individ-
uals and bond funds, with space institutional sales.17a
TAX INCREMENT BONDS
A relatively new and controversial use of tax-exemption is the tax
increment or, as it is sometimes called, the tax-allocation bond. These
bonds are a peculiar breed of the limited obligation security where
bonds are secured on a projected increase in property tax revenues
that will be generated from the improvement the bonds finance. The
key attraction is that the burden of debt does not fall upon the exist-
ing property or reduce the tax base of the existing property tax, but
rather falls upon future increases or increments in the taxable value
of the improved area. The bonds, when secured solely upon such in-
eremental increases in value, must be viewed as fairly risky, since
there is no guarantee that the development or renewal effort will be
successful and the tax base will rise to pay off the debt service.:'
Cities in California have been the most aggressive users of tax in-
crement bonds, evidently having issued over $230 million by mid-1974.
Reportedly, 13 other States have authority to issue such bonds and
several others are contemplating their use.9
Tax allocation bonds, which may be issued by a local redevelopment
authority or municipal government, are usually sold as part of overall
development plan that includes commitments by private developers
to the project. Often, they are also backed by long-term lease agree-
ments with public bodies for purposes of building public facilities.
Most tax allocation projects involve the redevelopment of urban blight
areas as well as new industrial or commercial facilities. As revenue
bonds, they do not count against the general government's indebted-
ness nor do they require voter approval.
The device has been defended on the grounds that it permits financ-
ing redevelopment without incurring general debt, burdening existing
property owners, or cutting into the tax base. Further, it is argued that
the projects must -be inhilerently productive-hience, an added tax
source-in order to be sarlable in the bond market b n
On the other hand, the device earmarks future taxes in the project
area for debt repayment, thereby freezing the tax base, even though
the development that is financed may engender higher levels of public
spending. Abuses have been reported -where the develoing agency
e"Hospital's Use of Tax Exempt Financing Tops $1.4 Billion," The Daily Bonp Buyer
(Oct. 15, 1975), p. 15.
17TIbid., p. 15.
17 Ibid., p. 15.
Gerald M. Trimble, "Tax Increment Finance for Redevelopment," Journal of Housing
(November 1974). G. 1t. Jefferson and Tee Taggard, "Tax Increments Criticized" Journal
of Housing (January 1975).
19National Council for Urban Economic Development, Tax Increment Financinl
has designated as the increment zone large areas that do not really
benefit by the project in order to capture the growth in future taxable
values. In addition, tax increment financing is a risky and expensive
use of tax exemption and one that can beneft a select group of private
parties. When incremental revenues fall short, a community, while
legally free of responsibility, is still faced with the ethical question of
.Whether it should bail out the bonds or face the opprobrium of default.
ADVANCED RFuNDiNG BoNDs
Another much-criticized use of tax exemption has been the advanced
refunding bond. These bonds are sold prior to the redemption date
of the issue which they replace. The proceeds from the sale of the ad-
vanced refunding issue are used to retire the outstanding bond when
it becomes callable. Since the old issue and issues to refund it are out-
standing at the same time, the total supply of tax-exempt bonds can be
inflated by a multiple of the amount actually needed to finance the im-
provement. In fact, prior to the enactment of certain constraints on
the use of advanced refunding bonds, advanced refunding issues were
pyramided in order to earn a profit from the investment of tax-
(exempt bond proceeds in higher yielding taxable securities.
Advanced refunding becomes increasingly attractive when interest
rates drop and as a result, most activity occurs when yields are at cy-
clical lows. The exact volume of refunding bond sales is not known,
but one estimate is that approximately $2.7 billion were sold between
1971 and 1974, with the bulk of sales occurring during the recoveries
of 1971 and 1972.21
There are three basic reasons for advanced refundings: 22
(1) Long term savings of interest cost, either because the general
level of interest rates has dropped or the borrower has improved his
relative credit position;
(2) Prevention of default because current debt service is reduced
by selling a refunding bond that stretches out the debt; and
(3) Modification of restrictive convenants on original issues -which
have inhibited present development or have become undesirable for
These purposes have traditionally been achieved by straight re-
funding, that is, selling a new issue to replace an outstanding one near
the maturity or at a call date of the original bond issue. Advanced re-
funding is different because the funds to be used to retire the original
debt are sold in advance of the maturity date. Thus, where advanced
refunding occurs, there are two bonds outstanding. The proceeds of
the advanced refunding bond issue are set aside in an escrow account
lnd the cash flow from the investment in escrow is used to support
the debt service on designated portions of either the original or re-
funding bond issues.
Most advanced refundings employ what it termed the standard de-
feasance method. With this technique, the issuer sets aside the full
amount of the outstanding bonds in a pledged escrow account. Under
most State laws this serves to "defease" the claim of the existing bond-
=iSalomnon Brothers Supply and Demand for Credit in 1975 (1975) p. 18.
2 C. W. Ritter, Advanced Refunding Tchn iquea of Municipal 1ebt Reorgattiatia
,(June 1975), pp. 1-3. See also Thomas F. Mitchell, "Advanced Refunding of Municipal
Bonds: Concepts and issues," University of Oregon (July 1975).
holders on revenues and frees the issuer to modify the original coven-
The effect of advanced refunding is to erase the original debt from
the issuer and owners of the original bond issue are given an alter-
native and usually superior backing for their holdings. Another im-
portant aspect is that when secured by a deposit of Federal securities
or their equivalent, the original issue becomes eligible for unlimited
holding by banks.
Traditionally, there have been two policy objections to advanced
refunding. First, the device has been used for the sole purpose of earn-
ing an arbitrage profit for the borrower. By investing refunding bond
proceeds at yields in excess of borrowing costs, issuers could earn a
profit without risk. This use has been almost eliminated by Treasury
regulation and the arbitrage provisions of the 1969 Tax Reform Act.2'
Second, advanced refunding increases the supply of tax-exempt secur-
ities without financing genuine public improvements. The added tax-
exempts keeps tax-exempt yields from being as low as they otherwise
might. The potential of advanced refunding issues acts as an overhang
on the market, since these issues frequently are sold when interest rates
drop and refunding savings are most attractive. This keeps the tax-
exempt market from recovering as quickly or completely as it might
and diminishes the reward to issuers who have stayed out of the
market during periods of high interest rates and congestion.
A third and more recent objection to advanced refunding derives
from the impact of current arbitrage regulations on potential profits
when borrowers can borrow at rates lower than they must pay. This
arises because the issuer is required by Federal arbitrage rules to in-
vest 85 percent of refunding bond proceeds at a yield that is not sub-
stantially higher than that on the refunding issue. As a result, those
supplying securities for the escrow account have a chance to price
those securities artifically at a price higher than they paid for them
or to bid an artificially favorable price for the refunding bonds,
knowing that they will make up the underwriting loss with compen-
sation from third-party profit. The existence of the third-party profit,
which issuers cannot themselves reap, creates an inducement for under-
writers to promote the issuance of advanced refundings, even when
they represent little or no gain to the issuer.25
The Treasury has been aware of the unhealthy pressures that can
develop from the existence of the third-party profit. In 1973 it pro-
posed changes in the arbitrage laws that essentially would require in-
vestment of escrow funds in special government issues.26
Tm POLLUTION CONTROL BOND
The use of tax-exempt bonds to finance pollution control expendi-
tures for private corporations has increased greatly over the past 4
years, posing both philosophical and practical problems in the munici-
= The obligation acquired usually is either direct or guaranteed obligation of the Fed-
eral government. This transforms the outstanding bond issue to "AAA" status. Ritter,
24Ibid., p. 17. See also Daniel L. Goldberg, "The New Proposed Arbitrage Bond Regula-
tions-And a Comparison With the Old," Urban Lawyer, vol. 6 (1974). pp. 76-77.
1 Unless the present value of all costs and future savings are calculated, issuers may
actually realize losses on future interest cost "savings" even though they may appear to
profit in the nominal amount of interest paid.
2 U.S. Treasury, Proposals for Tax Change (Apr. 30, 1975), p. 148.
pal bond market. Annual reported sales of these obligations-which
typically are for large amounts and issued for a long term-have
now reached a level of $21/ billion.
The pollution control bond is the product of two converging trends:
(1) The growth and transfiguration of the industrial development
bond; and (2) public concern as expressed in legislation to abate or
The use of public tax-exempt credit to finance private firms has its
modern origins in the industrial revenue bond. Beginning in the 1930's
in the South, industrial revenue bonds were issued by State and local
governments to finance the plant and equipment expenditures of new
or expanding firms and, thereby, to bolster their own economies. In
the early years, industrial development bonds were limited mainly to
small borrowers in the South and received little attention. Through
the 1960's, their use rose dramatically, culminating in $1.6 billion in
new issues by 1968--or 10 percent of all long-term tax-exempt bond
sales. Finally, the Department of the Treasury and then the Congriess
took steps to halt what became acknowledged as an abuse of tax ex-
emption and a threat to the conventional municipal bond market.27
As a result, idustrial development bonds were excluded from tax ex-
emption by addition of section 103(c) (1) to the Internal Revenue
Code. However, section 103(c) (4) of the code allowed an exception to
the exclusion. That section exempted certain facilities financed by in-
dustrial revenue bonds on behalf of private firms from the size-of-
issue restrictions, namely, residential property; sports facilities; con-
vention facilities; transportation facilities; sewerage, water, solid
waste, and energy facilities; industrial parks and-most notably-tair
and water pollution control facilities. The basic law ultimately
spawned the usual extensive regulations from Treasury. But, for the
time being, industrial development bonds were quiescent. Sales fell
from a peak of $1.6 billion in 1968 to only $50 million a year later.
However, a second trend was at hand, one which would make the
pollution control exception of particular interest. This was, of course,
the flood of Federal legislation aimed at cleaning up the environment.
In 1969 the National Environmental Protection Act was passed. Soon
after, Congress created the Environmental Protection Agency (EPA)
whose function was to establish and enforce standards of environ-
Two Federal acts provided substance and economic impact to the
EPA's mission: the Clean Air Act of 1970 and the Water Pollution
Control Act of 1972. The Clean Air and Water Acts together required
that certain standards be promulgated and enforced-primarily by
the States-to prevent or abate pollution by toxic and hazardous sub-
stances in air and water. The economic, effect was to require large scale
investments by industry.
The cost of the mandated national elean-up for industry (pollution
related to site or stationary point emissions) has been estimate at
$5-15 billion a year. Such investments are likely to reach a peak by the
late 1970's and to decline gradually through the 1980's. Recent re-
ports show expenditures to be roughly on target for the first few years.
Public Law 90-364, Sec. 107, 90th Cong. (Jue 28, 1968), as amended (Oct, 24, 1968).
In 1974, industry spent an estimated $5.6 billion on new plant and
equipment for pollution abatement.28
To be tax exempt, pollution control financing must be done through
a State or local government entity empowered to enter into agree-
ments and sell debt. Typically, special authority for this purpose is
created by legislation or constitutional amendment and exists in per-
petuity or for the life of a particular project. The borrowing under-
taken for this special and limited purpose constitutes a revenue obliga-
tion and is not a. general debt of the governing body that authorized it.
In their relatively brief existence, pollution control bonds have as-
sumed various financing arrangements. They share certain features,
however, that allow these bonds to qualify for tax exemption. While
pollution control bonds meet the statutory definitions for industrial
development bonds, they enjoy tax exemption through the exception
granted by section 103 (c) (4) of the code and a complex set of govern-
Besides helping to clean up the environment, the tax-exempt pol-
lution bond-much as its predecessor and companion, the industrial
development bond-has several advantages for the assisted company.
First is the savings in interest cost on borrowed capital (or the lower
lease payments). Pollution control bonds have sold at yields ranging
between 70 and 80 percent of those on comparable corporate, taxable
securities. In recent markets, this has meant savings of 1.5 to 2.0 per-
centage points or about $4 million in total interest expense on a 20-
year, $10 million issue. In addition to interest cost savings, certain Se-
curities and Exchange Commission registration fees and related legal
expenses are avoided because the bonds are not registered.
Acquired facilities may also receive advantageous tax treatment.
Generally, under the lease (or installment purchase) arrangement, the
leasing firm can treat the property as being owned and can depreciate
it. In addition, relief from Staten d local taxes may be offered. A final
advantage is that 100 percent financing is available for facilities that
do not increase productivity and profitability of the plant.
The growth in reported pollution bond sales since their inception in
1971 has been spectacular, rising from the $93 million reported by the
Bond Buyer in 1971 to an estimated $2.5 billion in 1975. In the last 2
-years, pollution control bonds have represented about 7-8 percent of
all long-term municipal bond sales. Together with "conventional"
'industrial revenue bonds, many of which are sold in conjunction with
pollution control bonds, pollution bonds for private firms represent
approximately 10 percent of all reported tax-exempt bond sales.
Widespread nonreporting of transactions makes it hard to compile
accurate figures on pollution control and development bond sales. Per-
haps the greatest uninown is the extent to which commercial banks
28John Cremeans et al., "Capital Expenditures by Business for Air, Water and Solid
Waste Pollution Abatement," Sirvey of Current Bueincss (July 1975), pp. 15-19
29Treasury Regulations, sec. 1.103-9. Generally, the regulations place heavy emphasis
on the relationship of the pollution abatement improvement to the overall Industrial proc-
ess and its design. The stickiest point comes in showing, as is required by the regulations,
that two significant purposes are met: (1) The improvement would not have been made
except to control pollution and (2) it is not designed to meet any significant purpose other
than pollution control. Unless both tests are met, only that part of the expenditure at-
tributable to pollution control-and not materially increasing productive capacity or
useful life of the production facility-can be used for the pollution control exception and
finance such facilities through tax-exempt loans. Combining unre-
ported bank lending and the estimates for unreported direct place-
ments (on the basis of the earlier development bond experience), it is
conservatively estimated that pollution control financing and industrial
development bond financings were under-reported by at least $1 billion
in each of the last 2 years.30
Forecasters agree that pollution control outlays will climb in the
years ahead under existing laws. Recent surveys initiated by the Bu-
reau of Economic Analysis show that non-farm business spent $5.6
billion on pollution abatement facilities in 1974 and planned to spend
$6.3 billion in 1975.81 These figures agree with both McGraw-Hill and
EPA estimates. However, in subsequent years the projections diverge
greatly (EPA envisages as much as $15 billion annually by the late
1970's whereas McGraw-Hill predicts a leveling off to $7 billion annu-
ally).32 Assuming that there is no substantial change in the pollution
control laws and allowing for inflation, a reasonable forecast for pollu-
tion control expenditures is $10 to $12 billion by the late 1970's. Given
the present patterns of financing, it is probable that pollution control
borrowings should reach a level of $4 to $6 billion through the late
1970's under existing laws.3
Pollution control bonds present major issues for the capital markets.
From the standpoint of the industrial borrower, the greater the cost
saving it can realize by borrowing on a tax-exempt as opposed to a
taxable basis, the greater the inducement to use the pollution control
bond. But, from the standpoint of the State and local borrower and the
public at large, the greater the sales of pollution bonds in the tax-
exempt market, the greater the supply of tax-exempt bonds will grow
in relation to the demand for them, forcing interest rates to rise. This
not only adds to the cost of all municipal borrowing, it also reduces the
efficiency of tax-exemption as a subsidy.
Recent studies of the relative market performance verify that net in-
terest cost savings on pollution control issues have dropped as volume
has grown.34 This means that tax exemption is increasingly less effi-
cient in lowering the interest cost of pollution control bonds. Thus. in
order to sell all the bonds desired, issuers must pass more of the bene-
fits of tax exemption to investors and keep less for the firm and im-
provement which is being financed. In addition, increased supply
raises interest costs for all municipal borrowers, who must compete for
limited funds seeking tax shelter.
On the basis of several econometric studies, the interest rate impact
of additional tax-exempt debt--given the level of funds available for
3o John Peterson, 'The Tax Exemption Pollution Control Bond," Municipal Finance
Officers Association, AnaZysia (March 1975), pp. 4-5.
"John Cremeans et al.. op. cit., p. 15.o a
3 George Peterson and Harvey Galper, "Tax-Exempt Financing of Private Indus.|
Pollution Control Investment," Public Policy (Winter, 1975).
3 Evidently, the share of pollution control outlays financed by tax-exempt bonds is ap-
proximately 40 percent and approaching 50 percent. Another factor in the growth of pollu-
tion control bonds has been adoption of enabling legislation by states. As of the end of
1974, all but two--Washington and North Carolina-had some legislative authority to
accommodate this type of financing. But, of much greater consequence are thp Feeral
laws and complex re ulations that permit use of the pollution bond. For example, It was
administrative foot-dragging and Treaeury opposition to certain techniques that kept
pollution bonds from being used until 1971. See Petersen, "Pollution Control Bond," pp.
84 Ibid., pp. 6-T.
the tax-exempt market-probably ranges between 5 and 20 basis points
per billion of added borrowing.5
Pollution control bonds also have been examined in terms of their
overall costs and benefits as a tax subsidy. The subsidy offsets part of
the expense incurred by private industry to reduce or eliminate indus-
trial pollution. However, the subsidy's costs are borne by the public in
three ways: Federal taxes on interest income are foregone when tax-
exempt bonds are used instead of taxable securities; State and local
taxes are foregone because of the exemption of such bonds from many
State income, personal property, and real property taxes; and bor-
rowing costs are higher for other tax-exempt bond issuers because the
increased supply of bonds pushes up interest rates. Benefits are distrib-
uted between the principal target-the firm making the improvement-
and an unintended beneficiary, the purchaser of tax-exempt bonds, who
receives greater tax shelter for otherwise taxable income.
A recent study of pollution control impacts in 1973 estimated that
the $2.1 billion sales in pollution control and industrial revenue bonds
resulted in combined first-year costs for Federal, State, and local gov-
ernments of $66 million.36
Looking at the benefit side, firms using pollution bonds saved $40
million in reduced borrowing costs for the first year. The other $26
million of the subsidy flowed to investors as additional tax shelter in-
come. Hence, industrial firms were able to enjoy only two-thirds of
the Government subsidy; the rest was passed on to purchasers of
pollution and industrial revenue bonds.37
While the 1973 figures are impressive, they are a dead letter. The
bonds have been sold, and the subsidies are largely sunk costs to be
incurred over the next 25 to 30 years. The real issue is future growth.
With the long life of the pollution bond and its ability to drive up
rates in tight money periods, it is the cumulative impact on the re-
main der of the tax-exempt bond market that should be examined.
Projecting to 1980, it has been estimated that the total annual tax
loss on $25 billion in outstanding pollution control (and industrial
revenue) bonds that will have been issued during the decade of the
1970's would be $640 million. In addition, State and local governments
by then would be paying an additional $150 million each year in debt
service costs. Corporations would enjoy a total of $425 million in inter-
est savings, while investors would be receiving about $365 million in
added tax-sheltered income. In that case, firms would be realizing
only 54 percent of the benefits of tax-exemption.38
Ibid., p. 9; footnote 26, pp. 12-13. In a recent study, Peter Fortune estimated that
in 1974, pollution control bonds had increased long term tax exempt rates by 30 basis
oints. See his "The Financial Impact of the Federal Water Pollution Control Act: The
ase for Municipal Bond Reform," Harvard Institute for Economic Research (October
1975), p. 12. See also Peter Fortune, "Impact of Taxable Municipal Bonds: Policy Simu-
lations with a Large Econometric Model," Federal Reserve Bank of Boston (1974) and
Harvey Galper and John Petersen, "An Analysis of Subsidy Plans to Support State and
Local Borrowers," National Tax Journal (June 1971).
3 The governmental cost Included foregone Federal tax receipts ($50 million), state
and local taxes ($3.5 million) and increased state and local borrowing costs ($12.5 mil-
lion). Since these bonds probably had an average life of 25 years, this means a total of
$1.35 billion in foregone taxes over their lifetime and $150 million in higher borrowing
costs over the typically shorter lifetime of the other tax-exempts sold that year. See Peter-
sen, "Pollution Control Bond," pp. 8-9.
7Ibid, p. 9.
16 Ibid., p. 9. These estimates, compared to what impacts could be, are conservative. For
example, were the stock of outstanding pollution bonds to be $40 billion by the end of
1980 (up from $4.5 billion at year-end 1974), interest cost impacts and foregone tax
revenues could push annual total costs of the subsidy to nearly $11/2 billion by 1980. See
Galper and Petersen, op. oit., p. 101.
The unfa vorable impacts on the State, and local bond market and tho
overall poor marks given pollution bonds on efficiency and equity
grounds are not the only criticisms of these instruments. Two oter
complaints are the pollution bond's relative lack of availability to
small borrowers (and, conversely, its overuse by large firms that could
finance control facilities by other means) and its potential for under-
mining the concept of tax-exemption.
The swelling body of evidence against the pollution control bond,
coupled with the recent lackluster performance of the tax-exempt mar-
ket, has led several industry and public interest groupsto oppose con-
tinued use of the device. The Municipal Finance Officers Association
adopted a resolution of opposition in April 1975.9 This was followed
by similar statements from the American Public Power Association,
the National Association of County Officials, the National League of
Cities, and, most recently, the Securities Industry Association.40
Meanwhile, the Treasury continues to express opposition both through
formal statements and informally by increasingly tightfisted interpre-
tation and enforcement of controlling regulations.
31Statement of John Petersen in Federal Response to Financil Em of Clites,
Hearings before committee on Government Operations, U.S. House of Representatives
(June 25, 1975), p. 144.
4 Statement of the Public Finance Division of the Securities Industry Asoclation before
the Committee on Ways and Means, U.S. House of Representatives (Jan. 21, 1976), p. 7.
Chapter III. A CHANGING FISCAL ENVIRONMENT
The emergence of the New York City crisis and related credit crises
in New York State brought from the cellar of neglect the question of
municipal bond credit quality. Since the Great Depression, few
analysts have devoted much time or effort to the financial health of
Stat and local governments or their ability to support debt. The
sector had shown stable growth through-the post-World War II period,
and there had been a noticeable lack of systematic default. There was
little doubt that the debt of local governments was "money good" and
that governmental borrowers had sufficient fiscal stamila and integ-
rity to meet contractual debt service payments. What concerns there
were (and payments difficulties) were restricted largely to more
speculative, revenue bond-fimanced enterprises that depended not on
taxes but on user charges from a commercial activity or were backed
by leases from private firms with shaky prospects.
By the end of 1974, bond market concerns over credit quality began
to surface. There were many contributing factors. Undoubtedly. New
York City's difficulties in its November and December 1974 borrowings
cast lengthening shadows not only over its prospects in the tax-exempt
-market, but also over those of many other State and local borrowers.
New York's ordeal. while pivotal to the municipal bond market's
recent performance, has been the focus of most attention and'has been
recounted in great detail elsewhere.' Here it is useful to examine the
impact of the crisis on the market at large and its consequences for
other State and local governmental borrowers-and, most particularly,
for those that have become tainted by the market's perception of them
as sharing common problems with the city.
THE LARGE CITY BoRRoWERs
The enormous bow-wave of investor concern created by New York
has had its initial and strongest impact on other large, old big-city
borrowers located in the East and Midwest. For years, an assortment
of social scientists and politicians have pointed to the decline of these
central cities and the implications for the Nation as a whole. Although
these borrowers were by no means the most favorable received, such
cities as New York, Philadelphia, Boston, Cleveland, Baltimore, and
Detroit had retained reasonably good access to the credit market. In
-fact, as sustained national prosperity rolled into the early 1970's, ac-
companied by fresh Federal cash infusions from general revenue
sharing, many of the governments either improved orat least main-
tained their credit ratings despite the gradual softening of their local
economies. By early 1975, the municipal bond market was beginning
'For excellent summaries, see Congressional Budget Ofice, Nc.w York City's Fi.'cal
Problem: Its Origin, Potential Repercussions and Some Alternative Policy Responses (Octo-
ber. as)9 And Jotnt Econonic Conmitte .of Congre s, The New York Fiscal Crisis (No-
to take a harder look at the bigger cities. Often, the market did not
like what it saw.
Opinion on the uniqueness of the New York City situation is divided,
but most would agree that many fundamental problems relating to
demographic-economic-fiscal relationships are shared by other major
urban centers. From the standpoint of city borrowing in the capital
markets, however, the ramifications of these problems and their rele-
vance to particular situations are usually obscure and often ephemeral.
Certainly, much of the investor's opinion will hinge on the existence of
problems or uncertainties, and how local politicians and administrators
will conquer, cope with or, perhaps, attempt to conceal them.
The debt-paying ability of cities can be changed by many factors:
the basic strength of the income stream and stock of wealth that can
be tapped by the local revenue system; the efficiency and resiliency of
the revenue-raising devices; the cost and controllability of expendi-
tures in the budget; the overall political and administrative climate in
a city that fosters fiscal prudence or permits profligacy; and, in the
final measure, the legal and political power to force the debtor to pay
in full and on time, even if this happens on his fiscal deathbed. Looking
first at the basic economic prospects of the major cities, it is clear that
many have declined in vitality over the past decade or so. Not only has
population dropped in several major eastern and midwestern cities,
it has changed in nature, becoming progressively older and relatively
less affluent.2 While the percentage of population below the poverty
line decreased nationally between 1960 and 1970 from 18 percent to 11
percent, the improvement was smaller in major urban areas. Of the 24
largest cities, all but 7 had higher than the national average of
population below the poverty line; only 1 did not show a relative
increase in the proportion of the Nation's poor living within its
Private sector employment-the generator of the income and wealth
that sustains the local tax base-has undergone a secular decline in
many central cities as industry and jobs fled to suburbia or exurbia.'
Between 1960 and 1970 about half the 24 largest cities saw a loss or
no significant increase in the number of jobs. Since 1970 the job flight
has been exacerbated by recession. Between June 1974 and .January
1975. the national unemployment rate increased from 5.2 percent to 8.6
percent. By June 1974, fully 21 of the 24 largest cities had unemploy-
ment rates higher than the national average (9 with 10 percent un-
employed or more), and 15 had seen their rates-already at rela-
tively high levels in June 1974-increase by more than the national
-econd set of concerns grew out of the rapidly rising costs of
governmental services which, when linked with declining economic
bases and absorption of high-need population groups, put the screws
2Joint Economic Committee, New York Financial CriS Ri pp 11-15. Of the 24 largest
cities. 11 of 13 In the East and Midwest experienced reduction fn population between 1960
and 1973. (One, Indianapolis grew only by virtue of annexation.) Of 11 southern and
western cities, 3 showed declines between 1960 and 1973, and an additional 3 declined
between 1970 and 1973.
3Ibid., p. 15-17.
4Roy ahl et al., "The Impact of Economic Base Erosion. Inflation, and Employee
Couppnsation Costs on Local Governments," paper 23, Maxwell School, Syracuse Univer-
sity (September 1975), p. 2.
8New York Fiancial Crisis, pp. 19-21, Survey of Curren Busines (October 1975).
even tighter to the governmental fiscs. State and local governmental
employment has grown rapidly in the past quarter-century-moving
from 7.6 percent of total employment to 13 percent by 1973-and aver-
age wages have risen faster than in the private sector.6 The myriad of
supplemental benefits in addition to wages grew even faster than did
wages themselves until they came to represent 11.5 percent of wages
and salaries. While cities shared in this growth in employment and em-
ployee compensation through the early 1970's, many began to slow
down or cut back on public employment by 1973 and 1974; but, not
until a wave of increased wages and benefits had passed over them.7
A special concern among rising employee costs centers on the cost
implications of public employee pensions. Either because of inatten-
tiveness to changing times or in a deliberate effort to hold down taxes,
many local governments in effect were transferring part of the rising
costs to future generations by insufficiently funding the pension liabili-
ties that public employees were accruing. Even in those cases where
funding was taking place, it was evident that pension costs were a
large and largely uncontrollable item in city expenditures.8
The problem of employee costs was reinforced by the unparalleled
pressure that the inflationary surge of the mid-1970's placed on local
g overnments. Recent research indicates that between 1967 and 1972 in-
flation had a fairly symmetrical impact on governmental expenditures
and revenues: While the cost of goods and services went up, they did
not on average outpace the inflationary increases in the tax base. Lo-
cal governments, on the whole, appeared to come out slightly ahead
in the early inflationary period.9 However, the hyperinflation of 1973
and 1974 caused estimated tax bases to grow by only 15 percent while
expenditures--holding 1972 levels of real goods and services con-
stand-increased by-25 percent. As a result, State and local purchasing
power between 1972 and 1974 declined by about 10 percent or $10
billion, an amount almost equal to the total general revenue sharing
entitlements in 1974 and 1975.10 Clearly, the State and local tax base
was incapable of holding real expenditure levels in place, much less
supporting higher levels of real public goods and services.
This erosion in financial power, while obvious in some areas, was not
immediately evident throughout the State and local sector. During the
early 1970's, Federal aid to State and local governments had grown by
leaps and bounds. With the initiation of general revenue sharing pay-
ments, Federal aid increased by 22 percent in 1972 and 25 percent in
1973, far ahead of the already impressive rate of growth of 13 percent
a year between 1955 and 1970." The aggregate figures fail to reflect,
however, that much of the aid in the case of large cities was a substitu-
tion for other Federal programs that were either impounded, cut back,
or shelved, so that the net benefits of the increase to such cities were
proportionately much less. Moreover, by 1974, the rate of growth in
Bahl, "Impact of Economic Base Erosion," p. 6.
7 Employment in cities of more than 50,000 grew by only 0.8 percent in 1974, and 10
of the largest 20 cities actually reported declines in employment in 1973, 1974, or both
years. biWd., p. 7.
8 See Bernard Jump, "Financing Public Employee Retirement Programs in New York:
Trends since 1965 and Projections to 1980," paper No. 16 Syracuse University (1975).
*D. Greytok and B. Jump, The Rffect8 of Inflation on i4tate and Local Grovn t F-
nance, Syracuse University (1975).
'0 Bahl et al "The Impact of Economic Base Erosion," pp. 23-24.
"bId., pp. N6-28.
Federal aid slowed temporarily, but dastically, to about 5 percent
a year. although by 1975 it appeared that Federal assistance, much of
it to provide temporary public employment, was once more on the rise.
Meanwhile, the States-many under fiscal pressure themselves-
showed little appetite for assuming the more costly functions of the
cities. Between 1965 and 1972, States increased their relative share of
combined State and local revenues by only 2.2 percent and of expendi-
tures by only 1.3 per cent.12
As noted earlier, the financial pressure began to manifest itself in
the growing deficits of the State and local general government sector
in late 1973 and 1974. While an analysis of these deficits cannot be sim-
ple or straightforward, it was obvious that the sector was depending
more and more on the capital markets and/or running down invest-
ment assets in an effort to finance itself. By the last quarter of 1974 the
State and local sector was dissaving at a rate of $16 billion a year, a
deficit position maintained through 1975.'
The tightening economic situation, against a backdrop of secular
decline, evidently brought forth the classic response from most city
governments. A survey by the Joint Economic Committee early in 1975
determined that cost cities were tightning their belts by cutting' ex-
penditures or raising taxes to cope with the consequences of recession
That study found that the burdens of the recession were falling in a
highly predictable pattern: those States and cities with the weakest
financial conditions-the smallest surpluses and poorest revenue pros-
pects-were taking austerity measures to balance outlays with dimin-
ished income. Not surprisingly, governments in energy-exporti 1g and
agricultural regions of the country-West and South Central-were
relatively best off with substantial surpluses and strong revenues.15
Local governments in high unemployment areas, with little or no
surplus M their operating budgets. where heading toward deficits
unless taxes were raised or expenditures cut back. The magnitude of
needed adjustments were five times as great (7 to 8 percent of the
budget) for high-unemployment governments than for those with un-
employment rates less than the national average. 16 The study estimated
that about $6(;) million to $1 billion in capital spending would also be
pruned, in order to reduce borrowing costs and thus free capital funds
for operating uses. All told, the JEC research estimated that State and
local governments in 1975 would make $7..5 to $8 billion in expenditun
cuts or tax increases in an effort to balance their budgetS.17
While the JEC study emphasized the deflationary nature of these
adijusftments, the alternative and. from the standpoint of financial
markets, thle most relevant interpretation was that States and localities
were playing by the rules. Unable to control their lomal economies and
without the benefit of unlimited access to credit, very few State and
local governments induced in rountereyclieal deficit spending; those
that hIave, do so only at their own peril. Investors might buy a specular
3 Sep Yoderal Rseer Board. Flow of PIud1I (vAtloug numbers), For the fist three
(Iuarters of 1975 the sector deficit was $13 billion.
1 Joint Economic Committee f the Congres, "The Current Fiscai Postionse! tate
rind bocal Governments" (1975).
Ibid., pp. 28-29.
Ibid., p. 31.
1 Ibid., p. 38.
tion of brick and concrete or forgive an occasional accidentally un-
balanced budget, but they have no confidence in a deliberate operating
deficit, and they abhor a string of them.
CITY FINANCIAL MANAGEMENT
Recognizing the rules of sound management for municipal bor-
rowers, the question of the fiscal condition of cities has another dimen-
sion. This is how well the government manages its affairs, acknowl-
edges its fiscal limitations, and lives within its means. A study, City
Financial Emergencies, done by the Advisory Commission on Inter-
governmental Relations in 1972, proved to be a thorough and some-
what prescient analysis of what brings on financial crises and how they
can be avoided. Its principal conclusion was that in the early 1970's
most large cities were "free of conditions that present a treat of finan-
cial emergency." 18 This was not to say the economic and public spend-
ing pictures were rosey for cities, but rather that budget crises could
be averted through good management.9
Management basically involved a set of traditional actions to re-
tain a balanced budget: (1) Keep operating receipts in balance with
expenditures and avoid deficit financing of current outlays; (2) do
not allow unavoidable deficits to extend past 1 year; (3) keep a con-
sistent pattern of operating expenditures; and (4) collect rapidly
any delinquent taxes. The Commission also cautioned that pension
fund liabilities were worrisome and that "poor budgeting, accounting,
and financial reporting may be indicative of impending financial
In a recent reappraisal of conditions, one of the principal authors
of the ACIR study, while acknowledging that times are tougher now
for cities, pointed to the fact that the majority knew the rules and
were applying them. He contended that there was no widespread in-
dication of fiscal trouble in major cities in 1974, save for New York
City, and concluded:
That a major factor has been strong financial management by most major
cities. The report of the Advisory Commission on Intergovernmental Relations,
Gity Financial Emergencies, pointed out that "sound financial management
stands out as a key element to the prevention of financial emergencies in local
government." A main component of financial management is balancing cash
receipts and expenditures on an annual basis. It appears that as fears about
the national economy have become widespread, city financial officials have ag-
gresively moved to balance their receipts and expenditures and to maintain a
good cash position. It is significant to note, that when receipts are compared
to expenditures . the average increase in revenues of 9.3 percent from the
prior year exceeded the 7-percent increase in expenditures. Thirteen of the 30
cities reported receipts increasing faster than expenditures in 1973-74.'
The studies cited above and widespread press reports of city budget
cutbacks document the rapid fiscal retrenchment of most State and
local governments. However, the unfolding spectacle of New York
City's excesses, the resulting closure of the bond market to it, and
the city's public humiliation as a supplicant for Federal help brought
n P. 56.
39 Ibid., p. 4.
20 Ibid., p. 4, p 59-73.
21 ilip M. DeParborn, Statement before House Committee on Government Operations
(July 15, 1975), p. 4.
on a wave of public concern over the financial conduct of State and
local governments and, particularly the large cities. A municipal bond
market, already sensitive to quality considerations and struggling
with a tide of new issues in the face of limited investor demand, be-
came obsessed with the need to search out and discover other "New
Yorks." As a result, pronounced size, location, and credit quality
premiums began to appear in municipal interest costs, rippling out
across the country from the desperate situation of the financial markets
in New York State. These are discussed in subsequent chapters of this
Chapter IV. THE IMPACT OF CHANGING MONETARY
The municipal bond market is influenced by many forces beyond
the immediate control of State and local governments. Major deter-
minants of the demand for, supply and cost of borrowed capital are
changing monetary conditions as influenced by the monetary and
fiscal policies of the Federal Government. Monetary policy, through
its impact on the level of interest rates and on the behavior of com-
mercial banks-the prime investors in municipal bonds for the last
15 years-has a significant impact on bond sales and capital outlays
by States and localities. Fiscal policy likewise works through a host
of specific revenue and tax measures, as well as through the total
balance of receipts and expenditures, to influence the overall level
and composition of municipal borrowing.
As is depicted in chart II, the last decade and a half has witnessed
a jolting rise in the cost of borrowing for all sectors, including the
municipal bond market. Because of certain peculiarities in its struc-
ture, the market for municipals has been subject to greater variability
than markets for taxable debt securities.
The impact of changing monetary conditions on State and local
governments has been the subject of much research. Numerous studies
have documented the response by State and local governments, be-
ginnig in the 1950's, to tight-money conditions, by adjusting their
financing and spending plans to varying circumstances in the credit
A survey by the Federal Reserve Board plotted the reaction of the
State and local sectors to the tight-money intervals of 1966, 1969 and
1970 and its behavior in subsequent periods of relative ease. In both
the 1966 and 1969-70 episodes, State and local governments displayed
a high degree of sensitivity to interest rates in their borrowing plans
and a lesser, but still significant, impact on their capital outlays'
1It has been estimated that States and localities in 1966 postponed $2.3 billion In bond
sales and reduced expenditures by $.7 billion because of high interest costs. In the 1969-70
credit crunch, the then record high interest rates derailed $5.2 billion in bond sales and
$1.6 billion in spending. See Paul F. McGouldrick and John E. Petersen. "Monetary Re-
straint and Borrowing and Capital Spending by Large State and Local Governments in
1966" and "Monetary Restraint and Borrowing and Capital Spending by Small Local
Governments and State Colleges in 1966," Federal Reserve Bulletin (July and December
1968). See also John E. Petersen, "Response of State and Local Governments to Varying
Credit Conditions." Federal Reserve Bulletin (March 1971) and Harvey Galper and John
Petersen, "Strengthening the Municipal Bond Market," pp. 7-8.
Corporate and Municipal Aaa Bond Yields
Annual Averages: 1960-1975 Est.
196b 196 1970 1975
Source: Moody's Investor Service.
Essentially, studies found that while all governmental units re-
acted to tight credit by postponing long-term financing, the effect
on spending plans varied directly with size and available financing
alternatives. Small units, in particular, displayed both the greatest
tendency to persevere in selling bonds, and if unable to do so, the
highest propensity to sack spending plans. But most governments
were able to keep their spending plans on track by a combined use
of short-term borrowing and running down financial assets. Subse-
(jluent to the tight money bouts, State and local borrowers rebounded
impressively in late 1971 and 1972, issuing more than $23 billion in
long-term debt and making up for repressed borrowing needs.2
= Paul Schneidermnan, "Planned and Actual Long-Term Borrowing by State and Local
Governments," Federal Reserve Bulletin (December 1971).
Conditions remained relatively relaxed in the tax-exempt market
through 1972 and 1973, as the annual volume of long-term borrow-
ing reached a temporary plateau of between $22 and $25 billion. Cer-
tain changes were taking place, however. Short-term borrowing
continued at high levels as many issuers and investors felt liberated
from earlier inhibitions against sustained short-term indebtedness.
Also, as has been reviewed in detail, new uses of tax exemption gen-
erated a growing supply of revenue securities, many of very long
maturity. On the investor side, the large banks began to cut back on
their holdings of municipal bonds. Their lessening interest went
largely unnoticed, however, as smaller or country banks stepped up
their purchases and fire and casualty companies gave strong support
to the long-term revenue bond market.
Another important development in the financial picture of State
and local governments was the reversal of strong gTowth in capital
outlays in the 1960's. The growth in fixed capital formation by the
sector dropped from about 10 percent a year in 1965-68 to only 4
percent between 1968 and 1972.3 Several factors contributed to the
decline in capital formation, including the higher level of interest
rates, the shifting of priorities to current operating outlays for social
welfare programs, and the generally lessened need for capital equip-
ment.4 Furthermore, growth in Federal funds for capital projects was
erratic and slower than that in other forms of Federal assistance be-
cause of impoundments by the Federal Government.
While capital spending perked up somewhat under the influence
of Federal revenue sharing and increases in categorical assistance in
1973, there.was growing evidence that State and local gross capital
formation in real terms was not keeping up with a severe inflation
in prices. Between 1968 and 1973, real capital formation was esti-
mated to have dropped at a rate of 2.5 percent a year. In 1974, a sharp
recovery in capital spending took place under the impetus of revenue
sharing, the freeing of impounded Federal assistance, and the recep-
tive bond markets of 1973 and early 1974. However, early estimates
for 1975 indicate that tight bond markets, a leveling of Federal grants,
and widespread stringency in the financial condition of State and
local governments kept capital expenditures from growing to any
noticeable extent in that year.5
Several econometric studies have explored the question of the im-
pacts of both interest rates and Federal grants as determinants of
State and local expenditure, revenue, and borrowing decisions. While
such studies can be confounded by rapidly changing conditions
and changes in behavior, they enjoy the benefits of specificity and
Turning first to the relationship between State and local borrow-
ing and capital spending decisions, several investigators have found
that rising interest rates decrease bond sales and, to a lesser extent,
construction outlays. While experts differ on ways to estimate this
effect, it appears that an elasticity of 0.4 to 0.6 (i.e., a 10 percent
3Paul Schneiderman, "State and Local Government Gross Fixed Capital Formation:
1958-73," Survey of Current Business (October 1975), p. 18.
4 Iti., p. 19.
5 Ibid., p. 26.
change in the interest rate involves a 4 percent to 6 percent change
in the opposite direction in the gross new supply of bonds) is about
in the middle of the range.6 The sensitivity of State and local con-
struction outlaw ys to interest rates has been the subject of recent stud-
ies. These indicate a fairly high sensitivity to rising rates, with a
negative elasticity in the order of -1.0 that over time dimilishes to
an equilibrium value of approximately -0.2.7
One recent review of the impact of the New York City crisis on
the bond market and capital spending has estimated that sustained
interest rate increases of 60 to 100 basis points would decrease total
State and local construction expenditures on the order of $31/ to
$4 1 billion in 1976.8 Spending cutbacks in response to high interest
rates are predicted to reduce total GNP by $5-$9 billion.9
6 See Harvey Galper and John Petersen, op. cit. (1972).
7See Edward Gramlich and Harvey Galper, "State and Local Fiscal Behavior and Fed-
eral Grant Policy," Brookings Paper on Economic Activity I (1973), pp. 30-36. These
elasticity values are somewhat higher than those found in the Federal Reserve Board
8 Edward Gramlich, "The New York City Fiscal Crisis: What Happened and What
Should Be Done?" A paper presented to the American Economic Association Meetings,
Dallas (December 1975), p. 21; F. G. Adams and J. N. Savitt, "Macroeconomic Impact of
New York City Default," Debt Financing Problems of State and Local Government: The
New York City Case, Hearings before the Subcommittee on Economic Stabilization of the
Committee on Banking, Currency, and Housing, U.S. House of Representatives, 94th Cong.,
1st Sess., II (Oct. 23, 1975), p. 1568.
P Gramlich, ibid., p. 21, and Adams and Savttt, ibi&
Chapter V. CHANGING PATTERNS IN THE DEMAND
FOR MUNICIPAL BONDS
The municipal bond market is part of the larger private capital
market where governmental borrowers compete for the investment
funds of private investors. In this competition for funds, municipal
securitries are sometimes more successful than others and the degree
to which they are depends greatly on the resources and appetite of
those investor groups that find tax exemption of advantage. But fac-
tors other than tax shelter condition the market's demand for munic-
ipal bonds. Investors must weigh available tax-exempt yields against
an assortment of risks to their funds that are committed, including
the possibility that borrowers may default or that securities will drop
in value for some other reason.
Out of the maze of calculations performed thousands of times each
day, the market establishes its price for borrowed money. That price,
in turn, enters into the decisions of would-be borrowers when they
elect to sell new bond issues or wait for a better day.
PA=mRws OF INVESTMENT IN MUNICIPAL BONDS
The municipal market is distinguished by the nature of the investor
and the volatility of his participation. The municipal security has
certain appeals. Typically, these have been the attractiveness of tax
exemption to those in high marginal tax brackets, the relatively high
degree of safety of the investment and the availability of serial matu-
rities. But at the same time, the demand for tax-exempt securitries
has become inordinately volatile because the major institutional invest-
ors on whom the market relies for support are unusually subject to
the pressures of monetary policy, the ravages of inflation, and sudden
changes in portfolio policies. Furthermore, the dowdy municipal bond
traditionally has been a second and third choice for investor groups,
who-unless they envisage a long-term stay in high marginal tax
brackets-usually seek out more lucrative and flexible tax shelters.
Records available on the ownership of municipals since 1933 indicate
that there have been only three major groups of investors in municipal
bonds: individuals, commercial banks, and insurance companies. Their
combined holdings have constituted between 70 percent to 90 percent
of all municipal bonds outstanding over the past 35 years."
The exemption of municipal bond interest from Federal and many
State and local income taxes is its greatest attraction to investors and
shapes the market for municipals. Generally, investors in high mar-
ginal tax brackets have found it worthwhile to buy municipals, so long
as the after-tax return is better than, or at least as high as, that on
1 Unless otherwise Indicated, the financial statistics in this section are taken from the
Board of Governorm. Federal Reserve System. Flow of Funds Accounts 1945-72 (August
1973) and Flow of Funds, 3rd Quarter 1975 (November 1975).
taxable investments of similar quality. By the same token, investors
who pay little or no taxes (pension and life insurance companies) have
exhibited little interest in municipals.
In the period immediately following World War II, municipal
bonds were a favorite form of investment by commercial banks, which,
with lots of government securities and little loan demand, found them-
selves in a very liquid position. As the supply of municipal bonds
expanded during the 1950's, commercial bank participation in the
market began to fluctuate in a manner that was to become an impor-
tant feature of the market. The household sector replaced banks as the
dominant buyer in the 1950's; increasing support was also given by
State and local retirement funds and insurance companies.
Higher rates of interest for tax exempt compared to taxable securi-
ties had an equally significant impact on the composition of the market
for municipals. Under the pressure of a greater bond supply, the ratio
of tax exempt to taxable yields went up from 60 percent for AAA
bonds in 1950 to 72 percent by 1955 and about 75 percent by 1960 and
1961. For the lower grades the relative escalation was even worse, as
the ratio of tax exempts to taxable bonds reached levels higher than
80 percent in the mid-1950's.2
Looking retrospectively at the 1950's, one notes that the rate of
increase in outstanding municipal debt was a spectacular 12 percent
per annum between 1949 and 1960 (at a time when a prices were rising
only 4 percent a year). During the same interval, commercial bank
deposits increased annually at only 6 percent, while bank loans rock-
eted upward at 10 percent per annum, as banks increased their loan to
deposit ratios and gradually ran down their massive holding of U.S.
Beginning in the early 1960's the municipal bond market entered
a new and more favorable phase of investor participation. The essen-
tial elements were a greatly increased interest by commercial banks,
which almost swamped the investment behavior of the market fairly
stable albeit relatively minor support from fire and casualty insur-
ance companies, and sporadic-but in time very important-support
from the formerly dominant household sector. The market was vir-
tually abandoned by the other investor groups, notably life insurance
companies and public pension funds.
These changes are reflected in the ownership figures for the last
25 years which are presented in table 5. As may be seen, between 1960
and 1970, banks acquired two-thirds of all the net new supply of
municipal bonds, increasing their holdings to almost one-half of all
outstanding municipals. This offset much more modest growth in
household and fire and casualty company holdings and a net decline
in municipals owned by all other investor groups.
Table 5, however, does not reveal an important characteristic of the
tax-exempt bond market that emerged in the 1960's: the rapid ebb
'nd flow of commercial bank purchases and offsetting investment of
the household sector. Careful inspection of table 5, which gives annual
net piirciases of municipal] bonds for the key investor groups from
2 John E. Petersen, The Rating qane, The Twentieth Century Fund (New York : 1974),
1960 throu-h 1975, shows a fascinating contrapuntal motion between
changes in bank holdings and those of the household sector. The rela-
tionship is particularly evident in the tight credit years of 1966, 1969,
and 1974-75. Looking at 1970-75, both tables 5 and 6 indicate a rapid
slowdown of commercial bank investment in municipal bonds since
1971 and the increasing importance of individuals and fire and
casualty companies. In the last 2 years, in fact, the household sector
has absorbed 60 percent of the net new supply of municipal bonds.
TABLE 5.-OWNERSHIP OF STATE AND LOCAL SECURITIES, 1950-75
[Dollar amounts in billions]
1950 1960 1970 19751
Percent Percent Percent Percent
Amount of total Amount of total Amount of total Amount of total
Banks -------------------- $8.2 32.6 $17.7 25.0 $70.2 48.0 $102.0 45. 7
Individuals ---------------- 10.0 39.6 30.8 43. 5 47. 4 32.5 72. 3 32.4
Fire and casualty insurance-.. 1.1 4.4 8. 1 11.5 17.8 12.2 33.7 15.1
Others -------------------- 5.9 23.4 14.2 20.0 10.8 7.3 15.2 6.8
Total ---------------- 25. 2 100 70. 8 100 146.2 100 223. 2 100
1 Estimate are the authors.
Source: Federal Reserve Board, "Flow of Funds."
TABLE 6.-ANNUAL CHANGES IN HOLDINGS OF MUNICIPAL BONDS 1960-75 (ESTIMATE)
[In billions of dollars]
Commercial insurance Total
Year banks companies Households Other change
1960 ------------------------------ 0.7 0.8 3.5 3.0 5.3
1961 -------------------------------- 2.8 1.0 1.2 1.0 5.1
1962 -------------------------------- 5.7 .8 -1.0 -.1 5.4
1963 -------------------------------- 3.9 .7 1.0 .1 5.7
1964 -------------------------------- 3.6 .4 2.6 -.6 6.0
1965 -------------------------------- 5.2 .4 1.7 0 7.3
1966 ------------------------------- 2.3 1.3 3.6 -1.6 5.6
1967 --.----------------------------- 9.1 1.4 -2.2 -1.5 7.8
1968 -------------------------------- 8.6 1.0 -.8 .7 9.5
199 6-------------------------------- .2 1.2 9.6 -1.1 9.9
1970 ------------------------------- 10.7 1.5 -.8 -.1 11.3
1971 -------------------------------- 12.6 3.9 -.2 1.3 17.6
1972 -------------------------------- 7.2 4.8 1.0 1.4 14.4
1973 -------------------------------- 5.7 3.9 4.3 -.2 13.7
1974 -------------------------------- 5.5 1.8 10.0 .1 17.4
19751 -------------------------------- 2 2 2.2 10.0 1.0 16.2
I Estimates are the authors.
Source: Federal Reserve System, Board
of Governors, "Flow of Funds."
COM MERCIAL BANKS
Over the last 15 years, changes in commercial bank behavior have
dominated the course of the municipal bond market. Besides being at-
tracted during the 1960's by tax exemption, banks experienced a rapid
growth in assets, changed their attitudes and strategies toward port-
folio investments, and developed new techniques for managing their
liabilities. The end result was that while bank assets increased at an
annual rate of 8.3 percent during the decade of the 1960's (while GNP
grew at 6.8 percent), bank holdings of municipal bonds grew at an
annual rate of 13.7 percent. Municipal bonds grew from 7 percent of
bank investments in 1950 to 22 percent in 1960 and finally peaked at
51 percent of portfolios by 1972. Banks thus were able to finance 70
percent of the growth in municipal debt between 1959 and 1969.
Although the market had its difficulties in periods of credit strin-
gency, the huge appetite of the banks was a boon to the nimble bor-
rower and municipal bond yields relative to those on taxable securities
were at their best levels of the postwar period. The 1960's was a time
of relatively sustained prosperity. With deposits growing more rapidly
than loan demand in the early years of the decade, banks sought
niuniclpals as a profitable outlet for funds. Toward the end of the
1960's. banks came under increasing reserve pressure on occasion
(notably in 1966 and 1969). But rather than keeping large stocks of
short-term securities, they found it more profitable to run off their
U.S. Governments and to meet their liquidity needs by promoting
purchase of their liabilities, particularly through the sale of market-
able certificates of deposit.3
Shorter term municipal bonds were also increasingly relied upon to
meet cash needs.
As the 1960's wore on, banks became increasingly aggressive bidders
for time deposits and. as the cost of these increased, so did their interest
in municipal bonds. Reportedly, banks came to depend more on pur-
chases of longer-term and lower-grade municipals in an effort to im-
prove their current income.4 The recurring tight-money periods toward
the end of the 1960's, however, encouraged prudence and banks began
to increase their holdings of short-term municipal notes. With the
switching out of U.S. Governments and the liquidity binds that matur-
ing CD's could create, the investment in municipal securities became
an increasingly important form of liquidity.5 Banks in the 1960's had
other reasons to find municipals more attractive than did other in-
vestors. Perhaps the most significant was the banks' privilege-not
shared by individuals-of deducting the interest cost of funds
borrowed to acquire tax-exempt securities. Thus, as interest costs on
deposits rose, banks were motivated to increase their holdings of tax-
By the early 1970's it was obvious that the powerful thrust of bank
support in the municipal bond market had certain one-shot qualities.'
Durin tim 1960's banls had switched heavily into municipals and out
of T.S. Governments, the latter falling from 31 percent of total assets
to 13 percent by the end of 1970. This seemed to be a dangerously low
lev 1 of liquid securities for banks, making them too dependent on their
ability to sell increasingly expensive short-term liabilities to meet cash
Robert TTmefner. Taxabre Altf-nratives to Municipar Bonds, Research Report No. 53,
Fedornl Reservo Bank of Boston (1972).
8 Ibfd., P_ 1.
BrIan .T. Fahhrl, Commfrrial Bank Investments in the Postwar Period (New York:
1f)7,). p. 27.
7 qpp Frank M[orris. ztaternent before the CoinnIttee on Wayq nnd MVesnq, .,q. Fonie nf
epr(-eTtntIrve. Pnnel No. S, An Alternative to Tax-Eempt State and Local Bonds (Feb-
rwirY i!)73). p. 29.
needs. Further, bank appetite for tax-exempt bonds was being dulled
by availability of other tax shelter vehicles. Most notable has been
increased use of direct leasing operations, which grew from almost
nothing in 1963 (when it was authorized for commercial banks by the
U.S. Comptroller) to $790 million in 1970 and then exploded to $2.4
billion by the end of 1974.8
In addition, banks have rapidly expanded foreign operations. In the
last 10 years, these have grown 16-fold to the point where they now
represent nearly 20 percent of total bank assets. Foreign assets report-
edly contributed more than 40 percent of the total 1974 earnings of
the 10 largest banks.9 Domestic banks are permitted to take a foreign
tax credit against domestic taxes and also, in the case of foreign sub-
sidiaries, are permitted to defer taxes on income until it is repatriated.
Both leasing and foreign income operations require large amounts
of capital and are therefore most attractive to the largest banks. And,
not surprisingly, it is those banks that have displayed the least interest
in municipals since 1970. In fact, bank support for the municipal bond
market has come almost exclusively from the smaller country banks.
From year-end 1972 through 1974, banks with deposits in excess of
$500 million actually ran down their holdings of municipals, while
banks with deposits of less than $100 million increased their holdings
by $7.2 billion or 75 percent of the total increase in bank holdings dur-
ing the period.
Another factor that has influenced bank demand, but one that is
changing, is the need for securities to act as collateral on public de-
posits, a practice known as pledging. Typically, U.S. Government and
municipal securities have been used for this purpose and, as public
deposits grew, so did the demand for these instruments. For many
banks, the volume of pledged assets has reportedly represented up to
75 percent of their security portfolio, and it has been estimated that the
share of pledged securities grew from 22 percent of total bank invest-
ments in 1959 to nearly 40 percent in 1974.0
In 1975, legislation was passed that raised the level on Federal insur-
ance on public time deposits from $10,000 to $100,000. Sincesuch insur-
ance usually suffices for a pledge, this action has probably diminished
the demand for municipals for this purpose. &
The most recent development in bank investment policy has been the
major shift into short-dated U.S. Government securities during the
present cyclical contraction, a time that used to favor municipal pur-
chases. Increasingly concerned about liquidity and quality and less
sanguine about aggressive liability management, banks have largely
forsaken the municipal bond market to finance the Federal deficit and
to stand by for the rise in loan demand which recovery is expected to
8 Fabbri, op. cit., p. 31. Leasing is extremely profitable in that It permits not only higher
income than normal loan charges, but enjoys the tax advantage of the investment tax
credit permitted of the purchased equipment to be leased and Its accelerated depreciation.
9Ibid., p. 32.
10 Ibid., p. 5.
"See John Petersen, "Pledging Requirements and Full Insurance of Public Deposits,"
Analysis, Municipal Finance Officers Association (1974). The effects of the change in the
level of deposit insurance are being examined In a study by the Advisory Commission on
Summarizing the recent developments in bank demand for tax-
exempts, one commentator has observed:
From the issuers' point of view, the increased portion of their debt
taken down by banks increases their financing exposure dispropor-
tionately to the vagaries of restrictive monetary policy. In addition, as
larger banks continue to expand their leasing and foreign branch
banking activities, their needs for tax-exempt income derived from
state and local securities will diminish. This further restricts state and
local governments into a more concentrated market for their debt
financing, since funds will be provided by only the medium and small
size banks, and thereby increases their market risks.12
FIRE AND CASUALTY INSURANCE COMPANIES
The only other consistently important institutional investor in
municipal bonds is the fire and casualty company sector. Though much
less important than the banks, the growth in buying interest of fire
and casualty companies has been relatively stable over the long run.
It too displays variability from year to year, however, that can either
offset or reinforce the demand of banks.
Fire and casualty companies' investment in municipals is affected
both by the availability of investible funds and by their needs for tax
shelter. Generally, these companies buy tax exempts only when they
need to shelter profits that otherwise are taxable at the full marginal
corporate rate. Their acquisitions have been shown to be sensitive to
changes in policyholders' surplus.3 When industry profits are declin-
ing, the companies will generally shift to taxable bonds. From time
to time., they also acquire equities, which is their alternative tax shelter
to tax exempts. Last, their investment demand can be subject to drastic
fluctuations due to large claims generated by disasters against which
they have insured.
Fire and casualty purchases are especially important to the longer
end of the municipal bond market, and, frequently, in lower-rated
revenue bond issues, since insurance companies buy for yield rather
than liquidity. In the early 1970's, these companies were unusually
active in the municipal bond market, as they acquired nearly 30 per-
cent of net new issues. (See table 6.) However, as a result of galloping
inflation and its impact on claim levels and the inability to raise
premiums, the fire and casualty industry has been depressed by operat-
ing losses.' Both their overall acquisition of assets and their demand
for mun i ci pal bonds have consequently dropped drastically. Prospects
for rapid recovery in the sector are poor, so it is unlikely that their
investment demand, apart from occasional spurts, will become pro-
The household sector, while diminishing in importance as an in-
vestor in municipal bonds over the past 20 years, has continued to play
2Fabbri, app. cit., p. 33.
Is Huefner, op. cit., pp. 172-74.
14, Salomon Brotbers, "Fire and Casualty Industry-Earnlngs Review" (Dec. 5, 1975).
3A Ibid., p. 4.
a vital role in the market. Historically, it has picked up the slack when
institutional demand has ebbed for tax exempts. At such times-gen-
erally, when money is tight-rates on municipal bonds have increased
faster than rates on taxable securities, and individual investors have
become very important in supplying funds to the market.
The household sector is, in fact, a conglomeration of investor groups.
It is the residual after known institutional holdings are subtracted
from the total stock and flow figures collected by various regulatory
agencies. As such, the household sector consists of individual investors,
personal trusts, unincorporated business holdings of bond funds, and
discrepancies. Individual investors are thought to own directly about
half of the household sector's holdings of tax exempts, with trusts and
bond funds accounting for the other half.6 Information on this in-
vestor group is scanty because there is no direct regular reporting of
individual holdings of municipals (a factor that probably contributes
to demand from more secretive investors). But there is no evidence to
controvert the widely-held and traditional belief that most individual
owners are wealthy, high-income individuals who- acquire fixed-income
securities because they are a relatively safe form of tax shelter. How-
ever, for certain issues and at times when municipal bond yields are
high, a cadre of smaller individual investors interested in high returns
at the sacrifice of some liquidity and risk probably swings into the
market. The advent of the tax-exempt bond fund has also made the
market more accessible to the smaller investor of moderate means.7
Information on the economic status and market behavior of indi-
vidual investors may be derived from several sources; none, unfor-
tunately, is of recent origin.'8 However, it is clear that although in-
dividual holdings of municipals are relatively important to the tax-
exempt market, they represent a small and relatively stable share of
individual holdings of financial assets. As table 7 shows, municipal
bonds have represented about 3 percent of wealth of the household
sector over the last 25 years. This is in contrast to stock ownership, of
which the relative proportion rose to more than 40 percent in 1960
and fell to 25 percent in 1974.
. Recent studies indicate that municipal bond ownership, while cover-
Ing a spectrum of income levels, is highly concentrated in the upper-
income brackets. The average marginal tax rate for municipal bond
owners has recently been estimated to be approximately 55 percent.
Evidently. about 70 percent of municipal bonds held by households
are owned by units with incomes of $50,000 or more.'9
Furthermore, because inflation pushes investors into higher
marginal tax brackets as nominal income rises, it can be expected that
tax-exempt holdings will increase in the highest marginal tax brackets
simply because more taxpayers find themselves there.
18 Petersen, Rating Game, p. 68.
17 See Huefner, Taxable Alternatives, pp. 168-170.
1 8Ibid., pp. 57-58.
Harvey Galper and George Peterson, "The Equity Effects of a Taxable Municipal
Bond Subsidy," National Tax Journal (December 1973), p. 617.
TABLE 7.-MUNICIPAL SECURITIES AND CORPORATE STOCKS AS A PERCENTAGE OF HOUSEHOLD FINANCIAL
Percentage of financial assets
Year stock bonds
1950 --------------------------------------------------------------------------- 30.9 2.9
1960 --------------------------------------------------------------------------- 40.9 3.2
1970 --------------------------------------------------------------------------- 38.2 2.4
1974 ---------------------------------------------------------------------- 24.0 2.8
Source: Federal Reserve Board, "Flow of Funds."
Some analysts contend that this "bracket effect" will be of growing
importance to municipal investment by individuals and might meet
the future demand for municipals.20 However, there is'no evidence that
it has been a significant part of total household demand to date.
20 A. W. Sametz et al., "The Financial Environment and the Structure of Capital
Markets In 1985," Graduate School of Business, New York University, Paper No. 24 (n.d.),
Chapter VI. GROWING CONCERNS OVER CREDIT
QUALITY AND INFORMATION
Throughout 1975, the municipal bond market experienced an erosion
in credit quality. That is to say, the market began to worry about
debt being repaid and, accordingly, began to demand higher rates
of interest on borrowings and, in some cases, was unwilling to muster
any bids at all for certain borrowers. Of course, other factors were
depressing municipal bond demand. Still, the bulk of recent evidence
indicates that the inarket Was turning a sharp and, for 'most govern-
ments, an expensive corner in its perception of the risk associated with
Credit crises of the Urban Development Corporation and New York
City led to financial turbulence in the municipal bond market, and
borrowing costs rose significantly in 1975 for some units. Front-page
examples of the erosion in credit quality were New York State and
its agencies and localities, as well as other large cities and various
At the same time, it was also clear that since not all borrowers faced
the same suspicions in the market, the cost of waning confidence was
not affecting all borrowers equally. In fact, some observers argued that
borrowers with high quality credit standing might even have benefited
by the flight of funds from lower-grade credits.
A review of the trend in bond rates prior and during the New York
debacle left little doubt that, whatever the specific reasons, the capital
market was casting an increasingly jaundiced eye on the borrowings
of State and local! governments. Interest rates rose throughout 1974
and, after a slight drop in spring 1975, displayed a volatile and uncer-
tain rise through June 1975. Thereafter, the rise in yields accelerated
through the third quarter and remained near their October highs for
the remainder of the year.
These general movements in interest costs reflect several forces at
work in the tax-exempt market and, indeed, in all the capital markets.
These include the credit crunch and associated bank liquidity crises
that peaked during the third quarter of 1974; the rapid deterioration
of the economy in late 1974; the emerging fiscal pressures on State and
local governments in 1974 and 1975; and, in the latter stages, a grow-
ing fear of the consequences of default by the two largest municipal
borrowers-the city and State of New York.
Such conditions make it difficult to identify a specific date signalling
a distinct erosion in market confidence about municipal credit quality.
However, from the present vantage point, it seems that the first offer-
ing of the Municipal Assistance Corporation (M.A.C.) bonds to assist
the city of New York at the beginning of July was a pivotal event.
Hopeful of persuading private capital to provide $3 billion in 3
months, the municipal market quickly acknowledged that its capacity
to absorb M.A.C. debt was practically exhausted by the first batch of
It became evident that there would be no solution short of default
without the involvement of the Federal Government and the market
slid even deeper through the fall of 1975.
When New York's problems reached the Congress and the question
of what to do about them became a national issue, greater attention
was given to the city's relationship with the deteriorating municipal
bond market. Rapidly rising costs of borrowing for all, and astronom-
ical interest charges for some, began to focus the attention of many on
the market's general woes. Moreover, it was clear to many that, what-
ever might be the longer term consequences of a default for the city
and State of New York, the market was discounting such a possibility.
The impact of this process on the market as a whole seemed serious
enough to justify helping the sick borrowers simply to keep the con-
tagion of weakening confidence from spreading throughout the munic-
ipal bond market.
Several attempts have been made to gage the costs of the New
York syndrome to the rest of the municipal bond market. Early esti-
mates were hampered by lack of data and procedures to make allow-
ances for other factors that were also changing. Nevertheless, even
casual review of bond sales and interest rate indices showed that bor-
rowing costs were rising severely, particularly for those borrowers in
the lower rating categories. However, a reasonably comprehensive sta-
tistical study releasedearly in November 1975 provided much evidence
that not only were interest costs rising for municipal borrowers
throughout the country, they also were displaying strong regional and
credit quality differentials.- The study estimated that, using the pat-
tern of interest rate impacts present in the third quarter, the deteriora-
tion in investor confidence was producing added interest costS for
State and local governments on the order of $150 million per year.
Because the debt sold under such conditions would be outstanding for
a period of years, the total additional costs would sum to approxi-
mately $11/2 billion over the lifetime of the bonds.2
The incremental costs, moreover, were not spread uniformly
throughout the Nation. The study estimated on the basis of k large
cross-section sample of sales that the increase in borrowing costs in
the third quarter of 1975 ranged from a relative small one-tenth of one
percentage point in the North Central region to approximately one-
half of a percentage point for New York State localities (other than
New Yorkc City) and borrowers in other Middle Atlantic States.3 Even
more startling than the increases in bond yields were the upsurgeq in
short-term interest rates, which the study estimated were hiking an-
nual short-term borrowing costs by $200 to $300 million, with most of
the effect concentrated in the Northeast.4
In another recent study, Edward Gramlich iised regression tech-
niques to measure the interest rate difference between yields on munici-
V'orhes nnd Pvterson, "rosts of Credit Erosion," op. cit
2 Tid, S.
1 Ibid., p. R.
Ibd., p. 17.
pal and corporate bonds of the same rating.5 He then calculated that
the interest rate spread between like-rated corporate and tax-exempt
bonds had narrowed in 1975 much more than historical experience
would have suggested. For the first three quarters of the year, Aaa
tax-exempt rates were estimated to be 13 basis points higher than pre-
dicted while those on Baa bonds were 74 basis points higher. Concen-
trating, on the third quarter, Gramlich found a weighted average in-
crease in yields on municipals of more than 60 basis points. While it
would be an extreme assumption to attribute all of this impact to the
New York crisis, it is clear that a massive erosion in credit confidence
had taken place and that the great majority, if not all, municipal bor-
rowers were suffering from increasing exactions for risk.
DExAND FOR MORE INFORMATION
Worries about fiscal condition of borrowers had several sources. An
important part of the speculation stemmed from concern over the
quality and timeliness of information about governmental finances and
how to interpret financial statistics, once having acquired them from
governmental borrowers. This concern was not limited to the citizen-
layman, but also infiltrated the highest circles of the national political
and financial community. The fact was that after years of disinterest,
the reading and understanding of public financial statements took on
an iminediacy and importance it had not had for 40 years. As the long
prosperity of the post World War II era had gained momentum, i-
vestment bankers and investors became less interested in the partic-
ulars of municipal financial statements and delegated the examination
of credits to a small coterie of experts and, in particular, to the na-
tionally recognized rating agencies of Moody's and Standard & Poor."
Aside from periodic squabbles with issuers who thought they de-
served higher ratings-especially New York City-the municipal
bond market and the public at large seemed content to see ratings gain
influence. It was, after all, an economical and easily understood sys-
tem. Besides, the impact of ratings and interest cost differentials, while
significant, declined throughout the past 2 decades as the market's
memories of Depression defaults dimmed.
Nevertheless, occasional fears were expressed that there was not
enough current information about financial conditions and that the
agencies, while meeting the market test for information, could not
and should not be expected to do the job for everyone. A major com-
plaint was that the ratings conferred were essentially public prop-
erty, being purchased by the issuers, but the criteria used to assign
them were not.7
Aside from greater disclosure of how ratings were constructed,
the 'other suggestion most often heard has been to establish a national
clearing house of information on State and local financial informa-
tion.s But even were such an entity to exist, there remains the problem
5 "The New York Fiscal Crisis, op. cit., p. 20.
For a recent examination of the credit rating agencies, their influence on the market,
and proposals for change, see Petersen, The Rating Game, op. cit.
7 Ibid., p. 8.
8 Ibid., pp. 14-18.
of timeliness, uniformity, and completeness in gathering financial
data. Obviously, the optimal solution to these problems depends upon
the use to which the information will be put.
State and local governments are capable, as are most organizations
in the age of the computer, of generating enormous supplies of data.
The questions of both how and what data should be provided to meet
the analytical needs of the financial markets is the subject of at least
one research effort, that being conducted by the Municipal Finance
Officers Association. With an estimated 40,000 State and local entities
having 120,000 outstanding bond issues and 8,000 new bond and note
sales occurring each year, the problem will not easily be solved.
With the current mood of caution and uncertainty, the municipal
bond market has displayed increasing wariness of all municipal bor-
rowers and, by latest reports, a disposition to shun or heavily penalize
those that might be suspect. In the absence of "enough" facts and
confidence in how to analyze them, it now appears that rumors might
suffice to discriminate among credits.
To complicate an already muddled situation, two other events un-
settled the municipal securities industry at the end of 1975: New,
less restricted Federal bankruptcy laws were progressing through
Congress and the industry was brought under regulation, from which
it had been previously exempted. The proposed amendments to the
Federal Bankruptcy Code, coupled with the moratorium on certain
New York City notes that was enacted by the State of New York,
reinforced doubts about the ability of some governments to pay, with
misgivings about their continuing willingness to pay their debts, when
presented with the option of going into bankruptcy. Promoted as part
of the New York City assistance package, the bankruptcy measure
sped through the House and Senate in December amid warnings that
its enactment would cause many investors to lose further confidence
in general obligation bonds in particular. As of the end of 1975, the
bankruptcy legislation still had not been subject to a final vote in
MUNICIPAL BOND MARKET. REGULATION AND DISCLOSURE
Another element of uncertainty in the municipal bond market has
been the passage of the Securities Acts Amendments of 1975, which
were signed into law on June 5, 1975. These amendments extended
regulation to the municipal bond market under the Federal securities
laws. The new municipal reglilation calls for registration and regufla-
tion of municipal security dealers, by the newly-created municipal
securities rulemaking board. Prior to passage of the amendments,
brokers and dealers doing business solely in municipal securities were
not subject to regulation by the Securities and Exchange Commission
or any other regulatory agency of the Federal Government. Now the
rulemaking board has the responsibility for developing regulatory
provisions, subject to SEC ovt'usiht.
As the central authority in what is basically a system of industry
self-regulation, the 15-member municipal securities rulemaking board
OJohn PetprRen and Robert Doty, "Regulation of the Muunielpal qecuritles Market qnd
Its RelationshlT) to tho Governmental Issuer," Analysis, Municipal Finance Officers Asso-
ciation (December 1975).
has very broad powers for establishing periodic examination and in-
spection programs, recordkeeping requirements, and rules to assure
fair market practices. Yet, while the board has power to adopt rules,
the SEC retains the ultimate authority to delete or amend such rules
or to compel adoption of new rules, if necessary.
Under the amendments, governmental issuers retained their exemp-
tion from the registration requirements of the Securities Act of 1933
and from the registration and reporting requirements of the Securities
Exchange Act of 1934. Of particular importance, neither the SEC
nor the board can require an issuer of municipal securities to file in-
formation prior to the sale of securities. In addition, the board can-
not require an issuer to furnish information on itself, either directly
or indirectly through a municipal securities dealer or otherwise. (The
board can require dealers to supply only such information about issu-
ers that is generally available from a source other than the issuer.0
However, the Senate report on the legislation noted that, although
the new law would not permit direct or indirect requirements for
review of issuer documents prior to sale, they remain subject to anti-
fraud provisions: "The bill assures that access of State and local
governments to the capital markets will not be regulated in ways not
now permitted under the fraud provisions of the Federal securities
laws." 11 Thus, from the perspective of the governmental issuer, the
exemptive amendments in the Securities Act Amendments of 1975
are of only limited effect. Despite these amendments, the antifraud pro-
visions of the Federal securities laws still apply to offerings and other
transactions in municipal securities. Consequently, issuers had and
are still meant to have an obligation under the Federal securities laws
not to misstate or omit material information.'1
The objective of the issuers' exemption was to preserve existing
practice and responsibilities in the municipal bond market for pro-
vision of information. However, with the eruption of the New York
Urban Development Corp. note default in March and the emerging
crisis in New York City, dealers began to believe that some control
over credit information might be needed. As a result, they objected
to some of the exceptive language.13 But these objections came late,
and the nature of these controls was never broached in the hearings
on municipal regulation.
Recently, amid the national focus on New York City and its finan-
cial practices, several critics have called for regulation of information
provided by issuers.'4 Proposed approaches have been registra-
tion of municipal securities under the Securities Act of 1933, or repeal
of exemptions under the 1934 act to permit regulation of issuer infor-
mation by the rulemaking board.'5 Another proposal has been the crea-
tion of a new regulatory scheme or body made up of issuers to deal
with governmental disclosure problems, probably under the Federal
10 Section 15B(d) (1) and (2) of the 1934 Securities and Exchange Act.
11 Senate Report No. 94-75 : Securities Act Amendments of 1975 (April 1975), p. 47.
12 The antifraud provisions include Section 17 of the Securities Act of 1933 and Section
10(b) of the Securities and Exchange Act of 1934.
U Committee on Interstate and Foreign Commerce, House of Representatives, Hearings
on H.R. 4570 (March 1975).
14 Robert J. Cole, "Holding Municipal Bonds up to the Light," New York Times (Oct. 26,
1975). Section 3, n. 1.
15 Bills to this effect were introduced by Senator Eagleton and Congressman Van Deerlin.
SEC Commissioner Arthur Sommer and Treasury Secretary William Simon have also in-
dicated the need for legislation in this area.
securities laws, or some form of regulation on a voluntary basis16' In
the absence of such regulation, the main discipline is provided by the
market, reinforced by state laws, to enforce the acceptance of stand-
ards of disclosure and diligence procedures that underwriters and
others would require of governments in order for them to sell
At the heart of the current disclosure problem is the uncertainty
surrounding legal liability of bond dealers for existing antifraud pro-
visions. The two forces converging are the evolutionary development
of the antifraud provisions (that predate the 1975 Securities Amend-
ments) and the fear of large-scale defaults in municipal bonds. Should
losses occur, they might give substance to long-standing legal expo-
sures of which securities dealers and others were oblivious when mar-
kets were better. In practical terms, regulation of the issuer and a
mechanism to promulgate and enforce disclosure requirements would
permit dealers at least to identify their duties and legal liabilities for
18 See Lennox Moak, statement before Committee on Banking, Housing and Urban Affairs,
U.S. Senate (Oct. 9, 1975).
"T See Petersen and Doty, op. cit., and "Suggested Guidelines for Disclosure and Municipal
Bond Offerings," Municipal Finance Officers Association (Nov. 10, 1975, draft).
Chapter VII. FUTURE DEMAND FOR CAPITAL FUNDS
The bulk of State and local borrowing over the next 5 years will
be to finance construction of public facilities. As discussed earlier,
these governments engage in numerous capital projects, although their
share of real capital formation in the economy has declined since 1965.
Looking ahead, one must make interlocking assumptions about the
real forces of demand for capital goods by State and local govern-
ments, how these demands will be constrained by the overall financial
resources of governments and, as a result, how much the capital
markets will be called upon to finance capital spending through the
sale of State and local debt. There are other problems, not the least
of which is whether the capital markets, as they seek to match the
supply and demand for funds, will have the capacity to absorb desired
levels of borrowing at rates of interest that governments are willing
The problem is complex, but, fortunately, there are studies that give
insights on how these factors will interact over the next 5 years to pro-
duce relative strain or ease in the tax-exempt bond market. From that
analysis one may infer also whether the market must be altered or
changed. The conclusions of these studies and assumptions which
underlie them are summarized in table 8.
TABLE 8.-SELECTED STATE AND LOCAL GOVERNMENT OUTLAYS AND BORROWING AS ESTIMATED FOR 1980
[Billions of dollars]
Estimate State and local in 1980
Total Capital Long-term Total
Source GNP expenditure outlays borrowing debt
Tax foundation I ---------------------- 2,140 326 58.4 35.0 285
Bosworth et a1.2................... 2, 387 381 66.6 33. 0 292
Fortune 3 ----------------------------- 2, 533 NA 69. 1 36. 5 NA
Taylor 4 ------------------------------ 2, 418 373 NA 41.7 351
Ott& Ott -------------------------- 2,428 399 55.0 31.0 NA
STax Foundation, "The Financial Outlook for State and Local Governments to 1980" (1972). GNP: 8 percent annual
growth rate, 1970 to 1980 (p. 25). Expenditure: $320,000,000,000 adjusted by ratio of expenditures as defined by Bureau
of Census to that defined by Department of Commerce in National Income Accounts, 1.018 for fiscal and calendar year 1973,
respectively (p. 75). Capital outlays, borrowing debt: as preceding the original figures have been adjusted to calendar
year by 1973 ratio of 1.008 (pp. 100-101).
2 B. Bosworth, J. Duesenberry, A. Carron, "Capital Needs in the Seventies" (1975). GNP 9.2 percent annual growth
rate 1973 to 1980 (p. 12). Other items are as published (pp. 35, 57).
3 P. Fortune, "The Financial Impact of the Federal Water Pollution Control Act; The Case for Municipal Bond Reform"
(1975). GNP 9.0 percent annual growth. Capital outlays derived from adjustment of construction expenditures by 1.180
(table 3); borrowing calculated from values on table 3 and equations (table 2); $4,500,000,000 in borrowing is for pollution
control purposes (table 7).
4 S. Taylor, "A Financial Background for Project Independence" (1974?. Current dollar GNP 9.2 percent annual growth
rate, 1974-80 (table 1); expenditure (table 1), borrowing $25,800,000,000, net flow (table 3) plus $15,900,000,000 long-
term debt requirements; debt (table 5).
6 D. Ott and A. Ott, "State-Local Finances in the Last Half of the 1970's" (1975). Current dollar GNP 9 percent annual
growth rate, 1974-80 (p. 91), Expenditures (table 5-2), adjustment to a capital outlay base; borrowing (calculated from
equation E.12, p. 28).
PUBLIo CONSTRUCTION IN THE YEARS AHEAD
The nature of State and local public construction will continue to
change. The prospect is for continuing reductions in real capital out-
lays for schools and highways, with moderate growth in other tradi-
tional categories and greater emphasis on environment and transit
needs. This was the thesis of the recent Brookings study, Capital Needs
in the Seventies, which called for generally higher levels of State and
local capital spending.' It is estimated that waste treatment and sewer
expenditures (in 1972 dollars) stimulated by the Federal water pol-
lution program, will rise sharply to $5.7 billion in 1977, easing to $5
billion by 1980.2 Of the total $38.8 billion the study projected to be
spent between 1972 and 1980 by State and local governments, a total
of $25.8 billion is expected to be financed by Federal grants. In the
area of mass transit, the Brookings Needs study foresees nonhighway
transit and utility system rising over the next 5 years, stimulated in,
part by increasing Federal grants.
The Brookings study foresees a continuing growth in total State and
local government spending, with capital spending staging something
of a comeback through the remaining 1970's. It predicts that construc-
tion outlays for waste treatment and mass transit will more than offset
slowdowns in school and highway construction, thus increasing total
capital spending by nearly 10 percent per year between 1973 and 1980.
This would be significantly higher than the 7 percent growth rate of the
1960's ,, and would reverse the decline in real capital spending of the
last 6 years.
The accuracy of these projections will depend heavily on available
methods of capital financing. Perhaps the most notable feature of the
Brookings report is the belief that a large part of increased expendi-
tures will be supported by Federal grants. Federal grants for capital
projects are expected to rise faster than other grants (9.9 percent
versus 6.2 percent), and they are estimated to support 26 percent of
state and local capital outlays by 1980. But grants alone won't do it,
and the Brookings study also foresees a growin re liance on additional
nondebt financing of funds. As a result, bond sAdes for capital purposes
are anticipated to grow at only 7 percent per annum through the late
1970's, as opposed to the 7.4 percent increase in the 1960's and 11.2 per-
cent in the 1950's. By 1980 it is estimated that bond issues will be sup-
porting 50 percent of State and local capital spending.4
The Capital Needs projections are unique in their integration of uses
and sources of capital funds and their implications for the financial
market. A study by the tax foundation also forecasts State and local
government spending and borrowing and thus presents us with results
from differing assumptions and a basis for analysis of Capital Needs'
conclusions. The tax foundation study, carried out in 1972 on the basis
of 1970 data, used the definitions and data bases of the Bureau of the
Census, and it requires some adjustments to facilitate comparisons. It
assumed less inflation and more real growth than the economy has ex-
perienced in the first 5 years of the 1970's.
IB. Bosworth, J. Duesenberry, A. Carron, Capital Needs in the Seventies (1975).
2 Ibid., pp. 20-21.
3 Ibid., p. 36.
'Ibid., pp. 56-57.
The major contrasts are that the tax foundation study forecasts a
somewhat smaller share of GNP for State and local expenditures (15.2
percent as opposed to 16 percent in the Needs study), their capital out-
lays as being a bit more important in such expenditures (17.9 percent
as opposed to 17.5 percent and borrowing as being much more signifi-
cant as a source of funds for State and local outlays (60 percent com-
pared to 50 percent). By and large, the tax foundation study provides
an estimate of capital outlays and demands for borrowing if the econ-
omy and State and local sector were to grow more slowly in accordance
with traditional spending and revenue patterns.
The above studies can be criticized on several grounds. Both suggest
high levels of Federal gants ($67 million for Needs and $63 billion for
tax foundation, annually by 1980), an assumption which is increasingly
less realistic. The $17.1 billion in Federal capital grants forecast for
1980 by the Capital Needs study would require a 121/ percent rate
of annual growth over the next 5 years to rise from the level of $9.5
billion budgeted for Federal grants in fiscal year 1975.5
The Needs study, as one critic has noted," calls for an absolute growth
in municipal bond issues equal only to that experienced between 1965
and 1973 ($1.5 billion a year). Correspondingly, it foresees a relatively
lar'cre increase in the amount of support to capital spending from non-
grant and nonborrowing sources. Other financing-short-term loans
and current receipts-is expected to triple by 1980--up to $16.5 billion
from $5.2 billion in 1973.7 Since is is unlikely that financing from other
sources, especially current receipts, will increase sufficiently to accom-
modate as much as 26 percent of capital expenditures, borrowing may
be expected to carry a greater part of the load. If, for example, the
composition of financial support were to remain the same in 1980 as it
was in 1973, bond sales would equal $41.9 billion, approximately the
amount of borrowing envisaged by the Taylor projections (to be dis-
cussed below. And if, indeed, the State and-local sector is experiencing
an $18 billion deficit by 1980, as the Needs study suggests, it is likely
that pressure on current revenues for current outlays will be too great
to permit much funding of capital expenditure.,8
A relatively optimistic view of the overall balance of receipts and
expenditures in the State and local sector and of the difficulties in meet-
ing capital financing needs is presented in David and Attiat Otts' re-
cent study. State-Local Finanees in the Last Half of the 19701s. Assum-
ing a relatively moderate rate of real growth and inflation, they project
the sector moving toward budget surpluses and, because of demo-
graphic changes, having relatively low levels of capital outlay require-
ments. Meanwhile, Federal grants are projected to grow rapidly to
meet most environmental and mass transit financing needs, reducing
the need for borrowing.
In fact, the Ott study foresees moderate capital spending as a critical
factor in helping to hold the lid on State and local spending and as
6 Special Analysis, Budget of the U.S. Government for fiscal year 1976 (1975), p. 69.
*E. Renshaw, "The Financing of Capital Expenditures by State and Local Governments
In the Remainder of the Seventies," mimeographed (1975), p. 10.
Capital Needs, op. cit., p. 69.
permitting a surplus to develop by 1980.9 The possibility of this out-
come is reinforced, they calculate, because it is based on experience in
the 1950's and 1960's when State and local revenues were estimated to
be somewhat more responsive to inflation than expenditures, thus giv-
ing a boost toward a surplus position.
Two other studies have concentrated on the role of municipal bond
demands in the capital markets, focusing on stresses and strains created
primarily by the financing needs of business. The study by Peter For-
tune on borrowing requirements to finance water pollution control
illuminates the potential demand which the pollution control bond
places upon the municipal bond market.'0 Fortune uses an econometric
model of State and local construction and borrowing demands to tie
additional capital requirements generated by the stiffening standards
of the water cleanup program to projected levels of GNP and other
investment determinants. Assuming a $2.5 trillion GNP by 1980, For-
tune predicts both higher capital outlays and borrowing levels than
those forecast by the tax foundation and Brookings analysts (although
as a percentage of GNP, the differences among estimates are not
drastic). The study is notable for the allowance for approximately $15
billion in tax-exempt pollution control bond demand over the last half
of the 1970's. (In 1980, such sales are estimated to account for a rela-
tively "modest" $2.2 billion in the total volume of tax-exempt sales
along with $2.5 billion in bond sales attributable to State and local
public plant and expenditure needs)."
The largest estimates of State and local borrowing needs in 1980
are contained in recent projections by Steven Taylor of capital mar-
ket stocks and flows for 1980 and 1985.12 Taylor's analysis, done in
1974. uses a national income real demand model to develop estimates
of credit flows on the basis of historical patterns. It posits municipal
bond sales at levels about 30 percent higher than those in the Brook-
ings study. Taylor's study. which does not explicitly relate State and
local expenditures to capital outlays, predicts a high. 12 percent an-
nual rate of increase in State and local net borrowing-greater than
that experienced in the 1960's. The Taylor study, like the Brookings
endeavor, assumes (rowing Federal surpluses and a high-investment
economy,' for capital spending and borrowing. It seems most real-
istic to forecost municipal bond borrowing nearer to $40 billion. This
has ramifications for the demand, in turn, on the capital markets.
B0ot h the Brookingas and Taylor studies project State and loyal bor-
rowin" needs as part of the total demand for capital in the economy.
Both, using somewhat different base years. call for a GNP of ap-
proximaltely $2.4 trillion by 1980. and both project generally higher
levels of private domestic, investment than those conceived in the
late 1960's and early 1970's. Perhaps most significant is the assump-
B lased on statilteal models, the Otts find forecasted state and local construction evpen-
diftirf- nre hold down by the pressure of inflation on interest rates (to which real capital
oxpenditure( are sensitive ; however. in dollar terms, they grow enough to offset the incts
of the higher cost of capital. State-Local Finances in the Last Ha~f of the 1970's (1975),
pp. 95 -98.
"The Ffinnelfal Tmpnet of the Water Pollution Control Act," op. cit.
11 Ibid., table 7.
SFinancial Background for Project Independence" (1974).
3 Ibid., pp. 15-16.
tion shared by both that the Federal Government will run surpluses
and, in the case of the Capital Needs study, ample ones. But the
studies vary considerably in their projections of capital market claims.
In reviewing the competition for credit, the Needs study makes the
major assumption that higher levels of business borrowing will be
largely offset by slower growth in State and local government debt
and a decline in the volume of publicly held Federal debt. Also fore-
seen is a growing role for depository institutions. Generally, the Needs
study is sanguine about the ability of the capital markets to absorb
State and local debt through the traditional source of demand, com-
mercial banks and people with high incomes.14 The Taylor study,
while projecting a much higher level of net municipal borrowing,
envisages a mixture of investors in municipals much as in 1970,
except that commercial bank holdings are supplanted by increased
holdings by individuals and, interestingly, by direct Federal loans. 5
1 Capital Needs, p. 69.
15 Taylor, Table 15.
Chapter VIII. POLICY OPTIONS TO IMPROVE THE
MUNICIPAL BOND MARKET
Preceding chapters have reviewed several changes in the municipal
bond market and a number of problems that attend them. Many con-
cerns are long standing-for example, those relating to the cyclical
nature of demand for tax-exempt bonds and the gyrations in their
rates of interest. Others are of relatively recent vintage-the soaring
use of tax exemption to finance nontraditional activities and the re-
appearance of apprehensions about municipal creditworthiness after
years of absence of doubt in the minds of investors.
Most problems in the municipal bond market have been the sub-
ject of professional and congressional discussion at one time or an-
other, and a host of solutions have been devised to moderate or
eliminate them. In this section, the problems of the tax-exempt bond
market are organized into broad groupings that are potential
targets for policy action. Briefly, such targets might be broadening
the market, improving the efficiency of the tax-exempt subsidy, im-
proving the tax equity of tax exemption, and lowering the cost of
borrowing for particular borrowers. Next, recent proposals for credit
assistance to State and local governments at a national level are re-
viewed. They are then discussed briefly in terms of this ability to meet
certain criteria, implicit or explicit, that have specified for Federal
involvement in the borrowing decisions of State and local governments.
BROADENING THE MARKET FOR STATE AND LOCAL SECURITIES
Many complaints about the tax-exempt market can be traced to
the nature of a market that relies heavily on a limited number of
institutional and individual investors with a limited appetite for a
long term, tax-exempt security. As a result, the supply of tax-exempt
bonds intermittently has outpaced demand, at which times the market
cannot be cleared except at higher rates of interest. At such times tax-
exempt rates rise relative to yields in other markets, tend to fluctuate
greatly, and occasionally, congestion occurs in the market.
There are several subarguments in this proposition. The major one
has to do with the peculiar attributes of tax exemption as a means
of attracting investor interest. Tax exemption, while it lowers the
cost of borrowing is of greatest benefit to investors in the highest
marginal tax brackets. By and large, investors in the highest margi-
nal tax brackets have only limited use for long term credit market
instruments. On the other hand, the bulk of long term money is ad-
vace(d by insurance companies, pension funds, and assorted thrift
institutions that are either untaxed or in relatively low marginal tax
ThWe is a limited supply of investible funds seeking tax exemption
at each rate of interest. As a result, municipial bonds must be priced
to yield progressively higher returns so that all the bonds outstanding
and coming on the market may find a buyer. Thus, when the supply
of bonds grows in relationship to funds seeking tax shelter, municipal
bond yields rise relative to other interest rates in order to appeal to
investors who are less in need of tax exemption. As interest rates on
municipal bonds approach those on alternative taxable investments,
the market is broadened in the sense that more investors can profit
from tax shelter. However, the smaller the savings from tax exemption
to the issuer, the greater is the return to the investor. The ultimate
extreme, of course, is when the supply of bonds so outdistances the de-
mand for tax shelter that tax exemption loses all value to issuers and
the tax-exempt and taxable bond market merge.1
The sign of a "good" municipal bond market from the standpoint
of borrowers in a low ratio of tax-exempt to taxable bond rates. Market
pressures have shown up in the municipal bond market in fluctuations
m the ratio of interest rates and, from time to time, in large volumes
of postponements caused by very high interest-rate bids, no bid, or
voluntary withdrawals of issues. Furthermore, as discussed above, the
ratio of tax-exempt to taxable bond rates is negatively associated with
high levels of investment by investors in high marginal tax brackets-
commercial banks and fire and casualty insurance companies. Con-
versely, participation on a large scale by the household sector has
typically been purchased by paying high interest rates and a resulting
relatively high ratio of rates.
The above discussion is a simplified presentation of some of the
many real-world factors which inhibit broader investor participation
in the municipal bond market. There are others. First, the municipal
market is broadest at the shortest end of the maturity spectrum, since
the ratio of tax-exempt to taxable yields is typically lowest in the debt
with shortest maturity and rises as the years to maturity lengthen..
This may reflect the preference of the high tax bracket institutional
investor for short term and relatively liquid securities. It also points
out that the benefits of near term tax shelter are fairly certain, but
that future benefits are speculative, depending upon the future tax
bracket of the holder. For individuals this can be a major reason for
demanding a higher yield than one's current tax bracket might imply;
much of the income on a bond held into the future may be taxed at
a lwer level as the investor passes beyond his peak earning period.
Another frequently cited constraint on the market for municipal
bonds is the diffusion and thinness of the secondary market.2 In part
this is attributable to the serial nature of most of the securities and the
comparatively large number of small issues, which make it difficult to
list securities and often impossible to establish continuous price quota-
tions for individual issues.
I Analytically, this relationship whereby the investor compares the after-tax yield
rt(1-tm), where tm is the marginal tax rate) on alternative taxable investments with
that available on tax-exempts, re, of like investment characteristics. Investors will continue
to purchase tax-exempts so long as the tax-exempt yield exceeds that available on com-
parable investments after taxes re > (1-tm)rt. When sufficient demand is forthcoming to
meet the supply of bonds, then for the market rate will equilibrate at rt (1-tm) re,
where tm is the marginal tax rate of investors who are at the point of indifference as to
whether they purchase a municipal or a taxable bond.
Very little has been written on the municipal secondary market, but see William
Staats, "The Secondary Market for State and Local Government Bonds," Vol. 8 Reappraisal
of the Federal Reserve Discount Mechanism ('1972), pp. 1-24.
It may be argued that such detractions could be remedied were- eco-
nomic incentives sufficient, but there are several institutional and
practical barriers to such a change. As a matter of fact, the serial
maturity-as opposed to the term bond structure used in the corporate
bond market-keeps the average maturity of municipal debt short
because banks prefer to buy shorter term tax-exempt bonds and are
willing to accept lower interest rates in exchange for greater liquidity.
On the other hand, designing bonds for long-liver projects for too
rapid a payback period and for too high a level of debt service can
seriously impair the borrowers' liquidity.
Additionally, certain aspects of the Tax Code as it applies to tax-
exempt bonds have been held to be prejudicial to a stronger market
for municipals. In particular, the prohibition against borrowing short-
term for investing in municipal bonds has been cited as contributing to
lack of speculative support for the tax-exempt market on downturns.3
The prohibition against open-end mutual funds being able to pass
through tax-exempt interest income to mutual fund investors has kept
financial intermediaries from supporting the market.' Unfavorable
legislation, later upheld by a U.S. Supreme Court decision, abolished
the practice of applying tax-exempt income against policyholder
reserves and succeeded in eliminating in the late 1950's what had been
the minor but growing interest of life insurance companies in munici-
As noted, certain tax changes have acted to stimulate some demand
for nmnicipal bonds.
While certain operational characteristics of the market might be
changed to reduce frictions in municipal bond transactions, few would
argue that this would tap any goTeat reservoir of new demand for tax-
exempts. Furthermore, as is discussed below, expansion of tax sub-
sidies. such as allowing more favorable tax treatment of interest costs
on funds borrowed to purchase municipals, has been resisted by the
Department of the Treasury. Thus, broadening the market signifi-
cantly, while maintaining a favorable ratio of interest rates between
taxable and tax-exempt securities, involves either tapping into some
major new source of demand for tax-exempt securities, reducing the
supply of tax-exempt bonds to allow the market to clear at a lower
interest rate, or a combination of both. A transfer of some portion of
State and local government borrowing to the larger, more stable tax-
able bond market could reduce the volume of bonds in the tax-exempt
market. This in turn could relieve the pressure of supply against de-
mand and lower interest rates on tax-exempt bonds relative to those
on taxable securities.
Another option. of course. is to "broaden" the market by simply
reducing the magmitude of the supply. This would involve limiting
tix-oxemption to a shorter list of allowable uses (most likely through
tighter restrictions in section 103 of the code) .
5 qeo Advisory Commission on Intergovernmental Relations, Federal Approaches to Aid
State and Lonal Capital Pinanoig (1970), p. 34 ; Life Insurance Company Tneome Tax Act
of 1959 (Public Law 8R-69).
r UTnited Statea v. Artas Life InRuranre Co. (381 U.S. 283 (1965)).
e This of course. has already been done in the prohibition of the bg-Issue industrial
rfvene bond and the arbitrage bond. The desire to limit supply Is also part of the
rationale behind recent moves to outlaw or curb the use of pollution control bonds.
Akin to efforts to broaden the market for State and local securities
is the desire to reduce the cyclical volatility of interest rates on
municipal bonds. As noted above, the ratio of rates tends to rise. in pe-
riods of stringent credit market conditions, when major institutional
support wanes. This is an indication of an over-reaction by tax-exempt
yields to changes in the interest rates in the larger, long-term taxable
securities market. The way to reduce the volatility of rates on new-
issue municipal bonds relative to those in the taxable area is to change
the composition of buyers to those who have a stronger natural inter-
est in long-term securities. But, as has been explained, these investors
have little or no interest in tax-exempt securities; hence, this sug-
gestion revolves around the transfer of State and local borrowing to the
taxable bond market.
Broadening and stabilizing the municipal bond market to provide an
increased flow of investible funds at generally lower and more stable
rates of interest is an objective advanced primarily on behalf of the
issuer of municipal bonds. But there are other-and intimately re-
lated-apprehensions about the efficiency and equity of the existing
method of subsidizing municipal bond sales through tax exemption,
which is discussed next.
EFFICIENCY OF THE SUBSIDY MECHANISM
A second major set of concerns arises over the efficiency of tax exemp-
tion as a method of assisting State and local governments. There are
several levels of sophistication to this argument. The first is that. for
better or worse, the tax-exemption of State and local governmental
interest payments cannot be viewed as a subsidy because it is beyond
the volition of the Federal Government to do much of anything about
it, at least as it applies to the essential money-raising functions of the
sovereign States and their subdivisions. Beyond the legal arguments
surrounding constitutional protections, it is clear that the economic
effect of tax-exemption is to lower the cost of borrowing for State :,nd
local governments. The exemption does cost somethin"-speciFically,
the avoided taxes-and, therefore, is fair game for analysis on efficiency
Before discussing benefits and costs of the present system, objections
to the prejudicial effect of tax-exemption upon the allocation of c.a pital
between the public and private sector and upon the use of capital versus
labor in the State and local sector should also be noted. Jideed. eco-
nomic theory holds that giving governments a preferential low cot of
capital tends to direct investment into public capital with a lower rate
of social return than capital in the higher-cost private sector. This has
the overall effect of lessening total productivity of the combined public
and private sectors."
Besides these broader objections, there is the policy question of how
efficient is the present subsidy and how might it be improved. The
efficiency problem revolves around the narrowness of the tax-exenipt
7 See David and Attiat Ott, "The Tqx Subsidy Through Exemption of Stnfe nd Local
Bond Tnterest," Tn Part 3: Tax, Subsidies in The Economics of Federal Subsidif Programw.,
Joint Economic Committee iJuly 1972), p. 305-316. The Otts roughly estimate that mis-
alloeatlon of capital in the state and local sector led to a reduction of income fromi tota9
capital stock of $100 million, which would equal 0.25 percent of total income from capital
in the period '1953-59.
market and what happens when, in order to sell bonds, tax-exempt rates
must be progressively raised relative to those on comparable taxable
securities. As rates rise to attract funds from taxpayers in lower
marginal brackets, tax benefits spill into the laps of investors in higher
marginal tax brackets and, at the same time, flow away from issuing
governments. This happens because the relatively fixed supply of funds
seeking tax shelter in municipal bonds at each taxable income level,
forces tax-exempt securities to be priced so that total investment de-
mand can absorb all of the bonds. From the standpoint of efficiency, it
is unfortunate that the municipal borrower-facing a competitive
market--cannot discriminate among buyers on the basis of their
marinal rates. Thus, investors who would be attracted at lower rates
still must be paid the higher rate of interest required to attract other
investors on the margin of indifference between buying a tax-exempt
bom( or some alternative investment.s
This suggests that tax exemption is less than totally efficient when
tax-exempt bonds are being sold at levels that make them attractive
to those in less than the highest marginal tax brackets. As a result,
there is a surplus of avoided Federal taxes that are not passed on to
the issuer of tax-exempt securitiesY
There have been numerous estimates of the efficiency of tax exemp-
tion., that is, the relative magrnitudes of the amount of tax revenues
forego ne by the Treasury and the amount by which State and local
o'ovei-nment interest costs are lowered.'0 Recent estimates suggest that
in fiscal 1976., of the approximately $4.8 billion in foregone Treasury
receipts, $3.5 billion was passed on to State and local borrowers in
reduced interest costs and $1.3 billion was retained by investors." Ex-
pressed as a ratio of interest savings to foregone tax revenues, this im-
plies a 0.73 efficiency.ratio.
Since interest savings and lost revenues are not directly observable,
they must be estimated and the estimates depend heavily upon basic
assiiptions on how the municipal bond market operates and the com-
1)(l1aabilitv of the tax-exempt security to other investments. First, it
1n1st be assumed that the Treasury loses an amount equal to taxes
investors would have 1)aid, were they to have invested in taxable in-
vestinicnts of essentially siia characteristics (usually assumed to be
a cororate taxable )onl). However. many believe that, because of its
poor secon(hlr market and other market characteristics of the tax-
exJinpt bond, these bonds carry higher interest rates than might other-
wise be expected2' To the extent that other tax shelters are available,
For example, when tax-exempt rates are at 80 percent of those on comparable taxable
y-ields, this leans that an investor in the 60 percent tax bracket is enjoying a before tax
re-turn equal to twice that which would he required to attract him to a tax-exempt
security. This happens because bonds are hMvlng to be i)riced to attract investors in the
'20 per ten t man rgia i I tax bracket.
State governments also frequently exempt interest income on their own municipal
bondsa !:d 1hose of their subdivisions (and, sometimes those of other States) from taxa-
Sion. Such exemptions face the same efficiency problems in terms of the benefits being
pased on to issuers. See Iluefner, Taxable Altcrnatives, pp. 170-171.
For a historical review, see It. Iiuefner, ibid., pp. 51-53.
.. "The Municipal Bond Alarket : Why It Needs Help," Congre8sional Record (Dec. 17,
1975), S. -2558.
0 For exam1inple, see Frank Morris, "The Case for Broadening the Financial Options Open
to State and Local Governments-Part 11, Financing State and Local Government8 (Sep-
to-mber 1 97() and .1avid Ott and Allen Meltzer, Fcdcral Tax Treatment of State and
investors in higher tax brackets would require higher taxable rates to
be attracted to fully taxable bonds than those involved in comparisons
of tax-exempt and taxable bonds. The effect of these arguments is
that the ratios used for comparison somewhat overstate the true ratio,
that the subsidy is more efficient than it appears.
Another key assumption concerns the marginal tax bracket' of cur-
rent municipal bondholders. By and large, this presents little problem
for institutional investors active in the tax-exempt market, but as noted
above, there are data gaps for individuals. Recent estimates place the
average marginal tax bracket at about 45 percent for all holders of
tax exempts. This, of course, is well above that implied by the histori-
cal 70-percent ratio of tax-exempt to taxable rates.3
An important point and one frequently lost in discussions of costs
and benefits of tax exemption is that the calculations of the amount of
tax avoidance and interest cost savings used for the entire stock of tax-
exempt debt outstanding cannot be applied to estimate results of in-
cremental changes in investor holdings as they move between tax-
exempt and taxable securities.4 Since this point and the assumptions
up on which it is based are important to understanding various pro-
posals to improve market efficiency, the reasoning will be examined
Estimates of the costs and benefits of tax exemption on the basis of
all debt outstanding differ from those based on incremental or mar-
ginal changes in outstanding debt. The main reason is that the average
of the marginal tax rates for all present holders of the outstanding
stock of municipal bonds (now 45 percent) is higher than the mar-
ginal tax rate of those investors who now find it just slightly more
advantageous to hold tax exempts rather than some form of taxable
investment (now 20 percent to 30 percent, depending on market condi-
tions and security characteristics). These marginal investors would
be those who would transfer their assets into taxable investments if
the taxable rate relative to the tax-exempt rate were to rise slightly.
Thus, the appropriate tax rate to apply in calculating changes in
Treasury revenues generated by switching from tax-exempt to tax-
able investments would be the average of the marginal tax rates of
those investors who are induced to make such a shift in their assets.'5
In addition, the tax-exempt bond market is likely to be least effi-
cient (the ratio of tax-exempt to taxable rates the highest) in times of
generally high interest rates and tight credit. As a coiisequence, the
level of tax avoidance is relatively greatest at the very time that the
actual borrowing cost is highest for States and localities. Thus, the
efficiency of the subsidy tends to fluctuate inversely with the degree to
13 From regulatory and survey information on holdings of municipal bonds, we can
identify the weighted average marginal tax bracket of holders of tax exempts, which is
approximately 0.45. Next we can solve for the implicit marginal tax bracket that equates
the historical series of tax-exempt and taxable yields (1-tm)rt--re; therefore,
14 See letter from J. Petersen and H. Galper to Congressman Henry Reuss in Housing and
Urban Development Legislation-1971, Hearings before the Committee on Banking and
Currency, U.S. House of Representatives, 92d Cong., 1st Sess. (September 1971), p. 852.
'1 For example: Were the ratio of tax-exempt to taxable bond yields to move from 0.75
to 0.65, the relevant marginal tax rate for estimating incremental revenues would be a
tax rate lying approximately midway between the rates that would equilibrate the two
yields. Such a movement in the yield ratio indicates an applicable marginal tax rate of
30 percent (because a rate of 25 percent would equilibrate the 0.75 ratio of tax-exempt
to taxable yields and one of 35 percent would equilibrate a 0.65 ratio.
which it must be used to attract marginal investors. Also, as reviewed
above, the ratio of tax-exempt to taxable rates tends to be highest and
efficiency lowest at the long end of the market when interest rates also
tend to be highest and where the future impact of current interest costs
will be of the longest duration.
In summary, the efficiency of tax exemption has been criticized be-
cause, on average, between 25 and 30 cents of every dollar of income
tax revenues foregone by Treasury is not passed on to State and local
borrowers, but is retained by high tax bracket investors. The efficiency
of tax exemption is lowest in times of tight money and in the long-
term end of the bond market, that is when the market is narrow and
the ratio of tax-exempt to taxable yields is high.
The cost to Treasury versus the benefits to State and local debtors
of incremental changes in the supply of tax exempts cannot be in-
ferred from the overall ratio of avoided taxes to reduced borrowing
costs for all bonds outstanding, but rather must be calculated on the
margin to those to whom tax-exemption is of the least value. This is
because both theory and observation indicate that it is those investors
at the margin-in the lower marginal brackets-that do the shifting
between tax-exempt and alternative taxable investments.
TmE TAX EQUITY EFFECTS OF TAx EXEMPrION
A major political argument against tax exemption has been its
effect on the equity of the income tax system. There are two facets to
this complaint: first, that the benefits of tax shelter are concenti ated
in the highest marginal tax brackets, reducing the effective progressiv-
ity of the income tax; and, second, that discriminates horizontally
among taxpayers in otherwise similar circumstances because it per-
mits one form of economic income to avoid taxes while others are
taxed. While these arguments occasionally crop up in discussions of
corporate tax treatment, for the most part they are directed toward
the high-income individual taxpayer.
As was discussed in a previous section on individual investors in tax
exempts, the bulk of interest income on State and local securities is
received by those individual taxpayers with the highest income, wealth,
and marginal income tax brackets. About 50 percent of tax-exempt in-
come is received by individual taxpayers with adjusted gross incomes
that exceed $50,000 and with marginal tax brackets ranging between
50 percent and 70 percent.
t is primarily because of the concentration of tax-exempt income
in the highest tax brackets that removal or significant reduction of tax
exemption has been an appealing tax reform measure to many and has
bee(1n proposed perennially.10 However, the spectacle of rich investors
who pauv no t;lxes becallse they clip tax-exempt. bond coupons, while
dagming t) the public's concept of tax exemption. is not accurate in
the case of rational investors. Practicallv all investorq in municipals
have some taxable income (that is why they are in high marginal tax
brackets!). They only seek out tax shelter income whei1 it renders a
TF-rn h:mtu11,cn1 dk cl|on of flbe rpreted assaults on the practice of tax-exemption.
4,e Iluefner, T'asable A iternatives, Chipter I.
higher return after tax than additional investment income from a tax-
The crux of the equity problem is not that the borrowing costs of
State and local govermnents are subsdized by the Federal Government,
but that they are subsidized through a progressive tax system that
increases the value of exempted income to those in highest marginal
tax brackets. Were tax exemption completely efficient in the sense that
each taxpayer accepted a reduced rate of return on tax-exempt securi-
ties that just matched his foregone Federal taxes, then tax exemption
would operate simply to transfer Federal payments directly from one
part of the taxpaying public (those that bought tax-exempt bonds) to
State and local borrowers, the intended beneficiaries of the subsidy.
However, as is true generally with tax deductions or income exclusions,
the value of the exclusion grows with the taxpayers marginal tax rate.
Since the supply of municipal bonds exceeds the volume of available
investment funds from the highest tax brackets, the level of tax-ex-
empt rates must be high enough, as we have seen, to attract lower tax-
bracket investors. Thus, investors in tax brackets above the marginal
rate that clears the municipal bond market-say, those above the 30
percent bracket--enjoy a surplus of tax-exempt income above that
which would just match the Federal taxes they would have to pay on
income from a taxable investment. Because the exemption means a loss
of tax revenues in excess of the value of the tax subsidy to borrowers,
it also means that taxpayers who do not purchase tax exempts must
subsidize those who do by making up the difference.
The real rub of tax exemption's effect on the progressivity of the
tax system does not revolve around the existence of tax-exempt in-
come or its receipt by a particular income group. Rather, the problem
is that taxes avoided exceed the lowered borrowing costs and that the
benefits of that excess are concentrated in the highest brackets and
increase in proportion to the level of the tax bracket.
This aspect of tax exemption's impact on equity is important because
it underscores a benefit of reforms that improve the efficiency of tax
exemption (by reducing the ratio of their rates to those on taxable
securities). The benefit is that such reforms will also reduce the amount
of tax shelter retained by investors and will increase the progressivity
of the tax system.
T he argument against the horizontal equity effects of tax exempts
is that within an income class, the exemption of interest discriminates
among taxpayers with different sources of income. This objection as-
surmes that the policy objective should be to subsidize the cost of capital
to State and local governments. It is relevant only to the extent that
there are barriers to individuals being able to invest in municipal
bonds or that the resulting dispersion in effective tax rates within a
given income class is inherently unfair. But aside from tax-exempt in-
vestment's requirement of a modicum of wealth-and a predictable
level of taxable income high enough to justify seeking tax shelter-
there seems to be nothing especially prejudiced about municipal bonds
from the standpoint of horizontal equity.
In summary, improving the equity effects of tax exemption is di-
rectly related to improving efficiency, so long as subsidizing the cost of
State and local borrowing is seen as desirable. Complete removal or
cuttingr back on the exemption through partial taxation or allocating
deductions against tax-exempt income brings greater progressivity to
the Federal tax system, but at the cost of increased borrowing costs for
State and local governments. To improve the tax equity of tax exemp-
tion while retaining benefits of lower borrowing costs for governments
requires a, method of transferring the Federal subsidy other than the
exemption of interest income.
IMPROVING MINIARKETABILITY AN D CREDITWORT1IInNESS
The target here is to lower the cost of capital or to make borrowing
possible for certain classes of borrowers. There are two problems that
policy might seek to overcome: (1) Removing barriers in the existing
marketplace that unfairly or inefficiently penalize certain borrowers, or
(2), if the market is already operating in an optimal fashion, then
changing its terms and conditions for certain borrowers. The latter
justification implies one of two things. Either the purpose for which
funds are to be borrowed is of high social priority deserving a sub-
sidy, or society should offset a lack of intrinsic creditworthiness in
the borrower by absorbing some or all of the risks normally left to
The municipal bond market, although dealing in governmental
securities, is a private market that rations private capital by matching
return versus risk. It is not surprising that borrowers who demon-
strate the least ability to repay are asked to pay the most. Until
recently, the trend in the market, because of the low historical inci-
dence of default in the state and local sector, has been to reduce in-
terest cost differentials among various quality classes of municipal
borrower.7 Still, there has remained a group of problem borrowers.
normally considered to be the very large cities or the very small local
As noted, many very large borrowers now must contend with credit
problems. In addition. there appear to be problems in the efficient
marketing of large and frequent issues because of the depressing in-
fluence of oversupply and a lack of bidding competition, especially in
times of tight money. Very small issuers also have problems, attribut-
able primarily to lack of borrower sophistication, a nonexistent second-
ary market, and the absence of economies of scale in the marketing of
small issues, and, occasionally, insufficient bidding competition. There
may also be a somewhat greater intrinsic credit risk for small issues.'8
Some states have taken active steps to assist smaller issuers in their
bond marketing practices. A prime example is the state bond bank that
bundles smaller issues in an effort to permit economies of scale and to
spread risk throughout a portfolio of underlying loans. Others have
gone a step further and revisedd sundry loan guarantee and insurance
programs for local borrowers. There are also private municipal bond
inlSurance pro 'aIms."
At the Federal level' assistance to problem borrowers raises the same
issues involved in any Federal program but are complicated by prob-
17 Forbes and Petersen, "Cost of Credit Erosion," p. 12.
1v'torsen, The Rating Gaie, pp. 132-135.
"#Ibid., 1Pp. 135-1.29.
lems discussed above in conjunction with tax exemption. Furthermore,
state and local governments have been leery of Federal aids that. bring
Federal participation in their financing decisions, unless there is ab-
solutely no alternative source.
Federal credit assistance can take several forms: Debt service sub-
sidies to lower effective interest cost to borrowers; direct loans at
subsidized levels; loan guarantees to assure payment in case of de-
fault; and loan insurance programs to which borrower or lender or
both contribute a premium.20 All have been used to assist State and
local borrowers at one time or another.
The use of credit assistance, while of obvious help to assisted units,
normally involves costs for unassisted borrowers-including the tax-
payer at large. First, there is the problem of "leapfrogging" borrow-
ers that normally would pay a higher cost to a preferred position by
virtue of subsidized loans or guarantees. This can place pressure on
other borrowers of superior credit quality to step down a notch in the
credit quality ladder and lower the cost of borrowing. Second, to the
extent that borrowers who would not borrow otherwise are given as-
sistance to do so, then pressure on the market increases and interest
rates for the remainder of the market go up. Insurance programs have
the drawback of being very expensive if the premium is based on true
risk or being a subsidy if they are not. And, since they too interpose a
reduced credit risk between borrower and lender, they can lead to the
leapfrogging phenomenon and operate to the relative disadvantage of
the unassisted borrower. Last, there is the traditional complaint that
insulation from the private market leads to a lack of fiscal discipline,
while inclusion in a Federal program leads to redtape, delay, and
Federal domination. But, direct loans, while they involve the maxi-
mum of involvement, also appear to be the most efficient and straight-
forward method of assistance.
Federal direct loans and, to a lesser extent, interest subsidies are
frequently frowned upon because they lead to budget outlays as op-
posed to various guarantee and insurance plans that can go off the
budget. The budget impact problem is frequently solved by creating
an off-the-budget agency and declaring its debt not that of the Fed-
These arguments against Federal credit assistance do not generally
preclude the desirability or necessity of such assistance in special cir-
cumstances that are clearly beyond the scope of the private market.
In fact, the arguments suggest the designing of special assistance pro-
grams to meet such cases as efficiently as possible to account fully for
the cost involved, and to have the least troublesome side effects for
RECENT PROPOSALS FOR FEDERAL CREDIT ASSISTANCE TO STATE AND
The last session of Congress, in grappling with the New York crisis,
brought forward many proposals to broaden and stabilize the munici-
pal bond market or to assist particularly hard-pressed local govern-
2 See Joint Economic Committee, Economics of Federal Subsidy Programs: A Staff Study
(January 19,72), pp. 31-35.
menth. As has been noted, these are two distinct, if interrelated, pur'
poses and the differences should be apreciated in the discussion of the
economic and political efficiency of such proposals.
State and local icsuers as a group traditionally have been wary of
Federal credit assistance. Their wariness springs from several sources:
a fear of undermining tax exemption, of becoming involved in redtape
and delays. and their desire to maintain autonomy as to borrowing and
capital outlay decisions. These views usually are shared by those who
niiderwrite and trade municipal securities, with the particular em-
pha~i.: that a private competitive market--one consisting of many
buyers and sellers-should be the centerpiece of the state and local
capital raising mechanism. These views have been cemented, there-
fore. around the preservation of the existing tax-exempt market and
the, subsidy it entails, which in almost any circumstances still provides
state and local borrowers with the maximum autonomy in decision-
nmaking and the lowest cost of capital in the financial markets.
The concerns of issuers, dealers, and investors were aroused in 1969
when Congress steered a course toward partially taxing municipal
bonds, in effect offering State and local governments a subsidized tax-
able bond in exchange. They were kept kindled in the subsequent 2
years when the administration and Congress begain proposing and. on
occasion, creating various new agencies and lending programs to fi-
nman,'e certain State and local activities. A perennial proposal was (and
continues to be) creation of a special agency, "Urbank," as it is usually
captioned, to provide direct loans to eligible governments who could
not find reasonable accommodation in the capital market.21 This led
to difficult questions as to eligibility, control of subsidy levels, and how
the a.rency might compete with conventional sources of capital.2- At
that time, there was a deep concern that the tax-exempt bond market
either would be swallowed up by a massive federally sponsored bank
or taken down in detail by an array of separate lending programs.
Furt]rmore, State and local governments were worried that hard
dollar grants would be replaced by soft loans on guarantees; in other
words, that Federal credit assistance would become a substitute for
Thus, in the early 1970's, with the market disruptions of tight money
and tax reform still fresh in memory and the developing threat of
IFoefle'al credit programs close at hand, various Interested parties-
i s1rs, induiistry, and academic-examined the relationship between
FaderI credit assistance and the traditional tax-exempt market. There
were differences in detail, but a consensus began to emerge that such
assB~flnce should be consistent with the following criteria:
1. Use of any Federal credit assistance programs by State and local
go verninent s should he entirely voluntary.
2. Such assistance should be free of Federal interference and inter-
vention in matters of State and local concern.
3. Such assistance should be simple, dependable, and free of delay.
ST'rbnk drivepq from the National Urban Development Bank proposed In 1968 by
Prr"4dnt Johnon'- Task Foree on Urban Problems. For a general description of the
mechanism, see Charles Teanr and Peter Lewis, "Where Shall the Money Come From ?" The
Pulh Interest (Winter 1970).
( Remarks by Senator William Proxmire, CongresRlonal Record (Feb. 22, 1972),
4. Such assistance should not be viewed as an alternative to Federal
grant assistance where the latter is appropriate and necessary.
These similar criteria were set forth by the National Governors'
Conference and supported by the National League of Cities, the
National Association of Counties, the Municipal Finance Officers Asso-
ciation, and the Securities Industry Association.3
Applying those criteria, the various groups began to focus on par-
ticular aid mechanisms. Cognizant of the difficulties of exclusive re-
liance on tax exemption and hostile to direct credit assistance, several
groups moved toward the proposition that a properly designed and ad-
ministered taxable bond option could meet those criteria. Approaching
the question from a defensive posture, many were agreed that it was at
least preferable to Federal taxation of traditional tax-exempt bonds
or to continuation of the proliferation of Federal lending programs.
Others were convinced that the option had strong positive advantages
in terms of lowering borrowing costs, increasing the efficiency of tax-
exemption, and providing stability to the market. The particulars of
the option's operation and its ability to meet various policy targets
have been discussed exhaustively elsewhere.24 In April 1973, the Treas-
ury introduced a taxable bond option as one of its tax reform pro-
posals of that year. However, soon thereafter attention began to shift
away from the option and the threat of Federal credit assistance
programs. The stream of special agency proposals receded and the
municipal bond market, while not without pressures, generally per-
formed well. Furthermore, opposition arose to the taxable bond option
idea, either on the grounds that it would not work, or if it did, that
the Federal Government-by intent or circumstance-would use an
option to entrap State and local governments and then would with-
draw tax exemption, leaving them at the mercy of the direct subsidy
In response to the fiscal problems of New York City and other
municipal borrowers, several, bills were proposed in 1975 to provide
a means by which States and localities could borrow, either to avoid
outright default or to improve their marketability and reduce their
interest costs. Such proposals can be divided into two groups: crea-
tion of a Federal Government agency designed to purchase, refinance
and remarket municipal debt instruments; and authorization of emer-
gency loan guarantees to State and local governments.
Despite certain mechanical differences, all of the proposals sought
to provide a bridge of stronger credit between the lender and the bor-
rower, thereby reducing the former's risk and the latter's cost of bor-
rowing. Most contemplated direct assistance and all called for direct
Federal assessment of the borrower's financial conduct.
23 See statements of the above cited groups in Federal Financing Aithority, he-arings
before Senate Committee on Banking, Housing, and Urban Affairs (May 15-17, 1972).
24The literature on the taxable bond is large and continues to grow. An intellectual and
political history of its development Is detailed in Robert Huefner, Taxable Alternatives;
the theoretical model of the subsidy Is developed rigorously and empirically by H. Galper
and J. Petersen, "An Analysis of Subsidy Plans"; an extensive discussion of its operation
and desiderata is found in Committee on Ways and Means, U.S. House of Representatives,
An Alternative to the Tax Exempt Bond: Panel No. 8 (Feb. 23, 1973) ; and extensive
quantitative analysis of the subsidy Impacts have been done in Peter Fortune, "The Im-
pact of Taxable Municipal Bonds: Policy Simulations With a Large Econometric Model,"
National Tax Journal (March 1973).
25See Grady L. Patterson, "The Case Against Tampering With Tax Exemption," Btlletin,
Municipal Finance Officers Association (January 1975).
As noted above, there are several potential problems with direct
assistance programs including the market impacts on unasisted bor-
rowers and the direct intervention of Federal authorities in setting
eligibility, terms and conditions of aid, and ensuring that the Fed-
eral loan or guarantee is adequately protected. While this level of
involvement was viewed as unfortunately necessary in the case of a
lender of last resort to one on the brink of default, it was not viewed
as desirable as a basis for assistance to State and local governments
Exhibiting a sensitivity to these reservations about direct Federal
credit assistance and looking for ways to revive the market as a whole,
first Treasury and then Senator Kennedy and Congressman Reuss
revived the taxable bond option.26
REDUCING TIE SUPPLY OF TAx-ExE-ir BONDS
With limitations on demand for tax-exempt securities, another way
to improve the market for them is to reduce the supply. Here too,
there is a Federal role; not by using the carrot of a subsidy to ac-
complish a transfer of debt to taxable status but rather the stick of
disallowing the use of tax exemption for certain purposes. The likely
targets are those industrial assistance bonds that have retained tax-
A major way to reduce the volume of tax-exempt debt is by amend-
ing section 103 to deny tax exemption for certain uses. Leading ex-
ainples of this in the past are the large issue industrial revenue bond
and arbitrage bonds. As was noted, the prohibition of industrial bonds
in 1969 was not complete. Several purposes are excepted from the pro-
hibition. including issues sold on behalf of corporations for pollution
control. Furthermore, conventional industrial development bonds are
permitted to be sold if they were below $5 million in size and met
certain other conditions. llese and other exceptions have grown
rapidly and the large volume of financing for such purposes in the
tax-exempt market has a depressing effect on that market.
Essentially all public interest groups and the Securities Industry
A.sso ciation'have adopted positions calling for the elimination or at
least a m ajor cutback of the pollution control bond and its replace-
1)wit by a more efficient subsidy vehicle. Other uses of tax-exemption
have been publicly criticized from time to time, especially advanced
refunding bonds, which can lead to a multiplication of outstanding
tax-exeml)t debt for a particular project.2
li sulmary the restriction of the supply of tax-exempt debt helps
h l()se borrowers and users that remain In that market, simply because
the value of tax eXem)tion is less diluted.
BY the same token, credit assistance plans, either specific or gen-
eral. that increase the sul)ply of tax-exempt bonds without in some
wUy inllcasing dlemlafld for them will lead to higher rates, relatively,
in that market.
I The Kennedy-Reuss bill was jointly introduced in December 1975 as 5. 2800 and M.R.
11214. Iharings on the House proposal were held Jan. 21, 22, and 23, 1976, by the House
Conllittee on Ways and Means.
Leinnx Moak, Outline of Statement, testimony before the Joint Economic Committee,
!!ctlr'igs on the Fi'nancial Condition of Cities (June 20, 1975).
Chapter IX. CONCLUSION AND POSTSCRIPT
At the outset of 1976, the municipal bond market was faced with an
inordinate number of uncertainties. It also was the object of an un-
accustomed amount of public attention. Much of the commotion was
the result of the recurring New York City financing crises of the
previous year-the lessons of which many hurriedly were attempting
to learn and apply elsewhere. But there were other, deeper anxieties.
These grew out of complex and often confusing arguments over the
appropriate size and future capacity of the tax-exempt market and
over the extent of involvement of the Federal Government in the
borrowing decisions of States and localities.
In January, the Ways and Means Committee of the House of Rep-
resentatives held hearings on the taxable bond option proposal spon-
sored by Senator Edward M. Kennedy and Congressman Henry
Reuss. Testifying in support of the taxable bond option were the
U.S. Treasury, the American Bankers Association, various tax re-
form groups, and the National League of Cities and U.S. Conference
of Mayors. While the mayors and cities favored the plan, the other
State and local organizations looked on apprehensively. Their earlier
opposition to the idea had obviously softened, as they became more
convinced of the economic logic of the option and more worried about
the future capacity of the traditional market. But, many still were
hesitant to embrace Federal participation in the marketing of mu-
nicipal securities which a direct subsidy payment would require.
Others continued in staunch opposition.' In light of the changing
mood of the intended beneficiaries of the taxable bond option reform,
it appeared likely that the option would be reported by the Ways
and Means Committee and might possibly have its market-broadening
promises tested before the year was out.
On other fronts, however, the State and local governments defi-
nitely were on the defensive. In December 1975, the House and
Senate passed differing versions of the municipal bankruptcy amend-
ments. The rush to amend the Federal bankruptcy statutes came in
response to the New York City crisis, and the obvious impracticability
of existing bankruptcy procedures. Although the administration-spon-
sored legislation had been aimed at New York City, the scope of the
bill, as it raced through Congress, was expanded to include all local
governments. But, these governments and the municipal bond indus-
try steadfastly opposed the new bankruptcy legislation. There was
a storm of protest both from Government officials and bond dealers
who thought that the integrity of their credit and merchandise, re-
spectively, was being unfairly impugned by the bankruptcy amend-
ments. The bankruptcy bills bogged down in conference in December.
The Treasury Department, desirous of having the bill pass, under
1 See statements before U.S. House Ways and Means Committee, "H earings on Proposals
Relating to Tax-Exempt Bonds" (Jan. 21-23, 1976).
pressure from issuers and aware of adverse market reaction, suc-
cessfully lobbied the conference committee to have the eligibility pro-
X isions of the bill stiffened. This unusual procedure was an effort to
reassure investors that getting out from "under" governmental debt
obligations would be neither an easy nor a commonplace event.2
Methods of reducing the supply of tax-exempt securities-other
than the optional substitution of taxable for tax-exempt securities-
were also being explored. Several of those who testified on the tax-
able bond option before the Ways and Means Committee pointed out
that removal of the pollution control bond would ease supply pres-
sures in the municipal bond market." Furthermore, the Internal Rev-
enue Service moved to curtail the use of tax-exempt securities by not-
for-profit corporations. Under existing regulations, such entities may
issue tax-exempt bonds on behalf of governmental units even though
they themselves do not possess governmental powers. The newly
proposed regulations impose stricter requirements on the relationship
of such authorities to governmental units and, thereby, restrict tax-
exempt financing by private, not-for-profit corporations. The new reg-
ulations would require large scale and, perhaps in some cases, impos-
sible statutory revisions of the structures of many industrial
development, educational, and health and hospital authorities. Thus,
their publication stirred strong protests from the affected parties.
Nowhere were the repercussions of the New York trauma more visi-
ble than in the new-found sensitivity of bond dealers and investors to
municipal credit quality and how information about credit quality
should be disclosed. Throughout the fall of 1975, as the extent both of
New York's budget gimmickry and the fiscal difficulties of other large
cities became evident, the municipal bond market became increasingly
anxious about the level and quality of credit information. This was
heightened by dealers' recognition that they were subject to the anti-
fraud provisions of the Federal securities laws. While State and local
issuers, and other market participants, also had responsibilities for
disclosure, they were not subject to direct regulation of the Securities
and Exchange Commission. A major problem, ironically, was that
there were no clear precedents regarding fraud by issuers; neither
court decisions nor SEC actions had defined the responsibilities and
liabilities of underwriters, issuers, and other participants under the
securities laws. The filing of lawsuits in August by aggrieved New
York City bond purchasers, broad allegations of fraudulent behavior
from various congressional and SEC sources, and the inclusion of
dealers under Federal securities regulation in December served to
exacerbate the tensions.
Although the market continued to function at a record-setting vol-
utile, several postponements of planned offerings did occur because
2 "Report Agreement on Changes in Municipal Bankruptcy Bill," The Daily Bond Buyer
(Feb. 19, 1976), p. 1.
As the Public Finance Division of the Securities Tndustry Aqsociation expressed It:
"This committee can act to reduce municipal borrowing costs and increase the efficiency
of the tax-exempt market by returning the market to exclusive use of public state mid
local governmental issuers. We ask this committee to eliminate private pollution control
and industrial development financing from the tax-exempt market." Statement before the
Ways and Means Committee (Jan. 21, 1976), p. 5. See also at the same hearings, the
statements of the Municipal Finance Officers Association (Jan. 22, 1976), and the Tax
Foundation (Jan. 23, 1976).
Department of the Treasury, "Interest Upon Obligations of States, Territories, Etc."
Federal Register (Feb. 2, 1976), p. 4829.
of disclosure or credit problems. Underwriters asked for large profit
spreads as insurance against uncertainties, and bond issuers saw
fewer bids or an insistence by underwriters upon negotiated offerings.
To add to the torment, New York State as part of the New York City
"solution" in November, passed a moratorium law that forced holders
of $1.6 billion in maturing New York City notes to swap or extend
these securities. In January, the SEC took the highly unusual step
of announcing an investigation of New York City for possible viola-
tions of the Securities Acts.5
The following month, the Securities Subcommittee of the Senate
Banking Committee held three days of hearings on measures to bring
the issuance of municipal bonds within the regulatory skein of the
SEC. The proposal that got the most attention, Senator Harrison
Williams' Municipal Securities Full Disclosure Act, S. 2969, called
for issues of $5 million or more to meet disclosure standards at the
time of sale along lines drawn by the Commission. Similarly, issuers
with more than $50 million in debt outstanding would have to make
audited annual reports. Accounting standards for the area would be
set by the SEC.
Reactions to the regulation plan varied, but from the governmental
issuers there was distress over the cost and controls of regulation and
concern about the unresolved questions of legal liability. However, it
was clear that more information, whether by market forces or govern-
ment fiat, would be forthcoming in the municipal bond market.
5 SEC press release, Jan. 17, 1976.
UNIVERSITY OF FLORIDA
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