The Regulatory Future of Municipal Financial Processes

The Regulatory Future of Municipal Financial Processes

Recent market turmoil has wreaked havoc on not only the individual mortgagee but on the finance market as collective mortgagor – and the result has been massive write-downs, losses, and uncertainty affecting every party involved - be it downgraded insurance companies, banks with unprecedented demands on their capital due to unforeseen exposures, and trending tightening credits, and certainly municipalities and non profits holding unsalable securities, and in some cases even becoming insolvent.

While many solutions have been suggested post-crisis, what remains omnipresent at all steps of any financial process is regulation. These solutions involve corrective actions such as Federal Reserve led bank mergers, the restructuring of current insurance agencies in order to liquidate ‘bad debt,’ and of course a brand new spurt of regulatory reform. However, what remains indisputable is that every time we witness a market meltdown or a municipality declaring insolvency, despite all the various modes of corrective action mentioned above, it happens again. Clearly then, all previous corrective action has been inadequate, particularly as applies to municipalities and public debt issuers. What can be said of economic crises, is that so far the root causes have varied greatly - from post-war optimism, to the sub-prime mortgage collapse. However, the same cannot be said of failed municipal debt issuers. Over the years, while many municipalities have defaulted on debt or even declared bankruptcy, the root causes for their financial demise are very similar - the transactional parties, the regulatory parties, and the transactional and regulatory processes have remained much the same since 1913.
This study focuses specifically on regulation governing the conduct of various parties within the framework of a municipal debt issuance; with particular emphasis on outcome and objectives based regulation tying incentives to performance and behavior. Furthermore, regulation has historically focused on back-end processes of debt issuance, i.e. regulation applying to parties participating, and transactions occurring, in the latter end of the debt issuance process such as lending institutions, conduit parties, insurance companies, rating agencies etc. This study posits that outcomes based regulation focusing on the front end of the debt issuance process, i.e. such that governs the actions of the municipality issuing debt, is more cost-effective, easily regulated, and provides more accountability, stability, and predictability to the municipal debt market.

The current regulatory framework for financial institutions is based on a structure that developed many years ago. The regulatory basis for depository institutions evolved gradually in response to a series of financial crises and other important social, economic, and political events: Congress established the national bank charter in 1863 during the Civil War, the Federal Reserve System in 1913 in response to various episodes of financial instability, and the federal deposit insurance system and specialized insured depository charters (e.g., thrifts and credit unions) during the Great Depression. Changes were made to the regulatory system for insured depository institutions in the intervening years in response to other financial crises (e.g., the thrift crises of the 1980s) or as enhancements (e.g., the Gramm-Leach-Bliley Act of 1999 (“GLB Act”)); but, for the most part the underlying structure resembles what existed in the 1930s. Similarly, the bifurcation between securities and futures regulation, was largely established over 70 years ago when the two industries were clearly distinct. In addition to the federal role for financial institution regulation, the tradition of federalism preserved a role for state authorities in certain markets. This is especially true in the insurance market, which states have regulated with limited federal involvement for over 135 years. However, state authority over depository institutions and securities companies has diminished over the years. In some cases there is a cooperative arrangement between federal and state officials, while in other cases tensions remain as to the level of state authority. In contrast, futures are regulated solely at the federal level.

In response, and perhaps somewhat concurrently to the current sub-prime mortgage crisis, the U.S. Treasury presented a conceptual model for an “‘optimal’ regulatory framework.” The new ‘Blueprint for Reform; argues that
This structure, an objectives-based regulatory approach, with a distinct regulator focused on one of three objectives—market stability regulation, safety and soundness regulation associated with government guarantees, and business conduct regulation—can better react to the pace of market developments and encourage innovation and entrepreneurialism within a context of enhanced regulation. This model is intended to begin a discussion about rethinking the current regulatory structure and its goals. It is not intended to be viewed as altering regulatory authorities within the current regulatory framework. Treasury views the presentation of a tangible model for an optimal structure as essential to its mission to promote economic growth and stability and fully recognizes that this is a first step on a long path to reforming financial services regulation.
Thus, even now, the Treasury is reluctant to “alter… regulatory authorities within the current regulatory framework.” It does though, propose to link regulatory action to “objectives” and “goals.” This change in thought is remarkable considering that the parties involved in municipal debt issuance – the debt issuer, the financial advisor, the rating agency, the insurance agency, the lending institution, the legal expert, - the role of each party, and the process by which debt is issued has remained largely the same for the last century. What follows is a discussion of the regulatory framework within which each involved party currently operates.


In the U.S. marketplace, there is a complex regulatory framework of federal, state and local laws that are designed to protect the interests of investors and bring about stability in the marketplace. However, it must be ensured that these regulations do not impede the efficiency of the marketplaces and allow foreign competitors in the global market to surpass the United States of America as the international capital of the financial world.
The municipal bond market is facilitated by several key players. The key participants are the issuers, bond insurers, financial advisors, bond counsel, ratings agencies and the investment banks. Each of these participants has a specific role in the municipal bond market and all must adhere to regulations or professional standards that control their actions.

The issuers of tax-exempt debt are governments, authorities, and 501(c)(3) organizations. These issuers of tax-exempt debt are required to meet the requirements stated in the IRS tax code to ensure that these securities retain their tax-exempt status. State and local governments are also required to comply with the principles prescribed by the Governmental Accounting Standards Board (GASB) regarding internal accounting processes as well as financial reporting. These principles seek to create a uniform and transparent way to evaluate the financial health of the governmental entity. State and local governments must also follow statutory requirements that control their public financial activities. There are concerns that despite the existing controls, governments are increasingly entering into complicated synthetic financial agreements such as interest swaps and caps. These instruments are a useful tool that can be used by the issuer to obtain lower debt service costs, lock-in lower interest rates and decrease debt service volatility. However, the outcome of these agreements can prove to be a costly mistake for unsophisticated investors who do not seek independent advice regarding the suitability of the agreement given unfavorable market conditions. When unsophisticated insurers enter into these agreements, they can prove to be costly mistakes that are not appropriate for their specific situation. It is often hard to predict the actual payments they can expect to be making on a semi-annual basis. There are also stiff financial penalties to prematurely terminate these swap agreements. There is the additional counterparty risk that has become more of an issue due to the current financial crisis many of the nation’s leading banks are in. Finally, since leverage is often used, small price changes are multiplied; resulting in large gains or loses for the counterparties.

The bond insurance market serves an important purpose; it lowers debt service costs for issuers and gives the investors added security. In the business of bond insurance, there are two parties that comprise the policy holders. On one side there are the governments that purchased the insurance and the investors who purchased the bonds. On the other side are the banks that purchase insurance for their structured products such as mortgage-backed securities. Insurance regulators are supposed to protect the interests of the policy holders by ensuring that the market for insurance productions is functioning in an efficient and a competitive manner. In the United States, regulation of the insurance industry is highly balkanized, with primary responsibility assumed by individual state insurance departments. Whereas insurance companies and markets have become centralized nationally and internationally, state insurance commissioners operate individually, though at times in concert through a national insurance commissioners' organization. In recent years, some have called for a dual state and federal regulatory system for insurance similar to that which oversees state banks and national banks. The New York State Insurance Department (NYSID) is currently the main regulator of most of the insurance companies in the municipal bond market. The State of Wisconsin is the primary regulator for Ambac, however they are headquartered in NYC. The State of Maryland is the primary regulator for Assured Guaranty, but its main office is in mid-town Manhattan. The NYSID has licensed Ambac as well as Assured to conduct business in New York.

The downgrading of bond insurers has lowered the value of bond insurance and increased the scrutiny of the underlying rating of the securities they insure. The lower ratings are a result of the losses these insurers have sustained from structured products such as CDOs and mortgage back securities. The insurance policies that these insurers were marketing did not accurately account for the risk associated with these complex investments. To date, the insurance market has not determined an appropriate way to calculate the default risks of these investments. The bond insurers are going to have to figure out a way to accurately assess the risk involved with these complex investment vehicles. If they are unable to accomplish this, it may be in their best interests to no longer back these risky complex securitized assets. The ripple effect of the bond insurance company downgrades has increased the borrowing costs in the significantly less risky municipal bond market. Most issuers use bond insurance in this market to lower their costs and increase the number of available buyers since some investors can only invest in Triple-A securities. To help prevent a massive bond insurance meltdown, New York State is thinking of barring bond insurers from backing CDO squared bonds:
The CDO squared bonds are made up of middle or mezzanine tranches of the CDO asset-backed securities and are also sold in tranches. A CDO squared groups these tranches together on the theory that the risk that all of them will default is small and so by pooling a large amount of these riskier loans into a small tranche, that tranche can be highly rated. At this point there have been two levels of tranching, and it becomes much more difficult to accurately determine the risk of these securities. The real problem is not the insurance, but the fact that the policies are not accurately priced to take into account the risk involved. If the structured product’s credit rating is accurate then the insurance model will allow the company to accurately price the insurance. If the price of insurance is too high, the product is probably not a very good investment. Until the ratings agencies figure out a way to accurately evaluate risk of these complex products, insurance companies need to do their own independent analysis of the product they are insuring. Otherwise they will continue to record huge losses on their structured products business and in turn upset the municipal bond business.

Financial Advisors are responsible for providing the issuers with complete, accurate and unbiased information. To avoid conflicts of interest, the advisor should be independent from the investment bank that is underwriting the deal. They should also be compensated without regard to the outcome decided by their client. The Financial Advisor should also be knowledgeable about the specific product or financial agreement that their client is engaging in. An Advisor who is only familiar with new issues is likely to be able to provide competent advice regarding a complex derivative transaction. It is also the Financial Advisor’s obligation to make sure the underwriter fully discloses all information that is material to their client’s decision making process. Financial Advisors fall under the regulation of The Financial Industry Regulatory Authority (FINRA). FINRA a non-governmental regulator is oversees the securities industry in the United States. FINRA was formed in July of 2007 and is charged with protecting the interests of investors and preserving market efficiency and integrity. They are also subject to federal, state and local laws. Financial Advisors also required to register with the state or the SEC “if they are compensated for determining specific recommendations, providing specific recommendations and advice on investments, managing client portfolios and accounts, and/or offering or negotiating the sale of investment advisory services.” Advisors are often members of larger advisory firms which are required to be registered as well. “Investment advisory firms must register with either the U.S. Securities and Exchange Commission (SEC) or the states. Larger firms with more assets under management register with the SEC. A firm ‘may’ register with the SEC, if they manage greater than $25 million in client assets, but they ‘must’ register if the total exceeds $30 million.”

The bond counsel is responsible for providing the legal opinion that confirms that the government entity has the authority to issued municipal securities. They also confirm that the issuer meets the IRS requirements that allow the interest to be exempted from taxation. The bond counsel also makes sure any other material information that is required to be disclosed to investors has been disclosed in the legal opinion. The bond counsel is subject to the professional standards of the applicable state bar association as well as the IRS tax code.

The credit rating agencies are responsible for evaluating and then assigning a rating to governments as well as to the securities they issue. The rating that a governmental body receives has a significant impact on the debt service costs that they can expect to pay in the marketplace. The market has recently become critical of the way these agencies have evaluated bond insurers and the complex securities they backed. If the market loses faith in the accuracy of these ratings, this could make the market less efficient. Most investors would spend more time and money to research issuers on their own rather than quickly purchasing bonds that have a certain credit rating. It would also be harder for small issuers with limited history in the market place to be able to issue large amounts of debt. The credit rating agencies should avoid assigning ratings to products that they truly do not understand. This practice upsets the market as the true risk has not been priced into the investment. The unexpected defaults can send shocks through the marketplace and cause investors in unrelated products to question the value of the entire rating system as we have seen in the case of the bond market. The shortcomings of the current rating system have been addressed by a 2002 SEC report called the Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets. It detailed how ratings are used by U.S. regulators and the concerns it creates. The International Organization of Securities Commissions (IOSCO) created a code of conduct in December of 2004 to deal with the conflicts of interest that are encountered by the credit rating agencies.

The Investment Banks are under the regulation of the Municipal Securities Rulemaking Board as well as FINRA. The SEC’s Division of Trading and Markets monitors the self-regulatory organizations like FINRA and MSRB. The bankers underwrite the new securities for their clients; they determine the price and the yields based on the current market conditions. On a new issue, the difference between the price that the underwriter pays to the issuer and the price sold to the investors is spread or profit for the bank. The banks also make a significant amount of profit from synthetic products such as interest rate caps and swaps. There are fees to enter into these agreements as well as fees associated with terminating these agreements. Public finance bankers are in a for-profit business even though their clients are often non-profits. They are trying to sell a variety of financial solutions to meet the varying needs of their client base. From an ethical standpoint, the bankers should only be marketing solutions that are suitable for their clients. This is not always the case and that is why it is important for clients to have their own independent advisors. There is also the issue with bankers not fully disclosing their fees to their clients. In this case, the seller often has a significant advantage because this is their profession and they have access to current market data that dictates the terms offered to the buyer. The issuer should only enter into a business agreement with an investment bank once they fully understand the risks and the benefits involved in the transaction. We have seen in the case of Pennsylvania where this was not the case and school districts engaged in complex interest-rate swaps and ended up losing significant amounts of money. There have also been a number of lawsuits against investment banks regarding these complex financial agreements, many clients argued that these products were unsuitable and that the banks did not properly disclose the risks involved.

Several mature markets have adopted more efficient regulatory structures to adapt to the new challenges faced by today’s securities markets. The United Kingdom reviewed their financial services regulatory framework and decided to create a tri-party system. This structure includes the central bank (Bank of England), the finance ministry, and the national financial regulatory agency for all financial services (Financial Services Authority). Each party has a specific, complementary role and it is widely felt that this system has improved the competitiveness of the economy in the U.K. Australia and the Netherlands meanwhile have adopted what is known as the “Twin Peaks” model of regulation. This system focuses on the objective-based regulatory approach. One financial regulatory agency is responsible for prudential regulation of relevant financial institutions, and a separate regulatory agency is responsible for business conduct and consumer protection issues. Globalization of the capital markets has been a significant development. Foreign economies are maturing into market-based economies, contributing to global economic growth and stability and providing a deep and liquid source of capital outside of the United States. At the same time, the increasing interconnectedness of the global capital markets poses new challenges; a major shock in one economy can send waves throughout the entire world economy. A strong and prudent regulatory system can help shield the U.S. from these potential financial threats.


Having kept him in office for 24 years, the voters of Orange County had every reason to believe County Treasurer Bob Citron was a capable, experienced financial manager. In 1994, the Orange County Investment Pool had $7.6 billion in deposits from the county government and almost 200 local public agencies (Orange County cities, school districts, and special districts) many of whom voluntarily joined, attracted by the high interest rates Citron realized and aggressively advertised. His strategy was to use the funds on deposit to borrow money to invest in derivatives, inverse floaters, and long-term bonds that paid high yields. In FY94, return on investment amounted to 12 percent of revenue for Orange County. The size of the pool increased to $20.6 billion as he borrowed $2 for every $1 on deposit. In essence, as The Wall Street Journal noted, he was "borrowing short to go long" and investing the dollars in exotic securities whose yields were inversely related to interest rates. Unfortunately, also in 1994, the Federal Reserve Board began and kept on raising interest rates and Citron kept buying securities in the desperate belief that what went up must come down. No one paid attention until the walls began to crumble. In November, auditors told county officials that Citron had lost about $1.64 billion. In early December, the supervisors realized that the county did not have the cash to withstand a run on the money by Wall Street lenders and the local-government pool depositors and asked for Citron’s resignation. As the county unsuccessfully tried to sell off the risky securities, the lenders threatened to seize the county pool securities they held as collateral. After the first bank took this action, the county government declared bankruptcy on December 6, 1994.

In the aftermath, the County choose to liquefy its falling assets and lock in its $1.6 billion loss rather than risk further losses. Thought it would get some of these losses back in form of a legal settlement with Merrill Lynch and other broker dealers and advisors, it was a far cry from their actual losses.
1. Bob Citron’s actions, while meant to be overseen, were not overseen or vetted by anyone else in the county.
2. Absence of/ misaligned incentives: Bob Citron, though not corrupt of gaining financially from his misdeeds did not act in the best interest of the county.
3. Interest linked securities which were not fully understood were used as a speculative tool in lieu of being used as an instrument to hedge and balance out the current asset/liability mix of the investment pool.
Corrective Actions:
1. Bob Citron was forced to resign and faced public humiliation as well as the prospect of criminal charges.
2. Orange County sued Merrill Lynch (the suit settled).
3. Orange County declared bankruptcy having realized the paper loss by liquidating its assets.

1. Contract an independent financial advisor, even if one’s staff is financially sophisticated.
2. If the organizational structure, planning and risk oversight mechanisms of an institution are fractured, it is easy for powerful individuals to hide risk in the gaps. Risk reporting should be complete, and easily comprehensible to independent professionals. Strategies that are not possible to explain to third parties should not be employed by the risk averse.
3. Restrict use of interest rate swaps as a hedging tool instead of a speculative tool to increase yield on principal: Borrowing short and investing long means liquidity risk, as every bank knows.

The Washington Public Power Supply System (WPPSS), a municipal corporation and joint operating agency of Washington State originally consisted of a group of publicly owned utilities. In July 1983, WPPSS defaulted on $2.25 billion of municipal revenue bonds making it the largest municipal default in US history. This crisis, less the result of fraud than misjudgment, has come to be known as the “Whoops” fiasco. In the midst of the energy crisis of the 1970’s, with energy prices expected to skyrocket in the Pacific Northwest, WPPSS approved the construction of five new nuclear power facilities. Prior to the approval of the construction of these facilities, WPPSS, was made up largely of smaller hydo-electric power generating facilities. Though it had no experience in nuclear power, a seemingly limitless access to the bond market made construction a possibility. When construction began on the five nuclear power plants in the 1970s, the estimated cost was approximately $7 billion. By 1981, the estimated completion cost was in excess of $23 billion. The second problem was that steep declines in the demand and price of energy following the various recessions and energy crisis of the 1970’s and early 80’s resulted in lower revenue projections for the power plants. This made the ability to raise further cash impossible and brought into question the ability of WPPSS to pay back its existing debt. After a financial review was performed in 1980, it became clear that $3 billion more was needed to keep the project alive. When the possibility of this was deemed impossible, the structure started to collapse. Originally, to finance plants 4 and 5, WPPSS sold all of the generating capacity to 88 municipal corporations or cooperatives. The construction was then financed by bonds sold by WPPSS which were guaranteed by the “take-or-pay” contracts with the 88 municipalities. Therefore, when the construction of plants 4 and 5 were halted in 1982, there was outrage at the prospect of paying off bonds in the form of several decades worth of higher electricity bills without any return on investment.

In June 1983, Washington State Supreme Court ruled that 28 of the 88 participants in WPPSS nuclear power plant projects 4 and 5 did not have the legal authority to enter into take-or-pay contracts. This in effect rendered the bond contracts, null and void, leaving WPPSS without the means of servicing the $2.25 billion in debt that had been issued for these projects. One month later, WPPSS would default on the bonds for plants 4 and 5 for the complete amount of $2.25 billion making it the largest municipal default in US history. Though $750 million was recovered though class action litigation several years later, many investors still lost more than 75 percent of their investment.
1. Project overruns caused the cost to balloon to three times the original estimate while revenue was over-projected.
2. The borrowers entered into illegal bond agreements which the court allowed them to default on.
3. A lack of transparency allowed cost overruns to go unchecked as the market overextended credit to the projects as costs ballooned.
Corrective Actions:
1. WPPSS suffered severe losses and defaulted on its debt obligations
2. Several lawsuits were initiated where 28 counties were declared unobligated to pay due to extra-legal contracts.

1. This crisis encouraged the passage of SEC Rule 15c2-12, which mandated increased reporting standards and transparency.
2. Increase standards for notification relating to adverse events or downgrades debt quality.

In 1996, a Federal court ordered Jefferson County, Alabama to upgrade its aging and polluting waster water facilities. The county estimated the cost of upgrades and environmental improvements to be $1.2 billion. Twelve years later, outstanding debt related to the sewer project has exploded to $3.2 billion with costs quickly on the rise. The county issued new debt for the sewer project in 1996, 1999 and 2001, increasing sewer related debt to $1.8 billion. In 2002, the county took another large step into the debt market by issuing an additional $1 billion of new debt, bringing its total outstanding sewer debt to approximately $2.8 billion. In 2002 and 2003 Jefferson County began down the road to insolvency when it refinanced nearly all of its existing debt. It was at this point that it entered into the auction rate and swap markets to squeeze out interest rate savings. While these tools can be used to build a sound portfolio and reduce overall interest payments, the county went full tilt. Moody’s Investors Service would comment that no municipal government would dig itself so deeply into swaps as Jefferson County. In 2003, after the county completed its last sewer refinancing, its traditional to synthetic fixed debt ratio was 1:14.

Currently, the county’s total sewer debt is $3.2 billion and total long-term debt is $4.6 billion. The county’s total notional value in swaps – all of them connected to sewer debt is $5.4 billion. Two features that made these series of refinancing and swaps unique are that the 2002 and 2003 series of refinancing occurred less than nine months after the initial issuance. Second, the refinancing changed annual debt service in ways that appear to lower tax payer costs in the short term while increasing them in the long term – giving the appearance that they were done for political expediency. Giving further credence to this idea is that the lead investment banking on the refinancing the lead banking on the refinancing served a three month prison sentence in connection with a municipal corruption case in Philadelphia. There is also further evidence that the deals went to firms with political connections to county officials. Jefferson County’s overexposure to the swap market would become heightened when the subprime mortgage crisis spread through the US financial markets. Starting with bond insurers having their ratings cut to the failure of auction rate securities. Jefferson County found itself dangerously overexposed to complicated and high-risk financial instruments. As a result, the County had its sewer bonds downgraded from investment grade to junk status. The county is currently renegotiating its debt schedule with Wall Street creditors to soften the terms of deals and allow them to avoid bankruptcy.

1. Government officials dealt primarily with bankers and organizations which they had prior relationships.
2. There was a lack of independent professional management verifying that the transactions were in the best interest of the county.
3. It is not clear if the government officials were actually aware of the full risks which they faced through their swap agreements or not, but they clearly took on more risk than the city’s financial structure would allow for given adverse events which took place.
Corrective Actions:
1. Jefferson County was downgraded.
2. The lead banker suffered punitive criminal action.

1. Increase the transparency and reporting standards for the government so that it was clearer that Jefferson County was overexposing itself to credit risk.
2. Increase the competition among swap proposals to ensure that the best price and quality is received.
3. Improve the standards for professional and governmental management.

What is most remarkable about the Erie Public School crisis is how pedestrian it is. There was no great scandal. They weren’t trying to hide cost overruns. They weren’t operating in secrecy – in fact school board meetings can be found on the internet. In September 2003, James Barker, Superintendent of the Erie City School District entered into a interest rate swap option with JP Morgan for $750,000. When the four interest rate variables to which the swap was tied changed for the worse, the Erie board paid $2.9 million to exit out of a contract which officials now say they didn’t understand. The deal which Erie entered into is similar to the type of swap options which many small cities and school districts have enter into in recent years. These agreements often carry hidden interest rate risk. When the credit markets were struck by the subprime crisis, that interest rate risk moved from abstract to real. These deals are also typically structured on handshakes and relationships and not open and competitive bidding. This lack of transparency has caused many municipalities and tax payers to question the soundness of deals such as these.

What is also alarming are the actions taken to make swap and derivative activities legal. Through lobbying, financial advisors and service firms were able to change a Pennsylvania law which forbid municipalities from entering into swap arrangements with banks. The new law allows these contacts as long as independent financial advisors examine and approve them. The problem with this law is that it creates only paper walls between the financial advisors and the banks that structuring the deal. Also, it didn’t remove self-interest from the arrangement as financial advisors get paid using money from the swap.
1. The financial advisors, who lobbied for changes in the swap law, are only paid for the completion of a deal. Therefore, their interests lie in the completion of a deal even if it is not in the best interest in the client.
2. The lack of market competition likely resulted in worse contracts for the city of Erie.
3. The city of Erie lacks of the financial sophistication to properly monitor and assess the risks posed by a swap option agreement. Board members, recognizing that they didn’t understand the mechanisms of the tool, and lacking an easy way to exit out of the contract should have never entered into it.
Corrective Actions:
1. The county paid more in fees than the money it received upfront to its lending institution.
2. The state government had to spend a large amount of bailing out the school district in order to terminate the swap transaction.

1. Increased market competition and transparency likely would have resulted in better contract terms for Erie.
2. An increase the liability, legal and ethical standards the financial advisors would more closely align their interests with client interests.
3. Necessitating training for board members would increase understanding of complex financial instruments.

New Yorkers still debate what caused it to be driven to the brink of bankruptcy in 1975. The confluence of several events forced the city to turn to the federal government for bailouts. Officials borrowed money freely to be spent on social programs and municipal unions forced the city into bad and unreasonable contracts. Meanwhile, it didn’t help that the city was hiding its true fiscal condition by cooking the books and increasing its short-term debt.
At the heart of this story are many years of unbalanced budget and barrowing that was used to pay for these budget overruns. Causing this strain was a social service system that was overly generous given the city’s budget constraint and powerful labor unions that had the city in a stranglehold. Ten years prior to the fiscal crisis, the subway workers, conducted a 10-day strike which brought the city to its knees. Finally capitulating to union demands, the city granted the union nine percent raises annually for eight years. Seeing the success of these strike tactics, the sanitation workers and teachers also went on strike. They too would also receive generous wage increases which the city could ill afford. In addition, this labor force, with its increasingly met demands, was ballooning. In 1975, the year of the crisis, the city directly employed 340,000 people, an increase of 100,000 since 1959. To put this in perspective, the city of Philadelphia currently has 23,000. To pay for these increased labor costs and ballooning welfare benefits, the city raised taxes with little forethought while also mortgaging its future by issuing successive waves of municipal bonds. This can be likened to borrowing against one’s house to pay for dinners at fancy restaurants.

Among the new taxes were a city income tax and commuter tax. These tax increases did have the benefit of increasing the city’s revenue. But it gave the city a reason to spend more – between 1970 and 75, expenditures rose by 80 percent.
Funding for this gap came in the form of short-term debt. In the four years between 1970 and 74, the city’s short-term debt nearly tripled to $3.4 billion. But in 1975, the gig was up. The city couldn’t find any buyers for its tax anticipation notes and the mayor had to fess up and admit that it was out of money.
1. The city was cooking the books and using financial games.
2. The city was relying too heavily on short-term debt to sure up their budget.
3. There was a lack of financial oversight on the part of banks that were making loans to the city.
4. Investors stopped purchasing city bonds.
Corrective Actions:
1. The New York City populace endured an increase in marginal tax rates.
2. New York City found itself on the brink of bankruptcy.
1. The establishment of a Financial Control Board to force the city to adopt accepted accounting practices, end budgetary tricks and restore investor faith in New York City.
2. The FCB was given power to approve the budget and issue debt leading to greater oversight of budget and debt levels.
3. Create a culture of accountability and trustworthiness to the city’s financial operations and condition.

An analysis of the above municipal failures illustrates that of all failures that a municipal transaction is subject to, the bulk of them occur relatively early on in the process. Counter-intuitively, reactionary regulation and corrective action tends to occur much later on in the process. In every case, the delay proves to be extremely costly, particularly when compared to what it would have cost to prevent such a failure in the first place. For instance, had Erie City School District employed an independent financial advisor, who was paid regardless of whether or not the transaction was completed, the financial advisor may have discouraged them from entering into such a risk-laden swaption. Had Jefferson County employed an independent financial advisor, he or she would have undoubtedly advised them that a fixed to synthetic fixed ratio of 6:94 was financially imprudent. Had Orange County instituted a regulatory mechanism by which the actions of even a financially sophisticated comptroller were audited regularly, insolvency might have been prevented. Had New York City instituted strict policies and better oversight regarding the “qualified purposes” for which they were so blatantly issuing debt, it may not have found itself on the brink of bankruptcy. And the list goes inevitably on.

The cost of such measures as mentioned above would have been negligible, albeit to mandate such measures on a state or federal level poses some problems, and each municipality could have escaped, conservatively, with a few hundred of thousands of dollars in up-front costs instead of shelling out millions of dollars on the back-end of the process. Thus, it is unmistakable that process fractures tend more often than not to occur on the front-end of the process, that reactionary regulatory and corrective action tends to be weighed towards the back-end of the process. In addition, the farther the point in the process at which such regulatory and corrective action occurs, the more costly it tends to be. Additionally failures such as those examined above, occur on the human level versus an economic one, and instituting regulation aimed at eliminating or at least reducing human influence on the front-end can go a long way in alleviating the decades of financial misfortune that have occurred due in part to misdirected regulatory measures.


As the U.S. Treasury Report duly noted, and as the private sector has amply demonstrated, uniting outcomes and objectives to behavior and incentives, provides for a more efficient market. As illustrated by the instances examined previously, desired outcomes in the world of municipal finance, from the perspective of a municipality are fairly universal. They include, but are not limited to, protecting one’s principal, preventing ignorance and corruption related losses, and insulating the municipality from the vagaries of larger national and global markets to some extent. Additionally, all parties have a vested interest in the prevention of regulatory duplication from a cost and efficiency perspective, governed to some extent by Adam Smith’s invisible hand.

To that end, one may draw conclusions about regulatory policy recommendations from the case studies above, the first of which is to focus on the front-end of the transactional process. Preemptive regulation that seeks to curb demonstrated and documented failures on the front end of the municipal debt-issuance process is not only more cost-effective, it may also help to promote more predictable behavior on the part of bureaucrats while also ensuring continuity in the methods by which a debt issuance is transacted. This may first be achieved by creating incentives where they are currently virtually absent. Negative or positive reinforcement, be they as inexpensive as a medal for “most-consistent reporting” or as gratifying as having the transparency of one’s processes tied to one’s credit rating, go far in influencing individual behavior. It also helps reduce the burden on creative and elected leadership. It can also convert what is a series of failure-prone human decisions into a series of automatic virtually fool-proof steps to be followed.

-One may go further and create small monetary incentives or insert punitive action for the most minimal infraction.
-Second, in order to insulate municipalities from market uncertainty due to no fault of their own (e.g. municipality auction rate securities failing due to crumbling insurance agencies), each municipality or debt issuer must acquire an independent credit rating.
-Third, metrics such as Value-at-Risk, and even the fees and such other particulars of a transaction should be consistently reported in a universal and easily accessible format. The SEC has already taken first steps here with EDGAR, the Electronic Data Gathering, Analysis, and Retrieval System, that “performs automated collection, validation, indexing, acceptance, and forwarding of submissions by companies and others who are required by law to file forms with the U.S. Securities and Exchange Commission (SEC).” While EDGAR serves its entire utility to experts, a Google based system where one could simply enter search terms related to the size of the issue, the insurance agency used, related fees, demographic constitution of issuer, etc. would provide information easily accessible to the most lay user and force more informed decisions on the part of municipalities- prohibiting state bailouts of an ignorant school board.
-Fourth, in order to alleviate the nepotism and cronyism that are part of any industry, RFP and RFQ processes should be mandated. This would allow a municipality to choose the “best value for money” without compromising on quality that a bidding process may force them to do. Further, if the proposals submitted were readily available to the general public through systems like EDGAR, cronyism may have a tougher time defeating merit.
-Fifth, and perhaps most important, is the use of independent financial advisors that collect fees regardless of whether or not a transaction is completed - a financial advisor should serve as a home inspector rather than a real estate broker. This also serves to re-align incentives. It is difficult to imagine a pure fiduciary relationship between a debt issuer and a financial advisor in the structure as it currently exists.

In sum, mandating investment in fixed front end costs, and focusing preemptive regulatory action on the front end, instead of traditional reactionary and misdirected regulation that is focused on the back end of municipal financial processes can provide better incentives, greater financial certainty, while avoiding human pitfalls and astronomical costs to which back-end regulatory and corrective action seem eternally tied.

Regulatory reform as proposed in this study, if adopted, may have a huge impact in municipal finance as we know it. It would reduce reliance on insurers and place greater credence on the independent credit rating of a debt issuer. It would, despite increasing interest rates for lower rated and smaller municipalities, provide greater budget certainty and predictability. As a consequence perhaps, municipal spending might decrease, focusing resources on things that are absolutely needed. The preferred argument, of course, is that municipalities need everything that they spend monies on, but perhaps they will be forced to prioritize. Whether our anti-tax society will be forced to swallow higher taxes is beyond the scope of this discussion, however, it is not an impossible outcome. Transactions that are more transparent will provide greater knowledge and enable municipalities to make more informed and savvy financial decisions. For instance Municipality A that is practically identical to Municipality B will be less likely to pay more in fees for a transaction because it would be aware of the fees that Municipality B incurred. Independent financial advisors could of course markedly change the face of municipal finance by ensuring, at least to some extent, that imprudent transactions are barred from occurring. However, what is the blessing of front-end regulation is also its curse. That front-end regulation provides predictable costs distributed over every debt issuer, by virtue of back-end costs being irregular albeit astronomical, may pose the first obstacle. Municipalities are less likely to want to spend money that they are not currently required to spend, particularly since all tend to believe that ill events will never befall them.

Further, it is widely known that current regulatory agencies and firms are mammoth in size and function. To repeal and regress may prove an arduous task - one that many governments are not be amenable to. Powerful political bank lobbies may make transparency regulation and impossible measure in Congress, not to mention the vested interests that many a politician may have in the profit margins of lending institutions.

Finally, of course, is the question of state autonomy. Standardized regulation to some extent requires federal mandates and federal authority impinging on state authority. As mentioned before, for instance, the regulation of insurance agencies is highly balkanized and varies from state to state. Federal mandates will certainly decrease states’ ability to compete with each other for the business of insurance agencies and like parties. That one will see such regulatory overhaul to the extent proposed in the short-term is unlikely for the various factors mentioned above. Preemptive regulation may be the slow and steady tortoise that will eventually catch up to the reactionary, spurt inclined hare that regulation has been for decades, and will perhaps be for decades to come.