How a Small Town’s Bond Bust Led to a Model State Debt Policy

By: - January 25, 2011 12:00 am

Courtesy Tennessee Comptroller’s office

Tennessee Comptroller Justin Wilson says many local governments do not have sound debt policies. He led an effort to end conflicts of interest and set guidelines on borrowing practices.

State treasurers do not usually intervene in the debt decisions of local governments. But when Justin Wilson took over as Tennessee’s comptroller in 2009, he saw no other way.

Lewisburg, a small town south of Nashville, had become entangled in a risky municipal bond deal. The fallout from the transaction exposed weaknesses in the borrowing practices of many of Tennessee’s small counties and cities. Wilson concluded he had no choice but to increase the state’s oversight of local government debt transactions to protect Tennesseans from getting socked by sudden increases in borrowing costs.
“We have to respond to a fundamental shift in the way in which local governments have been paying for parks, schools and other public works projects,” says Wilson.
First, Wilson cracked down on high-risk interest rate swaps, a form of financial instrument known on Wall Street as a derivative. Then, in an effort that concluded last month, he developed a model debt management policy for local governments. The goal is to ensure that county and city officials — as well as Tennessee residents — clearly understand the risks of debt transactions and the fees paid to make them.
“When our government officials make mistakes, they are usually doing so with our tax dollars,” Wilson says. “We are entitled to have governments set basic, common-sense guidelines so we can know what happens to our money.”
Tennessee was one of the first states to be dragged into the bad debt decisions of its local governments. It probably won’t be the last. Top officials in Alabama, have tried for two years to restructure Jefferson County’s .2 billion sewer debt to help the state’s most populous county avoid bankruptcy.
Harrisburg, Pennsylvania, partially financed a trash incinerator project with a swap arrangement that initially promised lower borrowing costs but instead resulted in prohibitively high interest costs. Then-Governor Ed Rendell agreed in September to bail out Pennsylvania’s capital city to avoid a default on its bonds.
Before Harrisburg’s troubles surfaced last year, the Pennsylvania Legislature considered but did not take a vote on a bill banning swap agreements by local governments. The lawmakers’ intervention was prompted by an investigation by state Auditor General Jack Wagner, who determined that the school district in the city of Bethlehem lost at least .2 million from a bad deal.  “The use of swaps amounts to gambling with public money,” Wagner says. “Swaps have no place in public financing.”
Troubled cities in California , Indiana, Michigan and Rhode Island also are having difficulty paying their bills, drawing the attention of state officials in varying degrees. Those cities are suffering more from a combination of falling tax revenues and rising public pension costs than from risky bond deals. Michigan officials have rejected a request from Hamtramck to allow the city outside Detroit to file for bankruptcy protection. Indiana lawmakers, with backing from Governor Mitch Daniels, are considering legislation that would permit distressed cities such as Gary to file for bankruptcy.

Quadrupled payments

In Tennessee, Wilson’s effort to clean up local government debt practices began in April 2009. That’s when the New York Times disclosed that officials in Lewisburg, population 11,000, had discovered that the annual interest payments on a bond for new sewers had quadrupled to million.

The report also detailed the lax regulation that allowed a Memphis-based investment bank, Morgan Keegan & Company , to teach a state-sponsored seminar on the benefits of municipal bond derivatives and then gain financially by selling the instruments to Lewisburg and 38 other Tennessee cities and counties. The Tennessee Municipal Bond Fund also promotes variable-rate debt to local governments. Stunned by the disclosures, Wilson moved to tighten state scrutiny of local government debt transactions.
The state comptroller already had authority to approve or reject local government swap contracts. But Wilson upped the stakes. He required cities and counties to employ a chief financial officer and an accountant, in part because he believed some small jurisdictions lacked the expertise to understand complex financial deals. If they wanted his approval, Wilson said, cities and counties would have to disclose how the debt will be issued and structured and tell him how much outstanding debt they planned to carry.   He also said localities needed to set up an audit committee to monitor bond deals. If a local government does not meet these requirements, city officials face the added pressure of meeting with Wilson personally to assure him they understand the risks.

“The goal here is not to prohibit cities and counties from entering into swaps, forward purchase agreements or similar transactions,” says Wilson, who was a lawyer in Nashville before the Legislature elected him comptroller. “Our goal is to make sure officials in these cities and counties really understand what they’re doing. And the taxpayers who live in these cities and counties should know what risks are being undertaken and what fees are being paid on their behalf.”

State and local governments turn to bonds with variable interest rates for the same reason a homeowner might take out a variable-rate mortgage: to cut borrowing costs. The rates on variable-rate bonds are usually lower than bonds with fixed rates. But they also come with the risk that the rates will go up. Interest rate swaps are a way for governments to protect themselves from climbing interest rates by swapping bonds issued with a variable interest rate for a fixed interest rate.
The deals in Tennessee and elsewhere collapsed when interest rates plunged to record lows and municipal-bond insurers, who investors rely on to guarantee they will be paid, lost their top triple-A credit ratings in 2008. Many local governments burned by the deals, such as Lewisburg, have paid steep fees to terminate swaps and have refinanced their variable-rate debt into fixed rate. As a result of these deals, the federal Securities and Exchange Commission is moving to improve disclosure and transparency of the municipal securities market.

A model policy

Once Wilson stabilized the swap crisis, he pushed through a broad, model debt management policy for Tennessee cities and counties to follow. Local government officials have until January 1, 2012 to draft their own policy, using Wilson’s as a template. Most states and many municipalities already have such policies in place because the agencies that rate credit expect them. In addition, the Government Finance Officers Association, a professional group, recommends a debt management policy as a best practice.

The smaller the jurisdiction, however, the less likely a formal policy exists. And if it does, the policy is not likely to be as explicit about exotic financing deals as Wilson is demanding.
In shaping the debt management policies, the comptroller is advocating four principles informally referred to as the “Wilson Doctrine.” These include:
      * Policy makers should clearly understand debt transactions;
      * Citizens should be able to get clear explanations about transactions;
      * The parties involved in debt transactions should avoid conflicts of interest;
      * The costs and risks associated with transactions should be clearly disclosed.
The debt management policy did not sail though the approval process. Local government officials and financial industry representatives objected because they believed Wilson was too heavy-handed. They said Wilson was rigidly prescribing what local governments should do and threatening them with sanctions if they did not adopt his suggestions. “Every municipality is different,” the Tennessee Municipal League said before hearings on the policy.  “A one-size-fits-all policy will not work.”
Wilson, in an interview, says he had no intention of dictating to local governments. He revised the guidelines and now believes he has the support of cities and counties and the state’s financial industry.  “We’re not in a position of telling them what they can and cannot do,” Wilson says. “There’s very little that’s prescriptive in the guidelines. The idea is to set forth basic principles of openness for all governments. I suppose I do have the power to enforce compliance but I don’t want to be in that position. We clearly put the responsibility on local governments to make the decisions.”
Morgan Keegan officials have maintained that the interest rate swaps performed as expected. The problem, they say, was the credit market collapse and the lowering of insurers’ credit ratings. The firm “totally supports” Wilson’s efforts, says corporate spokeswoman Kathy Ridley. She says the debt management policy was undertaken ” not in response to any one particular past financing, but as the result of the unprecedented downgrading of all the nation’s AAA-rated bond insurers. The comptroller’s initiative includes new guidelines for municipal issuers that reflect current market conditions.”
Wilson says the debt policies will not prevent all bad decisions or unforeseen events. But it should reduce the effects of another financial crisis like the one that has just happened. In the meantime, Wilson says he is happy Tennessee can serve as an example for the country. “We borrow from other states,” he says, “and other states are welcome to borrow from us.”

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Stephen Fehr

Stephen Fehr is a senior officer with Pew’s government performance portfolio. He is a lead writer on many of the products generated by the portfolio, specializing in state and local fiscal health.