The World Turned Upside Down: The Contemporary Revolution in State and Local Government Capital Financing

Abstract

Hard-pressed for capital funding, American state and local governments have turned to new, creative, or previously little-used devices which are largely unmentioned in the literature on public finance and which, for the most part, did not exist as little as two or three years ago. Traditionally, the long-term state and local bond market has been supported primarily by large institutions with profits to shelter. But, many of these institutions such as fire and casualty companies have curtailed their state and local government bond buying because of reduced profit margins. The lack of institutional buying has forced tax-exempt bond yields to unprecedented highs, or, putting it another way, has vastly increased the interest cost to bond issuers because they have been forced to make the yields on state and local bonds attractive to the remaining buyers-individuals with less concern about the tax-sheltered aspects of public bonds. Yields for 20-year obligations hover near an all-time peak of about 13 percent. The world has turned upside down. Traditionally, three out of every four state and local government debt service dollars went to repayment of principal and one went to pay interest. That ratio is now reversed. There are more than a dozen new fiduciary or fiscal instruments which have turned the staid, sedate bond world into an exciting, innovative aspect of public administration that bears scant relationship to the unchanging practices of the past. Confronted with nontraditional circumstances, both issuers and buyers of bonds have responded in non-traditional ways. In the constant quest for capital funds, necessity and hardship have become the mother and father of invention and innovation. State and local governments faced with historically high interest rates have frequently been unwilling to commit to long-term obligations that result in interest payments of three times the original amount borrowed. By the same token, buyers are unwilling to lock into fixed returns, feeling uncertain about inflation, tax liabilities and yield curves. However, governments still need to borrow; investors still need to earn returns. Creative financing seeks to marry the two, meeting their respective needs. The Tax Equity and Fiscal Responsibility Act of 1982, effective July 1, 1983, is an additional impetus to the revolution. Following the lead of the U.S. Treasury, which issued its first bonds in September 1982, state and local government bonds must now be issued in registered form. Gone is the traditional form of bearer bonds, payable to whoever presents the paper for redemption. In addition to increasing state and local government costs necessitated by the keeping and updating of the registers, public bond issuers will have to report the interest paid, to whom, and when. This will reduce the attractiveness of tax-exempt bonds to some buyers, undoubtedly forcing bond issuers to pay higher interest to make the bonds saleable.