The State Budget Crisis Task Force declared this week that U.S. local governments remain beset by “fiscal instability,” and called for reforms to eliminate budgeting “gimmicks and short-term measures that obscure actual financial conditions” of states and cities.
The group led by former Federal Reserve Chairman Paul Volcker and former New York Lieutenant Governor Richard Ravitch had made similar declarations in previous reports. This time, however, it added a provocative recommendation: Congress should revisit the 1975 Tower Amendment, which exempts municipal governments from Securities and Exchange Commission financial filing requirements, in many cases depriving investors of reliable financial data.
It was passed by Congress largely out of respect for states’ rights, and because of concerns over the potential cost to local governments providing mandatory financial data, according to a Senate report at the time. That report also noted “a perceived lack of abuses in the municipal market” that didn’t justify additional oversight.
Over time, however, the market for municipal securities, once characterized as “sleepy,” has grown vastly larger. Today about $3.5 trillion in municipal securities trade in new and secondary markets. Rather than merely issue debt to build bridges, roads and schools, governments now use borrowing -- including complex instruments such as derivatives -- to finance ongoing operations, bolster pension funds and raise money for economic development projects.
Defenders of the Tower Amendment typically argue that despite the explosive market’s growth, defaults among municipal securities have remained low. But muni defaults did spike sharply during the financial turmoil of 2008 and 2009, and the growth of state and local debt potentially exposes the U.S. financial system to new dangers. When Standard & Poor’s downgraded the U.S. credit rating in August 2011, it cited growing state and local obligations as a contributing reason.
The SEC has tried to bring order to the market through what has become known as “backdoor regulation” that compels the private companies that deal in municipal securities to collect financial documents from governments and make them available to investors. More recently, the SEC and the Municipal Securities Rulemaking Board, which regulates dealers of municipal bonds, established an online system allowing investors to access the documents.
This regulatory regime, which former SEC Chairman Christopher Cox once described as “technically voluntary,” has been inadequate. A 2008 study by DPC Data Inc. found that half of governments with municipal bonds that were outstanding for nine years or more had failed at least once to file financials on time, and a quarter of muni issuers were chronically delinquent.
In a follow-up study, DPC Data found hundreds of trades in distressed municipal securities that had been executed at the bond’s face value or higher, indicating that the buyer had no idea the issuer was experiencing “fiscal stress.” In half of those trades, the government issuer had filed no financial statements for at least two years.
Tardy financial information isn’t the only problem. Accounting standards employed by states and cities can vary greatly, and some use methods that don’t adequately reflect their fiscal situation. In its report, for instance, the Volcker-Ravitch group criticized states for still using “cash-basis budgeting,” a system that was long ago discarded by private-sector corporations because it ignores or understates long-term obligations such as retirement debt.
Governments also have wide discretion in deciding how to value the assets in their pension systems, and some have arbitrarily changed their procedures from year to year to minimize their debt. For instance, after 2008’s steep market declines, Illinois passed legislation allowing its pension system to value its assets using a five-year smoothing average that incorporated previous years of robust market gains and made the funds appear better funded than they actually were.
Still, federal securities law requires that municipal issuers adhere to anti-fraud statutes, and the SEC has become more aggressive about charging governments that intentionally mislead investors. In May, the SEC cited Harrisburg, Pennsylvania, for fraud because of deceptive statements by former city officials. As the finances of a major project funded with city debt deteriorated between 2007 and 2009, Harrisburg stopped filing timely financial data. But the mayor continued to paint an optimistic picture of the fiscal future. The city ultimately defaulted on about $13.9 million in debt payments, and the SEC pointed out that investors had no way of knowing that the city’s fiscal condition had been deteriorating.
Although the SEC’s new focus on fraud is welcome, its interventions have all occurred after the fact, when investors had already been exposed to risks. Those actions aren’t a substitute for providing timely and transparent financial data to investors.
The Volcker-Ravitch panel didn’t recommend specific changes, but the Government Accountability Office in July 2012 listed a variety of possible reforms, including standardizing the accounting methods that states and cities use in financial reports, requiring more timely reporting of financials and giving the SEC the power to enforce deadlines. More recently, a draft of a white paper by the National Federation of Municipal Analysts also recommended changes, including plain language summaries of the offerings in financial documents and clearer discussion of the source of funds that would be used to repay a debt.
The State Budget Crisis Task Force report, which carries the authority of a respected former Fed chairman, has raised serious concerns about accounting practices of local governments that should no longer be tolerated. The SEC should be given the power to police the $3.5 trillion market for municipal securities.
(Steven Malanga is a senior fellow at the Manhattan Institute.)
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