By Amanda Kass (University of Illinois at Chicago), Martin J. Luby (University of Texas at Austin), and Rachel Weber (University of Illinois at Chicago)
For most of the 20th century, the municipal securities market was a sleepy backwater where governments went to raise money for roads, bridges, and wastewater systems. Most cities financed their infrastructure with debt that relied on conservative or well-seasoned market structures. At the end of the century, however, local governments entered a period of “entrepreneurial” finance as federal support for urban development declined. In the years leading up to the global financial crisis, many US governments began utilizing new bond structures and riskier financial instruments to, potentially, lower borrowing costs.
We focus on one such novel instrument: auction rate securities (ARS), which are often paired with interest rate swaps. Unfortunately, the market for these securities seized up in 2008, and the risks of ARS were realized in penalty fees and a spike in borrowing costs, exacerbating the fiscal stress governments were already experiencing due to the Great Recession. We seek to explain why some local governments gravitated toward instruments with greater financial risks while others did not. Our case study of the Chicago Public Schools develops new propositions about why local governments, as organizations, take varied approaches to financial management. The Chicago Public Schools floated about a $1 billion in ARS, and, as such, represents an extreme case of financial risk-taking.
What kinds of organizational dynamics might influence the degree of risk a local government is willing to accept in its debt issuances? We frame our discussion in terms of the layered principal-agent relationships that influence issuer behavior, focusing on two main dynamics: (1) moral hazards that arise from unaligned risk preferences, and (2) information asymmetries concerning actual financial risks. Moral hazard occurs when government issuers, innocently or willfully, ignore the risk preferences of their principals in the use of complex financial instruments. Information asymmetries are present when governments lack knowledge about the risks involved in these instruments, particularly compared with their private-sector partners.
In Chicago, the Mayor appoints the Board of Education and has significant power over the district. Because of the hierarchal and insulated nature of the CPS’s administration, financial managers operated in an environment devoid of knowledge about the risk preferences of taxpayers – other than the fact that they generally dislike them but also want high-quality services and facilities. As such, CPS financial administrators lacked knowledge about whether voters preferred that they minimize risk and better utilize existing school buildings, or take on new debt and more risk to fund new construction. CPS, we argue, innocently ignored the risk preferences of its principals.
We also find evidence of a “willful neglect” type of moral hazard. The use of financing techniques like ARS fits into a larger pattern of the City’s debt management in the 1990s and 2000s. During Mayor Richard M. Daley’s tenure (1989-2011), the City’s primary economic development program was Tax Increment Financing, which relies on revenue bonds, displaces tax rate increases to other taxing bodies, and gives the illusion that development “pays for itself.” It also leased the Skyway (a seven-mile tolled highway) and parking meter system through public-private partnerships in 2005 and 2008, respectively. Both concessions generated revenues used primarily to fund short-term operating budget deficits while turning over potential windfall revenues to private operators for the subsequent 75-99 years. Considering the City’s history of discounting future risks and costs, the case of CPS’s use of ARS does not look out of place.
The case lends weaker support for information asymmetries as the key driver of CPS’s debt management decisions. On one hand, the district’s experienced board and management team were knowledgeable about the risks involved in ARS. The chief administrative officer, in charge of overseeing CPS’s borrowing strategy, was a former CEO of the Chicago Board of Trade and director of an investment firm. Several other Board of Education members came from the world of investment banking. Given their previous experience leading large private sector financial institutions, they were comfortable utilizing complex financial instruments for CPS in light of its need for additional resources.
In terms of information asymmetries caused by some incompetent advisory services and/or self-dealing bank behavior, the answer is less clear. While CPS’s advisors informed it of the fact that investment banks were not just selling but also purchasing ARS securities to keep the market afloat, CPS may not have understood the extent of this phenomenon. This ignorance could be the fault of CPS: a focus on past success may have kept them from incorporating the possibility of real danger. Or the ignorance could be due to intentionally duplicitous behavior by banks, which possessed more information than they shared with issuers about the ways they were propping up the ARS market through their own purchases of these securities. Unfortunately we lack evidence to determine whether optimism or calculated misconduct was at fault. However, the decades of financial expertise at CPS leads us to believe that information asymmetries contributed less to risk-taking by CPS than moral hazards, i.e., the fact that CPS was being run by a multi-term mayor and private sector professionals that could shift the risks of the district’s debt management strategy to other (future) stakeholders.
While ARS are unlikely to be used the same extent again, this case is illustrative of a more generalized phenomenon of governments drifting toward more complex and risky financial instruments. Governments have moved from relying on general obligation bonds with fixed rates to variable rate instruments to less-seasoned securities paired with derivatives. It is not surprising that several local governments – from Detroit to Jefferson County, Alabama to transit authorities in San Francisco and New York City — have experienced collateral calls and terminations of their interest rate swaps, which has triggered hundreds of millions of dollars in penalties and costs as well as subsequent service cuts and austerity measures. Understanding the motives of administrators and the political and fiscal contexts for adoption may help anticipate which governments will embrace the next financial ingenuity promising to cater equally to investors, issuers, and taxpayers.
Amanda Kass is a PhD student in the Urban Planning and Policy department at the University of Illinois at Chicago. She is the Assistant Director of the Center for Municipal Finance at the University of Chicago’s Harris School of Public Policy.
Martin J. Luby is an assistant professor in the LBJ School of Public Affairs at the University of Texas-Austin. His teaching and research broadly focuses on public finance with an emphasis in public financial management. Much of his research has focused on the use of debt finance by US governments including topics such as innovative government financial instruments, federal financing techniques, and municipal securities market regulation.
Rachel Weber is a professor in the Department of Urban Planning and Policy at the University of Illinois at Chicago. Her research focuses on the relationship between capital markets and the built environment. Her latest book, From Boom to Bubble: How Finance Built the New Chicago (University of Chicago Press, 2015), won the 2017 Best Book in Urban Affairs Award from the Urban Affairs Association.