By Akheil Singla (Arizona State University) and Martin J. Luby (University of Texas at Austin)
The use of financial derivatives, such as interest rate swaps, by city governments has been covered in the news media with some frequency over the past few years. The preponderance of these stories focus on the negative outcomes associated with these financial instruments, particularly in terms of increased interest payments, termination payments or other financial losses. While reporting on the issue often stops with simply stating the losses, some media accounts call into question the use of these instruments by governments at all, suggesting that governments 1) lack the financial sophistication to engage in these deals, 2) use the instruments out of desperation because of a declining financial health, 3) are increasingly staffed with finance professionals either at the administrative or board level that have experience with more complex financial instruments in their previous professional careers which leads to greater use and/or 4) are being influenced by financial sector firms that will benefit from the use of these financial instruments.
In terms of the urban studies academic literature, the financialization strand of research couched in the larger area of neoliberalism has conceptually and anecdotally documented the increased use of novel financial instruments by cities and local governments. Much like the media accounts, these studies have often focused on the negative financial outcomes in the use of these financial instruments. Both the media stories and previous research allude to or speculate on a broader point: why would a government choose to enter into a complex financial instrument like a debt-related derivative in the first place? To our knowledge, while media accounts have speculated on this question, the academic literature lacks a systematic, large-n empirical exploration of it.
Our UAR paper explores the following question: What are the associative factors for the largest U.S. city governments in choosing to use debt-related derivative instruments? This research posits three exploratory hypotheses (listed below) culled from media accounts and the urban studies literature on the use of debt-related derivatives by local governments in the United States.
H1a: Governments with worse cash positions will be more likely to use debt-related derivatives.
H1b: Governments with budgetary imbalances will be more likely to use debt-related derivatives.
H1c: Governments with worse credit ratings will be more likely to use debt-related derivatives.
H2a: Governments with a greater amount of recently-issued bonded debt will be more likely to use debt-related derivatives.
H2b: Governments with prior experience using debt-related derivatives will be more likely to use debt-related derivatives in the future.
H3: Cities with council-manager forms of government will be less likely to enter into debt-related derivative transactions than cities with mayor-council forms of government will be.
The paper empirically explores these hypotheses by examining the various fiscal, financial, and issuer characteristics of the largest 50 cities in the United States and their choices about whether to use debt-related derivatives (i.e., interest rate swap).
Based on our results, we find some statistical support for hypotheses 1 and 2 but not for hypothesis 3 related to political economy. Hypothesis 1 suggests more debt-related derivatives use when governments are in worse financial condition. Three sub-hypotheses explore this idea by using three financial condition indicators describing financial condition across different time horizons. For H1a, we find evidence that a decline in the cash position of a government is related to increasing use of debt-related derivatives. For H1b and H1c, we find no evidence supporting a relationship between budgetary solvency (i.e. operating ratio) and swap use but find evidence that a decline in credit rating is associated with increased swap use. On balance, it appears that governments in worse financial shape were more likely to use debt-related derivatives.
Hypothesis 2 focuses on financial experience generally and prior experience with swaps, each of which could simultaneously be considered a measure of financial savvy or financial sector influence. For H2b, we find that prior experience with interest rate swaps and derivatives is associated with increased future use of interest rate swaps and derivatives. The case for H2a related to greater amounts of previously issued bonded debt is made more complicated due to the nature of the statistical tests we employ. While we find statistical support for H2a, we must be cautious about overstating the strength of the evidence supporting this conclusion.
Another challenge is the inability to empirically disentangle financial experience and financialization. Though both constructs cannot be observed directly in a large N study, we argue that recently issued bonded debt and prior use of debt-related derivatives serve as relevant proxies. Our finding that both are positively associated with the use of swaps and derivatives suggests that some combination of financial experience in city governments and financialization may be comingling to drive financial engineering. The inability to distinguish between the benign and malicious influence of the financial sector further clouds the picture. Are more financially experienced governments more likely to engage in financial engineering because they understand the products, or are they less likely to use them because they understand the products and are less susceptible to malicious financialization?
The weight of evidence suggests both financial condition and the comingled-effects of financialization and financial experience are associated with the use of debt-related financial derivatives. These findings have important implications for the financial management of large urban centers, as they suggest cities with weaker financial health and larger exposure to financial markets are more likely to engage in financial engineering. Though the negative outcomes associated with swaps and derivatives during the Great Recession have dominated the news, these findings add context and improve understanding of financial engineering in large cities. Finally, despite the implication that debt-related derivatives may be the outcome of increasing influence of the financial sector, it seems premature to suggest that swaps and debt-related derivatives ought to be banned entirely, as some have suggested. The theoretical benefits of swaps and debt-related derivatives are still significant and can generate meaningful savings for governments in the right interest rate environments. More research is needed to understand the true costs and benefits of swaps and derivatives relative to other financing options available to governments.
Akheil Singla is an assistant professor in the School of Public Affairs at Arizona State University. His research focuses on public financial management, with a particular concentration on municipal debt and local government financial health.
Martin J. Luby is an assistant professor in the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin. His research focuses on public financial management with an emphasis on municipal capital finance.