Municipal bonds can help solve our funding problems


This post has been written by Stephen Kinsella of the University of Limerick and Karl Deeter of Irish Mortgage Brokers

Problem: Cash strapped local authorities, inadequate pension provision within an aging society, and reduced infrastructural development. Solution: Municipal bonds.

Municipal bonds are debt instruments issued by local authorities to finance investment projects. Yesterday’s announcement by government of a Recovery bond is a variant of the municipal bond idea, but on a national level. We have written about municipal bonds before, several times. We are interested in recapitalizing local authorities and regional authorities using these bonds, and we’d like to use this blog post to sound out possible issues with the idea, and compose a plan of action for implementing the idea if people think it is feasible.

Cash-strapped local authorities can use funds generated by municipal bond issues on a yearly basis to reduce their infrastructural deficits in transport, water provision, port equipment, broadband provision, and community initiatives. Ireland’s regions can compete on the quality of our infrastructure, rather than on direct wage competition.

Dealing locally but funded centrally to deal with extremely poor infrastructural provision with broadband, hospitals-both public and private, roads, amenities, playgrounds, local housing, homeless initiatives, and regeneration projects. Individuals can use municipal bonds in order to save and invest, or to fund their pensions, ensuring a guaranteed rate of return on their savings. Local authorities can respond to the needs of citizens directly using these bond issuances.

Ireland's recent flooding has exposed three painful facts. First, increased flooding as a result of climate change is inevitable. This 1 in 800-year event will be probably be seen again inside a decade. It should be remembered the flooding of 2008 broke all previous records in Dublin and Cork. Second, public services were not equipped to stop the flooding from occurring or to deal with the floods once they had occurred. Third, the government cannot pay for the cleanup operation, which may cost a half a billion Euros. In simple terms we need the infrastructure, we cannot go forward with the risk of recurrence unmitigated, and yet we equally can’t afford to pay for the improvements, it is a considerably difficult position to find oneself in nationally.

Municipal bonds can finance important local projects that won’t get funded.
Ireland's local authorities are underfunded, and have been systematically underfunded for decades have been systematically underfunded for decades. The current economic climate means Ireland will reduce its capital spending provision for several years on many crucial projects of long-term national importance, like flood prevention infrastructures, environmental cleanups, broadband provision, roads, port systems, and many more.

According to the Global Competitiveness Report, in the category of 'Quality of Overall Infrastructure' we rank 64th in the world. We will lag further behind as our investment reduces further in the next three to four years. A measure must be found to balance the need for public spending and public saving on a local basis, in order to develop investment strategies that are business-friendly and of long-term economic and social significance.

An aging population requires increased pension provision

By 2050, 1 in four workers will be over 65, 1 in 10 will be over 80. Regardless of the year of retirement of these workers, and the replacement rate of the old by the young, the implications of this demographic shift for our pension and health care system are enormous. Public pension provision may bankrupt the state unless private provision is instituted on a mandatory basis. Private pensions are risky, in particular Defined Benefit schemes, as Waterford Crystal employees found out last year to their dismay.

At present there are 1700 Defined Benefit schemes in Ireland. About 400 schemes are less than 50% funded, a full 1500 are below the 100% threshold, meaning there are only roughly 10% of active and deferred members who have coverage levels of 100% or greater. The scene is set for a social tragedy.

Municipal bonds represent a means to increase private provision of savings and pension entitlements while simultaneously recapitalising local and regional authorities. Authorities can reduce their other minor money-generating schemes such as rates and parking charges, and become more business-friendly, increasing inward investment by private business at the same time as providing world-class infrastructure.

Municipal bonds are working now in the US and Europe.

Municipal bonds are most developed in the US. Build America just increased and re-issued their tax-efficient subsidised debt product to the tune of 56 billion. The bond market in the US is currently thriving.

The State of Oregon is a prime example of municipal bond usage. Municipal bonds are very safe and historically have had a very low default rate. They are appropriate as a pension vehicle and also as a savings and investment vehicle.

How do Municipal Bonds work?

A simple diagram helps to explain how bonds work.

The bonds are issued by the local authority or a regional authority. They are underwritten, in this case, by the government, and rated if there is the ability to obtain a debt insurance (such as AMBAC in the USA) it reduces the cost to the municipality by ensuring they achieve a top rating. A consultant is required at this stage to manage the process. The bonds are issued to the markets at a fixed coupon and end date, usually 20 years, and their sale frees up funds to be used in the construction of large scale public projects.

Examples of projects funded by municipal bonds include: power plants and distribution systems, public markets, hospitals and health care centers, water supply, sewerage and sanitation, flood protection and prevention systems, schools and day care centres, broadband rollout, telephone and communication systems, toll roads, bridges, ports, airports and public transportation facilities, government housing and regeneration developments, development of industrial estates, tourism and green energy investment and research/development.

Broadly there are two types of bond that tend to issue, one is a ‘General Obligation’ which means that the regional authority/city/municipality are responsible for repayment of the debt out of their general revenue stream, the other is a ‘Revenue Bond’ which pays the debt via revenue from a particular project such as toll bridge/tunnel etc.

Advantages of Municipal Bonds

1. More certain payback for future pensioners, decreased volatility of pension funds, in particular if funds were moved into bonds on a dynamic basis whereby there is greater participation as you near retirement (ie: move away from equities as volatility risk due to retirement age approaching becomes a greater issue); easily transferrable title; increased savings provision for all.
2. Increases funding to local authorities for large capital projects: It would also place the full responsibility for timely and within budget projects upon the areas and taxpayers of the region that benefits from same.
3. Transparent and easily governed structure.
4. Government backed and insured.
5. Solves the 2050 pension provision problem if mandatory. Some form of mandatory participation is required, whether it is under the Singaporean Model (state managed) or Australian Model (individual managed) is a matter of process, but the need for mandatory pension provision is becoming increasingly clear.
6. If funds are never used to finance current expenditure, increased capital provision means the economy can develop in line with local voter's preferences.

Next Steps

1. Get buy in from Central government. Local authorities don't have the ability legally to do this. Yet. The current system is referred to as ‘tax and transfer’ and there are sizeable extraction costs before ground is broken on shovel ready projects.
2. Group spending priorities by region and by location first. Small projects ready to go with 3-5 year time horizon only. Essentially bonds could be part of an overall stimulus package, there is sufficient private wealth seeking low risk yield in this country which remains under utilized in terms of being a part of national recovery, there is no reason for investors not to be part of a coalition of the willing in terms of stimulus, but without the very vehicle to allow this to happen we cannot even bring them to the table.

In the example of infrastructure for floods, perhaps insurance companies would be happy to invest in these bonds as it would reduce liability to their insurance book in the future, they have a vested interest in not seeing the area under water, to the same degree residents do. Municipal projects can therefore bring together disparate groups within a common ideal, whereby profit is far from being a dirty thing, it is an honourable element of necessary infrastructural advancement.

3. Fully cost out a Municipal bond issue for the BMW region: population, prospects for issuances, new types of bonds, and new state pensions model.

Posted in: Banking and financeFiscal policy

Tagged with: stimulusmunicipal bonds



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