Unsanitized: How the Muni Bond Market Is Preventing Economic Recovery

The role of Wall Street financiers in forcing austerity on state and local governments. This is The COVID-19 Daily Report for September 25, 2020.

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First Response

Federal Reserve chair Jerome Powell and Treasury Secretary Steven Mnuchin spent the week fielding questions from Congress about the effect of their bailout rescue and whether it has delivered a broadly shared recovery. Even those who generally think the Fed has done a good job have criticized the orientation around the Municipal Liquidity Facility (MLF), which can offer direct loans to cities and states suffering through revenue shortfalls. Because of the counter-productive and unnecessary penalty rate and generally poor terms, the MLF has only been used twice, leaving close to $500 billion in borrowing authority unused.

According to the Brookings Institution, revenues will decline by between $467 billion and $544 billion between now and 2022. This compares favorably to the lending authority. And the Fed has tools to offer short-term, endlessly rolled-over loans under Section 14, outside the MLF, and give states and cities what they need to survive, and not completely stunt economic recovery.

“It’s driving me crazy, it’s almost like a fiduciary duty violation,” said Cornell University’s Robert Hockett, who has been pressuring the Fed to get more creative with its state and local lending authority. Given that the Fed has a mandate to maximize employment, and we know that state and local austerity was a lead weight on employment and economic growth during the Great Recession, it’s hard to argue his point. “It’s not even like a long time ago we have to look back, it’s within living memory for us,” Hockett said.

So why has the Fed been so reticent to act? Officials managing the program have expressed that the MLF serves merely as a lender of last resort, in case of a breakdown in municipal bond markets. Those markets are the concern, not the condition of state and local governments. And there’s a good reason for that: municipal bond markets are a powerful, concentrated spoke of the financial industry, and they don’t want to take the loss of revenue that would come with the Fed serving state and local governments well. So there’s a combination of lobbying and intellectual capture ensuring that nothing messes with their gravy train. 

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The numbers are significant. An analyst at consultant firm InRecap explains how “federally subsidized MLF loans would be an alternative to federally subsidized tax-exempt (municipal) bonds.” We have a choice, in other words: amend the MLF (or use Section 14), and send $500 billion in debt to state and local governments, or place $500 billion in the muni market through tax expenditures.

If you extend the MLF loan terms to 30 years—either by fiat or through committing to roll over the debt—and reduce the interest rate to the rate on Treasury bonds, the estimated credit losses would be about $6 billion for a $500 billion facility. (see the link for details.) $35 billion of the MLF is intended for credit loss absorption, supplied by Congress through the Treasury. So the minimal losses are already reserved.

The cost of doing nothing, InRecap estimates, is that the MLF goes unused, and state and local governments tap muni bond markets for the same loans at the same terms. In that scenario, because of the tax-exempt nature of the bonds and some other calculations (see the link), the government will lose tax revenue of $20 billion in the first ten years, and $35 billion over the full 30. If the calculation is correct, you’re talking about close to six times as big an expenditure, at the far end, if you just let the Fed handle the loans. The Congressional Oversight Committee (COC) could ask for a sharper analysis of this from the Joint Committee on Taxation if they wanted the numbers.

More important, if the Fed filled the gap, that $500 billion would be out of the muni markets, meaning those financiers would be denied the fees that go along with them. And this mentality has carried through to the government, through former muni traders now placed there.

That includes Kent Hiteshew, who is running the MLF for the Fed. Prior to his stints at the Fed and at the Treasury Department he had a “30-year career in public finance on Wall Street,” another way of saying muni trader. The announcement of the Fed hiring described Hiteshew as a “veteran muni banker.” (while at Treasury, he also worked on the junta, the financial oversight commission, in Puerto Rico.)

Hiteshew, in testimony before the COC last week, said that the MLF must not “replace private capital” and that the success of the MLF is based on “the condition of the municipal securities market.” During questioning, Hiteshew noted that his phone was ringing off the hook for the first time, alluding to his pals in the muni market. It was a moment where the mask slipped, and top officials revealed the influence peddling at work to deny the public sector needed relief.

“It’s a very clubby sector of the financial services industry, they have a kind of oligopoly status,” said Hockett. “That in turn stays with people who leave to go to work in government.”

Hockett shared with me email conversations he had with Marjorie Henning, a deputy to New York City Comptroller Scott Stringer who has been delegated to handle options for municipal lending. She expressed deep skepticism that the Fed could deliver favorable terms. “How can you say the terms will be generous when the FAQ clearly state that the interest rate will be a penalty rate, at a premium to the market?” she wrote. Henning was a Director in the Municipal Securities Division at Citigroup and spent three decades in the muni market. “It’s an intellectual capture or spiritual capture, they think of the muni market as a friend,” Hockett said. “They’re suspicious of anything that smacks of a public option.”

There are several examples of successful federal credit programs in competition with muni markets that have mysteriously disappeared. Build America Bonds, the successful stimulus program for supporting state and local governments, just vanished. The Water Infrastructure Finance and Innovation Act (WIFIA) loan program, with $13.6 billion in loan volume, has been a credible replacement for munis that allows local governments to increase their water bond financing. It’s been defunded in the House Appropriations Committee for technical accounting reasons. It’s hard to see these all as coincidences. 

If this hypothesis is correct, the muni market, therefore, is helping to ensure the essentially unusable nature of the MLF, to keep its profits fat. Progressive members of Congress have been calling for months to improve the terms of the program, but they can’t compete with Kent Hiteshew and other of Wall Street’s friends in high places.

One of the reasons to question whether the stock market reflects the real economy is that the majority of the workforce doesn’t work for listed companies. (Nathan Tankus’s linked piece has some interesting elements but my point stands.) That includes the 13 percent of the workforce at state and local governments. The Fed has the power to broaden its functionality to the local level so more people are affected by its actions. It chooses not to, and the links to the muni market have to be seen as part of that.

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