The Public Policy

Barney’s Big Idea

The name is bond. Municipal bond.

By 7.31.08

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A few powerful members of Congress have got it in their heads that it would be a good idea to shake up the municipal bond market. It's a bad idea, especially at time when most markets are troubled.

These bonds -- interest bearing notes from state and local governments -- tend to pay low, predictable interest rates. Most municipal bonds go to pay for workaday public infrastructure -- boring but necessary things like sewage treatment plants and highway interchanges. Given their staid nature, it's not surprising that the municipal bond market has remained much more stable than other parts of the currently chaotic financial system.

House Financial Services committee chair Barney Frank and Capital Markets subcommittee chair Paul Kanjorski, among others, want to change that by imposing a new regulatory regime on the municipal bond market. A bill they've proposed, the Municipal Bond Fairness Act (which the Financial Services Committee considered Wednesday), would give the government broad new powers to oversee the ratings firms that deal with municipal debt.

Although the legislative language doesn't look very radical, the bill essentially mandates that bond raters focus on default risk (the risk that it won't get paid) and use that to make municipal bond ratings mirror corporate bond ratings. Ratings matter because they determine interest rate a government will have to pay and, thus, set an effective cap on the total amount of debt that a government can issue, as well as the revenues it will have to raise to service the debt.

Greater ability to issue bonds at lower interest rates would let government do more. People who like small government have reason to be worried about this.

SO DO BOND investors. If corporate and government debt were held to equal standards based on default risk, this would result in significant "grade inflation" for all state and local government debt.

The bill's sponsors insist that municipal bond investors do almost always get paid. No state has defaulted on its debt since the 19th century. Cities, counties, and independent authorities have gone bankrupt but state governments have often helped out.

Sometimes -- in Washington, D.C. in the 1990s and New York City in the 1970s -- a higher level of government sets up a control board in order to help reign in a city's free-spending ways. These systems also protect investors.

But this starry eyed optimism glosses over the fact that major governments -- Orange County, California most prominently -- have entered bankruptcy court without any substantial bailout assistance from state or federal authorities.

Other substantial risks exist when investing in government debt. A legislature that authorizes an appropriation or creates a revenue stream for local government can almost always take it away whatever it gives without much warning. And mayors and governors who would get unanimous support from corporate boards can find themselves voted out of office for all sorts of things totally unrelated to fiscal management.

IN OTHER WORDS, corporate and municipal debt may well be different enough to warrant disparate treatment.

Given the recent collapse of apparently stable companies ranging from Bear Stearns to Countrywide, it's clear that at least some corporate debt analysts haven't been doing their jobs very well. Analysts also missed the early signs of mismanagement and risky investing strategies that lead to Orange County's own bankruptcy.

Quite possibly, the entire way the United States rates bonds needs an overhaul. It's even conceivable that, as Frank and Kanjorski argue, municipal bonds really should have broadly higher ratings than they do today. But the market, not the government, should and will determine that.

Especially in the midst of widespread financial market chaos, simply mandating broadly higher ratings for municipal bonds doesn't make any sense.

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