In Barron’s: Open Markets Institute research associate, Garphil Julien, addresses a longstanding structural problem—a group of the nation’s biggest banks that has cornered the market for municipal bond underwriting.

Cities and states are in a fiscal crisis. Municipal bond defaults are now at their highest in a decade. Despite a $500 billion Federal Reserve intervention, with more potentially on the way, regulators have yet to address a longstanding structural problem—a group of the nation’s biggest banks that has cornered the market for municipal bond underwriting. This concentration of power has the potential to raise the interest rates on the bonds local governments urgently need to salvage their finances and the costs could be in the billions. While some municipalities will default on their debt, others will need to increase borrowing to continue providing public services. But the structural issues in the municipal-bond market could make borrowing costlier and alternatives are needed.

The municipal bond market is “very concentrated,” said Margaret Levenstein, a University of Michigan professor who has testified before Congress on the issue. “It’s important to understand these firms divide markets in ways that definitely raise the cost to municipalities in issuing municipal bonds.”

States and municipalities pay for most public services and infrastructure projects, such as hospitals, bridges, roads, and broadband internet, by issuing bonds that are typically purchased by retail and institutional investors in the municipal bond market. Large Wall Street banks act as underwriters, purchasing these bonds and reselling them to investors. Taxpayers in states and municipalities then pay off the bonds through taxes and fees for public services, such as sales taxes or road tolls.

The problems for cities and states began decades ago when most bond issues still paid a fixed interest rate backed by the full faith and credit of the taxpayers in the issuing municipality.  In the 1960s and 1970s, deindustrialization contributed to a shift in population to suburban areas with a subsequent reduction in tax revenue and federal aid to cities. After several cities experienced fiscal crises, municipal budgets became the subject of new financing techniques by bankers to generate more revenue. Payments backed by services, rather than city taxes, formed these complex bond instruments. By the 1980s, these became the overwhelming majority of municipal bond issues. Local officials became even more reliant on Wall Street banks as they financed their budgets through high-risk bond instruments, including derivatives and variable rate debt.

“You’re cornered if you’re a city,” said Mark Kear, a geography professor at the University of Arizona whose work has focused on urban financialization. Many states have constitutional prohibitions on running deficits, and politicians have few incentives to raise taxes on their constituents and businesses. “You have no choice but to turn to financial markets, and they are well-positioned to extract high-interest rates.” 

In theory, variable-rate bonds move in tandem with a benchmark called the municipal swap index, run by the Securities Industry and Financial Markets Association. The index calculates the interest rates based on the supply and demand characteristics of the market. However, transparency issues have been a cause for concern among regulators, academics, and former workers in the industry, including claims of rate manipulation by the banks.

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