No Place Screws Up the Concept of Fiscal Responsibility Quite Like Rhode Island Does

The bill being heard today by the House Finance Committee that would give municipal bondholders a “first lien” on local government treasuries (H5376), introduced on behalf of the Rhode Island Department of Revenue and already passed by the Senate Finance committee (S0614), should not be passed into law. Peder Schaefer of the Rhode Island League of Cities and Towns, which has taken a position against the bill, relays a key rationale being advanced by its supporters, as offered at the Senate Finance hearing: “A bond lawyer retained by the Department of Revenue testified that the real reason for the bill was in the event of a Federal Bankruptcy in Central Falls. She testified that if this were to occur, bond holders would not have a first lien on city revenues. She believes that the language of the act would improve the credit quality of all municipal bonds in the state”.
In other words, the Chafee administration Department of Revenue believes that a community should not be allowed to drastically restructure its finances to deal with a financial meltdown until the bondholders are taken care of. The bondholders come first, and then everyone else can fight over what’s left.
But even those who don’t believe that full-blown bankruptcy for Central Falls or any other Rhode Island community is likely should be troubled by this bill.
1. Allowing “first liens” on general tax-revenue does damage to the underpinnings of democratic governance. Tax revenue is taken from the income and/or wealth of taxpayers; revenue doesn’t magically fall out of the sky, despite what some government officials might believe. To create a bondholder lien on general tax revenue is to create a bondholder lien on taxpayers, i.e. to grant one group of people long-term, legally enforceable claims on the incomes and wealth of another. This is less compatible with modern than with medieval concepts of government and property rights, and I don’t think there’s any case to be made that we will do any better than our ancestors did under a system where regular citizens can find a portion of their incomes automatically claimed by a class of people who assert their superior position in the order of things.
2. Consider possibile outcomes, short of Federal bankruptcy, in the case of Central Falls. Section 45-9 of RI law (already in place) gives a receiver the power to issue bonds on behalf of his municipality including the power to use them to fund a deficit or to fund pension obligations. (Regular municipal governments are barred from issuing bonds to cover a deficit; the current bill reinforces that a receiver is immune from this limitation). The receiver cannot break collectively bargained contracts, so union benefits are locked in. And if this bill is passed, bond-holding financiers will be locked in too — which means that it’s the people in-between who will absorb the entire burden of government’s inability to rationally finance itself, as everyone else will have to be paid first, before regular citizens get anything from government. Except the bill, of course.
3. I know there is a group of people who believe that financial efficiency is the primary issue that needs to be addressed by government, and who aren’t much concerned with the undemocratic system being installed for dealing with Rhode Island’s financial mess (I think there may be more than a few of these folks in the Chafee administration). But even those who believe in nothing but the brutal efficiency of markets should be troubled by the imbalance created by this bill. If government writes into law that bondholders have a direct legal claim to money in the public treasury, then there is little to no risk of them not receiving their scheduled payments, and every bond covered by the law should be given the highest possible rating with lowest possible interest. Financiers who want to assert a legal claim over a portion of the tax levy and a right to take money through legal compulsion are not assuming true market risks, and should be paid accordingly.
In a special report put out last November, the Fitch Ratings service concurred with the idea that “first lien” bonds involve very limited risk, because people are required to pay whatever amount government demands of them…

Question: Given the strained finances of most state and local governments, and the likelihood of continued difficult times to come, why do Fitch’s ratings suggest confidence in the ability of most to meet their debt?
Answer:…Other commonly issued municipal bonds are secured by a first lien on sales or income taxes, where there is little if any legal discretion for the taxpayer to choose not to remit the taxes owed to the government.
The attitude reflected above, by the way, is why you should never trust the “financial efficiency is everything” crowd to run the government.
Once upon time, in the Western tradition of democracy and self-government, it was understood that government’s ability to compel people to surrender a portion of the fruits of their labor was a critical reason for limiting government claims on the property of the citizenry and to err on the side of the taxpayer. Rhode Island is sadly leading the way in eroding this tradition, asserting instead that government power to compel payment of taxes is a valid reason for allowing groups of people favored by the political class to make near-permanent claims on the livelihoods of average taxpayers.

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13 years ago

Mixed feelings. Money is cheap for municipalities in part because it has always been understood that they won’t default.
If I now have a significant possibility of lost principal, then I want higher reward for the risk, just like with corporate junk grade bond, adjusted for the tax free status of the muni. Bringing this bill up and then failing to pass it leads to the suspicion that there might be defaults. Not a good message to send.
Do municipalities in RI have the option of making some bonds first lien obligations, or is that option in state control?

13 years ago

It passed the Senate.
So much damage has been wrought by decades of bad policies that the well-intentioned (in this case) legislature is overreacting by considering corrective policies that are very bad in another way.

gary sasse
gary sasse
13 years ago

You got this one mostly right.

13 years ago

Most people don’t realize that a municipal bond is bonded debt. It is not a typical “loan”. It has a specific status which implies a higher level of responsibility by the issuer.
Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders.
People on this blog and certainly the author do not seem to understand the nature of bonded, apecifically, municipal bond debt. Take a good course in municipal finance as well as “money and banking” and then try again. Otherwise, leave complex public policy finance to the experts.

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