News Analysis: The Foreclosure Credit Storm and Cities

The stakes are enormous: state and local governments have some $3.2 trillion in pension assets — assets of nearly 30 million current or retired employees, as much as $1.5 trillion in cash, and more than $2.66 trillion in outstanding tax-exempt municipal bonds that have become the single most important source of infrastructure financing for the nation.

With the safety and soundness of the nation’s financial systems at risk, cities and towns are at risk. Just as city leaders must be acutely attuned to the maintenance and health of the physical infrastructure of their cities, so too must you be to the financial infrastructure.

An expected, trillion dollars worth of assets in vaults in financial institutions under city streets in America, along with the capital and liquidity of banks and investment banks, are expected to be written off by the end of this year. That collapse will not only affect capital available for reinvestment in communities for commercial and residential investment, but also the safety and security of municipal holdings or investments in those institutions or their instruments. Municipal debt issuers have already moved to refinance or convert more than $80 billion of their $166 billion in auction-rate securities since that market collapsed on concern over the financial strength of insurers, which suffered billions of losses on securities tied to home loans.

One of the earlier manifestations of the credit crisis and its impact on cities and towns came earlier this year with the collapse of the auction-rate securities market last winter after downgrades of municipal bond rating agencies drove up yields on variable-rate demand bonds (securities issued by cities and towns that have long maturities, but typically pay short-term rates, because they can be sold back to brokers).

There were $375 billion of so-called variable-rate demand notes outstanding, according to the Securities Industry and Financial Markets Association, of which, Bloomberg News columnist Joe Mysak reports, states’ and municipalities’ made up half. By February, this mechanism began to collapse. Until then, dealers had been stepping in and buying whatever investors would not. But then most dealers stopped, allowing nearly 70 percent of auctions to fail. Investors, many of whom had purchased auction-rate securities with the impression that they were as safe and readily saleable as money-market instruments, found themselves unable to have access to their money. Some cities were forced to pay penalty rates, some as high as 20 percent. The municipal piece of the auction-rate market since then has shrunk by about half.

At the same time, in the mad scramble to move debt off the books, financial institutions began to not just slice and dice mortgages into securities that could be taken off their books and marketed to investors around the globe, but also other vehicles, such as Special Investment Vehicles (SIVs), used to borrow short-term in the commercial paper market in order to finance portfolios made of mortgage-backed bonds.

But as rapidly increasing foreclosure rates became a reality, the values of these securities began to unravel. To the extent cities had invested funds in state investment pools, and those pools had invested in those kinds of securities or in hedge funds; there were both significant losses and sometime fund freezes. 

The implosion of the municipal bond insurance companies added insult to injury. These firms had added on to their basic and low-risk business of insuring state and local debt by underwriting mortgage securities and other structured-debt instruments. As that structured finance market collapsed, the bond insurers were threatened with bankruptcy — which in turn undercut their credit ratings and therefore the ratings of municipal debt that carried their insurance. This created an upside down world where bonds issued by cities and backed by their taxpayers’ full faith and credit were abruptly subject to very high interest rates at a time when there were few safer securities available in this country.

Finally, as cities are caught between the Scylla and Charybdis of the new Governmental Accounting Standards Board 45 rules on post employment benefits and seeking good rates of return on pension and investments, leaders will need to tread with caution. Some two dozen hedge funds have recently locked in their investors, with no or limited withdrawals permitted. Don’t jump from the frying pan into the fire, and don’t assume the federal government will be there either to protect your city or bail it out. 

Frank Shafroth is chief of staff for Rep. James Moran (D-Va.) and an adjunct professor in the Graduate School of Public Administration at George Mason University. His views do not necessarily represent the views of NLC.