Summary:
– The finances of US states and local authorities are deteriorating significantly in the face of the health crisis, which is turning into a financial crisis on the municipal bond market, which brings together the various levels of local authorities in a very granular and extensive manner.
– The US financial pact dating back to the aftermath of the War of Independence at the end of the 19th century and the negotiating skills of Alexander Hamilton, then US Secretary of the Treasury, thus appears to be under threat, with some members of Congress rejecting the financial rescue of other states by the federal budget.
– Pending an adequate budget plan, currently under negotiation in Congress, the Federal Reserve is stepping in as the lender of last resort, mobilizing, with the Treasury’s guarantee, a refinancing facility dedicated to local authorities, by virtue of its special prerogatives, and de facto stabilizing the market.
In some respects, the United States is experiencing an « anti-Hamiltonian » moment—named after the first U.S. Secretary of the Treasury, who organized the federal takeover of local public debt following the War of Independence. Today, too, the US situation is marked by severe pressure on the local finances of various states, counties, and municipalities due to the Covid-19 crisis.
The health crisis is causing significant revenue losses and extreme volatility in the US local government bond market (commonly referred to as the « municipal » market). The Federal Reserve is attempting to respond to this new moment of truth for the US financial pact by deploying a new support facility dedicated to local authorities, fully playing its role as lender of last resort.
1. The health crisis is plunging US local authorities into a major financial crisis, weighing on the post-pandemic economic recovery.
State and local governments thus constitute an important part of the US economy, representing USD 3.7 trillion in annual spending (or 19% of US GDP) in areas such as education, health, and infrastructure. The operating expenses of US local authorities (i.e., their operating accounts) are constrained by the requirement to balance their books over one or two fiscal years. This is in contrast to capital accounts, which are used to finance larger projects, such as infrastructure, and are not subject to this balancing requirement, and may even run a deficit.
The resources of these local authorities come from property taxes or income and are therefore particularly dependent on the economic cycle. Beyond rainy day funds, which are mandatory for each state and total USD 62 billion, including nearly USD 10 billion for Texas alone, the states have no additional resources immediately available, except for support from the federal government. They are therefore currently unable to play their role in supporting the local economy.
Local vs. federal spending in the US before and during the Great Recession: a significant but limited countercyclical impact
In fact, in the face of the health crisis, local revenues are falling significantly, particularly those closely linked to the economic situation, while spending is increasing, with the result that some states, counties, and cities are already facing initial budgetary difficulties that are limiting their countercyclical action. Massachusetts, Missouri, Kansas, Pennsylvania, and Montana have seen their revenues fall by more than 50% between April 2019 and 2020.
According to a survey by the National League of Cities, US local authorities could lose more than USD 360 billion in resources by 2022: an additional 1 percentage point of unemployment would lead to a 3 percentage point drop in tax revenues, plunging some states into serious difficulties. Pennsylvania, for example, is expected to lose 40% of its revenue this year, while the city of San Francisco estimates that it could lose EUR 3.6 billion by 2024 (see illustrative map from Bloomberg News showing revenue losses as a percentage of total budget).
Furthermore, analysis of monthly data from the Bureau of Labor Statistics on employment in April and May shows that local governments have already shed 1.5 million jobs since the start of the crisis (vs. a total of 20.5 million non-agricultural jobs lost), as in 2009, when anecdotes about police and firefighter layoffs made a strong impression on the American public.
As a result, interest rates on local government debt reached a historic high of 2.6% in mid-March for the 10-year composite benchmark interest rate, which normally trades at levels close to or below US Treasuries, given certain tax advantages over US Treasury bonds. Other examples illustrate the difficulties faced by certain local authorities, such as the rise in rates on California state bonds (15-year rates above 4.5% in mid-March compared with an average of 1.9% for 2019, since recovered to around 1.5%) and the downgrading of New Jersey’s credit rating.
Performance of the 10-year composite benchmark bond for local authorities vs. the 10-year rate on US Treasuries (Financial Times)
2. The United States is experiencing an « anti-Hamiltonian » moment, with the federal government currently refraining from fully playing its role as the lender of last resort.
Led by Senate Majority Leader Mitch McConnell, political tensions are emerging between net contributor states (such as New York) and net recipient states. The budgetary difficulties of certain states, counties, and cities are reminiscent of this pivotal moment in the construction of the US federal government.
In 1790, at the end of the War of Independence, while the 13 states that made up the United States of America had incurred a debt of nearly $25 billion, the federal government was in debt for a total of more than $50 billion. Alexander Hamilton, the first US Secretary of the Treasury, in his First Report on the Public Credit, proposed that the federal government « assume » the debt of the 13 founding states in order to centralize its servicing and facilitate its refinancing.
After bitter negotiations with James Madison and Thomas Jefferson, representatives of the Southern states who were advocates of a decentralized system and opposed to any form of mutualization, Alexander Hamilton succeeded in mutualizing the debts of the various states and the federal government. The states that were reluctant to accept this debt takeover obtained in exchange the location of the federal capital on the banks of the Potomac River in Washington, D.C.
The Second Report on the Public Credit led to the establishment of an early form of central bank, the National Bank of the United States, with mixed capital (20% public) and responsible for supporting the financing of this new national debt by offering short-term facilities to the federal budget. However, this precursor to a central bank did not make its mark on history.
3. The Federal Reserve now fully plays this role of lender of last resort through a dedicated facility, the Municipal Lending Facility, which is guaranteed by the Treasury.
This « anti-Hamiltonian » moment currently applies to the debt servicing of US local authorities, which have been affected by a crisis in their bond market. The local debt market, known as the « municipal » market as opposed to the US Treasury market, developed historically following this great Hamiltonian moment after the War of Independence to finance the development of major local or national infrastructure projects (the New York City canal, the Northern Pacific railway network, etc.) within the framework of the prerogatives of US local authorities.
Now very large and deep, the usually quiet « muni » market, with USD 4 trillion of mainly investment-grade securities, but particularly fragmented among 50,000 issuers, some of which have unsustainable sources of income (e.g., nurseries, stadiums), is experiencing a period of extreme volatility.
This tension is global but more pronounced in the high-yield (and therefore riskier) sector, as illustrated by this comparative chart from Bloomberg News, which shows the loss in value of its benchmark indices during March, before rebounding following the Fed’s QE program and the announcement of the Municipal Lending Facility in early April. Rates normalized in May 2019 and clearly show the lower performance of riskier high-yield securities.
This tension has prompted a two-pronged response from the US authorities since late March and early April:
– On the one hand, a federal support plan (Coronavirus Relief Fund) worth USD 150 billion for states and local authorities affected by the health crisis (with a minimum of USD 1.25 billion per state), likely to be supplemented by another USD 1 trillion plan still under negotiation in Congress;
– On the other hand, the Federal Reserve has set up a Municipal Liquidity Facility (MLF) for a total amount of USD 500 billion (USD 464 billion from regional federal reserves and USD 35 billion from the federal Exchange Stabilization Fund), via leverage generated by a dedicated Special Purpose Vehicle (SPV), exceeding 14 (vs. levels close to 10 for other facilities introduced by the Fed during the crisis). It benefits in part from capital support from the federal budget, enabling it to absorb some of the losses if necessary, and effectively operating a form of mutualization.
This facility, which will remain in place until at least the end of 2020, aims to reduce the refinancing costs of local authorities. To this end, the Federal Reserve will be able to purchase up to 20% of the outstanding short-term securities (maximum 24 months) issued by US local authorities in exchange for a limited fee of 10 basis points. Its scope has been expanded twice, most recently on June 3, to include an ever-wider range of local authorities: counties with more than 500,000 inhabitants and cities with more than 250,000 inhabitants.
This support provides substantial assistance to US local authorities, as short-term debt represents more than $2.4 trillion, or 60% of the local authority market. This facility also complements its decision to accept local authority debt as collateral for its monetary policy operations. Its announcement led to a significant easing of municipal bond yields, thereby stabilizing the market.
The Federal Reserve is acting here under Section 13(3) of the Federal Reserve Act, which dates back to the Great Depression after 1929 and allows the Fed to provide liquidity to entities other than credit institutions (e.g., companies) subject to approval and oversight by the US Congress. Widely used in 2009 and again in 2020, Section 13(3) is a particularly effective crisis weapon for the Federal Reserve, which acts directly with companies, but also with money market management companies and primary dealers.
Above all, through this facility and its support for various states and other local authorities in difficulty, the Federal Reserve acts, with the guarantee of the Treasury, as the true federal actor of last resort that Hamilton wanted, completing, more than two centuries later, the work of the first US Secretary of the Treasury.
