Quasi-governmental debt from "independent authorities" is substantial

22 Dec 2010 by Jim Fickett.

State and local governments often set up independent authorities that issue debt to fund utilities, sports and entertainment centers, and other projects. While governments often have no legal obligation to stand behind such debt, a default would lower public ratings, and so there is, in practice, some level of obligation. The amount of such debt outstanding is on the order of $500 billion. It is extremely difficult to judge what fraction of that debt might end up defaulting and coming back to the governments that set up the issuing authorities. What one can say is that this is the one area of hidden state and local government debt that might be, if not as large as primary debt and unfunded retirement obligations, at least on the same scale.

I have written a series of posts about various sorts of hidden debt at the state and local government level (for links see the State and local government debt Reference page). The big one, of course, is unfunded retirement obligations, but there are many others, such as selling state assets and leasing them back, or borrowing from the US Treasury to pay unemployment benefits. So far the conclusion has quite clearly been that each category of hidden debt, while possibly significant in individual cases, is, in aggregate, very small compared the the two large categories of primary bond offerings and unfunded retirement obligations.

This is the last post in that series. The subject is debt issued by independent authorities. Rather like the Post Office or Fannie and Freddie at the federal level, these authorities are not officially part of state or local government structure, yet were set up to carry out a business that is a direct interest of the government. Governments are not legally obligated by the debt they issue, yet there are reasons to think that governments could end up making good on defaults.

The New York state controller has a good summary on the standing of such debt in the overall scheme of things:

Public authorities also issue debt for which there is no pledge at all of State payment of debt service. For example, the State Dormitory Authority issues its bonds and notes for facilities at private colleges and universities. The debt service on these bonds and notes is secured by a mortgage with the college or university. The State is under no obligation, moral or legal, to pay debt service on this type of bond.

These bonds may also be referred to as conduit bonds. A conduit bond is a bond sold by a public authority to benefit of a third party, generally non-governmental. For example, the New York State Energy Research and Development Authority (NYSERDA) sells its bonds for projects of public utilities. The security for the credit is in fact the responsibility of the public utility. NYSERDA merely serves as a conduit between the bond purchaser and the public utility.

Although the State is not obligated to pay this debt, a default may affect other State debt by making it more costly for public authorities to borrow. As such, it might be financially advantageous for the State to make payments in the case of a default by a public authority.

“Public authority”, “independent authority”, and “conduit” are, for our purposes, equivalent. Sometimes a government will accept a “moral obligation” to guarantee the debt of an independent authority. In such cases the obligation is still not a legal one. Ignoring all such distinctions, what we are interested in is all cases where an independent authority is set up by a state or local government and issues debt; the government has no legal obligation to guarantee the debt; but there is a reasonable likelihood that the government would cover a default.

It is very difficult to come up with any estimate of just how much governments have endangered their finances by debt in this area. The reason is that there is huge variation in the type, size, and riskiness of independent authorities. If you are interested in understanding more about this area, the Muni Net Guide has a list of over a hundred “state municipal bond conduit authorities”. I will just take two examples to give some idea of the range.

At the very conservative end of the spectrum, the Alaska Municipal Bond Bank Authority is basically a way for the cities and towns of Alaska to band together and issue bonds under a common umbrella. The state contributed to a reserve fund for the authority. This reserve, together with the fact that any one city's default would be a small portion of the authority's debt, allows the authority to issue debt with high ratings and low interest rates. At least on casual inspection, it would appear that the state of Alaska bears little risk from this authority.

But there are disastrous examples of independent authorities as well. The infamous incinerator of Harrisburg is one fairly well known, but still pedestrian, example. A byzantine and spectacular example is the New Jersey Sports and Exposition Authority. According to the NJSEA website, it is a spectacular success:

On May 10, 1971, the NJSEA was established with the stroke of Governor William Cahill's pen on Legislation that he had proposed. The Authority was given the mission of constructing and managing a new state-of-the-art sports complex. The Complex would provide a home for the New York Giants football team and launch New Jersey into the sports and entertainment big leagues. …

The Meadowlands has become an economic powerhouse for New Jersey.

But according to the NJSEA annual report, their operating loss was $85 million in 2008 and $81 million in 2009. City Journal writes:

In the early 1970s, New Jersey officials decided to build a sports facility in the Meadowlands, the state’s wetlands just outside New York City. To help pay for it, they formed the New Jersey Sports and Exposition Authority (NJSEA), a quasi-governmental agency with the power to issue debt. The authority floated $302 million in bonds, used the proceeds from the bond sale to construct Giants Stadium and a Meadowlands racetrack, and planned to pay off the debt in 25 years, largely with proceeds from the track but also with some help from the stadium. Horse racing proved a big hit, and the plan seemed bound for success.

But the pols couldn’t resist soaking the Meadowlands. They siphoned track proceeds into the state budget; repeatedly refinanced the NJSEA’s bonds, pushing repayment dates far into the future; and relied on the authority’s good credit rating to launch other building schemes, including a costly but unsuccessful aquarium in Camden. Today, 35 years after its first bonds, the NJSEA is $830 million in hock. Worse, it can’t repay that debt because business has cratered at the racetrack, still the Meadowlands’ principal revenue source. As for Giants Stadium, it was demolished this year, and its replacement won’t be contributing much to the debt repayments. The state, facing its own cavernous budget deficits, has had to assume the authority’s interest payments—about $100 million this year on bonds that now stretch out to nearly 2030.

In February of this year Governor Chris Christie set up a commission to study the situation and recommend changes. The ground rules included that, “Financial losses of the NJSEA must not be allowed to continue”. In the resulting July report, the commission pointed out major problems and recommended fundamental changes, for example,

NJSEA can no longer support losses in the racing business due to reduced racing revenues and lost stadium revenue …

For a fee of four million ($4,000,000) dollars to be paid to the NJSEA over the next two years the Nets will be permitted to opt out of the IZOD [sports center] lease …

Current cash reserves of the NJSEA (which are in excess of $50 million) should be used to offset operating expenses. Without state subsidy, NJSEA reserves should be at $5 million by December 31, 2010 (according to an independent auditor) if they are used to offset current operating expenses. NJSEA must be encouraged to create and maintain a break‐even budget. …

Planning should begin immediately to divest the NJSEA of all responsibilities related to venue operations

The NJSEA is likely to cost the state of New Jersey hundreds of millions of dollars before it is resolved.

Although is is nearly impossible to judge the aggregate risk, we can at least assess the overall size of the market in bonds from independent authorities. This whole area was brought to my attention by a post from “Bond girl”, apparently a bond trader, writing at the site Self-evident. I asked her how to estimate the size of the market, and she helpfully replied,

A quick and dirty source for quantifying the outstanding debt would be the US Census data on state and local finances, under the classification “public debt for private purposes.” That captures conduit bonds issued by state and local governments. Most recent data (2008) was ~ $588 billion total for the US (I believe).

Today the Financial Times quoted another source giving a similar estimate for what is probably a largely overlapping category of bonds:

Convention centres, sports venues and other US public facilities that do not provide essential services are a source of potential defaults in the $2,900bn municipal bond market, Fitch Ratings said in a report to be released on Tuesday.

Schools and courthouses are considered to be among municipalities’ core services. But bonds backed by so-called “non-core” services make up about 10 to 15 per cent of the market, estimates Matt Fabian, managing director at Municipal Market Advisors, a research group. …

The government itself may not sell these bonds, but they can be issued through what is a known as a “conduit,” like a development authority, and may be guaranteed by the underlying government at varying levels of legal obligation.

10-15% of $2,900bn is $290 - $435 billion.

On this last category of hidden debt, we have to be satisfied with a rather vague conclusion. There is on the order of $500 billion in debt from independent authorities, some (unknown) portion of which is at significant risk of default, and state and local governments may choose to take responsibility for those defaults. It seems quite clear that defaults by independent authorities will provide some great headlines in the next few years. It is less clear whether the problem is big enough to affect state and local government finances significantly, in aggregate. What we can say is this: if there is another area that comes close in size to primary debt and unfunded retirement obligations, this would be it.