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Building America's Next Bailout

Here we go again.

Oct 11, 2010, Vol. 16, No. 04 • By CHRISTOPHER PAPAGIANIS
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As Congress considers these bills, now is the perfect time for the U.S. government to include legislative language clarifying who exactly stands behind Build America Bonds—namely, the state and local governments that issue them. If this situation isn’t addressed and the program is extended for several years, foreign holdings of municipal debt could easily exceed $150 billion. This is not a small number, even for a market that’s measured in the trillions. In fact, it’s roughly equal to the total foreign holdings of Greek government debt, which was enough to spark a debt crisis in Europe earlier this year.

A key lesson from the financial crisis is that creditors based expectations on informal relationships between entities instead of strictly defined legal relationships. What began with banks having to rescue structured investment vehicles and other “sponsored” off-balance sheet entities (that were not technically guaranteed) only ended when governments stepped in with a broad banking industry bailout. The lesson to lawmakers should be clear: Seemingly innocuous promotional material or coordinated efforts to expand investor interest can be viewed as implicit backing for the creditworthiness of the underlying obligations. 

Build America Bonds are also blunting the incentives for states to borrow less, which would be a logical response to their deteriorating credit profiles. Access to a new class of bond buyers, in short, has fueled more borrowing by state and local governments. It’s a slow-burning fire (for now) that could get out of hand and require federal intervention. 

Harrisburg, Penn., for example, announced on September 1 that it will skip a $3.29 million debt payment that is tied to a $288 million incinerator project that has roughly $68 million of debt outstanding. Days later, the governor and the state government had to step in to help the city out. Unfortunately, some big state governments around the country—California and Illinois in particular—are severely strained and it’s possible that some other cities and municipalities won’t be as fortunate as Harrisburg.

While the numbers from Harrisburg may not sound that large, this situation was on track to be the second-largest municipal default this year, and many market analysts worry that it could be one of the early signals of more defaults over the coming months.

Making marketing materials clear and perhaps capping—or even lowering—the federal subsidy would lead to less borrowing by less-creditworthy municipalities and more borrowing by more-creditworthy municipalities. In this way, the likelihood (and magnitude) of municipal bailouts would decrease. The federal government can protect taxpayers and avoid building America’s next bailout. It just needs to prevent the BABs program from expanding until it’s too big to fail.

Christopher Papagianis, managing director of e21, was previously special assistant for domestic policy to President George W. Bush.

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