A Taxpayer's Paradise

Why the municipal bond market isn't helping with adaptation right now

The peculiar money machine known as the municipal bond market is chugging along this week, feeling less burdened by uncertainty post-election. It's a remarkable engine: tens of thousands of mostly unregulated, fragmented issuers (local governments), looking for support from a highly-concentrated pool of US taxpayers who are mostly interested in tax-exempt income and are largely price-insensitive. Everyone involved is comforted by a multi-decade history of rare defaults. They're confident that the tax exemption that powers the market won't be revoked by the new federal administration.

This is how we fund most local infrastructure in America. Unexamined, it's a calm and stately system, devoted to stationarity—it's called "fixed income," after all.

The trouble is that reality is changing fast. Given the unthinkable pace of climate-driven effects already being felt in America, sooner or later some level of government will need to spend very large amounts to ensure that residents can live decent, relatively safe lives. 

What if all the incentives that now power the muni bond market are muting the signals that would otherwise redirect planning and money toward this goal? Delay will just make the problems worse and the solutions far more expensive—at least ten times as expensive. What if a sudden set of defaults and bankruptcies triggered by extreme weather cause the money machine to grind to a halt? This will surprise and frighten investors as well as issuers. And it's not clear the new administration will be interested in bailing out cities it doesn't like.* 

The muni market, I'm learning, is not a very sensitive place. Just run down the cast of players: 

Issuers. Thousands of them. They may have some state oversight, but they're a huge, heterogeneous, mostly unregulated clump. The MSRB can't make them disclose physical climate risks, and the SEC can look only for outright fraud. Their incentives are to raise money whenever they can. They want high credit ratings so that the money they attract is cheaper, so they don't want to talk about physical climate risks to their operations or (usually) raise money aimed directly at adaptation.

Underwriters. These are the investment banks that run the transactions. They do have disclosure standards, are overseen by the MSRB, and will be liable for a long list of claims if things go badly—but they also have incentives to do the deal, because they're paid a percentage. 

Investors. They're grateful for the tax-exempt income. If they're institutional money managers, they're usually paid based on the amounts they're managing, not performance of their portfolios. Very few money managers understand or look for physical climate risk in their bond portfolios.

Bond counsel. Issuers hire lawyers to give opinions and draft disclosures. These individuals don't bear liability for what happens later. Apparently bond counsel traditionally look backward when assessing what risks are material enough to mention, and physical climate risk mostly doesn't make the list. The GFOA has issued guidance on this subject, but it's not widely followed. The bond lawyers are very pleased that the federal government has no jurisdiction over the muni market.

Credit rating agencies. These firms are usually paid by issuers for their ratings, which probably undermines their appetite for pricing in physical climate risks. Something like 85% of new muni issuances are rated investment-grade, and (as we've seen), the rating agencies don't draw distinctions between 30-year and 5-year  bonds.

Municipal advisors. Every issuer has to have one, and all of them need to pass MSRB exams. They have no liability if things go wrong later.

So even though it would be far less expensive to plan for transformative adaptation now, and to raise the funds to do it while the money is still flowing and relatively cheap, this system is not designed to make it in anyone's interest to do so.

There are exceptions: California just passed Proposition 4, which is a $10B bond issue to fund adaptation ("finance projects for safe drinking water, drought, flood, and water resilience, wildfire and forest resilience, coastal resilience, extreme heat mitigation, biodiversity and nature-based climate solutions, climate-smart, sustainable, and resilient farms, ranches, and working lands, park creation and outdoor access, and clean air programs.") 

I learned this week from a presentation by Nancy Wallace, a professor of finance and real estate at UC Berkeley, that many of the campuses of the UC system are located in Wildlife-Urban Interface areas, or WUIs. A WUI is where nature meets development. Paradise, CA is/was also in a WUI.

UC Berkeley, up in the hills; UC Davis, in the midst of a tinderbox of dryness; and UC Santa Cruz, in the mountains: all of these places are particularly vulnerable to ferocious wildfires spurred on by extreme temperatures and very low humidity. 

Both the UC system and Paradise fund their activities using state/local revenue bonds. After Paradise was severely damaged by the Camp Fire of 2018, its downtown redevelopment agency was unable to make interest payments on a TIF instrument it had issued.

The UC system has more than $36 billion in outstanding bond obligations, according to its most recent financials, but a recent Fitch report says nothing about physical climate risks to the system's operations. 

It's not that this system is necessarily going to break down. It's just that by not putting climate risk squarely on the table and pricing it into its operations, the muni bond apparatus has a tendency to squelch public finance aimed at adapting to climate change: investing in safer places, taking infrastructure out of commission in dangerous places, building in safer ways. By muting genuine disclosures about physical risks, it is failing to communicate infrastructural needs for adaptation.

The market will work well until, perhaps, in some places, it doesn't. There may be pockets of defaults that surprise investors and signal municipal despair. We can do better.

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* Here's where the recent election may present risks to the future of municipalities: Peter Thiel said this week, talking about new Trump administration policies toward high-spending "blue" cities, that refusing to bail out New York City when it hit municipal finance trouble in the 70s was one of the smartest things the federal government ever did: 

"There was a 1970s history in the Ford Administration where New York City almost went broke and Ford sat on his hands and it was the most popular thing. Ford was down 30 points, came back to almost winning reelection in 1976. It was very popular not to bail out New York City. People knew we don't want to throw good money after bad. If you look at the possibilities of changing the system, there's a way ... The inertia seems so high that if we have to get rid of the Department of Education, I don't think that will ever happen. And then I think the Democrats have nothing to worry about because Trump won't really do anything. But if actually for the system to continue, you need to get crazy new spending approved and all that Trump has to do is not approve the new spending. That's where I think you're going to be able to force radical change in California, in New York, in Illinois, where these places have to reform themselves or go bankrupt.