City as commodity

Why doubling down on coastal development can seem rational

If you want to understand why cities do what they do, particularly in a time of uncanny, obviously destabilizing climate change, it's useful to look for money flows.

The municipal bond market in the US is a fascinating subject. It's by far the largest municipal bond market in the world, accounting for two-thirds of the global market as of 2017. Few European cities have anything like the bonding powers that US cities do. These debts are hidden in plain sight! They drive city priorities! Whose interests are they serving? I have some ideas.

First, a little background. Most of the public infrastructure built or maintained by states and cities—like schools, streets, highways, sewers, and water utilities—is funded by loans, or debt, in the form of municipal bonds. Infrastructure is often very expensive to build, and issuing a bond allows a city to secure a large amount of cash upfront while spreading out interest (and principal) payments over an extended period.

Most local governments borrow money this way: of the roughly 80,000 local government entities in the US, 50,000 have issued bonds. It's a huge, largely self-regulated market that has grown enormously in recent decades: In 1950, just about $90 billion in bonds was outstanding. Today, that number has grown to $4 trillion, with about a million municipal securities outstanding at any given time. 

Why is this market so large? Because it's in the interest of a number of actors to keep it going. On the lender side, munis are the last great tax shelter for wealthy investors who want to diversify their holdings. Munis are considered to be safe investments. Their default rate is extremely low, especially when you exclude hospitals. They provide a bit of cushion against equity volatility while allowing investors to hang on to their capital. 

Here's how they work: Debt from a local government entity is bought by investors. In return, the investors, the bond-holders, receive interest payments—usually twice a year—and are paid back in full when the bond reaches maturity. Those payments, both of semiannual interest and eventually of the full ("par") value of the bond, are made from taxes or fees collected within the geography of the entity that issued the bond. Muni borrowers, like all bond issuers, aim to pay the lowest interest rate they can that will still attract investors.

The crucial element that sets muni bonds apart from other fixed-income securities is that those semiannual interest payments are not taxed by the federal government (and, sometimes, are also not taxed by the state where the bond is issued if the investor is in that state).

Let's assume that tax-free muni bonds pay about 81% of the interest a similarly-rated taxable bond will pay. Because that interest isn't taxed, a high-net-worth individual whose federal tax rate is 20% or more will find muni bonds attractive--this is called the "tax-equivalent" yield of the muni bond. High-net-worth people, both directly and through municipal exchange-traded funds (ETFs) and municipal mutual funds, seeing uncertainty in the equity marketplace, are increasingly interested in the predictable returns promised by tax-exempt bonds. (They may even pay a substantial premium for muni bonds just for the convenience of avoiding federal taxes.)

There are two types of muni bonds. General obligation bonds are backed by the "full faith and credit" of the issuer, meaning that the city's general taxing power is guaranteed to be deployed to ensure bondholders are paid what they are owed. Revenue bonds are guaranteed by the fees paid for use of the facility built with the borrowed money. Mass transit projects, port facilities, toll roads, and water facilities are all typical revenue bond projects. Tax-based revenue bonds are backed by streams of revenue from special-purpose taxes, like hotel occupancy taxes.

On the issuer side, munis provide an important source of capital for cities, who are otherwise forced to rely mostly on income from property taxes (and sometimes sales taxes, depending on the state) that is never enough to fund all the things cities are supposed to do. Support from the federal government used to cover 15 percent of city revenue needs in 1977, but now ordinary (non-COVID) federal aid is down to 5 percent of those requirements. State aid has also gotten sharply lower over this same period. At the same time, cities are on the front lines for a laundry list of social and economic problems. Bonded debt is central to modern urban life.

Here's an example: Just last month, NYC sold a $1 billion bond deal. The city, rated AA, sold 30-year debt with 4.35% interest. (That interest was .6% higher than muni debt rated AAA: lower credit rating, higher interest needed to borrow.) That may not sound like a good investment to you. But if you are a New Yorker making taxable income over $25 million, say, you're paying about 12% of that income toward a variety of taxes. All of the interest income on this NYC debt is exempt from all taxes—city, state, and federal. To compete with the amount you'll save by loaning NYC money, you'd have to hold stocks yielding about 9.8%. Given the vagaries of the stock market, you too would be delighted to hand over your money. This debt sold very quickly: The city received over $789 million in orders during a special period for retail investors, and another $5.1 billion in a session for institutional investors, according to Bloomberg. NYC's interest payment costs will be creeping up with this debt, but some of its largest taxpayers (on whom it depends for a large part of its income tax receipts) will be happy.

Here is the obvious issue: It's clear that city infrastructure and planning decisions are being shaped by the demands of the bond market (and capital markets in general), in a way that is at once highly subjective, difficult for the rest of us to see, and not necessarily aligned with the broad interest of city residents in planning ahead. Particularly in a time of rapid climate change.

That bond market has a very strong interest in ensuring that the governmental entity's capacity to charge fees and collect property taxes remains unconstrained and that its demographics remain favorable (in the eyes of credit rating agencies). The market also strongly prefers revenue bonds, because they're more easily understood and auditable—you can count the number of water subscribers and bridge-crossers. Capital Group's Mark Marinella said in 2019, "The vast majority of the holdings we have are going to be revenue-based bonds because we can trust that revenue, we can track it, we can analyze it, we can understand it, and we evaluate it." As you can see from the image above, about two-thirds of the municipal bond market is made up of revenue bonds.

City projects, and cities themselves, need to stay attractive to a wide range of intermediaries in order to keep these balls rolling in this expensive process. They need to hire a financial advisor to structure the securities, and a lawyer to give them advice. The bondholders will be represented by bond counsel, who will opine as to the validity of the bonds. Rating agencies play a pivotal role. (Often, all these people know one another well and have run into each other across multiple deals.) 

Moody's Investor Service and S&P Global together rate more than 80 percent of the municipal bond offerings in the US. They use similar scales: the best is AAA, and the bottom is BBB-. Anything below BBB- is considered "speculative" and essentially un-sellable.

We can't really tell what those credit rating agencies are saying to cities in private. We do know that Moody's says this publicly: about a third of its credit scorecard is based on residents' income and the area's economic growth; about a third is based on the city's financial performance; and about a third is based on how highly leveraged the city already is. "Climate" is mentioned only under "Other" factors (p.19) as part of "Environmental, Social, and Governance Considerations." Moody's has said that it's focused on "current and future [climate] mitigation steps" when looking at cities, and has acquired climate data research firms for this purpose, but how much any of this matters to a city's credit rating is completely unknown. A recent study suggests that the bond market, at least to date, has priced race but not climate risk; alarming, but not altogether surprising if true.

To be able to borrow money at the lowest possible interest rate, cities need high credit ratings. They need to please the investment banks that buy the bonds initially for resale (the "underwriters") that the bonds are marketable--and those actors likely are very powerful in this setting. If they are offering revenue bonds, they need to make sure that the number of rate-payers does not decline. If they are offering general obligation bonds, they need to make sure that property-tax payers don't decamp. Any decline in the property-tax-paying population or the rate-paying population (or the capacity of either of these groups to afford to pay taxes or rates) threatens a city's ability to repay debt or sustain its high credit rating. 

There are at least two implications of all of this. First, it seems clear that cities would need to choose projects to finance in the first place that serve to protect or enhance existing valuable assets, please the muni bond market, and provide the "strong demographics" that investors like to see. ("The Bonds of Inequality," a recent book by Destin Jenkins, discusses this foundational problem in vivid detail.) BlackRock recommended this summer that investors focus on revenue bonds issued by the "highest quality state and local issuers with broadest tax support."

Second, from a climate adaptation perspective, which in many instances will include the need to plan for relocation, cities have an additional problem: the work they do is made possible by taxing property and service-utilization that is linked to staying in place. It is absolutely in their interest to protect, at least in the short-term, activities that generate the revenue they have already used to back a bond or hope to securitize in the future—like commercial development resulting in property taxes, or tourism resulting in hotel taxes. It is also in their interest to avoid being perceived as risky places by underwriters, credit rating agencies, and high-net-worth individuals, even though doing so may bring future risk to more peoples' lives (other peoples' lives) because they have been encouraged to remain in place. 

How does all of this fit with a city's obvious need to help people survive an increasingly unpredictable and destructive environment, particularly along the coasts? 

Cities have to constantly tell the markets that they have a steady pipeline of projects designed to shield those existing assets from rising waters. The Moody's scorecard and mention of "mitigation steps" makes this plain. Cities have to choose projects that are specifically designed to protect the most valuable buildings and functions they have, because those buildings and functions are providing security to the muni bond marketplace. They have to announce they are building walls, or planning to build walls, that will keep storm surges away—even if those walls will likely be overtopped in a couple of decades, and even if those walls will do nothing to address increasingly intense storms and regular sunny-day flooding. If cities don't tell the municipal bond markets what they want to hear, their costs of capital will go sharply up or credit will be withdrawn entirely. 

Everyone involved has an interest in squeezing one last round of tax-exemption, one last bit of credit, out of the city. On this view, the city is a commodity, ranked and abstracted by a series of intermediaries, and then "financialized" in the muni bond marketplace. When the deluge arrives, all the intermediaries and beneficiaries will be safely living in retirement in the Berkshires, having extracted a comforting mound of tax exemptions over the years.

It is rational for city officials to delay any real effort to move people out of harm's way, or even to suggest that such a step may ever be necessary. It is sensible to encourage increased development for as long as possible. With any luck at all, they must be thinking, they’ll be out of office before the city bankruptcies begin. Until then, they believe they have no choice but to keep the game going.

Thanks to Ben Dinovelli for pointing me to The Bonds of Inequality.