Citizens versus bondholders.

• Author: Schragger, Richard C.

Introduction I. Monitoring and Risk Bearing II. Preventing Local Fiscal Distress III. Why the Preference for Bondholders? Conclusion INTRODUCTION

I own municipal bonds: Lowell, Massachusetts general obligation bonds; New York Metropolitan Transit Authority Bonds; revenue bonds issued by the Philadelphia Water and Wastewater Authority; some bonds issued by the city of Virginia Beach. I also live in the city of Charlottesville, Virginia, own a home and pay property and other local taxes there.

As a bondholder, do I pay attention to Lowell's, Philadelphia's or New York City's fiscal behavior? Do I know what these cities and public authorities are doing with my money? Could I tell you whether those bond issuers are good, bad, or indifferent managers?

Similarly, as a resident and citizen of Charlottesville, do I pay attention to the city's fiscal behavior? Do I have any idea what Charlottesville's budget is? (I do, but only because I teach local government law.) Could I tell you whether the city is a good, bad or indifferent manager?

In both these roles--as a bondholder and as a citizen--my incentive and capacity to monitor local government is limited. It is not nonexistent, but it is quite crude. Assuming that is true, what are the institutional mechanisms that encourage local governments to keep their fiscal houses in order? Moreover, in these times of fiscal distress, what are the implications of favoring bondholders or citizens when local governments come under fiscal stress and cannot pay their bills? Who should bear the risk of a default--citizens through tax hikes or bondholders through losses? And can the appropriate allocation of priority at the default stage help to prevent local fiscal distress in the first place?

These are centrally important questions as cities and other local authorities experience financial crises in the aftermath of the recent economic recession. (1) These are also the questions that Professor Clayton Gillette asks in his contribution to this Colloquium. (2) Gillette ultimately concludes that bondholders are in a better position to monitor the fiscal health of local governments and should thus be charged with the risk of default when financial trouble comes along. (3) He further argues that by placing the risk on bondholders, the chances of local fiscal distress will be reduced. (4)

I am somewhat less sanguine. I agree with Gillette that bondholders should be charged with the risk of municipal default, though my reasons are slightly different than his. I am also less sure than he is that such an allocation of risk will serve to prevent fiscal crises ex ante. And, unlike Gillette, I think that some judicial ambiguity as to the allocation of risk is not a bad thing.

In fact, Gillette's article has convinced me that neither bondholders nor citizens are particularly good monitors of local fiscal probity. If this is true, then it presents a puzzle. As Gillette observes, municipalities have significantly lower default rates than do their private-side counterparts. (5) Why do cities have such low default rates? Why do they generally keep their fiscal houses in good order?

Gillette's article raises a second puzzle as well. He observes that nineteenth century state courts and state legislatures were relatively sympathetic to cities and their citizens, often invalidating creditors' claims and placing losses at the feet of bondholders. (6) Twenty-first century state courts and legislatures have yet to make their sympathies fully known, but the assumption that bondholders must be paid seems to dominate discussion of local fiscal crises. This raises the following question: why were state courts and state legislatures relatively sympathetic to cities and citizens in the nineteenth century and why do public officials appear to be much less sympathetic to cities and citizens now?

Part I addresses the question of municipal monitoring, arguing (though for different reasons than Gillette) that bondholders are the appropriate bearers of the risk of municipal default. Part II explains why this allocation of risk is unlikely to have any significant ex ante effects on local fiscal discipline. Indeed, I have argued elsewhere and argue here that "fiscal discipline" is not the central problem for local governments; their fiscal woes originate elsewhere. (7) Part III then addresses the two puzzles raised by Gillette's article. I suggest reasons unrelated to creditor or citizen monitoring for why local governments generally do not default. I then argue that the currently fashionable functional arguments for paying off creditors are not particularly convincing and that the choice between citizens and bondholders is ultimately a political one.

1. MONITORING AND RISK BEARING

   Gillette's argument is straightforward: legal rules allocating the risk of default as between bondholders and citizens should make the choice that will induce the party that is better able to monitor local fiscal conditions to undertake that monitoring. (8) Bondholders are better positioned to monitor local fiscal decisions, either through the bond issuance process or by demanding ex ante compensation in the form of higher interest rates. (9) Therefore, when a default occurs and courts must make a decision about who gets paid (and how much), judges should favor citizens over bondholders. (10) In practical terms, courts should be more willing to impose losses on bondholders than to demand that a defaulting city raise taxes or decrease services. (11)

   I share Gillette's view that bondholders should bear the risk of default, but I am not certain that it is because they are better monitors ex ante. Indeed, problems of monitoring bedevil both citizens and bondholders.

   As Gillette points out, citizen monitoring is difficult because citizen preferences are heterogeneous and the burdens and benefits of local policies are unequally distributed. The central problem is that there is no consensus on what a citizen should be monitoring for. (12) Because a city is not a profit-making enterprise, its performance cannot be measured by a specific financial return. Moreover, citizen preferences depend significantly on citizens' time horizons. It may not be in the interest of present citizens to monitor in ways that are beneficial to future citizens. Current debt spending, for instance, might be supported by current residents even if future residents would oppose it.

   The free rider problems that Gillette points out are also difficult to surmount; any one citizen has little incentive, little expertise, and little time to monitor local fiscal health. This problem is exacerbated by the mobility of the American populace; local citizens are unlikely to monitor the long-term fiscal stability of a local government if they are not going to be there very long. (13) And finally, monitoring of local fiscal health is of limited usefulness when the economic health of any particular locality is dependent upon wider regional or national economies. Citizen monitoring of local fiscal behavior will be ineffective if local fiscal health is driven by developments that are beyond the local government's control.

   Of course, citizens have an interest in ensuring that local officials are not running the municipality into the ground. If that interest can be leveraged and free rider problems can be overcome, then monitoring might be possible. William Fischel has theorized that homeowners in smaller jurisdictions can assess the performance of their government by treating their home values as a barometer of fiscal health. If local government performance is capitalized into home values, then "homevoters" can easily vote their interest in the stability of their property values. (14) If the value of residents' homes increase, the city is doing well; if those home values decrease, the city is doing poorly.

   The difficulty is that while homeowners undoubtedly have a strong interest in maintaining the value of their homes, home values turn out to be a fairly inaccurate (and even misleading) barometer of local fiscal health. The recent housing bust provides some evidence that house values often have little to do with economic fundamentals. (15) It certainly provides evidence that house values often have little to do with any particular local government's fiscal policies. Local house values are often a result of factors outside the immediate control of local governments. (16)

   Moreover, homeowner-based monitoring can be pernicious. Fischel's homevoters might be eager to adopt policies that improve home values in the short term while sacrificing long-term fiscal stability, particularly in boom times. Indeed, one could argue that it was a nation of homevoters writ large that exacerbated local fiscal crises by demanding policies that artificially inflated house prices. (17)

   Gillette argues that bondholders are better positioned to assess local fiscal health. Individual holders of bonds are not likely to monitor; the free rider and information problems are likely insurmountable. But Gillette claims that even if the owner of a single municipal bond is not equipped to monitor, institutional gatekeepers like banks, credit ratings agencies, insurers, underwriters, and large investors generally have the incentive and capacity to keep an eye on local investments. (18)

   Gillette's assessment is replete with caveats, however. (19) He recognizes the obvious limitations of ratings agencies and other market actors and observes that the interests of bond market makers are not always benign. (20) Market makers are interested in selling debt and will take advantage of both issuers...