Regional President Speech

/ 1/,f: . 717/l) v s- ,/ · 17/R 72Jt/; RESTRUCTURING THE MUNICIPAL BOND MARKET Remarks of Frank E. Morris President, Federal Reserve Bank of Boston Before the Municipal Finance Forum of Washington Washington, D. C. , January 18, 197 1 For years students of the municipal bond market have been discussing five important structural defects in the market. First is the fact that tax exemption on state and local government bonds is a rather glaring source of inequity in our income tax structure. Second is the potential for the misallocation of capital which stems from the fact that the tax-exempt bond market creates a special incentive for very wealthy people, who can afford to be risk takers, to channel funds into securities in which the risk of default is little or none. Third is the fact that, from the standpoint of the U. S. Treasury, the subsidy given to state and local governments through tax exemption is an extremely inefficient one; since only a part of the subsidy is actually received by the intended beneficiaries. Fourth is the marked cyclical sensitivity of the municipal bond market which stems from its excessive dependence on the commercial banking system. Fifth is the fact that the secondary market for municipal bonds is, generally speaking, not as good as the secondary market for corporate or U. S. Government bonds; and municipal bonds must, accordingly, be viewed as less liquid than other bonds. So much has been written about these five structural deficiencies in the municipal bond market that I intend to make only a very few comments about them and to address the bulk of my remarks to what has more recently become the dominant issue; i.e., will the municipal bond market as it is presently constituted be adequate to serve as the sole financial vehicle for state and local governments in the decade ahead? -2- With regard to the efficiency of the subsidy given to state and local governments through tax exemption, I think it could certainly be said that if the Federal Government were to give a subsidy to hospitals and we were to find that, because of the manner in which the subsidy was structured, a substantial part of the money went not to the hospitals but to a group of the wealthiest people in the country, there would be an immediate public outcry. Although the analogy to the hypothetical hospital subsidy case is pretty close, there has been no widespread public outcry in the case of tax exemption of municipal bonds for two reasons. First, the American people, the press, and the Congress have customarily failed to consider a special tax treatment as being equivalent to a subsidy and cost-benefit standards, to the extent that they are applied at all, are generally much laxer in the case of special tax treatments than they are in the case of direct subsidy payments which must run the annual gauntlet of the budgetary process. Second, in the particular case of tax exemption on municipal bonds, the special tax treatment has been looked upon as a constitutional right of state governments, not as a benefit granted by the Federal Government. Until such time as this issue is finally resolved by the Supreme Court, we can do no more than to say that, if it is a subsidy, it is clearly a most inefficient one. With regard to the cyclical vulnerability of the municipal bond market, which I believe is a proper concern of the Federal Reserve, it is clear that the source of the vulnerability lies in the fact that the municipal bond market is highly dependent upon the commercial banks and the extent of commercial bank participation in the market is very volatile. Commercial bankers tend to look upon municipal bonds as a good source of earning power for marginal funds; that is, for funds remaining after their loan demand has been satisfied and their minimum -3- liquidity requirements have been met. Loans have the prime investment priority; and when funds get tight, bankers adjust by reducing the flow of funds into securities, both U. S. Government and state and local government securities. The extent of the swings in commercial bank participation in the municipal bond market may be seen in the following figures. Of the total increase in state and local government bonds outstanding in the relatively easy money year of 1965, the commercial banks absorbed 7 0%. This figure dropped to 41 % in the tight money year of 1966. When the pressures on the banks moderated in 1967, the figure rose to 116%, the banks in that year buying substantially more than the total incremental supply. Their participation dropped slightly in 1968 to 92% and then collapsed to less than 17% in the very tight money year of 1969. When the commercial banks pull out of the market, rates must rise sharply enough to induce the other major buyer, high-bracket individuals, to take up the residual supply. The market is isolated by tax exemption from the great bond-buying potential of the pension funds. These structural characteristics have made the municipal bond market more volatile than the other bond markets, they have produced str.ong contra-cyclical swings in the volume of state and local bond issues marketed and, in my judgment, they have rendered state and local government investment programs much more sensitive to monetary policy than would have been the case if these issuers had a broader market in which to sell their securities. Turning to the structural weakness of the secondary market for muni cipals, I think it can be said that there is no inherent reason why municipal bonds must be less liquid than corporate bonds. The source of the liquidity -4- problem is purely institutional and relates almost entirely to the size of the bond is sue. Corporate bonds typically are sold in large amounts with single maturities. Municipal bonds are customarily sold in small amounts with serial maturities. The typical municipal is sue is $10 to $20 million in aggregate amount split up into 20 serial maturities. This means that there are actually 20 different maturities of $500 thousand to $1,000,000 in size. It is a physical impossibility to maintain an adequate secondary market for bond issues of that size. I think most students of the market would agree that if municipal bonds were to be sold on a taxable basis, they would have to carry a somewhat higher yield than corporate bonds of the same rating to reflect the fact that they are not as liquid an instrument. This liquidity differential could only be eliminated by consolidating the many small serial offerings into fewer and much larger issues of centralized issuing authorities at the state level, the Federal level or both. The five structural defects of the market which I have enumerated have existed and been recognized for many years without generating strong pressures for change. Until recent years the market was performing reasonably well, warts and all. However, the events of the past few years have begun to raise doubts in many quarters that the municipal bond market as it is presently structured will prove adequate as the sole financing vehicle for state and local governments in the decade ahead. I share these doubts. I want to make it clear that I am speaking only for myself and not for the Federal Reserve System. To the best of my knowledge the Federal Reserve does not have an established position on this question. This is not to say, of course, that the Federal Reserve does not have a considerable interest. -5- One 0£ the most troublesome aspects 0£ monetary policy is that a restrictive policy does not affect the various sectors 0£ the economy in an even-handed manner. Some sectors, notably residential construction and state and local government investment spending, will be affected more than others. It happens that in both 0£ these sectors structural inadequacies in the market mechanism have rendered both housing and state and local government investment much more sensitive to a restrictive monetary policy than would be the case if they had broader and more flexible markets for their securities. In the housing sector, the Federal Government has initiated in recent years a number 0£ structural changes designed to improve the mortgage market. These changes bore fruit in 1969 and 1970 in maintaining housing starts at a considerably higher level than would have been possible if we had been operating with the pre-1966 mortgage market mechanism. On the other hand, very little has yet been done to broaden and strengthen the market £or municipal bonds. In a number of states archaic interest rate limitations have been removed or modified and in some states centralized bond marketing organizations of various sorts have been placed in operation, but in its essentials the municipal bond market is structurally little changed from 30 years ago. The heart of the problem £or the future is the capacity of the market as presently structured to absorb a sustained high volume of new issues in a reasonably efficient manner within the context of an expanding economy. It is clear that we are now going through a period of reorientation of our national priorities, much of which will produce pressures for increased investment outlays by state and local governments. There may be differences in the projections, but there -6- is general agreement among the authorities in the field that the volume of municipal bond offerings in the 1970' s will be very much larger than in the 1960' s. At the same time, as we move into the decade of the ?O's, we find the commercial banks, which constitute the heart of the municipal bond market as it is now constituted, in the least liquid position they have been in since 1929. Furthermore, there is considerably less confidence in the banking community than existed prior to 1969 that a bank will always be able to take care of its liquidity problems through liability management. Bankers all around the country have very fresh memories of the consequences of being frozen into a portfolio of intermediate and long-term municipals, and this memory is not likely to fade rapidly. This is not to say that the commercial banks are going to abandon the municipal bond market. They will remain substantial buyers whenever they find themselves with an excess of available funds over loan demand, which happens to be the case at the moment. What I am saying is that, given the huge financial needs of state and local governments, the commercial banking system is not likely to be able to take enough of the new municipal offerings, year in and year out, to make the market work with a high degree of efficiency in the 1970' s - - and by "enough" I mean the capacity and the willingness to absorb roughly 80% of the new issue volume year after year. The situation in the municipal bond market now is somewhat analagous to the situation in the stock market a few years ago. Everybody knew then that the transfer mechanism for common stocks was archaic - - after all, it had not changed essentially in 50 years -- but with all of its defects, the stock -7•·· transfer mechanism was capable of handling 8 to 10 million shares a day in a reasonably efficient manner and there was, consequently, no strong pressure for reform. However, when the volume grew to 15 to 20 million shares a day, the system broke down and some of the oldest firms on Wall Street went with it. Just as the impact of increased volume demonstrated clearly for all to see the weakness of the common stock transfer system, so I believe that the impact of sustained higher volumes of new issues will clearly demonstrate the inadequacy of the present, narrowly based municipal bond market. In my judgment, if state and local governments are to be able to obtain their fair share of capital flows in the years ahead, they must be able to issue securities which will appeal to all sectors of the bond-buying public and, in particular, to the largest and fastest growing sector, the pension funds. The proposals which have been put forth to restructure the municipal bond market fall into three broad categories: first, proposals involving some form of Federal Government interest subsidy on fully taxable bonds issued by state and local governments; second, proposals such as the Urbank, under which Federal Government instrumentalities would serve as the financing vehicle for state and local governments; and, third, proposals for a Federal interest subsidy to pension funds holding tax-exempt municipal bonds. Of these three classes of proposals, I think the first -- a Federal interest subsidy on taxable municipal bonds -- is the soundest. Specifically, I would advocate an automatic 50% interest subsidy on all municipal bonds sold on a fully taxable basis. If the municipal bond market were to be restructured in this manner, a state or local government seeking financing would ask under writers for bids on both a taxable and a tax-exempt basis, accepting the bid -8- with the lowest net interest cost to the issuer. If the tax-exempt market were very strong and the issue could be sold at a yield equal to or less than half the taxable yield, the issuer would stay in the traditional tax-exempt market. If this were not the case, the issuer would hav.e the option of moving into the broader taxable market. Given the broader array of financial options which would then be open to them, state and local governments would find themselves much less dependent upon the investment policies of commercial banks than they are today and, as a consequence, they would find themselves in a much stronger position to compete for their fair share of the flow of funds in a tight money market. The basic short-coming of the various proposals which have been made to date is that the proposed Federal interest subsidy has been too small. Most of the proposals have fallen within a 20 to 40% subsidy range -- largely because of what I consider an undue concentration on establishing a subsidy level which would provide a financial break-even point for the Treasury. It is not at all clear to me that,in an era in which the Federal Government is providing $27 billion in grants to state and local governments and in which there is widespread support for massive revenue sharing with no strings tied,the level of a Federal interest subsidy should be determined upon the basis of a narrowly conceived break even point for the U. S. Treasury. However, if the issue is to be decided on the basis of cost-benefit analysis, it should not be overlooked that there are two subsidies involved -- the subsidy given directly in the form of an interest subsidy if the is suer chooses to issue taxable bonds, and the subsidy given indirectly if the issuer chooses to issue tax-exempt bonds. It is axiomatic that the larger the direct subsidy, the -9- smaller will be the indirect subsidy; since a smaller volume of tax-exempt bonds would be issued. In measuring the cost to the Treasury, it is the combined costs of the two subsidies relative to the benefits actually received by state and local governments which is the relevant measure. In the framework of cost benefit analysis, it seems clear to me that the direct interest subsidy should be large enough to avoid significant "wastage'' in the subsidy given directly through tax exemption. Such a cost-benefit analysis would, in my judgment, support a 50% subsidy level. If state and local governments had the option of operating either in the tax-exempt market or in the taxable market with a 50% interest subsidy, I believe that they would realize substantial interest savings; because such a dual market system would avoid the overloading of the tax-exempt market and, in so doing, it would also eliminate most of the "wastage' of the benefit of the subsidy given through tax exemption which such an overloading inevitably produces. With respect to the other proposals, I think there may be a place for Federal Government financial intermediaries, such as the Urbank, but it seems to me that their operations ought to be restricted to those relatively few projects which, for one reason or another, would be difficult or impossible to finance through private market channels. I would not favor the broad application of the services of such a Federal intermediary institution because I fear that it would inevitably result in excessive interference of the Federal Government in the capital spending plans of state and local governments. I am not enthusiastic about the proposals to subsidize pension funds on their holdings of tax-exempt bonds for two reasons. First, from an administrative standpoint it would be much more complicated and more costly than the relatively simple job of subsidizing the bond issuer. Second, while I think it is vital for state and local governments to be able to tap the vast pension fund market, I see no reason to exclude other potential markets. Taxable municipals sold at going market rates would tap the broadest market spectrum. Such bonds would be attractive to pension funds, but they would also be attractive to other classes of tax-exempt investors and to many middle income investors who have been increasingly active in the bond markets in recent years. Quite apart from the marketing potential, I should think it socially desirable to encourage a broader group of people to own some of the obligations of their own communities. It may well be the case that a proposal to subsidize pension funds on their tax-exempt bond holdings would be easier to get through the Congress than a proposal to subsidize state and local governments on issues of taxable bonds, but strictly on its merits I would consider it the second choice. As an official of the Federal Reserve, my interest in the restructuring of the municipal bond market stems from a conviction that, if state and local governments do not have broader financial options open to them in the future than they have had in the past, they are going to find it increasingly difficult to finance their capital requirements in the years ahead within the context of a rapidly expanding, fully employed economy. At the moment we have an optimum set of conditions for the municipal bond market. There is considerable slack in the economy and business loan demand at banks is weak. The Federal Re serve -11- is following an expansionary monetary policy which is providing the commercial banks with an excess of funds available for investment. It is in this sort of climate that the present municipal bond market functions most effectively. The testing time will come in the next few years when the economy is returning to full employment levels, when business loan demand is again rising and when the commercial banks must reduce their participation in the municipal bond market at a time when state and local government capital requirements remain very high. It will be at this point in the decade of the 1970' s that it should become very clear that the municipal bond market as presently constituted is not performing effectively in the public interest. If my analysis is correct, it is high time that those involved in the market -- the financial officials of state and local governments, the underwriters and the investors -- begin to devote some time to thinking how this market ought to be restructured in the public interest.

Frank E. Morris (1971, January 17). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19710118_frank_e_morris

@misc{wtfs_regional_speeche_19710118_frank_e_morris,
  author = {Frank E. Morris},
  title = {Regional President Speech},
  year = {1971},
  month = {Jan},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19710118_frank_e_morris},
  note = {Retrieved via When the Fed Speaks corpus}
}