Clean water at the tap. A vital element of our modern society, and something we take for granted. Only 100 years ago, that assumption could not be made in many communities across America.
This was demonstrated in research published by Cutler and Miller in 2005, calling the "construction of municipal water systems … a major event in the history of American cities" that brought "relief from disease," provided "resources to combat fires, attract[ed] business investment, and promot[ed] development generally." To explain these important societal developments, Cutler and Miller "highlight[ed] the importance of municipal bond market growth as a facilitator of debt finance."
Cutler and Miller cited the demand for clean water in "neglected neighborhoods," and opined "Modern water systems frequently required transporting water from far away and investing in filtration plants," leading to "costs" that "were too large for private firms." Cutler and Miller continued that "the development of municipal bond markets was key to providing an adequate volume of water in many American cities."
Cutler and Miller added "Mortality rates in the United States fell more rapidly during the late 19th and early 20th centuries than in any other period in American history. This decline coincided with an epidemiological transition and the disappearance of a mortality 'penalty' associated with living in urban areas.
"We found that clean water was responsible for nearly half the total mortality reduction in major cities, three quarters of the infant mortality reduction, and nearly two thirds of the child mortality reduction. Rough calculations suggest that the social rate of return to these technologies was greater than 23 to 1, with a cost per person-year saved by clean water of about $500 in 2003 dollars."
Cutler and Miller went on to state that the "quantity of piped water supplied in American cities grew dramatically near the turn of the 20th century, and local government ownership seems to have been a driving force behind this surge in water system construction and expansion. Governments may have wanted to be involved earlier — and in fact were in the largest cities — but financial constraints appear to have prevented them from doing so. As innovation in local public finance made it easier for smaller cities to borrow, many American cities did in fact purchase or build waterworks. Even larger cities that already owned water systems were able to finance massive expansions to previously unserved neighborhoods."
In other words, municipal bonds brought us clean water at the tap only relatively recently in our history. With clean water, municipal bonds brought substantial improvements in public health.
This crucial development — one that makes possible our society as we know it — is in danger from proposals to eliminate the tax-exemption on municipal securities for essential governmental purposes.
How can this be? Is that an over-statement? I think not.
The Securities and Exchange Commission estimates that we have over 50,000 issuers of municipal securities, including special districts, authorities and one-time issuers. Whatever the precise number, there is a vast and diverse issuer universe. Virtually all municipalities need to borrow for water and sewage facilities as communities grow, environmental requirements tighten, and aging infrastructure must be replaced. Granted, states and large cities and counties have names that are recognizable readily. Those recognizable issuers may be able to sell taxable securities in a public market — albeit at increased interest rates and higher costs to local taxpayers and enterprise system users (including those who are not well off financially). The same cannot be said, however, for tens of thousands of smaller and even medium-sized local governmental entities.
The vast majority of local governments are likely to be excluded from, or to suffer poor reception in, the taxable bond market. Today, there is a smoothly-functioning tax-exempt municipal bond market that accommodates even tiny issuers. Retail investors, often retirees, attracted by the tax-exemption typically choose "buy-and-hold" investment strategies for stability of income and predictability of tax outcomes. Many of those investors are not overly concerned about liquidity issues presented by smaller issuers, and in turn, the interest of those investors assists liquidity.
In a taxable bond market, a "buy-and-hold" investment tactic is far less viable, as investors are more likely to seek to trade their investments in response to changes in tax laws, prevailing interest rate environments and other market conditions. Liquidity, which is heavily dependent upon issuer name recognition, is much more likely to concern retail taxable bond investors. Taxable muni funds also would focus upon liquidity, which supports net asset values. For similar reasons, then, those funds — which are owned by retail investors — will be less attractive sources of funding for small communities than are tax-exempt funds today. Re-emphasizing the crucial importance of recognizable issuer names, corporate investors and insurance companies that purchase municipal bonds also will seek liquidity in the taxable market.
Skeptics may ask, however, why these local governments cannot simply borrow from local banks to obtain financing for their water and wastewater systems. The answer is that most clean water financings need 20- to 30-year maturities in order to be viable. For less wealthy communities, even that is not enough. In those instances, 40-year maturities are used often for federally-subsidized rural development loans for small communities that later "graduate" by issuing tax-exempt bonds to repay the federal government.
If banks understand and provide governmental financing at all (and most local banks do not), bank lenders do not provide long-term, fixed rate financing. In general, bank lending is short-term, with maximum maturities limited to five, seven or usually at most 10 years. Banks having their own short-term lenders- depositors — cannot afford to carry portfolios containing heavy concentrations of municipal securities with today's long-term structures. Some substantial banks working with larger issuers do provide floating rate financing for longer terms, but those financings would place local water and wastewater users at risk of future inflationary interest rates or, as we have seen recently with the use of ill-conceived interest rate swaps as hedges by small unsophisticated communities, at risk of disruptions in the financial markets.
In the municipal market, water and wastewater financings are structured typically using project finance techniques in which self-supporting projects pay for themselves over expected long asset lives. That matches project costs to demographic changes over time among the actual users of the water and wastewater systems. System users pay rates that are relatively predictable, due in significant part to fixed interest rates on debt. With infrequent exceptions, local general funds and local taxpayers do not pay costs of water or wastewater systems.
These valuable finance structures, which emerged approximately 100 years ago, perform quite effectively. In fact, these municipal securities have a truly outstanding performance. Municipal Market Advisors determined in February that the default rate for outstanding water/wastewater bonds is very low — merely 0.112% of outstanding obligations (including even Jefferson County's defaulted obligations).
Clean water at the tap cannot, however, be taken for granted. Many other countries have substantial difficulty in delivering clean water to homes and businesses. One example is a country with which I have had the pleasure of becoming somewhat familiar, China. Despite adverse publicity in the U.S., China actually is a country quite aware of and concerned about environmental needs. China has placed a priority on delivering clean water to its citizens, but continues to find that to be a highly elusive goal, especially outside of major cities.
One approach Chinese local governments have tried is to contract with international private water companies offering guaranteed returns as high as 18% or more. As Cutler and Miller discuss in relation to the American experience with private water companies prior to the widespread use of municipal bonds, this has not produced the desired results for most communities in China. Private companies in China are interested in the largest communities and easiest projects, which leaves small communities and poor neighborhoods without clean water.
I believe two reasons help to explain why China is encountering so many impediments. First, there is not a developed local government finance market in China utilizing the self-supporting project finance model that has been so successful in the U.S. Local governments in China are much more dependent upon the largesse of provincial and national governments and attempt to fund project costs from short-term bank loans, tax revenues, and proceeds of property sales to developers. Second, Chinese culture resists long-term debt commitments. As I outline above, long-term debt is essential to project financing for expensive assets with long lives. I continue to advocate strongly that project finance concepts be applied in demonstration projects in China.
Now, however, I find that I must be concerned about matters here at home for the protection of the wonderful clean water achievements of financial ingenuity in the tax-exempt municipal securities market. Among other things, water and sewage treatment protect against the spread of water-borne diseases, such as cholera and dysentery. Moreover, new virulent viruses for which we have limited medical and biological defenses continue to appear around the world and often are transmittable from human to human.
It would be a misfortune if we were to destroy inadvertently the key market access that is necessary for tens of thousands of American communities to be able to provide, for citizen comfort, clean water readily available at the tap on an efficient and effective basis. It would be an even more serious tragedy if, in acting rashly, we were to endanger public health.
In the words of the glam metal band Cinderella, you "don't know what you got till it's gone."
Robert Doty is author of The Bloomberg Visual Guide to Municipal Bonds, which discusses the diversity and risks of municipal securities. He is also president and proprietor of AGFS, his private consulting firm, and is senior advisor and counsel to the Executive Team of Government Financial Strategies, a municipal advisory firm. AGFS is not a municipal advisor.
