NY Fed's Dudley Warns Municipalities Against Borrowing to Cover Deficits

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William "Bill" C. Dudley, president of the Federal Reserve Bank of New York, sits for a photo in New York, U.S., on Wednesday, Sept. 1, 2010. Dudley in July said the U.S. economic expansion may slow this quarter, while a relapse into recession is unlikely. Photographer: Stephen Yang/Bloomberg *** Local Caption *** William Dudley

WASHINGTON — Municipalities are getting into trouble by borrowing to cover operating deficits, Federal Reserve Bank of New York president and chief executive officer William Dudley told attendees at a closed-doors workshop on Tuesday.

Dudley expressed his concerns in a speech at the New York Fed's Chapter 9 and Alternatives for Distressed Municipalities and States Workshop. The event, which was closed to the press, featured bankruptcy experts, public officials, judges, and academics discussing Chapter 9 bankruptcy and its alternatives.

The New York Fed said the conference was closed because it was academic in nature.

"When a jurisdiction borrows to invest in infrastructure, the cost of the debt to local residents — and those considering locating in the jurisdiction — is offset by the value of the services that the infrastructure provides," Dudley said in his prepared remarks. "This tradeoff is part of the 'fiscal surplus' that a jurisdiction offers: the value of the services minus the tax price that residents have to pay.  A well-run capital budget will match these costs and benefits over the life of each project to ensure that the jurisdiction remains attractive to current and future residents."

But some municipalities are putting themselves in trouble by borrowing to cover operational deficits and achieve "balanced" budgets, Dudley said, just as New York City did in the 1970s leading up to its famous fiscal crisis.

 "The key distinction between these two types of borrowing is that in the former case an asset is producing services that help to offset the cost of the debt, but this is not so in the latter case," Dudley continued. "Indeed, using debt to finance current operating deficits is equivalent to asking future taxpayers to help finance today's public services."

Dudley said that residents of a municipality managing its finances that way could react by leaving, shrinking its tax base and exacerbating its fiscal problems. But he especially keyed in on the underfunding of public pensions, a practice that the Securities and Exchange Commission has targeted for enforcement actions and which regulators and market participants alike have said could be a serious threat to state and local finances and bondholders in the future.

The need to compromise with pensioners during Detroit's recent bankruptcy proceedings, for example, cost the insurers of the city's bonds millions of dollars. Dudley said Detroit's case, as well as that of Stockton, Calif., could be emblematic of more systemic problems.

"While these particular bankruptcy filings have captured a considerable amount of attention, and rightly so, they may foreshadow more widespread problems than what might be implied by current bond ratings," Dudley said.  "We need to focus our attention today on addressing the underlying issues before any problems grow to the point where bankruptcy becomes the only viable option."

"In summary, state and local governments have enormous financial obligations, as well as critical service delivery responsibilities," Dudley concluded.  "Managing their liabilities in such a way as to ensure that these vital services continue to be provided, and citizens view[s] that they are getting appropriate value in exchange for their taxes is a daunting challenge."

Workshop attendees included former Fed chairman Paul Volcker, former New York Lt. Gov. Richard Ravitch, Detroit bankruptcy proceeding judge Steven Rhodes of the U.S. Bankruptcy Court for the Eastern District of Michigan, and municipal bankruptcy expert James Spiotto of Chapman Strategic Advisors.

Atlantic City, N.J. Mayor Don Guardian and Syracuse, N.Y. Mayor Stephanie Miner spoke on a panel on avoiding fiscal distress that was moderated by former San Jose, Calif., Mayor Chuck Reed.

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