How Arkansas Solved Its 1930s Debt Crisis
Second of a three-part series.
Part one: Arkansas' 1930s Default Foreshadowed Puerto Rico
Part three: Is Puerto Rico on a Similar Path to 1930s Arkansas?
In 1933 the Arkansas state government proposed what would be the first of several efforts to resolve the state's debt problem through refundings. In the Ellis Refunding Act all highway, toll bridge, and district bonds would be converted into Arkansas bonds with 3% interest rates and a 25 year maturity. Bondholders sued the state, saying that their average interest rate was being cut by 35%, the bonds lacked the pledge on specific revenue streams the old bonds had, and maturities were being extended.
Initially the state supreme court ruled against the bondholders. Then bondholders and some states that held Arkansas bonds sued in federal court. In Hubbell vs. Leonard the judge held that the state government could be sued if it was acting outside the constitution. He further held that the refunding and the breaches of bondholder pledges approved in 1933 were unconstitutional. Coincidentally, Judge John Martineau had been the author, as Arkansas governor, in 1927 of the act under which the original state and district bonds had been issued.
In 1934 the legislature responded to its financial struggles by passing two state constitutional amendments. The first put limits on spending and barred increases of tax rates without voter approval, or, in emergencies, approval by three quarters of the legislators. The second barred the state issuing of new money bonds without voter approval.
The most important step to handle Arkansas' debt crisis came under Gov. Junius Futrell in Act No. 11 of 1934. Also known as the Highway Refunding Act, the law was drafted in conference with committees of bondholders, B.U. Ratchford wrote in "American State Debts," (1941). In this 50 page law all highway obligations were to be exchanged. While called a refunding, it was really a voluntary debt exchange. Neither Ratchford nor Lee Reaves, in his article "Highway Bond Refunding in Arkansas," (Arkansas Historical Quarterly, Dec. 1943), explains why bondholders accepted this debt exchange when they successfully rejected the Ellis Refunding Act a year earlier.
The current state highway bonds' principal was to be exchanged for Series A bonds of the same par value but maturing 10 years further out. Until April 1, 1937, there would be cash interest of 3.5%. From April 1, 1937, to April 1, 1939, there would be cash interest of 3.5% and an additional 0.5% paid in Series B bonds. The Series B bonds would mature in not less than 15 years and have a 3.25% interest rate. After April 1, 1939 Series A bonds were to pay 4% interest in cash.
The state's assumed district bonds received an inferior treatment. The principal would be exchanged for Series A bonds maturing in Jan. 1, 1949 offering 3% interest. Interest accrued but not paid to Jan.1, 1934 would be replaced with Series B bonds holding no interest and maturing Jan. 1, 1949.
The original bonds would be held by the state and could be redeemed by bondholders in case of default on the new bonds.
As part of the law, the gasoline tax was increased to 6.5 cents a gallon, equivalent in purchasing power to $1.16 in today's money, with 92.3% of this revenue going to the state and the balance to the counties. Arkansas promised that highway fund revenue would remain above $8.537 million per year and raise rates, if necessary, to ensure this. If gasoline revenues exceeded $10 million a year, the state could reduce the gasoline tax by no more than 0.5 cents per gallon.
As part of Act No. 11 the first 25% of highway fund revenues was allotted to highway maintenance. Interest and debt service had a second charge.
Fees on truck, auto, and commercial vehicle licenses were increased, according to "The Governors of Arkansas," 1941, edited by Timothy Donovan, Willard Gatewood, and Jeannie Whayne. Bridge tolls were also sent to the highway fund. All bonds were callable at par.
A state court in Sparling vs. Refunding Board approved the debt exchange. Bondholders generally accepted what was called a refunding, and it proceeded rapidly, according to Ratchford. "By the end of 1936 more than 99% of all issues except two had been deposited for refunding." The exceptions were a toll bridge issue for less than $500,000, of which 91% had been deposited, and a road district bond for $46.8 million, of which 95% had been deposited.
Highway revenues rose from $9.7 million in 1934-1935 to $12 million in 1936-1937. Without any principal to pay back, the state chose to purchase bonds for their retirement at discounts. In the first few years after the start of the program in September 1934, the state purchased bonds at average discounts greater than 30%, according to Ratchford. By the end of 1937 the discounts were closer to 10%. By June 1939 the state had retired $19.3 million in bonds.
The 1934 Act. No. 11 barred the use of highway revenues for road construction. Arkansans were unhappy with this and the relatively high interest rates paid on the bonds. To remedy the situation, they sought refundings of the bonds with lower interest rates so there would be some money for new construction. Generally, in the rest of the 1930s and early 1940s courts reversed these attempted refundings or they were not carried through for other reasons.
In 1938 Arkansas passed a law making all toll bridges free. Many considered this to be a breach of the 1934 law. The state took this action to qualify for a $3 million federal grant to be used for road construction.
"In 1938 the state collected tax revenues of $22.5 million and paid $5.8 million or a little more than 25% of revenues as interest on its debt," Ratchford wrote. At the time the state was not making payments on the principal of its highway, bridge, or road district debt. "Adequate provision for the repayment of the principal of that debt would require an additional 15 to 20%, meaning that the state would have to devote over 40% of its total revenues to debt service."
Lawmakers knew that the debt service schedule also was a problem. It was set at manageable levels that would not raise much above $6 million per year through fiscal 1943. It was to be from $6 million to $6.5 million per year from fiscal 1944 to fiscal 1958 except for three fiscal years. But in these years it would be $12 million in fiscal 1944, $51.6 million in fiscal 1949 and $16.6 million in fiscal 1954, according to Ratchford – very big obstacles.
While the state made two unsuccessful efforts to refund the highway debt in the late 1930s, success came only when Gov. Homer Adkins came to office in January 1941. In the approved refunding bond the first $10.25 million in the state highway fund each year would be divided 30% for maintenance and 70% for debt service. The following $2.5 million would be set aside for new roads and maintenance of the highways. Finally, the next $750,000 would be set aside to pay bridge improvement bonds or municipal improvement bonds for the continuation of the highway system.
After the refunding was passed, the state amended it to set aside a bond redemption fund with at least $3.5 million as a safeguard against default, according to Reaves. It was also amended to allow a federal agency to purchase the entire issue.
This second amendment proved important when the federal Reconstruction Finance Corp. bought the entire $136.3 million ($1.88 billion in inflation-adjusted dollars) bond in February 1943. The bond had faced a 3.5% interest rate if it had been sold to private sector purchasers. This was too high for a state to pay, according to "Fifty Billion Dollars," a memoir by Jesse Jones, the leader of the RFC.
Pres. Herbert Hoover and the U.S. Congress had created the Reconstruction Finance Corp. in 1932 as a response to the Depression. When some members of the Federal Reserve board were hesitant to aggressively lend money in the economic crisis, the government created the RFC as a more flexible and aggressive source of money.
Maturities from 1943 to 1969 for a total of $87.3 million had 3.25% interest. Maturities from 1969-1972 for a total of $18 million had 3% interest. Finally, an additional $31 million maturing in 1972 had a 3.25% interest.
The day after its purchase RFC sold $10 million of the bond to Chase National in New York at a 1% premium, according to Jones. Three weeks later it sold $15 million to Halsey, Stuart & Co. of Chicago and $35 million more to Chase National at a 1.5% premium. The rest of the issue was later sold to Halsey, Stuart at a higher premium.
Over the life of the bonds the 1943 refunding operation was expected to save Arkansas $28 million in interest, Jones wrote in his 1951 memoir.