Commentary: Restoring Investor Confidence and Reducing Borrowing Costs Through Greater Transparency
Over the last 70 years, local government bond defaults have been relatively rare. In a typical year, no more than one in 1,000 municipalities failed to make timely payments on their tax supported debt. An improving economy is lifting tax revenues and boosting pension fund returns, signaling a benign credit environment in the near future.
Yet, despite their solid credit history and favorable outlook, spreads on municipal bonds relative to Treasuries are near record highs. Widely publicized defaults, like those in Stockton, San Bernardino and Detroit, as well as dire forecasts from Meredith Whitney and others have scared off potential investors. The result is that many cities and counties are paying substantially more in interest than is warranted by the real risk of their bond issues. How can local governments remedy this situation and thereby achieve better results for their taxpayers? We believe the solution involves greater transparency. Just as greater disclosure by over-the-counter equity issuers in the 1960s resulted in a significant one time increase in their stock prices, improved disclosure by cities can produce a significant one time reduction in their spreads relative to Treasuries as fear and speculation give way to facts and figures.
Government bond issuers already produce reams of disclosure, including detailed budgets and audited financial statements, but these reports are typically available only as PDFs. With tens of thousands of audits appearing as text files that can easily run into the hundreds of pages, gathering financial statistics for government issuers often feels like looking for needles in a haystack. For municipal market disclosure to have its full impact on bond market liquidity, standardized fielded data must be timely, accurate and readily available. Just as stock market investors can visit a variety of websites to quickly obtain the latest corporate revenue and earnings information at no cost, current data on municipal revenues, expenditures, debts and retiree commitments should also be easily and freely accessible — not just to municipal bond investors, but to political leaders, government employees, city residents and other stakeholders.
Since becoming operational in 2009, the Municipal Securities Rulemaking Board's EMMA system has greatly facilitated the availability of municipal disclosure. But, as a recent Government Accountability Office report noted, there is a sharp contrast between corporate disclosure, which is now required to be in eXtensible Business Reporting Language (XBRL) format, and municipal issuer disclosure, which is solely in the form of PDF documents.
Analysts wishing to compare municipalities must undertake the laborious task of manually extracting data from PDFs or obtain fielded data from costly subscription services. We believe that the MSRB and SEC could substantially improve municipal market conditions by encouraging — and ultimately requiring — the adoption of XBRL for local government financial disclosures. XBRL has great potential for the production as well as the consumption of disclosures. Once municipal XBRL disclosures become available, they will be relatively simple for financial data providers to load the files into databases and make fielded data readily accessible via the Internet. Investors would then be able to easily locate fiscal performance data for specific municipal bond issuers, and to see how target issuers are performing relative to peers.
Beyond addressing ad hoc investor inquiries, standardized municipal financial data stores would also encourage the development of municipal credit scoring and default probability modeling. Currently, Moody's Analytics, Bloomberg, Morningstar and others use standardized corporate disclosures to estimate corporate default probabilities. Academic research in this dates back to a trailblazing paper by William Beaver in 1966.
A municipal default probability model would become practical once underlying data becomes readily accessible. As one of us found, a single ratio — General Fund Balance over General Fund Revenue — did a good job of differentiating Stockton and San Bernardino from most California cities that avoided default last year. More data is needed to see whether this finding stands up nationwide, but a lack of digitized fiscal data makes such analysis cumbersome and costly. The availability of both underlying fundamentals and derived analytics in digital form would increase municipal bond market transparency, enhance investor confidence and ultimately reduce borrowing costs for cities and counties.
The application of XBRL to US GAAP and other corporate reporting standards has received criticism in some quarters. Debate often focuses on which standard — CSV, JSON, XML, etc. — should be used by governments or anyone publishing information digitally. A more important question is how we are going to articulate, maintain, and otherwise manage the necessary financial reporting semantics to make digital financial reporting work.
This is not about debating whether CSV is bad and XBRL is good. These are two different tools for solving different problems. XBRL is well suited to reporting accounting data, and is thus the right tool for this purpose. Architects of municipal XBRL can learn from earlier experience by engaging a variety of end users from both the production (i.e., governmental accountants, elected officials, etc.) and consumption side of disclosures (i.e., investors, bond rating agencies, regulators, etc.).
XBRL is the right tool, and we are still learning how to use it the right way. Just because the use of XBRL is still evolving does not mean government should stand still and wait for the future to happen to them. Government should participate in XBRL's evolution. Producers and consumers of governmental disclosures should become proactive and advance their demands for improved digital reporting and analytics tools. Thus, the Center for Governmental Studies (CGS) at Northern Illinois University is leading a digital financial reporting project with the assistance of subject matter experts recognized world-wide, including Charles Hoffman (the father of XBRL). The project involves developing a basic U.S. local government XBRL taxonomy and creating XBRL files that conform to this taxonomy for a small sample of governments. CGS plans to consult with a variety of stakeholders including the Government Accounting Standards Board.
It's plausible that government can help become game-changers by demanding simplicity for the sake of transparency. End users cannot be expected to learn the nuts and bolts of every technology solution they need to employ (i.e. GIS, enterprise planning, emergency management, customer service responses, etc.). Local governments have limited resources and many responsibilities, of which financial reporting is just one in the mix. Nevertheless, governments must become active participants in shaping the solutions for increased access to tools that are affordable and business friendly. How does this look in practice? Government and consumers of fiscal information will first need to familiarize themselves with XBRL then test a variety of digital financial reporting software solutions and provide feedback, participate in conferences, make investments in products that advance the state of providing governmental information, collaborate with others to tackle tough problems, share the burden/investment of the change, and educate others on promising solutions as they unfold.
Abraham Lincoln said, "The best way to predict your future is to create it." Government should act now to create a future of greater transparency.
Marc Joffe is Principal Consultant at Public Sector Credit Solutions
where he researches municipal credit risk. Shannon Sohl leads the
Center for Governmental Studies' Digital Financial Reporting (DFR)
initiative and also focuses on fiscal condition assessments,
comparability models, financial processes, and systems improvement.