Low-cost federal loans to investment-grade state & local governments and infrastructure agencies are a powerful tool that works well on many levels, including for federal taxpayers. But the potential impact on the municipal bond market needs to be carefully — and explicitly — considered.
The classic role of a federal loan program is to be a lender in situations where borrowers don’t have many cost-effective alternatives, either because their credit isn’t yet good enough (student loans) or there’s something wrong in the capital markets (ARRA loan programs). In those cases, pretty much the whole cost-benefit story is about the impact of the program on two stakeholders – the borrowers and federal taxpayers.
But when a federal program makes loans to investment-grade state & local governments and infrastructure agencies, another stakeholder has to be included in the mix – the municipal bond market. A federal loan that by definition is intended to be advantageous to state & local public-sector borrowers will almost inevitably displace a municipal bond issue that the market would have loved to buy, an outcome that’s clearly disadvantageous to investors and market intermediaries.
In small scale and for specialized purposes, perhaps that’s not a big deal. But it’s easy and cheap to scale up federal loan programs for investment-grade borrowers to potential volumes that could have a major impact on the relatively small muni market. Two recent examples:
The HEROES Act recently passed by the House includes price and term amendment to the Fed’ MLF that would make borrowing from that facility a far better alternative than going to the market. The MLF would likely be fully utilized. This is well-intentioned in light of Covid-19 challenges that state & locals are facing and is even a great deal for federal taxpayers, but $500 billion in MLF loans will basically displace the entire muni market issuance for a year. A year is a long time for investors. If they’re forced to go away, they may not come back. Is that a good idea for anyone, state & local borrowers included? We’re going to need those market investors to stay dedicated to the US state & local public sector for the long term, which looks challenging enough even once Covid-19 crises are in the past.
As I’ve often noted here, the WIFIA loan program for water infrastructure usually (though unintentionally) displaces water revenue bonds, partly because of pricing but mainly due to the loans’ structural features for interest rate management and long-lived projects. So far, volume has been about $7 billion per year, which sounds minor compared to the overall annual muni market volume of about $425 billion. But WIFIA in fact competes in a market segment, water revenue bonds, where volume is usually less than $40 billion. WIFIA therefore already has about 15-20% market share, which in light of the vast need for water infrastructure investment and the growth potential for related finance is most likely about right. However, if Congress applies the usual ‘if some is good, more is better’ principle to this popular and a successful program and throw a little (in DC terms) more funding to it, things get complicated. If WIFIA was funded at the same $300 million level as its transportation analogue, TIFIA, the water program could theoretically displace the entire water revenue market segment. As with the MLF, future challenges in the US water sector are immense and nobody should want investors dedicated to this sector being forced to look elsewhere.
Despite the potential impact, federal loan competition with the muni market doesn’t get discussed much — a notable exception is a recent Hill op-ed. A lot of this is due simply to the novelty of the situation. The MLF was established as an emergency lender-of-last-resort response to a market liquidity crisis related to Covid-19. Amending it for actual lending wasn’t considered until a few months ago. WIFIA was originally intended as a project finance lender (like TIFIA) and its success as a lender to highly rated water agencies only emerged later.
But there’s another aspect at play here – the motivation to raise the issue — that should be borne in mind as these and similar federal loan programs for state & locals are being considered. The proponents of federal loan programs may not want to highlight a potential cost or deal with awkward questions about policy purpose. Muni market stakeholders might not want to criticize a loan program that benefits their customer base or explain why their effective monopoly is necessarily a good deal. In effect, the parties involved might be motivated to publicly ignore the issue and quietly work behind the scenes for their desired outcome.
A hidden path to a policy outcome is inevitably political, and that rarely ends well in the case of loan programs. Too much lending — even to investment-grade state & locals — will have a cost. But too little or none at all has its own opportunity costs. There’s a lot of scope for win-win solutions, but the path to those much-needed outcomes starts with all sides acknowledging that they’ve got shared stake in how a powerful tool gets used. This can’t be ignored.