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After assuming office last January, New York's Governor Hugh Carey surveyed the finances of the state and (especially) the city of New York, and announced, “ The days of wine and roses are over.” The nation's largest city—and the largest factor in the state-local financing equation—is encoun tering serious problems in placing its debt, which in fiscal 1976 could total as much as $14 billion. (The debt-service charge alone could approach $11/2 billion, an amount equal to the city's total budget 15 years ago.) Thus, New York's near bankruptcy has impacted as se verely on the municipal-bond mar ket as the Con Edison crisis did on the utilities market a year ago. Still, New York's problems are different only in magnitude, not in scope, from those of many other state and big-city governments. Surprisingly, the predicament could not have been foreseen two or three years ago. Just as the Vietnam peace dividend was sup posed to ease the Federal govern ment's financing problems, so was the revenue-sharing dividend sup posed to solve the problems of state-local government finance. Surpluses were projected—and for a brief time actually realized— because of increased aid from Washington, increased revenues from tax boosts at the state-local level, and decreased demand for certain services such as primary education. Digitized for FRA SER Buildup of deficits The financial situation has now altered considerably. State-local expenditures have risen sharply because of the impact of inflation on costs, because of the demands of strong public-employee un ions for inflation-offsetting wage increases, and because of the recession-related rise in demand for local services. Revenues mean while have failed to keep pace. Inflation has reduced the real impact of the massive $30-billion Federal revenue-sharing program. Inflation also has meant a loss in revenues, in real terms, from that half of the state-local tax structure that responds slowly or not at all to rising prices—primarily prop erty taxes and gasoline and liquor taxes. Meanwhile, the reces sion slowdown in income and sales has meant a slower flow of revenues from these major tax sources. The magnitude of these deficits tends to be masked by the steady increase in the surpluses of statelocal social-insurance funds. Un like their Federal counterparts, these surpluses generally are not available to finance capital spending projects or operating deficits. State and local govern ments have been running operat ing deficits for the last several decades, except for the initial revenue-sharing period of fiscal 1973—and they are now running an overall deficit even with the inclusion of social-insurance (continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. funds, despite legal or traditional rules against deficit financing. State-local operating budgets shifted from a $10-billion surplus to an $11-billion deficit between the fourth quarter of 1972 and the first quarter of 1975. The severe deficit position has led to cutbacks in capital spending and other projects. The situation has been aggravated by a shift in direction of revenue-sharing funds. According to Commerce Dept, estimates, about half of the first revenue-sharing payments went for new construction and equipment purchases, but pay ments today are more likely to go for current operations, partly be cause of the budget squeeze. Market pressures Given this shift, state and local governments are forced to turn increasingly for capital funds to their traditional source, the taxexempt municipal bond market. Cyclical forces are also likely to bring about greater dependence on this source, as governmental units which failed to find long-term financing in 1974's tight-money period rush to market to seek accommodation under today's easier conditions, just as they did in earlier recession years. Conse quently, new security issues this year could exceed the 1971 peak figure of $25.0 billion, after three intervening years of about $24.0 billion in annual sales. The 1975 Digitized for FRA SER total would probably be considerably higher, were it not for the high interest costs which still confront borrowers. General-obligation bonds, backed by the“ full faith and credit" of the issuer, have accounted for a little more than half of total bond issues in the past several years, compared with a two-thirds share at the beginning of the decade. Governments instead have relied more heavily on revenue bonds, which are backed by specific bondfinanced activities (e.g., subway fares or stadium fees)—and espe cially "moral obligation" revenue bonds, which carry the state or municipality's tacit assurance that the issuing authority's obliga tions will be met. When the New York State Urban Development Corporation failed to redeem $105 million of such securities this Febru ary, investors became wary of all moral-obligation issues. When New York City meanwhile showed increasing signs of inability to meet any of its obligations, the entire tax-exempt market came under pressure. Capital market yields generally have remained high, partly be cause of investor demands for a significant inflation premium, and partly because of the heavy bor rowing demands of corporations and (especially) the Federal gov ernment. Still, the pressures undoubtedly are greater in the municipal market than elsewhere, as exemplified by a relatively smaller drop in municipal yields since the 1974 peak. Moreover, a two-tier market has developed here (as in other markets) with investors turning their backs on lower-quality issues; thus, while the spread between Aaa and Baa tax-exempt yields averaged about 60 basis points in earlier years, this spring it has widened to about 100 basis points. (One percentage point equals 100 basis points.) In one extreme case, New York City this March was forced to pay an unparalleled 8.69 percent for $537 million of bond-anticipation notes, or about 200 basis points more than the average tax-exempt yield at that time. Disappearing buyers Some investors have been drop ping out of the municipal market, primarily the commercial banks. At the beginning of the decade, the banks took down more than two-thirds of all new issues, but last year their share dwindled to about one-fourth of the total, and this year they have been net liquidators of tax exempts. Banks, by sub stantially raising their loan-loss reserves in this recession period, now have sufficient offsets to taxable income, and do not need tax-exempt income from such sources as municipal securities. Moreover, banks prefer to re build their portfolios with the safest possible investment, U.S. Treasuries, rather than lowerquality municipals—especially when Treasuries are in such large supply as they are now. Also, bank holding companies engaged in leasing activities are able to gener Digitized for FRA SER ate large depreciation expenses, while those banks with established foreign branches are able to generate foreign tax credits, in both cases further limiting their need for tax-exempt income. With the commercial banks on the sidelines, and with fire-and casualty-insurance firms limiting their commitments because of recent unprofitable operations, the municipal market has been forced to rely heavily on the relatively small number of wealthy individual investors for whom the tax-exemption feature is an advantage. These individuals act only at unusually attractive yields, as in 1969 and 1974-75. With such a narrow base, the market apparent ly needs restructuring to attract more types of investors. Taxexempt bond funds may be one solution, especially for the large number of individuals who have relatively high incomes but not much wealth; these funds help avoid the usual muni-bond drawbacks such as high minimum purchase requirements and lack of portfolio diversity. Taxable municipals might be yet another solution, especially for those investors who are uninterested in the tax-exempt feature—mostly pension funds and life-insurance companies. But a broadened market for municipal securities is only one facet of the desperately needed cure for state-local financing problems. William Burke uo;SumsB/V\ •i)Bin •uo S o jo •BpeAafsj . oqepi MBMEH • BjUJOp|B3 • BUOZUy • E>|SB|V •|!|B 3 'o :)s p u e jj u e § ZSL ON ilWHHd aivd 3D VlSO d STI HVW SSV13 ISMIJ BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 5/14/75 Loans (gross, adjusted) and investments* Loans (gross, adjusted)—total Security loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities O ther securities Deposits (less cash items)—total* Demand deposits (adjusted) U.S. Governm ent deposits Time deposits—total* States and political subdivisions Savings deposits Other time deposits:): Large negotiable CD's 84,753 64,438 957 23,918 19,529 9,817 7,885 12,430 84,792 22,993 304 60,190 7,585 19,615 29,434 16,086 Weekly Averages of Daily Figures W eek ended 5/14/75 Member Bank Reserve Position Excess Reserves Borrowings Net free (+) / Net borrowed (-) Federal Funds—Seven Large Banks Interbank Federal fund transactions Net purchases (+) / Net sales (-) Transactions of U.S. security dealers Net loans (+) / Net borrowings (-) Change from 5/07/75 - + - + + - + - + + + 620 621 302 97 2 14 16 17 529 17 132 669 22 101 565 530 Change from year ago Dollar Percent + 2,056 + 101 294 + 696 + 412 + 542 + 2,743 788 + 6,123 + 1,053 435 + 5,443 + 346 + 1,709 + 2,481 + 2,262 W eek ended 5/07/75 + + - + + + + - + + - + + + + + 2.49 0.16 23.50 3.00 2.16 5.84 53.34 5.95 7.78 4.80 58.86 9.94 4.78 9.54 9.20 16.36 Comparable year-ago period 54 1 53 - 30 109 78 + 1,399 + 2,023 + 886 + + + 308 + 33 0 33 383 + 570 "■Includes items not shown separately. ^Individuals, partnerships and corporations. Digitized for Information on this and other publications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 397-11
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