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JOINT COMJIITTEE PRINT

NEW YORK CITY'S FINANCIAL CRISIS

AN EVALUATION OF ITS ECONOMIC IMPACT
AND OF PROPOSED POLICY SOLUTIONS

A STUDY
PREPARED FOR T H E USE O F T H E

JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES

NOVEMBER 3, 1975

Printed for the use of the Joint Economic Committee
U.S. GOVERNMENT PRINTING OFFICE
60-836 0




WASHINGTON : 1975




J O I N T ECONOMIC C O M M I T T E E
(Created p u r s u a n t to sec. 5 ( a ) of Public Law 304, 79th Cong.)
H U B E R T H. HUMPHREY, Minnesota, Chairman
W R I G H T PATMAN, Texas, Vice Chairman
SENATE

HOUSE OF R E P R E S E N T A T I V E S

J O H N SPARKMAN, Alabama
WILLIAM P R O X M I R E , Wisconsin
ABRAHAM R I B I C O F F , Connecticut
LLOYD M. BENTSEN, J R . , Texas
E D W A R D M. KENNEDY, Massachusetts
JACOB K. J A V I T S , New York
C H A R L E S H. PERCY, Illinois
R O B E R T T A F T , J R . , Ohio
P A U L J. FANNIN, Arizona

RICHARD BOLLING, Missouri
HENRY S. REUSS, Wisconsin
WILLIAM S. MOORHEAD, Pennsylvania
LEE H. HAMILTON, I n d i a n a
G I L L I S W. LONG, Louisiana
CLARENCE J. BROWN, Ohio
GARRY BROWN, Michigan
MARGARET M. H E C K L E R , Massachusetts
JOHN II. ROUSSELOT, California

J O H N R. STARK, Executive

Director

SENIOR S T A F F E C O N O M I S T S
JERRY J. J A S I N O W S K I
LOUGHLIN F . MCHUGH

J O H N R. K A R L I K
COURTENAY M . SLATER

RICHARD F . KAUFMAN, General

Counsel

ECONOMISTS
W I L L I A M R. B U E C H N E R
ROBERT D. H A M R I N
R A L P H L. S C H L O S S T E I N

W I L L I A M A. Cox
SARAH JACKSON
GEORGE R. TYLER

L U C Y A. F A L C O N E
L. DOUGLAS L E E
LARRY Y U S P E H

MINORITY
GEORGE D. KRUMBHAAR, J r . (Counsel)

(ID

M. C A T H E R I N E M I L L E R




LETTER OF TRANSMITTAL
OCTOBER 31,

1975.

To the Members of the Joint Economic Committee:
Transmitted herewith for the use of the Joint Economic Committee and
other Members of Congress is a staff study entitled, "New York City's Financial
Crisis: An Evaluation of its Economic Impact and of Proposed Policy Solutions." I t is intended to provide analytical background on the economic effects
of the financial crisis facing New York City. Since Congress is now confronted
with complex and important decisions in this matter, it is essential that we
do as much as we can to develop information on the subject. The study examines the current financial situation in New York, attempts to assess its
financial consequences and sets forth policy alternatives for dealing with
the problem.
The study was prepared by Mr. Ealph Schlosstein of the committee staff.
Secretarial and statistical assistance was provided by Marie Cunningham.
The views expressed in this document do not necessarily represent the
views of the members of the Joint Economic Committee or of the committee
staff.
HUBERT H.

HUMPHREY,

Chairman, Joint Economic
(in)

Committee.







CONTENTS
Page

Letter of Transmittal
Introduction
The Current Situation
General Description
The Underlying Causes
Impact of the Recession
Response to Underlying Developments
Response to the Recession
Three Year Financial Plan
The Economic Effect of a Default
The State and Its Agencies
Financial Institutions and Investors
Municipal Bond Market
National Economy
Region and the City
Policy Options
The City
The State
The Federal Government

m
1
3
3
11
18
22
28
30
37
37
41
46
54
56
59
59
60
62
(V)

VI
CHARTS AND TABLES

Page

Population of the 24 Largest Cities
Total Private Sector Employment in Selected Large Central Cities
Percent Population Below the Poverty Line; 24 Largest Cities
Measures of the Recession's Impact on the 24 Largest Cities
Number of Full-Time and Part-Time City Government Employees
Number of Full-Time Equivalent Employees per 10,000 Population for all Local
Governments Serving the Central County of the 24 Largest Cities
,
Recession Related Budget Adjustments for 18 Large Cities
New York City Revenues and Expenditures
Expenditure Cuts in the Controllable Portion of New York City's Fiscal Year 1978
Budget
Borrowing Needs of New York City
New York State Borrowing Requirements
Nonmember Bank Holdings of New York City Obligations
Ratio of Yields on Long-Term Tax Exempt Securities to Yields on Long-Term Taxable Corporate Securities
Total Volume of Tax-Exempt Borrowing
Yield Spread Between High Quality (Aaa) and Low Quality (Baa) Long-Term
Tax-Exempt Securities
Monthly Cash Needs of the City (Excluding Debt Service)




12
14
16
20
23
27
29
32
33
36
39
44
48
49
52
66

INTRODUCTION

New York City's financial crisis has precipitated a
considerable amount of debate about the ultimate economic and financial
consequences that will result from a default by a major city.

Undoub-

tedly, much of this disagreement results from the e n o r m o u s uncertainty
associated with any attempt to assess the consequences of default.
There simply is no meaningful historical precedent on which to base
sophisticated analysis.

Nevertheless, since Congress will soon be

confronted with a complex amd important decision, it is essential
that the best information be made available.

This study is designed

to clarify to the extent possible, many of the issues that have
been raised since New York City's financial crisis became a serious
matter of national concern.
The study is

divided into three separate sections.

The

first describes in detail the current fiscal position of New York
City.

It identifies the national and regional economic developments

that have contributed to the present situation and analyzes the
response by the City and State to these developments.

The first

section also compares New York City's fiscal problems with those
experienced by other major urban centers.
The second section identifies and quantifies to the
extent possible, the economic and financial consequences that have
resulted or will result as New York's financial problems develop.
Among the possible consequences discussed in this section of the
report are the impact of New York's financial problems on:

a) other

borrowers in the municipal bond market; b) on the strength of the




(i)

2
economic recovery;

c) the economy of the New York region;

d) the liquidity and solvency of various financial institutions;
and e) the State of New York.
The final section of the report discusses in detail
the policy alternatives available for averting default by New
York City or mitigating the impact of default.

It focuses

first on possible actions that the State and the City could
undertake immediately or over a period of time.

It then discusses

and evaluates three broad policy options available to the
Federal government:

I)

to provide no assistance; 2) to allow

the city to default and to provide Federal assistance to maintain
essential services; and

3) to provide sufficient Federal

assistance to avert default and to maintain essential services.




THE CURRENT SITUATION

Genera I Descr i pt i on:
The immediate budget crisis that New York City is currently
experiencing results from the city's inability to borrow money at any
price through the issuance of bonds or notes in the tax-exempt bond
market.

Like most large cities, New York is heavily dependent upon

borrowing to insure the adequate and efficient provision of services.
However, in order to better understand the problems associated with
market inaccessibility, it is important to examine the purposes for
which most

cites borrow and to describe New York's unique borrowing

requirements.

A more detailed discussion of the city's borrowing

needs and the problems associated with market inaccessibility appears
on Page 24.
First, New York, like almost all State and local governments
has borrowed to finance captial construction projects.
of capital

Financing

improvements through long-term borrowing serves to stretch

out the payments for capital construction over the I ife of the
improvements requiring all citizens who benefit from the facility
to pay a portion of its costs.

Like some other governments, New York

has also used short-term bond anticipation notes to fund capital
construction.

These notes are usually issued when long-term funding

is not available at reasonable prices, but are later converted to
long-term bonds when market conditions improve,,

If New York were

unable to borrow for capital construction purposes, its capital
improvement program would have to be gradually terminated causing a
deterioration in the city's capital stock and a deepening of the




(3)

4
recession in the

construction industry.

New York, like most other large cities, must also borrow
to prevent cash flow problems that inevitably result from uneven
spending and revenue streams.

While

spending generally occurs at

an even pace throughout the year; taxes and grants are received
on a quarterly, semi-annual or annual basis.

Even when the annual

budget is balanced,this mismatch inevitably results in periods of
3 to 12 months in which revenues are significantly below expenditures.
Most cities issue short-term, revenue anticipation notes over this
period to fund a normal rate of expenditures.
these notes as the revenues are received.
its normal borrowings in anticipation

They then retire

If New York could not make

of revenues, it would be

forced to rearrange its expenditures to conform more closely with
the revenue stream. At certain points in the year, this would require
cutbacks in current services of as much as 25 percent, imposing a
significant hardship on the residents and employees of the city.
In other respects, New York's borrowing requirements go
far beyond those of other cities.

Of major consequence is the larqe

amount of short-term debt that the city must roI I-over each year.

This

short term debt rollover has resulted from two basic developments.
First, the city has consistently operated with budget deficits.

These

operating deficits from past years, tota11ing approximately $2,6 billion
dollars, have been funded by issuing short-term notes which must be
rolled over continually.

Since the city also faces §n operating

deficit of approximately $700 million this year, the total borrowing
necessary to finance past and present operating deficits is $3.3 billion.




5
Second, the rollover problem results from the large amount of outstanding bond anticipation notes which come due each year.

The city

has been reluctant or unable to convert its short-term bond anticipation
notes into longer term securities.
While many of these short-term notes have been or will
be converted into longer term MAC securites the city still must
roll over $2.6 billion worth of notes from December I, 1975 until
June 30, 1976.

If the city cannot borrow sufficient funds to roll

the notes over, it will surely default.
Finally, New York has consistently funded operating
expenditures in its capital budget.

Expenditures for manpower training,

planning and other programs, totalling as much as $700 million
annually, have been funded up to now through the issuance of bonds or
notes.

If the city is unable to borrow, these expenditure or others

will have to be eliminated too.
In summary, New York City will default and experience
severe budget adjustments if it is unable to obtain credit from some
source.

The magnitude and severity of these adjustments will be

discussed at a later point in this report.
While New York's immediate problem is obtaining market
access, the borrowing problems of the City have been manifest for
some time prior to March 1975, when the city' was last able to market
its own securities.

Through the last half of 1974, New York City

notes and bonds were issued to yield, at that time, unprecendented




6
interest ratesi/ indicative of the market's inability to handle
completely the bonds and notes issued by New York City.

These high

yields were a precursor of the market access problems that have existed
since March 1975 and resulted from essentially the same combination
of factors.
In fact, the major factors affecting the city's borrowings
have not changed materially since last year.

First the City issues

a huge volume of bonds and notes annually, exceeding greatly the
borrowing requirements of other major cities.

Second, the City has

chosen to issue an abnormally high amount of short-term notes.

Since

these notes must be rolled over continually, they contribute heavily
to the large volume of New York City securities that are constantly
being marketed.

Finally, many of the City's questionable management

and budgeting practices

were beginning to come to public attention.

Since many investors rightly perceived that these accumulated problems
could seriously jeopardize the City's ability to meet future obligations,
they demanded higher interest rates and ultimately in March, refused
to i nvest at all.
Since March 1975, a series of emergency actions have been
undertaken to avert a default by the City on its obi igations.

In

early April, New York State borrowed $400 million, which was then
transferred to the City as an advance on welfare

\J
An issue of $615 million in notes yielded a record 8.34
percent on November 4, 1974, and an issue of $600 million in notes
yielded a record 9.48 percent on December 2, 1974




7
payments due in June.

In May, the State advanced the City an additional

$400 million, this time on welfare funds originally scheduled for
delivery in 1976.

These state advances were made with the hope that

investor confidence in the City's securities would soon be restored
allowing the city to borrow for its own purposes.
However, when it became apparent in early June that New
York City was still unable to market its own securities, the State created
the Municipal Assistance Corporation (MAC).
to issue up

MAC was given the authority

to $3 billion of its own securities, an

amount sufficient

to meet all of the city's obligations through October, at which time
investor confidence in New York City securities would hopefully be
restored.

In the course of providing the City with a temporary source

of credit, MAC also rolled over much of the City's short-term obligations
into longer term MAC bonds with maturities of up to fifteen years. The
purpose of restructuring the debt was to

reduce the enormous volume

of annual short-term borrowing that had originally contributed to the
City's market access problems.
The State legislation that created MAC

contained several

specific provisions which made MAC securities more marketable than
New York City securities.

First, receipts from the city's stock

transfer and sales taxes were segregated to meet all debt service
payments on MAC securities.

These receipts were channeled directly

to MAC and not to the City Treasury.

Second, MAC was a

state

agency

whose securities were backed by the "moral obligation" of the

state.

Finally, the legislation required that the city achieve a




8
balanced budget under accounting practices mandated by the State,
These protections were recognized by the private bond rating service
who rated MAC securities as a superior quality investment to New
2/
York City bonds and notes.
Despite these protections, MAC securities were not
well received by the market.

Although two-thirds of the $1 billion

first issue was privately placed with insurance companies and banks,
it still carried tax-exempt interest rates in excess of nine percent.
In mid-July, when these securities were freed of underwriting
restrictions and allowed to trade freely in the secondary market,
yields quickly rose to I percent.
I

No doubt, part of MAC f s problems
3/

can be attributed to the size of its first issue

but most of the

corporation's market difficulties must be attributed directly to
the fact that MAC T s securities were perceived by the market to
be tantamount to New York city issues.
By mid-July, major underwriters began to express their
reticence to participate in further MAC issues.

They pointed

out that they were unable to resell issues that they had underwritten and were unwilling to accept the entire $1 billion
issue themselves. MAC was able to complete another

$1 billion issue,

2/
Standard and Poors rated the MAC s e c u r i t i e s A+, although they
had suspended New York C i t y ' s r a t i n g 2 months e a r l i e r .




1/
The $1 billion issue was the largest tax-exempt issue ever.

9
but only with the participation of the City and State pension funds
and with an advance from the State government,—

One week later

half of the public offering remained unsold, causing underwriters to
raise interest rates to II percent and to buy $61 million themselves
to complete the package.

At that point, the underwriters also

suggested that it would be virtually impossible to market the final
$1 biI I ion MAC issue.
Faced with almost certain default by the City, the State
legislature passed the Financial Emergency Act.

This legislation

pieced together a $2.3 billion financing package, sufficient to
meet the City T s financing needs through early December.

In a move

designed to bolster investor confidence, the legislation also
created a seven-member Emergency Financial Control Board to administer
the City f s finances.

The Board, dominated by State appointees,

maintai rs aImost complete control over the City T s budget aggregates.
The Board must adopt a three-year financial plan which moves the City
toward a balanced budget by 1978.
for

lessening

the

The Board must also approve plans

dependence of the City on short-term borrowing

for removing operating expenditures from the capital budget, for controlling growth in expenditures and, if necessary, for freezing employee
wages.

In essence, the State, through the Financial Control Board,

has taken over much of the financial management of the City.
_




The second MAC offering was placed as follows:
$215 mill ion - City and State Pension Funds
$275 mi I I ion - Bonds sold to publ ic
$120 million - State advance
$350 mill ion - Bank purchase

10
The $2.3 billion financing package incorporated in the
State legislation has beem implemented by MAC, but not without great
difficulty.

The city and State pension programs that were requested

to purchase MAC securities have done so reluctantly.

The State has

also experienced great difficulty in borrowing the $750 million that
it has committed to +he financing package ($250 million for an advance
to the city and $500 million to pruchase MAC securities).

The

first $250 million in state notes issued to purchase MAC securities
bore an interest rate of 8.7 percent.

Subsequent to this issue,

Moody's investor Service lowered the rating of the State one grade.
This will undoubtedly lead to further increases in interest rates and
greater difficulty for the State in marketing its securities.
It now appears likely that the Municipal Assistance
Corporation will be able to provide sufficient funds to meet the
City's needs

up to the first week in December.

there is great uncertainty.

Beyond that point

The City, despite the austerity imposed

by the Financial Control Board, will clearly be unable to market its
securities in December.
access problems.

Even

MAC can be expected to face the same market
the state, according to recent market indications,

seems to have exhausted its ability to borrow on behalf of the City.
Since it is clearly impossible for the City and the State to develop
any package of tax increases and expenditure cutbacks sufficient to
meet the $4.2 billion in borrowing that the City must undertake for
the remainder of the year, it appears inevitable that the City,
absent Federal aid, will default on its obligations.
is likely to occur in the first week in December.




That default

11
The Underlying Causes:
New York, like many other major urban centers, has
been confronted with significant changes in its economic base o^er
the last fifteen years.

These changes have partially eroded the

revenue base of the city and increased the demand for the services
that the city provides.

However, these economic changes in manv

respects are not unlike those that have developed in other central
cities in the Northeast and Midwest.
From I960 to 1973, many older Northeastern and Midwestern
5/(Table I)
central cities experienced net declines in population.
tion declines resulted primarily from two factors:

These popula-

a) slower growth

in these regions relative to other regions of the country and
b) growth and migration patterns within these metropolitan areas
which caused suburban areas to experience significant population growth
while many central cities actually lost population.

In the period

from I960 to 1973, New York experienced a net population loss of
1.7 percent.

This population loss, while indicative of a stable or

declining central city, was the smallest population loss experienced
by any Northeastern city, and smaller than that experienced by all
but two cities in the Midwest.—

In other words, New York T s gross

population changes indicate that it has experienced far less revenue

See Table I.
6/
Columbus, Ohio, which is a state capital and thus
benefitted from growth in public sector employment and Indianapolis,
which annexed significant population additions.

60-836 O - 75 - 3




12
TABLE I
Population of 24 Largest Cities
(thousands)
Percent
Change
I960 to 1973
-6.5
-11.3
-1.7
-7.0
-20.7
-3.5

1973

NORTHEAST
Baltimore
Boston
New York
Philadelphia
Pittsburgh
Washington

1970

I960

878
618

906
641

939
697

7647
1862

7896
1950

7782
2003

479
734

520
757

604
764

3173

3369

3550

679
541

751
540

876
471

1387

1514

1670

728
691
558

733
717
622

476
741
750

-10.6
-22.5
14.9
-16.9
52.9
-6.7
-25.6

816
1320
522
659
573
756

844
1234
520
624
593
708

680
938
201
498
628
588

20.0
40.7
159.7
32.3
-8.8
28.6

2479
439
573
740
557

10.8
45.0
32.1
-7.2
-9.7

MIDWEST
Chicago!/
Cleveland
Col umbus^
Detroit
Indianapol\skf
MiIwaukee^/
St. Louis
SOUTH
Da I Ias5/
Houston
JacksonviIle^/
MemphisZZ.
New Orleans
San Anton io^'
WEST
Los Angeles^-/
Phoenix 10/
San Diego 11/
San Francisco
Seattle

2747

637
757
687
503

2812
587
697
716
531

1973 Figures Include:

1/
Annexation of

4,737

2/
Annexation of

26, 293

3/
Annexation of 306,732

4/

Annexation of

6,923

5/
Annexation of

11,336

6/
Annexation of

364,643

Annexation of

136,562

Annexation of

14,456

Annexation of

10,293

Annexation of

64,478

Annexation of

9,945

7/
8/
9/

10/
11/

SOURCE:

Bureau of the Census







13
base erosion due to population losses than other comparable
central cities.
At the same time that many central cities were
experiencing

population losses, they were also experiencing

significant reductions in private sector employment.

These

reductions resulted from a similar combination of factors that
led to net population losses. Many industries were moving from
the older regions of the country into the South and West where
cheap land for modern one-story manufacturing plants is more
readily available and where labor costs are lower.

Within

regions, employment opportunities have moved to suburban areas
where

employees now live and where land for expansion is

more readily available.

New York has been victimized by these

shifts in employment opportunities, experiencing losses of
private sector jobs equal +o< or in excess of losses experienced
by other central cities (Table II).

From 1970 to 1973, a period

in which total employment grew 7.4 percent nationally, New York
experienced a decline in total private sector employment of 6.2
percent.

The magnitude of this decline was approximately equal to

that experienced by other comparable central cities and/exceeded
by only one Northeastern central city and one Midwestern central
city.

Clearly, New YorkTs position is somewhat unique in that

its population, and thus its service demands, have remained somewhat constant, while a portion of its revenue base has been eroded
through losses in employment opportunities.

14
TABLE I I
Total Private Sector Employment in
Selected Large Central Cities (thousands)

1973

1970

Percent Change
(1970 to 1973)

328
2986
709
332

348
3182
777
343

.7
-5.
-6.
.2
.7
-8.
-3.
.2

1271
234
503
285
215

1367
203
581
285
228

-7.0
15.0
-13.4
0
-5.7

394
581

386
549

2.0
5.8

1315
409

1281
451

2.6
-9.3

NORTHEAST
Baltimore
New York
Philadelphia
Washington

MIDWEST
Chicago
Cleveland
Detroit
Milwaukee
St. Louis

SOUTH
Dallas
Houston

WEST
Los Angeles
San Francisco

SOURCE:




Bureau of Labor Statistics




15
This unique shift which has occurred over the last
fifteen years is further documented by examining poverty population data for the largest central cities (Table III).

From I960

to 1970, the percent of the population below the poverty line
nationally was reduced from 18.4 percent to 10.7 percent.

At

the same time, all central cities experienced declines in their
poverty populations, but at rates nowhere near the decline
nationally.

In fact, only two cities reduced their poverty

population from I960 to 1970 at a rate equal to the national
decline and both of these cities have benefitted from major
annexations of surrounding suburban jurisdictions.—

In I960,

only four cities had poverty populations (as a percentage
of total population) above the national average. By 1970, the
above the national average
number of cities with poverty populations/had risen to fifteen.
Thus, while significant reductions

in poverty population have

been made nationally, there has been a profound increase in the
concentration of poverty populations in the NationTs largest
central cities.
New York has been a major participant in this trend.
In I960, New York had one of the lowest poverty populations in
the country, well below the national average.

By 1970, New

YorkTs poverty population exceeded the national average, despite
the fact that by Census definitions,itTs poverty population had

V
J a c k s o n v i l l e , F l o r i d a and I n d i a n a p o l i s ,

Indiana.

16
TABLE I I I
Percent Of Population Below the Poverty Line-L'
24 Largest Cities
1960
18.4

Nation

1970
10.7

Percent Change
(1960 to 1970)
-41.85

NORTHEAST
Baltimore
Boston
New York
Phi lade I phi a
Pittsburgh
Washington

17.9
14.2
12.8
15.0
16.
16,

I I
l I
12

-21.79
-17.61
-10.16
-25.33
-30.00
-23.95

12,
14,
14.
16.
13,
9,
19.

10.
13.
9,
II.
7.
8,
14.

-11.67
-9.40
-30.99
-33.14
-48.18
-I 1.96
-24.61

16.
18,
28,
25.
25.
28,

10,
10,
14,
15,
21,
17,

-39.52
-40.88
-50.53
-38.67
-15.63
-38.81

I 1.6
14.7
12.0
12.1
8.6

9.7
8.8
9.3
10.7
6.0

-16.38
-40.14
-22.50
-I 1.57
-30.23

MIDWEST
Chicago
Cleveland
Columbus
Detroit
Indianapolis
MiIwaukee
St. Louis
SOUTH
Dal las
Houston
JacksonviIle
Memphis
New Orleans
San Antonio
WEST
Los Angeles
Phoen i x
San Diego
San Francisco
Seattle

1/
Poverty line is defined as follows:
Family si ze

I960

1970

2
3
4
5
6
7

$1894
2324
2973
3506
3944
4849

$2383
2924
3743
4415
4958
6101

SOURCE:

Bureau of the Census







17
been reduced over 10 percent.
population in 1970 did
central cities.

Clearly, New Yorkfs poverty

not exceed that of other comparable

But the shift in its population from I960 to

1970 has been more pronounced than for all other major central
cities except Cleveland.

Thus, while New York still does not

have an unusually high percentage of total population below the
poverty line, the growth in its poverty population from I960
to 1970 has been the second most severe in the Nation.
Finally, when examining the cityTs recent economic
changes, it is impossible to ignore the slow growth in New
York T s residential property tax rolls.

While no comparable

data exists for all large central cities, there is considerable
evidence that the growth in the City's residential tax base
has lagged behind growth in other comparable central city
residential tax rolls.

No doubt, much of this lag can be

attributed to the economic decline affecting other sectors
of New York's economy, but the effect of comprehensive rent control
laws cannot be dismissed. The City's rent
control legislation has already contributed to a rise in tax
delinquencies as landlords willingly abandon properties that
are marginal income producers.

Over the long run, it will also

affect the overall quality of the city's housing stock, as
landlords allow properties to deteriorate because they are
unable to pay for necessary rehabilitation with higher rents.
Ultimately, this will lead to a further deterioration of the
City's fiscal resources.

18
In summary, this comparison of New York City's
economic changes with those of other large central cities indicates
that New York's economic resources are presently not out of line
with those of other large central cities.

In an absolute sense, it T s

poverty population is not excessive; its population losses have
been moderate; and its job losses
comparable central cities.

were not much worse than other

However, it is clear that the

deterioration over time of its economic base and the shift toward
a more service dependent population has occurred at a faster
rate

than for

most other

central cities.

This faster rate of decline has undoubtedly imposed a greater
relative strain on the ability of the city to continue to finance
its past levels of public services.

The Impact of the Recession:
In most large central cities, the long-run economic
deterioration has been exacerbated by the recent recession.

In

general, high unemployment rates cause significant shortfalls in
receipts from sales and income taxes because these taxes are
8/
directly tied to the level of economic activity. -

High unemploy-

ment also causes increases in the cost of unemployment related
expenditures, such as welfare and public health.

Thus, recession

causes a combination of revenue shortfalls and expenditure

8/
As unemployment rises, growth in real incomes and
final sales are reduced, interrupting the growth in the income
tax and sales tax bases. Property taxes are less sensitive to
unemployment changes in the short run, except through increased
deli nquencies.




19
increases which greatly undermines the ability of local governments
to maintain balanced budgets without raising taxes or cutting services.
Needless to say, all cities have not been affected
equally by the current recession.

Some have maintained unemploy-

ments rates below the national average.
revenues from
falls.

Others, that derive all of their

property taxes, will experience minimal revenue short-

In order to better understand the vulnerability of large

central cities to the recession, it is necessary to evaluate the
magnitude of economic decline caused by the recession and the
vulnerability of the city's tax base and expenditures to changes
in economic activity.
Probably the best single measure 2/ of the recessionTs
impact on a central city economy is the change in its unemployment
rate. (Table IV). Since rising unemployment will inevitably
affect income and sales tax receipts, changes In unemployment can
be used to measure the overall magnitude of decline in the
central city's tax base.

As of June 1975, New York's unemployment

rate was higher than that of most other comparable cities.

While

a portion of this higher unemployment rate can no doubt be attributed
to the higher pre-recession unemployment rate in New York, the
predominant factor is the increase in New York's unemployment rate
over the last year.
increased 4.6

In fact, New York's unemployment rate has

percentage points from June 1974 to June 1975,

compared to an average increase of 3.4
other 24 largest cities.

percentage points for the

Since New York City's June

1974

The only up-to-date measure of central city economic
activity ava ilable.
60-836 O - 75 - 4




TABLE IV
MEASURES OF THE RECESSION'S IMPACT ON THE 24 LARGEST CITIES

NORTHEAST
Baltimore
Boston
New York
Phi ladelphia
Pittsburgh
Washington
MIDWEST
Chicago
Cleveland
Columbus
Detroit
Indianapolis
Mi Iwaukee
St. Louis
SOUTH

Unemployment Rate
June 1975
9.2
|2.8
11.4
||.4
9.4
6.7
9.8
8.7
7.4
|5.6
8.6
9.3
9. 1

Unemployment Rate
June 1974

Increase in
Unemployment Rate
(6/74-6/75)

5.2
5 .2
7, .5
7.5
6, .4
5.4
5, .9
5.9
5, .0
5.0

4.0
5*3
4.6
5#Q
3*5
L7

16,3
0
31.9
67.2
0
51.5

5.11
5, .
4. ,3
3.7
3. ,7
9, ,0
5. ,2
4. ,7
6. ,3

4.7
4.4
3.7
6.6
3.4
4.6
2.8

13.7
53.
79.4
35.6
0
0
41.7

2.9
1.0

19.5
26.2
0
0
40.4
28.6

6, . 8

Dallas
6.5
3.6
3. .6
4. 5
Houston
5.5
6. 5
Jacksonvi M e
8.3
5. 1
Memphis
9.I
5.I
8. 3
New Orleans
8.7
8.3
6. 0
San Antonio
10.0
6.0
WEST
7. 0
5. 9
Los Angeles
||,0
7.0
8. 3
Phoenix
12.5
5.9
8. 0
San Diego
| | .4
8.3
7. 1
San Francisco
10.7
8.0
Seattle
9_19
7.1
I? Recession sensitive taxes include income taxes and general
SOURCE: Bureau of Labor Statistics and Bureau of the Census.




Percent of the Total Taxes
Derived from Recession.Sensitive
Taxes (1975-1974)— 7

4.0
.4
4.*0

20.3
4.0
44.6
6.6
32.4
3."
13.5
2.7
15.0
2*8
sales and gross receipt taxes.

to

o




21
June 1975, unemployment rate increase probably underestimates
10/
the impact of the recession on New York T s economy,""

it is reas-

onable to assume that the New York economy has been more
seriously affected by the recession than the economies of
most other large central cities.
However, these large increases in the unemployment rate
rate are partially offset by the average vulnerability to
recession of New York CityTs tax base. (Table IV). Approximately
32 percent of the city!s

tax receipts are derived

from sales and income taxes.

While this percentage is slightly

higher than the average for the 48 largest cities,

I 1/
it certainly

does not compare to the sensitivity to recession of many other
central city tax bases.
However, the significant increases in the unemployment rate more than offset the average vulnerability to
recession of the cityTs tax base.

In fact, New York has probably

experienced greater revenue shortfalls than three-quarters of the
24 largest central cities.
The impact of the recession on expenditures is far
more difficult to measure. It is extremely difficult to isolate
_.
Recent cuts in public employment will undoubtedly
exacerbate the recession related unemployment increase.
I I/ 29 percent of their revenues are derived from sales
and income taxes.

22
expenditures tor recession sensitive purposes and even more
difficult to get current information on the size of these
expenditures.

However, New York CityTs heavy responsibilities

for welfare and health services will probably cause budget
difficulties in excess of those experienced by comparable
central cities.
In summary, it is reasonable to assume that the
combination of high unemployment rates, heavy city government
responsibility for welfare and health services, and a reasonably
sensitive tax base have caused New York City to experience more
serious recession-related budget difficulties than most other
central cities.

The City T s Response to Underlying Economic Developments:
Despite declining tax bases in many large central
cities, the period from I960 to 1974 was marked by a major
expansion of the economic role of state and local governments.
During these years, the functions of state and local government
were broadened, employee compensation was improved and service
levels were raised.

In general, these burgeoning demands were

met by increased revenues resulting from general economic prosperi
and from tax rate increases.
New York City, despite

its deteriorating fiscal base,

was clearly one of the leaders in expanding the economic role
of city government. From I960 to 1974, the number of full-time
and part-time New York City employees per 10,000 population
increased 69.6 percent, (Table V) a rate of growth that




TABLE V
TOTAL NUMBER OF FULL-TIME AND PART-TIME CITY GOVERNMENT EMPLOYEES
(Per 10,000 Residents)
Percent Chemge
I960 to 1974

Percent Change
1970 to 1974

960

1970

1974

Ba1timore
Boston
New York
Phi lade 1phia
Pittsburgh
Wash ington
MIDWEST

285
303
345
145
341

418
388
526
183
141
722

455
442
585
206
126
737

Ch icago
Cleveland
Columbus
Detroit
1nd ianapo1i s
Mi Iwaukee
St. Louis

105
159
88
155
82
127
184

135
215
103
176
83
147
225

143
198
I 19
199
138
146
252

36.2
24.5
35.2
28.4
68.3
15.0
37.0

108
90
208
294
150
108

136
85
131
393
173
121

164
92
199
357
179
142

51.8

2.2

8.2

-4.3
21.4
19.3
31.5

51.9
-9.2

144
74
83
210
158

154
99
83
285
205

164
120
95
313
201

13.9
62.2
14.5
49.0
27.2

liORTHEAST.

1 17

59.6
45.9
69.6
42. 1

7.7
1 16. 1

8.9
13.9
1 1 .2
12.6
-10.6
2. 1

5.9
-7.9
15.5
13. 1

to

66.3

°°

-0.7
12.0

SjDUT]H
Dal las
Houston
Jacksonvi 11e
Memphis
New Orleans
San Antonio

20.6

3.5
17.4

WEST
Los Angeles
Phoenix
San Diego
San Francisco
Seattle




Source:

Bureau of the Census.

6.5
21.2
14.5

9.8
-2.0

24
exceeds every large central city but Washington, D X . Since 1970, however,
the city's growth^in employment has been similar to that of other cities.
From I960 to 1974, public employment per 10,000 residents in the
24 largest cities increased only 36.5 percent, half the rate
of growth in employment in New York City.

Thus, while the

population of New York City remained virtually constant, the
total number of New York City employees increased almost 70
percent, mostly

during the period from I960 to 1970.

The

growth in New York City's public

employment over the past fifteen years is indicative of an
unwillingness or inability on the part of the City's leadership
to undertake the difficult austerity measures necessary to keep
the budget in balance.

Confronted with a deteriorating tax base

and rising expenditure demands, New York simply did not make the
difficult tradeoffs necessary to keep expenditure growth in line
with tax receipts.

Rather, the city resorted to a series of

fiscal gimmicks and dubious management practices that are
responsibile for much of the investor skepticism that New
York is experiencing today.

Deficits were funded by short-

term borrowing in anticipation of revenues that did not
exist. Operating expenditures were transferred into the capital
budget and funded through long-term borrowing.

And

pension

benefits, well in excess of the city's ability to pay, were made
available.

These dubious budgeting procedures contributed

directly to the City's short-term borrowing problems and
only postponed the need for later tax increases or expenditure
cutbacks; a need that the City is facing today.







25
It should be pointed out, however, that the City
continued its questionable

budget practices with at least the

tacit acquiescence of the State and the financial community.
The State clearly failed to exercise the necessary oversight
of the City T s budget.

And the financial community continued to

provide New York City with credit long after it was aware of
the questionable

budget practices undertaken by the City.

If the State or the financial community had required the City
to adhere to legitimate budgeting techniques, the current
market access crisis could conceivably have been avoided.
While the data in Table V correctly suggests a
huge growth in the number of New York City employees, it
partially misrepresents New York City's unique employment
needs related to other cities.
for two reasons.

This misrepresentation occurs

First, New York City is both a city and

a county and thus makes expenditures for services that are
normally provided by both levels of government.

Other cities,

which are located within a larger county usually have fewer
responsibilities.

Second, New York City has full or partial

responsibility for many functions that most cities do not
provide.
Some of these functions, particularly welfare, result
from the division of responsibility between State and local governments in New York State.

Others, such as the City University

system, the housing construction program, the hospitals and the
transit system are services which the City provides by choice.

26
Table VI adjusts for these two unique qualities
of New York City.

Column I adjusts for the fact that New York

is both a City and a county.

It shows the number of full-time

equivalent employees of all local governments servicing the
central city.

Nevertheless, New York City's employment needs

still exceed those of all other central cities, except Washington,
D. C.
The second column further adjusts for New York's
unique responsibilities.

It illustrates that New York City's

employee needs for services commonly provided by a city
government are not significantly in excess of the personnel
needs of other cities for simi lar services.

Thus, when

only common municipal functions are considered, New York
employee requirements, while still high, do not significantly
exceed those of comparable large central cities.
In Summary, from I960 to 1974, New York consistently
delayed tax increases and service cutbacks that were necessary
to keep current expenditures equal to receipts from its declining
revenue base.

This delay of fiscal austerity measures was

implemented by a series of questionable management practices
and fiscal gimmickry.

These gimmicks allowed New York to maintain

service levels and levels of employment in excess of those maintained by other large cities and probably in excess of the
city's own fiscal capacity.

However, closer examination indicates

that New York C i t y ? s employee requirements for basic services do







27
TABLE VI

NUMBER OF FULL-TIME EQUIVALENT LOCAL GOVERNMENT EMPLOYEES PER 10,000
RES 1 DENTS FOR ALL LOCAL GOVERNMENTS SERVING CENTRAL
COUNTY OF 24 LARGEST CITIES (1974)

All Functions

Basic City Services —

NORTHEAST
Ba1timore
Boston
New York
Philadelphia
Pittsburgh
Washington

434. 1
465.0
528.2
414.5
316. 1
752.0

324.8
259.7
300.8
305.9
247.9
418.4

352.5
383.2
294.4
354.3
337.3
381.7
424.6

269.9
278.6
240.0
266. 1
250.4
287.3
286.3

343.7
306.9
409.8
416.0
357.7
359.5

267.3
258.3
301.9
275. 1
274.3
256. 1

401.1
356.0
333.2
488.3
360.2

274.8
275.5
255.2
265.2
272.3

MIDWEST
Chicago
Cleve land
Columbus
Detroit
1nd ianapoli s
MiIwaukee
St. Louis
SOUTH
Dal las
Houston
Jacksonvi1le
Memphis
New Orleans
San Antonio
WEST
Los Angeles
Phoenix
San Diego
San Francisco
Seattle

1/
Basic City services includes education, highways, police, fire,
sanitation, recreation, libraries, financial administration and general
control.
SOURCE:

Bureau of the Census.

28
not significantly exceed those of other large cities.

Rather,

its enormous personnel needs result directly from the wide
range of non-municipal functions that the city chooses to or
is forced to provide.

The City's Response to the Recession:
The severity of the current recession and the federal
government's inability to reduce unemployment have forced many
large central city governments to undertake significant
budget adjustments this year.

Typically, these budget adjust-

ments take the form of tax increases, expenditure cutbacks and
delays or cancellations of capital construction programs.
They are necessary for cities to keep their budgets at or near
balance in the face of revenue shortfalls and expenditure
increases caused by the recession.
While New York City's response to long-term economic
developments was in many ways inadequate, it's response to the
current recession has generally exceeded the response of other
large central cities.

(Table VII). New York City's tax

increases have exceeded the tax increases of most other
central cities and its cuts in current service expenditures
have been among the highest in the Nation.

While it is more

difficult to measure changes in local employment, earlier
Joint Economic Committee surveys indicate that New York's
payroll reductions through attrition and layoffs have probably
been the most significant in the Nation. Thus, with the possible
and St. Louis,
exception of Detroit /New York City's combination of tax increases,
expenditure cutbacks and employee reductions has been the most




29
TABLE VI I
RECESSION RELATED BUDGET ADJUSTMENTS FOR EIGHTEEN LARGE CITIES Tax Increases as a Percentage
of Total Own Source Tax Receipts

BaItimore
Boston
Cleveland
Columbus
Detroit
1ndianapoli s
Jacksonvi 1le
Los Angeles
Memph i s
MiIwaukee
New Orleans
New York
Philadelphia
Phoenix
Pittsburgh
St.Loui s
San Francisco
Seattle

.8
4.9
5.3
6.5
6.9
7.4
10.7

6.5
7.4
4. 1

Expenditure Cutbacks as a
Percentage of Total Expenditures
1.3
6.7
.3
9.4
.9
5.8
3.8
2.9
5.8
.8

1/
The data in this Table is based on a Joint Economic Committee Survey of
State and local government finances. The survey was taken in April, so the budget
adjustment data may not be completely current. The budget adjustments are for the third
quarter 1.975, at an annualized rate. See: The Current Fiscal Position of State and
Local Governments.




30
expenditure cutbacks and employee reductions has been the most
severe in the Nation.
No doubt, the size of New York T s recession related
budget adjustments is directly related to the City f s inability
to respond adequately to its longer-term economic developments.
Had the City consistently reduced expenditures or raised taxes
to balance the budget in previous years, it would not have been
forced to undertake such large bydget adjustments this year.
Nevertheless, the current recession has precipitated a series of
major budget cutbacks by the City and probably acted as a major
catalyst for the City ! s current market access problems.

The City's Response in the Future:

The Three Year Financial Plan:

While the city of New York has enacted significant
economies in the first nine months of this year, these actions are
certainly not sufficient to offset the budget imbalances caused by
past problems and the current recession.

In recognition of

these future budget difficulties, the State Emergency Financial
Control Act established a Board to oversee the finances of the City.
This Board has produced a plan pursuant to the requirements of the
State Act, which moves the City toward a balanced budget by Fiscal
Year 1977-1978.

The following section examines the specific

provisions of the three year plan.
There is no doubt that the three year plan proposed by
the Financial Control Board will impose major reductions in current
service levels, affecting both the residents and employees of the







31
City of New York.

Some budget economies may be achieved through

more efficient management, improved productivity and more effective
revenue col lection procedures, but the great majority of the
expenditure modifications will result directly from a real
reduction in the range and quality of services provided by the City.
As Table VIM

shows, by fiscal year 1978, the City

will be forced to make expenditure cuts of $724 million to balance
the budget.

At first glance, it might appear that a cut of $724

million in a $12 billion budget is not an extremely difficult
accomplishment. However, like the Federal budget, a large

portion

of New York City's budget is uncontrollable.-^ Once debt service,
state mandated welfare expenditures, pension payments and other
uncontrollables are removed from the City's expenditures, only
(Table IV)
about $5.5 bill-ion remains at the discretion of the City/ Since
the dollar expenditures for the controllable portion of the
budget will be held essentially constant through the life of the
Financial Plan, the real value of these controllable expenditures
will be reduced approximately $335 million—from FY 1976 to FY 1978.
Thus, the real reduction in controllable expenditures by FY 1978
is approximately $1,050 million, or 18 percent of the projected
controllable budget.
12 / Uncontrollables are defined as those expenditures that are
mandated by State or Federal law, and thus not under the administrative
control of the City.
13 / An assumption of a three percent annual inflation rate reduces the dollar value of constant controllable expenditures by $335
mi I I ion.

32
TABLE VIII
NEW YORK CITY REVENUES
AND EXPENDITURES ($ MILLIONS)
BALANCE OF FY 1976
(Oct I to June 30)

FY 1977

FY 1978

Revenues

8392

1 1992

12294

Expenditures (except debt service)

7479

10634

10697

Debt Service

1669

2190

2191

100

100

12924

12988

-462

-724

12462

12264

-470

+30

1 100

930
596
333

Reserves for Overruns
Total Expenditures (without budget cuts)
Budget Cuts

0
9148
-92

Total Expenditures

9056

Surplus or Deficit

-664

Capital Spending (Total)
Operating Items in Capital Budget
Real Capital Items

1147
523
624

Source:




Office of the Controller of New York City

647
453

33
TABLE IX
EXPENDITURE CUTS IN THE CONTROLLABLE
PORTION OF NEW YORK CITY'S FY 1978 BUDGET

Total Controllable Spending in FY 1976

$5500 Mil lion

Controllable Spending in FY 1978 (Projected)!/

$5835 Million

Budgeted Controllable Spending in FY 1978^/

$5500 Mil lion

Cuts in Real Services Due to Inflation From
FY 1976 to FY 1978

$ 335 Mi I I ion

Budget Cuts Mandated by Plan

$ 724 Mil lion

Total Deflated Cuts

$1059 Mi I lion

Total Deflated Cuts in Real Services as a
Percentage of FY 1978 Projected Controllable
Budget

\j
2
V
Source:




Includes 3 percent inflation factor.
As it appears in the Financial Plan.
Office of the Controller of New York City

18*2 percent

34
A cut of this magnitude will constitute a significant
reduction in/real level of services provided by the City of New
York.

Many programs will have to be sharply curtailed and others

will, no doubt, have to be eliminated completely.

In fact, few

aspects of the City s budget will escape careful scrutiny under the
new plan.

Wages and salaries will be frozen for the two year period

beginning July I, 1976.
will be interrupted.
be delayed.

All major new capital construction projects

Many projects already underway will have to

The City's housing construction program has already

been discontinued.

In short, New York will finally be taking the

long delayed but necessary steps to put its budget in balance.
However, the budget balancing task is even tougher
than it appears.

Expenditure cuts and employee reductions will

further undermine the cityfs employment base and thus directly
affect the budget of the city.

Employee reductions and expenditure

cutbacks will lead to a further reduction in future city revenues
and to an increase in unemployment related city expenditures.
Without a meaningful recovery in the national economy, these cuts
will only serve to move the City's budget further away from a
balanced position, necessitating further cuts and greater hardships.
Moreover, it may be difficult to achieve the expenditure cuts
necessary without directly affecting the flow of grants-in-aid from
the State and Federal governments.

Cuts in programs which have

requirements that the city match funds from other levels of
government, may also serve to lessen the flow of intergovernmental
aid to the city, thus reducing its revenues.

Thus, the combination

of revenue and grants-in-aid reductions and expenditure increases




35
may force Mew York to make cuts in excess of 18 percent of the
control lab Ies In order to truly balance the budget.
The financial plan also presents, for the first time,
a detailed description of the City f s borrowing needs over the
next three years (Table X ) .

This table shows that the city will

have total borrowing needs of approximately $8.8 billion
the three year period (FY 1976 to FY 1978).

over

Approximately $2.9

billion must be borrowed to roll over outstanding short-term
debts maturing in FY 1976 and FY 1977.

Another $1 billion must

be borrowed to fund the operating deficits until the city's budget
is brought into balance. $3 billion is necessary to fund the
reduced capital budget and as much as $2 billion may be necessary

11/
to meet the city's cash flow problems.

Clearly, the City will be

heavi ly dependent upon access to some source of credit over the next
three years.

If this source of credit is not available, the city

will have no option but to default on its obligations.

I4_/
This intra-year debt will be retired within the fiscal year
and thus, does not have to be rolled over.
60-836 O - 75 - 5




36
TABLE X
BORROWING NEEDS OF THE CITY ($ MILLIONS)

FY 1976
(Dec I to June 30)
Debt Rollover!/

FY 1977

FY 1978

TOTAL

2560

New Rollover

300

2860

Operating Deficit

516

470

+30

956

Capital Program

992

1 100

930

3022

Intra-Year Borrowing

2000

200£

2000

2000

Total

6068

7938

8838

8838

_J Figures for debt rollover assume that notes issued to fund maturing debts,
capital construction and the operating deficit carry maturities of only one year
and thus must be rolled over in each ensuing year. If these obligations are funded
with longer-term bonds, the borrowing requirements of the City in FY 1977 and FY
1978 would be greatly reduced.
Source:

Office of the Controller of the City of New York




THE E C O N O M I C

E F F E C T OF A D E F A U L T BY N E W Y O R K

CITY

Definitive conclusions about the economic and financial
consequences of a default by New York City cannot realistically be
presented. The uncertainties about investor reactions and governmental responses are just too great.

However, it is possible to

analyze in detail economic and financial developments in the past
six to eighteen months and to use this analysis to formulate
credible assumptions about future developments.

These assumptions

can then be used to reach conclusions about some of the possible
consequences of default.

THE STATE AND ITS AGENCIES
Much of the concern about the default of New York City
revolves around the increasing involvement of the State of New York
in the City T s financial affairs. Some of this concern centers on
a real financial commitment by the State to the City of New York.
The State has already loaned the City $250 miiI ion and by December I
will have purchased $500 million worth of MAC securities.
securities are a relatively secure

The MAC

commitment but a default by

the City on its own obligations would ubdoubtedly jeopardize quick
repayment of the $250 million loan from the State. A default by the
City on that loan, combined with a State budget deficit of approximately
$600 million, would give the State a total budget imbalance of $800-900
million for FY 1976.

While this is undoubtedly a large deficit, it is

not significantly out of proportion with budget imbalances experienced




(37)

38
by other Northeastern and Midwestern states that have experienced
significant recession related unemployment rate increases.

Thus,

the State's deficit and real financial commitment to the City,
are not by themselves sufficient to undermine, significantly,
the State's ability to meet its obligations.
However, the involvement of the State in the City's affairs
goes well beyond the real financial commitment of the State.

Of

far greater significance is the questionable, but nevertheless,
very real

perception by investors that New York State's ability

to meet its obligations is directly tied to the ultimate fate of
the City.

Even before default, this perceived reduction in the

State's credit worthiness has imposed very real costs on the
State and its agencies.
The State agencies have encountered
market resistance.

most severe

Their securities, which are backed only by

the "moral obligation" of the State, have been victimized by the
tendency of investors to respond to uncertainty by seeking only
investments that are perceived as being perfectly secure.

Thus,

investors have exercised their preference for top quality general
obligation issues, while spurning the less secure moral obligation bonds.

As Table XI shows,the State agencies will have

average monthly borrowing needs of almost $200 million through
June.




39
TABLE XI
NEW YORK STATE BORROWING REQUIREMENTS ($ MILLIONS)
FY 1976

STATE

STATE AGENCIES 1 /

November

TOTAL

249

249

30

292

332

6

218

224

221

221

153

179

332

Apri I

800*(800)

165

965(800)*

May

800

85

885

June

950

158

I 108

December
January
February
March

DLL2Z7

TOTAL

_y

2739*(800)

1567

4316(800)*

Does not include the Municipal Assistance Corporation.

*ln FY 1976, the State advanced the City $800 million in grants that would
have been received later in the year. If this procedure is followed again in
FY 1977 the State T s borrowing requirements in April and May will be increased
$800 mi I I ion.
Source:




Office of the Controller of the State of New York

40
One of these agencies, the State's Housing Finance
Agency, barely averted default in October, but only temporarily.
At that point, the private market was completely closed to the
State Agencies.

However, the State Housing Finance Agency must borrow

over $100 million a month in each of the next six months.

Even with

the backing of the full faith and credit of the State, this would be
an extremely difficult task.

However, without this commitment I y the
p

State, the Housing Finance Agency will almost certainly default.
But the State's full faith and credit securities have not
escaped investor skepticism.

The last issue of State general

obligation rates carried a net interest cost of 8.7 percent.

While

this $250 million issue was made in behalf of New York City, and thus
may have been perceived to be strongly associated with the City, it was
indicative of the market's reaction to any security with the name
New York on it.

Fortunately, the State does not have great borrowing

needs until the second quarter of 1976.

However, in that three month

period, the State will have to borrow $2.7 billion to $3.5 billion
(Table XI). These notes are issued in the first three months of the
State's fiscal year (April, May and June) so that the State can
distribute State assistance to all the local governments within the
State.

Without the immediate distribution of this state aid, most

11/
New York local governments will be forced to default.
It is impossible to ascertain how investors will receive
New York State's general obligation notes in April if the City defaults
15/ Most New York local governments borrow at the beginning of
their fiscal years (July I) in anticipation of the State aid that is
forthcoming in April, May and June, or at the end of their fiscal year.
If this State aid is not forthcoming, they will be forced to default.







41
in December.

Many investors could express their concern about the

relationship between the City and the State by refusing to buy State
State securities

at all.

Others may conclude that the act of

default by New York City has removed a great financial strain
from

State resources.

However, the uncertainty is so great that

one cannot ignore the possibility that a default by New York City
could cause severe market access problems for the State and many other
local governments within the State.
Finally, one cannot ignore the impact that New York CityTs
financial crisis will have on the budget of the State of New York.
Significant employee reductions and expenditure

cutbacks within

the City will quickly have an effect on the State's tax receipts.
Revenues from the state income and sales taxes will decline as
unemployed public employees and construction workers suffer declining
real incomes.

Ultimately, state expenditures for welfare and other

related expenditures may also be increased.

While it is difficult

to measure the precise impact of the City f s expenditure reductions
on state receipts and expenditures, crude estimates suggest that
the total effect may be between $100 million and $150 million.

Thus,

the economies undertaken by New York City whether it defaults or not,
will lead to a widening of the State's budget deficit by $100 million
to $150 mi I I ion.

THE IMPACT ON FINANCIAL INSTITUTIONS AND OTHER INVESTORS:
Default, even under the best of circumstances, will lead
to an immediate reduction in the market value of outstanding New
York City securities.

The secondary market for these securities

42
will probably deteriorate greatly until the uncertainty about
repayment is resolved and any investors who are forced to liquidate
their holdings during this period will no doubt experience large losses.
However, the value of these securities subsequent to this
period of uncertainty is much more difficult to predict.

If a reason-

able repayment plan is developed, it is conceivable that New York
securities could be valued near pre-default levels.

But,if the City T s

resources are inadequate to meet all principal payments within a
reasonable period of time and it does not pay market interest rates on
delayed principal payments, the value of New York f s outstanding
securities could be reduced significantly below already depressed predefault levels.

There is no doubt, however, that a default by New

York City will affect the behavior of major investors in New York
securities.
Since banks are heavy investors in the municipal bond
market, holding almost 50 percent of the outstanding securities, it
is important to ascertain the impact of default on the banking
system and on individual banks that are large holders.

Under current

bank examination practices, the bank regulatory agencies allow banks
to carry assets, at book value rather than market value. A default by
New York City would necessitate an alteration in this practice as the
regulatory agencies require banks to write down the value of defaulted
securities to market values over a period of approximately six
months. These write-downs will reduce the capital positions of the
banks that are large holders of City securities.







43
Recent surveys by the Federal Reserve Board and
the Federal Deposit Insurance Corporation (FDIC) have identified
the number of banks that are potentially vulnerable to a default by
New York City.

The FDIC survey indicates that 56 of the 8,606 banks

reporting, had holdings of New York City securities in excess of 50
percent of their net worth. (Table XII).

However, most of these

banks are small and well capitalized, so there is little danger
of default precipitating a major bank failure among the non-member
banks.

The Federal ReserveTs survey of member banks reached similar

conclusions.

It discovered only six banks whose holdings of New

York City securities exceeded 50 percent of their capital.
Moreover, the Chairman of the Federal Reserve Board
has made it clear that the Board will take whatever actions are
necessary to preserve the stability of viable banking institutions.
First, the FED is prepared to lend unlimited funds through the
Federal Reserve discount window to any member or non-member bank
that needs assistance to meet its temporary liquidity needs.

Second,

the bank regulatory agencies will allow banks to suspend the writedown of defaulted assets for a period of six months.

This will

provide banks some time to rebuild their capital positions and also
allow the market to stabilize so that the bank regulators will value
these securities at their true post-default value.

Finally,

the FDIC is prepared to assist insured banks that require temporary
infusions of new capital.

These three actions are sufficiently

comprehensive to prevent any bank from going into receivership as a
result of a New York City default.

44
TABLE XII
NON-MEMBER BANK HOLDINGS OF NEW YORK CITY OBLIGATIONS

Current book value as

Number of

$ of Net Worth:

Banks

25,343

5,837

18,357

24,094

19,007

16,589

35,596

69,101

32,629

101,730

1121,615

$143,123

$264,638

36

50$ to 70$

22,223

54

40$ to 50$

Total
$77,875

125

30$ to 40$

Bonds
$53,325

3,120

20$ to 30$

Notes
$24,550

36
JZ0_

Over 70$

271

The 271 nonmember banks reflected in the above table are located in 34
states, with ten or more located in Alabama, Arkansas, Florida, Illinois,
Louisiana, Missouri, New York, Tennessee and Texas. The 56 nonmember banks
reporting the largest concentrations of New York City obligations, i.e. 50$
or more of their net worth, are located in 18 States, with only 5 States having
4 or more such nonmembers (Arkansas, Florida, Illinois, Missouri, and New York).
Source:

Federal Deposit Insurance Corporation




45
However, the fact that no major bank will become insolvent
does not imply that banking practices will not be affected by a default.
Many banks, particularly, clearinghouse banks in New York, have already
suffered a depletion in capital from REIT loan losses, the W. T. Grant
bankruptcy and other loans which have not been repaid promptly.

A

default by New York City, on top of these other loan losses, will
only serve to make bank lending practices more conservative than
they are already.

This will result in further reductions in the growth

in new bank loans, a development that will affect the strength of the
recovery.
In addition, to exercising greater caution, many banks will
choose to demand somewhat higher interest rates on their loans.
Higher interest rates will be necessary to improve the return a bank
receives on its loans and thus to strengthen the banks' ability
to rebuiId capital.
Finally, it is possible that large uninsured depositors,
out of concern about the solvency of specific banks, will exercise
greater caution in placing their deposits in particular banks. This
could cause a temporary flow of funds away from banks that are perceived
as vulnerable to default (i.e., the New York City clearinghouse banks)
and toward less vulnerable regional banks.

A similar development may

occur internationally as Eurodollar deposits are shifted from foreign
branches of U. S. Banks that have large holdings of New York City
bonds to foreign branches of other U. S. banks or to other international
banks.




46
A combination of a withdrawal of large uninsured deposits
and of Eurodollar deposits from foreign branches could increase the
temporary liquidity strains

on individual banks necessitating a

further increase in the size of Federal Reserve discount window loans.
Finally, it should be pointed out that if the State and
its agencies also default, the liquidity strains on the banking system
will be far greater. New York City securities, because they are a lower
qua Iity issue, are
as commonly held by banks as higher grade municipal bonds and notes.
Bank holdings of New York State and New York State Agency issues are,
undoubtedly much higher.

Thus, any series of developments which

jeopardize the State's own ability to meet its obligations will
significantly increase the liquidity strains on the financial system.
In summary, a default by New York City is unlikely to
cause any major solvency problems for the banking system.

However, a

default could lead to slightly higher interest rates, to somewhat
reduced bank lending activity and to temporary liquidity strains—all
of which could weaken the strength of the recovery.

THE MUNICIPAL BOND MARKET
Since August, the municipal bond market has been
characterized by considerable stress and strain, indicative of
the increased uncertainty surrounding New York's unresolved
financial crisis.

Institutional investors have sought to control

increases in their holdings of tax-exempts in an attempt to
minimize their vulnerability to losses.




Underwriters have

47
reduced their participation in new offerings, resulting in a larger
share of new issues being sold through negotiated rather than competitive bids.

And activity in the secondary market for outstanding

tax-exempts has slowed as investors hold back until the uncertainty
is resolved.

These factors have also contributed heavily to a
significant rise in the yields on tax exempt securities, both
absolutely and relative to yieIds in other markets. As Table XIII
indicates, the ratio of tax-exempt to taxable yields has risen
consistently throughout the course of the year.

This means that

interest rates on tax-exempt securities are moving closer to
interest rates on taxable securities, indicative of a decline in
the value of tax exemption.

The increase in relative yields clearly

has affected the entire tax exempt market as relative yields on
high rated securities (AAA) have increased almost as much as
relative yields on low rated (BAA) securities.
increases are particularly precipitous

Clearly, the

in September and October,

when the concerns about a default by New York City reached a peak.
This rise in tax-exempt yields relative to taxable yields
cannot be attributed solely to New York City f s financial difficulties.
Some of the rise in relative yields probably results from the large
(Table XIV)
volume of tax-exempt issues marketed this year./ This increase in
supply, combined with an increasing reticence by banks to purchase
new tax-exempts has created supply and demand pressures that probably
would have caused some increase in tax-exempt yields anyway.




48
TABLE XI I I
RATIO OF YIELDS ON LONG-TERM TAX-EXEMPT SECURITIES
TO YIELDS ON LONG-TERM TAXABLE CORPORATE SECURITIES

1970
1971
1972
1973
1974
1975 (average of first
nine months)
1974
September
October
November
December
1975
January
February
March
Apr! 1

May
June
July
August
September
October (first 3 weeks)
Week Ending
September 6
September 13
September 20
September 27
October 4
October 11
October 18

'/

TOTAL1/
.754
.708
.695
.669
.689
.733

Aaa
.761
.706
.699
.671
.687
.721

Baa
.741
.688
.686
.666
.687
.720

.700
.669
.681
.736

.702
.670
.682
.748

.709
.671
.668
.71 I

.721
.686
.722
.732
.728
.737
.750
.749
.775
.784

.724
.691
.724
.722
.721
.716
.723
.715
.751
.762

.702
.674
.705
.719
.715
.720
.736
.745
.767
.778

.765
.770
.779
.784
.797
.787
.769

.746
.745
.753
.759
.780
.761
.745

.757
.764
.771
,775
.789
.782
.764

Includes bonds that are rated Aa and A.

Source; Federal Reserve Bulletin




49
TABLE XIV
TOTAL VOLUME OF TAX-EXEMPT BORROWING ($ MILLIONS)

LONG-TERM

SHORT-TERM

TOTAL

1970

$18,188

$17,811

$35,999

1971

25,006

26,259

51,265

1972

23,748

25,270

49,018

1973

23,957

24,705

48,662

1974

24,317

29,543

53,860

1975*

31,995

31,757

63,752




*Annual rate based on January to July volume
Source:

Securities Industry Association

50
However, these supply and demand pressures were present earlier in 1975,
when the ratio

of tax-exempt to taxable yields was more in line with

historical trends.

For this reason, it is reasonable to conclude

that the large increases in relative yields in the last three to
four months result primarily from the uncertainty created by the New
York City financial crisis.
In order to evaluate the dollar value of these increased
yields, it is necessary to ascertain what tax-exempt yields would
have been had New York City's financial problems not

precipitated

upward pressure on tax-exempt interest rates. If it is assumed,
that supply and demand pressures would have pushed the ratio of
tax-exempt yields to taxable yields up to .733 (the average for
16/
1 9 7 5 ) . — it is clear that there is a five percentage point premium_LZf
in the yield ratio due to New York City. Since the Average
'

yield on all corporate bonds for October was 9.54 percent, a

5 percentage point reduction in the ratio of tax-exempt yields to
taxable yields results in a 48 basis point reduction (approximately
.5 percentage points) in the yield on tax-exempts.

If one assumes an

average maturity of ten years on the $32 billion worth of long term
bonds issued this year, the cost to all state and local governments
is approximately $150 million a year for ten years, or a total
of $1.5 billion.

Discounted to the present, the real increase in

interest costs is probably closer to $1 billion, depending upon the
discount rate one assumes.

In addition, if relative yields remain

at their October I eve Is,
16 / This is a conservative assumption, since the average tax
exempt/taxable yield ratio in the last five years was .703.
17 / The ratio for October (.784) minus the ratio for the year
(.733) equals .051, or five percentage points.




51
at their October levels, an additional annual interest cost of $150
million will be incurred on short-term tax exempts.

Thus, if

yields remainat existing high levels, the total costs in added
interest charges to all issuers is approximately $300 million
year

this

and $150 million for each of the nine following years.
While, yields In the entire municipal market are

clearly rising relative to yields in other markets, there are also
important changes occurring within the municipal market. Most
significant among these changes is a trend toward greater
/selectivity with regard to the quality of the issue.

Table XV

clearly indicates that the gap between the yields on high quality
(Aaa) and low quality (Baa) municipals is widening.

For the

first nine months of 1975, the yield spread between Aaa and Baa
municipals was 112 basis points, almost double the yield spread
of 64 basis points in 1974.

This move to quality by investors

probably began as a result of the financial problems experienced
by the New York State Urban Development Corporation, but New
York City's financial difficulties have certainly served to sustain
and extend this trend.
This trend toward greater investor selectivity could
be viewed as a positive development if it encourages states, cities
and other governmental units to manage their budgets more efficiently.
However, the credit ratings used to measure the quality of the
investment do not focus particularly on the management of
a unit of government.

Rather, these credit ratings are based

primarily on the government's long term ability to meet its obligations Thus, many well managed governments and public agencies that
serve areas with declining revenue bases will pay penalty




interest costs.

52
TABLE XV
YIELD SPREAD BETWEEN HIGH QUALITY (Aaa)
AND LOW QUALITY (Baa) LONG -TERM TAX-EXEMPT SECURITIES

1970
1971
1972
1973
1974
1975 (Average of fi rst
nine months)
1974
September
October
November
December
1975
January
February
March
Apri 1

May
June
July
August
September
October (first three
weeks)

Source:




Federal Reserve Bulletin.

.63
.77
.56
.50
.64
1.12

.69
.78
.95
.85
1.06
1.07

.97
.97
1.06
1.20
1.21
1.31
1.24
1.27




53
If this development continues, many soundly managed communities may well have difficulty marketing their securities at a reasonable
and affordable interest rate.
Finally, the unique difficulties experienced by all units
of government within New York State cannot be ignored.

The State is

seemingly unable to market its own securities, even at penalty
interest rates.

The State agencies, even those that are efficiently

managed such as the Housing
credit.

Finance Agency, are unable to obtain

Small and medium sized cities and counties within the State

are experiencing great difficulty and paying high costs to market
bonds or notes.

Even the City of Rochester with its Aaa rating

was forced to pay a net interest cost of 6.8 percent for one-year notes
that in any other state would have received bids as much as 200
basis points lower.

In short, New York City f s problems clearly have

affected other borrowers that are associated with the City by
virtue of geographic location.
The developments within the last three months, particularly
the rising tax-exempt yields and the increased investor selectivity,
suggest that the market has already discounted, to a certain extent,
a default by New York City.

If this proves to be true, a default

could conceivably lead to a reduction in uncertainty and thus to
a return to stability in the municipal bond market.

Howeveer

it is just as conceivable that a default could cause further
rises in municipal bond yields and lead to a greater skepticism
on the part of investors.

Fiduciaries could become reluctant

to invest in municipal bonds for fear of violating prudent
investment practices.

Banks and individual investors might

54
be unwilling to invest new capital.

In short, the problems

currently being experienced by a small groups of municipal borrowers
may only be a precursor of more widespread difficulties after default.

THE NATIONAL ECONOMY
While it is difficult to ascertain precisely how New York's
financial crisis will effect the national economy, it is very possible
that a default could weaken the strength of the economic recovery.
The major factor in a weaker economic outlook would be a significant
reduction in the rate of growth in State and local government expenditures.

This reduction in state and local government spending will

result primarily from higher borrowing costs

and reduced access to

the municipal bond market.
First, high interest rates, effectively prevent many state
and local governments from borrowing for capital construction or other
purposes.

Thirty-eight states have statutory or constitutional provisions

that limit the rate of interest that a state, its agencies or its local
governments can pay on bonds or notes.

While the specific provisions

vary considerably from State to State, most of the interest rate limitations
prohibit the payment of interest in excess of

7 to 8 percent.

Since

many states and localities are now paying interest costs close to or
in excess of these limitations, it is probable that some states and
localities will be effectively excluded from the market by their own
laws.
ic\ r e

Second, many State and local governments/reficent to fund
major capital construction projects as long as interest rates are at
record levels.

Marginal projects may go unfunded and delays and

cancellations of major programs may result.




In fact, the rise in




55
tax-exempt yields has already created difficult problems for many State
housing agencies that depend on credit at reasonable interest rates
to fund viable projects.
Finally, some State and local governments may be forced
to reduce their operating expenditures and bring their budgets into
balance.

The recession has caused some State and local governments

to borrow this year to fund small deficits, in the hope that the
recovery will generate sufficient revenues next year to return
their budgets to balance.

If these governments are denied access to

the credit markets they will be unable to fund their deficits
and forced to adopt some combination of expenditure cuts and tax
increases to bring their bduegts into balance.
A second factor which could impair the recovery process
is a reduction in activity by financial institutions.

Banks that

are large holders of defaulted securities will undoubtedly reduce
their expected loan growth in an attempt to avert temporary
liquidity strains.

These cautious lending practices may weaken

business investment and will probably reduce consumer loans.
Interest rates can be expected to rise as banks seek a high return
on their investments in an attempt to rebuild their capital posttions.
In order to ascertain the precise impact of these
developments on the overall economy

several assumptions have been.made.

First it is assumed that total state and local spending will be cut
$2 billion per quarter for each of the next four quarters.

Second,

it is assumed that the Federal Reserve will allow increases in

56
borrowed reserves to whatever level is necessary to stabilize
the banking system.

In essence, these assumptions suggest that

default will precipitate an adjustment in state and local
expenditures and major dislocations in the financial system.
Assessment of the economic impact of these developments was carried
out with the assistance of the Wharton

econometric model.

The result of this econometric analysis, modified by
staff judgements, suggests that a default by New York City could
have a meaningful effect on the recovery process.

The combination

of a reduction in state and local government expenditures and a
slight increase in interest rates could reduce the growth rate
in real Gross National Product by approximately one percentage
point by the fourth quarter of 1976. A reduction in real output of
this magnitude will lead to an increase in the national

unemployment

rate of about .3 of a percentage point above expected levels —

an

increase in the total number of unemployed persons of 300,000 above
expected levels.
Slower growth rates and higher unemployment rates would
also lead to an enlargement of the Federal government's budget
deficit.

Receipts would be reduced by approximately $3.5 billion;

and expenditures for unemployment compensation, food stamps and other
related programs -would rise by more than $.5 billion.

Thus,

the total addition to the Federal deficit resulting from one
reasonable default scenario is approximately $4 billion.
THE REGION AND THE CITY
The greatest costs associated with the City T s
financial crisis will undoubtedly be borne by the City itself.




Any




57
expenditure cutbacks or tax increases that the City enacts are bound
to further erode the City's tax base and accelerate the flight
of jobs and middle income people to the surrounding suburbs or
to other regions of the country.
In the short run, the reduction in public and private
sector jobs resulting from the fiscal crisis will prevent the city
from experiencing

any improvement in total employment as the

national economy begins to recover.

Approximately, 30,000 public

employees have already been removed from the City's payroll.

A

similar number will probably be eliminated as the city moves toward
a balanced budget.

In addition, the City's housing construction

program, which produced approximately 15,000 new units a year and
provided approximately 20,000 to 24,000 construction jobs
annually has been eliminated.

And capital construction

program, which provided further construction employment has been
severely reduced.

In fact, approximately 100,000 jobs will be

lost as a direct result of the budget economies that will be
achieved in the next two years.
Moreover, many of these cuts may turn out to be
counter-productive.

Large cuts in employment will probably lead to

a decline in receipts for the City and to increased expenditures
for welfare, medicaid and other unemployment related expenditures.
These additional budget pressures will ultimately lead to a need
for more expenditure cuts or tax increases to keep the budget in
balance.
Over the long run, tough decisions which the city is
making now may ultimately undermine the viability of the cityfs

58
economic base.

Reductions in the capital budget are just one

example of cutbacks that are necessary to reduce expenditures
and to lessen the City T s borrowing needs.

However, many of the

projects that are being indefinitely delayed or postponed would
ultimately have created new private sector jobs in the City and
taxable property to enlarge the Cityfs fiscal base.
Clearly, the City and the region face several years
of further job losses, eroding tax bases and increases in
dependent population.

But, it is certainly difficult to ascer-

tain any actions which the City could take to avert or mitigate
this downward trend.







59
POLICY

OPTIONS

Before the Federal government makes a decision about
whether to involve itself directly in the finances of a state or
local government, it is essential that the assisted government
has exhausted all possible local and state remedies to its
financial problems.

Thus, in the case of New York, Congress

should be convinced that every conceivable state or local
mechanism for relieving the crisis has been enacted and that
the resources of the City and the State simply are not sufficient
to meet total needs.

The City's Role
At this late stage in New York City's financial crisis,
there are very few options available to the City acting on its own
behalf.

At present the city has no direct or indirect access to any source

of credit.

Nor does it seem conceivable, even if the budget

were completely balanced, that the City could return to the market
immediately.
Thus, if the City is required to avert default through
the use of its own resources, sufficient funds wi I I have to be
diverted from the operating budget, either through tax increases
or expenditure cutbacks.

A brief look at Tables IX and X reveals

that this is a totally unrealistic alternative.

The City's total

borrowing needs from December I through June 30, even without intrayear borrowing to smooth out cash flows, are approximately $4 billion.

60
However, the controllable portion of the City's budget for the
remaining seven months of the fiscal year is only $3.2 billion.
Thus, even if the City were to suspend all of its police, fire,
sanitation and other controllable expenditures, it still would
not have sufficient funds to avert default.
THE STATE T S ROLE
Since local governments, under our Federal system, are
legal creatures of the States, the Federal government should not
consider assisting a local government until all reasonable state
remedies have also been exhausted.

The State of New York, although

it is a I ready heavily committed to New York City, theoretically has
several options available which could be used to avert default.
First, the State could make further attempts to.borrow
on behalf of the City.

Unless market conditions shift dramatically,

this alternative appears to be totally unrealistic.

At present,

it appears that the State of New York is unable to borrow the
$250 million it needs to complete the assistance package in the
Financial Emergency Act.

And this $250 million issue is backed by the

full faith and credit of the State.

If the State were to commit itself

to borrowing the $4 billion necessary to keep the City from defaulting,
it would have to be done through a MAC-type agency, which would only
19 /
be backed by the moral obligation of the S t a t e . — Since the
State is currently unable to market a small amount of general
obligation bonds on behalf of a state Agency (MAC) it clearly will not
J£/ 7/12 of the $5,500 million controllable budget.
-12/ The State constitution requires that significant increases in the
volume of outstanding general obligation State bonds be approved by a
pub Iic referendum.







61
be able to market a large volume of moral obligation bonds for
the benefit of the City.
A second form of state assistance would be to accept
responsibility for funding some of the services currently provided
by the city.

Clearly, there is some justification for this approach,

because the division of responsibility that currently prevails
within the State has contributed significantly to the City's
current crisis.

The two major functions that realistically could

be assumed by the State are welfare services and the City university
system.

State assumption of responsibility for the welfare system

could save the city about $1 billion while a state takeover of the
higher education system could transfer an additional $300 million
to the StateTs budget.

Clearly, these adjustments are not sufficient

to solve the City T s immediate financial crisis, but they may be
necessary and advisable if the City is expected to balance its
budget in the next two years.
It must be recognized, however, that any assumption
of City functions by the State will necessitate a significant
increase in tax levies on all residents of the State, including
the residents of New York City.

The net benefit to the residents

of the city would clearly depend on the responsibilities that were
the
assumed and upor/ method that the State used to
necessary revenues.

raise the

However, the government of the City would

clearly benefit from the reduction in expenditure pressures on its
own budget.

62
The final method of assistance that the state could undertake is a grant-in-aid sufficient to meet the borrowing requirements
of the City.

This would necessitate a $4 billion state tax increase

over a seven month period, equivalent to a surcharge of 65 percent
on a I I State taxes and fees.

Clearly, this would also be an

unacceptable alternative.
While the State realistically does not have sufficient
resources to avert a default by the City, this should not imply
that the State could not increase its participation in an assistance program i the Federal government does decide to prevent
f
a default.

Some modest and reasonable increase in the State's

commitment, through one of the mechanisms described in this
section, would be a reasonable quid pro quo for Federal assistance
in averting default.

THE FEDERAL ROLE
Since it is clear that the resources of the City and
the State of New York are not sufficient to meet the City's cash
needs through the remainder of the fiscal year, two broad policy
decisions confront the Congress.

First, Congress must decide

whether it will provide assistance to New York City, either to
avert default or to mitigate the consequences.

Second,, if

assistance is to be provided, Congress obviously must decide on
the type, scope and magnitude of the aid.
Conformity with existing principles of intergovernmental
relations would clearly indicate that the following principles govern
federal participation.
First, any action by the Congress will have to include
some provisions for







63
maintaining reasonable levels of public services for the citizens
of New York.

Any solution that does not meet this basic criteria

must be judged as totally unacceptable.

Second, the decision that

Congress makes should be, to the extent feasible, consistent with
the principles embodied in our Federal system of government.
solution should minimize the length and scope of

The

the Federal involve-

ment and incorporate strong provisions for State participation.
Third, the Congressional decision should avoid, to the extent
possible, increasing the borrowing costs of other state and local
governments and the Federal Treasury.

Fourth, the solution offered

should minimize the risks of damage to the economic recovery now
underway.

Fifth, any solution offered should aggravate as little

as possible the market access problems of New York State.
And finally, the Congressional decision should preserve the risk
element in the private investment decision.

Investors who have received

interest premiums associated with higher risks should not have
their investments made whole.
This section of the report will discuss and evaluate, on
the basis of the above criteria, three broad policy options available
to Congress.

The three options are: (I) "Federal Non-involvement"

—

this policy would involve a restructuring of the provisions in
the Federal Bankruptcy statutes dealing with municipal defaults, but
assi stance
would involve no Federal/in obtaining credit subsequent to bankruptcy;
(2) "Default with Subsequent Aid" —

this option would allow the City

to follow the same bankruptcy procedures as the "Non-invoIvement"
policy, but would provide some mechanism for obtaining credit subsequent to default;

(3) "Prevention of Default" —

this policy would

64
extend a line of credit to New York City through some Federal
mechanism, sufficient to avert default.

While there are many

mechanisms which could be used to implement a Federal commitment
(i.e. direct loans, bond guarantees, insurance, etc.) These
will be discussed only as they affect a broad policy options 1
ability to meet the criteria set forth in this section.
It is assumed for the purposes of this evaluation
that any option involving Federal participation will include;
a)

strict requirements that the City maintain a balanced
operating budget;
b) significant restrictions on the borrowing requirements of
the City;

c)

State control over the City's financial affairs;

d)

a forfeiture of state and city grants-in-aid
if principal and interest payments are not met; and

e)

other requi rements that will Iimit eligibi Iity to only
those governments that are totally excluded from the credit
markets.
"Federal Non-Involvement":

This option would require

Congressional amendments to the Federal Bankruptcy statutes to
allow a city to file for bankruptcy without the morass of legal
complications that would ensue under existing statutes.

The

primary element of this revision would give the court power to
allow priority claim on revenues for expenditures necessary to
maintain essential services.

Thus, employee wages and purchases

of goods and services necessary to the maintenance of health,
safety and public welfare would be paid before obligations to existing
bondholders.







65
The first and most important question that must be raised
about this option is will the City have sufficient funds available
to fund basic city services?

If we make the optimistic assumption

that the court will temporarily suspend all debt service payments
(both principal and interest)

it is possible to analyze the monthly

receipts and expenditures of the City to determine if sufficient
funds are available to maintain basic services.

As Table XVI

illustrates, the monthly shortfall of the city from December through
March averages $305 million.

Thus, during this time period the

City would have to reduce monthly expenditures by an average of
$305 million a month.
would have no

These cuts would be necessary because the City

access to the credit markets,

and thus would have

no choice but to operate with a balanced budget.
While the city does expect to receive offsetting
revenues in the final three months of the Fiscal Year, the result of
these draconian cuts in the period from December to March will
truly be chaotic.

Payrolls will be missed, massive layoffs will

be required and public assistance checks would have to be withheld.
A $305 million cut in the controllable portion of the budget would
represent a cut in current controllable services of approximately
50 percent.
Clearly, the "Federal Non-Involvement" option has such
a devastating effect on basic city services that it cannot realistically
be considered a viable option.

66
TABLE XVI
MONTHLY CASH NEEDS OF THE CITY
(EXCLUDING DEBT SERVICE) ($ MILLIONS)

MONTH

NET DEFICIT
OR SURPLUS

CUMULAT
DEFICIT
SURPLUS

REVENUES

EXPENDITURES

December 1975

589.2

978.6

-389

-389

January 1976

749.5

1078.9

-329

-718

February 1976

858.6

980.6

-122

-840

March 1976

730.4

I I 10.I

-380

-1220

April 1976

1085.3

1067.2

18

-1202

May 1976

I 140.0

860.6

279

-923

June 1976

1478.4

946. I

532

-391

Source: Office of the Controller of the City of New York.







67
"Default with Subsequent Aid:"

This option allows

the City to file for bankruptcy, but then provides some mechanism for
obtaining credit subsequent to default.

The advantage of this

procedure is that it gives a bankruptcy court the opportunity to
restructure the debt of the City, reducing the borrowing needs
of the city by lengthening the maturities of the short-term
rrotes that come due.

The court could also work out a reasonable

repayment plan under which the city will eventually pay all of
its creditors.

Finally, this procedure gives the court an opportunity

to restructure certain employee benefits that may have onerous
consequences for the future financial viability of the City.
The principal advantage of this proposal over the first
option,is that it gives the City some access to the credit
markets,a;nd thus

averts draconian expenditure reductions.
20/

the City will be in default

Since

under this proposal, the Federal

government will have to make some mechanism (i.e.

guarantees, loans,

insurance, etc) available to allow the City to enter the credit
markets.When a market access mechanism is made available the City can
continue to borrow to fund its operating deficit until its budget
is balanced pursuant to the provisions of the financial plan;

it

can continue to borrow to smooth out its cash flow problem; and it
can continue to borrow for essential capital construction.

Opening

the credit markets to the City insures the continued provision of basic
services and preserves its capital stock until the City can once
again borrow on its own behalf.
2d

It will have no access to the credit markets.

68
While this policy option requires a Federal mechanism
to give the City access to the bond markets, it does not have to
seriously disrupt the Federal system of government.

If the Federal

credit access mechanism is provided to the State, which would then use
that mechanism to make credit available to the City, the traditional
relationship between the state and local government could be
largely preserved.

However, there will undoubtedly be a need for

some Federal oversight which ultimately could lead to a direct
Federal involvement in the CityTs affairs.

It is probable that the act of default might lengthen
the period of time that New York is unable to market its own securities.

Fiduciaries and banks would certainly be very cautious about

investing in the obligations of a city that had defaulted so recently .
Underwriters would also be reluctant to participate in new syndicates. However,
will

it is also conceivable that the prevention option

be perceived as tantamount to default, and thus, cause the

same investor skepticism.
Nevertheless, in the event of default there may be
serious legal constraints to market reentry.

State laws in 34

states instruct banks, insurance companies, fiduciaries and
other agents about the types of securities that are permissable
investments.

These laws often preclude investments in securities

of an issuer that has been in default recently.

Some of these

statutes prohibit investment for periods up to ten years.

In

California, for instance, a default would preclude California commercial
banks from purchasing New York securities for a period of ten
years after default.




Thus, it is possible that the combination of

69
legal restraints on permissable investments and investor skepticism
about defaulted securities could cause a longer, if not larger
Federal involvement than a "prevention of default" option.
The effect of this policy option on other borrowers depends
greatly on the mechanism used for assistance.

If the Federal government

guarantees a tax-exempt issue, that security will immediately be
elevated to a position of preeminence in the market.

This will

undoubtedly effect adversely the borrowing costs of other governments
in the tax-exempt market.

Their securities will be viewed as inferior

because they carry no Federal guarantee.

On the other hand, if the

guaranteed security is taxable, other tax-exempt issuers will benefit
in two ways.

First, the source

of greatest uncertainty will be

temporari ly removed from the tax-exempt market.

And second, the

largest borrower (New York) will be temporarily borrowing in the
taxable market, partially reducing the supply and demand pressures in
the tax-exempt market alluded to earlier.
A guaranteed taxable bond would affect the Federal treasury
in three respects.

First, the Treasury will gain additional receipts

because interest on New York securities will no longer be tax-exempt.
Ultimately, this would yield a revenue gain of $30 million to $40
million for each $1 billion of guaranteed taxable securities.
the Treasury will undoubtedly receive a guarantee fee.
hand, this guaranteed taxable

Second,

On the other

bond will be perceived by credit

markets as a Federal government issue, and thus will increase supplydemand pressures in the Treasury market, possibly leading to increases
in Treasury borrowing costs of as high as ten basis points.




70
It is more difficult to ascertain the precise impact
of this proposal on the economic recovery.

State and local spending

probably will be reduced, even if the City does not default.

But

bank lending practices and interest rates would undoubtedly remain
more stable if default is avoided.

Thus, this policy option carries

with it the possibility that default could weaken the recovery now
underway.
Concern must also be expressed about the possible market
access problems that the State could experience subsequent to a City
default.

If current investor attitudes toward State securities are

indicative of a perceived link between the State and the city, a default
could easily serve to worsen this skepticism.
Finally, this option has the clear advantage

of imposing

on investors the full costs of the investment risk they have taken.
It will not relieve investors of losses resulting from risks that were
undertaken in their quest for higher yields.
In considering this option, two additional points must be
made—one relating specifically to New York City and one relating to
the overall municipal bond market.

With respect to New York, there is a

very real possibility that the act of default by New York could significantly undermine the property tax receipts of the City.

The State

constitution prohibits taxation in excess of 2.5 percent of total
assessed valuation unless the additional receipts are used to meet debt
service payments.

If the City was in default and thus not meeting

debt service payments, it is possible that the City would have to




71
forfeit the $1.4 billion in property tax receipts that it
received in excess of the 2.5 percent limitation.
With respect to the entire municipal bond market, it must
statutes that gives operating expenditures
be recognized that any alteration in the bankruptcy/priority over
debt service will constitute a weakening in the perceived security
of a general obligation bond.

Up to now, a major attraction of

municipal bonds was that they were considered second in security
to Treasury bonds because they were backed by the full faith and
credit of a State or City.

This pledge of full faith and credit

has traditionally been interpreted to mean that bondholders
have first access to city revenues in the event of a default.

A

change in the bankruptcy laws which weakens the position of
bondholders relative to other creditors will probably serve
to dilute the meaning of the words "full faith and credit" and
could lead to higher interest rates as investors perceive a
higher risk.

"Prevention of Default:"

This option is designed to

avert a default by New York City and any of the consequences that
might ensue. It would provide a temporary source of credit to
fund the City T s $4 billion borrowing needs this year.
funds would be made available to

Additional

meet intra-year borrowing

requirements, to fund the deficit until the budget is balanced,
and to support essential capital construction projects.
One principal difference between this option and the
second option is the manner in which the bondholders are treated.




72
Under option 2, the bondholders will be forced to take
whatever compensation the court decides is equitable.

At the very

least, the court will probably impose significant delays in principal payments on maturing securities.

These delays will lead to a

reduction in the value of these securities and render New York f s
bonds extremely

illiquid assets.

Under the prevention option, the bondholders will be
bailed out.

They will receive full principal and interest pay-

ments when their outstanding obligations mature.

In essence,

they will be rewarded for their risk taking with both high interest
rates and full and guaranteed payment on principal.
Without a doubt, a solution which awards payment
to the bondholders while city residents and city employees
are experiencing major cutbacks contains a great deal of inequity.
In fact on an ability to pay basis, the bondholders are probably
more capable of handling their losses than the city employees or
the city residents.

However, short of a voluntary restructuring

of the debt, there is no solution that avoids default and also
requires the bondholders to bear some of the burden.
Another distinctive feature of the prevention option
is that the elected officials of the State and the City will still
be responsible for the management of the City.

Some have

suggested that such a situation, particularly after Federal aid
has been initiated, could weaken the resolve of the City and State to
make the tough decisions that must be made. It has also been suggested
that other cities may be tempted to manage their affairs irresponsibly,
knowing that Federal aid would

always be forthcoming.

While these

factors warrant careful consideration, they could conceivably



73
be met if legislation were structured to make the Federal
assistance as undesirable as possible.
Offsetting these disadvantages is the fact that the preventive option completely avoids the uncertainty and possible
adverse consequences that surround a default.

The City, at least

in a legal sense, will experience less resistance when it returns
to the market to sell bonds and notes on its own behalf.

The State

government will be relieved of the pressure that a prospective City
default had placed on the StateTs own market accessibility.

Other

municipalities would no longer be confronted with the prospect
that an uncertain and disrupted post-default market might not be
able to absorb their securities.

Banks could avoid making

the adjustments that default would necessitate and thus will be
in a better position to finance a vigorous recovery.

And perhaps

most important, the uncertainty about default would finally be
resolved.
Clearly, the central issue that Congress must
examine is whether to provide a source of credit before or after
default.

On the one hand, if Congress opts for preventing

default, the Federal government will be temporarily involved
in the City's affairs and the bondholders will be rescued.
On the other hand, if Congress opts for "Subsequent Aid,"
the City will undoubtedly default and all of the adverse
consequences of default will ensue.

It is a difficult

decision—filled with uncertainty—but a decision that must
be made.




o