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Statement by-

Arthur F. Burns

Chairman, Board of Governors of the Federal Reserve System

before the

Subcommittee on Economic Stabilization

Committee on Banking, Currency and Housing

House of Representatives

October 23, 1975

I am here to discuss with this Committee the financial
crisis of New York City.
The difficulties now facing New York stem from the
erosion of its financial position over the past decade.


this period the expenditures by the City's government grew
rapidly while revenues failed to keep pace.

To close the gap

between its revenues and expenditures, the City relied increasingly on borrowed funds.

Not only capital expenditures,

but also the mounting deficits on current operations, were
financed in this fashion.

By the end of 1974, New York City's

outstanding debt amounted to over $13 billion, much of which
was in the form of short-term notes - - that is, obligations
maturing in a year or less.
As poor management of New York finances persisted,
at first a few but in time more and more investors became
concerned about the City's financial condition.

During the

past winter and spring the City began to experience very
serious difficulties in rolling over its debt - - t o say nothing
of adding to its outstanding indebtedness.

In the absence of

clear-cut remedial measures by the City, the possibility of
default on the City's obligations became very real, and it was
so portrayed almost daily in our newspapers.


The financial crisis confronting the Nation's largest
city prompted the government of New York State to offer financial and managerial assistance.

Starting in April, the State

put at the City's disposal substantial sums that were not
scheduled for payment until some months later.

Then, around

mid-June, the State legislature created a new instrumentality -the Municipal Assistance Corporation (MAC).

This agency was

empowered to sell up to $3 billion of its debt obligations, to
make the proceeds of its borrowing available to the City> to
wring some clarity out of the City's tangled finances, and to
help develop a budgetary plan that could lead the City back to
a balanced budget*
These measures, however, proved insufficient to
restore investor confidence in the City's financial management,
and even the new securities issued by MAC soon came under a

To ward off imminent default by the City of New York,

the State adopted firmer measures on September 9.


included creation of a State-dominated Emergency Financial
Control Board to manage the City's finances, expansion of
MAC's authority to issue securities, and a plan to arrange
additional financing of $2.3 billion for the City.

This financial


package was designed to tide the City over until early December.
It was hoped that by that time a strong program of budgetary
restraints would be in place and that it would enable the City
to resume the sale of its securities to the investing public.
But the new financial plan failed to elicit any enthusiasm
on the part of investors.

The financial community has remained

skeptical about the City's ability to avert default and rebuild
its financial strength.

Moreover, the intertwining of the

State1 s finances with the City's finances has troubled investors
and has damaged the State's credit standing.

The concern of

market participants was heightened this past week by the extraordinary difficulties encountered in arranging for the City's
refunding needs on October 17, and default was averted by only
an hour or two.

Thus, the stresses and strains that began to

develop in the municipal securities market in the summer have
become more acute with the passage of time.
Since the summer, and to an increasing degree in recent
weeks, the participants in the municipal market - - that is,
investment bankers, securities dealers, and ultimate investors have been attempting to reduce their exposure to the risk of

This has affected not only securities bearing a New York


name, but also issues of some other State and local governments.

Thus, many securities dealers have sought to cut

back on their inventory of municipal securities.


of municipal issues have generally reduced their participation
in new offerings, and some have withdrawn entirely from
bidding syndicates.

And investors - - the ultimate buyers of

municipals --. have been tending to shift to higher-quality
municipal securities or to categories of investment judged
to be less hazardous.
Trading in the market for outstanding tax-exempt bonds
has therefore slowed appreciably and the spread between bid
and asked quotations has widened.

These developments are

characteristic of a period when investor confidence has been
shaken, and they are indicative of a weakened market.
The behavior of investors and dealers in recent months
has resulted in a rise of yields on municipal securities to the
highest level ever experienced in the tax-exempt market*
Yields for even the highest-rated borrowers have risen
conspicuously, but a part of this increase is doubtless due to
the enormous volume of municipal securities issued during the
third quarter.

In the past two to three weeks, -open-market interest
rates have declined somewhat.

The municipal market has

benefitted from this development, as well as from various
indications that the Federal Government is becoming more
concerned about New York's financial problems.


investors in municipal securities remain highly selective.
The obligations of New York City, New York State, and certain
of the State's agencies continue to be shunned by investors.
And the effects of investor uncertainty have spilled over to
other governmental units as well, some of which have not
received any bids for their bonds or have rejected bids because
the interest cost was deemed excessive.
If the weakness of the market for municipal securities
were to persist and to spread further, many soundly run, creditworthy communities and public agencies could have difficulty - or suffer very heavy costs .-- in raising needed funds.


would tend to induce cutbacks or stretchouts in local spending

In addition, holders of municipal securities, which

include many banks and other financial institutions, would to
some degree be affected, as might the attitudes of others less
directly involved.

Hence, if the New York City crisis remains


unresolved, and if the fate of New York State remains tied to
the City's, the process of economic recovery now under way
in our Nation could be impaired.
In seeking ways to resolve New York City's crisis,
the suggestion has occasionally been advanced that the Federal
Reserve might serve as a source of emergency credit.


formal application for such credit has been received by the
Board or the Federal Reserve Bank of New York,

But I want

to explain why we probably would have disapproved such dn
application had it been made.
As the ultimate source of financial liquidity in the
economy, the Federal Reserve has certain powers to extend
emergency credit even to institutions that are not members
of the System.

But the use of that authority is tightly circum-

The basic provision — contained in Section 13,

paragraph 13, of the Federal Reserve Act - - states that
emergency loans with maturities no longer than 90 days maybe made by the Federal Reserve Banks on the basis of promissory
notes backed by Treasury or Federal agency securities.


qualify for credit assistance under this provision of law, a
local government would have to possess sizable amounts of
unencumbered Federal obligations.

This would be an unusual

situation for any distressed borrower and it obviously does
not apply to New York City,
The lending authority under paragraph 3 of Section 13
of the Federal Reserve Act is "broader, permitting the Board,
in unusual and exigent circumstances, to authorize Reserve
Banks to make loans on the kinds of collateral eligible for discount by member banks.

Such paper may not have a maturity

of more than 90 days and must afford adequate security to the
Reserve Bank against the risk of loss.

Furthermore, in view

of restrictions of law and Congressional intent, certain conditions must be met in order to permit the extension of emergency
credit under this authority.

Among these conditions is a require-

ment that an applicant has exhausted other sources of funds before
coming to the Federal Reserve, that the borrower is basically
creditworthy and possesses adequate collateral, and that the
borrower's need is solely for short-term accommodation.


does not appear that New York City is now in a position to meet
all these requirements.

Certainly, its finances would hardly

permit early repayment of emergency borrowings.
In addition to the emergency lending provisions in
Section 13 of the Federal Reserve Act, the Reserve Banks


have authority under Section 14(b) to purchase short-term
obligations of State and local governments issued in anticipation
of assured revenues, subject to regulations by the Board.
Legislative history indicates that this authority was designed
to assist the Federal Reserve Banks in meeting their operating
expenditures, and also to enable them to make the discount
rate effective when little borrowing took place at the discount

There is nothing in the Federal Reserve Act or its

legislative history to suggest that Section 14(b) contemplated
the purchase of municipal securities as a means of aiding
financially distressed communities.
The Congress, of course, could amend the Federal
Reserve Act so as to relax the requirements for extending
Federal Reserve credit to financially troubled governmental

But the Board of Governors would have the gravest

doubts about any such action.

If loans were to be made to

State or local governments, the Federal Reserve would have
to involve itself in the activities of these governmental units,
including particularly their expenditure budgets and the adequacy
of their revenues.

Moreover, since numerous demands for

credit might ensue, the Federal Reserve would have to set


standards of eligibility.

Being thus placed in the position of

having to allocate credit among governmental units, the Nation's
central bank would inevitably become subject to intense political
pressures, and ^


ability to function constructively in the

monetary area would be undermined.
The Board fully recognizes that the Federal Reserve
System has the responsibility, subject only to restrictions
under existing law, to serve as the nation's lender of last

Over the years, we have therefore developed contingency

plans to deal with possible emergency situations.

As I have

already indicated in testimony before the Joint Economic
Committee, our plans have been adapted recently to cope with
the financial strains that might be associated with the default
of a major municipality.
In that event, I assure you, the Board is prepared to
act promptly.

The contingency plan calls for lending to com-

mercial banks through the Federal Reserve discount window
beyond the amounts required by normal discounting operations.
Credit provided in this manner would assist banks in meeting
their temporary liquidity needs.

Not only that, the proceeds

of the special loans made at the discount window could also be
used by the banks to assist municipalities, municipal securities


dealers, and other customers who are temporarily short of
cash because of unsettled conditions in the securities markets.
In addition, the System would, of course, be ready to use its
broad power to stabilize markets through open market purchases
of Treasury or Federal agency securities.
In the event this contingency plan has to be activated,
the Board will make funds available on whatever scale is deemed
necessary to assure an orderly financial environment.


Board recognizes that sizable extensions of Federal Reserve
credit would run the risk of leading to a substantially larger
expansion of bank reserves and the money supply than is consistent with longer-run monetary objectives.

Clearly, there-

fore, any such expansion must be only temporary.

In time,

any excessive growth in bank reserves would need to be corrected through offsetting open market operations and through
repayment of bank borrowing from the System.
There are also certain supervisory and examination
questions that may arise with respect to banks in the event of
a major municipal default.

In this connection, the Board and

other agencies have plans to revise procedures that apply to
the valuation of defaulted securities, so that any writedowns


may be postponed until the market has had a few months to
stabilize and thus provide more reliable indications of their
Even so, a default might ultimately require writedowns
that could seriously reduce the capital of some banks.

In that

event, the Federal Deposit Insurance Corporation has statutory
powers to assist Federally insured banks that might find their
capital impaired by a decline in the value of securities in their
portfolios. I understand that the Corporation is prepared to
implement, with appropriate safeguards, its contingency plans
for dealing with insured banks that require a temporary infusion
of supplemental capital for the above reason.
I think it evident from the scope of our contingency plans
that we believe a default on debt obligations by New York City
could produce serious strains in securities markets.

For a

time, it could also adversely affect municipalities that need
to issue new debt.

The like is true of financial institutions

that hold such securities in significant volume, and also of
individual investors who have part of their life savings at
risk in these bonds.

I still believe that the damage stemming

from a default by New York City would probably be shortlived.


Indeed, the possibility of such a default has already been discounted to a considerable degree by the market.

But I am also

aware of the uncertainty that inherently attaches to a judgment
on this score; and I recognize that a default, besides being a
very serious matter for the City and State of New York, could
have troublesome consequences for the Nation at large.
The very fact that this Committee and other committees
of the Congress are holding hearings on New York City's
finances indicates that concern is spreading that a New York
default may injure the economic recovery now in process.


have said enough to indicate that I feel this possibility can no
longer be dismissed lightly.

That, however, does not ease

the task that the Congress faces in dealing with the New York
problem; for the precise issue is whether Federal financial
assistance to New York may not cause national problems over
the long run that outweigh any temporary national advantage.
As this matter is debated by the Congress, the adverse
effects of a New York City default will undoubtedly receive full
attention - - as they indeed should.

I would only urge that the

longer-run risks also be considered thoroughly.

A program

of Federal assistance to the City may well lead to demands for


similar assistance to other hard-pressed communities, even
though their distress may have been brought on by gross negligence
or mismanagement.

Substantial Federal aid -~ whether through

insurance, guaranteesf

or direct loans - - would compete directly

with the already huge amounts of Federal financing needs.


important of all, the provision of Federal credit for local governments would necessarily inject a major Federal presence in local
spending and taxing decisions.
These longer-run dangers have a vital bearing on our
Nation's future; but they can be exaggerated, just as the immediate
consequences of a New York default can be - - and perhaps are
now being - - exaggerated.

It is entirely clear to me that if

the Federal Government had previously yielded to the entreaties
for aid that New York officials kept pressing, neither the City
nor the State would have gone as far as they now have in restoring
some hope for eventual order in the Cityfs finances*


intervention would have been a disservice to the people of New
York as well as to the Nation at large.

But it also seems to me

that the effort thus far made by both the State and the City is still

And while I take a more serious view of the potential

economic consequences of a New York default than I did three


months ago or even three weeks ago, I am not ready to recommend
to the Congress that financial assistance to New York is now
required in the Nation's interest.
I was asked at a recent Hearing what advice I would
give if Congress were inclined to legislate assistance for New

My reply was that stringent conditions should in that

event be laid down, so that no municipality would seek Federal
financial aid unless such a request became unavoidable,


proceeded to list a half-dozen conditions; and, if I may, I
shall now restate them somewhat more fully.
One essential condition prior to receipt of any Federal
assistance would be that the municipality has exhausted all
other sources of funds.

This would require, of course, that

the municipality demonstrate that it is unable to obtain credit
through the public issuance of securities, or through private
placement of securities, or direct loans from banks or other
private lenders.
A second condition that seems to me essential is that
the State assume control over the finances of the municipality
in difficulty.

When a local government reaches the point where

no source of funds is any longer available, its management of


finances can no longer be relied upon.

State control would

mean that a local government has lost its fiscal authority,
and this should serve as a powerful deterrent to other mayors
or city councils across the Nation from ever placing their
municipality in such a position.
A third essential condition for Federal assistance, I
believe, should be that the State levy a special State-wide tax,
the proceeds of which are pledged to cover one-half of the
deficit faced by the municipality.

The requirement of such

a tax would materially strengthen the State's resolve to put
whatever pressure is needed on the troubled municipality to
work its way toward a balanced budget.

It would thus insure

that the State will discharge adequately its own responsibility
to enforce fiscal discipline on a troubled municipality.


governor or State legislature will welcome the prospect of
levying a special State-wide tax for the benefit of a municipality
that has mismanaged its affairs.

But this very reluctance would

provide some assurance that Federal assistance would not be
expected until an effective City-State program of remedial
action, no matter how politically troublesome this may prove,
has been developed.


Fourth, prior to receipt of Federal assistance, a detailed
financial plan would need to be presented for approval by the
Federal authority charged with administering the assistance

Criteria for accepting a plan would have to be spelled

out — such as the use of standard accounting procedures, unrestricted access by the Federal authority to all local financial
records, provision for retiring short-term debt other than that
required to handle seasonal discrepancies between expenditures
and receipts, and so on.

Clearly, the plan should provide for

restoration of sound municipal finances within a relatively short
period and certainly within two fiscal years.
Fifth, a municipality that obtains a Federal guarantee
for the payment of principal and interest on its issuance of new
securities should be required to pay an appropriate guarantee

The municipal security should be taxable, but tax-exempt

bonds might be permitted in special cases - - for example, if
return to non-guaranteed status were thus eased.

In such cases,

the guarantee fee would naturally have to be much higher than
if the security were taxable.
Sixth, and finally, the Federal guarantee program
should be of limited scope and duration.

The total amount of


guaranteed debt should he set at the idWist practical figure.
The debt instruments should foe of short maturity so that the
guarantee may be reconsidered periodically*

In order* to

minimise Federal exposure to risk and to assure compliance
with the approved financial plan, the Federal Government
should have authority to withhold revenue-sharing funds from
a delinquent municipality.

At the end of a relatively short

period, say three years, all Federally guaranteed debt under
the program should have expired*
If conditions along the several lines I have here suggested
were included in a legislative plan for assisting troubled munic*
ipalities, the number of applicants that might seek Federal aidi
would be severely limited.

It is highly important to recognise

that the issue of assistance to New York City goes to the very
heart of our system of separation of powers between the Federal
and State governments -± a system that, despite enormous economic and social changes, is still honored by our country* If
there is to be any legislation on assisting local governments,
it should at least be designed so that the longer-run risks to
our Federal system of government are kept to & minimum.


Before bringing this testimony to a close, I want to
make two additional comments briefly.
First, recent attention to New York City's difficulties
has brought to the fore certain shortcomings of our bankruptcy

It is highly important that the Congress enact legislation

that would enable the judiciary to deal with a municipal default
so that reorganization of outstanding debts, service or employee
contracts, and other financial obligations may proceed in an
orderly and expeditious manner.
Second, the behavior of financial markets has recently
been disturbed by the grave uncertainties surrounding New York
City finances.

A quick but well considered decision by the

Congress to assist or not to assist New York is now urgently

Almost any resolution of these uncertainties may be

better than prolonged debate and controversy.
markets do not thrive in such an environment.