Part one of a two-part series.
Buyers of municipal bonds are mutual funds, insurance companies, banks, hedge funds and individuals. The goal of these buyers is to make a profit, and many of the institutional investors have a fiduciary duty to their shareholders to do so.
Consequently, they do not take into account the impacts of bonds on communities of color when they purchase the bonds. Rather, supply, demand and profit motives drive purchase decisions.
The municipal bond market is assumed to be color-blind in its underwriting, rating and purchase decisions. This article describes the ways in which the municipal bond market has been impacted by historical bias. In the second part of the piece, it also proposes policy solutions to address racial disparities, including concrete steps that can be taken by the federal government.
The Emancipation Proclamation occurred in 1863. That is a mere 160 years ago. Black people living today had great grandparents and grandparents born into slavery. And since 1863 there was Jim Crow, racial terrorism, urban “renewal,” redlining and mass incarceration, all of which resulted in material gaps in education, healthcare, housing, income and wealth between white and Black communities.
Given this history, it should be no surprise that municipal finance has been intertwined with policies that had, and still have, a racist impact. Tax-exempt, government-subsidized bonds paid for segregated schools. Tax-exempt, government-subsidized bonds paid for highways that divided communities and segregated Black communities from well-paying jobs with no means of transportation to get to such places of work. Tax-exempt, government-subsidized bonds paid for the removal of Black neighborhoods in downtowns to be replaced with universities, hospitals, offices, parks and parking. Tax-exempt, government-subsidized bonds paid for the jails that, due to mass incarceration, overwhelmingly house Black men.
As explained through the lens of San Francisco in the book The Bonds of Inequality by Destin Jenkins, municipal finance projects not only had a disproportionate negative impact on Black communities, but they also had a disproportionate positive impact on white communities. The segregated schools, highways, universities, hospitals, offices, parks, etc. that displaced Black people and undermined Black communities were designed to improve the neighboring white communities, which were perceived as more economically viable. When municipalities issued bonds for projects in white communities, the projects primarily improved existing parks, schools and roads with minimal disruption. Meanwhile, all citizens paid taxes to pay the debt service on these bonds. These policies were not implemented with racist intent, but they all had a racial impact.
The bond market is not an inherently racist market but, it does not exist in isolation from society at large. As a result, the municipal bond market has acted against the financial interests of municipalities whose residents are predominantly Black.
Those of us participating in this market, which is meant to promote social welfare, should be particularly sensitive to the ways in which our market has been shaped by and intertwined with the history of our country as it relates to majority Black communities.
Lack of Diversity
Let’s start with what would seem to be obvious to the casual observer. The municipal finance industry of investment banks, commercial banks (as trustees and owners of bonds), law firms, bond insurers, rating agencies and municipal analysts (at mutual funds, insurance companies and hedge funds) is overwhelmingly white. Very few Black people work in our industry other than for municipalities and for minority owned investment banks. This limited diversity does not result in the best decision-making process because the life experiences, perspectives and lessons of a large portion of the population is missing from deliberations regarding underwriting and credit risk.
The inherent dynamic of credit analysis reinforces social and financial trends that are harmful to Black people. This is best illustrated by examining the cities in the country with populations composed of the lowest median credit scores. These cities are Camden, New Jersey; East St. Louis, Illinois; Chester, Pennsylvania; Harvey, Illinois; Detroit, Michigan; Inkster, Michigan; Darlington, South Carolina; East Chicago, Indiana; West Memphis, Arkansas; and Gary, Indiana.
All of these cities are majority Black except for Camden, which is majority Black and Hispanic. In the past 10 years these cities have filed for bankruptcy, defaulted on their bonds or been locked out of accessing the bond market. To the extent any may issue bonds, the city pays a high interest rate on account of the higher credit risk.
Some would claim that the discrepancy in municipal ratings and interest rates are purely economic, but there is convincing evidence that municipalities with significant Black populations pay higher interest rates than other issuers of the same credit quality.
Most states offer state tax-exemptions for interest income to residents who purchase bonds issued by that state’s instrumentalities, similar to the federal tax-exemption of interest income. Those residents receive a double tax-exemption for interest income from local bonds. Therefore, the investors of bonds issued by such states are more likely to be local.
Black Tax: Evidence of Racial Discrimination in Municipal Borrowing Costs by Ashleigh Eldemire, Kimberly Luchtenberg and Mathew Wynter found that these local investors are more susceptible to misperceptions that investments in bonds of municipalities of predominantly Black people present greater credit risk. Those investors hesitate to buy those bonds, and the lower demand results in a higher interest rate for those bonds.
Another in depth statistical study found that with all other factors being equal an increase by 10% of Black people in the population of a municipality results in a yield penalty of 1.9 basis points. A community which is 100% Black would experience a yield penalty of 19 basis points. This penalty would result in $900 million of additional interest costs for all Black Americans per year.
This bias reinforces financial challenges for municipalities composed mainly of Black people. A downward spiral develops and is continually reinforced. Investors and rating agencies require the cutting of expenses to prevent the lowering of ratings. These cuts further hurt the services provided to citizens and the public workers in these municipalities. And as more revenue goes to pay higher interest rates on bond debt, less funds are available for the provision of services.
It has been estimated that in 2017 the interest rate differential between bonds rated AAA and A-minus was 1.33%. Based on this estimate and by way of example, the City of Milwaukee had $1.2 billion of general obligation bonds in 2017 and an A-minus rating. This means that compared to a AAA-rated city, Milwaukee paid about $15.9 million more debt service on an annual basis. For 30-year bonds, this would mean $477 million more in payments over the life of the bonds. This demonstrates the significance of arbitrary rating differentials and their impact on lower-rated cities.
The significance of these racial disparities can be discerned from examining the impact of the Great Recession on municipal entities. A number of municipal bankruptcies occurred in the aftermath of the Great Recession. As demonstrated below, these municipal bankruptcies were by municipal entities with populations primarily consisting of people of color.
Bondholders in these bankruptcies understandably sought to minimize their losses, pitting them against the citizens, municipal workers, pensioners and taxpayers, who were all primarily people of color.
In part two, we will provide a case study of water and sewer systems.
The opinions expressed in this commentary are the individual views of the authors and do not reflect the views of ArentFox Schiff.