Private Placement of Municipal Debt: Lessons from California’s Mandatory Disclosure Rule
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This report was produced for the Stanford Public Policy Program practicum project on the topic of bank loans in California’s municipal financing market. This research should be of interest to policy groups, legislators, debt issuers, investors, and California taxpayers.
The Public Policy Program at Stanford is an interdisciplinary program connecting the theoretical and analytical tools of economics, political science, philosophy, psychology, and law with their real-world policy applications. The Program works with the Stanford Institute for Economic Policy Research (SIEPR), which supports research that informs economic policymaking while engaging future leaders and scholars. SIEPR shares knowledge and builds relationships among academics, government officials, the business community and the public.
Municipalities rely on the collection of taxes or transfer of state and federal taxes to meet revenue requirements. But they also make use of other instruments to raise revenue, such as publicly issued bonds, private placements of municipal securities, and direct loans from banks. The phenomenon of bank loans has raised important questions about transparency, the agreements themselves, and their impacts on municipalities, investors, and the market in general.
California is currently the only state to require the disclosure of bank loans to municipal government. This information is collected by the California Debt and Investment Advisory Commission (CDIAC). California is the largest municipal market in the country at $78.5 billion in 2016, with $11.0 billion in private placements and direct loans. This suggests that California’s annual issuance of public debt is 17% of the national issuance and California’s municipal bank loan market is also 17% of the equivalent national market. This study examines CDIAC data to characterize bank loans, identify areas of concern, and discuss roles for public policy.
The research analyzes state and local debt issuances between 2012 and 2016, as well as direct loan documents from 2016. It is also informed by interviews with representatives from municipal borrowers, financial institutions, bond counsels, regulatory agencies, and professional organizations. The findings can be summarized as follows:
- Private placements are increasing in California, rising from 688 to 1761 between 2012 and 2016. Even though CDIAC’s statue has always stated that issuers must report debt issuances, part of the increase is due to a 2014 clarification in CDIAC’s statute that issuers must report all types of debt.
- They are chiefly being used to fund residential energy improvement programs and build multifamily housing units and K-12 school facilities. The biggest issuers are joint power authorities that act as conduit issuers, such as the Western Riverside Council of Governments, California Statewide Communities Development Authority, and San Bernardino Associated Governments.
- Items in the Events of Default section and other covenants in direct loan agreements may be harmful to investors of public debt, municipalities, and taxpayers unaware of their existence.
- Some provisions in direct loan agreements, in conjunction with a lack of timely information for investors of public bonds, could enable banks to make deals with municipalities on claims on assets before other investors know the borrower is struggling and have a chance to come to the table.
These findings suggest that the absence of timely and clear disclosure of bank loans and their provisions could negatively impact municipal investors and citizens who are unable to properly assess the riskiness of municipal issuers. The availability of this information allows regulators to identify trends and bubbles at the macro-level, and reduce information asymmetry between issuers and their investors, creditors, and citizens at the micro-level.
Our recommendations can be summarized as follows:
- Increase enforcement of California’s 2014 law that requires municipalities to report private placements and direct loans to CDIAC.
- Improve public access to CDIAC data by developing an interactive website that uses a reporting format similar to the one shown in Appendix 2, in which a viewer could easily see the obligations of a particular municipality.
- Require Committee on Uniform Security Identification Procedures (CUSIP) identification for private placements of securities to ensure that securities transactions are correctly settled and matched.
- Clarify the definition of “material” in the Security and Exchange Commission's (SEC) Rule 15c-12 to encourage complete disclosure of events that substantially impact a municipality’s financial situation.
- Expand the definition of “financial obligations” of the SEC Rule 15c-12 so that pension obligations must be disclosed by municipalities.