Noteware: New York Fed warns Houston over its financial practices

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On April 14, the Federal Reserve Bank of New York, deeply concerned over the financial practices and growing fiscal distress of the nation’s largest cities, convened a workshop entitled, “Chapter 9 and Alternatives for Distressed Municipalities and States”.  William Dudley, President and CEO of the NY Fed, delivered opening remarks that address many of the practices employed by the City of Houston, and presented in my past columns.

On borrowing to finance current deficits – “When a jurisdiction borrows to invest in infrastructure, the cost of the debt to local residents – and those considering locating in the jurisdiction – is offset by the value of the services that the infrastructure provides.   This trade-off is part of the “fiscal surplus” that a jurisdiction offers; the value of the services minus the tax price that residents have to pay.  A well-run capital budget will match these costs and benefits over the life of each project to ensure that the jurisdiction remains attractive to current and future residents.  That is, both current and future residents are willing to pay the tax cost of servicing this debt because of the benefits they receive from the services supported by that debt.

“Now consider a different scenario – one in which the jurisdiction is borrowing to pay for a current year operating deficit.  This kind of borrowing is inconsistent with running a balanced budget.

“The key distinction between these two types of borrowing is that in the former case an asset is producing services that help to offset the cost of the debt, but this is not so in the latter case.  Indeed, using debt to finance current operating deficits is equivalent to asking future taxpayers to help finance today’s public services….In the future, the cost of servicing this debt will drive a wedge between the taxes paid by households and business and the current services provided to them….(They) can react to this wedge by locating elsewhere; this out-migration can lead to ever-higher tax rates or ever-diminished services for those who remain – typically those with fewer opportunities or resources to relocate.

“There are several ways that states and localities can borrow to cover operating deficits.  One mechanism is to treat borrowed funds as revenues that can be used to balance the budget.  Another form is asset sales – here, a jurisdiction receives cash today in exchange for a reduction in future assets.”

On deferring pension liabilities – “Finally and perhaps most importantly, is the practice of pushing the cost of current employment services into the future – the underfunding of public employee pensions and other post-employment benefits for current employees.  Both these practices add to the indebtedness of the state and local governments with the employees playing the role of creditors.”

On crowding out current services – “We have seen evidence that high debt levels combined with diminished services, in cases like Detroit and Stockton, make the public sector finances unsustainable.  At a certain point, the debt service burden clashes with maintaining a sufficient ongoing provision of services to forestall people voting with their feet.”

On bond ratings – “While these particular bankruptcy filings (Detroit and Stockton) have captured a significant amount of attention, and rightly so, they may foreshadow more widespread problems than what might be implied by current bond ratings.  We need to focus our attention today on addressing the underlying causes before any problems grow to the point where bankruptcy becomes the only viable option.”

In summary – “State and local governments have enormous financial obligations, as well as critical service delivery responsibilities.  Managing their liabilities in such a way as to ensure that these vital services continue to be provided, and citizens view that they are getting appropriate value in exchange for their taxes is a daunting challenge.”

While speaking to the broad subject of the fiscal distress of many of the nation’s cities, it is clear that the City of Houston precisely fits into the crosshairs of Mr. Dudley’s observations and warnings.  In other words, the City of Houston has borrowed $2.6 billion to finance its operating deficits every year since 2002; and in order to “balance its budget” has engaged in asset sales and continues to defer its pension liabilities; it has expense and debt service levels that are crowding out current services, particularly in public safety and infrastructure repair.  Many wonder how our bond ratings are maintained at their current high levels.

The City’s new “agreement” with the Firefighters, now a subject of intense debate in the Texas state legislature, is a prime example and continuation of the very practices Mr. Dudley is warning against.

All of this is why these topics have been the subject of this series of columns.  I hope that with the prestige and emphasis provided by Mr. Dudley and the NY Fed’s concerns, the City of Houston finally will begin to reform its financial practices.

A version of this article appeared was submitted to the Houston Business Journal in April 2015.

About Jim Noteware 18 Articles
Jim Noteware is a Houston-based real estate developer, focusing on suburban master-planned and urban infill communities. He also specializes in the turnaround of distressed properties, portfolios and organizations. He has served two big-city mayors, in Houston and Washington, D.C., working to improve the performance of large troubled public agencies.