Jan 31, 2009

Is your city becoming a hard-money lender?

The Wall Street Journal reported this week that some cities in California are providing subsidized loans to struggling auto dealerships. Even if you believe it is the government's job to finance private enterprise, this is a terrible way to do it. Why is this such a bad idea?
  • Municipal bondholders will be forced to take on more risk than they were expecting, pushing prices down and yields up. This will increase the city's cost of borrowing. Higher interest expense means higher taxes or a reduction in city services.
  • Rather than diversifying its risk, the city has concentrated it even further. Since it depends on tax revenues to operate, if businesses fail then taxes will decline. After making a loan to a struggling business, it's in even more trouble if things go bad - it will lose both the tax revenue as well as the principal on the loan. So the risk of financial distress for the city has increased (is this really a good time to be taking on more risk?).
  • The city is essentially engaging in interest rate arbitrage - using its strong credit rating to borrow cheap (plus taking advantage of the federal tax exemption) while lending to extremely risky businesses at below-market rates. If you found out that your city was using tax revenues to buy junk bonds, would you approve of that? This is no different. Actually, this is worse, because at least junk bonds might be fairly priced - the loans in this article are at below market rates, so the "investors" (the city's taxpayers) are not even getting a fair risk/return trade off.
  • The city doesn't have the resources to properly underwrite, monitor, or enforce collections the loans like a normal bank. A bank has departments that deal with all of these issues and as a result, can provide those services at a lower cost than a city that has to develop them from the ground up.
  • When things go bad, the city will face a lot of pressure to avoid calling the loan and foreclosing on the business. It creates a rat's nest of tangled political issues that will result in poor economic decisions being made.
  • It encourages a "race to the bottom" among cities to offer lower tax rates to prop up uneconomical or inefficient businesses while forcing the tax burden on the successful ones.

1 comment:

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