Ivan Ivanov: Senior Economist at Federal Reserve Board

Tom Zimmermann: University of Cologne Junior Professor


Although state and local governments in the U.S. have historically been regarded as some of the most financially sound entities, the aftermath of the Great Recession has cast doubt on this notion. The financial crisis also led to the collapse of most bond insurance companies, leaving the vast majority of obligations of state and local governments uninsured. At the same time, unmet needs for infrastructure investments, the bulk of which are typically funded by state and local governments, have been growing and estimated to amount to approximately $2 trillion in 2017.[1] In the presence of these funding shortfalls, municipal entities have rapidly increased their reliance on private bank loans. Specifically, state and local governments have increased their bank loan obligations from about $30 billion before the financial crisis to over $160 billion in late 2016

They show that most of bank lending to states and local governments is done via credit lines, terms loans, and to a lesser extent leases.[3] The majority of bank borrowing of counties, cities, and districts (both in terms of counts and funded amounts) is done via term loans. In contrast, states that have bank borrowing exhibit greater reliance on credit lines than local governments such as counties, cities, and districts. Additionally, municipal governments may have substantial additional ability to increase debt in a short time frame because of large unused revolving credit capacity.

The paper further demonstrates bank lending to state and local governments is heavily collateralized, has high contractual priority, and contains additional guarantees. For example, 60 percent of lines of credit and 80 percent of term loans are secured, with banks almost always having first-lien priority on the assets that secure the loans. Whenever a bank loan is unsecured, banks are almost always senior in terms of priority. In addition, bank loan maturities are short: only 2-3 years for lines of credit and 7-8 years for term loans. Overall, given the high collateralization of bank loans combined with maturities that are likely to be substantially shorter than those of public bonds, state and local governments with outstanding bonds may dilute public bondholders when they issue new bank loans. While such bonds claim dilution through collateralization and shortening of debt maturities may be a way to maximize external finance proceeds given the realization of an adverse income shock, it substantially limits the ability of a municipality to take on additional debt.

Many banks have viewed lending to municipalities as a relatively low-risk activity and an opportunity for the bank to earn other business from the municipalities, including deposits, cash management, and wealth management. Historically, loans to state or local municipalities were viewed as low-risk lending opportunities because municipalities frequently guaranteed repayment, which was often based on the state or local government’s taxing authority. The so-called Great Recession of 2007-2009 and its aftermath have taken a toll on the financial state of many municipalities, making repayment less certain than it once may have been.

As with any lending, it is important that bank management understands the financial condition of the borrower (in this case, the municipality) and the ability and willingness of the borrower to make the required payments. Management should also understand that not all municipal loans are created equal. Certain loans to municipalities could pose significant credit risks to the institution, which management must incorporate into its methodology for determining the adequacy of the allowance for loan and lease losses.

Tax and Revenue Anticipation Notes
Tax anticipation notes (TANs) and revenue anticipation notes (RANs) are generally short-term, self-liquidating loans or lines of credit to meet the cash flow needs of a municipality. These notes will be repaid with future tax collections, in the case of TANs, or revenues from the project that is being financed, in the case of RANs. Typically, these loans or lines of credit are tied to a specific revenue source and are collateralized by the revenue source. These obligations are generally repaid annually. New obligations are granted based on expected cash flow needs.

When a municipality is unable to repay a TAN or RAN or needs to fund fixed obligations, it will often turn to a financial institution or the capital markets to refinance the existing debt and amortize it over a defined period of time. In some cases, municipalities layer additional debt on the balance sheet in the hope that cash flow improves in future years. If cash flow continues to deteriorate or does not meet expectations, the municipality may be forced to borrow funds to meet the statutory requirement of a balanced budget. By borrowing additional funds, the layering of debt may place the municipality into a debt spiral that could lead to more serious financial problems. Bank management should carefully review these types of requests to ensure that it understands the challenges facing the municipality. Local leaders should also be prepared to make difficult decisions on taxes and expenditures if the municipality’s cash flow does not improve.

Towns like White Springs have ongoing funding needs, which can include managing cash flow (for which we have no one with that capability) , balancing the fiscal budget (hasn’t balanced in years) , purchasing new equipment (so far just for the office but the Police are going to need additional money for a new program), and financing improvements in infrastructure. This latter one is a big one for White Springs and I am not certain what type of loan we have in place, if it is a loan or if it is a security.

For those municipalities that are financially sound, the credit risk of lending for these purposes may be limited. However, Towns like White Springs which are financially distressed or are enduring significant financial struggles, management and staffing problems raise the question as to whether the Town is creditworthy. Fortunately the loan that Tommie Jones is now seeking for the Kendrick Street project has collateral in the fact that there is a promise by the State to reimburse us. As seen over the past two years, municipal bankruptcy filings are a real possibility. Therefore, to protect against financial loss and to mitigate risks, institutions are now implementing robust due diligence processes and are conducting ongoing monitoring to ensure the municipal debt outstanding can be satisfied, or in the worst case scenario. If it wouldn’t be for a state guarantee, we would be in a bit of trouble due to the fact that even Stacy Tebo had difficulty securing some type of loan on our infrastructure and we don’t know if it is a n actual loan or a loan security.

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