Part two of a two-part series.
Case Study: water and sewer systems
Water and sewer maintenance and development is the domain of localities. The federal government has not been involved in a centralized and systematic fashion since around 1980. In 2018, the Environmental Protection Agency estimated that about $472.6 billion will be needed for water system improvements over the next 20 years, and that amount does not include wastewater systems.
As we
The 2021 Infrastructure Investment and Jobs Act allocates funds to investigate and provide necessary repairs that address lead and PFAs in our water and sewer system. These are good but limited steps in light of the overall crisis of water and sewer systems. According to the U.S. Army Corps of Engineers, more than half of our critical water infrastructure (dams and navigation systems) are over their expected service life of 60 years. According to the American Society of Civil Engineers, there is a water main break every two minutes in the United States, leading to "an estimated six billion gallons of treated water lost each day."
Many waste treatment plants are approaching the end of their lifespans, resulting in more pathogens and chemicals in our water. None of these issues is addressed by the IIJA.
The conditions of water and sewer systems funded with municipal bonds rapidly deteriorated during the Great Recession. During this period, water bills increased by between 27%-154% in cities throughout the country. Median income increased by only 3%. This was on account of less federal aid and the increasing demand to address capital needs. Water and sewer systems throughout the country need significant repairs, replacements and upgrades. These capital expenditures must be paid for by localities.
Disparate impact
Water and sewer systems are particularly dilapidated and in disrepair in majority Black communities. And these communities have the least financial ability to address these critical needs, leading to their municipalities receiving lower ratings and higher interest rates. This issue is yet another example of majority Black communities being pitted against owners of bonds that financed water and sewer systems.
Water and sewer bonds are secured by the revenues generated by the water and sewer system. These revenues are the fees residents pay for water and sewer services. As these fees have increased in majority Black communities, more residents have defaulted on their payments. Rating agencies and bond investors have then insisted on persistent collection efforts coupled with the exercise of remedies against residents.
These payment defaults have led to many people losing water and sewer services in cities like Detroit, Baltimore and St. Louis, as well as people having their homes foreclosed upon. And even with such drastic actions, there are not sufficient local funds to address growing capital needs.
Current troubling situation
We are currently in a period of historically low unemployment and a robust economy, yet many of the most serious problems in the municipal market center around municipalities with populations composed primarily of Black people. Examples include:
- The only municipality that has filed for bankruptcy within the past year is Chester, Pennsylvania, whose population is about 72% Black.
- Flint, Michigan, is 57% Black and has been plagued by lead in its water.
- Prichard, Alabama's water and sewer system is severely deteriorating and failing to generate sufficient funds to pay the debt service on its bonds. Prichard is about 91% Black.
- Jackson, Mississippi's water and sewer system has billions of dollars of needed capital expenditures with no realistic path to raising such funds in the bond market. Jackson is 82% Black.
- Inner city hospitals in places with predominantly Black populations are closing or facing severe economic hardship.
- Rural hospitals are facing severe distress with many closing or filing for bankruptcy. These hospitals are disproportionately in communities composed primarily of Black people .
Possible solutions and/or grants
In light of the above, the question arises — what can be done to address institutional racism's impact on the municipal bond industry?
Federal guarantees
We suggest Congress pass a law (including an amendment to the tax code) that allows the federal government to guarantee tax-exempt municipal bonds issued by municipalities that have a credit rating no higher than 'A' and no lower than 'BBB' on S&P Global Ratings' scale (and the Moody's Investors Service and Fitch Ratings equivalents). Such a guarantee would level the playing field and reverse the downward financial spiral in these communities, many if not most of which are majority Black. Congress could accomplish such a guarantee through existing federal bodies, and legislative frameworks have already been introduced in Congress.
For example, the Federal Municipal Bond Marketing Supports and Securitization Act, introduced in the U.S. House of Representatives in 2009, would empower the Federal Financing Bank, a federal agency with the authority to tap the U.S. Treasury for money to support other government instrumentalities, to "provide credit enhancement or guarantees for municipal securities."
A federal guarantee of municipal securities would not meaningfully impact the federal budget. Municipal bond defaults are rare. The cumulative default rates for investment-grade municipal bonds total 0.09% over the last 10 years. A guarantee would not cost the federal government a meaningful amount while significantly assisting these communities in their ability to access the municipal market at reasonable interest rates.
An alternative to or possible companion with a guaranty program would be federal grants. Historically there have been many grant programs sponsored by the federal government in support of municipalities and water and sewer systems. These grants could be provided to municipalities with an A rating or lower and could be sized in an amount equivalent to the additional debt service on the municipality's bonds on account of its lower rating
Larger Federal financing role
Additionally, we think the burden of financing water and sewer systems should not be on municipalities. The federal government must have a central role in modernizing water and wastewater systems on a national scale in ensure all communities benefit for a 21st century water system. Congress will have to allocate more federal resources and create an apparatus that focuses on the most antiquated and deteriorated systems, most of which are concentrated in majority Black communities.
Again, there are several strategies Congress can employ to follow in passing such an agenda. If Congress would like to focus on municipal market interventions, they can model a program based off of Build America Bonds, bonds for the construction of new infrastructure created by the American Recovery and Reinvestment Act of 2009. Those bonds gave state and local governments the option of a direct subsidy to cover interest costs (direct pay) or to offer bondholders a federal tax credit on 35% of the interest earned (tax credit bonds) instead of having interest on the bonds exempt from federal income taxes.
A similar program can be created to support capital improvements of water and sewer systems in distressed communities across the United States. If Congress would like a direct agency intervention, they can model an agency based off of the U.S. Army Corps of Engineers, which is tasked with constructing and maintaining the majority of water control infrastructure in the United States. A similar body can monitor the modernization of our national water and wastewater systems or run a revolving loan fund that provides below-market-rate loans to water and wastewater systems.
Expanding ESG
The focus of the environmental, social and governance movement in the municipal space seems to be municipalities labeling their bonds as ESG bonds. In the municipal space given the public purpose of most bond issues it is a label that can be broadly utilized.
One possible avenue to support municipalities with majority Black populations that have ratings of A or below would be the creation of "S" funds that concentrate on increasing demand for bonds issued by such municipalities. This increased demand could have the impact of lowering interest rates on these bonds thereby saving significant monies for these municipalities to utilize for social services. A focused approach could have a significant impact.
Conclusion
These policies, together, can begin to address the impact of historical racism on municipal finance. With limited support from the federal government, numerous cities would be able to pursue projects that improve their communities without sacrificing their budgets to debt service. The proposals aid the issuance of municipal bonds throughout the country to assist communities in need.
David L. Dubrow, Partner, ArentFox Schiff LLP and Sterling Johnson III, Associate, ArentFox Schiff LLP.
The opinions expressed in this commentary are the individual views of the authors and do not reflect the views of ArentFox Schiff.
