An Essential Role for Fannie and Freddie

For all the talk about reform of the mortgage finance system, the anticipated changes to Freddie Mac and Fannie Mae are likely to be rather modest. In the run-up to Secretary Geithner’s end-of-January deadline to offer a proposal to Congress, only two options are under serious consideration to support the goal of ensuring long-term liquidity of the market for mortgage credit.

Option one envisions a model akin to the present government sponsored enterprise (GSE) but with a tighter oversight regime to protect the explicit taxpayer guarantees. Option two is a privatized model with a tight oversight regime and no explicit guarantee of government protection. Arguably, not much difference when you consider that the major investment banks were private institutions with neither an implicit nor explicit guarantee of solvency, but they received a federal bailout via the TARP law anyway!

While there seems to be some general consensus that more aggressive and transparent oversight will help ensure liquidity of mortgage capital and prevent a repeat of the present foreclosure crisis, there is less agreement on whether Fannie and Freddie should be in the business of supporting and promoting housing for the vast population of those with modest incomes and limited access to market rate credit.

Limiting Fannie and Freddie to a mission focusing only on liquidity means that the President and Congress will be left to the task of setting and implementing goals for affordable housing and broad based access to credit for underserved citizens. Given the limited effectiveness of measures, such as the Community Reinvestment Act, which was designed to accomplish just such purposes, one can be forgiven for not putting much faith in Congress and the Executive.

Perhaps, if the lessons of this crisis are well-learned and if new accountability procedures are well crafted and properly enforced, a reformed Fannie Mae and Freddie Mac are exactly the institutions able to help meet the nation’s goals of decent and affordable housing for a large portion of the citizenry. Moreover, The National Housing Trust Fund already authorized in law and waiting funding through an invigorated earnings portfolio from the “reformed” GSEs, would certainly bring a measure of stability to the housing market. For evidence, see the hundreds of affordable housing trust funds that already exist and operate efficiently and effectively at the state and local levels.

Crying Wolf on Municipal Defaults, Part 2

Here we go again.  Meredith Whitney, the Wall Street analyst who appeared on CBS’ 60 Minutes in December and predicted “50-100 sizeable municipal defaults” totaling “hundreds of billions of dollars,” appeared on CNBC this morning and claimed that there would be “indiscriminate selling” of municipal bonds because “local leaders want to default on debt investors and not on their constituents.”

NLC offered a rebuttal to Whitney’s 60 Minutes performance with Crying Wolf About Municipal Defaults.  We were in good company, including PIMCO’s Bill Gross and Federal Reserve Chairman Ben Bernanke.

Whitney’s comments reveal a stunning lack of understanding of the municipal sector and, unfortunately, seem based more on conjecture than facts.

Defaults or Cuts?

Whitney contends that local and state leaders do not have the political will to take policy actions to pay their debts, whether that is cutting services or raising revenues.

But, local governments have been and will continue to cut services.  NLC’s annual survey of City Fiscal Conditions found that 79% of cities cut personnel in 2010, 69% canceled or delayed infrastructure projects, 44% made cuts in services other than public safety, and 25% cut public safety or made across the board service cuts.  The latest U.S. jobs report revealed that state and local government employment levels were at a 4-year low.  In contrast, as of November 2010, there were 72 muni sector defaults, down from 204 in 2009 and 162 in 2008 (these numbers include technical defaults that do not result in losses to investors).

Furthermore, it is standard practice for many local governments to budget to pay their debt service before they fund other operational costs.

Just this week, state policy makers in Illinois, the poster child for state and local revenue shortfalls, moved to raise the state’s income tax rate in order to improve the state’s ability to pay its debts.  All Whitney had to say about Illinois was that the state is now “less favorable to business.”

The “Daisy Chain” of State & Local Finance

Whitney’s claims appear to be based on research that her consulting group has conducted over the last couple of years, analyzing the budgets of 15 states.  Yet, Whitney herself says it’s unlikely that states will default on their debt.

Instead, she says, her fears are for local governments – cities and counties.  Whitney predicts that states will cut aid to local governments – the “daisy chain” of state and local finance.  Whitney is right about the daisy chain.  States do provide aid to local governments, although there is considerable variation across the 50 states, and states are likely to cut aid to local governments as they continue to struggle with revenue shortfalls.

But, cutting aid doesn’t necessarily translate to defaults.  State cuts are common during economic downturns.  Yet, of the 54 municipal defaults (excluding technical defaults) that have occurred since 1970, only 4 came from cities and counties.  In other words, the overwhelming preponderance of local governments respond by cutting spending or raising other revenues, not by defaulting on debt.

When asked for details, such as naming the top three cities at risk of default, Whitney balked, saying “I don’t want to do that.”

Back Peddling

On 60 Minutes, Whitney remarked that defaults would total in the “hundreds of billions of dollars,” a claim that she back peddled from in her CNBC interview.  When presented with a critique of the magnitude of her prediction, Whitney responded “It’s not a severity issue. It’s a frequency issue.”  In other words, her prediction is that there will be an increase in the number of defaults, but the magnitude of the defaults may not be as significant as her earlier projection.

This is not a minor concession.  It’s the crux of the matter for investors.  It seems reasonable to suggest that we might see a few more defaults in the next couple of years.  But, a few more defaults, on top of a historical default rate of less than 1/3 of 1% hardly suggest investors should exit the market.  Bloomberg’s Joe Mysak recently cautioned that the defaults we might see in the next year would total between $5 billion and $10 billion – a small share of the total market of $2.7 trillion.

The Real Story

The bottom line is that sky-is-falling reports about the muni market are lacking in evidence, but are receiving a lot of airtime and print coverage because they make for attention-grabbing headlines.

The real story comes back to Whitney’s question about whether local leaders will default on investors or constituents.  It’s a false choice.  Defaulting on debt has dire ramifications for the shorter- and longer-term fiscal stability of local governments.  The overwhelming majority of local leaders will protect debt obligations and will, if necessary, make cuts in services and personnel or raise revenues via taxes and fees.  Those actions have ramifications for local economies and quality of life, issues which deserve considerably more attention.

We think Whitney finally got it right when she said “investors can still make money on munis, but need to be careful in how they proceed.”

Investing in People and Places

For the United States to remain globally competitive, our economy – especially its workforce – needs to continue to improve, adapt and innovate. The key strength of American enterprise has always been innovation. Here, in the rough and tumble competition of the marketplace, the lone entrepreneur toiling in the garage is the patron saint of economic prosperity.

In the modern parlance of public policy the term of art is “social capital.” The focus is on investing in people, in knowledge, in skills and in the coordination of knowledge and skills to yield outcomes such as patents and inventions and ventures and ultimately economic success. This is classic Americana. The country was built on the shoulders of individual improvement.

But what of places? New urbanist Jeff Speck reminds people that investment in good urban space does not just happen without a plan. In fact, if city leaders allow for an “organic” process, thinking that constitutes a citizen-driven plan, all they will get is a well-engineered city that is “great to drive through but not worth arriving at.”  Surely investments in the built environment – neighborhood parks, public libraries, waterfronts, sidewalks and street lights – affect the lives and aspirations of city residents and thus their opportunities to pursue prosperous and happy lives.

Building better places goes hand in hand with supporting individuals. In an interview for Next American City, HUD Secretary Shaun Donovan, the nation’s crown prince of urbanism, comments on the place-based initiatives coming out of the HUD-DOT-EPA coalition. His suggestion is that, in the absence of thinking about both people and places, the end result is an overabundance of unsustainable places, “places that are the farthest from jobs, the farthest from retail, in communities that don’t have a diversity of activity and quality of life.”

Bound up in place-making efforts by Secretary Donovan is the legacy of Burnham, Olmstead, Moses and Jacobs. From their observations and creations, today’s urbanists draw lessons; some contradictory but lessons nonetheless. At least one wag boiled their collective teachings down to just two words: “place matters.”

When all the attention gets focused on improving education and job skills, it’s important to remember that one genius in a garage can only be successful after he or she leaves that garage and engages with the stimulating and energizing world beyond its walls. Just ask Mark Zuckerberg.

To Grow Small Businesses, Doing What Local Governments Do Best is Best

The recent recessionary period has garnered new attention to the role of small businesses in generating economic growth.  As a result, many local governments have renewed interest in policies to support and grow their small business community.  But how do we know what really works? During a recent meeting of the Atlanta and Dallas Federal Reserve and Kauffman Foundation, NLC presented preliminary findings on those local government policies that create the most significant opportunities for small business growth…and the results may surprise you.  Research findings are based on NLC’s analysis of the International City/County Management Association and NLC 2009 Economic Development survey of city and county officials.

Doing What You Do Best is Best. Overall, the findings suggest that those local policies that have the greatest impact on small business growth, defined as the growth in the number of new establishments under 99 employees between 2007 and 2008, are providing regulatory assistance and creating a supportive culture between the local public and private sectors.  Regulatory assistance includes one-stop shops and streamlining permitting/zoning processes.  Creating a supportive culture means providing avenues for local small businesses to engage with each other and to be heard by policy makers.

These aren’t revolutionary measures. In fact, they are facilitative roles of local government that lie squarely within their purview, and are exactly those things that local small businesses expect from their local government.  Surprisingly, however, only 59% of cities report providing regulatory assistance and only 48% report creating partnerships with the private sector.

A Word of Warning. The study’s preliminary findings also suggest that the primary local policy used for providing small businesses access to capital – revolving loan funds (RLF’s) – likely has little of the desired impact on small business growth, and may in fact actually contribute in the opposite direction.  Similarly, while Small Business Development Centers (SBDC’s) had a positive effect on small business growth overall, they did not have the sizable impact we would have expected.

RLF’s and SBDC’s should not be ruled out based on our preliminary results alone, however. There are many examples of communities with successful programs. Our results represent the swath of local governments across the country and do not necessarily capture the reach of particular programs. In those communities that have had success, their small business programs have the appropriate level of resources and management and industry expertise, engage strategic partners, respond to unique needs of the small businesses in their community, support a broader economic development strategy, and have political support.

In the coming year NLC will work with local communities to better understand what makes programs successful, and also explore more innovative local approaches, such as economic gardening. In the meantime, the good news for cities is that they have options to support small businesses that are proven, within their scope to implement fairly quickly and easily, and are not necessarily costly.