History has some good names for financial bubbles – Tulips, Dot-coms, Housing. The next financial bubble will likely be called the Muni Bubble.
When state and local governments issue debt, they sell what are called municipal bonds, or munis. The market for U.S. municipal bonds is nearing $3 trillion, double its size in 2000.
Standard economic principles, and common sense, teach that when something is subsidized there is more of it. A higher quantity of the product or service is sold and consumed than would be otherwise.
A subsidy is any payment from the government to a buyer or seller in a market. Subsidies in the financial markets generally take the form of reduced interest costs to the borrower.
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For decades the federal government has subsidized home ownership through tax deductions for mortgage interest payments. The after-tax cost of borrowing money to own a home is much lower than it would be in absence of this government assistance.
Many have argued and shown good evidence that the homeowner mortgage interest deduction contributed to the housing bubble that burst in 2007. According to data tracked by the Organization for Economic Cooperation and Development, mortgage debt in the United States grew 118 percent between 2000 and 2007. The increase was much slower throughout the rest of the world. Canada, for example, saw home loans increase only 72 percent over the same period.
The housing industry was further subsidized through the government support of Fannie Mae and Freddie Mac, the corporations that buy mortgage loans off the books of local banks. These corporations increased the subsidy to the housing industry through lower credit standards that brought a greater percentage of the population into the market.
In addition to homeowner debt, the federal government now directly subsidizes local government debt. The economic stimulus plan of last year (the American Recovery and Reinvestment Act of 2009) created the Build America Bond program. The program allows state and local governments to issue taxable bonds for capital projects, like new roads and schools, with a subsidy payment for a portion of the interest expense.
About a third of the interest costs on these bonds are paid by the U.S. Treasury, not the borrower. Individuals also get about a third of their home borrowing costs paid through the tax deduction.
The Treasury Department reported June 3 that $106 billion of Build America Bonds have been sold since the program’s inception. The total for Idaho is $133 million.
The Build America Bonds are helping local organizations lower their borrowing costs. Boise State University cut its borrowing costs for the new College of Business and Economics building, and Southwest District Health’s new public health care building in Caldwell is financed with Build America Bonds.
Large banking institutions are key benefactors in this new program, as their fee income for issuing the bonds has risen. The Bond Buyer reported late last summer that fees for issuing new municipal bonds are at their highest level in years.
The reason for the higher charges is less competition in the banking industry. The financial crisis led to rapid consolidation in the muni bond issuance industry. JPMorgan purchased Bear Stearns, Bank of America got Merrill Lynch, and Wells Fargo bought Wachovia, resulting in fewer banks bidding for new bond business from state and local governments.
There is a lot of talk about the rapidly expanding debt of the federal government, but state and local government debt may be a bigger problem. States don’t have as large of a tax base to support their debts payments.
In any market, when you subsidize something you get more of it. Combined with fewer competitors, you get too much product for the benefit of too few.
Keep your eye on the Muni Bubble.
Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.