This is the title of a new paper by Steven Schwarcz of Duke University Law School on the shadowy phenomenon of states and muncipalities in the United States using special purpose entities to issue debt. It is written in Steve’s customary crisp and calm style but, well, there is reason for serious concern. Abstract:
In the American federal system, states increasingly borrow by issuing bonds indirectly through special-purpose entities. Although this represents a significant portion – in some cases, the majority – of state financing, relatively little is known or has been written about these entities. This article examines state special-purpose entities, comparing them to special-purpose entities used in corporate finance. States, even more than corporations, sometimes use these entities to obfuscate balance-sheet transparency and avoid public scrutiny of debt, seriously threating the integrity of public finance.
States increasingly are raising off-balance-sheet financing through special-purpose entities, or SPEs. The growing political pressure for debt reduction at the federal government level is likely to push even more of a financing burden onto states, which in turn will increase their incentives to raise financing off-balance sheet through state SPEs. Like corporate SPEs, which comprise a large part of the so-called “shadow banking system,” state SPEs are therefore creating a vast financing network invisible to the public.
Update: I think perhaps I have understated both the importance of the problem and the importance of this paper in giving a sound scholarly and policy framework for understanding it in public finance and law. The sovereign debt problems of the United States as a federal system are vastly greater than merely those of the Federal government, and by now we as a public are aware that the weakest links are in state and local governments – and all the special entities created to securitize their debts. Here is a further bit from the introduction:
Virtually all states obtain at least a portion of their public financing through state SPEs. Notwithstanding their long history and increasingly widespread use, relatively little is known about state SPEs. Originally modeled on the Port Authority of London, state SPEs were first used in the United States in the late nineteenth century. They were seen as a way to bypass various restrictions that hampered traditional government agencies, notably constitutional debt limits and jurisdictional limitations. In recent years, however, the use of state SPEs increasingly has been paralleling the use of special- purpose entities in corporate finance (hereinafter, “corporate SPE”s).
This is troubling, not least because the use of corporate SPEs is seen as a cause of the 2008 financial crisis. The off-balance-sheet nature of their debt—the liabilities of corporate SPEs often are not shown as liabilities on the balance sheets of their corporate sponsors—and resulting lack of transparency create a potential for abuse by undermining financial integrity. The failure of one or more of its corporate SPEs, for example, can unexpectedly undermine a corporation’s financial integrity, causing it to fail. Enron failed in this way by being unable to backstop its defaulting SPEs. Counterparty risk resulting from these types of corporate failures can have systemic consequences.
This article examines state SPEs and their functions, comparing them to corporate SPEs. Although the use of state SPEs is not inherently wrongful, they have a greater potential to be abused in public finance than in corporate finance. Several factors contribute to this aggravated potential. Reduced transparency of state SPEs, like corporate SPEs, can undermine financial integrity. Unlike corporate SPEs, however, reduced transparency of state SPEs can also undermine constitutional and democratic legitimacy. Moreover, state SPEs are more likely to be misused than corporate SPEs because public finance is more susceptible than corporate finance to monitoring failures.
The article sticks with a close analysis of the law and finance of these structures, but the political, social, and demographic implications in a Federal system are very large. Co-Conspirator Ilya has written extensively about “voting with your feet,” made possible by a system of different states with different packages of services, taxation, indebtedness, economic growth, employment possibilities, climate, natural beauty, etc. We are a mobile people in the US, in part because of a combination of a genuinely shared national culture, society, Federal government and Constitutional system and rights, money, and common market institutions that make movement easy – but also because there are differences across different states and jurisdictions that make them more or less desirable to particular people. You migrate in part because of similarities; you migrate in part because of differences. You wouldn’t migrate at all if everywhere were the same.
The economic factors that people traditionally looked at came down to employment. Sometimes someone had offered you a job and sometimes opportunities were better than where you came from. Changes in state and local finances, in considerable part done through the vehicles described in this article, are creating sharper differences in the fundamental terms of different states. For many people that won’t matter, because they are going to a particular job offered in a particular place; the job is “sticky.” For others, however, who are looking for opportunities in a general sense, these differences matter much more; Texas versus California, to choose the currently popular example, (although this comparison also illustrates just how complicated comparisons are, because so many factors weigh in).
Demographic changes along with the public choice mechanisms of political capture of state and local public employee compensation that create far greater state and local fiscal obligations shift the emphasis for why people move. A retiring public employee population creates increased demands for payouts. An aging and increasingly retired general population moves to escape the taxation required to pay the burdens of the obligations to retired and retiring public employees – rather than moving to take a new job. Both go on, of course; it’s a shift in emphasis. But these reasons for moving put much greater emphasis on the levels of taxation and services of the state or local government, rather than directly its economic climate measured as jobs. One eventually leads to the other, yes, and the efficiency and perceived utility of state and local services as a function of taxation affects conditions for job creation. But in the first instance it matters if the mobile population’s main concern is jobs or obtaining the highest state services for the aging at the lowest tax price. A population of retired but mobile citizens no longer tied to a job has very different criteria for re-location than a population that is concerned in the first place about jobs, schools, opportunities for their children, etc.
If this seems like a long ways from the topic of this paper – well, it’s not, considered as the motivating social and policy issue underlying the discussion. Although the paper doesn’t get near these social issues, it sets up the framework for understanding something directly impacting the fiscal possibilities and obligations of different locales in a federal system. What I’ve added here is that the differences across geographic and jurisdictional lines matter where there is a mobile population, where that mobile population’s reasons for moving are shifting from jobs above all, to jobs, yes, but also the package of services and tax burden on a non-working population. Differences in the full obligations at the state and local entities, including the public SPEs, will have a noticeable impact on the internal economic structure of the United States in the coming twenty-five years. This paper gives a foundation in public finance to understand the mechanisms by which those obligations are taken on in ways that are not well understood in discussions of public debt that focus on much more marque figures, particularly at the Federal level.