The Name is Bond, Muni-Bond

General Obligation Bonds, Revenue Bonds, and Moral Hazard

Photo by Sigmund on Unsplash

The Story

It all started at the 1990 United States Conference of Mayors in Chicago. As the story goes, Mayor Richard Daley II hosted a big reception for all the attendees at the city’s magnificent and historic Shedd Aquarium, and all the mayors went home from the conference thinking, “I need one of those!” Indeed, that event ignited a two-decade-long aquarium building boom around the country as this new economic development attraction became just the latest bauble of many in what is known as “The Mayor’s Trophy Case.” Sadly, many of these new aquariums were significantly less successful than the Shedd.¹

The bistate (PA-NJ) Delaware River Port Authority (DRPA), which is funded primarily by the tolls from four bridges connecting Philadelphia and South Jersey, also has an economic development mission, so it used revenue bonds to finance the New Jersey State Aquarium, in Camden. Completed and opened in 1992, the new aquarium focused on species of fish that were indigenous to the state. Take a minute and think about it: Yeah, mostly boring brown fish, except for the ones further north, around Bayonne, that live near paint factories and have two or three heads and glow in the dark. Just kidding, only some of them glow. Well, actual attendance at the aquarium never came close to projections, so in 2005, the aquarium underwent a major renovation, including the replacement of all of the brown New Jersey fish with the brightly colored kind of fish that people will actually pay to see. And some penguins. But the first thirteen years were a bust in terms of ticket sales, and there was also that major renovation project so, who actually paid for the aquarium…, twice? Well, the bonds were issued by the DRPA and were to be repaid with the proceeds from ticket sales to the aquarium, but the bonds were ultimately secured by those dependable bridge tolls, which the DRPA can raise to cover its debt, and that is what they did (it’s not that simple, but you get the idea). Does it seem fair to charge higher tolls to commuters to cover the cost of an underperforming aquarium built as a part of an economic development program designed to increase regional tourism?

Because the DRPA is one of the rare bi-state authorities in the US, its story is a little unusual, so here is a second, more typical story, from Tampa: In 1985, a businessman in Clearwater first promoted the idea of an aquarium, but the city opposed it, so aquarium supporters began planning for a site on nearby Tampa’s waterfront. In 1989 the city agreed to back the non-profit-led project with up to $84 million in bonds, and when the first site fell through, the Mayor proposed a different waterfront site owned by the Tampa Port Authority, a special district government. (If you missed it, you may want to go back and read last week’s post about public authorities and special districts, for a little more context.) The port was reluctant, but under pressure from civic leaders including the mayor, who had a seat on the port authority board, they agreed to contribute the property and $4 million in exchange for a seat on the aquarium board, and they agreed to a $1 million loan and a loan guarantee of up to $10 million, which was later increased to $14.3 million. The 120,000-square foot Florida Aquarium was completed in the spring of 1995, but initial attendance was significantly less than the projections produced by a well-known management consulting firm. In January 1996, the aquarium asked the city for financial support and in March announced that attendance for the first year had been 1 million, rather than the projected 1.8 million. In the fall of 1996, the City acquired the failing aquarium, absorbing most of the losses in the aquarium bailout. The port authority, which had already forfeited a prime piece of waterfront real estate and $5 million in cash, was required to make substantial annual payments to pay off its loan guaranty. In 1999 the City took over the aquarium’s mortgage and debt, and managers were forced to demote or layoff about a third of the staff. In the end, these losses were largely paid for by taxpayers in the city of Tampa and surrounding Hillsborough County, whether or not they ever wanted or needed an aquarium as a part of a larger economic development program.

Camden and Tampa weren’t alone. Between 1990 and 2010, new aquariums—often tied to larger waterfront revitalization and urban redevelopment projects—were also built in Corpus Christi, Chattanooga, Charleston, Denver, Long Beach, Houston, Gatlinburg, Atlanta, Boise, Sandy, UT, and major expansions were made to existing aquariums in Baltimore and Boston. They were all planned as largely self-supporting businesses and financed in part or whole with revenue bonds issued by cities, public authorities, or other special-district governments and backed by ticket sales. But back to the original question: Who really paid for these expensive projects in the end and was it fair?

The Theory

There are two types of local government. General-purpose governments—including cities and counties—provide a wide array of public functions within a jurisdiction, and special purpose governments, also known as “special districts,” provide one or several special functions in jurisdictions that may be coterminous with a city or may be larger or smaller depending on the service, for example, in the case of a port or a regional transit authority. Both types of governments have operating and capital budgets, but while general-purpose governments are funded with tax revenues, special districts are funded by the revenue earned by the specific project or system. Both general-purpose and special district governments borrow to fund high-cost, one-time capital projects and then repay those loans over many years. But rather than borrowing from a bank, these local governments use the proceeds of a bond sale to pay for the new asset.

Bonds: There are two basic types of municipal or “muni” bonds—General Obligation or GO bonds, and Revenue Bonds—and they are different from one another in two important but related ways. First, GO bonds are issued by cities and other general-purpose governments to finance public facilities and assets that provide basic public services that can be used without charge, such as public safety facilities, streets, parks, recreation centers, libraries, and government offices. Revenue Bonds, while sometimes issued by cities, are also issued by special district governments to finance projects that will earn income through rent, tolls, fees, fares, admissions, and other user charges. Special district projects and facilities include stadiums and ballparks, port facilities, airports, toll bridges and tunnels, public housing, convention centers, tourist attractions, economic development projects, parking garages, and, yes, aquariums. Second, GO bonds are backed by the “full faith and credit” of the issuing government, but revenue bonds are backed by the anticipated revenues of the specific project they are funding, based on estimates and income projections. As we saw in Camden and Tampa, projections can be—and often are—overly optimistic, so risk varies by project type. For example, a toll bridge is very safe investment if there are only so many routes across a river. However, a highly speculative tourist attraction, such as an aquarium, can be much riskier. It should be no surprise that Wall Street investors and the bond rating agencies consider GO bonds to be lower risk than revenue bonds because, if necessary, the city can always use its taxing authority and raise taxes to repay its debt. But what happens when a revenue bond-funded project does not earn enough income to repay its bondholders?

Moral Hazard: The idea of “moral hazard” has been around since the 17^th century, when it first appeared in relation to the English insurance industry, but we can thank economist Kenneth Arrow for redefining it in 1963 to describe the tendency of one party to a contract to accept a higher level of risk because another party will bear the consequences. The term came back into common use during the Great Financial Crisis of 2007-2009, when banks took huge risks by issuing tons of mortgages to unqualified borrowers, colloquially known then as “NINJA loans” – which stood for “no job, no income.” Since the federal government insures a banks’ depositors against loss, to paraphrase Arrow, the banks were willing to accept a higher level of risk because they knew that in the case of default, the federal government, and ultimately, US taxpayers, would bail them out.

But how does moral hazard apply to revenue bond-funded projects? Because they are usually exotic, unproven, and, therefore, backed by an uncertain stream of future revenues, these types of projects present higher risks—and not just to the bondholders, but to the cities that support them if the project fails. The bond rating agencies—Moody’s, Fitch, and Standard and Poor’s—evaluate the creditworthiness of governments that issue bonds, and issue a rating. A higher rating signals lower risk to investors, and lower borrowing costs for the city. But what if the city, or a related special district government, issues revenue bonds to finance a new aquarium for a nonprofit organization, and the bonds are backed by ticket sales that never materialize? Well, the city will feel pressure to bail out the nonprofit aquarium, because, while it is a separate organization or government from the city, if the aquarium defaults, the bond rating agencies will move to downgrade the city’s credit rating. Here’s why: In practice, as far as the rating agencies are concerned, the failure of a project sponsored by a special-district government or non-profit with the support of the city is still, well, the city. So, in the end, the city will use its “full faith and credit” pledge and raise taxes to bail out the aquarium, so as to protect its credit rating and avoid an increase in borrowing costs. This is why revenue bonds are sometimes called “moral obligation bonds:” Because if things go wrong, the project will always be backstopped by someone else, whether it is commuters paying higher tolls to drive from Camden to Philadelphia and back, or, more typically, a city or county increasing taxes on its residents to cover its debt service and maintain its credit rating.

The Lesson

It helps to understand which kind of financing your big capital project is based on: General Obligation bonds backed by taxing authority, or revenue bonds backed by the projected income from a speculative project. Will bond repayment be based on the full faith and credit of the taxing authority, or will a revenue bond-funded attraction turn into a moral hazard? How much income must a revenue bond-funded project earn if it is to repay its bondholders and avoid default? If you are working on this type of project, you might want to take off your rose-tinted glasses and examine the revenue projections one more time, before you close on the sale of the bonds.

An Apology: As a former resident of the Great Commonwealth of Pennsylvania and the tri-state area who has spent plenty of time in beautiful New Jersey, I hope my friends there will forgive me for poking fun at the Garden State, and its fish—I couldn’t help myself.

“Don’t reward bad behavior. It is one of the first rules of parenting. During the financial cataclysm of 2008, we said it differently. When we bailed out banks that had created their own misfortune, we called it a ‘moral hazard,’ because the bailout absolved the bank’s bad acts and created an incentive for it to make the same bad loans again.”

- Eliot Spitzer, Former New York State Attorney General

In 1975, after years of expanding its social programs and failing to align its budget with its spending, New York City was in a fiscal crisis and on the verge of bankruptcy. When the City sought assistance from President Gerald Ford and the federal government, Ford gave a speech explaining why he was refusing to bail out the city, which led to a famous headline in the New York Daily News on October 30, 1975: “Ford to City: Drop Dead.”

1. Most of the information in this essay—the narratives about the New Jersey State Aquarium and the Florida Aquarium, as well as the theory behind muni bonds, revenue bonds, and moral hazard—comes from my book, America’s Waterfront Revival: Port Authorities and Urban Redevelopment, Philadelphia: The University of Pennsylvania Press, 2009.