Economists and taxpayers, safe to say, always share at least one perspective: they hate to see inefficient markets because that means money is going to waste. Municipal bond markets are highly inefficient and could benefit from a good clean up to turn billions of dollars in back to investors and municipalities — and by extension, to taxpayers.
The value that is being siphoned away through the muni market, Professor Andrew Ang says, can be attributed to two flaws: the market is both highly illiquid and very opaque, costing investors and municipalities billions of dollars every year.
When states, cities, and other municipalities issue bonds to raise money for public projects, they depend on intermediary brokers to match them with buyers. These buyers face difficulties in selling these bonds if they require their invested capital back early because secondary markets are illiquid and trading costs are extremely high. Furthermore, no standard system exists to get timely, accurate information about the roughly 1.5 million bond issues on the market, or the financial condition of any of the 50,000-plus institutions that issue municipal bonds.
In practical terms, then, it’s difficult to meaningfully compare bond prices and other important market information valuable to buyers and sellers. “In any type of market where you have illiquidity and poor information, bad things happen,” Ang says. “In the muni market, that means unnecessary costs in the forms of interest expense, fees from brokers, and other transaction costs for investors and issuers.”
Ang worked with fellow economist Richard Green of Carnegie Mellon to develop a proposal for redirecting billions back to public coffers and investors. First, they documented the severe illiquidity and transactions costs in the municipal market and the lack of timely and useful information available to investors. Researchers estimate the annual amount that investors overpay combined with what municipalities are losing to administration and transaction costs at around $30 billion per year — interest costs to municipalities would be more than 1 percent lower if muni markets had the same liquidity as US Treasury bonds.
The solution proposed by Ang and Green could recoup many unnecessary costs associated with the muni market as it is currently organized, by creating an independent, nonprofit organization — CommonMuni — to advise issuers and provide better information to all players in the market.
CommonMuni would advise cities and states on best practices, for example, how to avoid refinancing that incurs long-term losses, or reduce costs associated with bond issues, or how and when to use derivatives with bond issues. Its other important activities, particularly early on, aim to increase transparency, since this would improve the quality and amount of information available to buyers and sellers, thereby improving liquidity.
Most importantly, CommonMuni could provide independent, high quality advice backed by its large resources to municipal issuers that would be prohibitively costly, or difficult to access, for individual municipalities to access on their own. Better structuring of municipal issues and lower issuance costs mean substantial savings to taxpayers.
CommonMuni would encourage the creation of simple bond issues, discouraging clients from structuring bond issues in overly complex ways and encouraging standardization. This would make it much easier for investors to compare bond features and prices, in turn facilitating buying and selling. Increased standardization could allow CommonMuni to pool small bond issues into larger pools, which would give smaller municipalities stronger footing in the market by broadening their potential market of buyers.
CommonMuni would help municipalities standardize, collect, and distribute financial reports, another activity aimed at improving information and transparency. CommonMuni can encourage the creation of centralized exchanges where muni bonds could be bought and sold, which would allow investors to cut out intermediaries, reducing costs.
In proposing CommonMuni, Ang and Green took many cues from the CommonFund, an investment advising nonprofit that was founded in 1971 by the Ford Foundation to help originally fewer than one hundred — now thousands — of colleges and universities pool endowment funds and obtain investment advice. The CommonFund has helped these schools dramatically reduce the costs of administering their investment programs, grow endowments, and increase endowment contributions to offset operating expenses.
Ang and Green estimate $25 million would be required to start CommonMuni. That is less than 1/10th of 1 percent of the total projected annual savings they estimate would be generated by the project. “There are few places where states and municipalities can find billions of dollars per year for effectively nothing, especially in this environment,” Ang notes.
By attracting private grant money to fund start-up costs, CommonMuni would minimize conflicts of interest that could arise with a city-, state-, or intermediary-funded effort. It would start small, offering basic services to a modest initial client base, adding services as it attracts more clients. In the beginning, some municipal officials might be reluctant to move to CommonMuni, if only out of simple resistance to change. But, once CommonMuni starts to become successful, by lowering the borrowing costs of its founding members, other municipalities will be drawn in further improving liquidity and information for all investors and issuers.
Retail investors should welcome CommonMuni as they are able to transact at better prices in more liquid markets. However, broker-dealers and financial intermediaries may lose money in a more transparent and liquid muni market, but in the long term, they would be fine, says Ang. “We once didn’t have very good disclosure for public companies. But the New Deal improved disclosure, and now everyone is better off.”
“CommonMuni is common sense, but there are a lot of players in this market who have a vested interest in the status quo and don’t want things to change,” Ang says. “But that money need not go to financial intermediaries; it belongs to taxpayers and investors.”
Andrew Ang is the Ann F. Kaplan Professor of Business in the Finance and Economics Division, a senior scholar at the Jerome A. Chazen Institute of International Business, and research director of the Program for Financial Studies at Columbia Business School.