PADDY HIRSCH, HOST:
This is THE INDICATOR FROM PLANET MONEY. I'm Paddy Hirsch.
STACEY VANEK SMITH, HOST:
And I'm Stacey Vanek Smith. And we are here today to talk about municipalities.
VANEK SMITH: Yes.
HIRSCH: That's a lot - I was going to say...
VANEK SMITH: Hang on to your hats, everybody.
HIRSCH: That's like six syllables. You know, that's a lot.
VANEK SMITH: It is a lot of syllables. And fittingly a lot of organizations fall under the definition of municipality. It is a term used to describe towns or cities or states. But it can also refer to school districts, government departments, even hospitals and universities.
HIRSCH: And municipalities, one thing they all have in common is that they get sued.
VANEK SMITH: This is America.
HIRSCH: This is America.
HIRSCH: They get sued all the time. Parents sue school boards. Patients sue hospitals. Companies sue cities. And sometimes, just like in real life, the municipality wins. And sometimes it loses. It's just the way it goes.
VANEK SMITH: And usually when a municipality loses a case and has to pay damages or a settlement of some kind, it will dip into its reserves - money that it's raised in taxes or some other way but hasn't spent, a rainy-day fund if you will.
HIRSCH: A piggy bank.
VANEK SMITH: Yes.
HIRSCH: Yes. But what's been happening a lot more often is that municipalities haven't been raiding the piggy bank but have instead been going to the bond markets - specifically the municipal bond market and very specifically to raise money to pay for these judgments.
VANEK SMITH: Judgment bonds.
HIRSCH: Judgment bonds.
VANEK SMITH: Judgement bonds.
HIRSCH: That is what some people are calling them - and not necessarily in a good way. So today on THE INDICATOR - judgment bonds, why they could be a problem for the people that buy them and the cities and states that sell them.
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HIRSCH: Today's indicator is 1.6 billion. That is the amount of money that municipalities in the U.S. raised through the bond market in the first six months of this year to pay for legal judgments that they lost. And that is more than double the amount raised for that purpose in the whole of last year.
VANEK SMITH: And this is a problem, according to Marilyn Cohen. She is the CEO of Envision Capital Management, a money management firm in Los Angeles. She invests money in the bond market for her clients. And she wrote an opinion piece in Forbes magazine recently warning about the dangers of municipalities raising money to pay judgments in the bond market.
HIRSCH: Now, she's worried about the increasing willingness of municipalities to raise money for judgments this way - instead of going to the piggy bank, going to the bond market. But she's particularly incensed by the way that some organizations are doing it. Instead of being upfront and calling it a judgment bond, some municipalities are disguising their intent, right? They're being sneaky and issuing so-called general obligation bonds instead. So I asked Marilyn to explain what those are.
MARILYN COHEN: General obligation bonds are issued by states, cities and counties. And historically they have been used for infrastructure, roads tollways, running business as usual. And for decades since they were invented, general obligation bonds were the safest and the highest on the pecking order.
HIRSCH: And they're really a way of the municipality borrowing money from the public in order to fund things like roads and schools and bridges and that kind of thing.
COHEN: That is correct. Those bonds are federal tax exempt and state tax exempt if you're in a state like New York that issues bonds or California that issues bonds. So you get totally state and federal tax exemption.
HIRSCH: So that tax exemption makes them super popular with investors.
COHEN: Well, especially high net worth individual investors and especially now based under the new tax laws.
HIRSCH: So tell me about judgment bonds.
COHEN: Visualize watching TV and seeing that two people have been put in prison or jail for 18 years on murders that they found out they didn't commit. And here these people have had a life sentence and all of a sudden a reprieve. You can bet your bottom dollar that there will be litigation, and somebody's got to pay. And it's usually either the city or the state or the county. And those payments are huge. So how are they going to pay these judgments? Certainly not out of there their general revenues - many, many times they go ahead and issue bonds in order to offload the liability, pay the harmed individual or the harmed entity, and then they're going to make interest payments and principal payments sometimes for 20 or 30 years on them.
HIRSCH: So essentially they're borrowing from the public in order to to pay off these judgments.
COHEN: That is correct. And some of the judgments are small - 3 million, 5 million. And some of them are ginormous.
HIRSCH: OK. But what's the problem with that? I mean, the city needs to pay for judgments, so why not raise the money through the bond market?
COHEN: Well, I think why not is because cities and the states and the counties in the United States already have enough financial problems.
HIRSCH: Right. I saw that - there was a report in Bloomberg that said that some municipalities have so far in 2013 raised $1.6 billion to pay for legal judgments. That's up from 826 million in 2017 and 281 million in 2016. So that's a huge jump.
COHEN: Exactly. And these types of incidences are only increasing - and so are the payouts.
HIRSCH: But if municipalities are issuing bonds that are actually called judgment bombs, at least you know what you're getting, right?
HIRSCH: But you're making the point that some cities or some municipalities are raising money to pay for judgment using general obligation bonds. What's the problem with that?
COHEN: Yes. Well, specifically Dallas, Texas, had had litigation going on regarding pay - back pay for police and firemen. They had to write a very large majority of this money is going to be paying past settlement agreement for the police and firemen. So that was a judgment against them that they issued a blanket general obligation bond. They disclosed it. It was all legal but sneaky - disclosed it in the official statement saying a good portion of this is going to go to pay for these settlements. And to me, that's sneaky. It's legal, but it's unconscionable because most individual investors, they don't read the official statements. They do not take the time to read the fine print. Or they buy the bonds as a new issue, and then they finally get the official statement, you know, three or four weeks later.
HIRSCH: OK. Now, you manage other people's money for them.
HIRSCH: But if you're an individual bond investor who's looking at attractively priced municipality general obligation bonds, how can you tell whether or not you're going to be buying something that's - the money from them which is going to go to judgment.
COHEN: Well, you have to do some homework. You have to, number one, compare and contrast yields. What is the yield of a Dallas general obligation bond versus a Houston general obligation bond? Is one yielding a lot more than the other? If the answer is no, and, you know, you're diligent, and you're a good student, then you have to read the official statement.
HIRSCH: Whereabouts in the statements would you find the detail about where the money is actually going to go to?
COHEN: Sources and uses of money and litigation - you look at the table of contents. And then you just - sometimes you have to go through 35 pages. Sometimes you have to go through 135 pages depending upon how they want to bury it.
HIRSCH: Again, if you were this individual investor, and you see that, oh, this is a really nicely priced judgment obligation bonds, what would your advice be to that person?
COHEN: Run. Don't walk. Run.
HIRSCH: Run for the hills.
COHEN: There's no reason because, at this juncture now, their yields are not commensurate to the risk that you're taking. I would rather have an airport revenue bond or a water and sewer bond, in which it's an essential service no matter what happens. Judgment payments are not essential.
HIRSCH: So what is - what are the repercussions for municipalities who raise money from the bond market to pay for court settlements?
COHEN: The biggest repercussion is the fact that they are bloating their balance sheets. They are taking on more debt, which means that they have to include in their projections the revenues to pay for that debt service.
HIRSCH: Right. And, of course, then there are consequences for the municipality beyond that in terms of their - presumably their ratings might go - are going to be threatened. It's going to decrease their ability to borrow.
COHEN: And lower ratings mean that they'll have to pay more interest on new bonds that come out. So there are grave consequences.
HIRSCH: Somebody I read mentioned this - mentioned that this was akin to paying your mortgage with a credit card in order to keep cash in your savings account.
COHEN: That's correct.
HIRSCH: But people do that all the time.
COHEN: They do. But they're not talking about hundreds of millions of dollars. And they're not talking about hundreds of millions of other people's dollars. They're talking about their own dollars. And just because they do it, doesn't mean it's right. It means that they're digging themselves into a hole also.
HIRSCH: More debt, more expensive debt, more long-term debt that erodes a municipality's ability to manage its costs over time and makes a bankruptcy so much more likely. And municipalities do go bankrupt a lot. Wow, that's a pretty sunny thought. Marilyn Cohen, thank you very much for joining me.
COHEN: My pleasure.
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