Senate “Rescues” PABs?

Unsurprisingly, the Senate’s tax bill does not include the repeal of PABs. Since the Senate version of tax reform is the tougher one to pass, and they’ve chosen some big fights as revenue raisers already (SALT etc.), my guess is that when the smoke clears PABs will simply remain in their current form, in terms of both eligibility and volume. Hard to see any other outcome on such a minor issue in the context of the overall battle.

But I don’t think the opposite approach to PABs in the House and Senate bills is necessarily meaningless political noise. The stark difference might indicate something about how infrastructure legislation might develop during 2018.

The House’s blunt repeal could be seen as primarily an ideological statement. This view would explain the distinctly un-nuanced language in the Tax Cuts and Jobs Act (“The Federal government should not subsidize the borrowing costs of private businesses”) despite the number of Republican members of the Committee sponsoring bills that actually expand PABs for new infrastructure sectors.

As such, the real TCJA message is: “Small-scale and more or less established usage of PABs for hospitals and low-income housing is OK. But don’t think that PABs will the path whereby private-equity high-rollers can establish large-scale ownership of public infrastructure. P3s or privatization deals might be beneficial is specific cases, but we’re not going to subsidize (or, more importantly, provide a federal endorsement for) highly-sophisticated, profit-oriented investors.”

With this warning shot clearly established in the TCJA, and with the usual suspects rising to defend PABs so the message is not missed, the Senate could turn to “rescuing” PABs by simply ignoring it. And with that, the Republicans move on to the real serious and immediate fights on tax reform. I wouldn’t be surprised if something like this was the plan the pre-arranged plan between the House and Senate from the start.

In effect, PAB repeal in the TCJA was probably meant to be a placeholder (and perhaps a tactic to smoke out private-equity supporter?) for a specific fight about infrastructure legislation in 2018.

Convertible PABs

Here’s a quick sketch of a ‘Convertible PAB’ in context of TCJA bill, the Move America bills and political reality:

  • Keep or even reduce current PAB volume allocations – not expansion like Move America. So price tag is $39bn or less – even $10bn starts a market. Maybe expand scope of qualifying projects – but I don’t care about outcome here.
  • Include the Move America 4:1 conversion option for QIFs and the other MAIFC mechanics, more or less.
  • Cut out the Move America project-specific conversion credits altogether – using straight PAB is the only P3 option.
  • Add a feature that monetizes tax credits through withholding taxes – but for ‘qualified retirement funds’ only, and only those that are public or large-scale (e.g. labor) US pensions. So the whole credit conversion option is strictly public QIF-to-public-ish pensions. No Wall Street involvement needed.

Chances? This depends on how hard the PAB fight turns out to be. If GOP is determined to repeal altogether, then there’s no chance. Or if GOP just caves on PAB repeal without modifications, then again no chance.

But a fight in the middle is possible – GOP willing to keep (some) PAB volume as long as a level-playing field option for public infrastructure is included – then there’s a shot. Worth thinking about anyway – if only for setting-up infrastructure bill concepts re QIF loan program support.


Defending PABs for High Rollers?

This post was recycled from an email exchange where someone suggested that the case for at least not repealing (and ideally, expanding) PABs should look like this: “PABs promote private investment in traditionally public infrastructure by lowering the debt costs for projects with private equity investment.” Although not explicit, the source and context makes it (somewhat) clear that what’s being contemplated are private-equity based P3s. As readers here will know, I’m not much of a fan. My response:

“Your case relies on the assumption that “private investment in traditionally public infrastructure” is such an obviously good thing that the federal government should subsidize debt costs for private equity. That might be heavier lift than complexity per se in current environment.

I don’t think anyone is arguing that private-equity P3s are always a bad thing – if the numbers actually work, and if the social value is really there, why shut the door on an option? But there’s apparently a lot of skepticism even in GOP about P3s now – Trump’s pivot not the cause but an effect – and if there’s widespread doubt about the effectiveness or social benefit of P3s, then the PAB case seems to boil down to subsidizing private equity to “give them a chance” to show how in fact good P3s really are. Tough sell.

That’s why I thought the Move America bill was especially interesting and subtle [this bill was part of the broader discussion – summary here]. Sure, it starts with usual case of expanding PAB volume (so P3 supporters and muni market are happy) but then pivots to converting the tax cost of the PABs into 2 types of tax credits. One is a project credit for private investment – again the usual P3 pitch. But the other is directed towards distinctly local public-sector Qualified Investment Funds like SRFs and SIBs (which do have a good track record and seem to enjoy widespread support even among the swamp-drainers). That’s the real new idea – and I think it’s there for a reason.

In effect, what the Move America bill is saying “yeah, we don’t know if P3s are always a good thing, but shouldn’t shut the door on them – let the states decide on individual cases. But if P3s don’t work, states then can use the tax cost to expand SRFs and SIBs for basic public infrastructure – and everybody likes that”

So I think the Move America bill conversion options (complex as they appear to be) are actually making a good and politically practical case for PABs – keep PABs around as a P3-oriented option (and avoid a fight w/ muni bond folks) but show how the tax cost of keeping them can be (and likely will be) used for something other than private equity – e.g. for ever-popular SRFs. That approach covers a lot of stakeholders and defuses a lot of objections, I think.

Worth noting that Move America lead sponsor is Republican Rep. Walorski from Indiana – a state which has big & successful SRF and SIB programs, and knows P3s, good and bad. More specifically, she’s on Ways & Means and her website is currently singing the praises of TCJA bill – at the same time her own bill is calling for PAB expansion. She definitely knows the full picture. I think there’s some subtle stuff going on here – so I wouldn’t be too quick to dismiss the Move America conversion approach, especially in the context of defending PABs.”

I’ll add an afterthought – private-equity is not a sector that gets (or needs, frankly) much sympathy. I think the real-world defenders of PABs definitely are not advocating “lowering [private equity’s] debt costs” for a reason. Far from it: what I see in the muni trade press is an endless litany about all the hospitals, low-income housing and campus facilities that have used PABs in the past, followed by a subtle conflation to PAB’s usefulness for ever-popular ‘infrastructure’ in general. This is clearly a tactic. All the more-or-less benign current uses of PABs rely on small-scale, relatively competitive and low-roller private equity specialist markets. But the potential real action is in much less benign large-scale, revenue-generating economic-core public infrastructure assets – that’s what the private-equity P3 high-rollers are looking for.

And why might these high-rollers care about something as pedestrian as PABs? I’m guessing it has less to do with “lowering debt costs” and more about getting their hands on juicy assets.
They’ve found it tough so far to make a compelling case for their product. States & locals under short-term fiscal pressure are naturally tempted – but there’s lots of internal dissension (quite apart from public resistance). In these political battles, I think anti-P3 officials use the public-sector’s more/less exclusive use of tax-exempt financing as a ‘shield’ – a simple soundbite excuse to dismiss private-equity owned P3s.

But if PAB volume and eligibility are expanded (and of course, avoiding repeal is a sine qua non of that process), this shield collapses. Which means a few extra basis points of yield for P3 owners courtesy of federal taxpayers, but I think the real point is that it allows private-equity – with a federal imprimatur – to get closer to ‘persuadable’ state & local officials. So I think it’ll be a serious fight.

Tax Reform and Infrastructure

Tax reform legislation, if and how passed, probably won’t have much in it about US infrastructure renewal per se. But I think the process will still be extremely enlightening about how Congress and the Administration look at economic and financial issues (with all their political and social ramifications) in the context of actually trying to pass an infrastructure bill in 2018. So well worth paying attention to it, and I’ll focus a number of coming blog posts on it.

To start, I read the House’s TCJA 80-page summary and went through the JCT numbers. There’s definitely a ‘drain the swamp’ theme against using federal tax code to support private investment even when that doesn’t count much as pay-for. PAB repeal rationale: “The Federal government should not subsidize the borrowing costs of private businesses” – sounds like an ideological ex cathedra statement. At least PAB cut gets about $39bn in revenue, but whacking tax credit bonds just gets chump change $0.5bn Cutting rehab and new market tax credits together don’t add up to much either – about $11bn. Also, it seems the PAB repeal in effect cuts about half of LIHTC credits.

Presumably Senate version will be much more moderate, but won’t they have to fight for the big stuff first (SALT, home mortgage, deficit itself etc.)? If GOP really is serious about passing partisan bill quickly (and it seems they have a lot of existential-type motivation for that), I could see an outcome where a lot of small-scale stuff stays on the chopping block.

Especially this outcome re infrastructure – wouldn’t one response to negative impact of TCJA PAB and tax credit repeals on infrastructure be: “we can always put infrastructure-specific PABs and tax credits back in the infrastructure bill if they’re all that important?” If so, then Delaney’s flashing billboard might end up as the real problem, apart from any further energizing of the drain the swamp animus if TCJA passes i.e. bait & switch.

Re chances of passing partisan bill, many folks know far better than I do about this stuff, but after reading the summary it struck me that this is very different than Obamacare attempt. In that mess, there was visceral consensus on ‘repeal’ but no unity or even coherence on the ‘replace’ part. In TCJA, there seems to be a clear unifying theme on the ‘repeal’ cuts (even apart from the need to raise revenue) –actually somewhat populist (look at cuts to executive compensation) – but more importantly, the ‘replace’ proposal is crystal clear: broad rate reductions and simplification. There’s a much better story to build & enforce consensus, even in the face of extreme Democrat and media (and lobbyist?) opposition. And 2018 mid-terms will definitely concentrate minds.

Looking For A Catalyst

The Wall Street Journal just ran an interesting article, mainly about the Trump Administration’s latest infrastructure proposal but including what appears to be an emerging set of guiding principles for infrastructure policy. The latter aspect is worth an extended look – specific proposals come and go, but principles reveal a continuing mindset about how the Administration views the problem and what they think the nature of a solution might be.

Raising a WTF Question

One idea pervades the article even though it’s explicitly highlighted in only a few places: the belief that states and cities themselves actually have pretty much all of the resources needed to meet the infrastructure challenge.

Of course that’s true. Individual US states have total GDPs that are comparable to those of whole countries elsewhere, some near the top of the list. On a per capita basis, the lowest ranked US state, Mississippi, still beats Italy, an OECD European country. Some US cities individually have world-class, country-sized economies. Places like Puerto Rico and Detroit are glaring exceptions that prove the rule – and provide fuel for the usual media misconceptions. The simple reality is that at some level of sub-federal jurisdiction, all of the resources necessary to make America’s infrastructure great again exist, along with the institutional and political machinery to access them.

Everybody involved knows this. What’s really important and interesting is the Administration’s willingness to actually say it and – more surprising – explicitly use it as a guiding principle for infrastructure policy. Why? Because it inevitably raises a rather pointed question from state and local officials: “Okay then, if we basically pay for it ourselves, WTF is the purpose of your federal infrastructure policy?”

Say what you will about the Trump Administration, they’ve proving to be effective at surfacing uncomfortable questions. What indeed is Washington’s role in making America’s infrastructure great again, given that almost all basic public infrastructure (the nuts-and-bolts stuff that really needs improvement) is already funded and managed at the state and local level? The standard Beltway answer: massive inter-regional transfer payments financed with federal deficits. An ARRA for infrastructure, in effect. That doubtless would have been Hillary’s plan and in some form is likely to be the Democrats’ approach. But if you take massive deficit-financed transfers off the table at the outset, as the Trump Administration seems to be suggesting, then what’s left?

Searching for An Answer

Obviously, the Administration can’t simply answer “not much really” or dodge the question, given the centrality of the infrastructure promise in their campaign and current legislative plan. But it is in fact a tough question, so it’s not surprising – nor discreditable, to be fair – that it’s taking them so long to provide the answer in the form a specific plan.

We’re seeing two Trump approaches to the question of Washington’s role so far. The first is actually a “reduced-role role” – cutting red tape and streamlining infrastructure approvals. I think that will prove to be effective, as far as it can go. But regardless of success, it’s hard to claim credit for a trillion dollars of infrastructure investment if all that you did was get out of the way.

The second approach, where the real action is, involves looking for something that (1) is a small but critical missing ingredient in the otherwise good-to-go mix of state and local infrastructure funding and financing options, and (2) can be uniquely provided by the federal government with an equally small cost but a big impact on infrastructure spending.

In effect, the Administration is looking for a catalyst.

Their search to date shows a learning curve and a steady evolution, I think. First up was Navarro & Ross’ tax credit for P3 private-equity investors – quietly dropped when it became clear that this P3 playbook solution applies to very few infrastructure projects, and not at all to non-revenue producing infrastructure. Politically somewhat toxic, too.

Next, we see Australian asset recycling, wherein a small incentive is meant to trigger sales of revenue-producing public infrastructure assets, the proceeds of which can then be used for the non-revenue producing sort. Very popular with US and foreign investors looking for brownfield assets. But my guess is that the idea is running into opposition because anything that looks like ‘privatization’ is distinctly unpopular everywhere else in the US, especially among Trump’s base. So I’d predict asset recycling will fade to a small part of the eventual package, or (as was the fate of its Australian predecessor) not survive at all. The WSJ article, filled with quotes from unnamed White House officials, did not mention asset recycling once. The trial balloon-like nature of the article is in any case an indication that the search continues.

This brings us to the current state-of-play – the ‘20% solution’. The approach is the most explicit one so far (perhaps consciously so) with respect to the objective of a ‘universal infrastructure catalyst’. Right up front, WH officials say in the article that localities are expected to find their own funding for their own chosen projects in whatever way they want to do it, implicitly including P3s, asset sales and user fees but not excluding traditional paths. So all the difficult politics stay local, with state and local governments setting up the basic almost-good-to-go mix without federal involvement. Only then, if there’s not quite enough funding juice in the mix, the current proposal would have Washington pitch in the rest, apparently up to about 20% of project cost. The rationale is that a cash-grant will be the catalyst that was needed to make the project happen — and so credit can be duly claimed.

To get the most bang for these federal bucks, the prioritization is very simple – those who ask the least will be served first, auction-style. This is meant to also change the dynamics of the federal role — no more pounding on the table, self-serving economic studies or lobbyists.  Of course, if the local officials are raising at least 80% of the cost themselves, they’ll need all those things to deal with local stakeholders — but that’s their day job after all, and they’re better at it (or at least more accountable) than out-of-towner feds.

Hope(ish) and Change, Actually

There’s a lot to like in this, I think. First, the evolutionary story as a whole shows that the Administration is taking the fundamental question of Washington’s role in infrastructure renewal seriously. They’re searching for something new in accordance with a principle, not just politics, and they’re showing flexibility and a willingness to learn. I don’t know how much of the principle is derived from ‘drain the swamp’ ideology, but the catalyst role happens to be the right one with respect to the federal government’s relative strengths and weaknesses in infrastructure finance.

Second, the Administration is acknowledging that American basic infrastructure, not big glamorous (and rare) projects, is really the focus of renewal. It’s an obvious point, but I think it does take some discipline to ignore political eye candy and stay focused on distinctly boring stuff.

The third positive point flows from the first two – the search for a catalyst to unlock resources for basic infrastructure leads inevitably to territory where state and local governments make the decisions and find the funding. This path changes the fundamental nature of a federal catalyst to something that isn’t really related to the infrastructure itself. Instead, finding the missing ingredient is all about what’s constraining localities from using their own resources (which they indeed have) on spending for basic local infrastructure (which they know very well how to do). We see this directly in the current 20% solution – the constraint is assumed to be that state and local governments can’t quite get to 100% funding, presumably after they’ve considered or included all the infrastructure-specific ways to achieve cost-efficiencies (e.g. P3 design-build). So the missing 20% really reflects – what? It could be a lot of things — local budget politics, state constitutional debt limits, rating agency pressure, anti-tax activism, etc. But not anything to do with the infrastructure itself. In effect, the 20% solution is not an infrastructure proposal as much as it is simply state and local fiscal support that’s related to their infrastructure spending. And that, I believe, is what’s really needed.

Overall, this is in fact a new direction that has the potential to “upend the way US public works are financed” – or at least Washington’s role in it.

Not There Yet

Still, we’re not there yet. Although the overall direction is transformative, I don’t think the 20% solution itself will accomplish the upending. My pessimism is based on some practical aspects of the idea:

•   A minor shortfall in the funding plan might not be the binding constraint in many situations. A cash grant of 20% of project capital cost translates to a reduction of about 1.60% in terms of the 30-year financing rate – so from 2.75% (AAA tax-exempt 30 year) to about 1.15%. That’s significant, no doubt, but will it unlock infrastructure spending? In one sense, this approach has been tried before on a macroeconomic basis – the Federal Reserve’s QE since 2008 and the subsequent (and significant) fall in long-term rates. The rate on the 30-year Treasury has fallen by 1.6% since May 2011. This prompted some volume in muni-bond advance refundings – but not much new issuance for infrastructure investment, which remains at historic lows. Why would a 1.6% reduction now be different?

•   Additionality will be an intrinsic problem. If a state or local government can do the heavy-lifting for stakeholder consensus and get 80-90% of the funding for a project in place, they often will be able, by hook or crook, to land the balance from their own resources. But if there’s a program in place that might award it from federal taxpayers instead – well, everybody likes free money, no? In effect, it will be difficult to ensure that the 20% grant is actually working as a catalyst as opposed to a windfall. And possible rule-oriented protections will likely lead back to the table pounding, self-serving economic studies and lobbyists that the Administration is seeking to avoid. It’s made even worse by the least-ask, first-served plan for prioritization coupled with an effort to streamline the process. I’d expect a flood of ‘last 5%’ requests in the lottery-ticket spirit of ‘hey, you never know’. That result will be glaring enough as to erode the credibility of Administration claims that the program was catalytic – even the mainstream can figure that one out.

•   More generally, the 20% solution is just a more tactical version of the standard Beltway inter-regional transfer approach, despite very different intentions. A cash grant is a comparative federal strength only in the sense that taxes or debt can be spread across a bigger base than any region has. For some insurance-type purposes that’s enough (e.g. FEMA), but for state and local constraints on infrastructure investment, I think the federal government may have other unique strengths that can be brought to bear, especially with respect to flexible long-term financing capacity. The direction is transformative, but the 20% proposal is not.  Why not keep searching?

What’s Next?

There’s enough in the story so far to make a few tentative predictions, based on a combination of apparent principles, search trajectory and (perhaps most importantly) state and local facts on the ground:

First, it’s hard to see how the Administration has any choice but to stick with the principle that the role of a federal infrastructure program is to provide a catalyst, not a massive transfer. This view doesn’t require the assumption of doctrinaire adherence. Instead, it’s simply the result of promising a trillion dollars of spending based on $200bn of appropriations. Any other path will break one leg of the promise, and it’s obvious that little forgiveness from any side will be forthcoming at this point. Finding a workable catalyst is the only way out.

Second, I’d expect another one or two iterations of trial-balloon concepts (as in the WSJ article) before specific plans are presented. This might be motivated by a sense that continuing their search could lead to something better than the 20% solution, but practically it’s simply because they have more time (the rest of this year is jam-packed with other issues) and they’re on a steep learning curve where further feedback can alter views. I’m sure the Administration always hears a lot from state and local officials. But since the latest plan specifically involves their fiscal situation, feedback in the next four or five months may be qualitatively different – more narrowly focused on what they actually need in terms of a catalyst. That kind of data will lead to a further evolution of the catalyst before the plan gets finalized, probably in early 2018.

Third – and going further out on a limb – my guess is that the next-generation catalyst plan will involve, not cash grants, but some sort of financing support to mitigate state and local short-term fiscal constraints. Prompted to look by a little feedback, these constraints are actually hard to miss. There’s been a veritable tsunami of local and national media articles and think tank papers about state and local public-sector travails since 2008 – revenue volatility, budget crises, ratings downgrades, emerging pension liabilities, etc. None of these problems seem to be getting better, and as state and local governments struggle to manage today’s mess, it’s not surprising that they’re reluctant to pull the trigger on infrastructure commitments, regardless of long-term resources. P3 tax credits, asset recycling incentives or a 20% grant won’t do much except chip around the edges in this context.

But infrastructure financing that is specifically designed to avoid getting caught in the web of constraints in the first place might in fact have a transformative effect. Which leads to up-sized federal loan programs.  As a patient, flexible and (if necessary) somewhat forgiving lender, the federal government really does have some unique strengths to offer that financing – all (like a true catalyst) without doing any damage to federal taxpayers. So I think this what the Administration is looking for. It’ll be interesting to see if they find it.

Federal Infrastructure Block Guarantee

I’ve frequently mentioned in this blog and presentations that federal loan programs can — and should — play a central role in helping state and local governments overcome short-term fiscal constraints on long-term infrastructure financing.  Easy to say as theory — but what’s a practical form?

Here’s an approach that I think plays to the strengths (and subtly avoids the weaknesses) of the institutions and agencies involved (PDF download here):



GASBzilla 68 and Hidden Wealth

Recognizing the full extent of liabilities is always a good thing, even if what emerges is pretty scary.  But it’s better if the discovery process also includes surfacing (or at least looking for) less-obvious, newfound public assets that can be used as raw material for real solutions. This is the immediate relevance of a new book, Public Wealth of Cities, by Dag Detter and Stefan Folster.  The authors’ central point is that cities — even US ones going through hard times — have a lot more assets with significant commercial value than people think.  Detter & Folster then describe how the value of these assets can be maximized if they’re kept separate from the usual political and fiscal constraints in an ‘Urban Wealth Fund’.  As you’d expect, I’m glad to hear the former and I agree completely with the principles of latter as applied to infrastructure recapitalization.

The prospect of putting together a single big wealth fund for a lot of public-sector assets might sound a bit daunting, especially in US state and local jurisdictional context. But I think most of Detter & Folster’s concept is scalable to managing one or a few basic infrastructure assets. That’s certainly realistic – if people are willing to look at P3s for some assets, then why not a ‘mini-urban-wealth-fund’?

For states & localities that have a budget-crushing ‘GASBzilla’ problem*, the best return on newfound assets might be as part of a solution to manage unfunded pension liabilities — in effect, ‘profit maximization’ for many places is actually ‘fiscal stability maximization’.

Whatever gets ‘maximized’, public asset management should include three principles that Detter & Folster list:

  1. Transparency
  2. Clear objective of value maximization [I’d add: “for all stakeholders and for the long-term“]
  3. Political independence

None of those are easy to achieve in the real world, but they’re crucial in the context of any newfound value of existing public infrastructure.  There’ll be plenty of (completely understandable) temptation to monetize unanticipated value in a quick way to solve a current budget crisis.  And there’s so much money looking for infrastructure assets — especially at fire-sale prices — that monetization will be all too easy.  That short-term approach might keep GASBzilla temporarily at bay, but he’ll soon be back, more-accrued than ever.  Using newfound assets for long-term solutions to unfunded pension liabilities requires a lot of discipline, innovation & grit, but I think that’s the only way to really defeat the monster.

*For an excellent summary of the technical background and impact of GASB 68 and 67 on state & local finances, see ‘State and Local Government Pensions at the Crossroads‘ in The CPA Journal, May 2017



Replacement Budget Flexibility

The July 2017 edition of Rockefeller Institute of Government’s (RIG) By the Numbers series on state fiscal issues has an especially interesting description of the difficult budget dynamics caused by the time frame of April-May tax revenues and June 30 fiscal-year-end for most states.

The whole thing is worth a read (as ever) but here are the most relevant sections (emphasis mine):

An April income tax shortfall or windfall comes at the worst time of year for three
reasons. First, by the time it is recognized in late April or mid-May, there are just six to
ten weeks before the end of the fiscal year for forty-six states. For states without large
cash balances, April windfalls or shortfalls can create a cash flow crunch or even a cash
flow crisis. There is not enough time to enact and implement new legislation to cut
spending, lay off workers, raise taxes, or otherwise obtain resources sufficient to offset
the lost revenue before the June 30th fiscal year end. As a result, a state without
sufficient cash on hand to pay bills must resort to stopgap measures to “roll” the
problem into the future. For example, states may delay income tax refund payments.
Such actions do not save any money, but they do temporarily avert a cash flow crisis. In
so doing, they increase the budget problem for the fiscal year about to start (by pushing
payment requirements into that year), requiring greater action to close that gap.

This sheds a lot of light on the motivation behind many can-kicking maneuvers. It seems less about conscious political gamesmanship and more related to getting a complex set of numbers to balance in a short period of time – call it ‘bureaucratic expediency’ as opposed to premeditated fiscal mismanagement. I’d guess that most short-term budget-balancing tactics are well-intentioned — and in any case I’m sympathetic to the officials that have to make government work in current economic conditions. Perhaps the bureaucratic aspect of time-pressured tactics also suggests why rainy-day funds don’t get used or expanded as much as you’d expect in the post-2008 world? I could see there might be some additional (and time-consuming) procedural and political hoops to jump through to access a reserve fund, and the fund might be formally or informally restricted to real emergencies or more profound budget shortfalls. If the shortfall is relatively small, unpredictable and has to be dealt with in a hurry, officials might find it easier and effectively more efficient to just quietly kick some maintenance down the road with the sincere intention to make it up later.

Second, an April surprise can have a “double whammy” effect on state revenue in the budget negotiation period. If the shortfall was caused by income that is lower than
had been estimated, then income may be lower in future years, and the state will have
to lower its forecasts for future years as well.[…]

This aspect of the time dynamic – the indications from a bad April surprise about next year’s budget – might explain the choices about which cans to kick. Delaying tax refunds or contractor payments might work for a few weeks or months but not much longer, so repayment has a hard edge in next year’s budget. Deferring maintenance or delaying pension contributions are fuzzier and more forgiving options.

Third, the April income tax shortfalls or windfalls come late not only in the fiscal year but in the budget process too, often as states wrap up their budget negotiations. It takes time for revenue analysts to evaluate the shortfalls or windfalls, and for budget forecasters to revise their forecasts, and for elected officials to come to grips with the magnitude of the new problem they face. The April surprises, whether good or bad, for elected officials can unsettle carefully balanced budget plans already tentatively negotiated.[…]

This kind of negotiation, where after protracted gives-and-takes people are suddenly disappointed or feel they could have got more, is never easy about anything, never mind politically-sensitive spending. The context doesn’t favor careful re-optimization of costs and benefits. Instead, the result is driven by raw power dynamics and horse-trading where the quietest party usually loses. What’s quieter in this sense than infrastructure? Deferred maintenance might indeed cause a lot of life-shortening ‘physical suffering’ to assets, but roads and buildings don’t complain. No surprise they often lose.

I don’t know what a practical solution for the overall April-June budget dilemma might look like. I’m sure that obvious ideas – e.g. just change the fiscal year-end – are equally obvious to public sector officials in the trenches, and they’ve not been pursued for good reasons. And since the RIG report did not mention any discussion of possible overall reform, I’m assuming that nothing is likely to change anytime soon.

So the April-June dilemma can be seen a permanent, highly-specific fiscal constraint in the Value for Funding framework. How much does it matter for infrastructure? I’d guess that a short-term budget scramble actually doesn’t have much effect on decisions to delay major infrastructure investment. These are probably made in the context of “carefully balanced budget plans already tentatively negotiated” by April with respect to longer-term and more predictable constraints like statutory debt capacity, rating agency metrics and overall voter mood.

Not so for deferred maintenance and delayed minor capex. In fact, from RIG’s detailed description, the mechanics of an April-June budget problem almost paint a target on these aspects of infrastructure spending as exactly the type of temporary solution that’s consistent with bureaucratic expediency. These cans may be kicked quickly and quietly as minor adjustments, without apparent immediate impact on the infrastructure itself or any obvious budget metrics, and the affected ‘constituents’ suffer their degraded efficiency and shortened lives in silence.

Obviously the cumulative effect of deferred maintenance and delayed capex is insidiously expensive and dangerously hidden, often emerging from the sub-budget depths only when it’s a serious problem. But in the heat of the budget process, this long-term result is easy enough to forget, especially because the cost of many other last-minute alternatives (failed budget process, skipped pension contribution, etc.) is just as bad or worse.

In the real-world budget environment of time pressure and bad options described in the RIG report, I don’t think that ‘just say no’ is a practical proposal to reduce deferred maintenance and delayed capex. But in effect, this is what P3 availability-payment (AP) proponents are suggesting by pointing out that the third-party AP contractual obligation requires adherence to (and regular payment for) an optimal whole-life maintenance and capex schedule. That’s clearly better in the long run – something I’m pretty sure most public sector officials already know. But if the solution was so simple why wouldn’t they have done it themselves – either as a matter of practice or perhaps by putting maintenance and capex in a restricted fund that was difficult to access for any other purpose? The fact that they haven’t is best explained I think, not by ignorance or political cynicism, but by the idea that the budget process needs some informal flexibility to function in an uncertain world – and the ability to defer some infrastructure spending is among the least bad options to accomplish this.

If this perspective is correct (and I think it’s worth some empirical work to find out), then proposals to keep infrastructure maintenance and capex on a whole-life schedule must include some way to replace the budget flexibility that’s lost by doing so. This is more subtle than it sounds. An effective replacement needs to provide the same features that made deferring maintenance such a ‘bureaucratically-expedient’ option in the first place:

*  Cash is available on short notice and without further procedures if the April/May numbers come up short

* The source of cash is informal (i.e. from delayed spending, not formal indebtedness) but still relatively certain to be there

* The source is outside the scope of formal budget negotiations and can be flexibly applied to last-minute adjustments

* Repayment does not automatically impinge on next year’s budget

The ‘built-in rainy-day financing facility’ (RDF) seems to dovetail into these requirements pretty well, at least on the surface. The basic idea of the RDF is to act as a generalized budget ‘shock absorber’ built into an infrastructure project financing in order to mitigate the effect of long-term fixed commitments in an environment of revenue volatility. But it might work even more precisely to provide replacement flexibility for April-June budget issues if (as should always be the case) deferred maintenance and delayed capex are not allowed in a Public Project Financing:

The RDF revenue index would be tied to the surplus or shortfall of the actual April/May results vs. official forecasts. If a shortfall occurs, scheduled project payments would be automatically reduced for the last payment of the current fiscal year and all but the last for the next. The last scheduled payment could be customized to be much larger than all the others – so a reduction makes a bigger impact for the June 30 numbers. That would free up cash for officials to work with in their efforts to make everything else balance, but it’s not a formal request from a reserve and it’s outside the budget process.

Project costs under the reduced schedule are financed with a built-in line of credit. That will need to amortize per a contractual schedule – no open-ended can-kicking allowed – but repayment via higher project payments won’t start until the end of the next fiscal year. And maybe not even then, if another unexpected shortfall occurs. Beyond two or three years of reduced payments triggered by shortfalls, I think some sort of trend line can be assumed – and so higher expected project payments can be included in the main budget process.

I’m sure there are many devils in all these details. Maybe some other approach would work as well or better. But one thing I remain convinced about – and even more so after reading the latest RIG paper – innovative alternative financing for infrastructure should focus as closely as possible on actual fiscal and budget realities for the US state and local public sector. If the ‘customer’ has a problem, the ‘product’ has to provide a practical solution – or it will simply stay on the shelf.


Creative Time Bombs

Great column by Liz Farmer in Governing last week:  States Get Creative on Pension Funding

My guess is that New Jersey’s transfer of lottery revenue is driven in part by disclosures required by GASB 67 – see pages 5-6 of the latest Center for State and Local Government Excellence report (which makes dismal reading in general).  GASB 67 applies lower discount rates to severely underfunded plans.  So the NJ Teachers Fund goes from actuarially funded status of 47% to (a probably a more realistic) 22%. Ugly enough as a balance sheet metric, this also makes the inadequacy of ADEC pension contributions even more obvious in annual budgets. As GASB 68 and 67 intended, the pension elephant in the room (and its growth trend) is getting harder to ignore.

Future lottery revenues, in contrast, don’t have the same forward-looking accounting reality.  So I can see the temptation to use a relatively invisible asset to reduce an increasingly visible and embarrassing liability.

You could argue the pensions need to be funded from revenue over the long run anyway, so regardless of motivation, dedicating the lottery (a long-run source of revenue) might make sense – in theory. In reality, if the deal in driven by short-term accounting fears, then the plan is unlikely to be optimized for long-term cost and benefits, especially with respect to the near-term loss of fiscal flexibility – note what Matt Fabian says about the $1bn hole starting next year. Has NJ really planned for spending cuts to deal with that? Or have they just kicked-the-can in the hope that tomorrow’s revenues will be better? There’s a high chance that this ‘creative’ tactic just adds to the vicious circle of kicking the can into an ever-more challenging future.

California’s creative one-timer is even worse – in effect, it is a floating-rate POB being funded by raiding a special liquidity fund. The usual POB arbitrage story with a twist – a leveraged carry-trade bet that relies on consistent positive-slope yield curve and low rates in general. An inverted yield curve followed by a general rise in rates will cruelly whipsaw this bet – probably exactly at the same time the state really needs the special fund’s liquidity. Another time bomb.

Note the ‘that was easy’ rationale for raiding the special fund:

Some governmental organizations, such as the California Budget and Policy Center, have also offered positive reviews, comparing the move to a refinancing of debt without the risk and exposure associated with owing money to bondholders.

Because the ‘risk and exposure’ of owing money to taxpayers on a non-transparent basis is easier to deal with?

One of the column’s conclusions is also especially worth noting:

With both of these approaches, much of their success depends on how well the pension investments perform. But no matter how that plays out, more governments are likely to follow with their own creative funding solutions.

I think that’s an admirably subtle and diplomatic way of saying: Long-term outcomes apparently don’t really matter to government officials. What counts is if a creative gimmick works in the short-term and solves today’s budget problem. Since budget crises are the ‘new normal’ condition for state and local government, more gimmicks are inevitable. Get used to it.

Creativity itself is not the problem – if anything we need more of that. The problem is the common underlying objective of many innovative tactics: to transfer today’s funding problem to tomorrow without either being sure or ensuring that tomorrow’s funding situation is actually better. In times of strong and steady economic growth, kicking a pension contribution into the future as a quick solution for a current budget shortfall might reasonably be expected to be manageable, by way of growing tax revenues and pension earnings. But in current economic reality – volatile tax revenues, slow growth, unpredictable investment returns and tapped-out central banks – betting on a rosy future is exactly the wrong move.

Instead, creative solutions to short-term problems should be structured around the expectation that the future will be worse, with a conscious sole objective to buy some time in the context of implementing a serious long-term plan for continued uncertainty and low growth.

Not easy, but not impossible. Obviously I think recapitalizing infrastructure to provide giant ‘shock absorbers’ to the budget system could provide flexibility with discipline so that real solutions can be worked out for the long-run. There are others not involving infrastructure, likely based on innovative ways to expand and use rainy-day funds. But whatever the approach, in addition to calling out ‘bad creativity’ we need to explore and define what ‘good creativity’ might look like. I think (hope?) most public sector officials already know that current set of creative one-timer options are bad, but feel they have no choice. If offered a path to something better, the ferocious pressure of pension liabilities could drive real reforms.

Five Implications of VfF

The Value for Funding hypothesis is that fiscal and budgetary constraints are a major impediment to public infrastructure investment for US state & local governments.

These constraints can be a more a much important factor than the typical ‘Value for Money’ project-level inefficiencies that most current non-traditional infrastructure alternatives are designed to reduce.  This is especially the case for social and relatively simple basic infrastructure assets.

A different type of problem requires different types of solutions — here are five implications for alternative infrastructure financing innovation that come from the VfF hypothesis:

1) Public-Sector Capital:  Improve Deployment, Don’t Replace

One explanation for inadequate infrastructure investment is that the cost of public-sector capital is higher than it was before even though financing rates are at historic lows.  The idea is that taxpayers want a higher return on the resources that they provide to the government to build infrastructure or pay off infrastructure debt, and that this factor overwhelms low interest rates.

This sounds like it might be true in distressed places where capital is scarce, but I think it’s a stretch for most US state and local governments.  There are solid reasons why the cost of public sector capital is low in relatively rich and politically stable communities and despite all their ‘new normal’ challenges that still applies.

I think the VfF hypothesis might offer a better explanation about what’s preventing more public sector capital being put to work.  Even if taxpayers are willing and able to commit to providing capital for infrastructure, I can see voters getting really angry if financing the commitment results in endless budget crises, frequent debt cap rises or ratings downgrades – all the noisy political hot points.  And it’s easy to see why public-sector officials want to avoid all that.  I think that what’s changed since 2008 – not the cost or availability of public sector capital, but the environment where it would be put to work is really uncertain and politically volatile – so fiscal constraints are really binding.

If this analysis is correct, then alternative financing should not try and replace capital that is actually pretty cheap – but instead look for ways to improve how that capital is deployed and financed with respect to fiscal constraints.

2) Risk and Uncertainty: Risk Transfer Rarely Necessary, But Uncertainty Transfer Often Needed

Risk transfer is often talked about as a rationale for alternatives.  I think this is correct in situations where the risk involved can actually be reduced by private-sector expertise or specialized management – in high-tech processes, some complicated construction projects or retail-store type operations.  In these cases, reducing risk means fewer bad outcomes and wasted resources for everyone – it’s a win-win for both the public and private sectors.

But a lot of the long-term risk involved with basic and social infrastructure can’t be reduced by anybody — public or private – because it comes from factors that aren’t manageable, like macroeconomic cycles or environmental conditions.  If you transfer this kind of risk, it’ll be a zero-sum win-lose situation – maybe the private sector will lose a round like ITR, but they’re playing the game to win, so I don’t think this will be typical.  So I think it’s debatable whether risk transfer really works for the public sector for a lot of cases.

But the VfF hypothesis does point to something that’s conceptually related to risk but not at all the same thing – uncertainty itself.  There’s a lot of technical economic literature about risk vs. uncertainty but the basic idea for our purposes is pretty simple – you can be very comfortable with the risk of your overall income over the next 5 years, but very uncomfortable with the uncertainty of sudden expenditures.  There’s no need to sell or insure your income to deal with that – instead you have some savings or a credit card that acts like a shock absorber to smooth out the impact

The public sector – in liberal democracies anyway – is institutionally bad at dealing with uncertainty – they’re really designed for long-term consensus and planning.  In contrast, the capitalist private sector is pretty good at dealing with uncertainty because in effect that’s their everyday environment.  So I think the VfF implication here is that transferring uncertainty – especially in the current new normal — will be a more broadly applicable rationale than risk transfer.  Basically that means looking for shock absorbers to add to alternatives, like rainy-day financing facilities and keeping debt limit and rating agency powder dry to help the public sector cope with uncertainty.

3) Funded Equity:  Contracts for Specific Performance Often a Better Fit for Public Sector

I can see a role for an equity component in an alternative financing when reducing risk or increasing performance efficiency really requires a significant amount of control over the asset and operations.  So again, complex systems, hi-tech or retail-type infrastructure makes sense.

I can also see a role for some small amount of equity with limited control even for the kind of basic or social infrastructure where risk can’t be reduced and performance improvement is pretty straightforward – like just sticking to a maintenance schedule.  In these cases, the equity is there to align incentives – so private-sector has some skin in the game.

That also makes sense – in theory.  But in practice, it seems that if performance contracts can do the same job in terms of incentives and alignment this might be the less controversial approach, even if the net cost/benefit is the same.  As you all know, there’s just a lot of politics out there right now.

I think the main VfF implication here is like a rule of thumb – if most of the benefits of an alternative proposal is coming from Value for Money and control over the asset is necessary to achieve that, the private-sector funded equity makes sense, even if controversial.

But if most of the benefits are coming from Value for Funding so control over the asset is not so necessary, then performance contracts might be the simplest choice to achieve some Value for Money benefits and avoid controversy at the same time.

4) Expanding Debt Options:  Many Fiscal Constraints Can Be Reduced with Innovative Debt

The biggest – and simplest – VfF implication is that different kinds of debt options might go a long way to helping the public sector reduce fiscal constraints, and since the infrastructure debt capital markets are hungry and pretty innovative, that might be a path forward to for alternative design.

There are two reasons I’m coming to this conclusion.  The first is that most currently binding fiscal and budgetary constraints are related to the debt financing of an infrastructure project – the fixed debt service obligations against volatile revenues, using up debt limits, fear of downgrades, etc.  So it makes sense to explore whether different debt structures might have less impact.

Second – and more fundamental — is that although debt is really bad at absorbing risk because the pay-out is asymmetric, it’s actually pretty good at absorbing uncertainty – specifically, the uncertain timing of cash flows – as long as a credit-worthy entity is on the hook to ensure final repayment.  Think of a line of credit.  In the current market, it’s also really cheap, and the US public sector is mostly very highly-rated investment grade, so plenty of capacity.

So if uncertainty transfer has value to the public sector, I think there’s a lot of scope for development in the debt capitalization side of an alternative proposal.

One important thing to note – none of this should preclude using as much traditional muni-bond financing as possible.  You don’t need the whole debt structure to be a shock absorber – just enough to deal with typical levels of uncertainty.  So the innovative debt I’m talking about should only be a small part of the overall capitalization and the alternative framework should not preclude tax-exempt debt issuance.

5) Federal Infrastructure Policy:  Focus on Reducing Constraints and Inefficiencies, Not Form

Finally, current federal infrastructure policy is a bit vague at the moment to say the least, but I think the overall objective of trying to support more non-traditional options for US state and local governments and get more private-sector expertise and capital involved is totally on target.

But I think also that focusing policies on specific forms and frameworks – like revenue-risk P3s – is a mistake.  That’s completely understandable in terms of what’s been talked about for many years, but it’s unnecessarily limiting and runs into some political preconceptions.  It’d be better to focus policy on the actual challenges that state and local governments face and where the federal government has some unique capability to help.

The VfF implication is of course that it would be very effective to focus some federal policy on specific challenges of fiscal and budgetary constraints if they’re the real impediment to local governments deploying their own capital.  Since mitigating these constraints doesn’t really require risk transfers or subsidies, some carefully thought out policies might be relatively practical in terms of the federal government’s own spending constraints.  In particular, I think there’s a lot of scope for federal loan programs to help deal with uncertainty.