House Democrats are making a serious mistake.

On July 1st, the Democrat-controlled House passed a massive, $1.5 trillion infrastructure bill. This bill is basically just a messaging bill, intended to serve as a display of Democratic priorities, since it has almost no chance of getting passed in the Republican-controlled Senate. This infrastructure bill has a lot of good things in it, but there’s one significant piece of the bill that should absolutely not be included: allowing states and municipalities to run side businesses, borrowing money and investing it through complex Wall Street deals through a process called advanced refunding.

In order to pay for large infrastructure projects, states and local governments often issue bonds, allowing the public to buy municipal bonds that pay them interest over time, giving the government an infusion of up-front cash and giving investors a steady stream of income. Normally, people who buy bonds have to pay taxes on that interest, but in order to support state and local governments, the federal government has decided that the interest on bonds issued by those governments will be tax-free.

That has allowed a whole industry (called Municipal Finance) to develop. There are investment bankers, and lawyers, and asset managers, and credit analysts who specialize in these municipal bonds. Municipal Finance is a huge and very lucrative sector of the Financial Services industry. A material part of my wealth comes very indirectly from the commission paid to sell the bonds that financed the Big Dig (the $8 billion plus project to reroute part of I93 into a tunnel beneath downtown Boston).

• This system works pretty well for everyone involved:.
• People who invest in municipal bonds don’t have to pay federal income taxes
• State and local government agencies pay lower interest rates on the bonds they issue than would otherwise be the case.
• Building stuff like bridges and schools is less expensive than would otherwise be the case.
• State and Local governments do lots of things that they would not otherwise do, by issuing bonds to then lend money to companies that they hope will create jobs.
• Lots of lawyers and bankers and investment advisors, etc. make a good living.

Now the lawyers and bankers who run these programs are smart people. It didn’t take long for them to figure out that if some bonds pay higher interest rates than other bonds, that they could borrow money at the lower interest rates (by selling bonds), invest that money into things that will give them a higher rate of return, and earn a profit on the difference between those two rates.

Sometimes when interest rates change, municipalities will borrow money (ie issue bonds) at lower interest rates in order to pay off their old debt that was held at a higher interest rate. That’s normal financial management (like a homeowner refinancing a mortgage), and under normal circumstances, there might be a bit of time between borrowing the money and paying off the old debt. A bit of time might pass, but not a lot, maybe a few days.

The new rule in the House infrastructure bill would allow that amount of time to be indefinitely long, even years, and would allow state and local governments to invest the money that they raise instead of immediately paying off their old debt.

This new rule isn’t actually new, however. It used to be allowed up until 2017, and it was almost always a disaster. The state and local governments that tried to take advantage of these complicated financial maneuverings often ended up losing money, in many cases a lot of money.

For example, in the early 1990s, the treasurer of Orange County California, Robert Citron, was in charge of several different government funds with around eight billion dollars. Mr. Citron and some of his staff who had discretion over that money saw themselves as financial geniuses borrowed billions more in complex transactions, to increase the amount of money they could invest. When a Goldman Sachs executive decided to refuse to help them borrow more money, Mr. Citron wrote a letter to Goldman Sachs saying that they did not understand finance and that Orange County would no longer deal with Goldman Sachs (I saw the letter framed and hanging on the wall in a conference room some years later). Shortly thereafter, in the spring of 1994 interest rates went up substantially, then the value of the highly leveraged investments declined, the interest that Orange County had to pay on its loans went up, various government entities incurred aggregate losses of around two billion dollars, over three thousand employees of various government agencies were laid off and Mr. Citron pled guilty to six felonies.

Allowing this reckless behavior again is a mistake that will end up hurting taxpayers, and it has no place in any bill passed by a Democratic Congress. It’s very profitable for the bankers and investment advisors who manage these transactions. They surely think that this is a great idea, and their influence might be why this was included in the bill, but if Democrats want to be serious about promoting good governance, allowing local governments to get involved in complex financial transactions has no place in their infrastructure bill.