TAXPAYERS, PAY ATTENTION: Residents should know how government borrowing uses and potentially abuses their money.

Editorial from the Los Angeles Times

August 3, 2008 - Californians can be forgiven if they're starting to feel nickeled-and-dimed to death. The Nov. 4 ballot is studded with requests by cities, counties, schools, transportation districts and other local governments to borrow money for projects by selling bonds. And when government borrows, the taxpayers become the collateral.

Investors buy general-obligation municipal bonds in part because interest earned on them is tax-free. But they also like such bonds because they are so safe -- and they are safe in part because they are backed by tax revenues. That's the reason they can be issued only on approval by voters: a majority vote for state bonds, and a two-thirds vote for local bonds (55% for many school bonds). Local bonds, especially, appeal to investors because everyone knows where the money will come from to repay them, with interest -- the property tax bills of the residents of the city, county or special district.

But the money residents pay to back up all those bonds is part of a financial chain that links institutions far beyond statehouses or local city halls. At the far end are Wall Street firms, which often see cities, counties, school districts and states, and ultimately their taxpayers, as cash cows. Populaces are essentially sold to investors based on their willingness and ability to tax themselves.

It can be a good deal all around. Residents get projects and services that enhance their quality of life, and that their governments otherwise would be unable to afford. But a growing number of the politicians who ask constituents to back those bonds are beginning to nip at the other end. Investment banks, they claim, and rating agencies and especially bond insurance companies have been gouging governments -- and taxpayers. It's what Connecticut Atty. Gen. Richard Blumenthal calls "a secret Wall Street tax on Main Street." These newly combative elected officials charge that abuses are now being uncovered because of the mortgage default crisis. They are rebelling. People who pay taxes should pay attention:

* Earlier this year, California Treasurer Bill Lockyer charged that the "big three" bond rating agencies have cost taxpayers millions of dollars in higher interest payments and unnecessary insurance premiums by intentionally giving lower ratings to municipal bonds -- which carry virtually no risk of default -- than they do to much riskier corporate bonds.

* In July, Los Angeles City Atty. Rocky Delgadillo sued companies that sold what the city claims was unnecessary bond insurance. Delgadillo alleged that the city should already have been getting the top ratings based on its virtually nonexistent chance of default and that, even worse, the insurance became worthless when the insurers bulked up on defaulting -- and undisclosed -- residential mortgages. He also sued investment banks over what he called collusion to hold down the returns the city got on short-term investments of bond proceeds.

* Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, held hearings on the double standard for municipal and corporate bonds. On Wednesday, the committee approved his bill to mandate a single rating scale.

* Also on Wednesday, Blumenthal sued the three rating agencies over the dual scale. Two of the three agencies have announced plans to recalibrate their ratings for municipal bonds.

All this public-sector activity against the bond industry makes sense only if taxpayers know how things got to this point. State and local governments have borrowed, by selling bonds, for years. But in the 1980s, the federal government began scaling back its aid to cities and counties for housing, transportation and education, and local governments tried to make up the difference by increased borrowing. Meanwhile, local and regional banks that once had face-to-face relationships with civic and political leaders were being supplanted by international institutions; investors lost their intermediaries and began buying bonds directly on the debt market, but they needed information about the riskiness of particular bonds. They began relying more than ever on the reports of the big three bond rating agencies -- Moody's, Standard & Poor's and Fisk.

Lockyer, Blumenthal and others claim that if state and local bonds were rated on the risk of default according to the same standard as taxable corporate bonds, almost all government bonds would be rated AAA (or, in the case of Moody's, Aaa; each agency has its own designations). They say lower ratings, made on a different scale, force state and local governments to pay investors higher rates than they should. The agencies counter that investors want ratings that compare one municipal bond to another, and not to corporate bonds.

To get ratings higher than those the agencies were offering, governments began buying insurance. They were, in essence, paying more upfront to rent the superior rating of the insurance company, which in theory would pay bondholders in the unlikely event of default. Such purchases were unusual until 1994 -- when Orange County declared bankruptcy. Then, suddenly, every muni bond buyer began to insist on insurance, although defaults remained rare.

Bond insurance was a lucrative business, and the companies began investing their newfound cash in ventures such as mortgage pools. But when the housing bubble deflated and mortgages failed, those same three agencies that rate bonds dropped their ratings on the insurers. And, according to Los Angeles' suit, the insurance companies' product -- higher ratings -- disappeared.

It is simply not the case that the plethora of bonds being sought by state and local officials is solely the result of private financial greed rather than governmental mismanagement or political opportunism. But taxpayers are indeed as tethered to Wall Street as they are to City Hall and Sacramento. Lockyer, Delgadillo and others understand that. Voters, and taxpayers, should too.