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STATEMENT OF THE MUNICIPAL FINANCE STUDY GROUP*

Before the

COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS

of the

UNITED STATES SENATE

February 26, 1976

*The research that is discussed in this statement has been supported by a research grant from the National Science Foundation, Program of Research Applied to National Needs, entitled Reporting, Evaluating and Improving Municipal Credit Condition.

Statement of the Municipal Finance Study Group

Before the

Committee on Banking, Housing and Urban Affairs

of the

United States Senate

February 26, 1976

Mr. Chairman, I am Ronald W. Forbes, Associate Professor of Finance at the School of Business, University Center at Albany, Albany, New York. I am appearing today as a member of the Municipal Finance Study Group, which is an ad hoc association of faculty and graduate students that are carrying out research projects on policy issues of concern to the municipal bond market. I would like to acknowledge the very substantial assistance of Christopher Carter, Steven Chilton, Harold Kreitzman, Paul Leonard and David Whitford in the preparation of this statement. We appreciate this opportunity to address the Committee on the matter of disclosure in the municipal securities markets.

State and local governments depend heavily on continued access to financial markets in order to raise the necessary funds for needed capital investments in schools, hospitals and water and sewer treatment facilities. Capital markets also provide the short-term funds needed in many jurisdictions to even out seasonal patterns of receipts and expenditures. To this point, the capital market has been able to accomodate many if not most of these needs; the market has even been willing to supply funds for somewhat more dubious purposes such as the use of public financing in support of private enterprises such as football stadiums and racetracks.

In 1974, some 7,701 new issues of long-term bonds and short-term notes were sold by state and local governments, amounting to $51.9 billions. In 1975, there were 8,080 new issues amounting to $58.2 billions. Indeed, the

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municipal securities market far surpasses any other public securities market

in terms of the number of issues and issuers that have been accomodated

(see Table 1) and is second only to the market for U.S. Treasury and governmental agency securities in terms of the amounts of funds raised.

The importance to state and local governments of continued access to the public market is attested to by the fact that over 50 percent of all state and local capital investment is financed through offerings of debt securities. In particular, the ability to market long-term debt permits governmental units to align the costs (of debt service) with the useful life of such capital projects and thereby avoid the sizeable tax burdens that would otherwise be required to fund, immediately and in full, outlays for new investment.

State and local borrowing is carried out in the context of the larger capital market where numerous alternative financial instruments are also competing for the available supply of funds. The exemption of interest payments from federal taxation generally permits municipalities to market their securities at lower interest rates, even when the marked cyclical volatility of the tax-exempt market is considered. Since 1955, for example, the interest rate on the highest quality of long-term municipal bonds (rated AAA) has averaged 72 percent of the rate on corporate bonds of comparable quality. (See Chart 1.)

Many factors other than the value of tax-exempt income are weighed by investors, but foremost among these factors is, perhaps, an assessment of relative risks and required returns on different securities.

The risk arises from the fact that investors in municipal securities (or in other securities) are purchasing claims on the future revenues of the borrower. One way to identify and perhaps reduce this risk and uncertainty

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is to seek out all relevant information on the borrower. In this regard, any information that allows investors to better estimate the likelihood that they will in fact receive the promised payments can be viewed as relevant information. Moreover, several facets of existing securities laws are addressed to the importance of information to the investment market. Rule 10b-5 of the Securities and Exchange Commission, which covers all securities transactions, states, in part, that it is unlawful for any person

"to make any untrue statement of a material fact or to omit

to state a material fact necessary in order to make the
statements made, in the light of the circumstances under
which they were made, misleading."

(17 C.F.R. $240-10b-5(1974))

Moreover, the thrust of judicial decisions on such questions has been to

reinforce the need for full disclosure.

As summarized by Professor Robert Doty,

these decisions widen the scope of relevant information that should be disclosed:

The "basic test" of materiality has been said to refer to
"whether 'a reasonable man would attach importance [to the
fact. . .] in determining his choice of action in the
transaction in question. '"
Whatever the boundaries

of even this vague definition, with its ties to the
Judgment of the market or to what reasonable investors
would do, the Supreme Court in a recent case constructed
even a more elusive definition: "All that is necessary is
that the facts withheld be material in the sense that a
reasonable investor might have considered them important
in the making of [his] decision."

(Robert W. Doty, "Application of the Antifraud Provisions
of the Federal Securities Laws to Exempt Offerings:
Duties of Underwriters and Counsel," Boston College
Industrial and Commercial Law Review, Summer 1974, p. 403)

It would seem, then, that all participants in the tax-exempt market have sufficient economic and legal incentives to provide just the "right" amount of

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disclosure.

Investors should demand it, to reduce their risks. Issuers should

be willing to comply, to achieve lower borrowing costs. And, underwriters and

other intermediaries have the added burdens of compliance with the securities laws.

Yet, the recent and frequent reports highlighting the difficulties of several well-known governmental borrowers, including the state of New York, New Jersey and Ohio, have cited alleged lapses in disclosure. Since there have been no systematic studies of the extent of disclosure in the municipal securities market, we have initiated a project designed to measure the extensiveness of the credit information reported in the documents (notices of sale, offering statements, or prospectuses) that are provided by issuers or their advisors. The first phase of this project was begun in September 1975: we requested copies of the offering documents furnished in conjunction with new bond sales for all issues listed on the "Sealed Bids Invited" section of The Daily Bond Buyer (Thursday and Friday editions) from September through November. We have received 174 offering statements covering as many general obligation bond issues and we are presently in the process of analyzing the content of these statements. As noted in Table 2, the bond issues associated with these statements cover all size categories; individual issues ranged in size from the very small $90,000 issue of general obligation street improvement bonds of Albert City, Iowa to the $50,000,000 capital improvement general obligation bond issue sold by the State of Delaware.

Each of these offering statements is being analyzed to determine whether sufficient information has been provided to enable an experienced analyst to arrive at a judgment of the relative credit strengths and weaknesses of the issue. Clearly, a good deal of subjective judgment must enter this process.

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