Negative Externality of Fiscal Problems: Dissecting the Contagion Effect of Municipal Bankruptcy

Abstract

The fiscal decision of one local government may spill over to other localities, and such externality could justify and inform policy making by a higher-level government. Theories of municipal bond market contagion postulate that once a local government files for bankruptcy, localities sharing similar characteristics will be perceived negatively by creditors and charged a higher interest rate. In this article, empirical examination of the second-largest municipal bankruptcy in American history shows no support for general contagion based on geographic proximity. That is, nearby localities did not pay a higher interest rate after the bankruptcy. However, case-specific contagion formed around borrower-and bond-specific characteristics contributing to the bankruptcy: general-purpose borrowers and general-obligation bonds experienced increased borrowing costs after the bankruptcy. These findings have implications for states considering granting authorizations for municipal bankruptcy or providing financial assistance to struggling localities, as well as for local governments planning to access the municipal bond market.

General‐Purpose Local Government Defaults: Type, Trend, and Impact

“…General obligation bonds are backed by the full faith and credit of an issuer, and compete with other types of credit in bankruptcy proceedings, especially if a statutory lien is not available (Moldogaziev et al 2017;Yang 2019a). Therefore, one may expect any spillover of a non-GO default to occur to GO bonds of the same issuer, but not to other types of non-GO bonds as they are secured by different revenue streams.…”

“…Second, information on related bonds of other issuers may also trigger market reactions. Yang (2019a) postulates that in an incomplete information environment, investors may assess and infer risk based on new information regarding a risk cluster of related bonds of different issuers. She finds that the 2011 Jefferson County bankruptcy caused an increase in yields across new GO bonds issued in the region, as investors adjusted their evaluation of "full faith and credit."…”

“…Finally, findings in support of the credit segmentation hypothesis add to our understanding of the municipal bond market. Although the literature on bond yield suggests that borrower and bond characteristics matter (e.g., Guzman and Moldogaziev 2012;Johnson and Kriz 2005) and that the fiscal decision of one borrower could spill over to other borrowers (Greer 2015;Yang 2019a), there has been no examination of the interaction between different credit classes of the same issuer. This paper shows that the market looks beyond issuer names and evaluates non-GO bonds supported by a specific revenue stream in isolation of bonds supported by other types of revenues of the same issuer.…”

Helping or Hurting? The Efficacy of Municipal Bankruptcy

“…Some of these 27 authorize it robustly, while others authorize it in very limited instances or only if specific conditions are met 1 . Of the remaining 23 states that do not authorize Chapter 9 bankruptcy, only two have specifically prohibited municipal bankruptcy, while the other 21 have no policy on the matter (The PEW Charitable Trusts 2013; Yang 2019).…”

For the Benefit of Mr. Thompson: Organizations, Uncertainty, and Administrative Science

“…Three articles examine complexity from a fiscal or financial perspective. In addition to Wise and Witesman's () look at perverse privatization, Yang's attention to the negative externalities of fiscal problems demonstrates a case‐specific contagion effect of municipal bankruptcy on cities with borrower and bond‐specific similarities without a geographic proximity effect (Yang ). Mughan () explores the conditions under which municipal consolidations reduce government expenditures, finding that voluntary mergers reduced spending, while higher government‐forced consolidations did not.…”