A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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Dealing with Failure
Felix Rohatyn and the lessons of Gothams seventies bankruptcy crisis for today
4 February 2011
Dealings: A Political and Financial Life, by Felix G. Rohatyn (Simon & Schuster, 304 pp., $27)
With many states and municipalities in trouble, its natural to remember 1975, when Americas biggest city faced bankruptcy. In Dealings: A Political and Financial Life, banker Felix Rohatyn recounts how he helped save New York back then. The book is good history. But the rescue that it describes wouldnt fix todays problems.
Rohatyn, who escaped Nazi-controlled France as a 12-year-old boy, was 47 and a Lazard Frères banker when New Yorks new governor, Hugh Carey, summoned him to an urgent meeting. As Rohatyn notes, there had been clear warnings about New Yorks Citys distress, and I, like nearly everyone on Wall Street, had been aware of them. In April 1975, a broker had called Rohatyn to try to sell him some of the citys short-term debt. The 9.25 percent interest rate on the tax-free bonds, the broker said, was the equivalent of a 17 to 18 percent return on a taxable bond. As Rohatyn remembers, It was a good dealtoo good. All his call had done was to convince me that there must be a reason why these notes would be paying such high interest. . . . New York City, I realized, must be in trouble.
Some things dont change. On January 12, 2011, a municipal-bond firm placed a full-page advertisement in the Wall Street Journal. A steady drumbeat of opinions is predicting a muni market meltdown, the FMS Bonds ad read. But there is significant opportunity amid the hyperbole. Today, for example, investment-grade, tax-free municipal bonds can be purchased to yield . . . the equivalent of an 8.46 percent corporate bond. To get a comparable yield, the ad continued, investors would need to turn to junk bonds, commonly regarded as riskier investments than muni bonds. Are these higher-than-normal interest rates opportunities or warnings?
In the mid-1970s, they were warnings. For a decade, New York City had increased spending even as businesses and residents fled rising crime and taxes. The citys solution, begun under Mayor John Lindsay and tolerated by Careys predecessor in Albany, Governor Nelson Rockefeller, was to borrow from banks. By 1975, after Abe Beame had succeeded Lindsay, New York owed $6 billion in such debt, up from nothing a decade before. The city had to refinance much of this astounding sum every few months, Rohatyn writes.
The banks grew nervous, all the more so after the Urban Development Corporation, a state-run public authority whose mission was to alleviate poverty via public investment, defaulted on its bonds. New York State, though indirectly in charge of the UDC, had no obligation to rescue its bondholders, so Carey said no to the banks that held the UDCs debt, Rohatyn writes. Bankers wondered: might the governor also say no to the banks that held New York Citys debt, should Gotham find itself unable to pay it back? They refused to refinance, pushing the city toward a bankruptcy filing. It was to avoid that outcome that Carey called on Rohatyn in June 1975.
Over the next few months, the governor, the mayor, and the banker worked with lenders and public-sector unions to try to repair New Yorks finances. To attract investors, for example, the state and city converted city sales taxes into state sales taxes. Albany would use the revenue to pay for new state-backed bonds that would refinance the citys debt; the state would send leftover funds to the city. That way, these bonds would offer protection from any future city bankruptcy. Both sides also hammered out agreements under which union workers would defer pay raises and use pension-fund investment money to purchase the new debt.
But the deal began to disintegrate as it became clear that the markets would require a federal guarantee, not just state backing, for New Yorks rescue package. President Gerald Ford wanted to let New York fail so that it could serve as a lesson for the rest of the nation; hence the famous FORD TO CITY: DROP DEAD headline in the New York Daily News. Ford eventually abandoned his stance. As Rohatyn explained to Washington officials, a city bankruptcy would have repercussions far beyond the five boroughs. The combined indebtedness of the city and the state represented about 20 percent of capital in the entire U.S. banking system, he remembers. In the fall of 1975, as Ford wavered, French and German leaders told Federal Reserve Chairman Arthur Burns that a city default was unthinkable. As they said, it would be seen as if America was filing for bankruptcy. Burns informed Ford, who gave in, providing the federal guaranteein essence, a bailoutfor New Yorks rescue debt.
Today, we see the same brinkmanship, with even higher stakes. As states like California, New Jersey, and New York face a fourth year of multibillion-dollar deficits, Republican figures, including former Florida governor Jeb Bush and former House speaker Newt Gingrich, are pushing for a federal law to let states go bankrupt to wriggle out of future obligations. (States, unlike cities, are sovereign entities and cant file for bankruptcy.) South Carolina senator Jim DeMint and Wisconsin representative Paul Ryan have said that they wont tolerate federal bailouts of insolvent states.
Yet should states be unable or unwilling to pay their debts, federal officials could find themselves backing down, just as they did 36 years ago. If New Jersey bonds, say, were to plummet in value, the turmoil would not confine itself to one side of the Hudson. Global banks, money-market funds, and insurers hold hundreds of billions of dollars in state and local debt. At best, the fear of big losses would make such firms curtail their lending and investment activity, harming recovery. At worst, financial markets would panic. A policy of allowing state bankruptcies today, Rohatyn tells me, would be too destructive. It leaves too much blood on the floor without getting the result that you want.
Indeed, we should act now to avoid a future situation in which states and other governments repudiate their long-term obligations. But we cant believe that what worked in the seventies can work again. Back then, Gothams problems were with short-term cash flow, and the rescue package that Rohatyn helped assemble didnt involve much long-term sacrifice, beyond union members improving their productivity. Short-term bondholders waited for repayment, but they got their money. Union workers postponed raises, but they, too, eventually got that deferred income. Union pension funds purchased city debt, as agreed, but they kept the guaranteed pensions that those funds supported. Today, by contrast, distressed state and local governments have problems beyond the current crunch. Their biggest problem is making contributions to future pension and health costs. Temporary measures, such as deferring employee raises or asking unions to purchase state debt, wont fix this problem.
Rather, states and cities must ask current public employees to pay more for their health care; switch new public employees to 401(k)-style retirement funds instead of guaranteed pensions; and require uniformed workersin police, fire, sanitation, and transitto work longer than the 20 years that remains the norm in, for example, New York City. If bond markets worry not just about todays deficits but also about states long-term challenges, investors may demand such solutions, rather than settle for more financial engineering of the kind pioneered in the seventies.
But calls for specific reforms may not come from muni-bond investors. The large financial firms that underwrite and manage municipal bonds also make money administering public pension funds. Theyre unlikely to call for reforms that would shrink those funds; they might well prefer a federal bailout of states and cities. Such a bailout could backfire, though, if U.S. Treasury bondholders were to wonder whether Washington could shoulder the burden that states and local government have taken on. That concern could weaken the federal governments credit standing, pushing up interest rates on Treasury bonds. In the end, it may be Treasury bondholders who prod states and cities to mend their ways.
Its possible that the states and cities will get lucky again, just as New York City did after its 1970s nadir. New Yorks economy, powered by Wall Street, took off in the eighties. Over two decades, it generated record tax revenues that enabled New York to avoid tough fiscal choices. Surpluses in the mid-1990s, Rohatyn writes, enabled the city under Mayor Giuliani to increase its police force by 11,000 officers. Yet even robust growth can only postpone emergencies. We should use the borrowed time to make our own luck.
Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst charterholder and the author of After the Fall: Saving Capitalism from Wall Streetand Washington.