Money and Capital Markets 20 C h a p t e r Eighth Edition Financial Institutions and Instruments in a Global Marketplace Peter S. Rose McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu State And Local Governments In The Financial Markets

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin  Learning Objectives   To understand why state and local government borrowing has grown so rapidly in recent years.  To explore the various ways in which state and local governments raise the funds they need.  To examine the marketing process through which state and local government bonds and notes reach investors, and to learn why these instruments are attractive to investors.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Introduction  The borrowing and spending activities of state and local governments have been one of the most rapidly growing segments of the financial system in recent years.  State and local governments are pressured by rising populations and inflated costs, while many investors are attracted by the high quality, ready marketability, active secondary market, and tax exemption feature of state and local debt obligations.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Growth of State and Local Government Borrowing $ Billions U.S. Municipal securities Data Source: Board of Governors of the Federal Reserve System

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Growth of State and Local Government Borrowing  What factors account for the strong growth in municipal borrowing?  Rapid population growth  Uneven distribution of population growth across the U.S. – smaller outlying communities were transformed into cities  Upgrading of citizens’ expectations concerning the quality of government services  Rising construction and labor costs

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Sources of Revenue and Expenditures For U.S. State and Local Governments ( For in Millions of Dollars) General revenues by source: Property taxes…………………………………….. 240,107 Sales and gross receipts taxes…………………….. 290,993 Individual income taxes………………………….. 189,309 Corporation net income taxes…………………….. 33,922 Revenue from Federal Government……………… 270,628 Other (other taxes, charges, revues, etc.)………… 409,505 Total revenues…………………………………….. 1,434,464 General expenditures by function: Education…………………………………………. 483,259 Highways…………………………………………. 93,018 Public welfare……………………………………. 218,957 Other (public safety, environment, interest, etc.)…607,134 Total expenditures…………………………………1,402,369 Data Source: Economic Report of the President

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Sources of Revenue and Expenditures For State and Local Governments Cash Inflows: Taxes (property, sales, income, miscellaneous) User fees Special assessments Intergovernmental transfers from federal and state governments Borrowings (net market value of municipal debt sold) States, Cities, Counties, School Districts, and Other Local Governments Cash Outflows: Schools and other educational facilities Transportation facilities (highways, airports, commuter systems, etc.) Social services (income and medical support, housing, public safety) Industrial development incentives Administration and employee payrolls Interest and debt repayments

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Motivations for State and Local Government Borrowing  State and local governments borrow money  to satisfy short-term cash needs and maintain adequate levels of working capital,  to finance long-term capital investment like building schools and highways, and  for advance refunding of higher cost securities. $

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Types of Securities Issued by State and Local Governments  Short-term securities are generally issued to provide working capital.  Tax-anticipation notes (TANs)  Revenue-anticipation notes (RANs)  Bond-anticipation notes (BANs) – for temporary financing of long-term projects until the time is right to sell long-term bonds

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Types of Securities Issued by State and Local Governments  Long-term securities are used mainly to fund capital projects.  General obligation bonds (GOs)  Revenue bonds – payable only from a specified source of revenue Student-loan revenue bonds (SLRBs) Life-care bonds Hospital revenue bonds Industrial development bonds (IDBs)

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Types of Securities Issued by State and Local Governments  In recent years, several new municipal instruments were developed.  Floating-rate bonds  Option bonds  Lottery bonds  Securitized bonds

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Key Features of Municipal Debt  Tax exemption  Less tax revenue can be collected from the high- bracket investors. However, the interest cost for municipal governments is low relative to the rates paid by other borrowers.  High credit ratings  Most municipal issues are considered to be of investment quality rather than speculative buys.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Key Features of Municipal Debt  Serialization  Most municipal bonds are serial securities.  Serialization refers to the splitting up of a single bond issue into several different maturities.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin How Municipal Bonds are Marketed  The selling of municipals is usually carried out through a syndicate of banks and securities dealers.  These institutions purchase the securities from the issuing government units and then resell them in the open market at a higher price.  Prices paid by the underwriting firms may be determined by competitive bidding or by negotiation.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Problems in the Municipal Market  Many observers question the social benefit of the tax-exemption privilege.  Although state and local governments can borrow more cheaply, the federal government must tax more heavily to make up for the lost revenue.  Many important investor groups (such as pension funds) have little need for tax shelters.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin The Outlook for State and Local Governments  With slower economic growth and less federal support, more states will be under pressure to force cities, counties, and school districts to deal with their own problems and find their own funding sources.  At the same time, the need for local government services and the interest of investors are not likely to fade, thus ensuring the future growth of the market for state and local government debt securities.

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Money and Capital Markets in Cyberspace  Find out more about state and local government activity in the financial markets at:       

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Introduction  Growth of State and Local Government Borrowing  Sources of Revenue and Expenditures for State and Local Governments  Motivations for State and Local Government Borrowing

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Types of Securities Issued by State and Local Governments  Short-Term Securities  Long-Term Securities  Innovations in Municipal Securities  Key Features of Municipal Debt  How Municipal Bonds are Marketed

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin Chapter Review  Problems in the Municipal Market  Problems Regarding Tax Exemption  The Outlook for State and Local Governments