Be cautious in assuming that markets don’t work, particularly when contemplating government financing of private construction. That is one lesson from the demise of the St. Paul Port Authority’s 876 Bond Fund.
Created in 1974 to spur economic development by financing development projects unable to get private financing, the fund operated like gangbusters at first. It borrowed nearly a half-billion dollars until rising defaults on the properties it had financed forced the end of bond sales in 1991.
Now it will be liquidated, with the remaining bondholders losing a third of their money. Specifics of the case are highly contentious, with bondholders accusing the Port Authority of mismanagement and bad faith.
The general lesson here is that resources get wasted when government assumes inappropriate functions. Agencies like the Port Authority are poor at judging risk and don’t face the incentives to do so thoroughly. Although they disclaim government status, their implicit association with government insulates bond purchasers from underlying risk.
This is a specific local case, but the broader implications apply to institutions like Ginnie Mae, Freddie Mac and the Farm Credit System that enjoy implicit federal agency status, and ultimately to multilateral institutions like the World Bank. While the 876 Fund is legally separate from the city of St. Paul, there are other cases, like the late 1980s bailout of the Farm Credit System, where taxpayers paid to clean up the mess.
The basic mistake in all such situations is to assume that if private capital markets are unwilling to finance private projects, it is due to market failure rather than the fact that the projects are not commercially viable.
A second mistake is to ignore the skewed incentives when administrators of an entity like the Port Authority do not answer to anyone with a financial stake in their efforts. Instead, they report to city officials whose objectives are political, not financial. Politicians have notoriously short planning horizons – usually until the next election – and are more interested in dirt being moved and buildings going up than in long-term financial consequences.
A third mistake is to assume that initial success – or at least the absence of failure – assured long-term viability. The Port Authority financed 139 projects over 17 years. The fact that some early projects met cash-flow requirements for a few years lulled both the authority and bond purchasers to increase their bets.
Despite the bondholders’ claims of bad faith, one need not grieve for them. A messy default like this reminds all investors not to ignore risk, even if veiled by a borrower’s quasi-government status. Specific complaints can be settled in the courts, which have shown little sympathy so far.
The core problem is that valuable resources are wasted in projects whose value to society is less than their cost. Such resources are diverted from other uses where they might do more good.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.