On the Quality of Municipal Bonds

Much of what municipalities spend is spent without a clear quid pro quo, merely to help people deemed unable to help themselves. At the same time, the fact that many municipalities are getting into financial trouble suggests that a limit is being reached. What sets the limits on a city’s power to tax? To borrow?

The power to tax and the power to borrow are not independent financial resources for the city. They are, rather, two aspects of the same resource. The measure of this common resource is the aggregate market value of the city’s real property. The financial consideration in the city’s decisions is thus their impact on this value. This is not to argue that every decision should be guided exclusively by financial considerations, or that eleemosynary projects are inappropriate to a city. On the other hand, allocation of limited resources among a number of such projects can be made rationally only if the demands for each project on the scarce resources are measured properly.

The fundamental criterion for the municipal bond investor is not willingness to pay, as measured by the current level of taxes, but ability to pay. In measuring this ability, the aggregate market value of the city’s taxable real estate plays a role analogous to equity in the balance sheet of the private corporation. Black and Scholes have explained how the market value of the debt claims on a corporation will vary with variations in the value of the underlying corporate assets. Analogy suggests that the market value of municipal claims will vary with the value of the city’s taxable real estate. When one uses the Black-Scholes option curve to estimate this value, no reference to bond ratings is necessary. There is no longer anything “qualitative” about the quality of municipal bonds.