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Lost causes
L O S T CAUSES A self-proclaimed defender of lost causes protests increasing federal intervention in local and state affairs and "the perverse and indiscriminate use of borrowing powers by the states."
FRANCIS R. SCHANCK
With many of my generation and probably a substantial proportion of t h e business and financial community, I am more often than not on the side of lost causes and have been so over the past fifty years. My membership in the small band of lost-cause partisans was brought home to me most poignantly on a recent occasion. I appeared in J u n e of this year as a witness before the Senate Banking Committee on the matter of federal loans or loan guarantees for New York City. On the scheduled day I was one of four witnesses and was among three who opposed federal loans or guarantees. As is customary, the witnesses had submitted in advance formal written statements. If the full statement t o o k longer than five minutes to read, summaries limited to that time span were presented orally. Out of the fifteen senators on the committee, only five were in attendance at all during the three hours, and several of those for only a few minutes. The chairman, Senator William Proxmire, who was there the
FRANCIS R. SCHANCK is senior partner with Bacon, Whipple & Company, a Chicago investment banking firm. He is a past president of the Investment Bankers Association of America and is active in Chicago investment and civic affairs.
whole time, and one or two others engaged in some dialogue with the witnesses. The two senators from New York, Jacob Javits and Daniel Moynihan, were in attendance for part of the session as guests of the committee. The oral summary I presented follows: Mr. Chairman: I will a t t e m p t to summarize the salient points of my prepared statement. It seems to me the greatest contribution I can make to y o u r deliberations is to get into the record facts about what really happens when municipalities default and, I believe of even greater importance, what will happen if entities which should default don't. Cities are aggregations of persons, families, and enterprises. The same principles that govern individual and family creditworthiness apply to cities. Borrowing to maintain a standard of living above the means of a family usually results in disaster. No reasonable person would believe it right to lend more m o n e y to a family, or group of families, if it is unable to cover its current living expenses and pay interest on prior loans. Those who are committed to "helping New York C i t y " should not be encouraging the city to borrow more but should force debtors and creditors to sit down together by slamming the credit
DECEMBER 1978
23
FRANCIS R. SCHANCK
24
window shut. If New York had been smitten with disaster, earthquake, fire, or flood, of course, necessary aid would be supplied, b u t to underwrite fiscal insanity is to support it. The Great Depression of the 1930s was the last period of numerous municipal defaults. Bondholders' protective committees representing creditors met with public officials representing debtors in Detroit, the state of Arkansas, and dozens of other communities. No more sympathetic group could be found because it is in the long- and short-term interest of bondholders to see that municipalities regain their financial health as soon as possible. Those who invested in New York City and Municipal Assistance Corporation bonds over the last few years knew they were buying risky securities. Yields of from one-half of 1 percent up to 4 or 5 percent above those offered b y good quality municipal bonds were obtained. MAC debt has doubled since federal assistance began in 1975. New York City and MAC debts total over $12 billion. Add to this the city's share of New York State debt and that of the various authorities serving the metropolitan area, and a frightening debt picture develops. The argument that New York is so i m p o r t a n t - t h e Big Apple, home of the United N a t i o n s - t h a t it is unthinkable for it to default makes no sense. Where will y o u draw the line? Can size or importance place a city above the principles that control other municipalities? Those who tell y o u that a New York default will make it impossible for all municipalities to borrow are either misinformed or paying no attention to history. The fallout from the proposed bailout of New York City will have far-reaching effects; these lie in three categories: 1) Effect on other local governments: "Profligacy vs. prudence"; "go thou and do likewise." 2) Effect on the free marketplace for municipal bonds: Why pay up for quality? What do ratings mean? If a big enough local
BUSINESS HORIZONS
government runs amok, the federal government will rescue it. 3) Effect on state sovereignty and local a u t o n o m y : Throughout all history men have sought a device to prevent the drift of power from the local clan, community, or state to the central authority. Our federal/state relationship is unique and is such a device. Mr. Chairman, the initial cost in dollars of a New York City default will be stupendous, b u t it will be finite and, based on historical precedent, will be temporary. This cost will be borne primarily b y institutions and investors. On the other hand, if federal funds or guarantees are used to prevent a default, the city of New York will b e c o m e a virtual ward of the federal government. The cost of this incursion into states' rights will be measured not in dollars b u t in personal f r e e d o m - t h e loss of meaningful decision making at the local level. In my opinion the New York City bailout, if it takes place, will be recorded b y historians of the twenty-first century as a major step in the collapse of our republic. Each witness was requested to deliver one hundred copies of his complete statement to the committee office forty-eight hours in advance of the hearing. Obviously, interested senators had adequate opportunity to study in detail the testimony of all witnesses. After the statements, or oral summaries, members of the committee as well as Senators Javits and Moynihan raised questions and usually added comments and opinions of their own. Senator Javits' only question to me served two purposes: First, it established that I was at least a conservative, if not a hidebound reactionary; and second, it served as a catalyst that generated this article. A copy of the edited, corrected transcript is not yet available. As nearly as I can remember, his words were: "Now, Mr. Schanck, I would like to ask if y o u also oppose federal insurance of bank deposits or federal guarantees of farm loans?"
Los~ Causes
?;/i I .1" '¸
"~.~ " /
• ::??(~L.
i. . . . . . . . . . . . .
;
...... i f..--- ..
i~
~
~ .... ,.....
=.,
~, " i
.
,
r....2~
• :ii
).:
e !..,"
25 My reply was to the effect that philosophically I was opposed to both. I felt the government had no place in guaranteeing business transactions between individuals or companies. But, inasmuch as these provisions have been law for over forty years, we have to live by them. Like the weather, they are there. The senator had me pegged as one with the hardhearted bankers dissipating the deposits of the little people and foreclosing on the defenseless farmer. From that point on, the small group of reporters and television interviewers covering the hearing seemed to consider m y testimony, no matter how logical it might sound, as probably irrelevant.
THE FREEDOM FRONTS The weathermen on television every day point out high-pressure centers with their frontal systems that at variable speeds move continuously over the earth, more or less follow-
ing certain established patterns. The weathermen are much like war correspondents reporting progress or change in the movements of opposing forces. Students of h i s t o r y Edward Gibbon, Arnold Toynbee, Will and Ariel Durant, among others-have charted for us the rise and fall of civilizations. It seems to me that the shifts in national and, on a grand scale, worldwide relationships between the individual and the state could be described as "freedom fronts." As the complexities of maintaining industrial societies increase, as shortages in living space, potable water, and easily accessible sources of energy make themselves more stridently evident, the relative value of the individual's freedom seems to fade. During the birth of our country, certain fundamental principles, known for several millennia, were reenuciated and one completely unique device was created. Throughout the history of civilization men had sought governmental arrangements or constitutions
DECEMBER
1978
FRANCIS R. SCHANCK
that would prevent the drift of power from the local family, clan, or community to the central authority or sovereign. When the several independent states, provinces, and commonwealths formed the United States of America, they surrendered some important rights to the national government but retained all others to themselves. A principle evolved, reinforced b y Supreme Court decisions in the 1 8 2 0 s - t h e concept that the power to tax is the power to destroy; it became known as the principle of reciprocal immunity. Applications of this principle exempt federal property and activities from state taxation and, conversely, bestow immunity from federal
When Senator Javits asked his question, touching off m y mental recapitulation of lost causes, the first that came to m y mind was municipal industrial financing, the practice wherein political subdivisions of states sell bond issues to finance certain capital needs of private companies. Beginning in a small way in the 1940s in southern and border states, primarily to attract plants from the northern and midwestern industrial areas, this concept spread rapidly following World War II. With the advent of public awareness of water and air pollution, it has burgeoned in recent years. Of course, the interest paid on such bonds sold by states, authorities, counties, or cities
"Local public works and community facilities are the physical links between families and government. Roads, streets, sidewalks, water supply, sewer facilities, police and fire protection, schools, parks-in general, it seems that decisions concerning these are better made at the local level. However, the freedom to make decisions at all levels depends upon the degree of responsibility and the quality of judgment shown." 26
income taxes on interest paid on state and municipal bonds. This device, if used properly and neither abused nor prostituted, prevents the drift of power from the citizen at the local level to the national sovereign. Local public works and c o m m u n i t y facilities are the physical links between families and government. Roads, streets, sidewalks, water supply, sewer facilities, police and fire protection, schools, p a r k s - i n general, it seems that decisions concerning these are better made at the local level. However, the freedom to make decisions at all levels depends upon the degree of responsibility and the quality of judgment shown. One would not expect a local government that did not have adequate schools or waterworks to embark on an elaborate program of park and recreation-area development. Nor would it seem reasonable for a substantial community, with all essential services provided at reasonable costs, to refuse to support a well-conceived park program.
BUSINESS HORIZONS
is exempt from federal income taxation. Obviously, it is to a corporation's advantage to raise as large a part of its capital needs as possible by this method. At this writing, top-quality taxable corporate bonds are selling at around 8 3/4 to 9 percent, while tax-exempt obligations of the best corporations are selling to yield 5 3/4 to 6 percent. For about t w e n t y years I was one of the small cadre of the lost-cause forces fighting a rear-guard action against municipal industrial financing. It was and is a perverse use of borrowing on behalf of the people. Congress finally did pass a law restricting such financing to small issues (under $5 million), but the incoming wave of pollution-control sentiment soon made restraints rather academic. In the last two years, issues ranging in size from $10 million to $125 million in tax-exempt bonds have been sold; they are, in fact, obligations of such major U.S. corporations as U.S. Steel, Exxon Corporation, Atlantic Richfield, Dow
Lost Causes
Chemical, Standard Oil of Indiana, Commonwealth Edison, Boise Cascade, and scores of others. Issues have been sold through cities or state agencies from Alaska to Florida, from New Mexico to Michigan. In two years, 1976-77, $4.8 billion of pollution-control and industrial revenue bonds were sold b y states and their subdivisions; $695 million were sold in the first quarter of 1978. In the past four decades, municipal industrial financing has become accepted as a fact of life. To many of us, it is wrong in a more critical way than federal deposit insurance, b u t it is n o w part of the scene. And what does it mean to corporate America? Where will we locate our new plant? Be sure to shop around for the best deal. Let's be absolutely sure that every dollar of cost of our new plant that can possibly be described as pollution-related is financed b y tax-exempt bonds. Such and such a state will not only furnish the site and finance the plant b u t may squeeze something out for working capital. H o w does all this relate to a federal rescue of New York City? What impact will this have on decision making at the local level, and how does it affect our hypothetical "freedom front"? Over the long course of history the tides of freedom ebb and flow. The record shows that it is easy to lose freedom and very hard to gain it. As societies become larger, as the various components become more specialized, the greater is the temptation to turn complicated and unpopular decision making over to someone else. In New York City's case each of the various groups involved could blame the others. City officials, bankers, investment bankers, rating services, employee unions, educators, and other groups, large and small, can all share in the responsibility for the super-colossal financial crisis that brought the city whining for help to the national sovereign. There is nothing new about municipal default. History tells us that the ancient Greek city-states b o r r o w e d from the trea-
suries at Delphi to finance wars and colonizations. All defaulted.
ETERNAL VERITIES Perhaps because of my direct involvement with these two lost causes-opposition to the federal financial rescue of New York City and to municipal industrial financing-I have become aware of what seem to me certain inescapable consequences of these aberrations. As is true of other attempts to substitute governmental edicts or pricing for the free marketplace, each further incursion creates new problems and requires additional governmental actions ad infinitum. By far the most serious o u t c o m e of these programs will be damage to the federal/state relationship. The shift of decision making from local to national levels is being accelerated at perhaps an irreversible rate. Our republic rests upon the maintenance of a system of delicate balance b e t w e e n local autonomy, state sovereignty, and federal authority. By federal intervention in local and state affairs and b y the perverse and indiscriminate use of borrowing powers b y the states and their subdivisions, the system can be destroyed. Municipal finance and constitutional law are relatively esoteric, highly specialized fields. Our nation, truly the "last, best hope," could have its unique birthright sold, with few of its citizens even aware of it. Thus on what is certainly an inconspicuous sector of the "freedom front," in what may appear to be an insignificant engagement, a great loss can be taking place in man's struggle for identity, self-realization, and responsible individual liberty. Principle and E x p e d i e n c y m e e t on a narrow f o o t b r i d g e over a deep chasm. With no r o o m to pass, they s t a n d nose to nose f o r s o m e time. Finally, Principle says, "'I've g o t it. I'll lie d o w n and y o u can walk over me. '" Eli
DECEMBER 1978
27
FRANCIS R. SCHANCK
With many of my generation and probably a substantial proportion of t h e business and financial community, I am more often than not on the side of lost causes and have been so over the past fifty years. My membership in the small band of lost-cause partisans was brought home to me most poignantly on a recent occasion. I appeared in J u n e of this year as a witness before the Senate Banking Committee on the matter of federal loans or loan guarantees for New York City. On the scheduled day I was one of four witnesses and was among three who opposed federal loans or guarantees. As is customary, the witnesses had submitted in advance formal written statements. If the full statement t o o k longer than five minutes to read, summaries limited to that time span were presented orally. Out of the fifteen senators on the committee, only five were in attendance at all during the three hours, and several of those for only a few minutes. The chairman, Senator William Proxmire, who was there the
FRANCIS R. SCHANCK is senior partner with Bacon, Whipple & Company, a Chicago investment banking firm. He is a past president of the Investment Bankers Association of America and is active in Chicago investment and civic affairs.
whole time, and one or two others engaged in some dialogue with the witnesses. The two senators from New York, Jacob Javits and Daniel Moynihan, were in attendance for part of the session as guests of the committee. The oral summary I presented follows: Mr. Chairman: I will a t t e m p t to summarize the salient points of my prepared statement. It seems to me the greatest contribution I can make to y o u r deliberations is to get into the record facts about what really happens when municipalities default and, I believe of even greater importance, what will happen if entities which should default don't. Cities are aggregations of persons, families, and enterprises. The same principles that govern individual and family creditworthiness apply to cities. Borrowing to maintain a standard of living above the means of a family usually results in disaster. No reasonable person would believe it right to lend more m o n e y to a family, or group of families, if it is unable to cover its current living expenses and pay interest on prior loans. Those who are committed to "helping New York C i t y " should not be encouraging the city to borrow more but should force debtors and creditors to sit down together by slamming the credit
DECEMBER 1978
23
FRANCIS R. SCHANCK
24
window shut. If New York had been smitten with disaster, earthquake, fire, or flood, of course, necessary aid would be supplied, b u t to underwrite fiscal insanity is to support it. The Great Depression of the 1930s was the last period of numerous municipal defaults. Bondholders' protective committees representing creditors met with public officials representing debtors in Detroit, the state of Arkansas, and dozens of other communities. No more sympathetic group could be found because it is in the long- and short-term interest of bondholders to see that municipalities regain their financial health as soon as possible. Those who invested in New York City and Municipal Assistance Corporation bonds over the last few years knew they were buying risky securities. Yields of from one-half of 1 percent up to 4 or 5 percent above those offered b y good quality municipal bonds were obtained. MAC debt has doubled since federal assistance began in 1975. New York City and MAC debts total over $12 billion. Add to this the city's share of New York State debt and that of the various authorities serving the metropolitan area, and a frightening debt picture develops. The argument that New York is so i m p o r t a n t - t h e Big Apple, home of the United N a t i o n s - t h a t it is unthinkable for it to default makes no sense. Where will y o u draw the line? Can size or importance place a city above the principles that control other municipalities? Those who tell y o u that a New York default will make it impossible for all municipalities to borrow are either misinformed or paying no attention to history. The fallout from the proposed bailout of New York City will have far-reaching effects; these lie in three categories: 1) Effect on other local governments: "Profligacy vs. prudence"; "go thou and do likewise." 2) Effect on the free marketplace for municipal bonds: Why pay up for quality? What do ratings mean? If a big enough local
BUSINESS HORIZONS
government runs amok, the federal government will rescue it. 3) Effect on state sovereignty and local a u t o n o m y : Throughout all history men have sought a device to prevent the drift of power from the local clan, community, or state to the central authority. Our federal/state relationship is unique and is such a device. Mr. Chairman, the initial cost in dollars of a New York City default will be stupendous, b u t it will be finite and, based on historical precedent, will be temporary. This cost will be borne primarily b y institutions and investors. On the other hand, if federal funds or guarantees are used to prevent a default, the city of New York will b e c o m e a virtual ward of the federal government. The cost of this incursion into states' rights will be measured not in dollars b u t in personal f r e e d o m - t h e loss of meaningful decision making at the local level. In my opinion the New York City bailout, if it takes place, will be recorded b y historians of the twenty-first century as a major step in the collapse of our republic. Each witness was requested to deliver one hundred copies of his complete statement to the committee office forty-eight hours in advance of the hearing. Obviously, interested senators had adequate opportunity to study in detail the testimony of all witnesses. After the statements, or oral summaries, members of the committee as well as Senators Javits and Moynihan raised questions and usually added comments and opinions of their own. Senator Javits' only question to me served two purposes: First, it established that I was at least a conservative, if not a hidebound reactionary; and second, it served as a catalyst that generated this article. A copy of the edited, corrected transcript is not yet available. As nearly as I can remember, his words were: "Now, Mr. Schanck, I would like to ask if y o u also oppose federal insurance of bank deposits or federal guarantees of farm loans?"
Los~ Causes
?;/i I .1" '¸
"~.~ " /
• ::??(~L.
i. . . . . . . . . . . . .
;
...... i f..--- ..
i~
~
~ .... ,.....
=.,
~, " i
.
,
r....2~
• :ii
).:
e !..,"
25 My reply was to the effect that philosophically I was opposed to both. I felt the government had no place in guaranteeing business transactions between individuals or companies. But, inasmuch as these provisions have been law for over forty years, we have to live by them. Like the weather, they are there. The senator had me pegged as one with the hardhearted bankers dissipating the deposits of the little people and foreclosing on the defenseless farmer. From that point on, the small group of reporters and television interviewers covering the hearing seemed to consider m y testimony, no matter how logical it might sound, as probably irrelevant.
THE FREEDOM FRONTS The weathermen on television every day point out high-pressure centers with their frontal systems that at variable speeds move continuously over the earth, more or less follow-
ing certain established patterns. The weathermen are much like war correspondents reporting progress or change in the movements of opposing forces. Students of h i s t o r y Edward Gibbon, Arnold Toynbee, Will and Ariel Durant, among others-have charted for us the rise and fall of civilizations. It seems to me that the shifts in national and, on a grand scale, worldwide relationships between the individual and the state could be described as "freedom fronts." As the complexities of maintaining industrial societies increase, as shortages in living space, potable water, and easily accessible sources of energy make themselves more stridently evident, the relative value of the individual's freedom seems to fade. During the birth of our country, certain fundamental principles, known for several millennia, were reenuciated and one completely unique device was created. Throughout the history of civilization men had sought governmental arrangements or constitutions
DECEMBER
1978
FRANCIS R. SCHANCK
that would prevent the drift of power from the local family, clan, or community to the central authority or sovereign. When the several independent states, provinces, and commonwealths formed the United States of America, they surrendered some important rights to the national government but retained all others to themselves. A principle evolved, reinforced b y Supreme Court decisions in the 1 8 2 0 s - t h e concept that the power to tax is the power to destroy; it became known as the principle of reciprocal immunity. Applications of this principle exempt federal property and activities from state taxation and, conversely, bestow immunity from federal
When Senator Javits asked his question, touching off m y mental recapitulation of lost causes, the first that came to m y mind was municipal industrial financing, the practice wherein political subdivisions of states sell bond issues to finance certain capital needs of private companies. Beginning in a small way in the 1940s in southern and border states, primarily to attract plants from the northern and midwestern industrial areas, this concept spread rapidly following World War II. With the advent of public awareness of water and air pollution, it has burgeoned in recent years. Of course, the interest paid on such bonds sold by states, authorities, counties, or cities
"Local public works and community facilities are the physical links between families and government. Roads, streets, sidewalks, water supply, sewer facilities, police and fire protection, schools, parks-in general, it seems that decisions concerning these are better made at the local level. However, the freedom to make decisions at all levels depends upon the degree of responsibility and the quality of judgment shown." 26
income taxes on interest paid on state and municipal bonds. This device, if used properly and neither abused nor prostituted, prevents the drift of power from the citizen at the local level to the national sovereign. Local public works and c o m m u n i t y facilities are the physical links between families and government. Roads, streets, sidewalks, water supply, sewer facilities, police and fire protection, schools, p a r k s - i n general, it seems that decisions concerning these are better made at the local level. However, the freedom to make decisions at all levels depends upon the degree of responsibility and the quality of judgment shown. One would not expect a local government that did not have adequate schools or waterworks to embark on an elaborate program of park and recreation-area development. Nor would it seem reasonable for a substantial community, with all essential services provided at reasonable costs, to refuse to support a well-conceived park program.
BUSINESS HORIZONS
is exempt from federal income taxation. Obviously, it is to a corporation's advantage to raise as large a part of its capital needs as possible by this method. At this writing, top-quality taxable corporate bonds are selling at around 8 3/4 to 9 percent, while tax-exempt obligations of the best corporations are selling to yield 5 3/4 to 6 percent. For about t w e n t y years I was one of the small cadre of the lost-cause forces fighting a rear-guard action against municipal industrial financing. It was and is a perverse use of borrowing on behalf of the people. Congress finally did pass a law restricting such financing to small issues (under $5 million), but the incoming wave of pollution-control sentiment soon made restraints rather academic. In the last two years, issues ranging in size from $10 million to $125 million in tax-exempt bonds have been sold; they are, in fact, obligations of such major U.S. corporations as U.S. Steel, Exxon Corporation, Atlantic Richfield, Dow
Lost Causes
Chemical, Standard Oil of Indiana, Commonwealth Edison, Boise Cascade, and scores of others. Issues have been sold through cities or state agencies from Alaska to Florida, from New Mexico to Michigan. In two years, 1976-77, $4.8 billion of pollution-control and industrial revenue bonds were sold b y states and their subdivisions; $695 million were sold in the first quarter of 1978. In the past four decades, municipal industrial financing has become accepted as a fact of life. To many of us, it is wrong in a more critical way than federal deposit insurance, b u t it is n o w part of the scene. And what does it mean to corporate America? Where will we locate our new plant? Be sure to shop around for the best deal. Let's be absolutely sure that every dollar of cost of our new plant that can possibly be described as pollution-related is financed b y tax-exempt bonds. Such and such a state will not only furnish the site and finance the plant b u t may squeeze something out for working capital. H o w does all this relate to a federal rescue of New York City? What impact will this have on decision making at the local level, and how does it affect our hypothetical "freedom front"? Over the long course of history the tides of freedom ebb and flow. The record shows that it is easy to lose freedom and very hard to gain it. As societies become larger, as the various components become more specialized, the greater is the temptation to turn complicated and unpopular decision making over to someone else. In New York City's case each of the various groups involved could blame the others. City officials, bankers, investment bankers, rating services, employee unions, educators, and other groups, large and small, can all share in the responsibility for the super-colossal financial crisis that brought the city whining for help to the national sovereign. There is nothing new about municipal default. History tells us that the ancient Greek city-states b o r r o w e d from the trea-
suries at Delphi to finance wars and colonizations. All defaulted.
ETERNAL VERITIES Perhaps because of my direct involvement with these two lost causes-opposition to the federal financial rescue of New York City and to municipal industrial financing-I have become aware of what seem to me certain inescapable consequences of these aberrations. As is true of other attempts to substitute governmental edicts or pricing for the free marketplace, each further incursion creates new problems and requires additional governmental actions ad infinitum. By far the most serious o u t c o m e of these programs will be damage to the federal/state relationship. The shift of decision making from local to national levels is being accelerated at perhaps an irreversible rate. Our republic rests upon the maintenance of a system of delicate balance b e t w e e n local autonomy, state sovereignty, and federal authority. By federal intervention in local and state affairs and b y the perverse and indiscriminate use of borrowing powers b y the states and their subdivisions, the system can be destroyed. Municipal finance and constitutional law are relatively esoteric, highly specialized fields. Our nation, truly the "last, best hope," could have its unique birthright sold, with few of its citizens even aware of it. Thus on what is certainly an inconspicuous sector of the "freedom front," in what may appear to be an insignificant engagement, a great loss can be taking place in man's struggle for identity, self-realization, and responsible individual liberty. Principle and E x p e d i e n c y m e e t on a narrow f o o t b r i d g e over a deep chasm. With no r o o m to pass, they s t a n d nose to nose f o r s o m e time. Finally, Principle says, "'I've g o t it. I'll lie d o w n and y o u can walk over me. '" Eli
DECEMBER 1978
27