“Perfect equity between debtor and creditor demands…that the authority to issue shall be unquestionable, and bond-houses and other large fiduciary institutions of today meet this requirement by retaining attorneys of ability, who instead of taking for granted, as in former times, that everything had been ‘properly done, happened and performed,’ now insist on all steps being taken in strict conformity with law.”
Text from a 1890 investment bank promotional brochure, quoted in Paul S. Maco, “Building a Strong Subnational Debt Market, A Regulator’s Perspective,” Richmond Journal of Global Law & Business (Winter-Spring 2001), 11.
Debt securities were the earliest financial instruments to trade in America. Municipal securities were popular since they gave bondholders a way to share in the growth of their towns and regions. Massachusetts appears to have issued the first such debt in 1751. By the end of the American Revolution, the continent was awash in colonial bonds, with tremendous implications for the young nation. Federal assumption of this debt bound the new states together in common cause, although controversy over assumption helped create the first political parties. Philadelphia and New York were the principal locales of early financial activity, and the latter remained the seat of the U.S. financial markets ever after.
The transportation revolution of the early 19th century spurred the growth of municipal finance. In 1812, New York City issued “general obligation” bonds, pledging the full faith and credit of the municipality to fund the construction of a canal. For the next century, bonds were the backbone of the exchanges. Erie Canal debt traded on the New York Stock and Exchange Board, the precursor to the New York Stock Exchange, in 1825. By the 1830s, Americans were feverishly engaged in building bond-financed roads, canals, railroads, and waterworks: one early railroad was described as “zigzagging across upstate New York in search of municipal bonds.” 3
But the municipal market was also at the center of the boom and bust cycles which characterized the economy of the 19th century and shaped the economic policy of the 20th century. Municipalities issued some $108 million in debt between 1835 and 1838. The speculative bubble burst in 1837; two years later, Alabama was the first state to default, with seven other states following. Still, the course of those defaults underscored a clear advantage of investing in public finance: states do not go out of business. Eventually, all but Mississippi and Alabama resumed payment.
The cycle recurred after the Civil War, as radical Republican governments ran up bills to reconstruct former Confederate states. When Democratic “redeemers” returned to office, they repudiated more than $250 million of debt. The results were restrictions in state borrowing and an object lesson in a chief hazard of municipal finance: political considerations can outweigh sound stewardship. The years after the Civil War brought another railroad boom. Although states did not directly fund these projects, many cities competed for service by issuing municipal securities and turning the proceeds over to railroads. In 1880, after that bubble burst, there was some $850 million in debt outstanding, $100 to $150 million of it in default.
The 16th Amendment and the Revenue Act of 1913 gave municipal securities the advantage of tax exemption that would ensure their popularity for the next century. The basis for that exemption dated back to an earlier attempt to impose an income tax. In its 1895 Pollock v. Farmers Loan and Trust Co. decision, the U.S. Supreme Court invalidated the income tax but implied that, under the 10th Amendment, state and local debt enjoyed “intergovernmental immunity” from federal taxation.
The 20th century brought other innovations that became hallmarks of the modern municipal debt market. Bond counsel originated as a way to reassure investors when issuers hired “reputable lawyers” to opine about the integrity of their securities following a late 19th century wave of defaults. Curiously, although retained by savvy issuers, counsel was generally considered to represent less-knowledgeable buyers. A few broker-dealers began to specialize in municipal finance. N.W. Harris & Co. was the pioneer firm, beginning in Chicago in 1880. John Nuveen & Co. followed in 1898, and Salomon Brothers & Hutzler opened in 1910. These national firms were complemented by regional broker-dealers specializing in municipal securities and public utility issues.
The municipal market boomed along with equities in the 1920s. State and municipal debt rose from $2 billion in 1900 to $12.8 billion in 1928. Then came the bust; from 1929 to 1933, some 4,700 municipalities defaulted on $2.85 billion in debt. When New Dealers began to draft legislation to regulate the financial markets, municipal issuers and broker-dealers were quick to claim exemption with some powerful claims. 4 In addition to the 10th Amendment argument, there was the fact that -- in sharp contrast to equities dealers -- the municipal brokers had not catered to the “widows and orphans” which legislators felt duty-bound to protect. Investors in municipal bonds were overwhelmingly banks, insurance companies and wealthy individuals who could look out for themselves.
While municipals were not subject to direct regulation under the Securities Exchange Act of 1934, Section 10b-5, the antifraud provision of that legislation, did provide a basis to prosecute municipal securities dealers in cases of outright fraud. The municipal market had another brush with legislation in the framing of the 1938 Maloney Act to regulate the over-the-counter market, but the old arguments, and issuers’ powerful political allies in nearly every state, maintained the exemption from direct federal regulation.
The municipal market also maintained its tax immunity. In the early 1940s, the federal government forced the issue in IRS v. Shamberg’s Estate. The Second Circuit upheld the tax exemption established by the Pollock decision and the Supreme Court refused to take up the case.
The aftermath of the Great Depression could be interpreted to validate the municipal market’s claims of exceptionalism. From 1929 to 1937, while 30 percent of industrial bonds defaulted, only 7 percent of municipals did. Of the 4,700 municipalities that defaulted in those years, nearly all made good on their debts by the 1940s.
(3) Jerry W. Markham, A Financial History of the United States, Volume I (New York, 2002), 154.
(4) Joel Seligman, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance (New York, 2003), 65; Bruce N. Hawthorne, “Municipal Bonds and the Federal Securities Laws: The Results of Forty Years of Indirect Regulation,” Vanderbilt Law Review (Volume 28, 1975), 561-619, see 582.
