In the past three months, bondholders have withdrawn more than $24 billion from municipal bonds. Moving to address this growing queasiness over the safety of state and local finances, Washington is cracking down on governments’ inadequate disclosures to investors. Last week, representatives Devin Nunes, Darrell Issa, and Paul Ryan, all Republicans, introduced a bill that would require state and local governments to offer better information, particularly about their pension liabilities. The Securities and Exchange Commission has already been investigating state disclosures of pension burdens; it settled a pension-fraud suit against New Jersey last year and is now looking into Illinois. All these steps are positive. But disclosing more facts and figures won’t ensure that state and local government dramas have a happy ending.

The feds are on the right track. The SEC should enforce its rules and bring civil—and even criminal—action when warranted. Moreover, the commission, with help from Congress, can mandate better practices. Regulators should demand that state governments publicly produce five-year projections of their expected revenues and spending, updated quarterly, as New York City does. States should report on their pension “debts” differently, too. To pay future retirees, many states count on their pension funds’ earning 8 percent annual returns. If returns fall short, state and local governments will have to pay more in the years and decades to come. Instead, regulators should require states to report a range of potential returns; investors then could decide on their own which return was likeliest and assess the states’ obligations accordingly.

But poor disclosure isn’t the most pressing problem, any more than it was in the financial industry before the 2008 crisis. Consider the disclosure habits of AIG and Lehman Brothers. In 2007, when AIG investors learned that the insurance giant had predicated its liquidity—and thus its right to exist—on its trading counterparties’ random estimates of the values of opaque securities, investors wondered why AIG hadn’t said something about this business model before. Similarly, following Lehman Brothers’ collapse in 2008, investors protested that the bank and its auditor had skirted accounting rules, to put it delicately, to pretend that the bank had borrowed less than it had.

Yes, disclosure was missing, and in some cases fraudulent. But adequate disclosure shouldn’t have been necessary for investors to figure out that something was wrong. It didn’t take analytical ingenuity to see that financial-industry debt had nearly doubled between 2000 and 2007. More debt would magnify the impact of inevitable mistakes. Moreover, public information indicated that investment banks such as Lehman were testing the limits of increasingly opaque markets to make ever-higher profits. The same holds for AIG. Way back in 2001, the Wall Street Journal ran an article about the insurer, “Deciphering the Black Box,” that concluded that no one knew exactly how it made its money. Three years later, a New York Times story called “AIG: Whiter Shade of Enron” informed readers of “disturbing similarities between AIG and Enron: Asleep-at-the-switch auditors. Secretive off-balance-sheet entities that should have been included on the company’s financial statements but weren’t.” Further, if investors didn’t like the information that AIG and Lehman were disclosing, they could have asked for more—and, if they didn’t get it, taken their money elsewhere. The reason they didn’t ask was that they didn’t care.

For people trying to decide whether to invest in states and municipalities, the big picture is likewise clear, thanks to what states’ annual reports and other sources—including newspapers—already tell us. Illinois and New Jersey have underfunded their pension plans for years, blatantly skipping multibillion-dollar payments needed to fund future benefits—or borrowing from bond markets to make payments—when ponying up hasn’t suited them. California hasn’t balanced its budget in at least a decade; its second-biggest use of borrowed funds is deficit financing. Publicly available information has allowed many people, including Joshua Rauh at Northwestern University, to do their own calculations of the condition of states’ pension funds and come up with shortfalls higher than the official numbers. True, of a recent sample of 17,000 municipal borrowers—mostly small issuers, including as school districts—more than a third hadn’t produced financial statements for at least three years, leaving investors with scant information, according to a study commissioned by the Wall Street Journal. But isn’t that fact alone a signal to be wary? Investors also have other resources to consult, such as a report from the Federal Reserve showing that municipal debt has doubled in a decade.

In short, you don’t have to know all the details to ask whether these growing liabilities are sustainable. If you think that stock-market growth and reductions in future workers’ benefits of the kind many governors are now pursuing will take care of retiree promises, or that borrowers will continue to uphold obligations to treat general-obligation and other senior bondholders as a top priority even if retiree costs someday overwhelm budgets—and you think that other investors will agree with you—then fine. A diversified portfolio of municipal investments will probably protect you from one-off mistakes and frauds.

If you think not, though, don’t be surprised by the dirt that emerges when the thing cracks, whether it’s tomorrow or 15 years from now. A rising market, enabled by willful investor ignorance, can hide bad things for years. Bad disclosures are a symptom of this problem—but they don’t cause it.


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