A strong bond rating can tell investors that a city is likely to repay its debt. It says much less about whether that city can afford to replace the roads, pipes, and other infrastructure its residents depend on. Richard Ciccarone, president emeritus of Merit Research Services, developed a new metric using financial statements from nearly 2,000 cities to estimate that burden. When he compared the infrastructure burden with government bond ratings, the correlation was surprisingly weak. Cities can remain attractive to creditors while aging assets accumulate replacement costs that no bondholder can force them to address.
Hey everybody! This is Chuck Marohn. Welcome back to the Strong Towns podcast. Today's conversation is going to be about a paper that tries to answer a simple but important and really elusive question: How much of today's public infrastructure has already been consumed, and what will it cost to replace? Richard Ciccarone analyzes the audited financial statements of nearly 2000 cities and develops a measure that he is calling the infrastructure and capital asset burden.
His conclusion is that local governments are carrying more than a trillion dollars in hidden replacement obligations, obligations that don't show up as formal liabilities, but nonetheless represent a significant financial risk. Today, I want to spend the conversation understanding his methodology, his conclusions, and what this means for the future of our cities. Richard Ciccarone, you are president emeritus at Merit Research Services. The report is called "Infrastructure and Capital Assets Commitment Burden: Quantifying the Hidden Risk."" I'm so delighted to chat with you. Welcome to the Strong Towns podcast.
I'm delighted to be here. I learned a lot about Strong Towns and what you're trying to do to build more resilient, robust communities, and that's something we need very badly.
Well, I appreciate that. I have only in the history of this podcast, I think I've been doing this 15, 16 years now. I think I've only had four people from the financial world on the podcast to chat. It's always been a bit of a curve for the audience because they're used to conversations about land use and planning and what have you. The finance conversation is a parallel one. It's such an important one, and I just wanted to start off at the beginning with asking who you are and what your background is to give the listeners a flavor of how this is going to be a bit different conversation than maybe what we're used to having here on this show.
Well, I'd like to tell you a little bit about myself. I've been in the municipal bond markets for approximately 50 years. If you count some of my graduate work that I had in the area, my graduate work started with the goal of working in public service. I graduated with a degree in public administration and urban studies. I've always been fascinated by cities and what we can do to help them to grow and to avoid the downward spiral that's usually associated with the Rust Belt. At the time I started, the Rust Belt conversation was in high gear.
It was post New York City, but we had many cities that were under the microscope that were strong cities at the time, but dropping very fast. Cities like Buffalo, Cleveland, Philadelphia. The list could go on, particularly in the Midwest, but in the Northeast, the same. Our interests, I think, from the financial community that I found, and that I had when I was coming out of the academic environment are similarly aligned. I was surprised when I got in the business how much of value that my education provided me in that area, and in many ways, the objective was the same.
We provided rewards financially by having lower rates for those governments that were doing their job well and growing their economy and helping themselves to actually live within their means if their economy wasn't growing. How did we take a look at that important objective? There are two cardinal rules that every analyst learns when he's new. There are two principles that you're evaluating: one, the ability to pay, and the second one is the willingness to pay a municipal bond. Now, the ability to pay would make sense. I mean, we have to say that not all cities are created equal. Not all local governments are. Not all states are.
In the world of municipal finance, not all airports, public power, and even we have in our world interest in hospitals and higher education, just to name a few. It's much more pervasive than people think. In all of those cases, how do we assess them so that we know that they're doing a good job? Now, management is a very hard, I think, a very difficult facet of when you're evaluating because you really need an up-close vision of what's really going on when it gets to management. Elected leadership, and so to achieve scale, we tend to spend all of our time looking at numbers. I, I say all of our time. I that's not fair.
When analysts evaluate municipal bonds, they're sizing up that ability to pay. They're looking not only at whether they are living within their means on a balanced budget, but they're looking very closely at the economic base that impacts that revenue stream or will take away from it. So you're looking at the trajectory of that particular economic growth area. So all those things are something that you would be interested too.
The difference, I think, from what Strong Towns does and what municipal bond analysts would do is that although they often get interested in coming up with bonds that they can invest in that are solution oriented to make these places better. Their primary job is to evaluate them on a quality scale relative to their peer groups. From that scale and where you find yourself, it is an input. It's not the only element, but it's an input to what the borrowing cost is going to be, and I think in your case you're looking to provide them with answers and ideas and energy to help them to find good solutions to making them better places.
So they're a little different on the endpoint, but they're very similar how they get there? You're looking, assessing the community, and saying what do we need to do to get it better. We're looking to assess the community, and we're saying where do they stand right now, and what does the future look like? A very important, I think, objective that I had in my career, and as well as any analyst that's in the business, is you're trying to assess where will this bond be in 30 years? So you have to think forward. Again, a resilience factor there because your bonds last 30 years or more, sometimes less, but you're looking long-term.
So you're looking at will they be able to sustain whatever path they're on, improve it or get worse. That is something that I have loved to do, challenged, but I, like many of my colleagues, do get excited about financing ideas that seem to be moving the community in the right direction, and we get very concerned as when budgets are not balanced and when debt gets too high. No analyst, good analyst, will ever give a higher mark to a bond just because it has more debt to sell. In fact, there will be a time in which they will back away from that bond issue because there's just too much debt.
Then finally, we'll get to the point here: is that we have learned over the years that there's more to worry about on the long-term than just the amount of debt outstanding that you have to pay, and that was very much an important part of the New York City crisis in the 70s, over too much debt, too much short-term debt as well as long-term debt, and they had trouble paying it back from their cash flow, but we have found as we put more concentration on what are the risks out there, is that we have to look at all their long-term liabilities, and they're identified today as pensions and OPEB, which is other employment benefits, public employee benefits, and I think the new area here in which we've been interested from day one-I've been interested-but I know when I started the business, it started to get interesting-is that of your infrastructure and its standing and its ability to be sustained as well.
Will it cause a problem in the future? Is it going to become too costly to repair and replace? So there's a lot of things that I like to talk about when I get into it. But my career started as an analyst. I've loved being an analyst.
I did have positions in the municipal bond market beyond being an analyst, including many years as a manager and director of research, and I was also on the investment side, where as an institutional investor, we bought the bonds, packaged them for our clients, and the idea was that we were protecting our clients from not only the risk of default but the risk of dilution, and that is that when you buy a bond, it's not the investment you choose to say you're going to get a big windfall out of that bond issue. We're you're looking for a safe return that's going to last.
It'll be higher than the inflation rate, and we used to say these are investments you can sleep on because they were not a source of concern. But as over those years, there have been many situations in which there have been bonds that have become problematic. So we try to avoid that. I have also been an elected official and put my skills to work as a government official for a town of 20,000 people in Illinois. A lot that I could say about that, and I've also involved with.
We tried in the 1990s to be one of the first parties to come up with a website designed to provide guidance for cities and states and counties and governments as to what would make a good website. Well, how would you provide the information that your citizens need in order to be a part of understanding the city Better so. Lastly, what I'm in today as president emeritus is, we started one of the very first municipal bond databases in 1985. In fact, very likely we're probably the first municipal bond credit database, and we started to build it up over time.
It was a very expensive proposition in 1986 when we started selling it, computers were 3,000, and if you do an inflation adjustment on that, that'd be equivalent of $9,000 today. Right. It was not an easy thing to get that off the ground, but it built a platform which today we are used. We stuck around a lot of the firms that I was with covered the deficits that it took to build this database up, and create the software that goes along with it, which allows us today that is to do the job that we are going to talk about with infrastructure. So that's not a thumbnail sketch. That's
Fantastic.
It covers a lot of territory.
The story I want you to talk about has an inflection point in the early 2000s, when we start tracking infrastructure. Can you talk about the kind of questions that you would have asked prior to that? What was the municipal bond market like in the 1980s and the 1990s, and what was the tension that got us to a point where, in the early 2000s, we started to ask maybe some different questions?
Well, it's interesting. If you don't mind, I could say that the interest in the subject matter has been going on before that. But let's just start with where you're talking about here. I think there's an awareness as you got to many studies about the Rust Belt, which included primarily the Northeast and Midwest.
Although you could find cities in the South, such as Birmingham, Alabama, that was steel oriented, that would have the same problems as you found up north, and even some of the cities by that time, and even as far away as California in the West, that had these, where they had industries that were no longer as competitive, and the global economy began to take a lot of jobs away from these improvements in the manufacturing process meant that they needed fewer jobs. Now, as those cities declined, it became much more apparent that they needed more money to fix their cities. But what happened is, about that time, it accelerated.
It had been happening before that, but it was quite apparent that our industrial cities, even the small cities that were industrial cities that we had in the past now were not attractive to a lot of new homeowners and or businesses. They weren't the place that people wanted to be in and grow, and therefore they did not have the tax bases to support the amount of infrastructure that they had when they were at their peak, which is a problem that becomes worse as you go on. At about the same time, we were dealing with a situation in which there was increasing awareness in the backdrop of the pension liabilities going on.
What does that do to? Well, pension liabilities were always tied to an index of compensation. So when I started in the business and I was looking at public administration jobs, public administration jobs at that time were paid pretty low on the compensation scale. So what you have is you start with pensions and you say was becoming more aware. Pensions had started to run up some big numbers, and the actuarial studies were nowhere as refined as they are today, and they had very high discount rates. The discount rate was a reflection of inflation to a large extent, as well.
As you go back to the previous 20 years, inflation rates were much higher. They're also supposed to reflect the investment return rates. They're in that investment return rates can be tied to some extent to the inflation, but the fact is the numbers were apparent. They didn't they didn't break open into the negative at that point yet, but that was in the backdrop.
So, how do you handle rising salaries that started to kick in the 1980s to pay for this growing workforce you had in state and local government, and pensions were based on a very low base at that time, and they were indexed, and when that formula did not change on a higher salary, these numbers start to get bigger and bigger and bigger. You add in the fact in the backdrop, you have people living longer, so the mortality rate is changing too. So your oh the other public employment benefits cost was also going up. Healthcare costs were going up. So as the 2000s came up, it didn't break open into a serious problem.
Some good stock market years that came in the late 1990s and into the as the internet age came into play, you saw some price spikes on stocks and investments that came in. It set the stage for where we are today. But what really where this broke open into a very serious problem when you put it together with infrastructure that is tied to aging economies that was not being kept up is that you had the 2000s? I think it started in 2007 with the collapse of a couple of important companies that were the precursor.
But by 2008, we were in a full-blown great recession, and at that point in time, investment returns dropped like a rock, of course and when that happened, we were exposed to seeing these pension funding ratios plummet to very low levels, and the benefit concerns were: Do we have enough money to cover? Do we have all enough money in our in our what we've amassed for funding to cover the pension benefits that were going to be down and were coming up in the future. So with that exposure of the pension crisis, we all took very hard looks at pensions and saying we couldn't handle this.
When you looked at the looming infrastructure crisis, it only looked worse because every dollar you set aside for other long-term liabilities, whether debt or pensions, meant that it was $1 less that was available to spend from your existing funds for capital improvements, and of course, it would have amplified your. If you go to the debt markets, you only increase the amount of total liabilities you have when you include both debt and pension liabilities, and later OPEB. So it became a massive number. So, where do we follow from those years?
What followed were years in which infrastructure in many of the most difficult cities was the last thing paid for in terms of repair and replacement, and therefore the funding gap for infrastructure and capital assets became a clear and present concern to me, and that's where we are today. If you go back to this issue when it was first raised in the 1970s, late 70s, and then highlighted in a book in 1980 by Pat Show with America in Ruins is that everybody talks about it, gives it lip service over the years, but as Mark Twain said, everybody talks about the weather, but nobody does anything about it.
Nobody was really doing enough in this area, and part of the reason we're not doing enough is because there was no way to quantify in dollars the replacement value of what you have to do, and I think that puts a target and an objective on it. It's not just a concern that could be swept aside because there's no deadline for when this amount has to be paid, and so we tend to put it into momentum and see how far these roads can go.
There's a point, and I remember it because I was working for a bunch of cities at the time who felt very stressed out about having to now account for infrastructure as part of their annual financial reports.
Now I know your base point. Why did you choose the year you chose?
There's an inflection point there. Where did that come from? I almost feel that today as we look and we feel like there's not enough information to make some of these decisions. There was no information prior to what was it? 2003. How did you work as an analyst without knowing this stuff?
It was a lot of talk. It was a lot of perception issues, and we were hungry for data, and in order to help us to assess it, and initially getting the data would not have been the end game. We'd really have to develop a timeline, a trend line, and put it in. Use the numbers in a way that would make sense, so we could account for them as a replacement cost and view them as a long-term obligation, which we weren't doing.
What really brought us to the point we're at today was a long period in which people on the governmental side of municipal finance, as well as the investment community, wanted to see better numbers, and the Governmental Accounting Standards Board had listened to that information and began to gather input that got us to the first step in putting numbers on the books of governments, which was around the turn of the century, around 2000, which is where you're, yeah, yeah. Where I know you're focused on that and have been, and that was an important first step. That took a tooth-and-nail argument.
Governments saw it as an unnecessary and very difficult task, and they did not keep the records.
At least that's what commonly was testified in the hearings, and they did not keep the records that would provide sufficient documentation of historical costs and the timing of when that infrastructure was put into service, and so to have a good accounting system, we need to know historical costs and we need to have numbers on estimated useful life that goes into that kind of assessment, and therefore, once you have that, you can set depreciation expenses, and you can formulate an accumulation of those depreciation expenses, and so one can see what that's running to.
But it's a very complicated area for people that have not been doing that, and in public administration programs, accounting was not a big part of those programs, and that's why many of your financial officers, but not all, came from a corporate background rather than a financial background, and the people in leadership as elected officials and in city management, didn't have that background either, so it was all new for these individuals come in.
When the rules were put into place with GASB Statement 34, it was fought tooth and nail before being accepted by government finance officers, and in fact, some of the government finance officers said they wouldn't implement it. They had been using a modified accrual-based accounting, which had very little inventory information in it relative to capital assets. At that point, the way I was looking at it, this information still was limited and not as robust as it needed to be.
I had been working on methods to take the information that we had over time, and turn it into a number that can be used to formulate an infrastructure and capital assets burden number, which is essentially an obligation that we can use today and put it in as an assessment and look at it relative to our other resources that a community has relative to its population, its tax base, the size of the government, and scalable issues like that, and say, are they? How do they compare to their peer groups? We felt that was an area need to be covered, and so we're getting that for the first time now with our numbers.
Let me walk through this for a second and make sure that I'm understanding, and I think the audience is understanding. At some point, cities had-maybe somewhere outside their financial records, in a capital report or tracking system. But really, I can tell you, I can attest from the cities I was working with, they had pipes in the ground, they had buildings in their care, they had roads that they had were obligated to maintain, and they had no inventory of it, no number for how much it cost to build, and no estimate of how much life was left. The basic like debate was: Can we actually ask local governments to track that stuff?
That seems like a very simple thing, or maybe not a simple thing to do, but like an obvious question to ask. It's tough for me to understand that not only was that question not being asked, but when it was asked, local governments said, "Hell no, we don't want to do that. How should I understand that debate? That it makes it sound like government accounting is kind of a joke, quite frankly. I know you don't think that, and I also don't think that. But why were we not doing this?
When you get into government accounting, it's relatively a young standards board organization, and its very founding was fought by governments. What rules you did have were very basic rules that were put together by states, and it had a lot to do with cash basis accounting, which is essentially just a checkbook style accounting, and many of them were comfortable with that. At the end of that, you just tabulated what you paid out and what you're getting in, and that was good enough.
Can I say this a different way, Richard? The city is making multidecade investments.
Yes.
When it comes to pensions, making multigenerational promises and doing it with a checkbook ledger.
That's not good enough, and that never has been good enough. In fact, they started to change that. Most governments, if you go back into the depression, and then you go back to the 1950s and 60s and early 70s, that's the way they ran their books. New York began to wake governments up of what we have because if you go to the New York fiscal crisis in '75, is that the books were inadequate and they didn't show how much debt they had outstanding on a on a liability basis.
You can't you got to take into consideration your liabilities and if you don't do that, then you're not prepared to handle future events, which may not fit into the mold in which you've seen the past or would like to see in the future, and therefore we have to constantly be prepared to what are we already committed to, which is your liabilities, as well as do we have any money coming in that could mitigate that, and they weren't doing that. So by the time you got to the 70s here, late 70s, and then the 80s, modified accrual accounting, which was one of the first areas of interest of the GASB, became the standard, which was a limited accrual.
Corporations do accrual; they look at both of their liabilities and their receivables. Governments were primarily looking only at when modified accrual came in, only looking at the liabilities and not much on receivables. Both are important, and I learned the value of audits that would come out during that time, and those that were doing it the right way, but I would find information in the footnotes, which are also supposed to explain things that are anomalies as well as some things that are just standard practice. I found cases of two big city credits, which we call we call a government a credit in our world.
In the case of two big ones, they were running into a cash flow crisis, and that was disclosed in the footnote. Had it not been an audit, had there not been a footnote, I would not have known about it, and we would have loaned money, and we would have sold that to our investors, who would have received defaults on their hands because the government was nowhere prepared to be able to pay back short-term debt in those cases? So, those were all critical elements we needed to advance along, and the world of modified accrual accounting, which was halfway there.
Meandered along in the government finance world, and governments got used to it. It was it was fund accounting, and when the GASB tried to put a full accrual system into place, which should include assets, not only desks and chairs and fire trucks, but it would include all of their infrastructure, and when that came in and that started to move along in the 1990s, governments again fought that. Going back to your original point, they said, "We don't have those records.". Well, I know that it's hard to penalize for something which has been a practice, and now you're changing the culture.
I'm willing to accept a system that is developed that really will kick in with full capabilities and up to its full potential. That if you look at it as be prospective, so you've got to get started on doing it the right way. Same issue we have today, but at that time, I mean, if we looked at it is what do we need to make this better? We don't have it all now. We may not have all of our historical records. Let's make sure we go back as far we can, be as complete as we can, and go forward, and providing no excuse that we won't have the records we need.
So in today's world here, I'd love to talk more about the issues you're bringing up and how they affect the accounting world today, as well as governments and what they're trying to avoid. But the last thing I'll say about the past is that when GASB 34 came in, because it was fought so hard, there were a lot of compromises made just to get it approved, governments have a very strong role on the GASB. I think they have very good representation on make decision making in that area, and there were compromises made, particularly in the arean infrastructure.
So any asset that had been put in place before 1980 was given a pass that they did not have to be in the books for historical cost, and that's a problem because there were governments that had let things go without updating them, and therefore, when their historical cost is not there, you don't have a depreciation expense number to work with, and you wouldn't be able to develop the system that I have been working with recently, and putting a number on it because there's no schedule for measuring, in dollar terms, the life of that particular capital asset.
GASB is the Governmental Accounting Standards Board, and I have been over the years a bit critical of GASB, largely because when I look at the way we do accounting for infrastructure, we put infrastructure on the city's financial report as an asset that depreciates over time. So if I build a million-dollar road, it's going to last 20 years. I just have a straight line $50,000 a year depreciation. My argument as an engineer is twofold. One, that's not how roads depreciate.
Like roads fall apart pretty quickly and then stay at a kind of crappy level for a long time, So they have kind of like an S curve depreciation schedule, and then second, it's not a it's not an asset. You can't sell it. Like it's not like a piece of equipment that I could salvage and sell. A road is a liability. Like the taxpayers are planning on me fixing that road. If I'm not accounting for that, I'm missing something. The report that you wrote is kind of trying to get at that to a degree. How should people understand government accounting today?
Which I'm glad you told the story because it feels like we are in a much better place than we were a generation or two generations ago in terms of knowing what's going on and understanding what's going on. What should we be thinking about this infrastructure gap? how do we get our minds around that? Yes,
Well, you've asked some good, good questions, and they were questions that I asked too. There's no perfect answer to your questions, and there won't be. So, what you try to do is saying, "What's the best we can do? Somehow, maybe in the future world of 200 years from now, artificial intelligence will tell us exactly how fast things are depreciating. Yeah, and you can take that. I mean, the engineers would love to have that in some ways. Maybe they can help promote that kind of thinking. But if you go back to the first thing that you mention here, and that is the estimated useful life.
That it's not necessarily straight line, which is what most almost all cities use or governments use. I don't believe straight line depreciation, which means every year it's sort of the same amount, is. Required, but everybody use it because the I just don't think that we have the know-how to do it any other way, and should not be comparable. We do always try to do when we evaluate things, try to find the most comparable methodology that we can compare one to the other, or because otherwise, what you have is we want to take, we want to use the numbers that are reported by the government that they're own.
We're not trying to create the world in our own subjective way because it would be a subjective measurement. If we were to try to do it, and so if you get into the subjectivity of you make assets with a shorter useful life. The way the numbers work is that your depreciation accumulation would happen much faster, of course, and therefore it looks like you need to rebuild or replace or repair much sooner than if you have something that has a much longer estimated useful life schedule.
When these were done, and when the standards were accepted, in what is really typical of these documents is that they're they usually rely on they usually rely on the engineers to tell us what is the generalized estimated useful life of different types of capital assets, which lies both a necessity but also a vulnerability and weakness. Because if you look at the numbers that are put in here, many of them are if you did the dollar-weighted average of all cities in the country, and say what is the dollar-weighted average of all their capital assets?
The number comes out to being around 34 years, and that would include because it's capital assets, it would include things that are shorter than 10 years, and it'll include things that are as long as 100 years or 75 years. So the dollar-weighted comes out. I looked at the cities. We did a very lengthy study before we finished ours of looking at that very issue. The other thing is the naming standardization of what you call what and is what kind of a number you sign to it for the SBU life. This is where it becomes at best an art. It's definitely subjective as to what you classify everything.
I would like to see, and I've asked for this in comments to the GASB, being more standardized in those areas. Now, infrastructure is better than the other capital assets on having definitions. The infrastructure definition is that it's a network; it's what you have in the ground, which would normally be associated with things like roads and bridges and sewer and water, but not does not include buildings unless they're ancillary to say an electric plant. A building could be very much an infrastructure to some places, and some people think of it as infrastructure.
Even if you look at it, is it whatever physical assets that you rely on are really important to the question because they are what makes a government work, and we know that roads and sewers are really critical to that. But we also depend on administration buildings and where you run your computers or you or you host the police station or the fire station, we have a fire department without fire engines. Can we have a police department without police cars? So there's sort of a core infrastructure that the engineering and accounting community have agreed upon of what is infrastructure.
But there is a begs the question: Should other things be in there, including park equipment and even statues that might be on the ground somewhere in one of the parks. All of these things here. The estimated useful life. It's not standardized as much as I'd like to see it. The range is we'd love it to be more precise, and we'd love it to be more periodic because what they will do in cities is they will establish 20 years ago that this particular our road system goes 30 years on average, or they'll say anywhere from 25 to 50.
Okay, what they should be doing is reevaluating what they're reporting as the measure they're using for depreciation if their roads are tending to go longer or shorter than what they have stated in the past, so we do want empirical evidence. We want actual evidence. Now, there's no periodic requirement. That's among the potential rule changes that are being considered by GASB. They're being bought, of course, again by cities, but that would make the system better. So we get more systematic ways to evaluate that, but you asked another question. We're asking about how these end up being a liability.
You see them as assets that we're not going to do away with. Yes, that's true. That's not really true completely because assets can go away in cities or any government. Sure. For instance, if you go to Detroit and you this was one of the largest land masses in the country, as a city on its heyday, and it had neighborhoods and streets upon streets, and they love roads, they have bridges, et cetera, et cetera. As that town shrunk dramatically from its peak period of time, you have neighborhoods that are large-scale open fields. Yes, you need all those rows. Well, if you never take them out, you do got to keep them on the books.
But if you start to condemn them, and let's say that we make fields out of them or undeveloped land, then these assets do come off the books. So they're not necessarily always going to be on there, nor should they be on there? As long as you want to keep them active as a as a part of the services to the community, they should remain on the books. Now, does that mean that everything is permanent? Most things are. Most of them we expect them to be, but it doesn't have to be that way. In the future, we may see changes in that area. The issue of liability when you say we put them in, then it's just a liability forever.
As we've talked about with depreciation schedules, it doesn't fit It doesn't fit the definition on liability of accounting, and that's true not only in governments, but it's true in corporations. To be a liability, you need to have a deadline for when it comes due. There's no deadline if you're saying that they go on forever. There's no deadline that you ever have to remove that road. It just gets worse and worse and worse if you ever fix it up, or the bridge gets worse and worse, and to the point that it collapses and becomes a critical danger for people. So the idea is does it technically meet that rule of liability.
No, does it meet the second rule of liability, that it's paid to a third party? Now, I fought for those issues myself, and I was in the same viewpoint that you were in when I first really got intensively involved in this project back in 2014. I originally called our metrics that we use to measure this infrastructure liability gap, but I walked away from those one that I think capital assets beyond infrastructure are important, although we will look at them as isolated.
But two, the more important one is that I called it a liability gap, much like you did, and I came away thinking I'm going to call it a commitment burden or obligation because it remains an obligation of the community as long as you keep those assets in place. If you take them off, they're no longer going to be on the books, and therefore you no longer have a liability to them. So the idea that it's a burden, it's something that means that you are going to have to cover to be in safe and reliable repair, but it's not required to be paid to a third party. The taxpayers are not necessarily going to be on the hook if you never fix it.
You can go to cities today, which I've seen, in which you look at their roads, their bridges, they're in horrible disrepair. At this point in time, they've been fully depreciated for decades, sometimes. Right. Right. The fact is, they're fully depreciated, and that will sit as long as they're still using that infrastructure. They sit on the books as fully retired, fully depreciated, and it should because it's a measurement that your roads have not been repaired and that they're overdue and they're not safe and they're not reliable, and therefore one should bring them up to code. So you do have those issues that are prevailing today.
The biggest problem is not with the assets that still have battery life left, you might say, but it's the assets whose batteries have been fully used up, and now every day you're praying whether it will work or not today, or not, and that's a problem.
This is where your report suggests that infrastructure burden, in a sense, the amount that has been depreciated out already, and you have an inflation multiplier that you use. It came up to around $1.2 trillion. It's over a trillion dollars was the was the headline number.
Well, it was $1.03 trillion at the end of April, and the number will keep going up over time because of inflation in another year. But yes, it was $1.03 trillion, and that was just on governmental activities, Chuck. I want to make sure that's just the governmental activity side, not the business enterprises,
Which means when you have a sewer district and a water district, and that's not counted in this. That's just the governmental activity side. Okay. When I saw that number, there were two things that came to my mind. Or I'm going to do three. First, wow, that's a huge number. Second. I think it dramatically understates kind of what the actual infrastructure burden would be. Then third, I thought your assumptions were very generous, like your inflation assumption and all that was very generous towards the underestimating side than overestimating side.
In other words, I didn't get the impression that you were going for a sensational number as much as you were going for one that could be defended to everybody. Is that fair? Am I?
Thank you, Chuck. That's exactly what we were going for. The number could have been higher. We removed a few things that would have made it higher, but we thought they were soft inputs as to whether they should be allowed to be in the study, we did not want to come across as just trying to have something that would be sensationalized. So the number could actually be higher.
I'm going to say this again. I feel you're an analyst, and your job is not to sensationalize. Your job is to paint as accurate a picture as you can of what's going on and what your understanding is. How should people who are not analysts think about a trillion-dollar and growing deficit burden? This seems like it should prompt a bit of urgency or a bit of concern.
I think we've known that we have to worry about infrastructure, without a good replacement-cost number or a way to do that on a city-by-city basis. It makes it very hard for analysts in our industry to actually provide this as an input to pricing bonds and actually credit ratings as well. So my first goal here was not just to create an end report. You do it once and that's it, and we're not going to worry about it. We didn't want to give them a big number, tell everybody to be worried, and go home.
What we're trying to do here is develop a methodology that's acceptable, that gets you in the ballpark, and that's what we're trying to do: get you in the ballpark of assessing just where your battery life is on your infrastructure assets and capital assets, and therefore you have a measure. It's very easy to see that you'll have a very high number. Our process works that you get penalized a great deal if you have a lot of fully depreciated assets that are on your books that are still being used-they're fully depreciated. Those are going to have the highest inflation rate impact, and we want those to stand out.
The results of our study showed that they did stand out. Many of the cities you would expect to be in bad shape did show up that way, and we didn't know how they'd show up until we ran the numbers. Our inflation rate was we thought reasonable in the sense that we used the 100 100-year inflation rate. Actually, if we used the 50-year rate, it would have been a lower inflation rate. The 100-year inflation rate was 2.95%. If you used a shorter one, if you start after the 1980s, it would be a lower inflation rate number. Sure, So the inflation-rate number is actually a little on the higher side.
There's a construction inflation rate that, when you look at it, is dramatically higher.
That's a fair point, but there have been people who would have asked, "How did you come up with that?" But I would love to collaborate. I would have done this, and still can, as we are still improving the pension actuarial pension side of the GASB 34, and have made improvements over time. I can tell you right now is if I was in their shoes, and I think as an analyst we would be supportive of that. If you had better methods to evaluate this from an engineering standpoint, I think you're absolutely right. It could be higher in that area because materials are becoming a difficult part of the proposition in that process for sure.
But materials were probably difficult throughout the last 100 years. So at some point in time, so that maybe we're okay with that. But the last thing we did that you would say keeps our number from being sensationalized is that we did not give an inflation rate to everything on the books that would be an accumulated depreciation, we only gave it on the portion that, based on a conventional financial analysis ratio, which is used for both corporates and municipals, is the average age of the in corporates we call property, plant, and equipment, in the muni world you might say capital plant.
So we say that the median for all cities is about 16 and a half years, and so that we used one that was specific to that city to apply to it. So if they're doing a good job and have a shorter average age, they. Will have a lower inflation impact if they have more assets that are fully depreciated or nearly fully appreciated. Then the impact of that will be a bigger burden number. So we did try to take that into consideration when we put our numbers together.
Can I ask? Let me ask you a technical question. I'm so grateful to be talking to you. This is not a gotcha question, but it is a probing one that I want to draw out a little bit. Let's say we have a brand-new suburb that's been building infrastructure, and it's relatively new, but they don't have the development to actually sustain it, they're hoping the development shows up at some point in the future. So, from a return on investment standpoint, they're going to be in a lot of trouble at some point.
They're actually going to look pretty good in the model because their infrastructure is relatively new, even though they don't have the tax base or the ratepayers or what have you to sustain it is that a fair nuance of this?
When you give your analysis that way, it's just the kind of analysis that I want our users of our system to do because I couldn't handle every situation in the analysis; this study is 40 pages long. That's rather in depth, and so in our world, that's longer than most people have time to do a detailed job in. But people do get into those nuances as they use something more over time and get the experience. But you're absolutely right. Those fast growing towns that put their infrastructure in but don't have the growth yet, that don't yet have the growth, which may or may not arrive, become really problematic if that growth is not achieved.
In the beginning, the numbers will look very good by our method of assessing them, because most of their assets have not been depreciating very long, and therefore they don't go into the accumulated depreciation column yet, which would be like saying we still have most of our battery life left.
However, in terms of paying for it, if it's an ambitious buildout, and we've actually seen cities that have done this and developments that have done this, they're very exposed if the development doesn't come because now they've got to pay for the debts that they used to finance infrastructure, so the problem shifts to the debt you took on to build that infrastructure. So if you want to know examples, I just exactly the point you're making. One is the Great Depression.
Most of the credits that defaulted during the Depression, 16% of all municipal bonds defaulted during the Great Depression although due to the fact that they the governments at that time had a very strong moral compass and they did everything they could to pay it back. So less than 1% eventually did not get paid back, which wouldn't happen today. Yeah, yeah, yeah. That was before the world of bankruptcy. But that said, the fact is the reason many of those defaulted
Most of the credits that did default were new towns in which the economy, when it sank rather dramatically was not going to live up to the expectations they had in order to be able to cover the debt, much less fill the infrastructure that they had built. That's number one.
Number two, you still see those, and we saw those in the late 1980s and 90s in the area of real estate and some of the big developments before Florida got hot, for instance, some of the southern states, they built developments on the on the optimistic side, and at that time the development was nowhere like it has been in the last 10 15 years, and they got stuck, and some of those deals did default, so your point's well taken, and we're just you're on the right track. I mean,
Let me ask you this as a final question, because I could do this for hours. I really hope we can do this again sometime soon. I watch city officials look at ratings they get from bond rating agencies and hold that up as an affirmation that they are doing well or not doing well. I met years ago with a group from Moody's, I think it was. I don't think it was S&P. I think it was Moody's. It's blurry in my mind, but I had the people who rate municipal bonds.
I had 30 of them in a room, and I went through our Strong Towns presentation, where I showed them here's a development, here's the cost to do this, and we're recovering 20-25% of that over the life of the project, and then the city has to fix it again. There's no money to do it, and I made a case that the return on the public's investment was not there, and so even though it looked good because we've got the assets in place, ultimately in a generation these are going to be really bad, struggling investments. This presentation went over; they were eating it up. They said, "Oh my gosh, we'd never seen this.
This is really helpful information. This is really good. When I got to the end, I asked these analysts a question. I said, "Well, is this going to change how you approach municipal bonds? The answer was no. I said, "Why? They said, "Well, because governments don't default on their debt, and until they start doing that, we are not going to change our ratings, and that has stuck in my mind as this dissonance. I wanted to ask you about it because I, how should I think about how should local officials who want to do a really good job and are being told by their financial people that hey we've got a great bond rating we must be really good.
How should they hear that information in a way that is most honest and helpful to their situation?
I think that the analytical community is always looking for new ideas and ways of assessing, but their execution of those ideas is not always as satisfying as you have found in your case here, and problem part of it is that the comparability, standardization, and methodology Has to pass the mustard, especially these days with the regulators. Who are the regulators? Well, in this case, the regulators are Congress, particularly since the financial crisis of 2008. When? I'm not sure when this occurred. Can you tell me when? Oh,
It would have been around 2014.
That's when they were feeling the heat. The process has evolved and become more sophisticated since I've been in the business over the last five decades. But the fact is, the pension analysis portion of that, which has become a critical element today, really didn't become a significant measure of credit quality until the financial crisis exposed the vulnerability, and when funding ratios were reset and we realized that we had a real problem on our hands, and then it became an input. So sometimes it takes a crisis.
There used to be a mayor who used to say, 'Don't pass up the opportunity to take advantage of a crisis.'
Rahm Emanuel, isn't it?
You said it a little differently, but you got it right.
I get the point.
Anyway, in this area of capital assets, we really have not had a good measurement tool. One of our greatest achievements was not telling you who ranked high or low this year. Our greatest achievement was to put together an objective methodology that could be used and to build on and improve over time, and so all these things are stepping stones to that end. But I think that getting to the really important question that you've asked, and we talked about it: why didn't it get put to use, and why did they say the default rate was low? When the crisis occurred, muni default rates in recent years had been very low.
Okay, and had been for some time, and many of the governmental ones. When I talk about muni's, we tend to think about the governmental portion of muni's. Munis are far more expansive than that. They include a lot of high-yield munis that are project financing. They include hospitals and nursing homes and retirement centers. But the portion that was government-oriented had a very low default rate. That particular fact, since the depression, that is, that particular fact was used by the House Ways and Means Chairman as one of his strongest criticisms of the crisis when munis froze in 2010 and did not have market access.
He said, "How can this be? This is not right. Don't these credits ever default. These bonds never default, and don't they all get bailed out? Which today, I mean, I think that was really a wrong-headed statement to make. But I think that the fact is that there are usually elements when you look at a muni when it actually defaults, it's due to a great deal of distress from lots of debt, lots of liabilities, which includes all the things we've talked about, including, potentially, the pressure you have to maintain your infrastructure. So if you're in that level of distress, that's number one. Number two, you're out of cash.
Okay, when you're out of cash, you can't make that payment. The third thing is the politics involved at that time. Now, politics can be everything from the political leadership's ability to get private financing to provide a financing interim tool to bail you out, which has happened, or it could be the state, it could be the federal government that would come in, and at that time it wasn't there either, because he wasn't ready to bail it out at that time. Although what happened is they actually ended up bailing out the muni's, and that's why the default rate is so low, which is another story. On another time, maybe you have me.
I'll tell you details on that. But I think that the fact is that he said, "These rating agents should be regulated. They're rating them too low. So ratings prior to that time were lower on governments, and they involved more subjectivity. Now they're saying, as a big part of your rating, you have to look at default history and compare it to global fixed-income instruments across the world, and sovereign debt in third-world countries, and on that basis they don't default anywhere near enough, and so therefore the ratings based on likelihood to repay become substantially improved.
Now I wrote an objection to that got a lot of attention in the bond market. I said it was not a good idea because the rating agencies responded and they recalibrated the rating. I wrote a response to that got a lot of attention that said that you can't necessarily base these kinds of things only on default rates of the past because every year brings new risks into the picture. Yesterday's assumptions may not all be there tomorrow, so we have to take a lot of consideration of risks that are perceived. I think that goes to the root of your of your question is you were talking about perceptions that you had for the future.
I think they're legitimate, and that's big part of why we did our study because we're trying to say that this is one of those long-term obligations that can affect you. So ratings tend to be for governments double A or higher. If you get to single A rating, it goes triple A, double A, single A, triple B. Then, if most of the ratings that are in the governmental sector, because of their general obligation pledge, it's a very strong security, will have a double A or higher, and therefore it's very hard to link the ratings.
I did a little analysis before I came on this podcast, and I looked at how our burden metrics, our model numbers, measure up against ratings, and this was, I think, a good thing. We did not correlate.
Wow. Okay.
The correlations were low. There was some correlation, but it was only 0.12 on our model. That's not really high enough, as far as I'm concerned.
Now, we have a second model we created based on fiscal ability that takes the capital, or the infrastructure and capital assets into the picture, into that into the model, but also other things, your other liabilities, your economics that are involved, other things that are in the picture, and now they match up a little better, as they should, because the other factors that the rating agencies take into consideration are in there, but the core capital assets infrastructure ratio, or what we call ICA, did not correlate strongly with the ratings because it's not a strong part of the rating evaluation.
It's based on the fact there's no deadline to pay it. They can just let them go and deteriorate, which is an objection for me and for you. Right, they can let that happen, and there's no third party is going to demand to be taken to court that they haven't done it. The citizens don't do that. So that gives you a lengthy, but I hope meaningful, response to the questions you've raised, and there's so much to this territory, I just can't answer everything the way I'd like to in short terms,
My argument has been the city will default on its promises to its residents before it defaults to its promises to investors.
I don't think it's just to investors, though.
Oh, okay.
They do default to their creditors. They do that too, probably even more frequently.
That's so interesting. All right, Richard Ciccarone. I'm going to put a link to your report in our show notes, so people who want to see that can go and see that. I hope you and I can talk again and keep in touch. I deeply value and admire your curiosity and your long-term interest in digging into this, which is a wickedly complex problem with no clear mathematical answer, but certainly there are strings there to pull on, isn't there?
You said it better.
Merit is the company that you are the president emeritus of Merit Research Services. Thank you, Richard, for being on the podcast. Thanks everybody for listening. Keep doing what you can to build a strong town. Take care.
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