State and local governments play an important role in the US economy. They account for about $4 trillion in public expenditures—corresponding to 15 percent of GDP—and employ some twenty million public employees. In addition, they play an essential role in public works, public health, and public safety of communities across America. Even so, basic financial indicators about their fiscal strength are difficult to access.
Over the past ten years, fiscal distress of city governments has become a recurring issue. After the Great Financial Crisis of 2008–9, several cities filed for Chapter 9 bankruptcy, including Detroit; San Bernardino, California; and Central Falls, Rhode Island. The recent financial distress of Chester, Pennsylvania, and Hopewell, Virginia, has demanded the attention and resources of their state governments. Recognizing the risk that municipal financial distress poses, state governments have increasingly turned toward supervisory mechanisms to intervene pre-emptively in the finances of local governments. While some state governments have established systems that allow for periodic monitoring and early intervention, a consistent methodology and systematic surveillance have been missing.
My latest research addresses this shortcoming by assessing the financial health of these governments using both market-based and accounting-based approaches. The results are publicly accessible via the Stanford Municipal Finance Dashboard. The dashboard, which is continuously updated, provides easily accessible metrics to monitor the financial conditions of state and local governments across the United States.
How to measure governments’ financial health?
State and local governments are complex operations, which makes it difficult to assess their overall fiscal health. In addition, the scope of operations differs significantly between medium-sized cities like Norfolk, Virginia, or Kansas City, Missouri, and large metropolises such as Los Angeles and Chicago. Providing a consistent framework that fits all municipalities and states is not a trivial task.
These challenges are, however, not unique to state and local governments. Firms show a similar degree of complexity and heterogeneity. Credit analysts, investors, and rating agencies have spent decades researching and refining their methodologies of assessing the financial health of private enterprises. Two major approaches have emerged: first, a market-based approach that uses information from prices that are observed on firms’ debt obligations; and second, an accounting-based approach that uses financial ratios derived from firms’ financial reports. In my research, I take a similar approach while recognizing the unique characteristics of state and local governments that differentiate them from firms, building on my previous work on governments’ capital structure and public pension promises.
Credit spreads: a timely, market-based indicator
Investors constantly monitor their portfolios and make decisions on what securities to buy or sell. The main trade-off that investors face when they buy a debt security is one of risk and return: the return is the principal and interest that the issuer pays, whereas the risk is that the issuer does not honor its obligations in full. One of the indicators commonly used to describe the return that an investor receives is the credit spread. Specifically, the credit spread is the compensation that an investor receives for bearing the risk associated with holding a risky financial asset relative to the risk-free benchmark—typically the return on debt of the US federal government.
At the country level, credit spreads are one of the primary indicators to assess the market perception of the fiscal stance of sovereign governments. For instance, when Greece was on the brink of bankruptcy in 2012, investors and regulators anxiously watched the credit spread on Greek bonds to assess the progress in the ongoing bailout negotiations.
One of the main advantages of credit spreads is that they can be observed on a timely basis. They provide an immediate, forward-looking indicator of how the market perceives the financial strength of an issuer. This timely assessment by the market has the potential to exert significant discipline on fiscal policy. For example, when former British prime minister Liz Truss introduced her budget in 2022, UK credit spreads spiked, and Truss was forced to withdraw her proposal. The pressure proved so great that she stepped down several days later.
While credit spreads are widely available for countries and corporations across the globe, credit spreads for state and local governments in the United States have largely been missing, despite the substantial role that state and local governments play in the US economy and the $4 trillion in outstanding US municipal debt.
The absence of credit spreads for state and local issuers stems from several challenges. First, the municipal bond market is highly fragmented. There are approximately 50,000 unique debt issuers in the market. Many serve as intermediaries, issuing debt on behalf of the state or local government. Historically, it has been difficult to identify all bonds related to the ultimate governmental issuer. This prevents the association of market prices with the overall credit quality of the issuer. My work solves this problem by drawing on the universe of mandated Securities and Exchange Commission (SEC) disclosures in the municipal bond market. I use these disclosures to link debt instruments and their issuers.
Second, a large share of municipal bonds contain embedded options. Approximately 60 percent of all municipal debt instruments have call options, put options, and early prepayment options. In addition, municipal bonds—unlike other fixed-income instruments—include sink and redemption schedules, which further complicate the pricing. A naive yield calculation—which omits the value of the option and/or prepayment—would thus misrepresent the true credit spread of the instrument. This is particularly salient for instruments with longer maturity. These bonds are especially sensitive to changes in the underlying credit quality of the issuer, and therefore particularly useful in measuring the financial health of the issuer. I overcome this challenge by developing a state-of-the-art pricing model that computes option-adjusted credit spreads for more than 99 percent of transactions in the municipal bond market.
The pricing model is able to simulate a wide range of interest rate scenarios and thus anticipate the potential use of the embedded options. By incorporating information about trade prices, contract characteristics, and market conditions, the model generates bond spreads that accurately reflect the return that market participants face. With these credit spreads in hand, the model then aggregates all available trading information into a single credit spread for each issuer. This model also provides extraordinary performance. It can price several hundred thousand trades in just minutes and can quickly deliver information to users about current market conditions.
Fiscal fundamentals
Accounting-based financial indicators—often referred to as fiscal fundamentals—are an alternative to market-based measures. Accounting-based indicators have the advantage of describing a variety of fiscal dimensions explicitly, yet their backward-looking nature prevents fiscal fundamentals from describing the future impact of changes in fiscal policy. Another major drawback of accounting-based indicators is that the financial statements of state and local governments needed to calculate them are published with a significant delay. This prevents the indicators from providing real-time information about government financial health. For example, the annual comprehensive report (ACFR) of the state of California for fiscal year 2021–2 was published in March 2024—twenty months after the end of the fiscal year.
The accounting-based indicators that my co-author, Seamus Duffy, and I developed mirror the financial ratio approach taken to assess the financial condition of firms. While there are similarities to firms, our approach reflects the unique characteristics of state and local governments that differ significantly from those of firms. We define ten financial ratios that measure dimensions of fiscal strength, including liquidity, reserve position, leverage, and the size and funding of retirement obligations.
California experienced several municipal bankruptcies after the Great Recession in 2009–10. In the following years, the office of the California State Auditor consulted a wide range of stakeholders and experts to develop a tool to monitor the financial health of its city governments. Other states have shown similar efforts, such as Michigan, Connecticut, and Virginia.
Even so, a consistent methodology that applies at the state level, let alone at the nationwide level, has yet to be developed. At the state level, scrutiny of fiscal fundamentals has thus far been predominantly exercised by rating agencies. Our scoring formula addresses this gap at both the state and local level by adopting a single, unified methodology for using accounting data to rate the financial stability of state and local governments. The result? More direct comparisons of state and local governments across the country.
Increased accountability paves the path forward to responsible fiscal policy. The Stanford Municipal Finance Dashboard is available to advance that goal.
Municipal Finance Dashboard
The municipal finance dashboard, accessible at https://municipalfinance.stanford.edu, provides credit spreads for a large sample of state and local governments. It uses transaction prices in the municipal bond market and a state-of-the-art pricing model to compute and aggregate price information for each issuer and debt type. The dashboard information is updated on a daily basis and thus provides quasi real-time information about the market assessment of the credit quality for a broad sample of municipal issuers. In addition, the dashboard features issuer fundamentals for approximately 500 local governments across the United States. The scoring system provides transparency about key determinants of financial strength, including leverage, liquidity, and reserve ratios among other indicators.
