by Patrick L. Dugan, Everett, Washington
Financial risk in local government not only involves investing money directly but can also involve using capital facilities to promote community development.
The collapse of global financial markets in 2008 demonstrated how important it is to appropriately manage financial risk. When the nation’s largest banks, financial institutions, and insurance companies mismanaged risk, our entire financial system had to be saved from bankruptcy by a federal government bailout. Our entire economy still suffers from the aftermath of that mismanagement of risk.
Mismanaging financial risk in local government can also severely hinder local governmental capacity to finance its services, albeit with far less dire consequences than what occurred at the national level. Financial risk in local government not only involves investing money directly but can also involve using capital facilities to promote community development.1
Financial Risk in Public Finance
As in the case of any organization, the primary financial risk in a local government is the risk associated with losing money in investments. Finance officials want any money that is not immediately needed to pay bills to be “working,” i.e., earning interest or dividends from investing such money. Usually, the more money an investment will earn, the greater the risk that the investment might lose money instead. Since most finance officials want to maximize their earnings from investments, there is always a temptation to pursue riskier investments.
In most states, such as Washington, public finance officials are restricted by state law to investing in investments that are relatively “safe” from potential loss (and, therefore, do not earn very much income). However, the national financial crisis has taught us that even investments that have been assumed to be “safe,” such as mortgage-backed securities, can be far more risky than anticipated and local finance officials need to be more careful than we might have thought. Unfortunately, finance officials are now under even more pressure to produce big returns on investments as the recession’s adverse economic conditions have reduced other revenues. To make up for those lower revenues, some finance officials may be tempted to pursue riskier investments to reap their potential higher returns.
Before the financial crisis, some state governments believed that financial markets were a relatively safe investment, and these states loosened investment restrictions on local government, allowing local finance officials more flexibility to make somewhat riskier investments in the expectation that they would yield higher returns. The poster child for what could happen to a local government if it took advantage of the looser requirements was Orange County, California, in the 1990s. For many years, the county was very successful in their investments, earning high returns and acquiring a national reputation for investing skill in the process. However, their investment portfolio suddenly collapsed in 1994 and the county faced a $1.6 billion bankruptcy from bad investments. Apparently, pressures from the great recession of recent years led the county to forget the lessons it learned from its risky investments in the 1990s, and on January 27, 2009, the LA Times reported another $62 million investment loss by the county.
Financial Risk in Community Development
Financial risks that may be less recognized than direct investment risks are those associated with capital improvements intended to support new development. Many cities use publicly financed capital facilities, such as streets, utilities, parks, etc., to stimulate and encourage private development.
Any time a community makes these types of capital expenditures, there is some risk that the planned private development may not actually materialize, and the financial investment will not achieve the “return” anticipated. Such risks are magnified if some of the financing of the facilities are planned to come from additional taxes or other revenue generated by the new development. In these cases, if the planned private development does not occur, then the funds used to finance the capital facilities must be made up from somewhere else. This is the same as if there was a loss from a bad investment.
I am aware of a few cities that were planning, and had already invested in, major downtown redevelopment programs when the great recession stopped the planned private sector development in 2009. These cities were left “holding the bag” for their investments and had to make up for the loss of planned income from the anticipated downtown development. This, of course, compounded the economic problems they, along with most other cities, were encountering from the recession itself.
A common example of potential risks of this type is utility line extensions. Many utilities will extend a utility line anticipating that the costs of extending the line will be more than reimbursed by new utility rate income from new development to be served by the line. However, if the development does not occur as anticipated, the utility may then have to raise its rates on other rate payers to make up for the loss.
This is not to argue, or even suggest, that cities should not make the kinds of investments described. These investments are often a vital part of achieving our visions for our communities. Nonetheless, we need to be cautious in how we evaluate the development potential that is anticipated to result from the investment in capital facilities. Are our expectations realistic or are we guilty of wishful thinking? Can we shift some of the risk to the planned development? Do we have contingency plans for an alternative development? Do we have a plan to make up for any losses? Potential investments of this nature should be treated the same as financial investments or other risks by hedging our bets, shifting risk whenever we can, and making sure that the potential rewards are worth the potential risks.
Risk managers often note that life is a risk that we cannot entirely avoid. It is risky to cross the street, but that does not mean we should not cross it; it just means we need to look both ways when we do. We still need to invest in our future with capital facilities, but we should be smart about how we do it.
Patrick L. Dugan has been a city planning director and a city finance director. During the last 30 years, he has held various financial and planning positions in cities, counties, and regional agencies in three states. Now a private consultant in Washington, he can be reached at email@example.com.
- This article is only intended to address “financial risk” and not the much broader topics of insurance and risk management in general.