Financial innovations and issuer sophistication in municipal securities markets

Financial innovations can interact with heterogeneous beliefs among investors and lead to an underpricing of debt.  Mispricing could encourage municipal borrowers, especially unsophisticated borrowers, to take on an unsustainable debt burden.  Eventually, this could harm taxpayers and investors, as well as destabilize the financial system.  This analysis uses municipal bond issuers' total debt outstanding as a proxy for their sophistication and investigates the relationship between sophistication and adoption of financial innovations. 

The primary dataset used for this study is the Mergent Municipal Bond Securities Database, which contains data on 2,678,171 municipal securities issued in the US between 1992 and 2012.  Financial measures for the issuing governments are incorporated via merging the securities data with Census of Governments micro data.  Using the detailed codification of the bonds’ features, I identify 25 innovations.  Products with these features were uncommon in the 1990s, and expanded their market share after 2000.  

The 600 issuers that back 75 percent of the outstanding debt adopted 21 innovations for a greater fraction of their new issuance, relative to the approximately 40,000 smaller market participants.  When innovation-linked debt issuance is measured relative to annual expenditures, the mid-level jurisdictions adopted innovations to a significantly greater extent than either states and sophisticated jurisdictions or unsophisticated jurisdictions.  The latter results suggest oversight should be concentrated on mid-level local governments where past innovations have made the greatest inroads.  

Numerous alternate proxies for sophistication are explored, including total expenditures, expenditures on financial administration, total tax revenue, and government type (city, county, school district, etc.).   The main findings persist through these alternate specifications.   The findings are also robust to the inclusion of measures of issuers’ fiscal conditions, such as growth of tax revenue and intergovernmental transfers.