On Tuesday the Wichita City Council will consider a bailout of a real estate development. If the council takes this action, it is one more step in a series of bailouts granted by the city, and it sets up expectations that the city will continue bailouts, creating a severe climate of moral hazard.
The property in question, owned by South Beech Development, LLC, received a loan from the city in 1995 under the HOME Investment Partnerships Program, a project of the U.S. Department of Housing and Urban Development, or HUD. According to city documents, the project has not generated sufficient cash flow to pay back this loan. The loan balance of $195,000 and $368,437 in accrued interest are unpaid.
The recommendation by city staff includes forgiveness of the $368,437 in accrued interest owed the city and a reduction in the loan interest rate, among other provisions. City documents indicate that if the project does not continue to meet the guidelines of the HUD grant, the city will owe HUD the loan balance of $195,000.
There is no way to characterize the recommend action as anything other than a bailout at taxpayer expense. It’s not the first time the city has done this. In 2008 the city made a $6 million no-interest and low-interest loan to movie theater own Bill Warren and his partners. The theater was in a tax increment financing (TIF) district. The city had borrowed money and used it to benefit the Warren project and others nearby, including building a parking garage that charged only $10 per month for each parking space. The expectation was that the theater would be able to pay off the TIF bonds through its property taxes. But when the theater wasn’t performing well, Warren threatened to close it. That would leave city taxpayers on the hook for the bonds, so the city lent Warren the money.
That’s a similar situation to what the council will face Tuesday. If it doesn’t prop up a failing investment, it’s going to cost us nonetheless. We find that government subsidy paves the way for bailouts, again.
There are other examples. Last October the city restructured the loan agreement for the Ken-Mar TIF district. This shopping center had already received $2.5 million in TIF financing, but the development turned out to be not as profitable as projected. Despite the fact that the city had a personal guarantee from the developers to cover any shortfall in TIF revenues, the city restructured the loan, saving the developers about $30,000 per year. Another bailout, and to politically-connected developers, providing another lesson on how Wichita and Kansas need pay-to-play laws.
Most recently the city bailed out new home developers with a program that rebates the first five years of city property taxes for buyers. City Manager Robert Layton said the “tipping point” for him was the ability for the city to collect delinquent taxes from the home builders. Despite the fact that the city tells us that there is a very low probability that these special taxes will go uncollected, the city issued another bailout.
Moral hazard
In economics, moral hazard describes “the idea that some actor will engage in overly risky behavior because he believes that he’ll be bailed out if the risk goes bad.” (Jagadeesh Gokhale, When to Worry about Moral Hazard?)
In a Cato Institute Policy Analysis, authors W. Lee Hoskins and James W. Coons write this regarding moral hazard: “It sends a message to investors, both foreign and domestic, that they can invest with little fear of a total loss. That weakens the integrity of financial contracts and the scrutiny that contracting parties would otherwise apply to each other. It also results in excessive risk taking because a third party bears the risk.”
The Wikipedia entry on moral hazard explains “Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions.”
All this applies to the City of Wichita and the bailouts it has issued, and the one to South Beech that it is considering next week. When people believe the city — or any other governmental or quasi-governmental agency — will come to their aid if something goes wrong, it means that the risk taken is not real. The taxpayers of Wichita have taken on the risk of these projects without agreeing to. The loan agreement between the city and South Beech didn’t say that the city would forgive the loan interest if business was not good. But now the city proposes acting as though there was such an agreement, shifting business risk from borrower to creditor.
This rewriting of contracts in arrears is a prime example of moral hazard. We have decreasing confidence that the City of Wichita is willing to hold its private sector partners to their word. This situation is sometimes referred to as socialization of risk, and privatization of profit. It applies to what the Wichita City Council is considering, and the council should reject this bailout.
Part of this article was rewritten to clarify the nature of the city assistance given to the Old Town Warren Theater.
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