The California Debt and Investment Advisory Commission (CDIAC) accepted the proposal Marc Joffe and I wrote, titled Assessing Local Agency Bond Default Probabilities. As a result, for the next several months we will be focusing on the critically important question of what determines when cities default on bonds they've issued?
Surprisingly, the economics literature on this question is not very well developed. Our goal is to spur understanding in this area, and we plan to do so by formulating a default probability model that is 1.) firmly grounded in economic and finance theory, 2.) completely transparent and 3.) parsimonious. We are going to use historical data to estimate our model, and then we are going to use the results to estimate current default probabilities for California cities.
The predictions our model will generate can be objectively evaluated. For example, if our model doesn't predict defaults for Vallejo, Stockton and San Bernadino and Mammoth Lakes, then it probably won't predict future defaults well either. But if it does, then this suggests that our work will inform the public about municipal credit worthiness, and help the State Treasurer's office develop an early warning system for troubled cities.
Moreover, because we are going to be producing some data products as a result of this research, this project will also facilitate future research. This means that if you don't like the model we produce, you can use our data to estimate your own model!
Cate Long has written a nice blog post on our project titled California moves toward open source ratings for city bonds.
This project will advance work Marc has done as part of his Master's thesis and with his firm, Public Sector Credit Solutions. I'm very happy to be working with Marc on this, and the State of California is smart to be investing in the public information goods we will produce.
Finally, in our press release, we were lucky to get a quote from California State Treasurer Bill Lockyer:
"The new model will provide the State an approach to identify troubled cities, and increase the amount of information available to investors and the public," said State Treasurer Bill Lockyer. As Treasurer, Lockyer serves as chairman of the California Debt and Investment Advisory Commission, which issued the RFP for the work and reviewed proposals.