A new paper argues that the collapse of municipal bond insurance is one of the root causes of the drinking water crises in several U.S. cities.

The full paper can be read here.

From the paper:

Public water infrastructure has traditionally been financed using municipal debt partly backed by a small number of monoline insurers. Starting in the 90’s, some of these insurers became increasingly involved with structured financial products unrelated to municipal water bonds, such as residential mortgage backed securities. We show that when these products crashed in value in 2007, municipalities that had relied more heavily on these insurers for water infrastructure financing subsequently faced higher borrowing costs. These municipalities then reduced their borrowing and scaled back investments in water infrastructure, which in turn, has led to elevated levels of water contamination. Our findings thus reveal how the U.S drinking water crisis can be partly traced back to financial market failures.

The findings are consistent with the hypothesis that credit rating downgrades of municipal insurers exacerbate financing frictions faced by local governments. We show that municipalities that had previously relied heavily on bond insurers that become downgraded due to their involvement in structured financial products, cut their investments into public drinking water infrastructure. These reductions in infrastructure investment are associated with subsequent increases 30 in drinking water pollution.

The findings illustrate that the failure to provide safe drinking water—perhaps the most critical public good provided by local governments—can be traced back to financial market disruptions. More broadly, the evidence in this paper suggests that theories of financial market imperfections, which are typically studied in the context of private corporations and households, can be useful for explaining how well municipalities are able to meet public infrastructure needs. Further exploring the ways in which theories in financial economics
can—and cannot—explain the provision of public goods is thus an important area for future research.