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  • The Municipal Bond “Storm” Is Still Coming

    Posted by Carl from Chicago on November 30th, 2012 (All posts by )

    A while back there was a furor over analyst Merideth Whitney, who made a “call” that the Municipal Bond market had serious issues and would have an increasing number of defaults. This comment was cited as irresponsible by cities, bond underwriters, and others involved in the municipal funding business.

    Many people have been gloating about the fact that these defaults haven’t occurred, such as this article in Bloomberg. The cities and states were bailed out by ultra low interest rates (ZIRP) and a demand for any sort of yield which made their bonds look good in comparison.

    While our insane ZIRP has given a lifeline to many municipalities and states, the facts are plain to anyone with any fiscal sense.
    1. Most states and municipalities are running annual deficits, meaning that they need to keep borrowing more money to keep functioning
    2. Long term liabilities like pensions and medical care for staff (and the many unionized staffers) are continuing to grow and are gigantic relative to money set aside to pay them
    3. Even if the state or municipality were to stop running an annual deficit, there is little capability to PAY DOWN this giant pile of debt

    Detroit, long a leader in social ills, is now a leader in fiscal ills. To be fair, the city is a shambles, with a vast acreage to support, a huge flight of anyone in the upper or middle classes, and a history of corruption and failed leadership.

    The city is down to its last bullet, and reliant on state aid. Per this article,

    Detroit had its bond ratings cut deeper into noninvestment-grade territory by Moody’s Investors Service, citing a cash crisis that may mean bankruptcy or default in the next 12 to 24 months.

    “These downgrades reflect the city’s ongoing precariously narrow cash position and a weakened state oversight framework,” Moody’s analysts Genevieve Nolan and Henrietta Chang said in a statement from the New York-based credit-scoring company. The downgrades affect $8.2 billion in Detroit debt, according to David Jacobson, a Moody’s spokesman.

    Who owns that $8.2 Billion in Detroit debt and what are they thinking right now? They can’t be assuming that Detroit will pay them back – Detroit can’t cover their CURRENT obligations and is shrinking rapidly – much less would they be able to ever pay down this debt.

    In reality they are likely counting on other groups to bail out Detroit, whether it is the state of Michigan, or the Federal Government, because Detroit itself as a stand alone entity shouldn’t be able to finance a night out on the town, much less support $8.2 billion in debt. This game made winners of some with Greek debt, for instance (buy on the cheap during distress and wait for the German taxpayers to pick up the tab) and absolutely could be the right strategy right now, as well.

    If it just was Detroit, that would be one thing, but California too is now starting to hand it to bondholders. Cities in California are now testing the limits of bankruptcy law, and not paying the debt nor the payments for retirees to the state system. Thus this article describes how the state retirement system (CALPERS) is suing to demand payment, and saying that retiree obligations come AHEAD of creditors (municipal bond holders) in the queue.

    “The issue is, do Calpers obligations supersede unsecured bondholders?” Fabian said in a telephone interview. “There’s an awful lot of unsecured bondholders in California. If you put pension obligations to Calpers as secured and senior to unsecured debt, in effect those bonds have been downgraded.”

    In the Stockton and San Bernardino cases, Calpers is arguing that pension contributions must be made ahead of payments to other creditors because they are so-called statutory liens, or debts that state law requires to be paid. Bondholders and other creditors that oppose Calpers argue that pension debt is a contractual obligation like any other.

    You’d have to be nuts to buy California municipal debt if Calpers has precedence and employee retirement benefits can’t be cut, since this is the MAIN THING that is driving these cities into insolvency. In the future likely these municipalities would just contract out everything to third parties that wouldn’t pay their employees those giant benefits, but the cities have to jettison these liabilities to put their fiscal house in order today.

    In New Jersey and New York, tropical storm Sandy was a sad reality and many lives were lost or disrupted as a result of the storm. Now who pays to clean it all up? Not the states of New Jersey and New York – it is the Federal taxpayer, and the precedent is Katrina (as if we did a great job with that) per this article. The damage to New Jersey is cited at 36.8 billion and

    “I’ve called this our Katrina, because the damage is like nothing we’ve ever experienced,” Christie, 50, told reporters today in Trenton, referring to the 2005 hurricane that left much of New Orleans underwater. “It’s going to require a great deal of federal assistance.”

    New Jersey will request funding from the Federal Emergency Management Agency as well as from Congress for supplemental appropriations, Christie said. He said his administration is seeking 90 percent reimbursement from FEMA, rather than the 75 percent it typically provides.

    Of course New Jersey and New York, two of the richest states in the Union, can’t support their own rebuilding, because they are both running structural deficits and their unfunded obligations to municipal employees grow year after year. Thus, similar to Detroit or California, they are assuming that the US government will bail out their economies, even to a larger percentage than normal (90% vs. 75%).

    The common theme with these three items is that they all represent “kicking the can” down the road as part of municipal financing, and the hope that some larger entity will bail them out, whether it is the state, or in the case of the East Coast, the Federal government, which I guess will just run a larger deficit and borrow those funds from China.

    In the end this can’t last forever – the system can absorb a few failures but it is very analogous to the balance sheets of banks in 2007-8 – they have only a little bit of equity to support a massive amount of liabilities – and if even a few of those liabilities go sour and they can’t instantly access backstop cash, they will fall apart.

    The only variable is what happens as they start to tumble – does the Federal government recognize the “moral hazard” of bailing out reckless or clearly unsupportable (Detroit) entities, and how that sends the wrong signal to everyone else? And they can only bail out a few of these entities before the backlog will get overwhelming.

    We will see, and perhaps municipal bondholders are in fact savvy investors, figuring that you can buy on fear and hold them until the last minute as different backstops (state, Federal government) kicks in. You just don’t want to be the last man standing as it all collapses.

    This is what investing has come to, not the fundamentals, but guessing who is going to backstop who, and how it plays out politically. We are a long way from Benjamin Graham and the basic concepts of solid investing.

    Cross posted at Trust Funds for Kids

     

    8 Responses to “The Municipal Bond “Storm” Is Still Coming”

    1. Death 6 Says:

      Carl,
      Thanks for the insight. I was thinking along those lines, but had not put the dominos all in a row.

      Mike

    2. Percy Dovetonsils Says:

      You mention ZIRP giving a “lifeline” to many local governments. It also takes away with its other hand, as pension liabilites are discounted at a much lower interest rate. Which only makes pension obligations swell further.

    3. Jason in LA Says:

      Meredith Whitney has been directional correct since she downgraded Citibank in 2007. Her timing may be off, but many of her calls have been correct. The fact that many of the investment intelligentsia disparage her at every step puzzles me. I thought we wanted analysts that are more skeptical.

    4. Percy Dovetonsils Says:

      Jason, no matter what the occupation, people who rock the boat aren’t appreciated. Whitney’s call did roil the muni market, leading to a lot of indiscriminate selling by retail investors, which likely burned a lot of institutional trading desks & managers.

      There’s also a lot of “she’s a banking analyst, who does she think she is, talking about munis?” going on, too. I don’t think it’s purely a sexism thing, either – I’ve heard female dealers be just as scathing in their assessment. Each sector of finance is pretty clubby.

    5. Mike K Says:

      “Jason, no matter what the occupation, people who rock the boat aren’t appreciated. Whitney’s call did roil the muni market, leading to a lot of indiscriminate selling by retail investors, which likely burned a lot of institutional trading desks & managers.”

      The folks who were warning of Fannie Mae and Freddie Mac in 2003 and 2004 were savaged, as well.

      At the end of 2004, Eisman, Moses, and Daniel shared a sense that unhealthy things were going on in the U.S. housing market: Lots of firms were lending money to people who shouldn’t have been borrowing it. They thought Alan Greenspan’s decision after the internet bust to lower interest rates to 1 percent was a travesty that would lead to some terrible day of reckoning. Neither of these insights was entirely original. Ivy Zelman, at the time the housing-market analyst at Credit Suisse, had seen the bubble forming very early on. There’s a simple measure of sanity in housing prices: the ratio of median home price to income. Historically, it runs around 3 to 1; by late 2004, it had risen nationally to 4 to 1. “All these people were saying it was nearly as high in some other countries,” Zelman says. “But the problem wasn’t just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami, 8.5 to 1. And then you coupled that with the buyers. They weren’t real buyers. They were speculators.” Zelman alienated clients with her pessimism, but she couldn’t pretend everything was good. “It wasn’t that hard in hindsight to see it,” she says. “It was very hard to know when it would stop.” Zelman spoke occasionally with Eisman and always left these conversations feeling better about her views and worse about the world. “You needed the occasional assurance that you weren’t nuts,” she says. She wasn’t nuts. The world was.

    6. Shannon Love Says:

      We will see, and perhaps municipal bondholders are in fact savvy investors, figuring that you can buy on fear and hold them until the last minute as different backstops (state, Federal government) kicks in. You just don’t want to be the last man standing as it all collapses.

      Historically, most people in a bubble know, or at least suspect, it’s a bubble, they just believe they can time their departure from the bubble market. Most can’t. I think the fear of missing out on potential wealth seems to overwhelm people’s fear of loosing current wealth.

      I am certainly no expert on the muni market but clearly their wink-wink, nudge-nudge implied insurance is a big part of their appeal just like the same informal insurance was a big part of mortgage based securities from Fanny Mae and Freddy Mac. What people neglect is that any insurance can be bankrupted by to many claims to soon. It is likely that when defaults start, they will snowball. Municipalities will quickly realize that the first to default will have their debts paid by others, while those who default last won’t if the system saturates.

      I suspect that both munis, Amazon and others are paying low returns now not because they are fundementally sound but because they look like a better risk than anything else. Investors are like someone carrying precious water in a leaky bucket, they’ve got to find the best alternate container quick. With inflation, hey don’t have the luxuary of just waiting.

    7. Robert Schwartz Says:

      Illinois is also in trouble. I was thrilled to be called out of a big investment in Illinois bonds because they could roll them over at 3%.

    8. Percy Dovetonsils Says:

      (BTW, Ivy Zelman is one analyst whose instincts I definitely trust. She’s off on her own now – http://www.zelmanassociates.com – and believes that housing is slowly recovering.)