Problems of state and municipal finance worsen. Governors announce new spending cuts at press conferences but inspire little confidence. The fury of emergency announcements leaves the listener (as well as the governors) in a daze. Research reports offer broad explanations but have left bondholders, as well as employees and local residents, unprepared for discontinuities. In other words, there will be instances when these constituencies will find themselves marched to the slaughterhouse without warning.
Following are corrections to the more common misunderstandings.
Claim #1: "General Obligation bonds do not default." Financial planners sometimes reassure retail clients with this claim. Following is a case study that shows how a truth may stumble into a half-truth. A half-truth is often more dangerous than a lie.
From a credit agency report: "Even in the event of default on [General Obligation] bonds, investors are likely to enjoy a full recovery of principal and interest because municipalities are required to levy additional taxes to repay debt backed by the general obligation pledge." The most significant word in that sentence is "likely." [Note: General obligation (GO) bonds are debt instruments issued by states and local governments to raise funds for public works. In contrast, revenue bonds are repaid from the revenue generated by the specific project that the bonds are issued to fund. Only GO bonds are addressed here.]
From a brokerage firm report: "General obligation debt is backed by a state municipal pledge to raise taxes to service debt if necessary." This is also true, but not the whole truth.
Courts have rebutted this pledge. A 1990 Missouri court ruled that "tax caps in effect when municipal debt was incurred cannot be overridden even if necessary to pay off the debt." (Kevin A. Kordana, "Tax Increases in Municipal Bankruptcy," Virginia Law Review) The court admonished the litigating bondholders: "[E]very purchaser of a municipal bond is chargeable with notice of the statute under which the bond is issued." (Missouri had a statutory tax rate cap.) In words the judge might have used: "Stop whining and wasting my time. Next time, read the bond offering."
Aside from a legal interpretation, raising taxes is often impractical. "At a certain point, raising taxes ceases to raise tax revenues." (McConnell and Picker, "When Cities Go Broke," University of Chicago Law Review).
The City of Vallejo, California may be an important precedent. It filed for bankruptcy in 2008. Both bondholders and city employees agreed to receive less money. The decision is before an appeals court.
Claim #2: "General Obligation default rate is 0.01%." This calculation is used to prove Claim #1. From a brokerage firm report: "The default rate on general obligation municipal bonds since 1970 is 0.01%." The calculation is correct. The brokerage firm used the default rate of Moodys-rated GO bonds since 1970.
Although true, this is misleading. It seems like yesterday when all - and it was all - the certified experts bellowed: "House prices never go down nationally." Just as mortgage payments had risen to uncollectible heights, municipal costs have risen to unsustainable levels. This is a different world than the period addressed by the Moodys study.
Even though money rained on municipalities during the salad days (sales tax revenue increased 46% between 2003 and 2007), it was only by playing games with the books and issuing a record amount of bonds that municipal spending grew so extravagantly over the past decade. States and municipalities issued $442 billion of bonds over the five years from 1998-2002. They issued $804 billion over the next five years, 2003-2007. The growth rate was not quite as steep, but, not dissimilar to mortgage securitizations and private-equity LBOs. The downward slope may not look that different, either.
Claim #3: "Most states are required by law to balance their budgets." This implies the restriction on revenues diverging from spending reduces the possibility of default. Municipal finance is often a shell game, shifting capital-project funds to meet today's burgeoning payrolls and benefits. [See Miami's Municipal Woes (Again): Exiting Before the Tide Goes Out].
Claim #4: "States cannot declare bankruptcy." This is a conclusion drawn by statements such as the following from a brokerage firm report: "The state is not permitted to file for Chapter 9 bankruptcy. Such filings are permitted only for 'municipalities' (e.g., levels of government below the state) under certain conditions." This is true. Bankruptcy law in the United States does not address the states. This does not mean states will not default. They might be in limbo according to the bankruptcy code, but still bankrupt according to the dictionary: "Any person unable to pay his creditors in full." Bondholders should take heed of the dictionary instead of waiting for the law to codify state bankruptcy.
Claim #5: "There has never been greater demand for municipal bonds." This is a sales pitch that implies "buy now, or you'll regret it later." Evidence for this claim is the willingness of retail investors to buy California municipal debt that yields 2% (for debt maturing in 2012; 5.8% for debt maturing in 2030). Another "get 'em while they're hot" argument is an initiative in Congress that would end the tax deductibility on interest from municipal bonds issued in 2011 and after.
First, the possibility of Congress passing such legislation is remote. Second, the "safe" asset classification by financial advisers is the real energy propelling retail investors into municipal issues. It was only two years ago when money market funds were thought of as "safe." They were often classified as "risk-free." (Beware of investment categories and classifications. Labels are often applied after their characteristics have been deemed predictable. By the time the predictable has been awarded a classification, the category has probably attracted too much attention and mindless buying.) After panic selling in September 2008, the federal government guaranteed the net asset value of money market funds.
Municipal appetite is also strong because Federal Reserve Chairman Ben Bernanke has chased savers out of short-term investments. His monetary policy (zero percent fed funds rate) is designed to refloat too-big-to-fail banks (that invest at zero percent and buy 3% Treasury notes) while leaving savers in the poor house. Municipal bonds produce some income, so are the new "cash" option.
Individuals are the only remaining net buyers. In 1975, commercial banks, savings banks, life insurers, and casualty insurers were municipal bond buyers. Only the individual is left today. This is a lonely outpost.
Frederick Sheehan writes a blog at www.aucontrarian.com
