Will there be a wave of municipal defaults?

By Felix Salmon
April 23, 2009

So that went quite well, I thought — in any case I’ve pretty much guaranteed myself an invite back next year if there turns out to be a wave of municipal defaults between now and then.

I got a little pushback, in the Q&A, about my assertion that once municipalities start defaulting in any serious number, the cost of default to a municipality drops sharply — perhaps even below zero. One questioner came back with the obvious response: OK, in that situation the market for all municipalities might end up closing, for a while. But at some point, the market will reopen. And when that happens, municipalities with no history of default will find it much easier to raise funds than those who did default.

My answer to that was “not really”. I gave the example of Colombia and Peru to show that entities which have avoided default in the past don’t necessarily have more or cheaper access to debt capital markets in the present — in fact, they often have worse and more expensive access, just because they have more debt as a result.

Another questioner responded that municipalities weren’t like Latin sovereigns — you can’t really argue with that, since it’s impossible to imagine any municipal issuer behaving like, say, Ecuador. All the same, I said, if the muni market closes, it will close for all borrowers, whether they have defaulted or not. And if and when it opens again, it will open for all borrowers, whether they have defaulted or not. Lenders only really care about future defaults, not past ones, and past default is not necessarily a good guide to future default, especially in the municipal context where default decisions are made by elected officials who will almost certainly not be in power the next time the do-we-default question arises.

Of course, the balance of probabilities is still that there won’t be a wave of municipal defaults. But bondholders generally want more than a balance of probabilities: they want near-certainty. And I don’t think they’ve got that, right now.

4 comments

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Certainty? In U.S. government-backed securities? You can’t get more secure than that!!!

Posted by me | Report as abusive

Westfall Township, PA, filed chapter 9 a week ago. For what that’s worth.

I wonder whether Chicago would have more trouble than most cities recovering from a default because of its mayors’ long tenure and heritable succession.

Your picture of defaults could suggest the slogan:
Default early, default often.
That would add a whole new area of moral hazard. But it isn’t the behaviour that we see in the marketplace. Even Ecuador and Peru exhibit considerable caution in their defaults.
I suggest there are several restraining factors:
- creditors may be forward looking, but part of their assessment will be developed by looking at past behaviour;
- there may be a diminishing cost to the borrower of successive defaults, but there is still a cost to each default and pretty rapidly the market value of new bond issues by a party that has repeatedly defaulted in the past will fall to zero;
- there are wider linkages: any nation or municipality has a complex web of direct and indirect financial relations with local and non-local financial intermediaries; mess up one set of relations enough and the others will start to close down.

As long as Washington is amenable to giving billions of printed dollars to the States, defaults will be deferred. The risk then will be inflation and fiscal irresponsibility as long as Uncle Sam will continue to bail us out. Does any one remember the Weimar Republic?

The U.S. has roughly 40 trillion dollars in unfunded liability for Social Security. The Fed, FDIC and Treasury have given as much if not more in the form of guarantees for the banking and insurance industries. The 11 trillion or so in Treasuries seems small in comparison. This information has not been ignored by China who’s Premier recently expressed concerns about the U.S. honoring it’s financial obligations with China.

How about a U.S. default instead?

Posted by Anubis | Report as abusive