Opinion

Felix Salmon

Beware municipal bonds

By Felix Salmon
September 28, 2010

Meredith Whitney has a 600-page report warning of municipal bond defaults. I think she’s right — and I also think she makes a very smart distinction between municipal debt, as in the debt of towns and cities, and state-level debt.

The states are spending 27% more than they’re raising in taxes — but states can and will get bailed out by the federal government, in extremis. Cities, by contrast, are on their own:

Municipalities receive one-third of their revenue from the states. If the states hold back that money for their own stricken budgets, towns and cities won’t have the funds to make their interest payments. “It has to happen,” says Whitney. “The states will secure their own shortfalls, and leave the cities to fend for themselves.” It’s all about inter-dependency, she says, with the federal government aiding the states, and the states funding the last and most vulnerable link, the municipalities.

I’m not sure that interdependency is really the mot juste here: what we’re seeing is good old-fashioned dependency, with cities reliant on states and states reliant on the federal government.

And then, of course, there’s the monolines. Very few cities issue unwrapped bonds, and as a result it’s not the bondholders who are going to be hurt the most here. Instead, it’s the bond insurers. Insurance in general, and bond insurance in particular, is one of those businesses where you can make steady profits year after year until you lose a fortune. So while a lot of people reading Whitney’s report will be looking for clever positions they can put on in the market for municipal credit default swaps, I’d be careful there: the recovery value on defaulted bonds, at least in the first instance, is likely to be 100%, thanks to those bond insurers.

The more lasting effect of widespread defaults will be in the real economy, where public employees and public services will start feeling the pinch of forced austerity. Once you approach default, no one will roll over your debt any more and no one will insure your bonds. So you have to slash your budget: you have no choice. That process has barely begun, in the U.S., and depending on the timing, it could contribute markedly to a bout of deflation or even a double-dip recession. If the first recession had its causes in the nexus of finance and real estate, its follow-up could well be based in local government.

Comments
13 comments so far | RSS Comments RSS

the Fortune article puts the deficit at a mere $192 Billion… that’s nothing Bernanke couldn’t take care of in a few weeks – the Fed can just buy the States’ debt. (/sarcasm, kinda)

*shaking head sadly, hoping this doesn’t happen*

Posted by KidDynamite | Report as abusive
 

Muni Bond Insurance is the definition of a suckers bet. You can’t buy insurance on the end of the world that will actually pay you off because hey it’s the end of the world. We tried this already with AAA rated MBS backed CDO’s… they didn’t pay 1/10th of what they promised. They claimed that the policys were invalid because the risks were misrepresented ect.

That’s all they could do afterall… the Monolines took in premiums of less than 1% of what they insured… so a 2% default rate would have wiped them out… what they got was more like a 20% default rate!

It will be the same with Muni bonds as it was with AAA MBS… they will simply pay out the coupons until they can’t. Any economic enviroment that causes major municipality A to default will likely have the same effect on municipality B.

What will be interesting is the conflict between the state and feds and the states and the locals. I think you will need to see public elections invalidated because locals will always vote their way out of paying.

IE… we borrowed too heavily for our new school/communitycenter/officepark/wastei ncenerator/seniorcenter and now the bill is comming due and we revuse to raise property taxes 100% to cover the short fall… we vote to default. The govenor of that state is going to have something to say about that. If he or she dosen’t than the Feds are going to have something to say about that… ect.

The era of free rides is comming to a close and the era of consequences is upon us!

Posted by y2kurtus | Report as abusive
 

When did Meredith Whitney become an expert at municipal finance? I recall seeing her work away in the trenches for years as a bank analyst. But when did she become an expert in public finance?

There are a lot of factors involved in Chapter 9 bankruptcy, or Chapter 11 of municipal corporations. Have you seen a decent predictive model of municipal default? I thought not.

Felix, why are you so confident of a Federal bailout of the States? Is it because of the precedent of Arkansas in 1937? What makes you so sure?

Posted by Publius | Report as abusive
 

Before jumping to conclusions it pays to look at the facts.

As of today, according to Bondview.com, there are $2.8 trillion in outstanding muni bonds and 99.7% have not defaulted. That leaves about .03% of muni bond that have defaulted. Of those, most are not safe sector bonds like land use (ie, Florida housing developments) , private activity ie, (Harrisburg Incinerator), Hospital, Casino, Retirement.

Safe Sector bonds like General Obligation, water, sewer, power rarely default. We are only now seeing the outcome of defaults. In almost all cases, the state has stepped into and taken over the finances of the local municipality until they can get back on their feet. Harrisburg, PA. is a good example.

To see a portfolio of muni bond defaults go to:

http://www.bondview.com/reportcard/index  /portfolio/656

Good Luck To All
Jim Walker
http://www.BondView.com

But this is all just common sense. The best way to see whats happening in the muni marketplace if to

Posted by Jim_Walker | Report as abusive
 

why am I so confident of a Federal bailout of the States? Because California will be the first to go, and it’s TBTF?

Posted by FelixSalmon | Report as abusive
 

And I’m sorry, Felix, but your comment about insurance is so 2007. Didn’t you hear that the monolines largely went toes-up? And investors don’t trust the ones that remain because their ratings aren’t Aaa and aren’t stable, so there’s not nearly the marketing advantage to having insurance. As a result cities don’t pay for it.

Many issuers have since been refunding their (insured) debt at lower rates with (uninsured) new bonds. Oh, and with lower interest rates, that’s improving their finances. But I bet that’s not in Meredith’s report, nor is the fact that debt service for all state, county, and city/town debt is only about 1.5% of the economy. That figure, by the way, assumes debt retirement, not just interest payments.

But I’m guessing that that’s not in the report, either.

Posted by Publius | Report as abusive
 

a look at debt to GDP with state debt added in. http://www.gogerty.com/?p=1438

Posted by Nick_Gogerty | Report as abusive
 

“THE mot juste?” Oh boy, does that ever clang. No half-measures in linguistic snootiness, yes? That sort of thing is only for hoi polloi.

Posted by ckbryant | Report as abusive
 

I have to agree with Felix here. With California and Illinois likely first to go, the Feds will have to step in.

Of course, who knows – we might have a Congress that would happily plunge us into the dark ages to avoid giving a bailout in six months.

Posted by AnonymousChef | Report as abusive
 

Though I guess in that case maybe — just maybe — the Fed starts buying California bonds. Probably still worth more than the AAA subprime mortgages they bought earlier.

Posted by AnonymousChef | Report as abusive
 

CA’s problem is GOP obstruction of tax increases. The state can easily pay for its debt. So your predictions are not, pace Whitney, analysis but political speculation: that the state GOP is willing to push the state government not just into stress, but also into default.

Me, I don’t see it.

Posted by wcw | Report as abusive
 

Tax increases will be a forced issue. Then the questions becomes who pays, those who benefited the most or those who benefited the least from lowered taxes.

Posted by tscott3 | Report as abusive
 

Insured, Tax Free, Municipal Bond CEFs Yielding nearly 7%. Interested?

For the second time in recent years, we have a tremendous opportunity in high quality municipal CEFs — don’t miss it!

Of course you should be interested!

There are at least eight reasonable explanations for recent Municipal Bond price weakness — there are at least eight excellent reasons why investors should be viewing this weakness as a buying opportunity.

Contact Steve for a list of ten Closed End Funds to check out for appropriateness.
http://kiawahgolfinvestmentseminars.net/ Inv/index.cfm/18393

Posted by sanserve | Report as abusive
 

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