What are the chances of muni doomsday?

December 22, 2010
60 Minutes this week:

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Meredith Whitney took her muni-doomsaying to 60 Minutes this week:

“There’s not a doubt in my mind that you will see a spate of municipal bond defaults,” Whitney predicted.

Asked how many is a “spate,” Whitney said, “You could see 50 sizeable defaults. Fifty to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars’ worth of defaults.” …

“When individual investors look to people that are supposed to know better, they’re patted on the head and told, ‘It’s not something you need to worry about.’ It’ll be something to worry about within the next 12 months,” she said.

Whitney’s appearance on the telly has prompted another round of rebuttals from those who think that the threat to the muni market is massively overblown. Cyrus Sanati, for one, reckons that there’s “a myriad of safeguards” in place to prevent a big round of defaults. And first on the list is the standard logic that we’ve been getting from California, especially, for years:

States are not people or corporations — they cannot declare bankruptcy. A large portion of California’s debt is in general obligation bonds, which are mandated to be paid first before anything else in the state – period. That means it comes before paying for education, pensions, state worker salaries, transportation and the thousands of entitlement programs in the state’s budget.

This is true, but I don’t find it particularly reassuring. A bond is a promise to pay; the mandate that Cyrus is talking about is essentially a promise to keep that promise. If you can break your promise when you default, you can break your promise to privilege bonded debt over other obligations.

The other big argument in Cyrus’s piece is that munis won’t default in the future because they haven’t defaulted in the past:

Even though Orange County, CA declared bankruptcy in 1994 (the largest municipal bankruptcy in US history), it never defaulted on its bonds. It just cut services and raised taxes to pay off the $1.6 billion it owed its creditors. In fact, Moody’s has counted just 54 defaults in the muni market from 1970 to 2009. That’s it – 54 out of the hundreds of thousands of bond offerings that have ever been issued to the public over the last 40 some odd years…

Bondholders will only really lose everything if the entire population connected with that municipality leaves. What’s more likely is that governments will push through higher taxes and slash services to pay their debts — losing access to the debt markets is far worse than anything they can imagine.

My response to this is that access to bond markets is extremely valuable for municipalities, and that they won’t default so long as it stays that way. But if a handful of big municipalities do start to default, then that access will probably disappear for thousands of municipalities around the country. And without access, the incentive to keep on paying rapidly disappears.

Joe Mysak is another commentator pushing back against Whitney, and he writes this:

Hundreds of billions of dollars? The one-year record, set in 2008, is $8.2 billion. You can see how an estimate of “hundreds of billions” would get people’s attention…

Hundreds of billions of dollars in default? The number is in the realm of the fabulous. If pressed, I would say that we might see between 100 and 200 municipal defaults next year, maybe totaling in the $5 billion or $10 billion range.

The problem with this line of argument is that it ignores the way in which correlations all go to 1 in a crisis. There are significant linkages and contagion channels between different municipal issuers: the bond insurers are one, and the fact that a huge proportion of municipal bonds is held by dedicated municipal bond funds is another. If a couple of high-profile defaults cause people to start dumping those funds, the funds in turn will have to start selling into a falling market, and all muni bond prices could easily fall to the point at which funding costs would be prohibitively expense.

Mysak, too, says that the bond market is municipalities’ “best source of finance” — something which is true until it isn’t. But he follows that up with a stronger argument: that debt service just isn’t a big enough deal, in terms of municipal budgets, to make it worthwhile defaulting. In most cases, it’s less than 10% of the total budget, which means that a default — which doesn’t come cheap, in terms of legal and other costs — simply doesn’t look cost-effective.

The strongest argument against Whitney, however, isn’t mentioned by either Sanati or Mysak. Here’s Bond Girl:

Bondholders may also seek a writ of mandamus from a court to compel government officials to take some specific action to cure whatever problem caused the default. (Seeking court mandates to make government officials do things is practically a form of recreation in California, for matters not necessarily related to debt.) For GO bonds, this would involve collecting taxes. For revenue bonds, this would involve, for example, raising rates in accordance with a rate covenant (assuming this covenant exists with a particular bond issue). Creditors can and will make life an absolute living hell for government officials and cost taxpayers a lot of money in attorneys’ fees if it comes to this. Aside from losing access to the capital markets, this is a very good reason governments do not generally repudiate their debt. The legal process of answering for defaults only exacerbates officials’ administrative, financial, and political problems; it does not solve them, as some people have suggested.

The point here is that any municipality mulling default will have to have some very good lawyers. Defaulting on your debt might help a little in terms of short-term cashflows, but it doesn’t actually reduce the total amount of debt you have outstanding — which means that the upside to doing it is decidedly limited. Municipalities aren’t sovereign nations: they can’t assume that the courts will find in their favor, and in fact it’s reasonable for them to assume that the courts will find against them.

I also haven’t seen any evidence of the kind of populist anti-bondholder rumblings which tend to precede bond defaults: I might have missed it, but local politicians don’t seem to be making much hay by complaining that money which should be going to teachers and firefighters is being spent on bondholders and financiers instead.

So my feeling is that Whitney is probably wrong, and that we won’t see a lot of municipal defaults next year. But at the same time, the tail risk here is significant. If it gets bad, it could get very bad.


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