Felix Salmon

Roubini’s big muni report

By Felix Salmon
March 2, 2011

The RGE report on muni bonds is very good, and I’m sad I’m not allowed to share it with you. (On the other hand, according to former CEO Camille LeBlanc, “pick a bank, pick a hedge fund—they’re probably a client.” So if you know anybody on Wall Street, they might well have a copy lying around somewhere.)

I can, however, share the five-word executive summary from authors David Nowakowski and Prajakta Bhide: “Overblown default risk, underestimated problems.” It’s a neat formulation, since it helps to concentrate attention on the real fiscal issues facing the states, without getting alarmist and unhelpful about a possible wave of defaults.

There have always been some muni defaults, of course, and chances are that number is going to rise over the next few years. But RGE isn’t all that worried on the default front. For one thing, muni bonds tend to be pretty robust in downturns, for another, defaults will likely be clustered in non-rated issues. And from a systemic perspective things look even better: banks and other leveraged institutions don’t hold much in the way of muni bonds, and it tends to be leverage, rather than default itself, which causes the real damage.

On the other hand, the effects of avoiding default will be large and painful, with layoffs and tax hikes seemingly unavoidable.

RGE takes a very long view, looking at the history of US municipal debt since 1790. The worst that it ever got was the 1873 Long Depression, when muni bondholders suffered 25% defaults and 15% losses. They write, plausibly enough:

In RGE’s view, this period following Civil War, Reconstruction and Carpetbagging, and economic collapse goes far beyond stress tests and even most tail risks.

Two datapoints underline just how bad the 1873 depression was: indebtedness in the south was 295% of GDP, much of it money which had simply been trousered by corrupt politicians. And wealth in the south fell by 59% between 1860 and 1870. We’re nowhere near that bad today, or in the foreseeable future.

My own view of the the tail risk in the muni market is that it’s linked to monoline wraps: that if defaults rise high enough that munis can’t borrow any more, the political cost of default is diminished by the fact that bondholders will still get paid by insurers. In other words, you don’t need economic collapse for munis to default, you just need a critical mass of lots of other people doing it, and a colorable claim that default will be painless for most of your constituents. But RGE’s point is well taken — munis are pretty tough, as 220 years of history demonstrates. Let’s not write them off just yet.

And if you’re holding general obligation bonds, there’s another thing helping to support them: the diversification of revenue sources available to state and local governments.


You can see this graph as bad news, showing that states are increasingly reliant on fiscal transfers from the federal government. Or you think of it as good news, showing that when push comes to shove the government is willing and able to bail out the states, which are after all too big to fail in many cases. And as for the other revenues, only income taxes have failed to bounce back from the financial crisis. All other revenues, even property taxes, have stayed pretty stable, as tax rates have tended to rise to offset any fall in property values.

All that said, the fiscal situation facing the states is pretty bad. Fiscal transfers are certainly going away for the next couple of years, and expenditures are growing even as revenues aren’t. The figures for a state like, say, New Jersey are alarming indeed: a 2011 deficit of more than $10 billion, unemployment of 9.2%, and a debt-to-gross-state-product ratio of 11.8%. There will be cuts, and they will be harsh.

Finally, there’s the question of legal protections, and it turns out that bondholders are pretty well situated on that front:

The laws regarding debt restructuring are complex, and the status of bondholders in such cases is much higher in the “capital structure;” in many cases, more akin to secured creditors at an operating company level than a typical senior unsecured corporate bond at a holding company level…

The U.S. court system is highly unlikely to allow a state to impose permanent losses on investors in GO debt…

Bond security is very strong for most debt issuances, and is provided for in state constitutions, statutes, covenants with bondholders, and local ordinances. U.S. state and local government bonds are usually secured by a general obligation of the issuer. For local governments, this is generally accompanied by an unlimited property tax pledge and such taxes are senior to the property’s mortgage obligation. Other commonly issued municipal bonds are secured by a first lien on sales or income taxes.

The RGE report is very strong on this, and has set quite a few of my worries to rest. I feared that bondholders would have little recourse in the event of default, but it seems the opposite is true: they really hold all the cards, and even in the case of Chapter 9 bankruptcy they’re pretty well positioned.

None of this means, of course, that muni bonds are going to go up in value rather than down. If retail investors leave the asset class and institutional investors are forced to step in, they’re likely to demand much higher yields since they don’t get the same level of tax benefits. Or to put it another way, just because default risk is low doesn’t mean that credit spreads are going to be low too — there are a lot of supply-and-dynamics going on here which can pull prices far away from their fundamentals.

But it does seem that the main thing to worry about is muni bond prices falling, rather than municipalities actually defaulting. If prices fall, there will always be talk of default — but talk is cheap. Default, by contrast, at least for the time being, remains very expensive.

6 comments so far | RSS Comments RSS

Also interesting is the fact that many lazy bloggers and journalists used the MUB or some other muni bond ETF to demonstrate the “condition” of muni markets this past fall/winter apres le deluge du Meredith.

In reality, the muni market is fairly illiquid (compared to, say, corporates) and has no business being so heavily ETF’d to begin with. Because of this illiquidity, the book’s cover looked worse than the prose contained inside.


Posted by ReformedBroker | Report as abusive

@ felix, if I own an issue which is insured by Ambac, and the issue defaults, how do I get Ambac’s bankruptcy trustee to pay me?

It’s also worth considering that institutions are for the most part funded by individuals. If I am an individual and see an excellent opportunity in the muni market, I’m likely to redeem my investment in an institutional fund to buy the attractive muni rather than insist that the taxable institution buy it with my money.

Posted by johnhhaskell | Report as abusive

What exactly are fiscal transfers and why do you expect them to fall off? If this partially represents the fed’s share of welfare programs like Medicaid and TANF, I don’t hear anyone talking about slashing those budgets.

I might even imagine the % share increasing if payments stay constant, since income taxes have likely fallen off from the peak years.

Posted by djiddish98 | Report as abusive

“there’s the question of legal protections”

Math has a funny way of changing the rules/laws on the fly. While the issue is hotly debated by some in the media there was UNIVERSAL agreement in the investment community that senior secured bond holders in GM were way above the union pension obligations. I’m willing to bet that GM issued 50 billion in debt in the 5 years prior to filing… no way on earth could they have done that without investors thinking they were senior to the pension mess.

What they got was between 20 and 25 cents on the dollar and the union got between 50-60 cents on the dollar. The law was the law until it wasen’t. That legal battle will take a decade to settle but it’s clear that senior secured bonds aren’t as secure as everyone thought. Ditto WAMU senior bonds vs depositors over the FDIC limits.

Several muni’s including some State GO’s like Cali and Illinois will eventually offer forced bond swaps just as failing corporates did. You’ll get 70 cents on the dollar cash or a new bond with a longer term and lower rate than the open market would dictate.

The instant a municipality is shut out of the new issue market the incentive to stay current on the old debt drops almost to zero.

Posted by y2kurtus | Report as abusive

I want to second y2kurtus on this. The difference between political institutions and corporate institutions is that the political institutions make their own rules while the corporate institutions must lobby to change the rules in their favor. While there are protections for debt (and public pensions) written into the state constitutions, these protections are not immutable.

Posted by TFF | Report as abusive

“And wealth in the south fell by 59% between 1860 and 1870. We’re nowhere near that bad today,”

If you mean there wasn’t a civil war that destroyed 1/2 of an entire country…you’re right…

Posted by mw1224 | Report as abusive

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