Felix Salmon

If you want to wade through some unutterably depressing reading on this Monday morning, you should spend some time with the official Detroit Proposal for Creditors. It starts by noting that the city’s per capita income, averaged over its 684,799 residents, is just $15,261 per year. (That’s less than half the income of neighboring Livonia.) Auto insurance alone eats up a good $4,000 of that, for residents with a car.

And then comes the litany of municipal woes: Detroit has the highest violent crime rate of any major US city, at five times the national average; there were 344 murders in 2011, of which just 39 were solved. Right now, the average response time, if you put in an emergency call to the Detroit Police Department, is 58 minutes.

Detroit’s infrastructure is crumbling: 40% of its street lights are out of order, and it has 78,000 abandoned and blighted structures, of which 38,000 are considered dangerous buildings. Those buildings account for a large proportion of the 12,000 fires Detroit has every year. At the moment, firefighters are instructed not to use the hydraulic ladders on their firetrucks unless there is an immediate threat to life, because the ladders have not received safety inspections for years. Detroit also has just 36 ambulances, of which generally no more than 14 are in operation at any given time. And in terms of the city’s IT infrastructure — well, you can probably guess; suffice to say that a recent IRS audit characterized the city’s income tax system as “catastrophic”.

As far as Detroit’s balance sheet is concerned, there is $9 billion of debt, excluding pension liabilities, and also excluding healthcare and life insurance obligations which are calculated at roughly $6 billion. Debt service in 2013 is projected at more than $240 million, or about 22% of total revenues. Worryingly, under the section of the proposal headed “Realization of Value of Assets”, one finds the priceless collection owned by the Detroit Institute of Arts:

Bill Schuette, the Michigan attorney general, has declared in no uncertain terms that DIA’s collection is off-limits when it comes to satisfying the obligations of the City of Detroit; he’s absolutely right. But you can be sure that there will be arm-twisting all the same: Detroit’s emergency manager, Kevyn Orr, doesn’t seem to think of DIA as anything beyond a store of recoverable value.

He wants to write down some of Detroit’s debt, as well — although far from all of it. Cate Long has a good round-up of how various bondholders will be treated under his proposal; she concludes that he’s treating bondholders in good faith, but that he’s behaving less fairly towards retirees. (It’s a combination you might expect, given that Orr was appointed by a Republican governor; it’s basically the opposite of how the Obama administration treated the bankrupt Chrysler and GM.)

It’s worth noting that even though Detroit is defaulting on millions of dollars of debt obligations, bondholders in general are not going to be hit, thanks to the wonders of third-party guarantees. For instance, Bloomberg reports that the 2028 general-obligation bond is currently trading at 96 cents on the dollar, “the lowest since March 2012″ (it’s backed by Assured Guaranty).

As a result, the real pain here is going to be felt by two main groups. The first is the companies who provide wraps for municipal debt — companies whose muni arms somehow managed to escape the financial crisis largely unscathed, and which had to expect some losses on all the debt they were insuring. It’s hard to feel any sympathy for them. But the second group — Detroit’s municipal retirees — had much less choice about taking on their unsecured exposure to the city’s finances. Looking at the straits Detroit is in, the bond default makes sense. But it’s not being driven by stratospheric pension costs, and the swipe at pensioners does look rather gratuitous.

As Long says, “this is merely an opening gambit by Orr”. Let’s hope that Detroit’s unions, as well as the people representing non-unionized workers, fight him aggressively. Because Detroit’s population is poor enough as it is. Those pension payments are needed — and what’s more, they will overwhelmingly be recycled straight back into the local economy. Unlike bond coupons.

Josh Barro has a strong column today on the confusion and hypocrisy in Rhode Island; he gets equally strong support for his position from Ted Nesi.

The argument here is pretty simple. The state of Rhode Island has various obligations; among those obligations are pension obligations, general obligation bonds, and moral obligation bonds. The legislature and governor of the state are happy defaulting on their pension obligations, which are contractually obliged to rise in line with the cost of living: by freezing the pensions instead, some retirees will see their incomes slashed by a third.

Yet at the same time Rhode Island is determined to pay out the holders of moral obligation bonds in full.

Rhode Island’s pensioners would seem to be more deserving than the moral obligation bondholders, who sought out those bonds precisely because they carried an excess yield. The market priced in the fact that the bonds were more likely to default than general obligation bonds — and yet, when push came to shove, the state is standing behind those bonds, even as it cuts a billion dollars from promised future pension payments.

I think the argument here is a solid one, but there’s a gentle whiff of the faux-naive about it, as well. So without taking Lincoln Chafee’s side of the argument, let me try to explain what he might say, were he in a position to be honest about things.

The key here is the legislature voters. Why would any state ever issue non-legally-binding moral obligation bonds rather than legally binding general obligation bonds, given that the moral obligation bonds cost more to service? The answer is simple: general obligation bonds can’t be issued without the legislature’s voters’ approval, and getting that approval is a pain. So the executive doesn’t bother, and issues moral obligation bonds instead.

This is the first reason why the governor won’t default on the bonds: they’re obligations of the executive, and governors tend to honor each others’ obligations.

On top of that, when the governor signs into law a pension default which has the strong support of the legislature, that’s the whole government making the decision to cut pensions: it’s not a purely executive action. Blame shared is blame diluted. The governor is also in a weird way hewing to the principle underlying general obligation bonds: once the legislature electorate has managed to agree on something, then at that point it carries especial authority.

There’s also a more important reason why Rhode Island isn’t defaulting on its moral obligation bonds — and that’s the simple fact of what a moral obligation is. It’s true that moral obligations don’t carry the force of law. But they are pretty much equivalent to the US government, for instance, using its “full faith and credit” to backstop Treasury bonds. Governments don’t pay bonds because they’re legally obliged to do so; they pay bonds because they promised to do so. That’s what “credit” means.

Rhode Island’s moral obligation bonds, then, are a bit like the bonds of a sovereign nation: they’re a measure of willingness to pay. And when it comes to public-sector borrowers, willingness to pay is all important. Yes, it would be legally possible for Rhode Island to default on its moral obligation bonds while staying current on its general obligation bonds. That legal possibility is exactly why the moral obligation bonds do trade at a higher yield. But the holders of the general obligation bonds aren’t happy with their lower yield just because they know that in the event of default they can go to court: none of them ever wants to do that. They fully expect Rhode Island to pay its bonded debts in full, just because it promised to do so.

There are implications to this line of reasoning, which Nesi explains quite clearly.

If that’s the case, a moral-obligation bond is effectively a general-obligation bond in all but name, with full repayment by Rhode Island taxpayers promised no matter what. If so, shouldn’t voters have to approve moral-obligation bonds at the ballot box as they already do with general-obligation bonds – and shouldn’t Rhode Island be paying the lower interest rate investors get on a lower-risk general-obligation bond?

The answer is that yes, moral obligation bonds are effectively general obligations bonds in all but name. The state has found a way of issuing bonds without having to get the approval of the legislature electorate, but they’re still obligations of the state, and the state doesn’t distinguish the two types of obligation. And yes, Rhode Island should be paying the lower interest rate rather than the higher interest rate. But that doesn’t mean that voters should have to approve moral obligation bonds: it could equally mean that voters should stop having to approve general obligation bonds.

That is what all governors really want: to have the legislature and voters stop interfering in their borrowing strategy. And that is the real reason why Chafee is staying current on his moral obligation bonds. He wants the world to see voter approval as an anachronism, and in an ideal world he would love it if moral obligation bonds had the same legal backing — and therefore the same lower yield — as general obligation bonds. That way he’d never need to issue a general obligation bond, or get voter approval for such a thing, ever again. It’s a very attractive vision — and it’s not one he’s going to give up just because Rhode Island is suffering a fiscal nightmare these days.

Remember the Poway school district? They did a horrible bond deal, borrowing $105 million now and promising to repay a total of $981 million by the time 2051 rolls around. The deal was broken up into lots of tranches, none of which start paying back any money at all before 2033. The most egregious tranche of all was the longest one: a bond with an original principal amount of $13,986,037.80, which matures in 2051, when bondholders will receive a total of $321,740,000. That’s more than $22 of interest for every dollar borrowed today.

One of the most distasteful parts of the deal — whose prospectus can be found here — comes in a short and bold-faced single-sentence clause right at the front:

No Optional Redemption

The Series B Bonds are not subject to optional redemption prior to their fixed maturity dates.

In other words, Poway has no call option on these things, and now that they’re issued, it has no choice but to pay up the whole $321,740,000 in 2051.

But that doesn’t mean it’s too late to fix this mess. Matt Levine has an absolutely wonderful post up about SunTrust’s stake in Coca-Cola — a true marvel of clear, funny, approachable prose explaining highly-recondite concepts. In this case, SunTrust, a bank based in Atlanta, has agreed to sell off a stake in Coca-Cola which it has held since 1919. Even though, at least as far as US regulators are concerned, it already sold off that stake, back in 2008.

But the way that deal was structured, SunTrust got some but not all of the proceeds in 2008, and was still massively exposed to Coca-Cola shares: so long as the shares were worth more than $33 each (they’re now at $38), SunTrust was due another $14 per share between 2014 and 2015. And this deal, too, could not be undone. Here’s the language, from Levine’s footnote:

SunTrust generally may not prepay the Notes. The interest rate of the Notes will be reset upon or after the settlement of the Agreements, either through a remarketing process or based upon dealer quotations. In the event of an unsuccessful remarketing of the Notes, SunTrust would be required to collateralize the Notes and the maturity of the Notes may accelerate to the one year anniversary of the settlement of the Agreements. However, SunTrust presently believes that it is substantially certain that the Notes will be successfully remarked.

But in light of new regulations, SunTrust decided it that it did want to prepay the notes after all. And — guess what — it has found absolutely no difficulty in doing so.

And if SunTrust can prepay obscure and highly-illiquid equity-derivative instruments, you can be quite sure that Poway, if it put its mind to it, would be able to prepay some of those horrible 2051 bonds. One obvious way of doing so would be to just go out into the market and buy them: they’re trading pretty much at par, and my guess is that if they offered to pay say 105 cents on the dollar, they’d be able to buy back many if not most of the outstanding debt. Which is a hell of a better deal than paying back 2,300 cents on the dollar, which is what they’re currently contracted to do.

Since the details of this bond deal were made public, the San Diego population has reacted as you might expect — with no little outrage. They want the deal unwound. And although there’s nothing in the letter of the contract which makes that possible, a decent banker should be able to get them out of this dreadful obligation at relatively little expense. Especially compared to the cost of staying in it.

There’s a distinct whiff of the faux-naive coming off Mary Williams Walsh’s article about the fate of Jefferson County’s general-obligation bonds:

People who own what is considered the safest type of municipal bond may be in for a surprise.

This safe debt, called a general-obligation bond, is said to be the next strongest thing to Treasuries because it is backed by a “full faith and credit” pledge. That means the government that issued it will pay it on time, no matter what.

But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.

While we’re repeatedly told what “conventional wisdom” has to say on such matters, or what certain fund managers might once have been taught, not once is any authority actually cited saying that GO bonds are “the next strongest thing to Treasuries”.

Which is hardly surprising, since the muni market hasn’t been considered particularly strong for some time now. Back in February I blogged Michael Corkery’s article on how individual investors were abandoning the market, precisely because they had become aware that it was anything but safe. When 60 Minutes is running alarmist pieces on how hundreds of billions of dollars of muni bonds could default, no one’s sitting back with a smug expression and saying “well, your muni bonds, backed by actual cashflows, might default, but my muni bonds, backed by some amorphous ‘full faith and credit’, are perfectly safe”.

And in truth no one ever said that — it’s hardly been a closely-held secret that Jefferson County has no tax-raising abilities. In fact, that’s one reason why revenue bonds came into being: as in most other markets, there’s a strong case to be made that secured bonds are safer instruments than unsecured bonds.

Indeed, if you carry on reading through the end of the NYT piece, you’re eventually told that Jefferson County’s MBIA bonds were wrapped (that is, insured) by MBIA. Obviously, if everybody thought they were perfectly safe, then no one would have demanded them to be insured.

But the biggest problem with the NYT article is its deep premise: that Jefferson County is some kind of harbinger, and that if it can default on its GO bonds, then lots of other municipalities can as well. This meme is both very pervasive, and very dangerous, as Bond Girl explained in a long blog entry in October:

Some people mistakenly characterize Jefferson County’s financial problems as a canary in the coalmine for the municipal bond market, which suggests that they still have no idea what transpired there (or how long Jefferson County has been in financial distress). Portraying Jefferson County as a typical municipal credit is akin to portraying Enron as a typical corporate credit. With Jefferson County, various financial firms – but primarily JP Morgan – exploited an existing culture of corruption and made taxpayers the victims of one of the largest frauds in the history of the financial markets.

I’ve been saying at least since at least April 2009 that munis are one of those asset classes which is safe until it isn’t — that once you get some unknowable number of municipal bond defaults, suddenly no one will have access to the market any more, and the whole market could implode:

If five or six munis default, things get much, much worse. At that point, the cost of default for a wrapped muni issuer plunges, and possibly even goes negative. Once a few munis default, no one’s going to lend to any muni, even the ones which are current on their debt. So why bother staying current? Why not just default and let the insurer, rather than your local taxpayers, take most of the pain?

In other words, there’s a very serious, and pretty much impossible to hedge, risk of snowballing muni defaults.

But the point here is that Jefferson Country is sui generis and emphatically not one of those five or six munis. It’s a case unto itself, cut through with corruption and fraud, and is in no sense an example for any other municipality to follow. Jefferson County’s GO bonds are not an example of the safety of GO bonds more generally: as Bond Girl says, they’re more akin to the way that people lost their money with Enron or Madoff. The germane risk in Jefferson County is fraud risk, not GO-bonds-defaulting risk.

And remember that no one knows what the recovery value is likely to be even on Jefferson County’s bonds: it could yet turn out to be quite high.

Now I’m no great believer that bondholders should be senior to everybody else, to the point at which bond coupons are more important than vital municipal services. But let’s not look to Jefferson County to blaze a trail on that particular front. What’s going on in Jefferson County is an interesting datapoint, but it’s in no sense the beginning of some kind of muni-default snowball.

I’m normally a big fan of Bond Girl, but today is obviously the official day when bankers talk their book with no particular logic. In this case, the proposal which has attracted her ire is the idea that part of the jobs bill will be paid for by capping itemized deductions for individuals earning more than $200,000 a year and married couples earning more than $250,000. Basically, you can deduct away to your heart’s content — until your tax rate reaches 28%. At that point, you can’t deduct any more.

Amazingly, this simple and pretty modest proposal would raise a whopping $400 billion — pretty much the entire cost of the jobs bill, right there. And it doesn’t go nearly as far as I would: I’d abolish all deductions altogether, in an attempt to radically simplify the tax code.

But Bond Girl finds a lot to hate, all the same.

This would likely reduce demand for municipal bonds substantially – you know, the primary vehicle for infrastructure investment in this country. According to the Bond Buyer, “Internal Revenue Service data from 2009 shows that 58% of all of the tax-exempt interest reported to the IRS was from individuals with incomes of $200,000 or higher.” Prices for outstanding municipal bonds will decline and borrowing costs for state and local governments will increase going forward. This means state and local governments will have to levy more taxes to construct projects as planned, postpone projects, or cut spending elsewhere.

I’m happy to grant, here, that demand for munis might well decline if this proposal goes through. But would that really hurt infrastructure investment, or mean higher local taxes? Unless and until I see some hard numbers, I’m going to be very skeptical, given the existing ultra-low interest-rate environment. Sure, it’s nice for individual muni investors right now that they don’t need to pay income tax on the puny interest payments they’re getting. But the reason those interest payments are so puny is mostly a function of interest rates, rather than tax-deductibility.

In the absolute worst-case scenario here, all individual investors would shun the muni market entirely, and municipals would have to fund themselves in the institutional market, with taxable bonds. What’s the difference in yield between taxable and tax-free bonds? Right now, it’s not very much.

Realistically, then, how much would municipalities’ cost of funds rise if tax-deductibility were curbed in this way? 20 basis points? 30? 40? We’re not talking, here, about the kind of numbers which change the economics of an infrastructure project. And we’re certainly not talking about the kind of numbers which would necessitate local tax hikes to pay for suddenly-higher construction costs.

Whenever you close a tax loophole, you’ll have a series of consequences. Some will be intended, and some will be unintended. Some will be positive, and some will be negative. But closing loopholes in and of itself is a good thing — and when doing so gets you an extra $400 billion, it’s a no-brainer. If necessary, calculate the added interest expense that municipalities will have to pay, take it out of the $400 billion saved, and just give it to those municipalities as an outright grant. I doubt it would amount to very much money.

And it’s certainly no reason not to go along with this very welcome idea to start cracking down on deductions in the tax code.

Is there something fishy about the bonds used to finance the parking lots at Yankee Stadium? Of course there is. And you don’t need to look far before you see two big reasons why. The first is that the bonds were issued by the Empire State Development Corporation. That’s Empire State as in New York State, one of the most corrupt and dysfunctional states in the union. The second is that these are conduit bonds — an asset class which, as Nathaniel Popper explains, is only for the very brave:

Conduits have grown roughly three times faster than the general municipal market over the last five years, according to data from Thomson Reuters, a New York data firm; $84 billion of these bonds were issued last year alone…

Although conduits account for roughly 20% of all municipal bonds, they have been responsible for about 70% of all defaults in the municipal bond market in recent years, according to Income Securities Advisors, a Florida research firm. Over the last two years, the five municipal bond issuers with the most troubled bonds have all been conduit bond issuers.

Conduits constitute a brilliant boondoggle for everybody except the taxpayers who end up out of pocket. You want to build a parking lot next to Yankee Stadium? That’s probably not a great idea, as is evidenced by the fact that this season the lots are only 31% full on game days. Clearly Yankees fans are more than capable of attending games without needing to use anything like the 9,000 parking spots that Yankees management pushed for when they negotiated their new stadium. And parking lots are inherently ugly and unhappy things; Bronx borough president Ruben Diaz’s idea to build a hotel on some of that land instead is clearly a good one.

There’s no public interest in having all that space taken up with empty parking spots. So why on earth did New York State subsidize the construction of the lots by issuing $237 million of bonds whose interest payments are exempt from all state and federal income taxes? The people who bought those bonds financed a commercial venture and hoped to make a profit by doing so. If they did make a profit, there’s no reason at all for them not to pay income tax on that income.

Popper’s concerns about conduits in general go in spades for these parking-lot bonds:

“A lot of these are corporate bonds disguised as municipal bonds,” said Michael Lissack, a former municipal investment banker at Smith Barney who is now a critic of the industry. “How is this a good use of our tax expenditures? I would prefer to use that money seeing that kids get vaccinated or learn to read.”…

Frank Hoadley, who is in charge of selling traditional municipal bonds for the state of Wisconsin, said that the riskiness of conduit bonds has driven up borrowing costs for cities and states. He said Wisconsin paid $4 million more in annual interest than it would otherwise have had to on new bonds issued in January because of investor fears about the municipal market.

“Government issuers like Wisconsin are swept up in the smear that is tarnishing the whole municipal market because of conduit borrower problems,” said Hoadley, Wisconsin’s capital finance director.

The parking-lot project was particularly risky because it was structured with no equity. (Much like Goldman Sachs’s notorious Abacus deal, come to think.) All the money to build the lots came from tax-free bond investors, rather than the owner of the project, a tiny mom-and-pop nonprofit 100 miles from the Bronx which has a history of defaulting on tax-exempt bonds. Parking projections are notoriously error-prone at the best of times, but in this case the project was financed with a debt service ratio of just 1.2: the projections didn’t need to be far off before the lots ran into serious financial trouble.

The biggest winners in this story are the Yankees. They are luxuriating in the presence of endless parking infrastructure, they didn’t need to pay a penny for it, and they can offset the blame for misuse of public land by saying that it’s not their project and they don’t own the land. Even the bondholders will probably come out alright in the end. The losers are the general public, twice: first by dint of having to live with far too much parking provision, which serves no useful purpose in this urban environment, and second because of the tax break we gave the buyers of the bonds.

As a general rule, conduit bonds are always a bad idea. I’m no great fan of the tax exemption on muni bonds at the best of times — if the federal government wants to subsidize the states, there are much easier and more direct ways of doing that. But giving the tax exemption out for boondoggles like this is, well, mind-boggling. Let’s hope the latest wave of defaults helps speed their demise.

You’re probably not going to read all 3,700 words of William Alden’s huge article about the vicious financial circle in Milwaukee, Wisconsin, where local-government cutbacks are hitting the bus service, with the knock-on effect that a lot of jobs are literally out of reach for people without cars. But it’s a great article, and a fine example of the kind of in-depth original reporting being done by HuffPo.

Alden’s story centers on Petty Schulz, a 53-year-old woman out of work for almost two years who doesn’t own a car. That was fine during the halcyon days of, say, 1999, when the American Public Transportation Association bestowed its Outstanding Achievement Award on Milwaukee County transit. But already the seeds of disaster were being sown: in 2000, when the county Board of Supervisors increased the pension multiplier which determines the percentage of final salary that an employee gets upon retirement, it made a contribution of just $600,000 to the pension fund — down from over $20 million five years earlier.

Today, the cutbacks in bus service have been so severe that even a job at the Milwaukee County Transit System required that Schulz have a car. And the cutbacks don’t just prevent the unemployed from getting new jobs, either: they also force the employed to give up good jobs and become unemployed when they can no longer make it to work.

Of course, the fewer people with work in Milwaukee, the less the city earns in taxes, the more depressed the local economy becomes, and the more the government has to cut back. This is why you can’t cut your way to growth. In the meantime, locals are left to calculate whether they can possibly afford a $25 cab ride each way to get to and from a job which pays $13 per hour. And to wonder how on earth their city can get out of its current predicament.

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.

A couple of big names are out with cautious bond market views this week. For the big picture, turn to Bill Gross, who’s worried about what’s going to asset prices — both bonds and stocks — when QE2 comes to its scheduled end on June 30. He has two main points:

• For the duration of QE2, the Fed has been buying 70% of all new Treasury-bond issuance, and foreigners have been buying the other 30%. When the Fed stops buying, who will step in to replace it? After all, with a $1.5 trillion budget deficit, there’s a lot of new supply coming.
• Treasury yields are about 150bp too low. The yield on the 10-year Treasury is typically the same as the GDP growth rate; it’s now 150bp below that. Real 5-year Treasury yields are normally about 1.5%; they’re currently negative. And, of course, the Fed funds rate is artificially low. All of this implies that yields will rise. When that happens, it’s reasonable to assume that discount rates and credit spreads will rise along with them, driving all asset prices lower.

This need not happen immediately upon QE2′s demise, but it might: Gross foresees “immediate uncertainty and fear” come June 30, and strongly implies that he’s not going to be venturing far out the curve unless and until rates rise significantly. For the time being, he’s derisking: “PIMCO’s not sticking around,” he tells us.

Meanwhile, on the state level, David Nowakowski and Prajakta Bhide of Roubini Global Economics have a big report out called “States of Despair,” in which they estimate that muni defaults could reach $100 billion over the next five years. They do stress, however, that the recovery value on those defaults is likely to be very high — roughly 80 cents on the dollar — and that “state and local debt problems are not systemic in nature, and will not infect the financial system, though they will dampen economic recovery.”

Indeed, the report is actually bullish on the muni market: if recoveries really are 80%, then you’d break even buying the MCDX index even if the five-year default rate hits 34%. In other words, even if there are $100 billion of bond defaults over the next five years, you’d still make good money buying munis at these levels.

There’s lots of very good analysis in the report, which I’ll come back to later today. But my main takeaway is that this is clearly a market requiring good analysis — it’s not something that individual investors should buy blithely, as they have in the past, on the assumption that muni bonds are not only tax-free but also risk-free. As such, the muni market has a similar problem to that facing the Treasury market: when the biggest buyer of the bonds goes away, who will replace them? So far, the answer in both markets is very unclear.

Who is responsible for turning New Jersey governor Chris Christie from an uninspiring and inchoate peddler of conservative platitudes into the major anti-union force that he is today? Step up, Mr Squid:

Christie won by about four points on Election Night in 2009, with little notion of what he was going to do next. When I asked him if there was any one moment of clarity that put him on the path from cautious candidate to union-bashing conservative hero, Christie pointed to a meeting about a month into the transition, when his aides came to him brandishing an analysis of the state’s cash flow produced by Goldman Sachs.

Goldman Sachs, of course, is the company where the CEO recently said of his employees that “If we could do it, we would have their bonus be 100 percent of their comp” — in other words, no salary whatsoever, no job security, give all the power to management and give the workers no rights at all.

All of which makes Christie’s improbable victory over former Goldman chairman Jon Corzine so much more ironic. Only someone who has beaten a squid himself, it seems, is capable of taking Goldman’s advice to its logical conclusions.

Ed at Gin and Tacos picked up on a particularly audacious section of the Wisconsin budget-repair bill yesterday: the governor can sell off any state-owned heating, cooling, and power plants he likes, at any price, to anybody he wants, without any kind of auction or bid-solicitation process, and such a sale would be defined as being in the best interest of the state and to comply with criteria for certifying such a transaction.

Ed calls this “a highlight reel of all of the high-flying slam dunks of neo-Gilded Age corporatism: privatization, no-bid contracts, deregulation, and naked cronyism” — but as Yves Smith notes, the sad fact is that all this language is gratuitous: if you’re a state, there are essentially no legal restrictions on how to privatize state-owned industries and franchises if you’re so inclined.

It probably comes as little surprise to note that the most lucrative privatizations have generally been done by parties of the left: I’m thinking in particular of the UK’s auction of 3G licenses, which netted the Exchequer $35.4 billion at the height of the dot-com bubble.

Right-wing parties, by contrast, are more prone to thinking of privatization as something inherently good, and of monies flowing to the government as a kind of taxation which is inherently bad.

And then of course there’s the other spectrum, from clean to corrupt, which is orthogonal to the left-right spectrum — the more beholden the government is to special interests, the more likely those interests are to wind up with sweetheart deals. Sometimes, the special interests in question are public-sector unions, which find themselves able to negotiate the kind of final-salary defined-benefit pensions which are now threatening state solvency and municipal bond markets around the country. At other times, the special interests are large corporations looking to buy up lucrative monopolies on the cheap. In both cases, elected politicians are not the best people to ensure a good deal; non-partisan career civil servants tend to generate much better results.

The advantage of privatization in cases like the Chicago parking meters is that it removes the utility from political meddling — in that case, from local aldermen who would always agitate for parking rates well below the optimal level. (Relatedly, if you haven’t read it yet, go read Ed Glaeser’s Atlantic essay on the massive economic cost of urban zoning regulations.)

But in the case of Wisconsin-owned energy plants, such considerations don’t come into play. There’s no reason to believe that the private sector will run those plants in a way that is better for the public, and every reason to believe that they will run the plants in a way that is worse (ie, more expensive) for the public. If the state wants to cut such a deal in return for a one-time check, that check had better be enormous. And there’s absolutely no reason to believe that it will be.

(Crossposted at CJR)

When I was worrying about munis last week, I said that “the amounts here are far too big for states to go to the loan market instead: if investors won’t buy bonds, banks won’t lend the states the money they need.”

Which might be narrowly true, when it comes to state borrowers in particular. But other borrowers are finding the banks quite eager to lend to them:

J.P. Morgan Chase & Co. is devoting billions of dollars to direct loans this year to both refinance deals and for new projects, according to a bank official. Last year, the bank made a few hundred million dollars of direct loans to municipalities. Now, the bank would consider making a single loan for hundreds of millions of dollars, the official said. It also is dispatching teams to explain the concept to wary public borrowers.

Citibank also is courting municipal borrowers with direct loans, according to several bond issuers. A spokesman for the Citigroup Inc. unit declined to comment.

“This used to be unheard of,” says Eric Friedland, managing director of public finance at Fitch Ratings…

For banks, this is a potentially lucrative business at a time when they are sitting on cash that isn’t earning huge interest and are reluctant to make loans for mortgages and other areas they see as risky…

When word got out that Riverside, Calif., was floating a bond recently, several bankers called offering direct loans.

This is a welcome development, I think. It brings a whole new investor class to the muni market, as well as a lot more serious underwriting in an area where the amount of diligent credit analysis has always been much lower than it should be given the size of the market.

That said, if banks start picking off the most attractive borrowers in the muni market, that might only serve to reduce the overall quality of outstanding municipal bonds. Every time a municipality issues a bond from now on, potential investors will start asking themselves whether they’re being offered the sloppy seconds which various banks have all passed on. Direct loans might be very attractive, on a case-by-case basis, to both borrowers and lenders. But if people continue to look for reasons to mistrust the municipal bond markets, this isn’t going to help.

The muni-market hearings in Washington today might be a bit of a snore, but Michael Corkery’s long curtain-raiser for them in the WSJ is a good one, and serves to begin the slow yet necessary process of moving beyond loud and simplistic questions along the lines of “Meredith Whitney: threat or menace?”. Whitney is certainly a natural locus for debate, but the problems of the muni market are much bigger than one loudmouthed analyst trying to make a splash while at the same time keeping her report secret.

For one thing, as I said back in December, the question really isn’t whether Whitney is right or wrong. Chances are, there won’t be hundreds of billions of dollars in defaults. But so long as such a thing is possible, and the markets are having difficulty quantifying and pricing in the relevant probabilities, the muni market as a whole is going to remain in difficulties.

More immediately, munis have a very real liquidity problem, and no easy way to deal with it. Here’s Corkery:

If the $2.9 billion market continues to struggle, it will be because of the attitude of investors like Barry Fiske, an account manager for a Boston-area heating and air-conditioning contractor.

Mr. Fiske, 61 years old, had long considered muni-bonds a safe investment. But late last year, he says, he “just felt very uneasy” about the “threats [facing] certain states like Illinois, California, New Jersey and maybe New York.” He slashed his holdings in muni-bond funds to 5% of his investment portfolio, from 20%…

Individuals like Mr. Fiske own about two-thirds of U.S. municipal bonds, directly or through mutual funds. This was long seen as a positive, because individual investors tend to “set it and forget it,” says Ms. Fell. But individual investors have been sellers of shares in muni-bond mutual funds for 12 consecutive weeks. Since early November, individuals have pulled a net $23.6 billion out of these funds…

When individuals step away from the muni-bond market, there are a limited number of other investors to take their place. The tax-exempt returns that lure individuals aren’t as attractive to larger investors, such as hedge funds and investments banks.

Some states and cities have cut back on borrowing in the face of diminished demand for their bonds, which creates higher costs for borrowers. A New Jersey agency trimmed a refinancing by 40% last month.

But states don’t always have that option.

If the individual bid continues to go away, there’s a real problem here for the muni market — at some point, the amount of bonds that states need to issue might well exceed the amount of demand in the market. At that point, bad things happen. The amounts here are far too big for states to go to the loan market instead: if investors won’t buy bonds, banks won’t lend the states the money they need.

So what happens? Bonds designed to finance infrastructure investment would probably not get issued at all: that means layoffs in big construction projects, and a big overhang of unissued debt which would make it that much harder for the muni-bond window to open again. More generally, states would have to start becoming much more attractive to institutional, as opposed to retail, investors. But because institutional investors don’t get the same tax benefits that individuals do, yields would have to rise — and prices would surely fall.

In other words, there are lots of very good reasons why we might see substantial price decreases on muni bonds, even without any fears of default. All you need is the retail bid to go away, which happens for all manner of reasons: fewer bonds are being insured, for one thing, and also individual investors are generally smart enough to know that they’re not remotely sophisticated enough to judge creditworthiness on their own. Muni bonds have always been a safe investment with tax advantages; now, they’re something else. They’re much more volatile (ie, less safe), and the market is showing that there’s substantial credit risk where none was really considered to exist in the past. In other words, there’s risk in these things, and muni investors tend to be extremely risk-averse.

It makes sense, then, that there’s a lot of interest in shorting the muni market, even among people who don’t take Meredith Whitney seriously at all:

“There is a lot of blood in the water in the municipal space. Hedge funds smell that blood and are trying to figure out the best way to make money in the marketplace,” says Rob Novembre, head of municipals at Arbor Research and Trading…

Citigroup, for example, is studying a structured bond which would be directly linked to the performance of the municipal bond index, called MCDX.

This is clearly bad news for municipal issuers: investors wanting to buy the muni market on dips will now have a more liquid alternative to buying actual bonds, and can buy Citi’s synthetic instrument instead. Already the rise of muni ETFs has exacerbated volatility in the market. Expect the muni market to become more financially sophisticated in coming months, with a corresponding uptick in volatility. This is going to be a very bumpy ride for anybody issuing general-obligation bonds, even if there isn’t any signifiant default risk. Just because you’ll pay the money back, doesn’t mean you can borrow the money.

Talk of introducing legislation allowing states to declare bankruptcy began in earnest in November. A speech by Newt Gingrich was followed up by a big Weekly Standard piece on the subject by David Skeel, and soon the meme filtered into the blogosphere. Unlike most political chatter, this kind of talk isn’t cheap at all: it’s very expensive. As the subject has refused to go away—which means, as House Republicans have continued to work on drafting some kind of bill—the municipal debt market has plunged.

Now, with a massive front-page story in the NYT, the stakes have got even higher. Mary Williams Walsh is well aware of what she’s doing: she talks explicitly about “the fear of destabilizing the municipal bond market with the words ‘state bankruptcy’”; while at the same time splashing those very words across the most influential public real estate in the world. She frets that the mere introduction of a state bankruptcy bill could lead to some kind of market penalty, even if it never passed—but the fact is that her own article, in and of itself, is almost certain to drive up borrowing costs and uncertainty.

Walsh’s piece comes on the heels of an important report from the Center on Budget and Policy Priorities, which makes a compelling case that state bankruptcy is neither necessary nor desirable:

It would be unwise to encourage states to abrogate their responsibilities by enacting a bankruptcy statute. States have adequate tools and means to meet their obligations. The potential for bankruptcy would just increase the political difficulty of using these other tools to balance their budgets, delaying the enactment of appropriate solutions. In addition, it could push up the cost of borrowing for all states, undermining efforts to invest in infrastructure.

But the message isn’t sinking in. James Pethokoukis is a reliable guide to what the GOP is thinking:

The NYT article raises the specter that states would be shut out of credit markets if allowed to declare bankruptcy, or if one should actually take that step if federal law is changed. That seems unlikely, although some may have to pay higher interest rates. Municipalities and even countries repudiate debt and yet continue to borrow. And even investor apprehension would be balanced by states getting their finances in order, which should appeal to potential lenders.

This is completely bonkers. If states are allowed to file for bankruptcy, then Illinois, for one, would be shut out of credit markets. And if Illinois or any other state were to actually go ahead and file, then many other states, including New York, would be shut out of credit markets. That’s not “unlikely,” it’s certain.

As for Jim’s idea that “municipalities and even countries repudiate debt and yet continue to borrow,” he’s just plain wrong about that. A country which repudiates debt has no access to private credit markets: the only borrowing ever available to such a state is from official-sector institutions. I defy Jim to name a single municipality or country which has repudiated its debt and yet continued to borrow money in the private markets.

That said, it’s pretty unthinkable, even if a state were to declare bankruptcy, that it would go so far as to repudiate its debts. Indeed, bankruptcy is a formal recognition that a borrower is sinking under the weight of far too many legitimate debts; it seeks to restructure some of those debts to make them manageable, rather than repudiating them outright.

On the other hand, Jim’s utterly wrong that somehow bankruptcy is costless to the states, and that the downside of forcing a haircut on lenders would be fully counteracted by the upside of putting the states on a solid fiscal footing. Lenders really don’t much care about fiscal sustainability: all they care about is that they get their money back, as contracted, in full and on time.

It’s worth remembering here that most municipal bondholders are individuals, rather than sophisticated institutional investors. If your aunt Sally put her savings into state bonds, she is not going to be happy if she can’t get her money back, and she is certainly not going to be mollified by talk of lower deficits in future. The deficits are what allowed her to buy the bonds in the first place; she doesn’t particularly want them to go away. But there’s no way she’ll stand for a haircut. And, of course, she votes.

The fact is that states are not going to declare bankruptcy, and they’re not even going to be allowed to declare bankruptcy. So the worst thing that can happen, for the municipal bond market, is that people continue to talk about municipal bankruptcy for the next couple of years. Let’s take the option off the table, once and for all, rather than taking it seriously and thereby only making it harder for states to borrow the money they need.

How much are municipal bonds worth? There are lots of indices purporting to follow the market, but these days all the attention is on exchange-traded funds, which are plunging alarmingly. The volatility in municipal ETFs has already caused Vanguard to pull its plans to issue three more such funds, and the total amount of money in them seems to be falling fast:

Individual investors, who represent two-thirds of the market, withdrew more than $13bn from muni bond mutual and exchange traded funds in the last two months of 2010, an outflow that exceeded the sums they cashed out at the height of the financial crisis in 2008, Thomson Reuters data show.

When individual investors only owned specific bonds or muni mutual funds, outflows in the muni market were much less visible than they are today. With ETFs, outflows cause immediate and significant price drops, and that kind of volatility can in turn prompt even more selling from muni investors—who are, after all, risk-averse by their nature. Aaron Pressman writes:

Amid the turmoil, ETF investors have complained that some muni ETFs are not properly tracking their underlying market indexes. During the fourth quarter, for example, the share price of the $2 billion iShares S&P National AMT-Free Municipal Bond Fund, closed as much as 2.4 percent below the value of its assets, according to the iShares web site. The fund closed on Wednesday at a 0.5 percent discount.

Tracking problems arise because muni ETFs own only a portion of the thousands of bonds included in their underlying indexes. Fund managers try to create a representative sample of bonds but the technique sometimes goes astray when the market moves sharply.

But Dan Seymour has a different take, in a fascinating article about the increasing disconnect between municipal bond indices and the ETFs which try to track them, and comes to the conclusion that the ETFs actually do a much better job of price discovery than indices do—given that the indices, by their nature, comprise thousands of bonds which simply aren’t trading at all.

In other words, it’s not the fact that ETFs don’t own all bonds in the index which is the problem here, so much as the fact that the price of the index is a largely arbitrary measure, determined by implausible pricing services with the impossible job of evaluating the value of bonds that aren’t trading.

Financial markets often operate on the basis of a deliberate refusal to mark to market. In a crisis, all banks are insolvent on a mark-to-market basis, since there’s no real bid for that kind of quantity of loans. But they keep on servicing the loans, mark down the really bad ones, and often manage to come out the other side.

Similarly, in the municipal-bond market, in times of turmoil issuers simply stop issuing, and investors just keep hold of their bonds. Eventually, the market reopens, and things get back to normal; the official indices need not have moved very much at all in the interim. Many individual investors need be none the wiser; and as far as institutional investors are concerned, their best course of action is to simply sit tight, rather than try to sell into a bidless market.

The rise of the muni ETF changes all that. ETFs trade every day, and everybody knows their price. If bids dry up, as they’re doing right now, the price falls, in a very visible manner, to whatever the market-clearing level might be. In turn, that fall in price only serves to exacerbate the problem and the panic.

The observer effect, in physics, refers to the way in which a phenomenon is changed by the act of observing it. ETFs would love to be neutral reflections of the state of the muni market, but they’re not: they change the dynamics of the market dramatically, and not necessarily in a good way. Munis aren’t as safe, now, as they used to be, and the existence of ETFs is one reason why.