Felix Salmon

Should states be able to go bankrupt?

Felix Salmon
Dec 7, 2010 22:42 UTC

Jimmy P has discovered a secret GOP plan to push states to declare bankruptcy in order to avoid bailing them out. Like most secret plans, it was splashed all over the Weekly Standard in a piece by David Skeel, and it does make a certain brutal sense:

Although bankruptcy would be an imperfect solution to out-of-control state deficits, it’s the best option we have, at least if we want to have any chance of avoiding massive federal bailouts of state governments…

The effectiveness of state bankruptcy would depend a great deal on the state’s willingness to play hardball with its creditors. The principal candidates for restructuring in states like California or Illinois are the state’s bonds and its contracts with public employees. Ideally, bondholders would vote to approve a restructuring. But if they dug in their heels and resisted proposals to restructure their debt, a bankruptcy chapter for states should allow (as municipal bankruptcy already does) for a proposal to be “crammed down” over their objections under certain circumstances.

Skeel doesn’t mention the single biggest problem with this idea. If it were implemented, or if it even looked like it might get implemented, prices of municipal bonds would plunge, and most states would find it pretty much impossible to borrow money. As such, facing a massive and immediate liquidity crisis, they would be in more need of a federal bailout than before the bankruptcy legislation was seriously mooted.

The fact is that there’s only one reason to invent a Chapter 8 bankruptcy provision for states—and that’s to come up with an efficient and legal way to impose losses on bondholders and other creditors. (Chapter 9, which applies to cities and other municipal entities, doesn’t apply to states.) The creditors, fully aware of this, would immediately cease lending, certainly to the rockier states like California, Illinois, and New York. That’s not what we want. As a result, unless or until those states can bring their budgets into a primary surplus, introducing such a provision would certainly do more harm than good. And if those states can bring their budgets into a primary surplus, then we don’t need the bankruptcy provision, since they’ll be easily capable of rolling over their debts.

If the states had a bankruptcy provision all along, then I’m sure some people would be thinking seriously about whether it made sense for one or more states to file. But they don’t, and there’s basically no way of getting there from here. As such, the idea’s a non-starter.


“The reality is that most red states are tax parasites. IOW they receive more federal dollars back than they send in for taxes to the federal level.”

I belive that is true of all 50 states… think about it, the federal goverment currently spends very roughly 150% of what it collects… so all states get more than they pay in.

I accept that there is inequity between states and that red states get a better deal than blue states… but all states eat more gubmint cheese than they paid for.

It will be very unpopular for stingy states to bail out generous ones. Can you imagine states where workers get 60% final average salary pensions at 65 are asked to bail out states that get 100% of final average sallary pensions indexed for inflation at 60? Hardly fair.

Best hopes for more forced savings in the future… otherwise the prudent will be required to support the shortsited more than they currently do.

Posted by y2kurtus | Report as abusive

Chart of the day: California taxes

Felix Salmon
Dec 7, 2010 18:02 UTC

ARJTurgot2 left this comment on my chart of US taxes:

You are, of course, going to follow up this chart with a second one that comprehensively reflects the changes in State and Local taxes, especially including sales taxes, that have changed since 1950. And that data is going to include things like registration and usage fees, especially gasoline, telecommunications and sin taxes on things like liquor and cigarettes. I understand that is going to vary widely from state to state, so two, perhaps, should be instructive: say New York and California?

If someone wants to point me to a dataset which gives me that information, I’ll happily chart it. But in the meantime, I pulled table D1 (Californian GDP) and table M13 (Californian state tax collection) from the California statistical abstract. That only gives data from 1967 to 2007, unfortunately, and the GDP series changes slightly in 1997. But in any case, here’s the result:


It seems to me that tax revenues have been floating pretty steadily around roughly 5.5% of GDP since the mid-70s, with a brief blip up to a high of 6.8% during the dot-com bubble. I’m sure that the recession has brought the ratio down of late. But what I’m not seeing is any indication that the decline of federal tax revenues is made up for by a concomitant increase in state tax revenues.


For a long time California was the reddish state that gave us Reagan, and present tax boundaries locked into California statute are a reflection of this.

As the influence of public unions increased, we moved to our present situation where prison guards in California earn six figures and eye-popping retirement packages are the norm. The result is a rather Greek-like combination of generous public spending and low tax receipts with massive bond sales to make up the difference.

At least California has Google, Apple and wonderful and productive agriculture. Under higher taxes the farms at least would have to stay put.

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Expertise mission creep datapoint of the day

Felix Salmon
Nov 23, 2010 17:01 UTC

Last week, Chris Whalen appeared on Tech Ticker with Henry Blodget; he said, in the accurate if sensationalist words of the Business Insider headline, that CALIFORNIA WILL DEFAULT ON ITS DEBT.

The interview was actually pretty intelligent and informative, by the standards of financial TV. Whalen talked about the politics of federal-state relations; about prior cases where states defaulted; about California’s pension obligations; about the ability of a Republican-controlled House to pass any kind of bailout bill—all things which are decidedly germane to anybody looking at California’s credit.

But Brett Arends didn’t like what he was hearing, and decided to push back a bit. The results were much more illuminating than anything Whalen said on Tech Ticker.

When I e-mailed Whalen, asking him for specific calculations, none were forthcoming.

“My general comments have to do with my guess as to the impact of mounting foreclosures and flat to down GDP on state revenues,” Whalen replied.

Your guess? These are important problems, to be sure. But do you have any actual numbers?

“Revenues fall and mandates rise to the sky,” he wrote. “You do the math.”

Er, no, actually. It’s your assertion. You do the math.

Whalen blamed the matter on Blodget.

“I am a bank analyst,” he wrote. “I have not written anything on this. My comments have taken on a life all their own… This is all Henry’s fault.”

Henry’s fault? Not really: Henry wouldn’t have started asking Whalen questions about California if he didn’t already know pretty much what the answers were going to be. And Whalen was clearly prepared for Blodget’s questions.

In reality, what we’re seeing here is expertise mission creep, and a rare example of an expert admitting to it. Whalen’s company is highly regarded when it comes to analyzing banks’ balance sheets, and as a consequence of that regard, Whalen has gotten for himself a nice perch in the punditosphere, as well as a new book.

But Whalen, as he admitted to Arends, is no more an expert on municipal finance than Freeman Dyson is on global warming. And so the proper stance for Blodget to take was not to deferentially pose questions to Whalen and then passively receive his oracular words of wisdom, but rather to push back and have a proper debate about Whalen’s assertions, much as Arends might have done.

The California debate is an interesting one: the state has massive future liabilities, in the form not only of debt payments but also of public-sector pensions, but at the same time its legislature is incapable of raising taxes in order to ever pay for them. It’s a fundamentally unsustainable status quo—something has to give—but realistically no one knows what will give, or when, or how. It might be those debt payments, but a debt default wouldn’t really solve California’s problems, since California’s debt isn’t actually all that large, as a percentage of GDP.

More generally, the municipal bond market is a very complicated place, where expertise is hard-earned and voluble new entrants are inherently mistrusted, normally for good reasons. (See Bond Girl on Meredith Whitney; she doesn’t even mention the conflicts inherent in having a rating agency give investment advice.)

But complex doesn’t play well on TV; strongly (if briefly) held opinions do. So, as ever, expect more heat than light whenever you see an expert on TV talking about anything.


I don’t see how they get from budget shortfall to default? The ‘juice’ they pay is roughly $6B in a $85B budget… the gap is about $25B! Defaulting would only be a drop in the pan of a single year’s shortfall, and so wouldn’t serve any purpose except to curtail their ability to borrow tremendously.

The talk of Cali default is dumb, but discussing the shortcomings of California legislature and budget practices DEFINITELY warrants more conversation.

Posted by CDN_finance | Report as abusive

Rating munis

Felix Salmon
Nov 19, 2010 15:12 UTC

When Meredith Whitney released her magnum opus on America’s municipalities in September, there was lots of grumbling about why an expert in financial stocks should be listened to on the subject of municipal bonds. But she’s serious about this: building on the work that she did for that 600-page report, she’s now formally setting herself up as a credit rating agency in direct competition with Moody’s and S&P.

I see two forces at work here. One is the way that the reputation of Moody’s and S&P was shredded in the crisis, creating an opening for competitors; Jules Kroll sees that too. The second is the continued failure of the independent-research business model to actually make money. Many have tried and few have had any success: while financial institutions on both the buy-side and the sell-side do value high-quality research, they tend not to want to pay for it.

So Whitney is building a second revenue stream here: alongside selling research to investors, she’ll also sell ratings to issuers. I wish her luck: breaking the ratings duopoly is very hard, as anyone at Fitch will tell you.

But she’s chosen the right corner of the market to get involved in: municipal ratings are a racket. Municipalities are forced to pay big fees three times every time they issue debt: first to the bankers and lawyers for the debt issuance, then to the ratings agencies for a rating, and finally to the monolines for a wrap. The ratings agencies make sure that the ratings they give municipalities are lower than the ratings they give the monolines, so that the municipalities are forced to pay up to bridge the difference.

John Carney has published his theory that investors are wise to the idea that monolines are rated more leniently than municipalities, so none of this matters:

We’d only want to require the same criteria for corporate bonds and muni bonds if we discovered that measuring them by different criteria created some serious market failure. But markets aren’t as stupid as that. Markets are very much aware that muni bonds rarely default, regardless of the rating. This is why muni bond investors accept lower yields—they know they are getting less risk…

Rating munis according to the same criteria as corporate bonds would reduce the amount of information available to the market by obscuring differences in the risks of different municipalities. If two-thirds of munis were rated triple-A, investors would lack guidance about real differences between the issuers.

The truth is that different types of debt are rated on different scales, and the market is very well aware of this.

Muni spreads have gapped out since Carney wrote that, and so he’s changed his tune a little:

Without an exchange traded equity market, and free from many financial disclosure rules governing public companies, muni investors are dependent on analysts and ratings agencies to discover information about the financial health of issuers.

How bad can things get for munis? Very, very bad. During the 1873 Depression more than 24 percent of the outstanding municipal debt defaulted.

I’ve been saying something similar for a while, although I’ve been concentrating more on moral hazard than on financial considerations. (When a municipality’s bonds are insured, the cost of default falls quite a lot.)

What’s clear is that there’s real credit risk in the muni market, and that bond investors are very bad at doing the enormous amounts of legwork needed to measure it. Whitney sees profit there. And the more trouble munis get into, the more money she’s likely to be able to make in this market.


Kid Dynamite asks exactly the right question. No one pays for bad ratings and that’s the only kind Whitney will be giving out relitive to Moodys and S&P.

I’m kind of supprised that Bill Gross wouldn’t higher her and groom her for succession.

Posted by y2kurtus | Report as abusive

Beware municipal bonds

Felix Salmon
Sep 28, 2010 19:24 UTC

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.


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Posted by sanserve | Report as abusive

Harrisburg defaults

Felix Salmon
Sep 1, 2010 14:17 UTC

The Daily Beast kicked off this week’s offerings with a slideshow listing “20 Recession-Proof Cities”: the ones with high pay and sustained economic growth. I’m not entirely clear on how to link to any given city on the list, but if you click through you’ll find Harrisburg, Pennsylvania at #7, the very picture of a hale urban center.

Which is now defaulting on its municipal debt. It’s the largest municipal default of the year, after Jefferson County in Alabama, and it surely presages more to come.

It also shows the moral hazard of bond insurance:

A missed payment is “a bad signal,” said Alan Schankel, managing director at Janney Montgomery Scott in Philadelphia, adding that it raises the concern that some distressed issuers may be more likely to skip bond payments guaranteed by insurance companies.

It’s worth noting that Jefferson County, too, had its bonds wrapped by an insurer.

No one explains this better than Warren Buffett, who laid it all out in 2009: the people running municipalities are far more likely to default if they end up harming only insurers than they are to default directly on their bondholders — who are also likely to be their personal friends and colleagues.

Which might partially explain — along with an incinerator fiasco — why Harrisburg, which is doing quite well, economically speaking, has now contrived to default.


My roommate from grad school is a prominent educator in Harrisburg: “Yep, it’s all true. The story behind the story is that our mayor of 28 years was defeated last year by a brash city council president who blocked the plan to prevent default that the previous mayor had fashioned. In her now 8 months in office more than a third of the city’s capable government people have left and those she’s appointed have lasted at most 6 weeks before throwing up their hands in disgust and saying “She’s crazy!”. As you can imagine they are already lining up for the next election in 3 years and there is a recall movement gaining traction. Had she worried more about the city’s health than her election we’d not be reading the story you sent.”

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Institutions exit the muni market

Felix Salmon
Jul 8, 2010 18:11 UTC

Jenn Ablan takes a look at the muni market today, and although inflows have been strong this year, the smart money seems to be moving out of the market, positioning itself for a gruesome second half of the year.

The muni market is a curious beast. Most of it is highly illiquid, with small issuers, buy-and-hold retail investors, and tax-exemption rules which make enormous differences to the value of securities depending on where you live and what your tax rate is. At the same time, some big institutional players like to rotate in and out of the market on a speculative basis, with short time horizons, and when they do, they’re big enough to act as marginal price setters. If they’re moving on to the next thing, then prices are likely to fall a little — which is actually no big deal, for anybody but institutional investors who mark to market. Municipalities will pay a little more to borrow, but rates are still extremely low, and their investors, who are also their voters, will get slightly more attractive rates on their money.

The big danger in most markets when institutional investors leave it for dead is that it closes up entirely, and that borrowers have no market access at any price. That’s less of a worry when it comes to munis because they’re mainly reliant on individuals. At some point, if there’s lots of talk of default, then retail investors might stop buying municipal bonds, but that’s a little bit down the road. First you get the price decline (and CDS spreads widening out further still), then you get the default talk, and only then do you get the retail well drying up.

For institutions who mark to market, then, it makes sense to avoid munis for the time being: they have more downside than upside. But for buy-and-hold individuals, there’s no real reason to panic: you’re going to hold your bonds to maturity anyway, so it doesn’t really matter what happens to their value in the interim. And the chances are that they’re not going to default; what’s more, even if they do, you’ll probably end up getting your money back eventually in any case. And if you’ve lent to a big state-level borrower like California or New York or Illinois, you can be pretty sure that there will be some kind of government bailout too.

The real worry here is with the monoline insurers: municipalities are more likely to default if they know that their voters are still going to receive their coupon payments from an insurance company which provided a wrap for their bonds. But for the time being, at least, I’m not worried about a complete collapse of the muni market, where local governments in need of funds can’t raise the money at any price. That could yet happen, but I doubt it’s going to happen this year.


CNDRebel? What about the ARS securities they issued that the banks were forced to buy back? I also recollect the mortgage market was the same only a couple of yeahs ago.

Finally, shouldn’t these buysides being doing due diligence anyway? Crazy, outrageous idea I know. After all if they lose money they can just blame it on Goldmans.

Posted by Danny_Black | Report as abusive

Why munis don’t pose a systemic risk

Felix Salmon
Jul 7, 2010 21:48 UTC

David Goldman has reacted with a curious mixture of alarm and reassurance to Dakin Campbell’s story about U.S. bank holdings of municipal debt:

If municipal debt actually defaulted, the capital position of the banking system would be impacted, bank preferred debt might stop paying, and the holders of bank preferred debt–starting with the insurers–would be in serious trouble…

Why buy munis? For all of Warren Buffett’s dire warnings about municipal finances, the fact is that the federal government can’t let major municipal debtors (at the level of states, for example) go under without also bringing down the banking system and everything else.

If it goes, it all will go together. That’s why munis ultimately will be bailed out.

This is altogether far too sanguine. And if you look past the alarmist headline that Bloomberg has put on Campbell’s story, and the out-of-context numbers in his first few paragraphs, he eventually reveals just how much of a non-issue muni debt really is to the banks:

Lenders hold just 8 percent of the $2.8 trillion state and local government debt market, and municipal bonds are only about 2 percent of total bank assets, according to the Fed.

Muni bonds are relatively safe for two reasons. Firstly, they very rarely default; and secondly, when they do default, they generally have very high recovery values.

But let’s get ultra-pessimistic here, and say that 25% of municipal bond issuers will end up defaulting, and that recovery on those bonds will be just 50%. Then banks would have to take a hit of 12.5% on their muni bond holdings, which would correspond to a hit of about 0.25% of their total balance sheets. Needless to say, that’s not the kind of event which would precipitate a default on their preferred debt.

A widespread municipal default would be harmful to the economy more generally. With $2.8 trillion of munis outstanding, a hit of 12.5% would mean $350 billion of losses, spread across individual investors who were looking for safe, tax-free investments, and a lot of monoline insurers. That kind of thing can hurt. But investments in municipal bonds tend not to be leveraged, and for long-only investors, a drop of $350 billion is equivalent to roughly a 2.5% wiggle in the level of the U.S. stock market.

So I don’t think that munis pose a major systemic risk in and of themselves, although a handful of them — California first and foremost — are probably too big and politically important to be allowed to fail. There will certainly be a lot of wailing and gnashing of teeth if munis do start defaulting, since they’ve long been sold as extremely safe investments, and because they’re largely held by individuals rather than institutional investors. But no one’s going to bail them out because they’re worried about the banks.

When states don’t pay their debts

Felix Salmon
Jun 17, 2010 21:11 UTC

Greg Ip reports on how Illinois is going to have to start making unnecessary unemployment payments just because it’s refusing to pay its debts:

Illinois owes Shore Community Services, a non-profit agency in suburban Chicago, some $1.6m for services to the mentally disabled. The agency has had to lay off a dozen staff. Jerry Gulley, the executive director, says his outfit’s line of credit could be exhausted soon. The bank will not accept the state’s IOUs as collateral. “That’s how sad it is,” shrugs Mr Gulley.

Ip explained to me that these aren’t physical IOUs, like California issued, and they’re certainly not bonds — they’re just unpaid receivables. But even so, this is crazy: there’s no way that Illinois should allow the employees of a noble non-profit to be laid off just because it hasn’t got around to paying its bills. It’s the job of the state to encourage employment, not layoffs.

Other banks are reportedly accepting state receivables as collateral, but it seems to me that Illinois would do well to set up a formal system of paper IOUs, which would presumably be much easier to borrow against. More generally, I think that there’s a very good chance we’re going to see quite a lot of state-issued scrip in the years to come, not only from Illinois but also from other states with similar CDS spreads, like Portugal. As Ip notes, these states “do not issue their own currency, so inflating away their debt is not an option”. But issuing scrip is the next best thing.

The problem with states like Illinois, California, and New York is not the willingness of the executive branch to remain current on its debts; rather, it’s the ability of the legislative branch to make the kind of tough fiscal decisions which are politically dangerous. The more dysfunctional the state legislature — and all three of them are pretty gruesome in that regard — the more likely it is that the state treasury will find itself in a position of simply not being able to meet its contractual obligations as they come due.

Outright default on a state’s bonded debt is still unlikely:

The assumption of many investors is that the federal government would never let a state default. It might allow an isolated case, but if a default looked like the start of a wave, the federal government would surely blink—just as Europe did when confronted by Greece.

This is surely right, and I doubt that any state is going to attempt to pay its bond coupons in scrip. Everything else, however, is fair game — including payments for services to the mentally disabled.


This is a real problem, before retirement our company cleaned fleets of vehicles, and about 30% of our business was fleets owned by government agencies (all levels of government) and in the 80s, I cannot tell you how bad the receivables had gotten, 120-180 days out was common, it was a nightmare. Many small businesses think they are set to have government contracts, not so, you become their bank, and when they cut budgets or run out of money, you don’t get paid, it’s crazy. Most people don’t realize how they use the business community, state governments are the worst, your money comes out of another area or region usually, and they don’t care, and when they cut staff, they don’t return calls either.

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