Would the real default rate stand up?
So let’s start with the big picture. From Publicbonds.org:
In 1988, a study by Enhance Reinsurance Co. looked at historical patterns of municipal defaults from the 1800s to the 1980s and concluded that municipal defaults usually follow downswings in business cycles and are also more likely to occur in high growth areas that borrow heavily.
Following the 1873 Depression, when more than 24 percent of the outstanding municipal debt was in default, the greatest number of defaults occurred in the South, the fastest-growing region at the time.
Factors that caused defaults included fluctuating regional land values, commodity booms and busts, cost overruns and financial mismanagement, unrealistic projections of the future, and private-purpose borrowing. The report also said that since World War II, revenue bonds have been a new source of default, largely a result of revenue overprojections.
In 1999 Fitch Ratings published its first study of municipal defaults, which was updated in 2003. The latter study covered 2,339 cases of municipal defaults worth $32.8 billion between 1980 and 2002. It found that the cumulative default rate on bonds issued through 1986 (as they approached or reached maturity) was 1.5%, while the cumulative default rate on bonds issued between 1987 and 1994 was 0.63%.
Municipal bonds issued on behalf of corporations or by municipal entities had a much higher overall default rate because of their exposure to corporate risks such as bankruptcy.
Cumulative default rates were found to be lower for bonds issued after 1986. Fitch attributed this to the Tax Reform Act of 1986 (which restricted the issuance of tax-exempt debt).
Well that is the big picture. Basically muniland is challenged in difficult economic conditions and revenue bonds (those not backed by the obligations of the state) are more likely to default.
When I first saw the chart above with Income Securities Advisor data I didn’t remember hearing of 84 municipal defaults last year. Fitch Ratings said there was one muni default and Standard & Poor’s said that there were three last year. That is a big difference between Income Securities Advisor and the rating agencies.
The markets generally rely on credit rating agencies for these numbers. The major raters employ hundreds of municipal analysts so I’ve assumed they would have the most complete data. Rating agencies don’t rate bonds unless they are paid a fee. So maybe bonds near default stop paying the rating agency fees and never get counted as defaulted?
More data is needed. And there will be more coming. Stay tuned.
Standard & Poor’s: 2010 default and transition study
Fitch Ratings: U.S. Public Finance 2010 Transition and Default Study
Muniland: Muni default spreadsheet
Moneyshow.com Will the Muni Market Collapse? Richard Lehmann of Income Securities Advisors interview