Do muniland’s flare-ups signal a bigger fire?

July 16, 2012

Now that three California towns have declared bankruptcy in the past few weeks, the mainstream media is abuzz with headlines of imminent doom for state and local governments. Adding fuel to the fire were Warren Buffett’s comments on Bloomberg TV about how cities may find it easier to declare bankruptcy after seeing others do it:

“The stigma has probably been reduced when you get very sizeable cities like Stockton or San Bernardino to do it,” Buffett, 81, said in an interview today on “In the Loop with Betty Liu” on Bloomberg Television. “The very fact they do it makes it more likely.”

He said the nation isn’t on the brink of hundreds of billions of dollars in defaults, as banking analyst Meredith Whitney predicted in 2010. “I don’t think we’re at the precipice,” Buffett said. “People will use the threat of bankruptcy to try and negotiate, particularly pension contracts, with their employees.”

Unlike Buffett, I’m not sure that public unions will yield to local politicians who wave the threat of municipal bankruptcy at them. As soon as there is a case when labor and pension contracts are actually crammed down in a bankruptcy proceeding, then public unions might start to worry. The closest muniland came to this kind of restructuring occurred in the bankruptcy proceeding in Central Falls, Rhode Island. There, labor and pension contracts were modified, but its situation is unique because of Rhode Island’s law prohibiting any haircuts for bondholders. Unions had to take all the losses in the bankruptcy proceeding because no one else would.

Furthermore, Buffett might be talking his book here. Bloomberg reports that Berkshire Hathaway held municipal bonds valued at about $3 billion as of March 31 – about 9 percent of its fixed-maturity portfolio – and as much as $16 billion in derivatives tied to such debt. That his company’s position in muniland CDS is much bigger than his position in municipal cash bonds indicates that he is very pessimistic about muniland’s prospects and is willing to bet on that outlook.

In contrast, Guy Davidson of AllianceBernstein, a firm that has about $31 billion in municipal bond assets under management and about $3.3 billion in California bonds, has written that recent California bankruptcies don’t make a trend:

On Tuesday, San Bernardino, California, became the third California city in three weeks to announce its intention to seek bankruptcy protection. Does this mark the beginning of a significant trend toward bankruptcy, particularly in California?

The speed with which San Bernardino made its decision, the size of its announced budget shortfall, and the city’s claims of a long history of fraud are puzzling and alarming. It will be important for investors to understand both the cause of the announced $45 million shortfall and the charges of fraud. The more pressing issue, however, is whether more cities will follow it into bankruptcy. While we think a few more might, we don’t think it’s the beginning of a major trend.

Although I’m not a believer in muni credit default swaps, the CDS data vendor Markit reported that CDS spreads on California were slightly wider on the week by 6 basis points, or 2.4 percent, to 248.

California has been on the muniland radar for several years because of ongoing budget deficits, high unemployment and the acuteness of the housing crash. Municipal bond market participants have been monitoring it closely and are aware of its weaknesses. You can see how the market has been charging more for California paper in the chart at the top of the post, prepared by Dan Berger of Thomson Reuters Municipal Market Data. I called him to see if my sense of muniland’s rough patches was borne out by the data. We agreed that muniland overall is in good shape with the exception of the names in the chart above.

Of course Puerto Rico, which no one discusses, is the worst credit in muniland. Even at a time of impossibly strong demand for muni bonds, its 10-year bonds trade about 2.2 percent higher than AAA general obligation bonds. The second-worst credit is the state of Illinois, and Dan Berger suggests that we include the bonds of Chicago in the same bucket. In the third- and fourth-worst positions are California and Nevada.

American cities and states are enduring a lot of fiscal stress, and in some cases their municipal bonds are showing stress too. But overall the muni bond market feels comfortable with the debt of U.S. states and cities. The data does not suggest a broad meltdown.

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