Dark clouds in the Golden State
In a YouTube address released last Friday, California Governor Jerry Brown shocked his constituents with an announcement that the state’s projected revenue shortfall had increased to $16 billion. This followed very weak April state income tax collections, which deepened the budget hole from the $9 billion that Brown had originally forecast in January. The new deficit is a result of a reduced revenue outlook for California, higher school funding costs, and decisions by the federal government and courts to block certain budget cuts. New cuts that Brown floated yesterday will reduce General Fund spending as a share of California’s economy to its lowest level since 1972‑73.
The $92 billion budget that Brown had proposed in January for the fiscal year 2012-2013 (which starts on July 1) looked like this: With the new revenue shortfall, almost every area of the state budget has been targeted for cuts; education, which accounts for 53 percent of General Fund spending, is the only category that was spared. In his revised proposal, Brown substantially increased K‑14 spending (i.e., includes two years of community college or vocational training) and protected the University of California and California State University from further, deeper cuts. School spending is mandated by Proposition 98, which requires that California pass through a substantial portion of state revenues to local governments to fund education.
Overall, Brown proposed that half of the budget hole should be plugged with spending cuts, 35 percent with tax hikes and 15 percent with financial gimmicks. Brown’s preferred budget cuts (pages 5-7) total $8.3 billion and include a $1.2 billion reduction to California’s medicaid program (Medi-Cal), an $880 million reduction to welfare (Temporary Assistance to Needy Families payments) and a 7 percent reduction in hours to in-home supportive-care-services providers.
These monies are the lifeline that millions of Californians rely on. It’s hard to get a sense of the human side of this, but it’s enormous. And without additional revenues, deeper cuts will be required.
Reuters’ Jim Christie picks up the story here:
In California, where local property taxes are limited by law, and local services, including schools, are thus largely funded by the state, the most important source of government revenue by far is personal income taxes. Capital gains income from the state’s wealthy residents helps fill the state’s coffers in good times, but falls sharply in bad times.
California’s larger-than-expected deficit did not faze traders in the $3.7 trillion U.S. municipal debt market, said Gary Pollack, managing director at Deutsche Bank Private Wealth Management in New York.
“The market is taking it in stride for the time being,” he said.
California bonds have been trading a little better over the last few weeks, aided by rising prices and falling yields in the overall municipal market, Pollack said.
California, the muni market’s biggest borrower, has about $80 billion in outstanding obligation debt, compared with its $1.9 trillion in economic output.
The impact of defense cuts
Reductions to our outsize military budget are scheduled to take effect in 2013. Congressional Republicans have vowed to reverse these mandated reductions, but so far organized resistance in Congress has not appeared. President Obama has vowed to veto any legislation that would overturn the cuts.
I previously described the size of the annual reductions:
President Obama proposed spending approximately $924 billion on defense, veterans care and international affairs for 2012. This represents about 24.7 percent of the $3.729 trillion federal budget. The automatic cuts to these areas required by the Budget Control Act of 2011 will equal about $75 billion per year over eight years. This would be on top of already enacted Defense Department reductions of $45 billion per year over 10 years. The combined $120 billion of annual spending cuts will equal about 12.9 percent of the joint budget for defense and intelligence. It’s a big cut, but it would barely dent the capabilities of the biggest military force on earth.
Annual reductions of 13 percent are substantial, but the nation will still spend significantly more than any other on earth. And it’s important to remember we will be spending 25 percent of our federal budget on the military even though, it is hoped, we will not be fighting a war. It’s not clear that the U.S. would have the “fiscal space” to ramp up spending to fight another big war and care for Social Security, Medicare and Medicaid beneficiaries.
Where will these cuts come from, and who will be affected? Politicians, credit-rating agencies and defense contractors have been poring over the bits and pieces of information coming out of the Pentagon. Today the Department of Defense released the following:
There is no municipal CDS market
California Treasurer Bill Lockyer, who is responsible for issuing new debt for the state, takes a lot of interest in the price of California’s municipal credit default swaps. The price of muni CDS can affect the cost of issuing new debt, since some investors use muni CDS as a pricing benchmark. But new work published by risk-management firm Kamakura suggests that there is no real market for municipal CDS and prices are generated primarily by broker-dealers posting their best estimates. If a specialty market is just a matter of a few dealers privately sending quotes back and forth, is it a real market? I’m not sure that it is.
There was a big story last June about Treasurer Lockyer rooting out some inconsistencies in muni CDS prices. He noticed that there was a sudden drop in the day-to-day price of the CDS used to insure California’s bonds. Katy Burne of Dow Jones reported in June:
California’s state treasurer is looking into what he believes were erroneous prices reported last month for credit-default swaps tied to the state’s debt.
The annual cost of protecting $10 million of California debt against default over the next five years fell by $45,000 from one day to the next last month, an extraordinarily big overnight move. Tom Dresslar, a spokesman for Treasurer Bill Lockyer, said that CMA Datavision provided the prices to Bloomberg’s fixed-income data service.
Lockyer suspects the cost of credit-default swaps, which are expressed as a percentage of the amount of debt covered, was artificially high before the adjustment.
“To the extent our prices are wrong, particularly if they are on the high side, that presents an inaccurate picture of our creditworthiness, at least in some corners,” said Dresslar in an interview Tuesday.
The sharp-eyed treasurer noticed the pricing blip, which could have been either an error — a trader’s attempt to recalibrate the CDS in one shot — or the result of a real sale rather than just best-estimate price quotes. I noticed the same thing for eight states whose muni CDS blew out in December. During that time the muni CDS for New York State leaped 17 percent in one day. This suggests that the market was very thinly traded and when a seller showed up to unload securities, not many were there to buy them. In this case the buyer has a very strong advantage and can force a deep discount to “help out” a panicked seller.
The newly published work of Kamakura confirms that muni CDS markets are very, very thinly traded. In their groundbreaking work Kamakura showed that almost no real trades happen within the municipal CDS markets, and the few trades that do happen are between broker-dealers. Kamakura found:
- The median number of non-dealer trades per day over the 77-week period among the 9 municipal reference names was 0.06.
- The highest average number of non-dealer trades per day for the full 77-week period among the 9 municipal reference names was 0.36.
“We find, unfortunately, that (in the words of Gertrude Stein) ‘there is no there there,’” Kamakura says. With a median of only 0.06 of trades per day being done by non-dealers, I would definitely say there is nothing there.
Muniland’s most active states
In the municipal bond market, one of the most insightful ways to examine a state is to look at how actively its bonds trade. Broker-dealers make money by trading, so naturally they go where the action is and commit market-making resources to those states. It’s generally true that the most populous states are the ones with the most traded bonds, but if we map the wealth of a state’s citizens to how often that state’s bonds trade, we get some interesting results. For example, New Jersey, which has only 2.8 percent of the national population but a high proportion of its wealthy citizens, might have the highest number of municipal bond owners as a percentage of state population.
The municipal bond market does not trade on an exchange but rather on “alternative trading systems” (ATS). These are systems where dealers post inventories of bonds to be aggregated. The largest of the retail ATS is Bonddesk, which does some excellent data analysis for both the municipal and corporate bond markets.
From Bonddesk’s December Transparency Report I pulled the data for these charts showing the seven most actively traded states’ bonds. Bonddesk uses “investor buys” data, which represents trades that end up in a retail investor’s account. In the bond markets there are often many trades between broker-dealers before the securities land in an investor’s account, so Bonddesk scrubs the data to show the real level of investor demand.
California is the largest state by wealth, population and municipal bond issuance. Although it represents about 12 percent of the U.S. population, it dominates with 30 percent of muniland trades. Even with its substantial demand, the state still has somewhat higher yields, as seen below. All seven states are rated AA, but Illinois and California trade with higher yields given their weaker fiscal position.
Let Europe kill municipal CDS
The solution to Greece’s debt crisis that Europe’s leaders announced on Thursday has market participants and commentators howling. It includes a provision that changes long-established rules for credit-default swaps mid-game. Mike Dolan, Reuters’ Investment Strategy Editor in Europe, said this:
For all the ifs and buts about the latest euro rescue agreement, one of its most profound market legacies may be to sound the death knell for sovereign credit default swaps — at least those covering richer developed economies.
I’d suggest that death knell just rang for U.S. municipal credit-default swaps (CDS), too. They’ve recently been on their last legs amid collapsing volumes, but actions in Europe just might have delivered the deathblow.
Credit-default swaps play an arcane role in financial markets. Firms allegedly buy them for protection against the default of bonds they hold in their portfolios. For example, if XYZ Investment Group owned $10 million worth of Greek government bonds that matured in 10 years (GGGB10YR:IND) and the Greek government couldn’t pay their obligations, then the seller of the CDS would step in and pay the CDS owner. Think of the CDS seller as a guarantor or insurance provider of sorts.
CDS are marketed as protection against the risk of default of the cash bond that they reference. Contrary to standing convention though, when the announcement was made that Greek bondholders would be asked to take a 50 percent haircut (or markdown) on the value of their bonds, the CDS governing group announced they would not be triggered. Their rationale was that the bond swap would not be compulsory and that CDS sellers would not need to make payouts to make up losses. Here is how a twitter user responded:
@amb5160 amb5160 the real story today is that CDS, a multi billion (trillion??) dollar asset class is GONE in one day! no more quotes on bberg. insanity
Why invest in insurance if the insurer says no payment is necessary because we have new conditions? It’s easy to understand the outrage.
I was under the impression that ISDA had not made a ruling yet on whether the haircut would be considered a default event triggering payment. If they do not it, I agree it will be a disaster for the cds market.
All high government approval ratings are local
This great graphic from Visually maps the public’s great discontent with the federal government using data from the Pew Research Center. It’s hard to imagine the numbers being any worse than this: 11 percent of the public is satisfied with the officials in Washington, DC.
Given Pew’s research, it’s somewhat counterintuitive that a recent poll from Gallup shows Americans pretty content with their state and local governments. From Politico:
Trust and confidence in local government has hovered around 70 percent for the past decade, and the recent gridlock at the federal level has done little to sully local impressions of government. In fact, 68 percent of respondents to a new Gallup poll on Monday said they had a “fair” or “great” deal of trust and confidence in their local governments.
State governments also received good reviews compared to their federal counterparts. A solid majority, 57 percent, viewed their state governments with a “fair” or “great” amount of trust.
It’s unclear why people trust local and state governments more. Personally I think all levels of government are susceptible to outside influences and corrupting internal players. People actually see the benefits of their local governments through roads, schools and garbage collection and maybe this boosts their trust.
The great muniland refi
Bloomberg picks up the theme I wrote about on Friday of the very favorable conditions municipalities are enjoying as they finance their debt. Bloomberg reports:
Thumbs down on infrastructure bank
Thumbs down on President Obama’s infrastructure bank
The Bond Buyer is reporting that U.S. transporation groups have given the thumbs down to President Obama’s proposed infrastructure bank. The core repayment mechanism for loans guaranteed by the proposed bank would be user fees and tolls. This contrasts to the current methods, which involve state and local governments borrowing in the municipal market to fund projects or the federal government collecting gasoline taxes to fund highway infrastructure. Given the growing opposition globally to the privatization of public assets, the core purpose of the infrastructure bank is bound to create more unease among public players and citizens. From the Bond Buyer:
American Trucking Associations president Bill Graves was skeptical.
“We’ve long advocated that roads and bridges should be paid for primarily by their users, through the most direct taxes possible: fuel taxes,” he said. “Allowing private capital to take their cut as part of an infrastructure bank, or by taxing other sectors to pay for roads and bridges, takes us further away from this core principle.”
Direct grants to state and local govts most popular part of Obama’s jobs bill
President Obama is struggling to get traction for his jobs bill. From Bloomberg:
A majority of Americans don’t believe President Barack Obama’s $447 billion jobs plan will help lower the unemployment rate, skepticism he must overcome as he presses Congress for action and positions himself for re-election.
By a margin of 51 percent to 40 percent, Americans doubt the package of tax cuts and spending proposals intended to jumpstart job creation that Obama submitted to Congress this week will bring down the 9.1 percent jobless rate. That sentiment undermines one of the core arguments the president is making on the job act’s behalf in a nationwide campaign to build public support.
But there is enthusiasm for direct grants to state and local governments.
‘Direct grants to state and local govts most popular part of Obama’s jobs bill’…..
You can’t really report the unemployment rate at 9.1% can you Bloomberg? Come on!
Since the real unemployment rate is considerably higher why not give the money back to the people who make up these states and call it ‘direct grants’. That would be a win-win situation. Let the people spend their money where they want to spend it rather than giving it to some public servants who work for the state and whose only expenditures will be to serve themselves.
Planning a 21st century power system
Planning a 21st century power system
One of the biggest issues for America’s infrastructure is improving the national grid that moves electricity around the nation. From Wikipedia:
Historically, local governments have exercised authority over the grid and have significant disincentives to take action that would benefit states other than their own. Localities with cheap electricity have a disincentive to making interstate commerce in electricity trading easier, since other regions will be able to compete for local energy and drive up rates. Some regulators in Maine for example do not wish to address congestion problems because the congestion serves to keep Maine rates low.
In the US, generation is growing 4 times faster than transmission, but big transmission upgrades require the coordination of multiple states, a multitude of interlocking permits, and cooperation between a significant portion of the 500 companies that own the grid.
To address the conflicting interests and lack of local coordination the Council of State Governments will be convening a national advisory panel to consider the possibility of developing a Transmission Line Siting Compact. It’s a good step forward and generally an area of economic development that needs much more attention.
The fight is about control
Sarah Kliff, writing in Ezra Klein’s blog at the Washington Post, says that the recent initiative by the Republican governors to reduce the federal role in the administration of Medicaid is about “process.” I think she is halfway there, but the fight is really about “control” of how Medicaid is administered. I believe this fight will be a central one in the Congressional supercommittee. From the Washington Post (emphasis mine):
California: the queen of borrowers
California is the queen of U.S. states given her size, wealth and desirability. Her economy is the eighth largest in the world and, as of 2008, the gross state product (GSP) was about $1.85 trillion, or approximately 13 percent of the country’s gross domestic product (GDP). It makes sense that she is the largest municipal bond issuer given her population, geographic size and infrastructure needs. California dominates muniland on many levels.
Although California has a large and powerful economy, she also has a history of more dynamic economic swings than the rest of the nation. I’m not sure where the volatility comes from but I thought the comparison between the U.S. unemployment rate to the rate of joblessness in California over several economic cycles was interesting. In 2010 California’s rate was 12.4% while the national rate was 9.6% (data provided by the California Department of Finance). There are substantial regional weaknesses in the Golden State.
The Treasurer of California, Bill Lockyer, keeps track of the state’s borrowing and provides the graph below showing that $71 billion of general obligation bonds have been issued. The state legislature has set a debt ceiling of $150 billion and it’s likely that the Treasurer will be coming to the municipal bond market to issue more bonds soon. In July he borrowed $5.4 billion through a bridge loan from Wall Street banks to tide the state through the turmoil of the U.S. Congress raising the federal debt ceiling. Market talk is that he will borrow approximately $11 billion in the fall to repay the short-term bridge loan and fund additional infrastructure projects. The Golden State issued $10.5bln of general obligation bonds during 2010.
My Thomson Reuters colleague, Dan Berger of Municipal Market Data, sent over the graph below which shows what happens to the price of California general obligation bonds as new bonds are issued. You can see the additional yield that must be paid on the bonds rises every August after more bonds were put into the market. The additional supply lowered the price of the bonds and made the yield go up. This is a good example of the dance all issuers play as they try not to flood the market with paper and raise their borrowing costs.
The gusher of municipal bond information
The municipal bond market is often thought of as complex and murky. This is understandable; after all, there are over 50,000 issuers of bonds and a million plus specific municipal-bond issues. It’s staggering to imagine so many different securities.
A specific bond issue can be as small as the $995,000 offer that the city of Moose Lake, MN has coming to market this week, or as big as last week’s jumbo-sized $10 billion “State of Texas Tax and Revenue Anticipation Notes, Series 2011A”. (The Texas notes mature in one year and are paying 2.50 percent interest — they’re hot as griddle cakes.)
Municipal bonds also come in many different shapes because there is very little standardization of structure among municipal bonds. A straight bond generally has a fixed interest rate, or yield, and a set maturity date, or time of repayment. But many municipal bonds have floating interest rates; many others can be called or refinanced when interest rates go down. Regulatory agencies like the MSRB or the SEC don’t require that bonds have a certain structure or feature, only that the details are fully and accurately disclosed.
Beyond understanding the structure of a specific bond most investors want to review the health of its issuer. The Bond Buyer describes what information investors need to access to:
Investors will need to understand the issuer’s underlying finance structure, sources and uses of cash, and the cost structure of an issuer’s budget, as well as their own economic and legal rights as investors — in and out of court — in the event of a bond default.
Several regulatory changes in the last few years have increased the flow of information about issuers in muniland. With the full implementation of the Municipal Securities Rulemaking Board’s EMMA system, investors now have near real-time disclosure of the offering details of bonds and continuing disclosure of the financial condition of bond issuers.
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Resident Muniland expert
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