MuniLand

Central Falls, Rhode Island — the smallest city in the smallest state — filed for bankruptcy today after years of decline. It is the fifth U.S. municipality this year to seek protection from the courts under the bankruptcy law. The Governor of Rhode Island stood with city officials as the bankruptcy process commenced. Reuters quoted him as saying in a statement:

“The current situation is dire and it necessitates decisive steps to put the city back on a path to solid financial footing and future prosperity,” Rhode Island Governor Lincoln Chafee said in a statement.

Central Falls’s population peaked in 1930 and has declined ever since; it currently has only 19,000 inhabitants. The town is extremely poor with median household income of $22,628 and per-capita income of $10,825, according to the 2000 Census. Central Falls, like many hidden American towns, is at the end of municipal row.

The city was placed in state receivership last year as its pension problems spiraled out of control. The twin municipal demons of debt and pension obligations have burdened this community with unsustainable costs as the population and revenue bases shrank. Bloomberg reports:

The pension’s obligations were $48 million greater than the fair value of its assets as of June 30, 2010, according to data compiled by Bloomberg.

The theatrics in Congress concerning the debt ceiling, now in their seventh month, have sent increasingly strong shock waves throughout the U.S. and global financial systems. The debt ceiling is the legislatively-imposed limit for the nation to issue debt to fund its activities. It’s been stalled at the same level of $14.3 trillion since May 16. The U.S. Treasury has been scrambling to find extra monies, including borrowing internally from the federal government workers’ pension plans, so that they can continue to pay the nation’s obligations. They say the cash drawer is near empty.

The United States borrows or issues debt for 40 cents of every dollar that it spends — that is a lot to borrow. The federal government turns around and distributes this borrowed money, along with taxes collected, to Social Security and Medicare beneficiaries, states and local governments and defense contractors. It also returns some of it to bond holders as interest payments. The federal government is so massive that this flow of payments equals about 24% of the gross national product. If this flow stops, substantial parts of the economy will stop.

Organizations that oversee, or participate in, the financial system are rightly concerned. One positive benefit of these long, drawn-out Congressional deliberations is that there is time for extensive planning and analysis. Credit rating agencies have particularly been concerned with the downstream effect on state and local governments. Today Moody’s issued a press release that affirmed the strong AAA rating of 400 local governments while saying it would review the AAA rating of 162 other local governments (emphasis mine):

Thanks to Jordan Eizenga at the Center for American Progress, you can see some scenarios of the impact of the halt in payments to states if the debt ceiling is not raised. Jordan says:

The key thing to remember is that these are cuts that would occur even if we protected Social Security, Medicare, Medicaid, defense, and UI. Failing to raise the debt limit causes unavoidable pain to states.

Roll your mouse over to see the effect on each state. More analysis here.

It’s on in Alabama

The crisis in Jefferson County, Alabama is quickly coming to a head. The County Commissioners’ willingness to file for Chapter 9 municipal bankruptcy is putting a lot of pressure on bondholders, led by JP Morgan, to agree to a settlement. It appears that the entire Alabama political structure is aligned to do the best for their citizens. Right now the epicenter of the struggle between the people and Wall Street is Birmingham, Alabama.

There has been a lot of discussion over the past few days about whether the United States deserves a triple-A rating. The weak and meandering attempts of the Congressional leadership and President Obama to reach a consensus on raising the debt ceiling has prompted this storm of confusion. The political theater is painful.

Most of the talk about ratings revolves around whether the level should be lowered one or more notches. But in The Telegraph today Ambrose Evans-Pritchard goes further and says it’s not really that important whether the United States retains a triple-A because the credit rating agencies don’t have the credibility to strip the rating to the world’s largest sovereign debt issuer (emphasis mine):

Yes, the US may be stripped of its AAA by Standard & Poor’s. A nice one-day story, but otherwise irrelevant. Global bond vigilantes are quite able to make their own judgement on the substantive default risk of the US. The rating agencies are out of their league on this one.

The debate between President Obama and Republicans in Congress is getting more and more confusing. The graph above might help a little in understanding what the basis for the argument is. There is a large and growing gap between revenues and outlays. The deficit, or the difference between what comes in and what is paid out, is funded by selling U.S. Treasury bonds. We have reached the upper bound of what we can issue unless the Congress increases the debt limit. This has repercussions everywhere, including states.  Reuters has an excellent overview of the effect on the states since they rely on the federal government for a significant portion of their funding.

A very good discussion of the larger issue is happening at Econbrowser:  Data: Spending and Tax Receipts, 1967-2011.

Data in the graph comes from the Congressional Budget Office.

Another short-term loan for California

The uncertainty about a federal debt deal has California seeking a short-term loan in the private loan market. This will carry the state until it can issue short-term bonds or revenue anticipation notes (RANs) in the bond market in August. Bloomberg reports:

If you say “Jefferson County” to a professional in muniland, you will likely get a shudder of mild revulsion. This Alabama county is the biggest example of Wall Street aggression towards a public entity since Orange County, California declared bankruptcy in 1994 after buying too many interest-rate derivatives. Dodd-Frank, the financial-reform law that’s been in effect for a year, changed the rules for municipal bonds and derivatives.  But did it change them enough to avert a repeat scenario?

First, a little background: Jefferson County was ordered by the federal EPA to build a sewer system at an estimated cost of $1.2 billion. The construction went over budget and was rife with massive corruption that has ensnared 17 people. The funding of the sewer project was equally corrupt. JP Morgan was under investigation for bribery in 2009 and eventually reached a settlement with the SEC. The Washington Post reported this at the time:

J.P. Morgan Chase agreed to a $722 million settlement with federal regulators over accusations that the bank and two former executives made illegal payments to win municipal bond business from Jefferson County, Ala.

Meredith Whitney has made a reputation for herself in muniland as an analyst that came from the equity markets to predict an impending municipal bond cataclysm. Municipal bond experts were flabbergasted at the enormity of Whitney’s call, as well as the lack of data she had to back it up. Her bark ended up being many times worse than her bite, and now my antennae are on high alert for analysts who come out of nowhere and make big, unfounded calls.

While working this afternoon I noticed John McDermott, a Financial Times blogger, tweet the following:

@johnpmcdermott MF global write that Moody’s underestimates vulnerability of school districts to a US downgrade — http://cot.ag/odqdwL

Muniland has always been a sleepy corner of the financial markets. This all changed last winter when, from out of the blue, dire predictions of the market’s imminent collapse were made on national television. Since then, there has been a lot of uncertainty about the stability of state and local governments’ revenues and their ability to support their debt loads. States took steps to tighten up the ship and get ahead of the problems. Now the data is starting to come in, and although muniland has many problems to address, matters look much better than were predicted.

Sanity Prevails On CNBC

I took this headline from a note published this morning by Daniel Berger of Thomson Reuters Municipal Market Data. Daniel says:

Yesterday afternoon we were pleased to see CNBC finally air an articulate case about the value of municipal bonds. On CNBC’s Fast Money afternoon show we saw Alexandra Lebenthal present an intelligent case that municipal bond investors can find value in long-term municipal securities.

Quis custodiet ipsos custodes? Or “who watches the watchmen?” Credit-rating agencies are the main watchmen of the financial system.  But can we judge their performance, or are they just black holes filled with “opinions?”

The credit-rating agencies continue to make headlines as they try and keep pace with a slowly sinking Europe and the efforts there to rescue bondholders. European banks, the ECB, and officials from the EU are trying desperately to concoct some kind of structured investment vehicle that will solve the Greek sovereign debt crisis without requiring a default. So far, the rating agencies are not eating their “inventive” cooking, and they have yet to bless any new “solution.”

Many observers believe that credit raters completely mis-rated mortgage bonds and that this caused the global financial crisis. Meredith Whitney implies that credit raters are vastly underestimating the riskiness of municipal bonds and have overlooked pension and other liabilities when judging state and local governments’ creditworthiness. But do we have any statistical evidence of any this? Are credit raters getting the ratings wrong on every type of bond?

For many years, a AA-rated municipal bond did not have the same risk of default as a AA-rated corporate bond. In fact, the corporate bond was about 6 times more likely to default.

Over the last two years, credit rating agencies have standardized the municipal and corporate rating scales. This was a substantial change for the municipal bond market and had the effect of raising the credit rating of thousands of municipal issues. Many don’t understand why this large structural change was made, so I thought it would be helpful to share the history.

Many professionals within muniland have said that a substantial amount of “granularity” was lost in the municipal rating scale when it was equalized with the corporate bond scale. A municipal bond previously rated A2 was likely moved four notches up the rating scale to Aa1. This has the effect of “bunching” municipal ratings into a tighter band than they had previously been in, and it obscured the prior “granularity” that the muni scale had.