MuniLand

Illinois, the state in the weakest fiscal position, is planning two big bond deals in the first quarter of 2012. Next week they plan to raise $800 million in general obligation bonds to finance various transportation projects, followed by another $750 million later this winter in long-term bonds to fund construction projects.

Although the state is drowning in debt, unfunded pension liabilities and unpaid bills, these debt offerings are very restrained compared to the last two years when it borrowed to make obligatory payments to its heavily underwater pension system.

The State Treasurer, Dan Rutherford, had opposed issuing debt to fund pension obligations and managed to raise the alarm among his former colleagues in the Illinois legislature about the dangers of endless borrowing. Rutherford’s actions may have reversed the momentum of Illinois’s debt issuance. He is certainly the first fiscal officer that I have heard of who threatened to call the rating agencies to slow his state’s bond issuance.

In another important step for the cash-strapped state, Illinois raised the personal income tax last year:

An income tax hike enacted in early 2011 that will raise $6.8 billion in new revenue annually helped ease the state’s cash flow and budget woes, but its unfunded pension obligations still pose a daunting challenge to efforts to stabilize its fiscal house. The state’s funded ratios were the lowest among states last year based on fiscal 2010 results.

Matt Taibbi’s latest piece for Rolling Stone, “How Banks Cheat Taxpayers,” blasts a common municipal bond market practice in which a state or municipality selects an underwriter for an offering without soliciting competitive bids for the project. These are called “negotiated bond offerings” in muniland parlance, and Taibbi likens them to a legalized form of bribery:

By “negotiated underwriting,” what Bloomberg means is, “local governments just hand the bid over to the bank that tosses enough combined hard and soft money at the right politicians.”

I really hope that Taibbi’s is making a hyperbolic statement to draw attention to his main premise that new bond offerings should done on a competitive basis, with which I agree entirely. But he implies that all state and local politicians are standing around with their hands out and are actively being bribed by Wall Street banks. If our country is that corrupt, we are in for a lot of trouble.

Recently the International Monetary Fund and David Wessel of the Wall Street Journal compared market dynamics for European sovereign bonds and U.S. municipal bonds. I suppose the thinking was that America is a developed fiscal union and could offer lessons to the less politically unified EU, but it’s an impossible comparison. Europe’s market for sovereign debt and the U.S. muni market have practically nothing in common except that they are composed of bonds and trade over-the-counter. They display idiosyncratic behaviors based on fiscal practices, market structure, securities ownership, market liquidity and their use as collateral at central banks.

The most basic difference is ownership. In the case of U.S. municipal bonds, households hold over half of the $3.7 trillion market (seen above). Retail-bond ownership is typically very stable, and most investors buy and hold bonds til maturity. American banks hold less than 10 percent of the muni market because they typically get little benefit from the exemption of federal, state and local taxes.

In contrast, EU sovereign bonds are widely held by European banks as part of their capital base as seen in this excellent Reuters graphic by Scott Barber. Scott’s graphic shows that the banks of every EU nation are deeply interconnected to other nations through their ownership of sovereign bonds. This interconnectedness creates channels for contagion to spread, but there is no equivalent for the U.S. muni market.

Bloomberg had a great piece that rounds up the factors that made municipal bonds the best performing financial asset of the past year. The story is framed as a knock on Meredith Whitney for her scare call a year ago:

This was supposed to be the year the $3.7 trillion state and local debt market would be rocked by an exploding pension time bomb and “hundreds of billions of dollars” of defaults, according to analyst Meredith Whitney.

Whitney’s Armageddon never came. Instead, munis became the star performers of 2011.

Lots of excellent municipal bond market analysis is coming muniland’s way, and I’ll be sharing some of it through the end of the year. First up is Daniel Berger of Thomson Reuters Municipal Market Data, who makes an interesting point about the municipal bond yield curve. He notes that the 10-/30-year slope (or difference in yield on 10-year AAA bonds and 30-year AAA bonds) has rapidly steepened since August 1. Berger attributes this to the great performance of 10-year AAA bonds over that period. In a little over two months their yield has dropped from about 2.55 percent to under 2.00 percent. Investors are loving these bonds — it’s a full on “flight to quality.”

Berger next gives us a snapshot of flows in and out of municipal bond funds. After a very rough beginning to the year it looks positive going into year end:

Muni bond funds posted about $1.04bln of net inflows for the week ended December 7, according to data released on Thursday by Lipper. This was the biggest inflow since March 10, 2010, when investors put $1.13 billion into the funds. The latest week’s inflows were a sharp turnaround from the almost $298mln of outflows seen in the prior week, which was the first negative reading in seven weeks.

The Federal Reserve has quietly admitted they had undercounted about $840 billion of municipal bonds. Bloomberg reports on this new pile of assets:

The U.S. municipal-bond market is 28 percent larger than reported in June, according to a quarterly Federal Reserve release, which used new data showing individuals own more state and local-government debt.

[...]

“The estimate of household holdings of municipal securities and loans is revised up by about $840 billion, on average, from 2004 forward,” according to the Fed’s Flow of Funds Accounts report for the third quarter.

It seems like foreign governments and corporations are craving U.S. public assets like toll roads, electrical grids and railways. In the case of our largest creditor, the Chinese government, they don’t want any more U.S. Treasuries, but they do want to own the hard assets that comprise our nation’s infrastructure.

Reuters Beijing bureau reported:

China may channel part of its huge pool of foreign exchange reserves into investment in U.S. infrastructure, including rail and transportation networks, Commerce Minister Chen Deming said on Friday.

“China is unwilling to take on too much U.S. government debt. We are willing to turn that money into investment,” he told U.S. Ambassador to China Gary Locke and U.S. businessmen.

I saw a strange tweet this morning that said “State CDS blew out yesterday per Bloomberg. Not sure what I missed here.” The anonymous tweeter attached the image above of graphs of credit-default swaps for 9 big states. Notice the very sharp one-day spike for every state except Ohio. Those spikes mean that those who trade muni CDS suddenly thought U.S. states were riskier, by anywhere from 2.09 percent to 17.02 percent, in one day. That is a big gap up.

Municipal CDS reference the equivalent cash bonds of the obligor. So a NY10Yr CDS references New York State general obligation bonds that mature in 10 years. CDS and cash bonds use different units of measurement but generally move proportionally to each other. So if investors no longer want New York State general obligation bonds and their price declines, one would usually see the CDS sell off too.

But municipal cash bond markets didn’t sell off yesterday. You can see in the Thomson Reuters Municipal Market Data chart below that New York State general obligations have been trading pretty steady recently. There certainly wasn’t a 17 percent drop yesterday like there was in the NY10Yr muni CDS. What’s going here?

Most everyone knows that the Federal Reserve Board is responsible for making monetary policy, handling prudential oversight of many of the nation’s banks and keeping the clearing and payment system flowing. But the Fed has another fundamental function that often goes unnoticed: collecting financial and economic data.

Good policymaking flows from having fresh and accurate data. From my little experience with the Fed they are not doing very well at this task.

Reuters is reporting that Fed Governor Elizabeth Duke believes that household debt has declined since the financial crisis of 2008 and that this reduction in household balance sheets will position families to participate in the recovery when conditions tick up. From Reuters:

All year long, muniland has been dragging its feet on issuing bonds. Budgets have been much too constrained to take advantage of historically low interest rates. At the end of the third quarter of 2011 issuance was 39 percent lower than 2010, according to Thomson Reuters SDC data. Nine-month issuance for 2011 was $160 billion versus $262 billion for the same period last year.

It’s a veritable drought.