MuniLand

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.

Like U.S. Treasury debt, muniland securities have been hot, hot, hot. Investors have been piling into municipal bonds for about 16 consecutive months. At first, demand was driven by investors who were attracted to the high yields in the wake of Meredith Whitney’s predictions of default, which scared retail investors out of the market between November 2010 and February 2011. Demand then accelerated as the Federal Reserve kept interest rates at artificially low levels, driving investors out of Treasuries and into riskier assets. Steady municipal bond mutual-fund flows, coupled with the reinvestment of muniland proceeds into new bond issues, has also helped keep demand elevated.

On the supply side, municipal bond issuance in 2011 slowed to $295 billion, down 32 percent from 2010 and the lowest level since 2001. This lack of supply, along with massive demand, has covered over a lot of issuer weaknesses that would normally drive yields higher. Bloomberg reports:

“There’s a shortage of bonds out there,” said Paul Mansour, managing director at Hartford, Connecticut-based Conning, which oversees about $10 billion of municipal bonds. At the same time, “there’s a rush for yield, and it’s masking the differences” in issuers’ credit quality, he said.

Puerto Rico is a small island with a population of 3.7 million people and a municipal debt load of $104 billion. Only Florida, Illinois, New Jersey, New York, Ohio, Pennsylvania and Texas – states that are all substantially larger – have more debt outstanding. Puerto Rico’s government has been financing its deficits with bond issuance, although it recently vowed to put an end to this practice in 2014. The island’s economy has been contracting for several years, but recently it began to move slowly toward positive growth. Puerto Rico’s labor market is similarly weak, with an unemployment rate of 15 percent, nearly double the national rate of 8.1 percent.

In short, Puerto Rico’s debt-to-GDP load and unemployment rate are greater than those of any state in the country. It’s on a knife’s edge, and it’s easy to imagine several black swans that could precipitate real fiscal distress.

Puerto Rico’s bonds enjoy some special qualities that keep demand for it at high levels. The island’s municipal debt enjoys a triple-tax-free exemption across the country, meaning that investors in any state do not have to pay federal, state or local taxes on it. Wealthy bondholders in high-income tax states like New York and California can earn more yield by purchasing tax-exempt Puerto Rican debt than they could if they purchased the bonds of other states. Moreover, many municipal-bond single-state mutual funds are able to take advantage of this tax-exempt status and invest in Puerto Rico’s bonds. For instance, a mutual fund that is nominally invested only in California bonds is allowed to own Puerto Rico bonds as well, but not bonds from Texas or New York.

Last month, Puerto Rico Governor Luis Fortuño delivered a speech at the libertarian Reason Foundation on “how Puerto Rico avoided becoming “America’s Greece.” In his talk, the governor espoused the anti-government ethos of Grover Norquist, whom he cited as a friend in the first minute of his remarks. Fortuño has been a staunch advocate of “right-sizing” government: Soon after taking office, he laid off a substantial number of the commonwealth’s employees and reduced the island’s personal, corporate and property taxes.

Despite these cuts, Puerto Rico’s budget is still unbalanced. Fortuño has been relying on bond issuance through COFINA, the government’s off-balance-sheet, special-purpose vehicle, to make up for annual shortfalls to his budget.

Now, Republicans in Congress are working to blow another hole in Fortuño’s budget. As part of their effort to stave off the impending, automatic cuts to the defense budget, House Republicans passed legislation that kills a special provision of the Affordable Care Act increasing Medicaid grants to Puerto Rico. Faced with the threat of losing billions of dollars in federal payments each year, Fortuño now seems to think that lower federal spending is not that appealing. He pushed back on these cuts in an op-ed on CNN.com:

Dear Governor Fortuño:

I wanted to write you to discuss the condition of Puerto Rico’s economy and its municipal debt load. After I wrote a column last week entitled “Puerto Rico is America’s Greece,” I was surprised to see the piece get a lot of attention. What I said has been common knowledge in the U.S. bond market for some time, and the facts that I brought up have been previously pointed out by the major credit rating agencies. For those in municipal bond markets, I wasn’t really adding much that was new to the conversation.

But it turned out the attention my piece was getting was from people outside the bond market. Those who were responding to it were those who love Puerto Rico and are concerned about its future, namely its citizens. They seized on what I wrote and passed it around on Facebook. Newspapers like elnuevodia.com and blogs picked it up and debated the fine points of the island’s unemployment rate and deficit spending. I’ve never seen anything like it in the United States.

Now, before going any further I need to mention that I made one mistake in that piece, which I did not discover until I read the rating agencies’ reports about the commonwealth. Your constitution requires that bond principal and interest be repaid before your government can make any other expenditures. That means bond repayments take precedence over payments for education, healthcare, government-worker wages and pensions. Bond markets cheer for this, of course, but I’m not sure that your citizens are entirely aware of it. Michael Corkery of the Wall Street Journal also wrote about your bond offering last week and didn’t mention the seniority of payments that makes your debt so appealing to investors.

Muniland was quiet today as market participants confined the bloodbath to the equity markets. Investors mainly sat on the sidelines and benchmark yields were unchanged. The Thomson Reuters Municipal Market Data 10-Year AAA Scale closed at 2.38%, unchanged from Friday. Reported volumes were light.

The worst muniland event of the day occurred when Moody’s announced that they had cut Puerto Rico’s general obligation debt rating to Baa1, a level close to the bottom of the investment grade scale. Because it is a territory, Puerto Rico has the unique distinction of enjoying national exemption from local and state taxes, so its debt is widely held across America. It is also among the cheapest municipal bonds available because the market believes it has some likelihood of default due to high levels of debt and unfunded pension liabilities.

The muniland non-story that commanded headlines was the expected downgrade of state and local bonds due to the Standard & Poor’s downgrade of the United States. Chris Mauro of RBC Capital Markets has some very good analysis about the arcana of this market and how the headlines are wildly overblown:

According to the credit rating agencies and the bond markets, these are the 8 states with the weakest credit profiles. These states may be weak because their debts are too big, because their economy is flagging or because they haven’t adequately funded the retirement of their employees. If this were a school, these would be the students sitting in the back of the class. Maybe it’s time for these states to do a little more homework.

We start with the weakest Puerto Rico, a United States commonwealth. #1 – Puerto Rico

#2 – Illinois

#3 – California

#4 – Michigan

#5 – Nevada

#6 – New Jersey

#7 – District of Columbia

#8 – Rhode Island

Happy days may be over in our 51st state. Joan Gralla of Reuters reports:

Puerto Rico’s credit rating might be cut due to its “deeply underfunded” pension system, Moody’s Investors Service said on Tuesday, in a reminder of one of the biggest threats to state and local finances.

Puerto Rico now is rated A3 by Moody’s; about $28 billion of debt issued by the Commonwealth was affected by the warning from the credit agency.

Puerto Rico’s financial problems are not only deep but long-standing. Moody’s cited years of over-estimating revenues, underestimating expenses and relying on deficit borrowing.