municipal bond defaults (ll): implications

size of the market

Outstanding municipal debt amounts to something over $3 trillion.

I can’t find good figures for the breakout of the state vs. the local government portions of the debt (feel free to comment if you know).  The state portion, however, appears to be $2 trillion+ and the local government part $1 trillion-.

Over the past 15 years, the dollar volume of issuance has been roughly split into 1/3 GO, 2/3 project (revenue bonds).

State and local governments report unfunded deficits of around $1 trillion in the pension plans they offer to employees.  Independent observers suggest that if more conservative (and realistic) assumptions about the growth of assets are used, the underfunding may top $3 trillion.

Annual state revenue amounts to around $1.2 trillion.  Local government intake is about $900 billion.

hair-splitting, or maybe something a little more serious than that

Yes, there are unrated bonds.  Small local governments may find it too expensive to pay for a rating, for example.  Let’s ignore that market and ask:

How likely is it that fifty to one hundred cities or towns, involving hundreds of billions of dollars, default on their debts in 2011, as Meredith Whitney claims?

Eliminate GOs from consideration, since

–tax revenues are rising again,

–governments have lots of money relative to their outstanding debt,

–governments can be legally forced to reallocate funds to repay GOs, and

–GO defaults have been almost non-existent.

That leaves project bonds.

By far, the largest number of the 51 project loan defaults over the past forty years have been in health-care (21 instances) and housing (also 21).  The two currently comprise 6.6% and 10.6% of all rated municipal loans.

As I pointed out in yesterday’s post on municipal bonds, about .5% of the outstanding municipal project bonds have defaulted over the past forty years.  33 of those defaults occurred during the past decade, giving a ten-year default rate of .3%.


–to get $200 billion of defaults from the roughly $2 billion total outstanding of state and local project loans, it would be necessary for 10% of the loans to default, assuming defaulters were of average size.  That would be 333x the average number of yearly defaults over the past ten years.   Is this likely?  Unless municipalities want to default, probably not.

Others have commented that if we’re talking about bankruptcy rather than just default, the pool of possible dud loans shrinks to $600-$700 million.  If so, you can only get to $200 billion of defaults if a third of the outstanding loan amount goes bad.  This, in turn, can only happen if several of the biggest cities in the US, like New York City, or Los Angeles, go under.

My conclusion about the Whitney assertions?  I don’t know enough about the muni market to have an opinion.  My hunch, though, is that she has no case.

there is a problem, though

It’s possible that Ms. Whitney simply said what she thought she needed to say so that she would be endorsed as an expert on municipal bonds by Sixty Minutes–and thereby jump-start her new business. Arguably, she knew, or should have known, that what she was saying had little factual support.  But that doesn’t mean there’s clear sailing for state and local governments.  What got her on Sixty Minutes is the growing awareness of problems in municipal finance.

Two related problems actually.

The first is the size–personally, I believe the $3 trillion figure–of the unfunded pension liability for state and local government workers.

The second is the issue of state and local government budget deficits.  My thumbnail description is that governments are sized for the boom times of 2005-2006, and now are being forced by today’s lower revenues to downsize.

These are not problems of the magnitude of the financial crisis, when world commerce froze and corporations made massive layoffs. But they are significant.  And they’re gradually building, as companies and retiring Baby Boomers increasingly migrate away from high taxes and cold weather in the northeast and the midwest to warmer–and lower-cost–areas elsewhere.

Unattended, the pension problem will grow worse.  Balanced-budget requirements are forcing the second to be addressed.

effect on the stock market

…which is mostly what I’m concerned about.

I think the major effect will be to slow improvement in the unemployment rate, as state and local government layoffs offset private sector hiring to some degree.

I think it’s also possible that some municipalities will take the occasion of dealing with a budget deficit as an opportunity to address the pension issue by entering Chapter 9 and hoping to renegotiate contracts with employees.  That would doubtless make headlines and depress stock prices.  The process of change would also be long and arduous.  My guess, though, is that such events will be small enough that they’d represent buying opportunities rather than causing permanent damage to the market.

That leaves the states.  I think it’s telling that high-tax dysfunctional states like California, New Jersey and New York have recently elected governors who have run on platforms of fiscal responsibility.  As an equity investor, I find it impossible to handicap the chances of a material negative change in the financial situation of places like this.  I think Wall Street’s default option in such a case is to assume that the entities will muddle through.  Therefore, a sudden change in sentiment that had bond investors denying a state access to new financing could easily clip 5% off the S&P’s market cap.





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