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.





municipal bond defaults (l): general

I’m finally trying seriously to formulate a detailed strategy statement for 2011.  As usual, I’ve waited to the absolute last minute.  In thinking about what might go wrong on a macro level, two issues stand out:

–possible EU sovereign debt problems and

–potential municipal financing difficulties in the US.

So I started doing research on municipal bankruptcies.

the slapstick

I learned there’s been a media firestorm over this topic during the past week, with real slapstick comedy overtones.  Putative municipal credit rater Meredith Whitney appeared on Sixty Minutes last week to predict that 50-100 cities in the US will declare bankruptcy next year, defaulting on “hundreds of billions of dollars” in debt.  This compares with the current record default year of 2008, during which cities stopped paying on about $8 billion of their obligations.  Muni experts were not amused.  They point out that the figure mentioned would imply just about every large city in the US going belly up.

Ms. Whitney is probably best known for being the spouse of former professional wrestling “champion,” John Layfield,  who performed under the nommes de guerre of “Hawk”  (a member of the Undertaker’s “Ministry of Darkness”), “Bradshaw,”  and “JBL.”  He is now a seller of herbal potions, as well as a financial commentator for Fox.  Whitney, also a financial commentator for Fox, gained fame while a bank analyst at Oppenheimer for her well-publicized (and correct) opinion that the financial crisis would be far worse than the consensus expected.

Though widely criticized for her non-consensus views on municipal finance, Whitney has found defenders, including Henry Blodget, a former Oppenheimer analyst himself, who is now barred from the securities industry as part of his agreement to settle securities fraud charges brought against him by the SEC.

the rationale

It’s not clear that Ms. Whitney has any deep knowledge of the municipal markets.  She does “get” the value of publicity, however.  And she has already been a big winner from understanding and exploiting two aspects of the traditional for-sale information business on Wall Street:

1.  Industry analysts depend for their livelihood on the viability and importance of the industry they cover.  As a result, they tend to gradually become like home-town sports announcers, that is, industry apologists.  They screen out any negative information.  That allows someone like Ms. Whitney to play the role of the boy who shouted out that the emperor wasn’t wearing any clothes.

2.  Sell-side analysts get noticed by staking out positions that are unusual and controversial, not by clinging to the consensus.  If radical positions prove wrong, customers quickly forget.  If the ideas are right, they’re the ticket to fame and fortune.  So a junior analyst has nothing to lose by getting as far away from the consensus as possible.

So not only is there a good chance that long-time observers of a section of the capital markets like municipals will ignore seemly obvious problems, but trying to point them out is a no-lose proposition.  So Ms. Whitney’s strategy of going out on a limb makes a lot of business sense.

the facts about municipals

two types of bonds

Municipal bonds are generally classified either as:

general obligation bonds, which means that the full faith and credit of the issuing government stands behind the issue, or

project bonds, or revenue bonds, which is basically everything else.  These bonds are backed by the revenue-generating power of some specific government-related endeavor.  They can range from a power plant or a road, to a nursing home or some more dubious private enterprise that uses municipal finance as a “conduit” or wrapper.

default rates are extremely low

According to data complied by Moody’s about issues rated by the agency, defaults on municipal bonds have been relatively rare.  Moody’s latest study covers the forty years from 1970-2009.  Of the 18,400 issues considered, 47% were GO issues, 53% project bonds.

Over that time period, 54 issues, or .3% of the total, defaulted.  Three of them were GOs, implying a default rate of .03% for GOs.  The project bond default rate was about .5%.

There has been some acceleration in the default rate, though.  36 issues, including all three GOs, have defaulted since the turn of the century.

In the defaults, investors’ recoveries have averaged 67% of principal.  The median recovery has been 85%.  The difference is caused by a few real clunkers of project financings where investors lost 95% of their money.

municipal bankruptcy isn’t easy to do

States can’t go into bankruptcy, period.

Cities and towns can go into Chapter 9 of the bankruptcy code, but require the permission of their states to file.  In a little fewer than half the states municipalities are simply prohibited from doing so.  In others, the process may be a lot more complicated–and time-consuming–than simply throwing a switch.

Chapter 9

Chapter 9 differs from the corporate Chapter 7 (liquidation) or Chapter 11 (reorganization), in that:

–the municipality must elect to enter Chapter 9.  Creditors can’t compel them to, as they can with corporate debtors

–Chapter 9 provides only for renegotiation of debt terms, not for liquidation

–the municipality continues to be in charge of operations, not a bankruptcy judge

–the municipality can’t enter Chapter 9 in anticipation of running out of money or even if it has decided to default on loans by simply not paying.  It has to be actually unable to pay.

In the case of a GO, if a municipality stops paying creditors can get a court order telling the municipality to raise taxes or do whatever else is necessary to raise the money need to cure the default.

Some commentators have observed that in the case of states, even those in the worst financial conditions, raising taxes by 2% would wipe out the budget deficits.  I don’t know if this is true or not.  I do think that matters are not that simple.  Higher taxes may increase non-compliance.  They may also hasten migration to areas (in the South or West) that don’t have income taxes.  As a practical matter, it’s entirely possible that raising taxes may result in a government getting in less revenue than before.

I’ve read, but been unable to confirm from the agency website, that the federal Government Accountability Office has recommended that municipalities use Chapter 9 as a vehicle for renegotiating employee pension obligations that they have previously agreed to but now find they aren’t able to afford.  In the few cases where this has been tried, however, the process is–as you might imagine–protracted and very contentious.

(In all this, remember that I’m an investor, not a lawyer.  My main point is that this area is much, much more complicated than it might seem at first.)

That’s it for today.  Tomorrow:  the scope of the problem and what effect it might have on the stock market.