The Municipal Bond Bubble: "Tip of the Iceberg" or Safe Bet?
The municipal bond market is large at around 3.7 trillion dollars. It is also essential. Municipal bonds allow the decentralized system of American federalism to provide highly localized critical social services. Your new school, new firetruck, new water-treatment plant, renovations to the library, and that noisy sidewalk repair project were most likely financed using municipal bonds. Most of the time local governments do not have cash on hand to finance costly infrastructure development projects. Instead, they borrow. And investors lend to towns and cities expecting a healthy R.O.I. About.com reports that indexed municipal bond mutual funds offer "Attractive After Tax Yields" outperforming treasuries by a little more than a percent.
Teachers, policeman, firefighters, town librarians, to quote Steve Miller "make a living on other peoples taxes." So do municipal bond investors. Cities make bond payments using receipts from current taxes. Most localities receive the majority of their income from property taxes (...and the rest from speeding tickets). The housing bubble burst. Property values plummeted. Tax receipts suffered as localities were hit hard by the financial crisis.
Bond investors were banking on the upward trend in property values. In effect, the borrowing costs and habits of America's local governments rested implicitly on the assumption of continued increases in home prices. Around a year ago, investment analyst Meredith Whitney predicted a massive wave of default in the municipal bond market. The prediction roiled speculators, but her doomsday prophecy has yet to occur.
Bloomberg reports: Instead, 2012 is shaping up as a year of diminishing failures. Forty-two issuers have defaulted for the first time this year, compared with 68 for the same period of 2011." Mary Williams Walsh o,f the New York Times, counters that claim. She reports Municipal bonds, widely seen as one of the safest investments, actually default more often than most people realize." Walsh cites research recently released by the Federal Reserve Bank of New York. Cities were much more likely to default on unrated bonds. "The biggest portion of defaults" Walsh reported were from, "industrial development bonds....issued by a government authority on behalf of a company... account[ing] for 28 percent of the defaults."
While ability to pay has decreased, municipalities continue to borrow.
Since the financial crisis, new debt issues have grown rather than decreased. Faced with shortfalls, and budgetary demands states, and localities have continued to look to the bond market for financial solutions. The future of the bond market seems less certain, as housing prices refuse to rebound, and local governments are faced with another year of deficits. The Wall Street Journal reports: "A decision by Warren Buffett's Berkshire Hathaway to end a large wager on the municipal-bond market is deepening questions from some investors about the risks of buying public debt."
Buffet earned one of the largest investment fortunes in history by understanding risk. His exit of the bond market could be a signal of deeper problems to come. Already a number of American cities have declared bankruptcy. Most notably Stockton, California, pop. aprox. 300,000, filed in U.S. Bankruptcy Court earlier this year. According to Bloomberg in Stockton after the Bankruptcy: "since at least 1981, and possibly as far back as the 1930s, no U.S. municipality has used bankruptcy to force bondholders to take less than the full principal due." Cash strapped cities such as Stockton may force Federal Bankruptcy Courts to choose between paying investors and public employees.
Meanwhile, in Stockton, things are getting worse. Shanty towns reminiscent of a scene from City of God mar the landscape.
With housing prices stubbornly sticking in the gutter tax revenues are unlikely to rebound soon. In a place like Stockton financial distress will leave a legacy of violence and degradation that could take decades to overcome. According to Reuters, Central Falls, RI may default and Jefferson County, Alabama has declared bankruptcy. Some investment analysis are claiming that this is only the tip of the iceberg; while municipalities try to convince would be investors of their creditworthiness. Only time will tell if governments and markets will work to produce more responsible outcomes in the future; but if states and localities don't take concerted steps towards greater fiscal responsibility, scenes like the one in Stockton, California may be coming to a locality near you.
- John Louis
About the author: John Louis is a Graduate Fellow at the Clough Center for the Study of Constitutional Democracy. He writes on political economy, public finance, and infrastructural development. His views do not necessarily represent those of the Center.
Please if you read the article. Post a comment.
ReplyDeleteWhy am I not surprised by this passage?
ReplyDelete"The biggest portion of defaults" Walsh reported were from, "industrial development bonds....issued by a government authority on behalf of a company... account[ing] for 28 percent of the defaults."
--
Cheap credit has paved the way for a serious debt crisis across the board. As borrowing standards become more stringent and prospective borrowers practice austerity, our credit-based economy is at risk of grinding to a painful halt. Because so much of the economy is wrapped up in the credit game one way or another, it's hard to imagine a realistic strategy—and crossing our fingers isn't a strategy.
Just as the first wave of the financial crisis exposed weaknesses in the banking industry via the housing market, I wouldn't expect these ongoing credit issues to remain confined to municipalities for very long. I fear this will hurt more (both in severity and ripple effects) than the initial housing market crash.
What's the solution? Am I too pessimistic?
Greg,
DeleteThank you for your reply. Yes "so much of the economy is wrapped up in the credit game one way or another, it's hard to imagine a realistic strategy." Credit contraction has been a major driver of the recession, despite the injection of "free money" from the FED in the form of artificially low interest rates.
There may be no solution. At least not from a policy standpoint. Fiscal austerity from government, although necessary, will be difficult to implement.
On the personal side. We are to used to fast money and cheap credit to actually save. Research suggests that since the recession American's have been saving less and not more since the recession.
see: http://money.cnn.com/2010/06/30/news/economy/personal_savings_decline.fortune/index.htm
We enjoy the benefit of easy credit without the cost of domestic investment in the form of household savings. If these fed funds targets and free money aren't encouraging more lending, then perhaps Bernake and Co. should consider something along the lines of what Greenspan did following the dot.com burst. Raising interest rates. A gradual increase in interest rates would help encourage savings and investments. That would at least be a step in the right direction.
You gotta know how to pick em. Some munis will default, most of them wont. Look at G.O bonds regarding hospitals. That would be your best bet in the muni game. Besides, our tax bracket isn't condusive to muni investing just yet.
ReplyDeleteThe real bubble is in junk bonds. High Yield is one of the worst things you could buy right now.
ReplyDelete