We have two opposing camps in the muni-market at the moment: those who say it is the next systemic shoe to drop and the rating agencies that are systemically raising ratings.
Which is right?
We have moved from a market that has had heavy intermediation from the bond insurance companies to one where investors are on their own. Bond insurers historically performed heavy analysis and monitoring of the credits they insure and actively affect the legal protections embedded in a security. Bank credit enhancers have done the same, although in some cases their agreements allow them out of the risk under certain circumstances. Rating agencies assign their rating on sale and their business model has never been designed to provide robust monitoring of issuers in the secondary market. The Moodys and other agency default studies covered this time period – a relatively prosperous period from 1970 – 2007 when pending defaults on the investment grade level were mostly managed by bond insurers. Further, the default studies did not include insured bonds.
Municipal bonds do default and have throughout this period –not at all in large numbers by any comparison to the corporate world. Knowledgeable high yield investors are aware the risks in hospital, senior care, land development, and corporate-style tax exempts such as industrial revenue bonds. Project finance, such as the Harrisburg incinerator, Las Vegas monorail and Connector 2000 also carry high risk. (I should add WPPSS and other nuclear power projects to this list.) These should not be lumped together with the other 30,000 or so municipal bond issuers. Like the stock market, there are many, many nuances among borrowers. Only now the investor is left to grapple with his own resources – and the loss of granularity among this diverse and deep market from ratings “re-calibration”.
(Concerning re-calibration of ratings: As I have said before, lowering corporate ratings to their appropriate probability of default relative to municipals – would achieve the same effect, and be truer to their own research. Instead, the agencies are compressing ratings into fewer categories and eliminating much granularity for investors. But of course the other approach would have been business suicide and harmed many corporate portfolios.)
Within this, market prophets are now generalizing greatly, mostly those who have not spent their careers in this non-standard, messy, sometimes corrupt and poorly understood state and local financial world.
This brings me to some comments on Rick Bookstaber’s recent post. Many of his points are strong and need to be actively debated, but others generalize to the detriment of this very varied marketplace.
Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.
Agreed. The Tower Amendment should be abolished and municipalities that want to participate in public capital markets and be rated like corporates should be held to the same reporting standard. Period. Would you buy a corporate bond whose disclosure was two years old?
The argument that it’s too expensive and too burdensome for smaller municipalities to achieve transparency can and must be resolved. Technology and know-how exist to achieve this in a cost effective manner. Those municipalities that cannot produce timely and accurate reporting – should borrow locally and not expect to participate in national markets. Or they should not be given (potentially misleading) ratings. Borrowing locally will likely end up costing more than paying the auditor to get the report done in a timely manner. Hiding behind the “municipals don’t default, so what difference does it make?” argument is so yesterday.
The rating agencies still do not fully incorporate pension and other benefits into the debt statement that produces their debt ratios and medians. Taxpayers certainly do consider these factors. All obligations that are paid from the public purse should be clearly disclosed. Understandably, rating agencies argue that they serve investors not taxpayers. But political risk – unwillingness to pay – clearly reaches back into the investor’s pocket.
Size and potential systemic effects. That this is a big market in the credit space goes without saying.
This is a big market, but is not uniformly systemic like housing.
Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?
In some cases. Given our federal system, each state has its own set of rules for local municipal finance. For example financing infrastructure for housing and economic development is vastly different in structure and credit quality in California (Mello Roos for example) vs. Florida (community development districts) vs. Texas (municipal utility districts).
Bookstaber’s point does apply to the municipal market in several ways. Investment portfolios and cash management are prey to marketers of the security “du jour”. As one of his commenters suggests, Fannies and Freddies could put municipal investments systemically at risk of a federal policy change — affecting many municipal government investors at one time. I would add to this list: securities lending practices among pension plans and other large public funds (which some practice but others do not).
Ratings triggers on counterparties that create terminations, unwinds and a change in interest rates, basically legal provisions that automatically change the terms of the deal — also create across the board risk for those borrowers involved. Examples include variable rate securities, swap transactions, LOCs and GICs. These structures effectively embed corporate and market risk into municipal credit.
At the traditional fixed income municipal debt level however, there is significant diversification among security types and legal structures – given the 10th amendment and individual state peculiarities.
Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky — the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.
Agreed. Analysts and investors should incorporate a haircut for unfunded pension and benefit liabilities that use overly ambitious earnings as a discount rate. The debate about “risk free” vs. a historical earnings rates is an important one. Stated another way, this debate points to the fact that public pensions (defined benefit) are irrevocable, guaranteed and must be paid. How would you invest funds when you could not afford to lose a penny vs. money you are willing to take on more risk? Since pension obligations are long-lived, the counter-argument that earnings over time should be used has some merit as well. But the inequities between public retirees and the rest have piqued the taxpayer whose 401K and life savings have been subject to market losses. Also, the “defined benefit” retirees are facing off against the “defined contribution” beneficiaries. Fairness is an important public good, as difficult as this debate may be.
Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the underfunded portion of the portfolio.
Absolutely. Maybe they don’t have to do a site visit on each review, but they should disclose the date of their latest full review for each rating, no question. How many of the re-calibrated ratings have been freshly reviewed?
Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.
Disagree. See my comments above and other blog posts on this site. Municipalities do not behave the same as homeowners. Clearly there are scoundrels and irresponsible politicians who just want out of obligations they did not understand or were misled from the get-go.
Even with debt repudiation talk in the air, it is difficult to file bankruptcy in most states, and default is not a good option for a municipality that needs capital markets access. Plus, as covered elsewhere, given the 10th amendment, bankruptcy does not give the federal courts the same kinds of control over a municipality as a corporate entity.
Keep in mind that the majority of municipal borrowers (like the majority of homeowners) want to do the right thing.
Neither are taxpayers irrational. Protests are explainable. There are only certain states where initiatives and referenda are permissible (and this too has historical roots). There are correlations between rapid growth in taxable assets, public spending increases and taxpayer protest. (I have written about this on my blog and elsewhere.)
Taxpayers are right to be angry at politicians who are spending their money mainly to buy votes and for poor policy reasons. We need to look at the spending patterns in government and have this debate. How many say, “It’s a pre-election year, of course nothing will get done.” In the private sector, someone with that approach would be fired.
Two important worries Bookstaber hasn’t addressed directly:
Liquidity: There are major liquidity issues at some of the states, quickly filtering down to the local level. At least three states have held back making payments to localities and vendors – California, New York and New Jersey. At some point liquidity markets may stop lending – or the cost will become prohibitive — which will have immediate impact on the economy in those states. Where enough taxes roll in the next month to cover payments, these states will limp along until they are able to cure their structural imbalance or they will hit the wall. While some look for a federal bailout in this situation, a failure to tackle the cure for structural deficits is bad policy. As we learned in recent banking crisis, institutions that require regular market funding for survival will fail in a liquidity freeze.
State solvency: tied to the first point, there is no mechanism in our society to address state insolvency. States, as sovereign entities, do not go bankrupt. There simply does not exist any legal or political institution with the authority to facilitate an orderly reorganization of state obligations. We need to think up objective, non-political structures that put the brakes on spending increases when times are good and that facilitate reorganization when times are bad.
A typically informed, thoughtful and thorough analysis of the fiscal and financial problems states and governments currently face and a good response to the Bookstaber posting.
Very well reasoned and supported. Thank you for sharing this.
Thanks Natalie for your thoughtful comments.
Natalie,
You have performed a rare, and thought provoking piece on the muni sector.
Thank you for the Bookstaber response, as I thought it to be shallow and painted with a broad brush.
Keep up the great work.
Interesting analysis. The cool light of reason emanates throughout.
My own very non-technical opinion is that this issue will turn on the question of public sentiment, which is becoming more caustic and more cynical by the day. Speaking as a resident of Las Vegas, a city especially hard hit by this economic downturn, more and more people in this community are looking for two things: pitchforks and scapegoats. People are angry and desperate. Rational thought is deteriorating into an “us-them” mentality, the tide of which may rise to overcome whatever opprobrium may be attached to dishonoring bond obligations.
If, after bearing all measure of service cuts by their municipal and state governments, taxpayers are confronted with the choice of imposing higher taxes on themselves or inflicting investment losses on investors who are perceived to be fat cats feeding off taxpayer misery, the choice will be both straight-forward and, indeed, rational, but only from the perspective of the taxpayer.
The “reasonableness” assumed by this response to Dr. Bookstaber is the reason of people living normal lives in a normal economy. While I believe that many states and municipalities will be able to maintain this assumption and act effectively on it, I also believe that some higher-than-normal number of municipalities are going to have politicians voted into office who are not sympathetic to the concerns of bondholders, especially if those bondholders are perceived to be inflicting life-threatening harm on families.
With respect to your concerns about liquidity, I’m prepared to suggest that Dr. Bookstaber baked that issue into his thinking as an underlying assumption. To quote from his book, A Demon of Our Own Design, “most importantly, it is in the froth of liquidity that profits are made and that the market demons are spawned.” If profits are being made at the expense of human life, it seems reasonable to expect an antithetic spiritus mundi to arise from public outrage and despair. “And what rough beast, its hour come round at last,
Slouches toward Bethlehem to be born?” -Yeats
I offer the following articles in support of the Bookstaber thesis:
1. Frye, Andrew, and William Selway. “Buffett Says He Expects `Terrible Problem’ for Municipal Debt.” (2010). .
2. Malanga, Steven. “The Muni-Debt Bomb.” (2010). .
3. Gelinas, Nicole. “Beware the Muni-Bond Bubble: Where State and Local Finances Are Untenable, Investors Should Stop Throwing Good Money after Bad.” The Wall Street Journal (2010). .