The Coming Collapse of the Municipal Bond Market

A money manager friend showed me an interesting research report by Frederick J. Sheehan titled “Dark Vision: The Coming Collapse of the Municipal Bond Market. This is a product of weedenco.com and available only to subscribers, but I will summarize it here.

Sheehan starts off by noting that a lack of panic by the ratings and government agencies does not indicate health for a financial market. He cites the fact that the Fed did not anticipate how bad the subprime collapse was likely to be and obviously the Moody’s and Standard and Poor’s ratings were ridiculous.

Sheehan notes that “spending is rising and revenue is collapsing” for all levels of government. Pension fund losses will require governments to double their contributions to pension plans (see my blog posting on public employee pensions). Spending is rising, e.g., in New York City from an average of $65,401 in compensation per public employee in 2000 to $106,743 in 2009. The number of full-time employees in NYC grew as well, despite falling school enrollment. The number of state and local government workers grew from 4 million in 1955 to 20 million in 2008 (5x growth, against less than 2X growth in U.S. population). Those workers receive an average of 43 percent more pay and benefits than a private sector worker.

Municipalities dealt with the separation between taxes and expenses by borrowing. In the mid-1990s, states and cities were retiring as much debt as they were incurring. During the 2000s, though, they borrowed about $150 billion per year in aggregate, peaking at $215 billion in 2007 by which time $2.7 trillion in debt was outstanding, more than two years’ worth of tax receipts.

Barring some sort of miraculous boom in the economy and pension fund investment returns, state and local governments are headed for insolvency and default. This means that valuing a municipal bond becomes a matter for a legal expert rather than an accountant. Even for the legal expert, it is apparently tough to predict what will happen. Let’s start with the Wikipedia article on Chapter 9 bankruptcy: “Previous to the creation of Chapter 9 bankruptcy the only remedy when a municipality was unable to pay its creditors was for the creditors to pursue an action of mandamus, and compel the municipality to raise taxes. During the Great Depression this approach proved impossible so in 1934 the Bankruptcy Act was amended to extend to municipalities.”

Without bankruptcy protection, a city that couldn’t pay bondholders would be forced to raise taxes until it could. This happened to West Palm Beach, Florida in the Depression and property tax rates rose to 42.5 percent of assessed value. Potentially bondholders might demand that the city hand over real estate to satisfy its debts. With bankruptcy protection, it is unclear what happens. Vallejo, California went bankrupt 18 months ago and their obligations have not yet been resolved (story). If courts allow municipalities to walk away from debt they’ll have every incentive to declare bankruptcy and start afresh. There are no shareholders in a municipality to wipe out and therefore the only negative consequence of a bankruptcy filing would possibly be having to pay higher interest rates for future borrowing. If on the other hand, governments are not allowed to walk away from many of their obligations, they will simply run out of cash. Are bondholders senior to pension obligations or not? It may be up to the individual judge. This is “uncharted territory for investors” as my money manager put it (he does not buy U.S. muni bonds).

Municipal bonds are still perceived as almost risk-free by most investors and consequently offer a low yield, according to Sheehan. He points out that if the municipalities don’t default, the investor gets only a slightly better return than in Treasuries. Why take the risk if you’re not getting paid for it?

This ends my summary of Sheehan’s report. My own opinion is that the main lesson of subprime is that an investor cannot rely on the ratings agencies or the government to protect his or her interests. ┬áThe never-employed guy in Cleveland with the house in a crummy neighborhood and no down payment? The risk that he would never make a payment should have been apparent to any investor who dug underneath the asset-backed security. Similarly, an investor in muni bonds can look at the municipality. Does the state have a shrinking population, high public employee salaries, and a big pension obligation overhang from when the population was larger? They probably will eventually default. And if an insurance company was dumb enough to insure the bonds, they’ll probably be bankrupt too.

http://www.taxfoundation.org/research/show/268.html gives a table of per-capita debt in each state and also the ratio of that debt to GDP. Massachusetts comes in at #1, with more than $10,000 of debt for each citizen and 20 percent of GDP. Each Texan owes about $1,000, by contrast, or 2 percent of GDP. The difference in yield between a Massachusetts bond and a Texas bond is probably not large enough to compensate for the increased risk of Massachusetts defaulting. This LA Times article contrasts California’s spending versus Texas’s.

[Separately, this table should be looked at whenever you're reading about an economist who says that the U.S. should borrow and spend more on "stimulus". They'll tell you that we can afford to borrow another 20 percent of GDP, citing the current federal debt-to-GDP ratio. What they don't tell you is that your state and local government may already have borrowed an additional 20 percent of GDP!]

The most serious weakness in the article is that Sheehan does not identify the mostly likely candidates to default. Surely Greenwich, Connecticut, whose residents were recently showered with billions of dollars in federally-funded bonus payments, is not going to have trouble repaying obligations incurred when investment bank salaries were much lower. But what about the Rust Belt? There must be cities whose factories have closed, residents have moved on, yet whose bond obligations remain. If so, let’s have the names! If not, how bad can the “crisis” really be?

More: A discussion of Sheehan’s report is available at the Daily Kos.

19 Comments

  1. jay

    November 3, 2009 @ 10:43 am

    1

    It’s interesting to look a that debt table and correlate it to red vs blue state. I have no idea what it means, but there certainly appears to be something there.

  2. philg

    November 3, 2009 @ 11:53 am

    2

    Jay: I don’t have 100 percent confidence in the debt table. I wonder if it is more a measure of how centralized a state government is. For example, Texas may borrow less at the sate level and more at the local level. I’m pretty sure that the Massachusetts state+local total would be greater than for Texas, but I find it hard to believe that there is a 10X difference.

  3. Jim Howard

    November 3, 2009 @ 12:50 pm

    3

    Glen Reynolds at Instapunidit has been giving a lot of attention to government pension induced insolvency.

    Here is a highly relevant link Glen provided today concerning the impending bankruptcy of City of Auburn Hills Michigan:

    http://theblogprof.blogspot.com/2009/11/city-of-auburn-hills-on-brink-of.html

  4. Chuck

    November 3, 2009 @ 1:57 pm

    4

    I think the debt table is misleading for some states.

    Take Alaska, for example. It is right behind Mass. at #2 on the list. By my calculations, their total debt (not per capita) is ~$6.6B. Yet, the Permanent Fund holds close to $40B, according to Wikipedia. Therefore, I’d imagine that Alaskan bonds were safer than others, because they could blow through that fund to pay creditors instead of giving handouts to citizens if they ran short of revenue.

    Unless, of course, my accounting is wrong, and the Permanent Fund is included in GDP somehow…

  5. philg

    November 3, 2009 @ 2:04 pm

    5

    Chuck: Obviously this table is not the full story. In the case of Alaska I wonder if it reflects the fact that nearly all debt is centralized. A small town in Alaska does not have a significant government (except for Wasilla, of which Sarah Palin was mayor!). The only paved road through town would be a state highway so if it were necessary to build a bridge or repave that would be financed by the state.

    Separately, Alaska is a young and growing state and should have some debt for recently built infrastructure. Massachusetts and New York are mature states with barely perceptible growth and an infrastructure more than adequate in size for the current population, so you wouldn’t expect them to have much debt (just as a 70-year-old person should not be taking on debt; he or she should already own a house, a car, furniture, appliances, etc.).

  6. David Jones

    November 3, 2009 @ 6:01 pm

    6

    I have been a Muni Bond investor since 1984. I called the last two stock market crashes almost to the day-having liquidated almost all of my equities to cash several weeks earlier. I have stayed out of the Muni market for about two years now. Recently, I cashed out some Trueasuries and bought a few rural Minnesota offerings–but I did my own Due Diligence on the towns. The thing I really worry about is Retirement obligations. Even small villages will continue to maintain their high staffing levels for public employees–sometimes at all costs–they are most likely relatives, and who wants to lay off relatives?
    What I worry about is Obama doing a GM-like screw job on bond holders if there is a debacle. I am being very conservative. As my Treasuries mature, I am even considering going to greenbacks or Euros and sticking them in a fireproof safe…Pilot Dave

  7. Bob_in_MA

    November 4, 2009 @ 11:58 am

    7

    It seemed to me pretty obvious that that chart was suspect, so I did a little research.

    Massachusetts ranks 1st in state debt, but 49th in local debt. Much of what is financed by localities in Texas is financed by the State in Massachusetts, e.g.

    So I found total state and local debt here:
    http://www.census.gov/govs/estimate/

    Then I came up with the number of households and arrived at the total debt per household. Then I divided that by the median household income.

    For Massachusetts, the the state and local debt per household was 46% of median household income. For Texas it was 44%.

    Lies, damn lies, and statistics….

    That’s not to say municipal debt levels are, or are not, sustainable.

  8. Jack Strong

    November 4, 2009 @ 2:41 pm

    8

    In your eminently correct analysis you fail to point a finger at the cause of exploding local and state debt, which is the rise of public employee unions. In many states and municipalities, certainly in California and New York, for example, public employee unions exercise nearly absolute control over the politicians. They offer overwhelming financial support to the candidates who support their agenda, which invariably is to increase their own pay and benefits, as well as to increase the size of their organizations. The conflict of interest inherent in allowing public employees to organize, and use taxpayer revenues to promote their political agenda, should be obvious to any voter, as well as members of the press, but it is only now, slowly, coming to light. Public employees now enjoy pay and benefits 2-4x what similarly skilled taxpayers earn in the private sector, with far less job insecurity. Their unions not only control the politicians, they control the bureaucracy and the public employee pension funds. The influence and role of public sector unions in the Wall Street meltdown, because their pension fund managers were dishonest about what might constitute a sustainable return, alongside the bankruptcies-in-waiting that now define every city, county or state they control, is a story that needs to be told. Public sector unions should be illegal. But the damage they have done will take a generation to undo.

  9. philg

    November 4, 2009 @ 3:46 pm

    9

    Jack: It is not my analysis! I’m giving you a book report of what this Sheehan guy wrote. As far as public employee unions go, I proposed in http://philip.greenspun.com/politics/economic-recovery that they be de-recognized. I personally think it is immoral to tax a 67-year-old working at Walmart for $10 per hour so that you can pay a 50-year-old retired government worker a $70,000 per year pension. The economy is a tough enough place for an older worker in the private sector. Government does not have to make it tougher by taxing that person so that young people can be paid not to work.

  10. PaulS

    November 4, 2009 @ 3:50 pm

    10

    Good analysis Bob_in_MA. The other thing you need to consider is the revenue side. We have many NH residents who drive many miles each day to work Massachusetts, leaving behind 5.3% of their earnings when they high tail it back across the boarder at night, not to mention tolls and other taxes. This doesn’t show in the per capita numbers. When you consider this, plus the diversity of jobs in this state, the bond issue does not look as bad here.

    Once again, we should be very concerned about out of control spending, but a bond bubble burst would seriously hamper gov’t's ability to finance projects and debt for at least a generation, I’m pretty sure the solons would not allow that to happen.

  11. Jack

    November 4, 2009 @ 4:04 pm

    11

    Muni bond collapse is a great thesis. And, that full weedenco report is available elsewhere online, for free. unfortunately, it reads more as a bunch of assertions and randomly gathered factoids rather than an actual logical case systematically derived from data. a lot of the report focus on the fact that few commentators saw other bubbles/collapses coming, so thus the public confidence in muni commentators is misplaced. true dat, but necessary evidence ain’t necessarily sufficient evidence.

    Nice work Bob_in_MA… would love to see that work for all the states. Not to mention broken down by municipalities — then we’d really know where to place our bets!!!

  12. Thisson

    November 4, 2009 @ 5:16 pm

    12

    Not to mention that some of those “retirees” receiving pensions continue to work in lucrative “consulting” positions for their former employers while they receive their pensions.

  13. RD

    November 4, 2009 @ 10:25 pm

    13

    It will take true calamity to do anything about local unions. The purest technocrat in the country (Bloomberg) spent a year fighting them during the last budget crisis. He failed to gain meaningful concessions, and got so badly burned in the attempt that he’s barely touched it since. Court-imposed contract modifications or New GM-style union bribery are probably our only hope.

  14. Karen

    November 5, 2009 @ 9:18 pm

    14

    First, the stat in the article compared average public employee pay to average private-sector pay OVERALL, with no attempt to compare jobs with similar levels of responsibility or skills. It could very well be that there are a lot of low-skill private-sector jobs skewing the ratio.

    In my field (bridge design), engineers working for the state Transportation Department get great benefits and good job security, but they don’t make more money than engineers working for private consulting firms do.

    Like Jack, I read the report by Mr. Sheehan and was similarly unimpressed. Apparently in the ’30s there were repeated attempts to rewrite the law to allow municipalities to default on bonds rather than to raise taxes – but then you read on and discover that each attempt failed.

    And the information on state-government debts is presented with no mention of the apparent fact (per a Reuters article on Oct 9 2009) that “every state but Vermont is required by law to balance their budgets.” At the least, that would demand a more careful look at what state governments are borrowing for. If it’s major capital-improvement projects with credible future revenue sources (toll roads?), maybe that’s not a disaster in the making.

  15. philg

    November 5, 2009 @ 9:39 pm

    15

    Karen: A lot of bond issues recently by states seem to be to make up for underfunded pension liabilities. They are borrowing money with a bond and then paying the cash into a pension fund for public employees. The automakers did a lot of this too in the years leading up to bankruptcy. (The book While America Aged covers one of GM’s pension bond offerings.) http://articles.latimes.com/2003/jun/29/opinion/op-smalhout29 talks about this as well.

  16. Charles

    November 7, 2009 @ 7:04 pm

    16

    “Those [state and local government workers] workers receive an average of 43 percent more pay and benefits than a private sector worker.” I’ve never seen anything like this in other developed countries (I have no idea how much public employees earn in third world countries and in developed nations), neither in countries with a large public sector nor in the richest ones. If anyone happens to know: Is this a US-only phenomenon or are there other examples?

  17. philg

    November 7, 2009 @ 11:00 pm

    17

    Charles: A Google search for “public versus private sector wages” in various countries revealed that most of the time government workers are paid more than those in the private sector. The 43 percent number is probably not accurate. http://www.cato-at-liberty.org/2009/08/24/federal-pay-continues-rapid-ascent/ shows that, including pensions and other benefits, federal government workers are now paid twice as much as private sector workers. That isn’t adjusted for job security or working hours, so probably the difference is closer to 3X. It may even be infinite for a lot of government workers. Think about the last few government workers with whom you interacted. Given their level of initiative, drive, and responsiveness, would they have been able to obtain private employment at any wage?

  18. Friedrich

    November 8, 2009 @ 2:42 am

    18

    I do not feel this will be the worst coming. What about the credit card debts? What about the governement bonds?

    I do not have the figures for the (C)US handy but here in Germany we’re talking about
    http://www.handelsblatt.com/politik/deutschland/1000-euro-mehr-schulden-fuer-jeden-buerger%3B2375071

    Our whole budget was planned at around
    283,2 Milliarden (that are Billions in US) so we have 86 billions new debts in 2009, will say 1/3 of the whole budget are new debts.

    This is insanity driven to the max. But it could be worse. Why not break the 100 Billion or 140 Billion barrier. I can not see any reason why we should stop here.

    Money is just a sheet of papter and isn’t that the saying:
    “ashes to ashes, dust to dust”….

    I can’t not see how they will get away with it… But…

  19. carlgjr

    November 13, 2009 @ 1:12 pm

    19

    This is all very interesting, and most based on certain facts gleaned from various reports.

    The bottom line is simple:
    As a taxpayer, in any state or municipality, you have no hope at all, because,
    government agents (all of their employees, unions, politicians, etc.) have your checkbook with all checks already signed.

    Oh sure, you could throw then out in the next election, but, just how many of the electorate are sharp enough to understand just what is going on??? Therein lies the real problem that we deal with. The NEA, by design, is doing everything in its power to keep the electorate “barefoot and pregnant”. Its the only way to lead the ‘sheep’. Get a smooth talker (with no substance) like obama, and the sheep will follow.

    What was it that Benjamin Franklin once said, “Well done is better than well said”.?

    It is a hopeless spiral and has been repeated many times throughout human history.

    I am loathe to quote statistics or reports because as some of us know, you can get statistics and reports to say and reflect whatever you are trying to put forth.

    The key is: Educate the populace with Civics (understanding just what your government is and just how it functions), Math (New York is just finding out how their High Schools and others are failing in this endeavor), Reading/Comprehension (how many times have you given the cashier $10.36 when the bill was $5.36 and they get this blank look on their face?).

    Our society is doomed to the waste heap of humanity like so many others, because of the NEA, pure and simple.

    Normally I am an upbeat guy.

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