A bit of back-story is in order here.
Before the tech crash I moved my portfolio almost exclusively to municipal bonds via a number of instruments. I did this because I knew that the Internet bubble would be popping, but not exactly when it would happen, and I wanted a place to hide that would provide reasonable shelter from what I expected to be a 30% or greater market decline.
The fact that munis also tossed off tax-free income was a bonus. I could have hidden in general corporates or even Treasuries (which had a fairly attractive yield at the time) but on a tax-adjusted basis nothing looked better than a portfolio full of munis - and all that matters, in the end, is the total return after you pay the tax man.
The strategy was successful, and my 1040 for those years where I hid was very nice to file indeed. Lest you think I didn't pay tax I indeed did, but indirectly - the yield on munis is a bit lower, which means the state and local government get the tax I would otherwise pay through indirect means. (If you didn't understand that last sentence then you still think there is such a thing as a "free lunch" - there isn't.)
So in 2007 when I also smelled a rat, and in fact posted several tickers warning people to get the hell out of the market, why didn't I go hide in the same place? Mostly for one reason - I had come to the conclusion that state and local governments were just as overlevered as everyone else, and that strategy had the potential to fail with catastrophic consequences.
There is a common premise that municipal bonds that are "general obligation" bonds are essentially as safe as Treasuries, in that they're backed by the full taxing authority of the issuer. In other words, they have priority over everything else. If you buy a municipal bond that funds a specific project (e.g. a sports stadium or something similar) you're taking materially more risk, since there's one cash-flow stream behind it. But with a GO bond you were presumed to be, for all intents and purposes, immune to this risk.
That turns out not to be quite true:
But now Jefferson County, Ala., has stopped paying such debt, breaking with convention and setting up a fundamental test of what full faith and credit truly means.
“We all want to know, ‘What’s the truth here?’” said Richard A. Ciccarone, chief research officer at McDonnell Investment Management. “The way I learned it, full faith and credit was considered all the taxing power of a community, and that means there’s an infinite pledge. When you get into bankruptcy court, truth is something that can be revealed in a new way.”
Jefferson County, if you remember and as I have written about repeatedly, had a little problem with its sewer system. The courts began by ordering improvements. As the process of fixing the problems wound onward, someone got a bright idea to use swaps on interest rates as part of the funding process. Unfortunately there was actual official corruption involved in the "decision-making" process with actual bribes given to certain officials. Some of our largest banks, including JPMorgan, were involved in the funding process. They made a lot of money with these instruments while the county got the short end of the stick and residents have seen a literal 400% increase in their water and sewer bills. Ultimately the corrupt pestilence that had interweaved its way into the county on this set of "deals" drove the county to file bankruptcy.
I have often written about the fact that in order to receive a bribe that someone must offer a bribe. Further, the outsized profits that came from this set of transactions were of great financial benefit to those who crafted this scheme. While a number of officials and others have in fact been found guilty (by either plea or trial) and thus the fact that these crimes occurred is not conjecture but rather falls into the category of a "statement of fact," the general premise that has long existed in the law that one is not entitled to keep the fruits of a criminal enterprise has not been enforced against the beneficiaries of these schemes. That is, the financial institutions involved have not been forced to disgorge their outsized profits nor have the failed financing structures that came about as a consequence of this corruption been voided. The people of Jefferson County are thus still left with the results.
Well now those bondholders who had no part in the scheme might get left hanging too.
Bankruptcy experts have long known that in theory a municipality could use the stay to revoke its full faith and credit pledge, but they have not watched a big distressed city or county go through with it. “You’ve got a case here where the rubber has hit the road,” said Kenneth N. Klee, a bankruptcy lawyer representing Jefferson County, whose debt grew out of poorly conceived efforts to finance a court-ordered rebuilding of its sewer system.
It wasn't poorly conceived. It was, at least at some level, corrupt - and criminally so.
Oh, but as they say, it gets better. Alabama is not permitted to issue actual general-revenue bonds without a referendum authorizing them. As a result the county hasn't issued any - for 50 years. Instead it issued warrants, which look like the same thing but legally are not.
The assumption has been made that creditors could take the county to court to force the raising of taxes to whatever level was necessary to actually make payment. Unfortunately it doesn't work that way - only the State can raise taxes unilaterally and that pesky referendum thing now comes back to bite.
This, incidentally, isn't an isolated incident. Nearly half of the counties in the United States appear to be in the same position and have been issuing "full faith and credit" bonds (and/or warrants) without the authority to raise taxes to cover them if it was to become necessary.
In short, don't believe everything you read - or are told. Always look at the facts and the back-story, and if you can't figure out whether there's a way for you to be left holding the bag the answer is "yes" and the rube who is likely to get nailed by it is you.
