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Stay Away From Muni Bonds

Dec. 10, 2010 1:11 PM ETMUB, SHM, ITM, TFI21 Comments
David Goldman profile picture
David Goldman

I’ve been warning for months that a few state and municipal bankruptcies (actually, a few states and a great many city bankruptcies) will be required to slay the beast of government-union pension liabilities. The total size of the muni bond market is about $2.4 trillion. Unfunded pension liabilities (calculated with a realistic discount rate) are almost as high, according to one study. Now comes James Pethokoukis of Reuters to tell us of a “secret GOP plan” to bankrupt local governments and crush the government unions.

Congressional Republicans appear to be quietly but methodically executing a plan that would a) avoid a federal bailout of spendthrift states and b) cripple public employee unions by pushing cash-strapped states such as California and Illinois to declare bankruptcy. This may be the biggest political battle in Washington, my Capitol Hill sources tell me, of 2011.

That’s why the most intriguing aspect of President Barack Obama’s tax deal with Republicans is what the compromise fails to include — a provision to continue the Build America Bonds program. BABs now account for more than 20 percent of new debt sold by states and local governments thanks to a federal rebate equal to 35 percent of interest costs on the bonds. The subsidy program ends on Dec. 31. And my Reuters colleagues report that a GOP congressional aide said Republicans “have a very firm line on BABS — we are not going to allow them to be included.”

In short, the lack of a BAB program would make it harder for states to borrow to cover a $140 billion budgetary shortfall next year, as estimated by the Center for Budget and Policy Priorities. The long-term numbers are even scarier. Estimates of states’ unfunded liabilities to pay for retiree benefits range from $750 billion to more than $3 trillion.

This article was written by

David Goldman profile picture
David P. Goldman was global head of debt research for Banc of America Securities and earlier global head of credit strategy at Credit Suisse. He was until July 2008 the strategist for a credit hedge fund, Asteri Capital, one of the few credit funds to show a profit between July 2007 and July 2008. He is now Associate Editor of First Things (www.firstthings.com) and a columnist (under the byline "Spengler") for Asia Times Online.

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Comments (21)

dcfusor profile picture
Wow, this looks like what happens when you dis gold to a group of gold bugs "don't mess with my religion". I see what I see, and mostly agree -- munis are in trouble, no question. How to short them is my only question. You do better to keep some weird belief system out of your trading, the writing is really on the wall here.
Yeah, some entities can't declare bankruptcy. So? If they can't pay their obligations, they can't. So the difference is what? Oh, the lack of the bankruptcy system to apportion what's left fairly. How again is that a good thing?

At the very best, they will threaten, then do, laying off of all the parts of local government that actually provide any services to us -- cops, firemen, teachers, while keeping their nice buildings and bureaucrats and perks fully intact. I've seen this movie before.

Could be sloth rather than unions (though I have zero sympathy with unions myself). If the place you're going to work needs one -- don't work there, dummy. The having of two bosses, one of which you have to pay, in an adversarial environment just isn't worth it to anyone with any sense of having a good life. If it's the only job you could land -- get your skills up so you can get a good job instead.

Ever wonder why the fed unions didn't kick up a big fuss when Obama "froze" their pay at historically high levels, when cuts are truly in order? Jobs AND pay, cuts. At no time in previous history have government jobs that amount to advanced secretarial work paid so often in the 6 figures and up -- we are at an all time high (and you can take that backwards adjusting for inflation). Not to mention job security -- the Civil Service is utterly out of control and in far too much control over us (TSA comes to mind on that, but it's a tiny example considering the total bucks involved, just a funnel of money to contractors who make nudie scanners and so on).

I found here that our government puts up a big fight when you try to get your taxes lowered to some assessment that has something to do with current land values -- based on actual sales, because guess what -- there aren't many to go by....and is talking about the alternative of raising rates. Like the banks, they're going to find out that winding up owning a bunch of unoccupied homes doesn't do much good for them when people can't/won't pay. Their sense of entitlement is undented at the moment, disgusting.

Good luck on your munis, you're going to be needing it. Or your increased local taxation is going to eat any money they do make you, not much of a choice.

How again can I go short these guys? TBT and TMV on the fed side are doing nice for me just now....for example.
Timmothy Posey profile picture
I'm buying the dip in MUB. QE3 will be about Fed purchases of muni's. There is a Goldman Sachs article on ZeroHedge alluding to such a thing coming up for 2011.
Bankruptcy laws have had some stunning re-interpretations in the last few years as shown with the GM bondholders going to the back of the line. Given, these were not muni's, but they were bonds.
With this bunch in office, expect the worst.
Gotta agree that this author really doesn't know anything about how the municipal debt markets work. Just uninformed generalities thrown around. Great way to get your name in print, however.
Not all munis are awful. Just be careful.

A good approach is (for income) to buy individual bonds from solid states (Tennessee, Virginia, Texas, etc.) and hold until maturity.

Stay away from muni *funds* unless you do *thorough* homework.
jack kreg profile picture
1-CA's new gov, Jerry Brown, goes to DC, hat in hand, needing $25 Billion,
2-Young gun Repubs, Paul Ryan, tells Jerry, tough luck, but??
3-Ryan might say, fix pensions, cut salary's and head count, and freeze spending for a decade, and pay back your fed loans, then maybe DC will send a few $$.
4-my opinion, having lived in CA for 60 years, this would be a great moment for CA. Even with Jerry (moonbeam) Brown at the helm.
5-i'm not sure where the Muni's get a hair cut in this picture?
I was also curious about the fact that most muni investors are retail investors, and voters... I also am not in the bankruptcy camp. But even if I were, wouldn't it be a little dangerous to force states not to pay back voters when we have bailed out of private companies. Additionally, some Muni ETFs are trading at a discount, even if you think rates have nowhere to go but up, there may be some value there.
David...You should take a deep breath before you write another over-the-top article about municipal bonds. First of all, most retail investors in ARC's were made whole through the brokers' settlement with the attorneys general of the states. Second, 'a 40% haircut' on bank porfolio positions is preposterous. In the remote event of a munincipal bankrupcy, the investors recover most of their principal. Finally, debt service costs for states is a fraction of the annual budget. Skipping debt service payments on outstanding bonds is not going to save the states.
Never fear, if the BAB program isn't renewed and states are hungry, BB will roll out QE 3.0...
bluesmoke profile picture
I'm no expert, but this article is full of too many generalizations. I can't see how expecting the states of CA or IL to declare bankruptcy would improve anything. Sure, in the short term it would release their debts, but the overall fallout would be incalculable. The political pressure and will to fight the unions is growing by the day, and will soon boil over. That's when you strike.
Texas talks about wanting out of the union. Maybe California should be first. It sends many more tax dollars to Washington than it gets back yet now they may be the poster child for bankruptcy. How about Mississippi or Alabama or one of the states that send far less dollars than they get back. Maybe even Alaska! But, that can't happen as these are republican states -- they win again!
thank you for focusing on the political forces at work to sink BABS

your experience background and past articles show deep thinking
just one thing: why are you not into foreign debt if the USD is going down?
waldipup profile picture
Isn't this what was said several years ago? - you know , as my large muni portfolio rose dramatically in value , and I cringe at calls and pre-refunds because I cant replace my yield.....

It is a given that you stay with the better credit entities - that is generic in any investment as well as this one.

If one were to check out the nature of muni defaults , I think it would be seen that most are project backed muni's - a nursing home or something of that ilk that failed and was backed by muni status.

Very few actual municipalities have defaulted , and by sticking with the better credit rated ones and avoiding hair brained project backed ones , risk is minimized.
A legal know-nothing author: under the US Constitution, States cannot declare bankruptcy. See also, US Bankruptcy code. What can happen, is they can refuse to bail out cities with unrealistic public pension schemes, which CAN declare bankruptcy, e.g., Vallejo, CA. Also, they can refuse to pay or issue script, as cali did 1-2 yrs ago. A lot of bonds are issued by development arms with no guarantee power for harebrained private business schemes gone awry: e.g., Florida Developers, Solar and Ethanol cos. Illinois did issue bonds recently to fund its public pension funds, as many other issuers did. Those bondholders may get workouts in the end.
You are correct. Neither States can declare bankruptcy. Whether or not municipalities can declare bankruptcy is State specific - for example, in Louisiana, cities are not incorporated entities merely subdivisions of the State. Cities in la. cannot declare bankruptcy. Nor can they be sued by creditors unless they consent to the suit being filed.

Author: What do you mean will happen when you say it will "push" California and Illinois into "bankruptcy"?
What would be the impact of a state bankruptcy on a money market fund that invests in municipals? Will we see some of these funds potentially "break the buck"?
Steve in Greensboro profile picture
Check your money market fund prospectus. If it is invested in munis, move your cash to one that isn't (VMMXX isn't) or move it to a "too-big-to-fail" bank.
mind_geek profile picture
Unions have wiped out just about every public company (GM, Ford..etc), so its only a matter of time before it does the same to local gov. Its a numbers game, at some point these entities were paying for more employees who DIDNT work there rather than did. Pensions and paying for your healthcare after retirement are dinosaurs and bad business. Its great if your a recipient of those funds like my retired mother gets...shes set for life!

I would avoid most munis for now, more so because of impending rate increases (they have no where to go but up). Wait 6 months and see where were at and then maybe get back into a nice inter muni fund. You'll be lucky to break even in any type of bond fund for the next 2 years unless your a trader of individual munis and have a keen eye for bargains.
14 Dec. 2010
"Unions have wiped out just about every public company (GM, Ford..etc)..."

Poor management has ruined a lot more companies than unions. It wasn't unions that planned, designed, and tried to sell cars that nobody wanted. Too many CEO's are chosen like frat presidents.
Guardian3981 profile picture
The problem is those states would then have to pay higher interest rates for the foreseeable future which really costs the country as a whole even if its simply via less GDP increase from the state.

I am not saying States do not need to streamline and get more efficient, but having them declare bankruptcy is not the wisest solution. Even the states that do not have deficits would likely face higher interest rates as the market would worry any month or year they could run a deficit and be the next bankrupt state.

Does not set a good precedent. One positive thing the US and its States have is cheap financing, take that away we will be crippled. We have abused this advantage I agree, but we need to slowly scale everything back to balancing not bankruptcy.
Dave Wrixon profile picture
Did that actually need stating?

I guess you could always get the contract revoked anyway by pleading insanity?
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