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Are Muncipal Bonds the Next Disaster

|Includes: iShares National AMT-Free Muni Bond ETF (MUB)
Are Municipal Bonds the next disaster?
The three biggest issuers of debt in the United States are the federal government and its agencies, mortgage debt and municipal bonds. The municipal markets have moved from being the haven of widows and orphans to a 2.5 Trillion dollar active, sophisticated market complete with its own indices, ETF and credit default swaps.   It has been an article of faith that munis, as they are called, were safe investments. It is possible that the complacency about the safety of munis may be proven untrue for the following reasons:
1.        The last time there was a serious problem in the muni markets was during the Depression when numerous municipalities defaulted.   In my 40 year career I have found that problems often occur in areas that are not subjected to continuous rigorous scrutiny and are given a pass because of a record of safety. Remember that prior to 2008 the last sustained national drop in residential real estate was in the 1930’s. The Black Swan is an unpredictable event of large import, it comes from the area you least expect.
2.       The states have for years been underfunding their pension plans, while at the same time increasing their scale and inclusiveness. There are large gaps between the present value of the future benefits and the value of the assets available to pay them. This is a structural problem that will not go away without a number of years of extraordinary investment returns, a reduction in benefits, increased taxes or a combination of all three. In addition, other state mandated spending (schools, medical support, and public assistance) has increased to the point where it is more than 50% of the revenues taken in via taxes. This mandated spending has been met without the politically unpopular solution of increased taxes. Rather it has been met in large part by the issuance of bonds
3.       The current economic downturn has negatively affected the main sources of state revenues, property, income and sales taxes. If a home has declined in value then with some delay the property tax assessment will also fall, houses that stand vacant often do not pay taxes, and homeowners in default on their mortgage are unlikely to pay their property taxes. Tax receipts will not recover until house prices get back above their pre crisis levels- does anyone want to predict when that will happen?
4.       The legal framework for redress of defaults on municipal bonds is obscure to say the least. There is a legal provision (Chapter 9) for a city to go bankrupt but there is no such provision for a state to file bankruptcy. The terms and conditions of a municipal bankruptcy are difficult to execute and require virtual liquidation of all the assets of the municipality. This lack of transparency of a way to redress losses creates or should create an uncertainty in the minds of bond holders.   Ultimately, the decision to pay interest on bonds is made by politicians who are immune from lawsuits, and therefore the risk of an unsound decision increases in direct proportion to the number of votes to be gained. 
5.       Over the years states have received more and more transfer payments from the federal government. Most are unaware that Medicare is administered by the states but is funded by transfers from federal coffers.   States have had to bear the increased administrative burden of expanding programs without being compensated for those increased costs. The funds they do receive go to benefits not administration. The current Build America bonds are perfect example of federal dollars going to lower interest costs of unsound borrowers. It was supposed to be temporary but now there is talk of making it permanent. It really is a reshuffling of the deck chairs on the Titanic
6.       Under the laws of most states all revenues or other money collected within their borders goes to the state general fund and is then distributed to the various needs via the budget process. Since the budget process is politically motivated there is little assurance that revenues for a specific bond are set aside in an account for that bond. The reality is that in more cases than anyone will admit revenue bonds are really subordinated debentures of the state.
7.       The advent of ETF in the municipal bond area and the continued inflow of money to open and closed end muni funds has created a continuous bid under the prices of the bonds preventing any serious correction encouraging states to issue bonds to capture the lower interest rates. In many cases this borrowing is new debt not refinancing of existing debt. As such the overall interest burden of the state increases but at a slower rate.
8.       The monoline insurers, already reeling from the mortgage mess, cannot stand a mass default of bonds. So the security of bond insurance might not be what it appears.
9.       Forecasts of state revenue and income are pretty much a moving target.   California when through a prolonged and acrimonious debate over its recent budget. The debate focused on every way to raise or save money nothing was spared. Finally a budget was approved but 45 days later the state “discovers” a new $6 billion in underfunding. Can you say Greece? If the states ever had to properly reserve for workman’s compensation insurance pools, high risk auto insurance pools or hurricane or earthquake insurance, the current deficits would appear minuscule.
10.   The cost of insuring against a default of muni bonds via credit default swaps is large as shown in the chart below:
Issuer
10 year CDS levels
California
299
Illinois
304
Portugal
380
Spain
250
Ireland
478
Iceland
253
Remember that Iceland is bankrupt, Spain is leaning that way, and the EU is forcing Ireland to accept a bailout and California and Illinois are judged to be only slightly less risky!
11.    The number of muni bonds on dealer desks wanting bids is as large as at any time in history. Maybe this is dumb money getting out creating a golden opportunity or it could be smart money running from a problem that has a lot of the characteristics of the mortgage markets such as lack of transparency, legal obscurity, inflated values and deteriorating economics.
12.    There is a change in the belief in the sacred nature of contracts. We have seen untold numbers of homeowners default on mortgages with the justification that the bank should never have lent them the money. We have seen the banks improvidently speculate with other people’s money and then justify it with ‘we where only doing what the customer wanted’. This same mentality is evident in municipal government as so 'eloquently' stated by Harrisburg (PA) councilwoman Susan Brown Wilson, "By no means should the citizens of Harrisburg (alone) be strapped with the debt created eight years ago by a prior administration." So let me see, people today should not be responsible for what past administrations have done? Isn’t that the whole security concept behind any bond issuance? Isn’t it a contract between lender and borrower? If that is the attitude then bonds are nothing more than colorful paper.


Disclosure: we own muni bonds for clients and for ourselves