Wednesday, February 23, 2011

A Municipal Score Card

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(, 2009)

Meredith Whitney has kicked up a storm with her 600-page, municipal-bond report. She was one of the first analysts on Wall Street who warned the banks were going to topple well before they toppled. (Standard & Poor's downgraded Bear Stearns three notches - to BBB - on March 14, 2008, two days before J.P. Morgan acquired Bear's carcass.) Whitney told 60 Minutes on December 19, 2010: "You could see...50 to 100 sizable [municipal] defaults.... This will amount to hundreds of billions of dollars' worth of defaults." The municipal bond CABAL (issuers, fund managers, analysts, the municipalities) denounced Whitney and her predictions.

In concert with the times, the debate is superficial. It is not even a debate but a tryout for the Society of Mind-Numbing Auctioneers. The drift on Bubble TV goes something like this:

Bubblehead announcer: "You there - at the other end of the camera! Wha' da' you think of Whitney's hundred defaults?"

Muni Expert #1: (everyone on Bubble is an Expert): "No. That's extreme. Municipalities are having their problems, but they know it and are taking action..."

Bubblehead Announcer: "So - how many - 10?

Muni Expert #1: "It is hard to put a number on it, but I estimate [pause] none."

Bubblehead Announcer: "Yo! Number two! - Zero or 10?

Muni Expert #2: "Between zero and 20."

Bubblehead Announcer: "I have 20 defaults, 20 defaults, 20 defaults, He-e-e-re! Hey, producer! [Offstage] Will you give me 30? No? [Turning to the camera] There you have it folks. Whitney is a scaremonger who is trying to make money off your fears!"

These discussions do not enlighten. The typical municipal bond investor - and that is to whom the following is addressed - is older, may or may not still be working (the following will be directed more towards the retiree), has accumulated a pool of assets, and that pool is heavily weighted towards municipal bonds. This investor depends upon coupon income as a major source for spending. Municipal bonds are often preferred by this cohort because the stream of income is usually not taxed at the federal, state, or local level. Also, it is a top choice because investment advisers tell old people this is the safest investment. That statement is probably correct, historically, but then, "House prices have never gone down across the U.S." was the pitch line into 2007. (The demise of the house market is intertwined with the drum beat to destiny in the municipal bond market, for obvious reasons. But members of the CABAL ignore this.)

Newspapers are filled with stories of towns running out of money, municipal employee layoffs, reduced services, and taxes being raised. The resolution to these disputes will be as varied as the municipalities engaged in such struggles.

There are helpless cases, probably those identified by Whitney. She is an excellent analyst. Whether her forecast for the size and timing of defaults is accurate does not matter other than to a municipal bond insurer and credit-rating agency. It is whether the retiree receives the expected coupon payment from a specific bond or portfolio of bonds that is of first consequence.

There are four competitors in this struggle for municipal funds; the battle among them will potentially deny the bondholder full payment. It would be convenient if the parties could be split into four pieces of a pie, the pie being of a fixed size. There are two means, however, by which the pie may inflate, meaning new cash inflows that could delay the immediate prospect of defaults. These will be discussed next, after which the fixed pie will lie center stage.

First of the two is the bond market. Municipalities will continue to issue bonds until they cannot. Currently they can, notwithstanding some recent problems of specific issuers.

Today, many bonds are issued to meet not only current expenses (vs. capital expenditures), but also projected expenses in future years. This evolution is presumably not stated in bond offerings, but is known sotto voce. (Friendly city hall clerks are good sources for such information.) Municipal bonds were traditionally floated for capital requirements: construction, for instance. It was considered reckless, if not illegal, to sell bonds to pay this month's salaries. Today, it should be assumed that a cash-poor city will use bond proceeds for immediate needs - if it can get away with it. This is fraud. See the Miami Herald from February 17, 2011 "Audit: Miami Misused Millions in Public Works Funds."

Second, is the federal government. There has been talk of federal bailouts for states and cities. If the federal government is to pick up expenses for Illinois; California; New York City; Harrisburg, Pennsylvania; and a hundred others, the cost will be enormous. The federal government has plugged non-federal gaps at an increasing pace since the $787 billion stimulus bill was passed in 2009. It has also established avenues to keep paying state and city bills after the $787 billion is depleted.

This will not be sufficient though, so let us assume a Big Bailout Bill is proposed. This may or may not pass. If it passes, the pie (flows to the mendicants) will grow. This should help boost the municipal bond market, but it should be remembered that we will live to see the moment when yields of 10-year, U.S. Treasury bonds double, possibly precipitated by such a reckless Bill as this. When yields double (this is not a question of "if"), municipal bondholders may satisfy themselves that coupon income will still be paid, but that will only be of momentary consolation given the chaos of a broken bond market.

If such a Bill does not pass, Federal Reserve Chairman Ben Bernanke may buy a trillion dollars worth of municipal bonds before Congress acts. Some congressional committee would then interrogate this unaccountable public servant, doubting the legal authority for his purchases. Bernanke; in his vague, impenetrable mien; will claim he had authorization and cannot reveal which securities the Fed bought since disclosure would endanger the solvency of the parties involved. ("Parties" - including the balance sheet of the Federal Reserve.) The New York Federal Reserve Bank will publish 12 papers, simultaneously, with both historical and legal justification for the Fed's purchase of municipal bonds. That will be that. Assuming the bond market shuts down (it will, at some unknowable point) and the Feds, as well as the Fed, do not inflate the pie, the fixed pie with the four parties can be viewed as follows. (Eventually, the deleverging U.S. economy will shrink this fixed pie. Tendencies during the time when America is miniaturizing will probably resemble those discussed below.)

#1 - Bondholders - want to be paid interest and principal. (General Obligation bonds are addressed here. The distinction from Revenue bonds is explained on page 20, footnote 20 of The Coming Collapse of the Municipal Bond Market.) Aside from not being paid, most bondholders do not want to be scared. ("Most" - because some thrive on these fears.) Fears can be precipitated by potential default. Prices are likely to fall when default threatens. For example, see six-month charts of California and New York State municipal bond funds. Very few bonds in California have defaulted, possibly none in the funds. Therefore, all interest and principal payments may be current. There are many investors who will not be reassured (and, already, in California and New York are dismayed) should the market value of their investments fall 20%.

The fact that many municipal bond investors are not sophisticated, and look to these assets as their source of retirement income, means this market could be particularly subject to panic. On the other hand, the highly vulnerable investors may be too petrified to act.

Default may mean no more than a few missed payments that will be paid later. (A technical default means no missed payments at all, but it would be surprising if the Bubble media is able to explain this material distinction to its viewers and readers, who may be deaf to legal talk when their remaining assets are plunging in value.) The holder of a bond in default may not listen to promises that missed payments will be paid in the future, no matter how likely. The sales pitch is often that "municipal bonds are the safest of all investments." These investors have heard this before (stocks, houses), so may have lost heart.

Therefore, the bondholders are not interested in grievances of public employees, the loss of municipal services, or, a tripling of tax rates to avoid default. The municipal investor being discussed needs this money.

#2 - Municipality - the state, town, county, or other administrative district does not want to change its mode of operation. It would like to continue building monuments to folly, hiring campaign workers in permanent jobs, awarding higher benefits to employees, and selling bonds since tax receipts do not meet this largesse. See: Illinois is not Peter Pan.

Some, of course, know better and are cutting expenses and attempting to corral employee benefits. Some were always managed well. But those in the headlines pretend to address current circumstances with no intention of balancing their budgets. They have more to lose by doing the right thing - such as, laying off workers, or, halting the construction of a new $100 million high school that is intended to provide 3,000 union construction jobs. Often, this is the reason schools, stadiums, museums, and other white elephants have been built.

The ostriches with their heads in the sand can not conceive of a time when the bond market will shut down. They have little motivation to close funding gaps. The ostriches are also very American; specifically, the vintage of Americans who have been swept into the post-modern guise that everything will work out well. In this case, the federal government will fill the gaps. They may be right, but for how long?

Municipalities hold a trump card that has not received much attention. Many state and city expenses are mandated by the federal government. Congress imposes new regulations that include more school administrators, demand access ramps, the expansion of health benefits, and on it goes, but the Feds do not fund these declarations of magnanimity. In 1970, Medicare cost the states $2 billion. The estimate for 2008 was $158 billion. Some state or city is bound to tell the Feds "you pay for it, or we're stopping it." From a spectator's point-of-view, the scuffle that follows will be engaging.

#3 - Employees - want to keep what they have and many want more. The United States is a large country so it is hard to generalize about the stubbornness on either side. Recent histrionics in Wisconsin, including the juvenile comments by President Obama, represent the aggressive union position. The unions will not budge. In such situations, when the negotiation of benefits and pay fails, court decisions will intercede. Bondholders are the least of the unions' concerns. In such circumstances it is prudent for bondholders to expect the sort of vilification heaped on the owners of General Motors' debt.

As a reminder, the Obama administration and the unions accused hedge funds of forestalling justice. The greedy Greenwichites claimed General Motors' bonds were a contractual arrangement (a bond being a contract). This would not do and a ukase was imposed on hedge fund managers that satisfied the President, a graduate of Harvard Law School.

Crucial to the propaganda campaign was the false representation that hedge funds owned most of the bonds. In fact, a large contingent of GM bondholders fit the profile of the municipal investor. General Motors' bondholders wanted their day in court.

The Family and Dissident Bondholders group was denied official status to represent bondholders by the bankruptcy court. [In re General Motors Corp., 09-50026, U.S. Bankruptcy Court, Southern District of New York (Manhattan).]

The group was overwhelmed by the machinery of the state. A spokesman for the Unofficial Committee of Family & Dissident GM Bondholders said: "The committee members today simply lack the resources needed to mount an effective appeals process on the accelerated basis that would be required here." The "accelerated basis" indicates the Dissident Bondholders were denied Due Process, a potential hazard to municipal bondholders.

Peter Kaufman, president of the Gordian Group LLC, an adviser to the Family and Dissident Bondholders, stated: "It's a tragedy. Twenty-seven billion dollars of bonds, many if not the majority of which are owned by mom and pop, have been essentially wiped out."

Not many municipal bond managers and brokerage firms have considered such a reoccurrence when municipal workers tread the same path. The mom-and-pop holder of a Wisconsin general obligation bond should be prepared to sell in a hurry. In fact, mom and pop should not own Wisconsin general obligation bonds today. Wisconsin sold 10-year bonds in January, 2011, with a yield-to-maturity of 3.75%. Given our state of affairs, which includes Ben Bernanke's campaign to ruin the dollar, the entire structure of interest rates will double at some point. Consumer inflation is at least double the 10-year yield today - 7.5%. Mom, pop, grandma, and grandpa are not being paid an adequate yield given the risks, and given that these securities only repay a fixed amount of dollars. Bonds do not go Verticalnet.

The militant public employee and compromised court scenario is the worst case. There are many municipalities where pay and benefits remained within reason. There are other states and cities with more important troubles. There are some with no problems.

#4 - Taxpayers - are not happy. Homeowners are often paying more in property taxes now than before house prices fell 10% - 50%. States have also raised sales taxes and imposed fees on the most basic services. The citizenry is awakening to the mismanagement and criminal racketeering that created the fiscal abyss Meredith Whitney so ably quantified.

Taxpayers grit their collective teeth as they are learning of outrageous pension and health benefits awarded to their neighbors, the contractual skullduggery between city officials and parking-garage managers, and the fleecing of the taxpayers through incompetence that is barely conceivable to any bystander with an IQ above 70. To all appearances, the taxpayer is facing an infinite tax bill since general obligation bonds are sold with the promise that the issuing authority will "in good faith use its taxing power as may be required for the full and prompt payment of debt service."

This belief is another reason legislators are slow to act and that some public-sector unions are unwilling to negotiate pay and benefits. This is in contradiction to the workers best interests, but they will be the last to accept the Deleveraging of America. Taxpayer resentment is building, a pustule with the ulceric properties that may corrode this mountain of municipal malpractice.