Are munis the next shoe to drop?
Rick Bookstaber certainly thinks so. He recently wrote a piece which defines the pressure points for market risk and found the municipal bond market to be a problem in need of a solution. Rick writes:
I don’t think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.
So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:
- Problems occur when things get leveraged and complex (and thus opaque).
- If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
- The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.
- A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
- Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
- Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages). .
Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?
Answer: The municipal market.
It’s encouraging to see that Rick’s position at the SEC doesn’t preclude him on talking publicly about risk. His framework for assessing market risk is unique and bears using as a tool in other markets. I agree with his assessment about the muni market, as I have written about this on several occasions. The most notable posts were from November 2009.
- The coming collapse of the municipal bond market
- Chanos says dump munis as distress mounts and ratings attacked
They echo many of Rick’s concerns about ratings agencies. But, my basic problem with states and municipalities is the same problem I have with Greece. They are revenue constrained by a fall in taxes and cannot use fiscal policy to stimulate their economies. This means they must make budget cuts, raise prices (college tuition fees) and raise tax rates in order to make ends meet. Remember, they are not sovereigns issuing debt in their own currencies any more than is Greece.
Moreover, as with Greece, they cannot rely on the next level of government for support. There will be no aid forthcoming for states anymore than there will be for Greece (see Europe puts the loaded gun on the table but no bailout for the fig leaf of support Greece is now receiving).
And, again as with Greece, the cracks are starting to show because investors are waking up to the fact that default is a likely outcome in some cases. Below are two recent articles that show both the debt difficulties now and the shell games now ongoing:
- NY state masks deficit by shuffling money | Reuters
- Could debt send California the way of Greece? : The New Yorker
This is a slow-moving train wreck. Don’t mistake the relative sense of calm for a lack of distress. The risk assessment that Rick makes demonstrates that contagion will be large, the key factors being the size of the market and the likelihood that risk has not been adequately hedged despite geographic diversification. As the incident in Dubai which triggered the sovereign debt crisis demonstrates, all we need for this muni problem to move front and center is a trigger. What that trigger is has less importance than the pre-conditions in the market when the trigger comes. In my view, it is less a question of ‘if’ we will see a raft of muni defaults and more a question of ‘when.’
The Municipal Market – Rick Bookstaber
“Moreover, as with Greece, they cannot rely on the next level of government for support. There will be no aid forthcoming for states anymore than there will be for Greece (see Europe puts the loaded gun on the table but no bailout for the fig leaf of support Greece is now receiving).”
How can you be so sure? Fiscally it might not be possible, but how can (or will, given your position) the Feds justify not assisting states and municipalities after bailing out all of the banks. In short, how will it be politically feasible for politicians to allow teachers’ and policemen pensions to get cut while giving Goldman $17b in CDS payments?
I don’t think the states should be bailed out (and certainly not the banks); however, I just have trouble reconciling the hostile political climate with the correct course of action.
This may be a game of chicken, but I think the constraints for the Obama Administration do necessitate it. In late 2008, as I made my top ten predictions for 2009, I wrote “The Obama Administration will be faced with a state government bankruptcy. They will bail out the state and promise to do the same again, much to the liking of liberals and municipal bond holders.”
At the time I was thinking specifically of California, but it became clear early in the Obama Administration that there was not going to be a ‘bailout’ for California. Yes, because of the federal nature of the U.S. and the stimulus package, California received aid, but I was wrong in assuming that California, like the banks would receive a bailout.
Fast forward to 2010 and the hub bub in Washington is less about saving banks or states from economic Armageddon and more about the need to rein in deficit spending given the perceived precarious position of the U.S. government. That is how the debate is now being framed politically. And the Obama Administration buys into this framing.
Therefore, in an election year in which the Obama Administration is touting the recovery of employment as the last ‘lagging’ indicator on the road to business as usual, it is LESS likely that a ‘bailout’ will be forthcoming. Moreover, it is also less likely that any substantial stimulus package designed to aid states will be forthcoming.
That’s how I see the political constraints now. Stimulus is out and bailouts are a non-issue because they simply won’t happen.
The conditions in state and local governments are terrible, of that there is no doubt. I would add that a recent Chicago/Northwestern research paper in the Journal of Economic Perspectives reveals that state pensions, properly discounted at the risk-free rate rather than assumed returns of around 8%, reveals a $3.23 trillion underfunding gap. Those are properly capitalized contractual obligations that should be scored on the balance sheet.
Second, however, I would not totally concur that the states are revenue constrained in the same sense as Greece. To be sure, they cannot issue their own debt; but a de facto fiscal stimulus plan via federal government grants-in-aid to states has been used – and will probably continue to be – to mask some of the budget shortfalls. This was a hefty part of the last stimulus bill, which allowed states to “extend and pretend”, much like banks.
25% of state revenues were derived from federal transfers this latest quarter. On a rolling 4-quarter sum basis, there was a quarter over quarter increase of $100 billion in aid to states.
The next problem as I see it is when the debts become impaired and governments are forced to come clean on the issue. Potentially, the cascading event might be a normal repricing of credit risk on the bonds, but with a magnitude that moves systemically through the financial system…though I do not claim to know exactly what those dynamics will look like when they occur.
I attempted to use qualifying language to make a directional comparison between Greece and state and local municipalities in the US. While directionally the comparison is apt, I was using the qualifying language to signal that I don’t think the situation in the U.S. states is as stark.
So when I say “revenue constrained,” I am saying that states face a funding problem if they cannot reduce the gap between revenue and taxes which is the source of very large deficits all around. Does that mean the problem is as large as it is in Greece? No. It does mean, however, that the constraint is the same one facing Greece i.e. states are not debtors in a currency which they print and therefore must meet deficit spending via the issuance of debt. And that makes them vulnerable to debt revulsion. In this environment, it makes it almost compulsory that the funding gap be closed by raising revenue via taxes and fees and cutting spending via layoffs.
One key difference between the US and the Eurozone is the fiscal transfers from which states benefit in hard times. Automatic stabilizers via the federal government provide a cushion that the likes of Greece does not have. Another key difference is the debt, which in Greece is an order of magnitude larger than in States for the simple fact that Greece is a sovereign where most long-lived social claims reside (think social security, health care).
The bottom line is that the states have a funding need which the federal government is resistant to meeting. In order to meet that need without being shut out of the market is going to require ‘austerity’ by the second half of this year. My sense, however, is that even so, we are going to see debt revulsion in munis as we are now seeing in Greece.
One last point: while I paint with a big brush, there are clearly differences between states and between individual bond issues based upon the revenue streams collateralizing the bonds. Some issues are going to outperform, so you have a relative value play developing. That’s not an issue I am pursuing here. But, I don’t want to make it seem like the whole market is going down the tubes. It’s just that, in my view, the contagion I see as likely will have a measured impact on everything in this market.
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