Municipal bonds: A Balancing act
By Nicole Bullock and Aline van Duyn in New York
Published: February 27 2011 20:18 | Last updated: February 27 2011 20:18
Our New Fairfield taxes are going up but the municipal budget is once again at a zero or near zero increase ... soooooo, why are the taxes going up? The Popeye cartoon featuring Wimpy and his famous line is reminiscent of how the present administration uses taxes. The sham of using a 'pearl in an oyster' is how the various town funds are used and spent down. Now for the rest of the story.
It was October 1975 and New York City was about to run out of money. The city had to meet its payroll obligations for police, firefighters and other employees. Payments on the city’s bonds were due on the same day. There was not enough cash for both.
Harrison “Jay” Goldin, who as the city’s comptroller was in charge of its finances, was summoned to a meeting with mayor Abraham Beame and a group of leading New York bankers and chief executives of companies including insurers and retailers.
“I was told the group had decided that I should meet the payroll the next day and not make the payments on the debt,” Mr Goldin recalls, sitting in the offices of his financial advisory firm in Manhattan’s Empire State Building.
But the next day, he made the debt service payments. “The priority under the New York state constitution was to make payment on the debt first and the obligation to do so was my duty as comptroller,” he says.
A commitment to repay debt, even in the face of severe financial problems, is the bedrock of the modern US municipal bond market, a $3,000bn part of the credit markets where states, cities and other public bodies borrow for roads, bridges, schools, hospitals and utilities that their regular tax revenues cannot fund.
The depth of the latest US recession and the ripple effects of the financial crisis have shaken that foundation. Since 2008, states have managed to close budget gaps of more than $400bn, according to the National Conference of State Legislatures, a bipartisan research group, by steep cuts in spending or rises in taxes and fees.
As lawmakers struggle to plug the latest deficits – most states are constitutionally required to balance budgets annually – investors have started to worry. Some states are still spending more than their revenues, which come mostly from taxes: receipts remain below pre-crisis levels. Their expenses could also rise in the coming years as they pay out pension and other benefits promised to public sector employees in better times. A public backlash has already begun to emerge as lawmakers push for deep cuts and concessions, particularly from trade unions.
Will states and cities slash spending and increase taxes, and continue to prioritise payments on debt? Or will some US states and cities try to restructure their debts, forcing bondholders to swallow losses alongside concessions from citizens and unions? Will the federal US government step in with a bail-out? Unlike local governments, the federal US government is allowed to operate at a deficit.
“With many states and local governments struggling to close large deficits, it is time to acknowledge that defaults could happen, even in large and systemically important municipal issuers,” says Christian Stracke, head of credit research at Pimco, which runs the world’s biggest bond fund.
Concern has arisen about the implications. First of all, a continued squeeze on local spending could restrain the national recovery. The $800bn US economic stimulus introduced to stem a slide into another Depression included multifaceted aid for states and local governments both directly and through programmes such as subsidies for cheap debt. This federal support largely runs out this year. Economists at Goldman Sachs, for example, predict that local government spending cuts required as part of their belt tightening will snip half a percentage point off US gross domestic product this year. More drastic spending cuts could result in an even more significant drag.
Second, many Americans have some of their wealth tied up in muni debt. About two-thirds of the muni bond market is in the hands of individual investors. In many cases, local residents buy the bonds sold by states and cities because those provide tax-free interest income. This means that losses on such bonds would also hurt local residents, further hitting local economies, local banks and US economic growth.
Third, any bail-out could further strain the finances of the federal government, which is already raising eyebrows at home and around the world for its ballooning debt. Lawmakers, particularly Republicans, vehemently oppose local bail-outs, just as many on Capitol Hill are fighting against a rise in Washington’s debt ceiling.
Muni borrowing costs have risen from historic lows, as more investors recognise that the risks in the market have grown. For 10-year bonds, top-rated municipal borrowers pay about 3.1 per cent, up from 2.5 per cent just four months ago and a three-decade low of 2.17 per cent last summer, according to the benchmark index from Thomson Reuters MMD. For the more hamstrung borrowers, the rise is more pronounced.
F ew municipal market experts agree with the predictions of Meredith Whitney, the analyst who foresaw trouble at large US banks ahead of the financial crisis. Ms Whitney caused a stir last year when she warned of 50-100 local muni defaults totalling “hundreds of billions of dollars”. But many now doubt whether the rock-bottom default rates of recent memory can persist.
“The kernel of truth here is that in the case of six or seven states, their long-term financial condition is quite bad if they do not do anything,” says Ken Buckfire, chief executive of Miller Buckfire, an investment bank. “But companies, and by extension states, only default on debt when they run out of cash, not because they have too much long-term debt.”
Mr Buckfire cites Illinois, California, New Jersey, New York, Connecticut, Massachusetts, Ohio and Rhode Island as among the most troubled states. Cities and towns are seen as more vulnerable because they rely on aid from states, which states are cutting, and property taxes. With more than 50,000 diverse issuers in the muni bond market, it is hard to pinpoint the trouble spots.
Wisconsin’s budget battle‘What will this do to my high school, and to the college I want to go to?’Jonah Walker has never been involved in politics. But last week the 17-year-old travelled from the small town of Viroqua to Madison, Wisconsin’s capital, to join protests against the state’s proposal to end collective bargaining for its employees, writes Hal Weitzman.A student with a greasy fringe and an earnest air, Mr Walker says he fears the plan’s effect on his father, a state employee, and on his own education. “What will this do to my high school?” he asks. “What will it mean for the college I want to go to?”Such unease has fuelled protests for the past 13 days at the state Capitol building against Governor Scott Walker’s “budget repair bill”, which has turned Wisconsin into a battleground between union activism and small-government conservatism.Mr Walker, a Republican elected in November, says the state must restrict bargaining rights to tackle a $137m budget shortfall, projected to hit $3.6bn within two years. Public-sector unions say they will concede cuts but refuse to budge on bargaining. Indeed, critics accuse the governor of turning the debate into an attempt to weaken the unions, big donors to Democratic party campaign funds. They note that he need not scrap collective bargaining to balance the budget in the short term.The issue has split the state. While polls suggest most Wisconsinites think unionised state employees enjoy generous pensions and low healthcare costs at taxpayers’ expense, there is little support for ending collective bargaining. Nonetheless, both sides depict the fight as one of national importance, a test of the power of unions relative to states with new Republican majorities seeking to address unsustainable finances.The bill has been stalled since the week before last, after Democrats in the state senate fled to neighbouring Illinois to deny the Republicans a quorum. Mr Walker warned last week of “dire consequences”, with up to 13,500 state job losses, if they did not return and allow his bill to pass.The struggle is spreading. Indiana Democrats seeking to block “right-to-work” legislation, which would outlaw making union membership a condition of employment, also fled to Illinois last week, while thousands protested outside the Ohio Capitol against a proposal to limit collective bargaining for state employees.
States are generally expected to muddle through. Compared with cash-strapped eurozone countries such as Greece or Ireland, US states’ debt tends to be much lower relative to the size of their economies. There are also many liabilities that the US government absorbs, such as the cost of bank failures and a chunk of unemployment and healthcare benefits. Using Census Bureau data, Pimco reckons that the median state has debt of just 7.3 per cent of gross state product, the equivalent of GDP.
Unfunded pension liabilities, which are estimated to total between $700bn and $3,000bn, are a looming problem but states still largely have time to address it, though the battle will be tough. Future pensioners can expect to make bigger contributions to their retirements and perhaps enjoy less generous benefits. Existing pensions are difficult to touch, although some politicians may try.
Among the states, Illinois has stood out recently for its deeply underfunded pension pot and because it borrowed to pay its annual contribution. Illinois wants to borrow more to address a backlog of bills for goods and services depending on the state.
As more attention focuses on governments’ efforts to make ends meet, there is the potential for a crisis of confidence in the market that would dry up sources of funding. The millions of individuals who own munis bought the bonds on the assumption that they were safe and that they would always be repaid. Yet in recent months, the market’s turmoil has resulted in paper losses showing up on their account statements.
With so many different types of debt and of individual issuers, some problems may be hidden from view. Munis are not held to the same stringent disclosure requirements as, say, corporate bonds. As investors by and large hold munis for the long term, trading can be thin and prices therefore uncertain. “It is the ultimate shadow market. There are thousands of issuers, it is remarkably illiquid and there is a lack of disclosure,” says Mr Buckfire.
Investors used to rely on bond insurance to protect themselves – but that industry collapsed after many insurers also guaranteed risky mortgage debt.
In response to the growing uncertainties, people have sold their bonds. Since November, retail investors have withdrawn more than $26bn from mutual funds that invest in munis, or about 7 per cent of assets, in the biggest selling rout ever. Roman Orenchuk, a 59-year-old from Sacramento, California, became one such seller in November. Like most investors, Mr Orenchuk, who owns a manufacturing business with his son, lost money when financial markets plummeted in 2008. “When the market starts to go sideways, rather than waiting like I used to, I pull the plug.”
It is this type of behaviour that could turn jitters following one problem area into a more widespread retreat from the muni market. “Because market participants have generally viewed [municipal debt] as a risk-free area, [the question is] whether an individual credit problem can create a broader confidence problem,” says Raymond McDaniel, chief executive of Moody’s, the credit rating agency. “That’s where the systemic implications come in and what we and others are trying to be alert to.”
The potential for systemic risks beyond the municipal markets cannot be excluded, he adds. “We consider it very unlikely. We do not rule that out. There are many different types of credits in the municipal sector, with many different forms of support.”
But municipal experts take comfort in that many bond payments rank high in the priority of bills that state and local governments pay, much like the payments did 35 years ago in New York City. In California, the largest state, these debt payments rank only after education. During its budget crisis two years ago, “California paid its vendors with vouchers instead of cash in part, so it could safeguard cash to pay its bonds”, says Matt Fabian, managing director at Municipal Market Advisors, a research group.
Lawmakers also have believed that they need to protect access to the capital markets. “They aren’t paying us because they love us,” says Joseph Pangallozzi, a credit research analyst at BlackRock, the money manager. “There is not another stream of capital” on which states and municipalities could draw instead.
Many believe that large US banks would step in, however, should the markets ever close for big states. JPMorgan Chase and others provided bridging loans to California during past budget crises. States and local governments also have the power to increase their revenues by raising taxes. Illinois recently boosted its taxes by an average of 67 per cent.
Analysts point out, however, that such moves may ultimately backfire, driving citizens and businesses to healthier parts of the US that impose lower levies. The political mood in many statehouses around the country is also vehemently anti-tax, they note.
At some point, it may become difficult for lawmakers to ask for deep sacrifices from labour unions and citizens without some backlash against bondholders. “The jury is out on whether there will be a spate of defaults and with that a collision of borrowed money and labour,” says Bruce Bennett, a partner at Dewey & LeBoeuf and the lawyer who represented Orange County, California, in its 1994 bankruptcy (in which bondholders were paid in full).
A key factor in whether the municipal stress is contained will be the extent of the US economic recovery. Tax revenues have risen as growth has returned to parts of the US. Preliminary figures for October-December 2010 for 41 states show collections in the period were up 6.9 per cent from a year earlier, according to the Nelson A. Rockefeller Institute of Government. If confirmed in the full fourth-quarter data, the gain would represent the strongest growth in tax revenues since the second quarter of 2006, the research group says.
Political will, however, plays an enormous role in a state or local government’s success in dealing with adverse conditions and the unpopular choices that accompany them. But polarising political lines are now being drawn as states begin to take on unions in an effort to cut labour costs.
Back in 1975, New York successfully negotiated for one of its pensions to lend it money through the purchase of bonds, because the financial markets had shut to the city. So it was able to make both payments by midnight on that day in October. In the year that followed many sacrifices were made. Those included cuts in the municipal workforce, the introduction of tuition fees at city universities for the first time, sharp rises in public transport fares and more borrowing.
“You need political will and the will to sit everyone down at the same table,” says Felix Rohatyn, the Lazard banker who advised New York City at the time. “Now, the lack of relationships between the people making the decisions is part of the problem.”
