Putting the risk of municipal bonds in perspective

There is a blog written by someone with a very impressive resume published Sunday which had a dire prediction for municipal bonds. Normally, I would not mention this as most people would not see it, but it is being repurposed in the New York Times and Yahoo Finance, so it is “out there’. I have earlier warned people there were more dangers in municipal bonds than people realize, in fact in bonds in general, muni or not because of interest rate risk. I still believe interest rate risk a far greater risk for all classes of bonds than default risk.
Here is link to the blog:
While I think there are certain issuers and certain types of muni bonds that carry more risk than is being priced into market, I do not believe as this article suggests that there is a systemic risk of muni bond defaults – however if we get a couple, we might get some panic selling, but nothing like we saw in the stock market.  Even on states that I think people should avoid like California and New York, there is a yield where I would invest and take the default risk -but we are not close to those today. I just think it is crazy to take credit risk to get another 100 or 200 basis points in yield, but 1500 points, that is another story.
The NY Times article mentioned the derivatives blow up in Jefferson County, Alabama as an example of the risks alluded to in this blog. If you are not familiar with it, don’t worry, Jefferson County was an extreme outlier and is not typical of the way most municipalities act. Orange County, California which is a much more important county blew up on derivatives in 1994 and filed for bankruptcy and it did not trigger a wave of other defaults across the country and in the end all municipal bond holders were made whole.  For those of you interested in the Jefferson County situation or want a good read on how Wall Street banks corrupted and financially devastated a local government, there is a new article out in Rolling Stone magazine that is fascinating and here is the link:
The Jefferson County situation is littered with corruption that is so extensive it is shocking and unique even as corruption in municipal finance goes.  While “pay to play” is not new, Jefferson County takes the concept to a depth I have never seen before. I would not as the Rolling Stone article suggests assume that other municipalities that entered into swap agreements are in any danger. In fact, in the case of Los Angeles, not only has Los Angeles made money on the deal, if it wanted to terminate them, it could well afford to do. Both these articles suggest there is something implicitly evil about interest rate swaps – there is not and they are responsible financial tools that actually mitigate risk if used appropriately. So the extrapolation that all these municipalities are in danger because they used derivatives particularly swap agreements is fallacious. A swap agreement in its simplest terms is simply agreeing to pay a fixed interest rate while receiving a variable one or vice versa.
By the way, as of today even Jefferson County has not defaulted on their debt though they might. They have done what I expect many municipalities to do before default, cut services and raise fees and taxes, but pay their debts. That is why I don’t expect a wave of municipal defaults. But I expect to see very difficult decisions and maybe political impasses that might lead to some “temporary defaults” – because states like California and New York have no good solutions and it is possible they might need to use a default as the political cover for the budget cuts they need to make.
Every year there a handful of municipal defaults but they are almost never cities or counties, but special purpose entities. If you own your munis through a fund you should be diversified enough not to feel it. If you buy your own bonds directly from a broker you need to be aware of what you are buying. Most people buy bonds off ratings and yields and don’t look beyond that. If you are buying your own bonds, there should be certain classification of bonds that you should avoid regardless of the ratings and regardless of whether they are “insured” as the meltdown exposed the muni bond insurers as financial basket cases themselves. Two of the biggest municipal bond insurers are Ambac and MBIA, their stocks peaked at around $90 and $73 in 2007 and 2006 respectively, today’s those stocks are worth 55 cents and $6.78 today – municipal bond insurance is worthless. Even before they got themselves involved in insuring non-municipal debt which caused the recent problems, the reality is the amount of municipal insurance in force they had relative to their asset size meant they could never payoff a wave of municipal defaults should they occur.
The riskiest of muni securities are those that are not backed by the “full faith and credit” of a state, county or city or what are known as General Obligation Bonds. The other major type of bonds are called revenue bonds, though they may be issued under the auspices of a state or city, they are backed only by the project revenues of what the money was used to finance. Such is the case of the Las Vegas Monorail Bonds – which though technically issued through a Nevada state agency is only backed the revenues generated from the fare box and Nevada has no responsibility for it. When the fares proved to be inadequate to support the debt used to build the monorail, it filed for bankruptcy. I should point out that one of the bonds issued for the monorail was guaranteed by AMBAC which has already said it won’t be able to pay the interest on the bonds when the monorail misses its next payment as expected because Wisconsin which is their insurace regulator is prohibiting it for now because of AMBAC’s large financial problems.
Some revenue bonds though are very high quality as they backed by an essential service that has the capacity to raise rates if necessary – the municipal electric utilities in Los Angeles and Sacramento are two such examples, in the short run they are better quality than even a California GO and that is reflected in their ratings. Of course if California completely goes off the rails and people leave the state, there goes the rate base.
One of the riskiest forms of revenue bonds are certificate of participation which are backed only by a lease agreement from a municipality. If the municipality decides it does not need the facility anymore and stops the lease payments, those bonds will not be paid. These types of bonds should be avoided by individual investors.  Two other classes of municipal bonds with a higher degree of problems than average are housing revenue bonds and bonds to finance health care facilities like hospitals and individual investors should avoid these also. Even though most of these types of bonds perform, individual investors without the appropriate background (almost all of you) – can’t tell the difference between the good ones and the bad ones, so just avoid them.
While the Bookstaber article is correct that municipal accounting is opaque and it is more opaque than SEC registrants such as corporations, this has been the case since 1933. That does not make it good, it just means it is nothing new and in fact financial disclosure by municipalities and states is far better today than when I studied this subject in graduate school. In 2004, the Government Accounting Standard Board (GASB) required governments to disclose and value their long term retiree health and life insurance benefits and in 2007 the made the same requirement for public employee pensions. Now corporations have had to do this for a much longer time, but municipalities are catching up on disclosure. However,  the use of fund accounting by governments and that municipal bond issuers are exempt from SEC registration requirements will always mean that municipal finances will always be more opaque than corporate issuers  and there will be less information easily available on the Internet for muni bond issues than most corporate ones.
Lastly, I take exception to Bookstaber’s analogy to the housing credit crisis where national diversification didn’t shield people from losses. Number one that is true because your loss on mortgage bonds was more predicated in what tranche you were in (first to get paid, second to get paid etc) than in what state the mortgages were issued. Secondly, mortgage funding was completely unregulated – in contrast municipal bond issuance is governed extensively be state constitutions and statutes, that alone means there is significant differences between bonds issues by one municipality and another as each state have different limits on much debt can be issued. You also need to be aware that some states like New York have been very aggressive in issuing “moral obligation bonds” when they hit debt limits in their State Constitution. Moral Obligation bonds are not legally enforceable, it is essentially the state saying “wink, wink”, trust us we will pay you but legally we cannot actually pledge that.
I would also be more concerned now about school district debt, which is usually only backed by property taxes and with the housing crisis etc… – Kansas City and Detroit are two school districts with deep financial problems.