There is been much press lately about problems in the municipal bond market. Meredith Whitney the bank analyst who was more right than others on the financial crisis has now turned her focus to public finance and apparently has predicted 50 muni defaults in 2011. I have not seen her report as I am not a client – so based on press reports though she is apparently referring to 50 significant defaults such as cities and counties. I have little doubt we can see 50 defaults if you include special purpose entities like the Las Vegas Monorail which did default (one year ago) , but I do not believe there will 50 defaults in 2011 of traditional municipal bonds.
The problems are real – government spending is on an unsustainable path. But unlike private companies, most municipalities have the sovereign ability to tax which in the short term can advert a default. Of course eventually, you end up with the basket cases like Camden, New Jersey which is already partially supported by the State because it cannot support itself. You can’t raise taxes forever because eventually business gets chased away and then when you realize that like Camden, you start tax-exempting everyone remaining to keep jobs and then there is no tax base.
But the point is municipal defaults take a long time time to materialize amongst traditional issues like general obligation debt and school district debt. Special purpose or more complex instruments like Certificates of Participation are and have always been more risky. People should be very concerned about any debt that is backed by lease payments municipalities can walk away from if they don’t need the asset.
While I don’t envision a federal bailout of specific states like California – as that is not politically tenable -I do foresee eventually the complete federal takeover of Medicaid which even Republican Governors would support and that will give states breathing rooms and the ability for states to help struggling municipalities and school districts. The ability for governments to find short-term bandaids is quite extensive like New York State selling the Attica prison to itself like it did a few years ago. This is why 50 GO defaults in a single year is hard to believe particularly for any entity of size.
At some point, society will need to make a hard choice between shrinking the size of government or default – but 50 large municipal entities will not face this choice in 2011, though over next many years, many will face this choice. There is an article that Forbes just published this week:
What the article does not say is that the VRDN has been large for sometime, are the amounts that need to be rolled over in 2011 that much higher than in 2010 or in 2004, it does not say. In any event, the end result will most likely be higher interest rates paid, less government spending to cover the increased interest costs, but that is far short of default.
While people talk about 75% increase in income taxes in Illinois, it avoids the issue that Illinois had a very low top personal tax rate for a major state around 3% and even bringing it to around 5%, so it is really more like a 66% increase, but it is still half the top rate faced by Californians and less than the top rate in New Jersey and Oregon to name a few. I think the increase in corporate income taxes in Illinois is more problematic, but Illinois because its taxes were lower than other for years had the headroom to make these moves where California and New York are out of options – even Andrew Cuomo conceded New York must live with a smaller government and that tax increases continue to drive people and jobs from New York.
Though munis have sold off recently, they are far from trading at distressed prices, so I am not recommending diving head first in, but people with large holdings of munis do not need to panic if they are properly diversified as to geography and most importantly by type of issue – as I always I would be wary of housing bonds, healthcare bonds, certificates of participation and any muni backed by lease payments.