How Muni Bond 'Molotov Cocktail' Could Do Big Damage
It's the other U.S. debt problem.
States are scrambling to close $114 billion in budget shortfalls over the next year and a half. For now, they can borrow at curiously low rates in the bond market — but they better hurry.
Lenders are still throwing money at the federal government, despite its trillions of dollars of debt. But when it comes to states, cities and local governments deep in the red, their generosity appears to be running out.
Prices of municipal bonds, which are issued to build schools, lay water pipes and pave roads, dropped last month at one of the fastest clips since the credit crisis two years ago. Shares of mutual funds that hold the bonds have fallen hard, too.
Some experts worry that problems in the municipal bond market could spread to other markets. Their worst case: A plunge in muni prices triggers panic among investors and widespread selling of other financial assets. That happened during the 2008 credit crisis, when the market for mortgage-backed bonds collapsed. Credit markets froze and stock prices plunged worldwide.
A recession that had begun nearly a year earlier became the worst downturn since the Depression.
"It's a Molotov cocktail," Envision Capital founder Marilyn Cohen says of the muni market. "It could explode."
The causes of turmoil in the $2.8 trillion muni market are myriad, but critics say one was misplaced investor enthusiasm.
State and local governments have rarely been in worse shape, but the average investor was convinced they would always pay back what they owed anyway. So bonds were scooped up, prices rose and yields, or the interest paid each quarter as a percentage of those prices, fell to the lowest in decades. New buyers of muni bonds earned less in interest, even as the risk grew that a state or city or town couldn't pay it.
At this point after a recession, the economy typically would be growing strongly, raising the tax revenue needed to close budget gaps. And if the economy snaps back, city and state tax revenues will grow quickly, making the crisis a memory.
A 'Quick Path to Ruin'
But so far, that isn't happening. As a result, local governments are turning to states for emergency funds to pay for services and salaries. Others are looking at plans to sell or lease public property to raise money fast. And some have taken the unusual step of using proceeds from muni bonds to meet payroll or other immediate expenses instead of funding big projects.
"It's like using your credit card to cover living expenses," says Richard Lehmann, an investment adviser and author of the Distressed Debt Securities Newsletter.
"It's a quick path to ruin."
In Illinois, a pension plan for teachers that was short of money sold $1.3 billion in investments set aside for future retirees. The state budget deficit nearly tripled last year. Yet some investors have been accepting less and less interest on their bonds, just as they would if finances were improving.
There are plenty of other ominous signs. Some voters in San Diego are pushing the city to file for bankruptcy to get out from under $3.5 billion in unfunded pension and health care costs for workers. The possibility of bankruptcy has been looming over Detroit's school system for nearly two years. The city council of Harrisburg, the capital of Pennsylvania, recently voted to hire a bankruptcy adviser.
"Do we cut salaries or operate fewer buses — or do we pay all the interest" on our bonds? says Michael Aronstein, chief investment officer of Oscar Gruss & Sons Inc., a research and brokerage firm. "All these are possibilities when the numbers no longer work."
The numbers stopped working for Vallejo, Calif., two and a half years ago. Faced with rising bills for its public workers and falling property taxes, the city of 20,000 filed for bankruptcy. Though it has promised to make good on its debt eventually, it isn't paying full interest on all its bonds.
Whether there will be many more Vallejos is anyone's guess, but the history of munis is not completely reassuring. In the Great Depression, governments defaulted on 11 percent of munis, notes James Grant in a recent issue of Grant's Interest Rate Observer. The lesson: In times of crisis, moral compunctions about reneging on promises to investors are forgotten.
The $114 billion budget shortfall confronting U.S. states is down from $191 billion in fiscal 2010, according to the nonpartisan Center on Budget and Policy Priorities. States tapped special federal aid to plug one-third of last year's record gap. Most of that aid runs out this summer.
Another looming problem: woefully underfunded pensions. To make good on promises to current workers, state and local governments need to inject $3.6 trillion into the funds, according to a study by Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester.