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Lessons for Munis From the Mortgage Market

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In many ways, this seems to be the perfect time to be buying municipal bonds. The yield on muni debt is now equivalent to the yield for treasuries, which means that investors can get the tax advantages of munis for free.

The headlines warning of a wave of defaults has scared away some buyers, potentially creating bargains. The default rate on munis remains microscopic.

Unfortunately, the bullish case for munis has a very frightening precedent. Two of the arguments for munis resemble those made for mortgages—just before the mortgage market melted down.

A diverse marketplace.

Although the total amount of muni debt is now $2.9 trillion, one quarter of GDP, the muni bulls say that it is a mistake to look at muni debt as a monolith. There are many types of debt that go under the guise of “muni,” and some are not that risky at all, the bulls say. They argue that some states and local governments are nowhere near as risky as others. The risky munis are only a tiny fraction of the market.

Back in the first half a dozen years of this century, we heard a lot about how there couldn’t be a national mortgage meltdown. Real estate is local. Mortgage lending is local. Each market has its own peculiarities. We also heard that problems would be confined to the riskiest part of the market, subprime.

As late as December 2007, you could find all sorts of sensible people arguing that mortgages losses were being exaggerated, the economy would be robust even in the face of subprime losses, and the biggest expense to the federal government would probably just be a loss of tax revenue when subprime lenders stopped being as profitable.

As it turned out, there was far more inter-relatedness in the housing and mortgage market than most people anticipated. Housing prices dropped far more than the pre-crisis consensus viewed as realistic. Losses were not confined to subprime loans. The U.S. economy was far more leveraged to the housing market than was understood.

The federal government wound up spending far more as a result of the crisis than anyone thought likely. The alleged diversity of the housing market broke down, pushing losses into supposedly safe asset classes.

Could something similar happen in the muni market? The simple answer is yes. If the riskiest munis are downgraded or actually default, it could cause a credit crunch. Some investors may flee the market. Others will be forced to pull-back in order to firm up their regulatory capital ratios after taking losses in the market.

The opacity of the muni-market will leave many investors uncertain which debt-issuers are safe and which are not, which could result in a shunning of all issuers until clarity is provided. As yields on munis climb, defaults could climb as states and localities find it increasingly expensive to roll their debts.

The Lesson of History

Historically, the default rate for municipal bonds has been miniscule. The average cumulative default rate for investment-grade municipal debt is 0.03 percent. Out of a universe of tens of thousands of municipal-debt issuers in the country, only 54 rated by Moody's have defaulted since 1970. Only three of those have been have general-obligation “tax supported” debt. Some bulls have told us that we’d have to go back to the Great Depression to find levels of defaults that would justify the implications of today’s yield levels.

Much of the same kind of reassurance was heard when it came to mortgages. In 2005, the serious delinquency rate for subprime ARMs was around 5 percent. The worst it had ever been was in 2001-2002, when it hit 10 percent. By mid-2008, the serious delinquency rate had climbed to nearly 30 percent. By the end of 2009, it hit 42 percent.

What the mortgage meltdown taught us is that forecasts based on historical measures of risk can be misleading. Market breakdowns can go non-linear. History can be particularly misleading when the market has changed dramatically—as it certainly has for muni debt.

Just as the historical measures of risk in the mortgage market did not fully account for the dramatic decline in credit quality and increase in the size of the subprime market, much of the bullish analysis of muni bonds ignores the explosive growth of muni debt.

Since 2000 the total outstanding amount of inflation adjusted state and municipal bond debt has soared from $1.5 trillion to $2.8 trillion. What’s more, this explosion of debt continued even as the recession ate away at the tax bases of the states and localities. Debt levels grew while income stagnated or fell—does that sound at all familiar?

Munis and Mortgages

Of course, just because we saw the arguments for diversity and historical precedent fail in the mortgage market, doesn’t mean they won’t work in the muni market. Maybe it is different this time. Or maybe munis are different enough.

The question investors should ask, however, is whether the yields they are getting are compensating them for the risks that history and diversity will once again fail to protect them.


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