We’ve heard this kind of talk about “temporary market dislocations” before—back when the market for mortgage-backed securities began to fall apart in 2007 and 2008. There was lots of confident talk back then, about market prices not reflecting fundamentals and too much risk being priced into mortgage bonds. As it turned out, market prices were accurately reflecting the climb in mortgage delinquencies and decline in revenue streams from the bonds.
A far less benign explanation for the decline of issuance could be that the muni market is freezing up. We’ve now seen month after month of outflows from muni funds, forcing funds to sell bonds to pay off exiting investors. It’s very likely that some of the decline of issuance results from advice from bankers, who fear they cannot sell the bonds at yields attractive to the borrowers.
The mortgage-backed security market froze up in a similar way prior to the finance crisis. Take a look at the chart above, which shows the decline of private label mortgage backed securities that began in mid-2006. That decline, as it turned out, anticipated a huge jump in mortgage defaults.
It might make sense to take another look at the effect of the BABs. Instead of seeing the end of the program as an explanation for this decline, I can look at the beginning of the program as an artificial boost to the market. Without BAB, the evidence of trouble in the muni market may have been apparent even earlier.
I don’t think that the muni market is transparent enough to allow for accurate forecasting—which is why I’m not predicting a surge of defaults. But I do think it makes sense to watch for potential warning signs in the market—and the dramatic drop in issuance could well be flashing: DANGER AHEAD.
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