A $20 Billion Muni Problem?

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A new paper from Rockfleet Financial argues that claims that municipal debt investors will incur hundreds of billions of dollars of losses are outlandish. Muni default rates, however, are likely to rise above historical levels and cost investors between $10 billion and $20 billion over the next ten years, Rockfleet argues.

Rockfleet starts with a big number — $4 trillion of outstanding muni bonds — and whittles down the potential losses through a process of elimination. The basic idea is that some classes of bonds either won't default, or, even if they do, will eventually result in 100 percent recoveries for investors.

Munis worth $468 billion are prefunded, which makes them extremely safe.

Another $823 billion of munis are covered by monoline insurers. Rockfleet considers these safe.

Rockfleet entirely carves out $1.1 trillion of state and local general obligation bonds on the assumption that these will all be repaid in full, with defaulted bonds eventually seeing 100 percent recoveries.

Finally, Rockfleet rules out losses on any revenue bonds for what are sometimes called essential services.

This leaves us with just $1 trillion of bonds that pose risks of losses to investors.

The next step in Rockfleet's analysis is figuring out how many of the bonds in that $1 trillion basket are likely to default. It arrives at a figure of $69 billion by projecting discounted corporate credit loss rates onto munis. (The math here is actually quite clever, but I'll leave the details for those of you who want to actually read the paper.)

The next step is to look to see how much investors in those $69 billion of bonds may eventually recover. Using Fitch data, Rockfleet says muni bond recovery is likely to break down into three rough groups: recovery rates of 90, 70 and 40 percent, depending on the source of payments. (The worst category includes hospitals, student loans and Indian casinos.)

This leads Rockfleet to conclude that over the next decade, investors are only at risk for $20 billion in permanent losses.

Both John McDermott at FT Alphaville and Cate Long at Reuters Muniland have raised some important caveats about this conclusion.

But this is, by far, the clearest attempt we've seen of trying to put a solid number on muni risk.


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