US Municipal Bonds: The Next Crisis?

Municipal bonds are bonds issued by lower level governments (county, city or state) in the United States to raise capital for public works projects, such as sewerage, water treatment plants and roads.

For decades, municipal bonds have been a favourite amongst investors in the higher tax brackets since they pay higher yields than Treasury bonds and are also exempt from federal taxes and, in many cases, state taxes.  

These bonds have also been considered one of the safest income investments around. Between 1970 and 2000, the default rate for all municipal bonds was only 0.04% in comparison to the 9.8% default rate on corporate bonds during the same period. There has also been a degree of moral hazard attached to municipal bonds, since many investors assume that the Federal Government would bail-out any defaulting issuer.

However, as the state and local governments continue to rack-up large sums of debt, it appears that municipal bonds might soon lose their “safe status”. According to Business Insider, the total outstanding state and municipal bond debt, adjusted for inflation, has soared from $1.5 trillion in 2000 to $2.8 trillion in 2009 (see below chart).

In a recent interview on 60 Minutes (video below), prominent banking analyst, Meredith Whitney, predicted that there will be between 50 and 100 counties, cities and towns in the U.S. that have “significant” municipal bond defaults in 2011 that total “hundreds of billions” of dollars in losses and that local insolvencies could be widespread.

Graham Summers, from Phoenix Capital research, suggests that many US states are already in trouble, and that the situation is deteriorating fast:

Many US states are running major deficits this year. California is the most glaring example, but all in all the US now has 48 states facing deficits ranging from 15% (Arizona) to 0.6% (Florida). In nominal terms, we’re on pace to see $178 billion in state deficits: an amount equal to 26% of total state budgets.

The picture doesn’t get prettier in the future either. When you add in 2011, you’re looking at a total $350 billion in deficits for the two years (2010-2011). And that’s assuming unemployment and other economic issues don’t worsen from here (meaning tax revenues don’t continue to fall).

The only problem is they are.

As of last week, the US Treasury’s “withheld income and employment taxes” is down some $48+ (roughly 7%) billion from last year. Similarly, non-adjusted jobless claims continue to rise: a whopping 500,000+ for the first week of February 2010.

The logic here is quite simple:

Lower wages + higher unemployment= lower tax revenues.

Lower tax revenues + greater government spending= greater deficits.

Greater deficits eventually = insolvency or default.

Which brings us to today. The city of Vallejo, CA declared bankruptcy back in May 2008. Now we see Harrisburg, Pennsylvania passing a 2010 budget which doesn’t include debt payments (as in payments on Muni bonds and other debts the city owes) which is essentially a default.

We’re only just getting started here…With tax revenues falling and major debt issues to consider we are going to be seeing a heck of a lot more defaults and bankruptcies coming from local, city, and state governments…

Mr Summers also questions whether the Federal Government will be in a position to bail-out the municipalities: 

Obama already threw $140 billion towards helping state deficits over a 2.5 year period. But remember, states are facing $350 billion in deficits. So the Federal Government could DOUBLE its handouts and states would STILL be underwater.

Given the increased outcry against additional bailouts / stimulus (see the Massachusetts election), the likelihood of another massive stimulus plan to help states is small. Regardless, if the Federal government did start issuing handouts to states, it would require another $160 billion in cash just to meet demands for the next two years assuming no increase in unemployment or decrease in tax revenues.

Good luck with that.

The fact of the matter is that we are on the verge of a muni bond crisis. The issues plaguing Greece and other eurozone countries are taking place in our own backyard just on a smaller level (for now). Muni bonds were often thought to be a safe haven, but given the economic outlook in the US, that may no longer hold true.

The sharks also appear to be circling. According to Business Insider, short sellers are “jumping into the credit default swap (CDS) market to bet against cities, towns and states”. Spreads on CDS (an insurance contract that protects a bond holder against default) have been widening, and the dollar amount of CDSs on municipalities is growing, signalling that speculators are building short positions against the municipalities.

Watch this space…

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Unconventional Economist

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.

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Comments

  1. Agreed. This year is going to be really messy for a lot of municipalities and their bonds. One of these days I’ll finally get around to writing something about the fiscal problems of the states!

  2. I had a friend of mine living in Chicago and over Xmas he drove to see his family which was about a 3.5 hour drive. It took him 6.5 hours to get there because of the snow that they got. The reason, the interstate was coverd in snow and the state of Illinois could not afford to send their trucks out to clean it off. Cities and States are running out of salt because they cant afford anymore. I am hearing more and more stories like this. Whether Americans like it or not. When the US recovers from this Great Recession taxes are going to go through the roof. Some states are already raising them. My prediction the first US state to default California.

    LBS

  3. Hi Guys,
    Not a question about this story but more about Phoenix Capital and their paid services. Does anybody here subscribe to their PWA or RFA services? Been getting his emails for the last 6 months and they are interesting but cant find anybody who actually pays and recommends either services.

    • They feature occasionally on Zero Hedge as contributors, if you do a search of their recent offerings there you can check that against market performance and make up your own mind.

  4. Debt on more debt, the only way they know until the tap is turned off.

    To add to states woes Republicans are proposing tax changes that, if they pass, will hit Democrat states hard.

    As to it being the next crisis, it has some competition. A Federal court in East NY just described MERS (50% of US residential mortgages registered) as unlawful.

    Almost time for the TV pundits to dust off the “perfect storm” comments again.

  5. Correct me if I am wrong,

    US States aren’t permitted to file for bankruptcy, and municipalities, which have access to Chapter 9 of the bankruptcy code, only rarely do.

    Aren’t some New York hedge funds snapping up these bonds because of the high-yields and relatively low long-term risk of default?