Over the past eighteen months we have been pressing our listeners in regards to the dire fiscal situation of a large swath of our states, cities and municipalities. This situation could very well lead to an extraordinary amount of municipal bond defaults over the next several years. Investors are starting to take notice by unloading holdings at the fastest pace in at least fourteen years. Over $2.72 billion was pulled from municipal bond mutual funds in the week ending December 15, 2010 which was the fifth straight week of outflows. Currently American cities and states have debts in total of as much as $2 trillion, and are planning to borrow another $500 billion in 2011. Meredith Whitney, the U.S. research analyst who was one of the few of us that saw the global credit crunch and housing meltdown, thinks that more than 100 American municipalities could go under in 2011. She stated on the television show 60 Minutes that local and state debt are the biggest problem facing the U.S. economy and one that could impede any recovery.
“We spent too much on everything. We spent money we didn’t have. We borrowed money just crazily. The credit card’s maxed out and it’s over. We now have to get to the business of climbing out of the hole. We’ve been digging it for a decade or more. We’ve got to climb now and a climb is harder.” New Jersey Governor Chris Christie
Let’s Go Jets! Let’s Go Giants! Pay Up Taxpayers!
I had the opportunity to attend the inaugural Monday Night Football at the new Meadowlands Stadium between the Jets and Ravens. It is a nice stadium with great sight lines with the obligatory surplus of corporate boxes that the big investment firms can utilize to tempt/sell/dupe prospects. The stadium replaced Giants Stadium which also was home to both the Giants and Jets. The stadium will be home to the 2014 Super Bowl. The cost of the stadium was $1.6 billion. The opening weekend was highlighted with great fanfare and pomp and circumstance with honors being bestowed on legendary players from both franchises. There was one major oversight in regards to the individuals that were honored…The taxpayer.
40 years ago the state of New Jersey borrowed $302 million to begin construction on the original Giants Stadium. The goal was to pay off the bonds in 25 years. Politicians, unfortunately, could not resist from rolling over the debt and refinancing the bonds, taking money out and using it to fund other unsuccessful government building projects all over the state. The authority that runs the Meadowlands is now in hock for $830 million which it cannot pay back. The state (the New Jersey taxpayer), which is in fiscal disarray now has to assume $100 million a year in interest payments that will drag on for decades.
Many municipalities, for the past two decades have been playing a risky arbitrage game called the Pension-Obligation Bond. The government issues the bonds and then deposits the money in their pension funds to be invested in the stock market with the idea that the money will outperform the interest rate on the bonds. It is funny how many investors had the same ridiculous inclination to borrow money and buy dot-com stocks a decade ago or buy condos five years ago. Due to the mismanagement of many of these pensions, these Pension-Obligation Bonds have taken on the characteristics of toxic waste. The Center for State and Local Government Excellence noted in a report that most pension bonds issued since 1992 have been huge money losers for states and cities, exacerbating severe underfunding of pension systems.
These abuses came to light during the second half of 2008 when investors started to question municipal debt and leave the market in sync with many bond insurers. Uncle Sam decided to step in and bail out municipalities on the taxpayer’s dime by issuing the down-right-evil Build America Bonds. We subsidize the interest on these bonds allowing the same idiot politicians and bureaucrats to borrow money at interest rates that are not in line with their credit-worthiness. There was $58 billion in Build America Bonds issued in 2009. Rick Bookstaber, a senior policy adviser to the Securities and Exchange Commission recently warned that the muni-market has all the characteristics of a crisis that might unfold with “a widespread cascade in defaults.”
You want scary? Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester assert that the unfunded pension bill for all fifty states is at $3 trillion. The municipal tab for pensions could reach $500 billion. This is on top of the current $2.8 trillion outstanding in state and local borrowing.
Pauly Walnuts Sells Jersey Bonds…(with the help of Morgan Stanley/Bank of America/Merrill Lynch/Goldman Sachs/ Barclays)
The Securities and Exchange Commission accused the State of New Jersey of securities fraud for claiming it had been properly funding public workers pensions when it was not. The commission settled its suit by issuing a cease-and–desist order which was accepted with the parties neither admitting nor denying the findings. No penalties were imposed. The commission stated that from 2001 to 2007, New Jersey claimed to have money set aside in a “benefit enhancement fund” as part of a “five year plan” to fund new benefits for teachers and general state employees. In reality it was all a grand accounting illusion and no money was available. Robert Khuzami director of the SEC’s division of enforcement stated, “The State of New Jersey didn’t give its municipal investors a fair shake, withholding and misrepresenting pertinent information about its financial situation.” Due to the untruthfulness of the state of New Jersey’s, the SEC stated that investors bought more than $26 billion worth of bonds without understanding the severity of its financial troubles. A spokesman for the New Jersey Treasury, Andrew Pratt, stated that the state had “never failed to pay a bondholder.” In which Markowski Investments replied, “Never say never!”
Sell Warren Sell
Warren Buffett recently has been echoing the warnings we have been relaying on our radio show. Berkshire Hathaway has been scaling out of its positions in municipal debt. Buffet stated, “There will be a terrible problem and then the question becomes, will the federal government help? I don’t know how I will rate them myself. It’s a bet on how the federal government will act over time.” In a letter to shareholders he also warned about the risks of insuring municipal bonds. He stated that public officials might be tempted to default on bonds whose payments are guaranteed by insurance companies rather than push through needed tax increases.
Is the Federal Reserve Going to Buy Municipals or is Bankruptcy the Only Option?
California’s delay of a $10 billion municipal bond sale has many talking about the possibility that Ben Bernanke and the Federal Reserve would step in and start buying. The Fed does have the authority to buy any domestic government debt. The Fed buying California debt is similar to the European Central Bank buying Greek debt as they did earlier this year.
Where would the incentive be, for California or any other fiscal basket case state, to get their house in order if they have been deemed too big to fail by the Federal Reserve?
Erskine Bowles, co-chairman of Barack Obama’s deficit-reduction commission stated, “The markets will come. They will be swift, and they will be severe, and this country will never be the same.”
What should our government do when states start coming hat in hand looking for a bailout? University of Pennsylvania law professor and bankruptcy expert David Skeel writing in The Weekly Standard suggests that Congress pass a law allowing states to go bankrupt. He states that a Depression-era statute allows local governments to go into bankruptcy. A state-bankruptcy law would not let creditors push a state into bankruptcy which would violate state sovereignty. But it would allow a state government going into bankruptcy to force a “cram-down,” giving all of the municipal bond holders a haircut worthy of Mr. Clean, and to rewrite union contracts.
Does anyone think that Governor Jerry Brown, who allowed California state workers to unionize, is going to redo their contracts? Me neither.
Ben Bernanke has stated that a central bank bailout of state and local governments that are laden with huge debt burdens are not the Federal Reserve’s problem.
“We have no expectation or intention to get involved in state and local finance. The states should not expect loans from the Fed.”
Fiscal Magic If you had neglected funding your retirement account or 401K for an extended period of time and found yourself behind the eight ball, would you take a second mortgage out on your house to make up for the shortfall? I certainly hope not.
However…The state of Illinois happens to think that is a wonderful idea. Illinois has been failing to make the required annual payments to its pension funds for years, so it borrowed $10 billion in 2003 and used the money to invest in its pension funds. Poor money management sent their desired returns below what the super-smart bureaucrats expected, and now the state must repay the bonds with interest. Guess what their solution was? Borrow an additional $3.5 billion this year, and are hoping to borrow $3.7 billion more next year.
Build America Bond Scam
$160 billion and counting…That is what states and municipalities have racked up in new debt over the past nineteen months. Build America Bonds, a title George Orwell would love, was a part of the ever-popular and super-duper stimulus package. Unlike the usual municipal bond where the state or municipality has to go out and sell through their banker their bonds and a prevailing market rate, the Build America Bonds are subsidized by you and I to the tune of a 35% subsidy on their interest rates. Congress has authorized the program through 2010 but Congress is unfortunately considering extending this debacle. Dozens of governments and other municipal issuers have hired lobbyists to push Congress to extend the program. President Obama has actually proposed making Build America Bonds permanent in his 2011 budget with a permanent taxpayer subsidy of 28%.
Why should we be subsidizing these fools? This past June, the cost for investors to insure against default by the state of Illinois on its bonds rose to a record high of $309,100 on $10 million of debt. The national average is $190,000. Based on the cost of insuring California and Illinois debt, CMA Datavision has named both states among the ten biggest government default risks in the world. Subsidized debt or in other words, allowing any entity to borrow money at rates that are not dictated by the market is a recipe for fiscal disaster. It does not matter if it is a no-doc home loan or letting California, New York, New Jersey or Illinois borrow funds at rates that are not commensurate with their fiscal condition. In a Rasmussen poll, taken before the midterm election, half of the respondents said that members of Congress who supported the 2009 federal stimulus didn’t deserve to be re-elected. The reality was that many were not. Let us hope that the 112th Congress does away with this state welfare scam that misallocates resources.
From the December 4th, 2010 issue of The New York Times…
The State of Illinois is still paying off billions in bills that it got from schools and social service providers last year. Arizona recently stopped paying for certain organ transplants for people in its Medicaid program. States are releasing prisoners early, more to cut expenses than to reward good behavior. And in Newark, the city laid off thirteen percent of its police officers last week.
While next year could be even worse, there are bigger, longer-term risks, financial analysts say. Their fear is that even when the economy recovers, the shortfalls will not disappear, because many state and local governments have so much debt, several trillion dollars worth, with much of it off the books and largely hidden from view that it could overwhelm them in the next few years.
“It seems to me that crying wolf is probably a good thing to do at this point,” said Felix Rohatyn, the financier who helped save New York City from bankruptcy in the 1970’s.
There are plenty of reasons and a plethora of examples that I could use to highlight the impending municipal debt bomb that is ticking away. I know it sounds harsh but I hope that we allow states and municipalities to fail. It is sad, but true; the only way to change their profligate ways is to take the proverbial credit card away and make them deal with reality. Politicians will never deal with a problem until it turns into a full blown disaster.
For example: The Alabama town of Prichard was warned for years that if it did nothing, its pension fund would run out of money by 2009. Sure enough it did, and it stopped sending monthly pension checks to its retired workers. Or, Prime Minister of Greece George Papandreou, who ran for office on the platform of raising salaries and pensions for government and union workers only to get smacked upside the head with fiscal reality and forced to do the inverse.
In my opinion, the entire municipal/government securities market is one big scam/misallocation of resources. Why should the government be allowed to borrow money at rates that other private entities cannot? It is wrong that municipalities are able to sell debt securities with tax free yields; not only is it a major give-a-way to the super-wealthy, but a misallocation of resources. How much capital would flow to the private sector if bonds were priced on a level playing field?
I don’t care what the ratings agencies are telling you. (I would like to remind everyone of the glorious ratings put on those toxic mortgage backed securities that are still stinking up the real estate market and the banking sector). In fact, the credit ratings of a number of municipalities actually improved this year. This was not because they were doing the right thing and getting their fiscal house and order. It was due to the way the wizards of smart at the ratings agencies changed the way they analyze governments. I could not make this up if I wanted to…The new higher ratings, which lower the cost of borrowing, are due to the idea/hope that the municipality would be bailed out by the taxpayer if they defaulted.
Remember when housing was a sure thing?
God is not making any more real estate! Housing prices could never fall all across the country at the same time!
Municipalities are the safest form of investment because the government can just raise taxes to make good.
Harrisburg, the capital of Pennsylvania, considered bankruptcy this year because it faced $68 million in debt payments related to a failed incinerator, which is more than the city’s entire annual budget. Government officials have refused to raise taxes. In fact, the Congressional Budget Office, in a recent report actually published the “Benefits of Bankruptcy.”
One key advantage of bankruptcy is the automatic stay which is issued by a court and prevents creditors from taking action against the municipality and its officials without approval from the court. Another important advantage of bankruptcy is that courts can implement a restructuring plan without the consent of every creditor. The bankruptcy process may also allow a municipal government to reduce its labor costs by facilitating the consent of employee unions to changes in labor contracts. While a stay is in place, bondholders cannot force municipal officials to raise taxes in order to make debt-service payments.
Do yourself a favor…Take a closer look at your bond portfolio.