Sunday, May 17, 2009

The Scary State of the Municipal Bond Market

In light of the Obama Administration running rough shod over the rule of law and the rights of senior secured debt holders in the Chrysler bankruptcy, investors are going to start looking a lot more carefully at other possible investments which may be vulnerable to the rule of law being violated and the rights of senior secured debt holders being trampled.

Who wants to own debt in a risky operation when it won't be clear if your written contractual obligation will be honored?

A consequence of Obama's Chrysler maneuvers may be that municipal bonds will become more risky and, thus, it will become more difficult for lower rated cities to raise money.

That's what Accrued Interest thinks Warren Buffett is alluding to when Buffett writes in his most recent Berkshire Hathaway annual letter:

A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.

To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belt tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.
Accrued Interest then extends this curious comment from Buffett:

At the time the letter was made public, back in February, I thought it was mostly just Buffett's way of 1) Making sure he could keep charging exorbitant sums for muni reinsurance, and 2) Temporing shareholder's expectations for the muni insurance sector. After all, there is no record of insured bonds defaulting at a higher rate than uninsured bonds, controlling for all other factors...

Given the state of XLCA, CIFG, FGIC, and Ambac, I'd say that de facto, most issuers have a fair number of bonds that are now uninsured. Certainly its fair to say that the local investors, who Buffett argues prevented politicians from ravaging bondholder rights, would suffer a large market value decline if any issuer fell into default, even if the bonds were insured, since all insurers are seen as weak... I've argued many times before that state and local governments can't choose to pay teachers and not bond holders. But can we universally assume this will remain the case? As readers undoubtedly have read numerous times, Chrysler's "secured" bondholders suddenly found themselves unsecured by Fiat (pun intended). Why? Because it was politically expedient.

Couldn't the same thing happen in a municipal bankruptcy? Especially if the Federal government gets involved? Absolutely it could.

I don't see this happening with some local school district someplace. Take Vallejo or Jefferson County, both of which are going on right now. So far it looks like the courts are playing a lesser role in both cases, with politicians and debt/swap holders negotiating directly. These are the kinds of bankruptcies I expect out of munis in the next few years.

But what if a really large issuer, like the city of Detroit, were to enter Chapter 9. Then what if the Federal government stepped in to provide some sort of bridge financing. Then suddenly the Treasury gets to dictate terms, and Obama has shown he's not going to make the unions bear the same burden as bond holders. I'd argue that the public employees unions are more powerful than the UAW!

If that happened, then immediately local governments would see bankruptcy as an expedient solution, solving structural deficits by punishing bondholders.
How scary can all this get? Accrued Interest sees the Federal government as potentially the only source for municipal funding.
Ultimately, this would be an incredibly foolish course of action. Consider the consequences: the municipal bond market would shut down, with only the strongest issuers able to come to market, and maybe not even those issuers. Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.
This is not the time to own municipal bonds, except from municipalities that can get a triple A rating without muni insurance. And, even with stong municipalities, you have the looming inflation threat.

This is not your grandfather's America.

1 comment:

  1. When Bernanke indirectly promised to "buy anything that moves", he wasn't kidding, was he? And the government is there to back him up - making sure there is only one buyer.

    It seems the stealthy road to fascism is not mainly done by forcing everyone to comply - but by making an example of someone in each market you wish to conquer, sending investors fleeing frightfully into the next market.

    I guess the circle is complete when there are no more markets. The fact that the US will be brought to it's knees by the corrupted banking conglomerate is getting more obvious by the day.

    And now that auto-companies and trucking-companies are financial institutions, it may only be a matter of time before financial regulation applies to freedom of speech. After all - with arbitrary definitions there is no end to the possibilities.