The Coming Collapse of the Muni Bond Market

Written November 4th, 2009

We have written multiple times on the lurking dangers in the municipal bond market, but this article by Phillip Greenspun articulates and summarizes the dangers even better than we have. Here are some excerpts:

…Sheehan notes that “spending is rising and revenue is collapsing” for all levels of government. Pension fund losses will require governments to double their contributions to pension plans (see my blog posting on public employee pensions). Spending is rising, e.g., in New York City from an average of $65,401 in compensation per public employee in 2000 to $106,743 in 2009. The number of full-time employees in NYC grew as well, despite falling school enrollment. The number of state and local government workers grew from 4 million in 1955 to 20 million in 2008 (5x growth, against less than 2X growth in U.S. population). Those workers receive an average of 43 percent more pay and benefits than a private sector worker…

…Without bankruptcy protection, a city that couldn’t pay bondholders would be forced to raise taxes until it could. This happened to West Palm Beach, Florida in the Depression and property tax rates rose to 42.5 percent of assessed value. Potentially bondholders might demand that the city hand over real estate to satisfy its debts. With bankruptcy protection, it is unclear what happens. Vallejo, California went bankrupt 18 months ago and their obligations have not yet been resolved (story). If courts allow municipalities to walk away from debt they’ll have every incentive to declare bankruptcy and start afresh. There are no shareholders in a municipality to wipe out and therefore the only negative consequence of a bankruptcy filing would possibly be having to pay higher interest rates for future borrowing. If on the other hand, governments are not allowed to walk away from many of their obligations, they will simply run out of cash. Are bondholders senior to pension obligations or not? It may be up to the individual judge. This is “uncharted territory for investors” as my money manager put it (he does not buy U.S. muni bonds)…

The article continues to outline statistics and implications of default, but I will take it a step further. The municipal bond market is a retail market. It is made up of mostly local (in-state) residents and diversified muni bond funds, the holders of which are individual investors. Because of the tax exemptions, public pensions and institutions tend to prefer taxable bonds. This has an interesting implication for politicians: they will have to raise taxes on the same investors that are holding the muni bonds – which is political suicide. Instead, the federal government will have to step in, along with politicians needing to find a way to influence the courts when thinking about some workouts. The question of state pensions and benefits will be addressed in the coming years, one way or the other as states face the prospect of default with limited ability to raise taxes.

If anyone has any information to counter or make me a believer in the sustainability of the currency tax and borrow regime, PLEASE forward it along, because the way things are looking now, I’m very wary of the muni market.