Harrisburg’s well-publicised default on $282m in debt on an incinerator project it partially guaranteed already sparked concern. But the far smaller sum of $3.3m, the coupon on its tax-free general obligation (GO) debt, has really spooked the market. Bond-insurer Ambac put its backing behind the issue, the sort of backstop that was criticised as taking money for nothing, since cities’ and states’ power of the purse were thought to make additional guarantees redundant.
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We haven’t visited muni land in a while, but some recent developments made me shudder. Defaulting on a GO bond? That is never supposed to happen. But then again, for those who remember, in 1997 Russia defaulted on ruble denominated bonds, which also wasn’t supposed to happen. The Russia event brought down Long Term Capital Management and supposedly almost brought down the entire financial system, prompting the Fed to step in for a quick save.
In the case of munis, what’s the end game? Well, municipalities will take the long term risk of increased cost of capital for current funding needs and by extension political necessity to appease current voters. Current bond holders, however, tend to be retail investors who need the after-tax income of muni’s, so really, their putting the politicians between a rock and a hard place – on the one hand, voters don’t want to see decreases in municipal services, on the other hand, they face a decrease in the price of their bonds and decreased income from lack of payments. There’s the problem – no one wants to sacrifice on any aspect.
So, politicians will be forced to take the short term beneficial route of rallying the base against corporations, assuring bond holders that their bonds are insured, and putting future town residents on the hook for higher interest payments. In the meantime, the federal government will need to bail out Ambac and the other bond insurers in what will be called a black swan event, but which is so predictable Warren Buffett wanted to stay away from it at any price.
Simultaneously, of course, tax receipts are dropping as real estate values, capital gains, and income taxes get squeezed. Thus, states will not have the ability to backstop the municipalities and local governments. The federal government will be the lender of last resort and with limited ability to increase taxes, will be forced to print. Inflationary? Maybe – certainly on a theoretical level if jobs remain, but could just be desperate if wage inflation doesn’t show up and velocity stays low. If nothing else, it will lead to an increased debt burden and eventually lead to increased rates across the debt markets and all along the curve. While munis won’t be the trigger (I believe lack of foreign buying will be), weak local and municipal positions will certainly contribute.