Home » Articles » Munis About to Blow Up

Munis About to Blow Up

by John Rubino on May 24, 2010 · 20 comments

So I’m sitting here trying to turn a pile of (mostly terrifying) data on muni bonds into a post that explains why this is the next domino to fall, and here comes Time Magazine with a feature on that subject:

Municipal Bonds: The Next Financial Land Mine?

As Wall Street nervously watches the sovereign debt crisis unfold in Greece, another potential landmine is looming closer to home, one that could bring U.S. cities and towns to their knees, force the federal government to cough up another bailout package, and potentially send the unemployment rate much higher. The danger this time? Municipal debt.

State and local governments are frantically scrambling to meet budget shortfalls as high unemployment and shaky consumer confidence mean less income tax and smaller sales tax revenue for government coffers. At the same time, falling home prices and rising foreclosures will start to hit municipalities hard this year as all those property reassessments done over the past 18 months kick in.

A couple of municipalities, such as Los Angeles and Detroit, have even whispered the “B” word. Former Los Angeles Mayor Richard Riordan argued in an editorial in the Wall Street Journal earlier this month that the city will likely have little choice but to declare bankruptcy between now and 2014. Also, several smaller markets, such as Harrisburg, Pa., and Jefferson County, Ala., have openly talked about filing for Chapter 9 bankruptcy — a reorganization available only to municipalities.

In general, municipalities try to avoid Chapter 9 filings. Although such filings make it easier for a city to break onerous labor contracts or make other politically tough cost cuts, they can have hidden costs, such as distracting politicians, alienating business and making it more difficult for a city to raise cash in the capital markets going forward. The city of Vallejo, Calif., for example, has been in Chapter 9 since spring 2008, and observers say the process has been costly and hurt the city’s ability to attract new business. “It’s been two years and the case is still going on and there’s still significant disputes with the unions,” says Eric Schaffer, a partner at Reed Smith LLP. “Ultimately you hope to bring everybody to the table and share the pain, but that can be a messy process.”

Bankruptcy is a particularly unnerving prospect for bondholders. Municipal securities are a $2.8 trillion market, according to Municipal Market Advisors. An avalanche of investors sought refuge in the sector in recent years, lured by the stable, tax-free nature of muni bonds. More than $69 billion flowed into long-term municipal bond mutual funds in 2009, up from only $7.8 billion in 2008 and $10.9 billion in 2007, according to the Investment Company Institute. Another $15.2 billion has been added so far in 2010.

But increasingly munis are seen as vulnerable to the same forces that have put companies and some sovereign governments in crisis. “The whole system is pretty fragile,” says Brian Fraser, a partner at the law firm Richards Kibbe & Orbe LLP. “The assumption has always been that municipalities aren’t going away and that they can always raise taxes to pay debt,” but that’s no longer the case, he says. He noted how Jefferson County, which is teetering on bankruptcy, was unable to raise sewer rates to meet its sewer bond obligation. Adds Richard Raphael, executive managing director at Fitch Ratings: “This is the worst downturn … and most pressured environment for municipals in decades.”  Read the rest of the article here

Some thoughts:

  • Note the process at work: The housing bust caused home prices to fall, which over time causes assessments to decline, which results in lower property taxes. This is just now playing out, lowering tax revenues for cities that are already unable to pay their bills.
  • Along with U.S. Treasuries, munis are where capital hides during uncertain times. This isn’t speculative money; it’s “cash” that risk-averse investors assume will hold its value and be readily accessible. So most muni owners aren’t paying attention and will be doubly shocked when they not only lose money but can’t get at it because of default or bankruptcy.
  • This is America’s Greek crisis. A major city or state will default on its debts, threatening a cascade failure of the many others in similar straits. The federal government, like the EU, will stare into the abyss and will blink, agreeing to take muni debt onto the federal balance sheet.
  • At some point the global markets will notice that the U.S. is just California writ large and will treat the dollar accordingly. Maybe munis are the wake-up call.
  • Brutlstrudl

    Sounds deflationary to me. Roll the presses.

  • ben pierce

    This is what one would expect to happen. The central planners in the US and Europe continue to bail out big bond holders.

  • Gargamel

    I wonder how the deflation level is in the eurozone after the currency dropped from 1.60 to 1.25 versus the dollar, never mind the real drop versus oil and gold.

  • David Ziffer

    A common theme that I’m seeing unfolding here is that there is no safety in numbers or even in the traditional notion of “safety”.

    When the EU created the Euro back in 1999 I was wondering how it was possible for a bunch of disparate governments with different fiscal policies to manage a single currency. The answer unfolding now is that it can’t.

    During the housing bubble I was continually wondering how all these people investing in houses, which are actually consumer goods with enormous ongoing expenses (repairs & taxes) attached to them were going to all somehow cash in on the incredible oversupply that was being built. The answer is that they couldn’t and aren’t.

    Way back in the 1980s I was wondering how all these people anxiously shoveling funds into their IRAs and 401Ks were going to ever find the buyers to sell all these assets to later in life, especially since there were going to be so many of them trying to sell at a time when there would be relatively few to buy. The answer is that they won’t. Most Boomers who think they’re going to retire some day aren’t.

    So in response to a housing and employment crash, everybody has ironically shoveled their money into muni bonds, which derive their interest-paying power from an employed population paying ever-increasing taxes on ever-appreciating property, apparently based on the historical safety of such things. Right.

    My analysis suggests there’s another huge bubble in the making, and that is the market in gold. I have spent many hours analyzing the actual price curve of gold, fitting it against various different models of the presumed consumer price index, and I just can’t make it look like a good investment, especially at this time. If we assume a low CPI then gold is currently terrifically overpriced. If we assume a higher CPI then gold starts looking like it is perpetually underpriced and incapable of maintaining its buying power, despite all the claims of the people hawking it. Oh and yes, I now get about five calls a day from people trying to sell me some.

    My general rule for investments is becoming: “If everybody is already flocking there, go somewhere else.” We have built a fundamentally unsound economy, and this means that anything in which the majority is involved is inherently unsafe. Hanging out in the middle of the herd is a fine strategy most of the time, but on the day that the entire herd is swept away by a mudslide, it is a prescription for personal doom.

  • Bruce C.

    Yes, I agree that a funding crisis at the municipal level seems fairly inevitable and, therefore, municipal bonds are at risk. I’m looking forward to seeing how it unfolds. Banks may not be the majority holders this time. If they’re mainly owned by unions, pension funds, institutions, and individual investors then things could get interesting. I won’t be surprised if muni holders get screwed, under the guise of “no more bailouts” (for non-banks). Maybe I’m wrong. Were the 401K’s of Bear Stearns’ employees made whole when the shake down took place? I suspect something similar will occur.

    Anyway, I’d like to address some of David Ziffer’s comments about gold.

    David, I agree with you that there are a lot of mixed signals going on about gold. I think that’s a reflection of the different levels of understanding about what’s going on and what is likely to unfold. The embarrassing advertising shills for gold I liken to the periodic real estate experts who crop up after every bust to get people to invest in real estate. Their arguments are similar and they tend to play on one’s fears and greed. Ironically, they may be right this time, but not for any insight on their part, they just want to sell something (and they obviously would rather have your dollars than their gold).

    Robert Prechter of Elliott Wave Intl. is one of the few prominent “deflationists” and he seems to agree with you that gold is not a good investment, that it does not do well in deflation, and that dollars are what you should hoard in Treasury money market accounts and short-term Treasuries. EVERYTHING else will fall in value relative to the dollar in the years ahead. I’m still trying to understand his reasoning. So far he seems to think the FED/Treasury will not or can not stop global deflation by creating more of it. I’d like to know what he thinks of Bernanke’s recent comment to literally distribute more dollars to individual citizens if necessary, or drop interest rates below zero.

    Mike Shedlock is also a “deflationist” but he DOES think gold is a safe haven.

    To me it all comes down to whether or not the US has a currency crisis. If it does, then dollars are toast and Prechter will be wrong. If, on the other hand, we’re just going to have “another depression”, as Prechter puts it, then I suppose gold may still be treated as just another (and useless) commodity – true relic.

    A currency crisis is a social phenomenon, not an economic one, so it’s a question of whether or not people will ever suddenly see/accept gold as the only sound currency. That seems to have occurred in Europe already to some extent. In a way, accepting gold as money/currency is no less rational than accepting paper dollars, and I think many could argue that it’s actually much more rational. But, that doesn’t mean it will happen. It has always assumed that role in the past, but it may be different this time. We shall see.

    By the way, if you want to buy gold but think the price is too high then wait for a pull back (which should occur, especially if it is “over priced”.) Maybe then you’ll have a better sense of what’s going on.

  • David Ziffer

    Bruce: Thanks for your comments. I feel compelled to clear up something that I suspect you have misinterpreted.

    My doubts about the price of gold do not in any way constitute an endorsement of the dollar, which I believe has a strong possibility of vaporizing completely. Because we measure gold price in dollars, people seem to imagine that there is some sort of inverse relationship in their values, just as many imagine that there must be some sort of inverse relationship between the dollar end the Euro, probably because people are constantly comparing them. But these comparisons are irrelevant and the inverse relationships are imaginary.

    So let’s take the dollar out of the equation. Let’s price gold instead in terms of bars of soap, and let’s say that in order to get an ounce of gold today I’d have to barter a thousand bars of soap. The question is, did I pay too many bars of soap to get my gold coin? Now let’s suppose that there is a total dollar collapse and the price of both a bar of soap and an ounce of gold both go to infinity. No matter. Now afterwards all the stores are closed and I need to get some soap back in trade for my gold coin that I bought before the collapse. Will I get back a thousand bars, or maybe half that, or maybe more? It all depends on whether gold was “overpriced”, in terms of any “currency” you wish, when I bought it. If it was overpriced, I might have been better off just keeping my thousand bars of soap (but not my dollars) instead of trading them for gold, assuming I had the resources to store them.

    The price of gold has really nothing to do with the value or the viability of the dollar, which is immaterial. The question is, am I better off investing in something else, such as commodities or emerging-markets stocks of companies that do not export to the “first world”, than in gold?

  • Jordan Greenhall

    Bruce and David – these are great comments! I’ve long wondered if we haven’t been handed a false dichotomy between gold and dollars. I agree with most (here) that fractional reserve dollars are ripe for vaporization, but I just can’t get satisfied that a retrograde to gold is scalable. IMHO, the right answer is something like “currency 3.0″. Something that is more robust than gold and more flexible than fiat currency.

  • Lee M.

    Perhaps its time to dust off and buff-up the ideas of “Multi Commodity based” currencies again. With modern 21st Century information and communications systems in place now–it just might work and the transition might not be as painful as one might think. It would put universal constraints on governments addicted to fiat currencies. In a world though run on fiat currencies, who can really say which one is truly any better than another? Its all just promises, pretty paper and electrons.

  • Mell

    Pricing dollars with Gold may not be a solution as is explained aboveGold IS preferable to me.
    If Gold goes up like dollars or soap in our country, does not meanb it goes up in other countries. If it is not priced in terms of dollars then having dollars bears no value- but holding the Gold DOES. The goods we will have to buy, due to our crazy import craving over the years and sending the factories elswhere, will cause the price of those goods available to be – high in terms of worthless dollars.
    Yet one should note that Many goods like seafoods, and other durable goods(tv’s, electronics etc) are imported into the US at 80% or better rate. These countries will price gold according to their currency and thus will demand gold payment or backing based on their cost of production of the goods. Their costs will be lower due to Labor costs(rerason factories moved) and the fact that since they PRODUCE A tangible good we need they have a trade vale – weighted against gold in their currencies. Gold and dollars may be detached, yet they will not rise in sync in a coordinated manner. At some point the price of gold will outpace the value of the dollar and the dollar cost of Gold will go to the moon in dollars but not all other currencies in which we will need to import the goods. The dollar reserve will change and you will find yourself a serf, looking at your Asian master, or better put “if the American people ever let the Banks control the currency, they will find themselves paupers in a land their forefathers conquered, and founded.” Those banks are the Fed controlled by international bankers.

    Got Gold?

    I’ll hold Gold

  • Keith

    I think we’ll all be surprised at how long it takes for the final total meltdown. That’s the nature of bubbles, they last and last until they just can’t possibly be sustained and often that is beyond any early predictions of their demise. Look how long it took for the RE bubble to collapse in the U.S. and it still hasn’t collapsed/deflated in places like China and Australia. Also there is always the chance (slim may it be) that the people in charge will wake up to the problem and actually take positive steps for a change rather than kick the can down the road again.

    The global economy may just limp along for decades or gradually get worse and worse in fits and starts. Then again maybe we’ll have some rapid sickening lurch to the bottom. I vote for stagnation or slow decline unless there is some sudden catastrophic event like N. Korea and S. Korea finally have that devastating war they’ve been preparing for since armistice.

  • MarkyMark

    I’m not so sure that municipalities and states will be treated the same in terms of Washington bailouts.

    My gut feeling is that the States will receive continued bailouts but that some municipalities (particularly smaller ones) won’t receive the bailout that some investors expect.

    I say this based on the following:

    - the bankruptcy of a state would have a far bigger psychological impact than that of a municipality and remember the concern is another “Lehman moment”. It will will also appear to the media, particularly the international media, and public as a bigger event than the bankruptcy of a city (although this may not be the case).

    - a municipality might only have 1 congressman whereas a state will have two senators and many congressmen to press the case in Washington.

    - State bailouts can be accomplished much easier and away from media and public attention (think federal interest free loans for unemployment insurance, fed grants for educational spending, forgiveness of payments due from the states to Washington). From a practical perspective it is harder to bail out municipalities.

    Washington might go half-way by standing behind the muni-insurance in some way. Investors would then be much keener to lend at lower rates and municipalities could keep borrowing just that bit longer. Can. Kick. Road.

  • Doug

    How many times is this going to repeat? A debt problem is ignored until it blows up, the government talks tough about not bailing them out, they do anyways, and the market calms down and moves to the next thing.

    How long can this go on? Will all of the world’s debts eventually be on the balance sheet of the World Bank and then Mars will bail it out?

  • Brad Thrasher

    “There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Ludwig von Mises, 1881-1973

    A more contemporary economist, Michael Hudson noted in 2009,

    “The (US) economy has reached its debt limit and is entering its insolvency phase. We are not in a cycle but (at) the end of an era. The old world of debt pyramiding to a fraudulent degree cannot be restored.”

    Ironic that von Mises is revered by conservatives/libertarians and Hudson by liberals.

    The suggestion that the US could somehow bail out state, county and municipal governments doesn’t pass the laugh test. Many point to another bailout as politically impossible due to anger among the populace. Fact is, there won’t be another bail out simply because there is no money. Unless of course we simply print more.

    The government’s ability to tax, once considered unlimited, is near exhausted. Look no further than the Tea party movement and California. Governor Arnold has been begging Washington for an additional $7 billion for about a year and has been rebuffed.

    We have exhausted our ability to borrow. We have exhausted our ability to tax. War is no longer a reasonable option, everybody loses.

    Bring on the collapse. The sooner we reach our reality check moment, the sooner we rebuild.

  • Bruce C.

    Hey Thrash,

    Of course “we’ll” print more, but why the long face? Think of it as a late hail-mary score that sends the game into overtime. It’ll give us more to talk about. What’s gonna happen to web sites like this one when the crises end? Think about that.

  • J W

    Let them eat cake.

  • David Ziffer

    You all may find this article very interesting:

    http://dailycapitalist.com/2010/05/22/seth-klarman-is-worth-listening-to/

    I actually worked for Seth Klarman’s company (Baupost) for over a year as a consultant, flying back & forth to Boston once a month. Klarman’s company consistently earns more than Bernie Madoff was claiming to earn, and Baupost is not a Ponzi scheme. While I was there in 2005/6, Klarman was earning about 20% for his clients while keeping half their investments in cash (due to a lack of buying opportunities). To say that he is an extreme value investor is an understatement.

    Among other things, according to this article, Klarman is buying “puts” on bonds. Specifically the article mentions Treasurys, but probably when smart people start betting against Treasury bonds, other types of bonds will be in trouble as well. Food for thought.

    By the way, for Klarman to publicly announce this level of uncertainty and worry is simply unimaginable to anyone who knows anything about him. I am reminded of the saying: Be afraid. Be very afraid.

  • Brad Thrasher

    It’s more a confused than long face Bruce C. Since arriving at middle age I am constantly facing problems that I cannot fix. It’s very humbling. A couple of weeks ago I watched my son fix a toy for Grandpa’s Princess ll. As he handed the toy back to her he said, “Daddy can fix anything.” I smiled.

    As you know, I’m an immigrant. If only I could find the words to share with you how as a young a boy growing up in a Canadian border town how we looked forward to the arrival of the Americans every summer. Things got done. Little things. From trimming trees to improve the view of the water. It didn’t take a budget proposal, competitive bids, and a vote. It required only a conversation among neighbors and for me a an instruction from my Dad to, “Go help.”

    As a teenager I witnessed commercial fishing die and come back after Nixon established the EPA. My life experience is that people and government are essentially good. That the Americans can do anything. They make a mess. They clean it up.

    And oh man, what a colossal mess we have made this time. Long term, I remain hopeful. BTW, Niall Ferguson misquoted Churchill, but communicated the essence, in “Fiscal Crisis and Imperial Collapse” linked below in JR’s Best of the Web. It’s about 45 minutes minutes but well worth it. You will get some timing tips in the form of signs to watch. “Events my boy. Events.”

    David Ziffer, thank you for introducing me to Seth Klarman.

  • Paul

    Bruce/David/Keith,

    Excellent posts, however I’d like to return to the ‘Gold’ question and the differing opinions on whether it represents a sound investment.

    I was once advised to ‘Invest in anything that comes Out-of-the-ground’. Amongst other things, my portfolio consists heavily of Coal producing, Oil producing and Gold mining concerns. I’ve done modestly well, even during the recent and on-going GFC.

    Also, and more to the point, I bought physical Silver bullion a while back at US$9 p/oz, it’s certainly been a good ‘Investment’ for me so far & taking current prices into account. However, I didn’t buy it with the sole intention of making ‘Investment Profits’, instead I bought it more for ‘Storage of Value’ (GFC inspired I hasten to add).

    Storage of value, which, in my humble opinion, is a fundamentally different thing altogether than an ‘Investment’. Is it not that it is actually inflation that has caused paper money to be worth less compared against Gold/Silver et al….and not that these commodities have actually INCREASED in value?

    …and for that matter ‘Value’ as compared to what……A ‘Paper Promise’ with no backing other than good will & trust in god????????

    Do you not agree that this could be the reason Gold (Or other commodities for that matter) do, ultimately, make a sound ‘Investment’ and that irrelevent to the previous, current or future tradable price in paper money that they all represent ‘True value’?

    Afterall, you may swap 1000 bars of soap for 1oz of gold now, then find later down the road that 1oz of gold is only ‘Tradable’ for 500 soap…but surely that’s because the demand for soap would have increased and not that Gold had lost it’s actual ‘Value’. You can’t just ‘Print’ Gold to de-value it. And how many pieces of paper would you then need to purchase just 1 bar of soap?

    You’re right, it does seem at the moment as if everyone is jumping on the Gold bandwagon. Certainly here in Australia, which appears not to have suffered finacially nearly half as bad as other western countries recently, we are now being subjected to media advertising pleading to buy our junk Gold, not sell it. Media also tells us China’s population are being encouraged to buy the yellow stuff, ‘Gold bar’ vending machines are being opened in Middle Eastern airports and that Greeks are queing at banks to buy Sovereigns.

    I’ll admit, all signs of a bubble. But, will the paper currencies this Gold bubble is measured against ever recover enough to burst it?

  • Robert Happek

    The discussions about gold overlook one important point: People buy gold because central banks hoard gold. If a currency fails, the central banks usually introduce a new currency. Gold is the only asset that central banks will accept as payment for the new currency because gold is the only financial asset that can not be devalued by the issuance of a new currency. The flight to gold is therefore simply an attempt to maintain negotiating power with central banks by maintaining a position in a currency accepted at all times and at all locations regardless of financial calamities.

    To sum up: Gold is valuable because central banks believe gold is valuable.
    Why would the US government hoard 8,000 tons of gold, if that were not the case?

    Regarding gold versus soap, the relative value of soap (or any other commodity) could rise temporarily due to scarcity effects. That does not mean that gold is less valuable because it buys less soap. If gold buys less of all commodities in the marketplace, yes then and only then gold is less valuable.

  • http://chaosandconspiracy.wordpress.com CompassionateFascist

    You are all in dreamland. What is coming – around about spring/summer 2012, after the Iran War begins and the dollar gets run – is not only U.S. economic collapse, but SYSTEMIC collapse, that is, including the government. Expect the Regime to invoke martial law, attempt a gold-and-gun grab, which will provoke violent opposition, including numerous state secessions. In a word, Civil War II. Locally, there will not be, for instance, any “grocery stores” (or anything else you are used to)….you will be lucky to find food at a green-market. And there the operative currency will be commodities: gold, silver, fuel, guns, ammo, etc. That’s the reason to stock up on these things now. Not as an “inflation hedge”; not to “make money”; but to survive.


[Most Recent Quotes from www.kitco.com] [Most Recent USD from www.kitco.com] [Most Recent Quotes from www.kitco.com]