In Muni-Bond Ills, Danger and Hope
"State and Municipal Debt: The Coming Crisis?" is the provocative topic of a congressional hearing Wednesday, which among other things will consider whether states should be allowed to file for bankruptcy protection.
It's a reflection of more than three months of turmoil in municipal bonds—a period that has stoked fears a crisis in that market could set off a chain of events that would cripple the economy, in much the same way the subprime-mortgage fiasco sparked the recent recession.
That seems unlikely to many experts, who see big differences between the muni-bond troubles and the mortgage woes that triggered the global credit freeze in 2008.
"The near-term budget problems of states are difficult, painful, but survivable,'' says Jay Powell, a former U.S. Treasury official who is now a visiting scholar at the Bipartisan Policy Center, a Washington, D.C., think tank. "Yes, this is the worst stress the system has been under for many, many years, but predictions of widespread defaults are overblown."
The list of reasons analysts cite is long. Municipal bonds are held primarily by individuals, not by financial institutions. Compared with mortgages, they aren't nearly as intertwined with the global financial system in opaque derivatives, hiding unknown risks and linkages.
Most states and municipalities owe long-term debt, and they don't typically rely on short-term borrowing in the way that, say, the now-defunct Lehman Brothers Holdings Inc. did in 2008. In contrast to any kind of corporate borrower, state issuers of muni-bonds are in the rare position of being able to boost their revenues almost at will, by raising taxes (as Illinois recently did).
Moreover, states find their revenues are on the upswing as the economy grows and as inflation, while modest, helps to buoy the incomes and corporate profits that many states tax. During the 2010 fourth quarter, state tax revenues were up 6.9% from a year earlier, according to preliminary data from the Nelson Rockefeller Institute of Government in Albany, N.Y.
This isn't to say that cash-strapped states won't face higher borrowing costs, which could prove excruciating for some governments that rely on debt to fund their operations. Analysts also said that it is possible that the historically low rate of defaults could rise somewhat. What many analysts and investors do doubt is a scenario outlined by one independent analyst, Meredith Whitney, who has publicly predicted "50 to 100 sizable defaults" amounting to "hundreds of billions of dollars."
Municipal bonds—which are issued to finance projects such as airports and dormitories—yield interest income that's free of federal and, often, state income tax. They began their slide last fall. If the $2.9 billion market continues to struggle, it will be because of the attitude of investors like Barry Fiske, an account manager for a Boston-area heating and air-conditioning contractor.
Mr. Fiske, 61 years old, had long considered muni-bonds a safe investment. But late last year, he says, he "just felt very uneasy" about the "threats [facing] certain states like Illinois, California, New Jersey and maybe New York." He slashed his holdings in muni-bond funds to 5% of his investment portfolio, from 20%.
States face budget gaps totaling at least $125 billion as they plan for the coming fiscal year, the Center on Budget and Policy Priorities calculates. Long-ignored underfunding of public pensions is out in the open now, and setting off alarms. States in the coming year also must tackle their budgets largely without the federal assistance that the 2009 stimulus law gave them for a couple of years.
Default was rarely much of a concern in past muni-bond downturns. But now the long-held assumption that states and cities will always pay their debts has come under attack. "Credit concerns are much more prevalent and broad-based than they have been in the past 20 years," says Elizabeth Fell, a fixed-income strategist at Barclays PLC.
Individuals like Mr. Fiske own about two-thirds of U.S. municipal bonds, directly or through mutual funds. This was long seen as a positive, because individual investors tend to "set it and forget it," says Ms. Fell. But individual investors have been sellers of shares in muni-bond mutual funds for 12 consecutive weeks. Since early November, individuals have pulled a net $23.6 billion out of these funds.
Heightening concerns for some of them: Far fewer newly issued muni-bonds are insured now—6.2%, versus 57% in 2005, according to Bank of America Merrill Lynch. Many insurers have stopped issuing guarantees because they themselves are still struggling with their losses in the financial crisis.
"People have been through the tech bubble and the real-estate bubble, and they are scared," says Peter Demirali, a managing director at Cumberland Advisors, an investment firm in Sarasota, Fla. "When they are told there is another bomb to go off, they head for the hills."
Yet the sell-off that began last fall wasn't due just to weaker state an
![[CONTAGION-cht-0]](http://si.wsj.net/public/resources/images/OB-MK935_CONTAG_NS_20110208224102.jpg)
d city finances. The market also was hit with a massive supply of new bonds, which put downward pressure on prices. A key reason was the looming Dec. 31 expiration of a federal program, called Build America Bonds, under which the U.S. provided a subsidy to states that wanted to borrow.
In addition, the Federal Reserve's program of buying bonds to encourage economic growth drew some investors into a rallying stock market, instead of to bonds.
And long-term Treasury bonds—which municipal bonds tend to track—began to decline, as the Fed bond-buying program emphasized shorter-term debt.
Finally, the December extension of the federal income-tax cuts made it a bit less urgent for some individuals to seek out tax-exempt investments such as muni-bonds.
Some of these factors, such as the subsidy expiration, no longer are pressuring the market.
But once muni-bonds began to slide last fall, their declines were exacerbated because of the structure of some mutual funds that hold the bonds. These funds enhance their exposure to the market, leading in some cases to forced selling when prices went down.
When individuals step away from the muni-bond market, there are a limited number of other investors to take their place. The tax-exempt returns that lure individuals aren't as attractive to larger investors, such as hedge funds and investments banks.
Some states and cities have cut back on borrowing in the face of diminished demand for their bonds, which creates higher costs for borrowers. A New Jersey agency trimmed a refinancing by 40% last month.
But states don't always have that option.
Moody's Investors Service has identified states that rely on the debt markets to fund their deficits and current operations, and thus will likely have to venture into the bond market even if it's inhospitable. It was an urgent need for short-term borrowing that fueled the European debt crisis last year, when countries such as Greece found investors would lend to them only at exorbitant interest.
California typically borrows billions each year to cover seasonal shortfalls in its cash flows. Illinois is proposing this year to issue an $8.75 billion "debt restructuring bond" to pay past-due bills to suppliers and a $3.75 billion bond to make required contributions to its pension system.
A spokesman for the California Treasurer's office said the state "will deal with market conditions as they come and we will get the best deal possible for taxpayers." In Illinois, a spokeswoman for the governor said, "we do not see a loss of muni-market access" because the state is working to close its budget deficit.
Ms. Whitney, the analyst who has forecast many defaults, has drawn criticism from others in the muni-bond world for that dire prediction. The analyst, who correctly predicted future bank troubles in 2007, hasn't widely disclosed the research on which she bases her outlook.
Ms. Whitney declined to comment. She declined an invitation to appear at Wednesday's congressional hearing, which is before a subcommittee of the House Committee on Oversight and Government Reform, because of a scheduling conflict, a committee spokesman said.
A default by a major borrower could ripple out in hard-to-predict ways.
"In the highly unlikely event of a state default, you could have major macro-economic dislocations—teachers not getting paid, roads going unplowed,'' says Mr. Powell, the former Treasury official. "Once that tree comes down, look out—it is falling on everyone, both the innocent and the guilty."
A major default "would rock credit markets,'' agrees Harvard economics professor Kenneth Rogoff, co-author of a history of financial catastrophes. He says it would likely affect financially stressed national governments: "If I were Spain, I wouldn't be too happy if New Jersey defaulted.'' He adds, "Clearly, we are in situation where markets are very skittish and there is uncertainty about how much risky debt there really is out there."
Yet some factors would tend to limit the impact even of a big default.
Banks, while they do a brisk business underwriting muni-bonds, are less active as owners of the securities. Banks have a total of 1.3% of their assets, or about $175 billion, invested in muni-bonds, according to Federal Deposit Insurance Corp. data.
Mortgage-backed securities, by comparison, made up about 10% of federally insured banks' assets when the mortgage market began its slump in 2007, according to the FDIC.
Banks' relatively modest position in muni-bonds means that further price declines wouldn't likely crimp their ability to lend to businesses and homeowners, as occurred during the mortgage crisis.
The next-largest muni-bond holders after individuals are insurance companies, mainly property-and-casualty insurers, with about 15%. But muni-bond price fluctuations don't hamper insurers' income statements because the insurers tend to hold bonds to maturity; bond losses on paper generally remain unrealized. In an extreme case, state insurance regulators could force a firm to set aside more capital to guard against losses.
There are a few small muni-bond defaults every year, but the default rate on a broad index of municipal bonds rated by Standard & Poor's was just 0.21% in 2010. Many investors and economists maintain that a default by a state or large city is unlikely for several reasons.
For one, U.S. states' debts relative to the size of their economies are low, when compared with, say, the European governments that ran into deep trouble last year. Illinois's debt, including bonds and unfunded pension obligations, is about 13% of the state's gross domestic product, according to Moody's. Greece's debt, excluding pension liabilities, is about 144% of GDP.
Politically fraught as bailouts are, many investors and economists think Washington would ultimately come through with some kind of help before a state or large city defaulted. "It would be difficult for the federal government to say yes to AIG and no to Illinois,'' says Hugh McGuirk, a portfolio manager at mutual-fund firm T. Rowe Price, referring to insurer American International Group Inc.
Most states must balance their budgets, and governors are now proposing spending cuts to do so. Illinois imposed sharp income-tax increases last month and is preserving cash by putting off paying vendors.
"What we are seeing on the ground is that states are taking actions that are good for bondholders,'' says Daniel Loughran, a senior portfolio manager at OppenheimerFunds.
The higher yields and lower prices on muni-bonds are luring some investors. An especially prominent one stepped up in December.
Bill Gross, co-chief investment officer at Pimco—the Pacific Investment Management Co. unit of Allianz SE—put money into five of its muni-bond funds, federal filings showed. Pimco said Mr. Gross wasn't available to discuss his investments.
One muni-bond issuer that didn't manage to sort out its problems is Vallejo, Calif., which more than two years ago filed for bankruptcy reorganization. (Many cities can do that, though states can't.) Vallejo Mayor Osby Davis says the likelihood his government won't be able to borrow for many years has a silver lining.
"We ought to stop living on credit and find ways to offer the same level of service for less money,'' he says.
—Jeannette Neumann contributed to his article. Write to Michael Corkery at michael.corkery@wsj.com
It's a reflection of more than three months of turmoil in municipal bonds—a period that has stoked fears a crisis in that market could set off a chain of events that would cripple the economy, in much the same way the subprime-mortgage fiasco sparked the recent recession.
Muni-Market Woe
Municipal bond investors have grown increasingly concerned about some states' ability to pay their debts. This map reflects perceived risks on 10-year general-obligation bonds for states versus an AAA rated 10-year muni bonds.
That seems unlikely to many experts, who see big differences between the muni-bond troubles and the mortgage woes that triggered the global credit freeze in 2008.
"The near-term budget problems of states are difficult, painful, but survivable,'' says Jay Powell, a former U.S. Treasury official who is now a visiting scholar at the Bipartisan Policy Center, a Washington, D.C., think tank. "Yes, this is the worst stress the system has been under for many, many years, but predictions of widespread defaults are overblown."
The list of reasons analysts cite is long. Municipal bonds are held primarily by individuals, not by financial institutions. Compared with mortgages, they aren't nearly as intertwined with the global financial system in opaque derivatives, hiding unknown risks and linkages.
Most states and municipalities owe long-term debt, and they don't typically rely on short-term borrowing in the way that, say, the now-defunct Lehman Brothers Holdings Inc. did in 2008. In contrast to any kind of corporate borrower, state issuers of muni-bonds are in the rare position of being able to boost their revenues almost at will, by raising taxes (as Illinois recently did).
Moreover, states find their revenues are on the upswing as the economy grows and as inflation, while modest, helps to buoy the incomes and corporate profits that many states tax. During the 2010 fourth quarter, state tax revenues were up 6.9% from a year earlier, according to preliminary data from the Nelson Rockefeller Institute of Government in Albany, N.Y.
This isn't to say that cash-strapped states won't face higher borrowing costs, which could prove excruciating for some governments that rely on debt to fund their operations. Analysts also said that it is possible that the historically low rate of defaults could rise somewhat. What many analysts and investors do doubt is a scenario outlined by one independent analyst, Meredith Whitney, who has publicly predicted "50 to 100 sizable defaults" amounting to "hundreds of billions of dollars."
Municipal bonds—which are issued to finance projects such as airports and dormitories—yield interest income that's free of federal and, often, state income tax. They began their slide last fall. If the $2.9 billion market continues to struggle, it will be because of the attitude of investors like Barry Fiske, an account manager for a Boston-area heating and air-conditioning contractor.
Mr. Fiske, 61 years old, had long considered muni-bonds a safe investment. But late last year, he says, he "just felt very uneasy" about the "threats [facing] certain states like Illinois, California, New Jersey and maybe New York." He slashed his holdings in muni-bond funds to 5% of his investment portfolio, from 20%.
States face budget gaps totaling at least $125 billion as they plan for the coming fiscal year, the Center on Budget and Policy Priorities calculates. Long-ignored underfunding of public pensions is out in the open now, and setting off alarms. States in the coming year also must tackle their budgets largely without the federal assistance that the 2009 stimulus law gave them for a couple of years.
Default was rarely much of a concern in past muni-bond downturns. But now the long-held assumption that states and cities will always pay their debts has come under attack. "Credit concerns are much more prevalent and broad-based than they have been in the past 20 years," says Elizabeth Fell, a fixed-income strategist at Barclays PLC.
Individuals like Mr. Fiske own about two-thirds of U.S. municipal bonds, directly or through mutual funds. This was long seen as a positive, because individual investors tend to "set it and forget it," says Ms. Fell. But individual investors have been sellers of shares in muni-bond mutual funds for 12 consecutive weeks. Since early November, individuals have pulled a net $23.6 billion out of these funds.
Heightening concerns for some of them: Far fewer newly issued muni-bonds are insured now—6.2%, versus 57% in 2005, according to Bank of America Merrill Lynch. Many insurers have stopped issuing guarantees because they themselves are still struggling with their losses in the financial crisis.
"People have been through the tech bubble and the real-estate bubble, and they are scared," says Peter Demirali, a managing director at Cumberland Advisors, an investment firm in Sarasota, Fla. "When they are told there is another bomb to go off, they head for the hills."
Yet the sell-off that began last fall wasn't due just to weaker state an
In addition, the Federal Reserve's program of buying bonds to encourage economic growth drew some investors into a rallying stock market, instead of to bonds.
And long-term Treasury bonds—which municipal bonds tend to track—began to decline, as the Fed bond-buying program emphasized shorter-term debt.
Finally, the December extension of the federal income-tax cuts made it a bit less urgent for some individuals to seek out tax-exempt investments such as muni-bonds.
Some of these factors, such as the subsidy expiration, no longer are pressuring the market.
But once muni-bonds began to slide last fall, their declines were exacerbated because of the structure of some mutual funds that hold the bonds. These funds enhance their exposure to the market, leading in some cases to forced selling when prices went down.
When individuals step away from the muni-bond market, there are a limited number of other investors to take their place. The tax-exempt returns that lure individuals aren't as attractive to larger investors, such as hedge funds and investments banks.
Some states and cities have cut back on borrowing in the face of diminished demand for their bonds, which creates higher costs for borrowers. A New Jersey agency trimmed a refinancing by 40% last month.
But states don't always have that option.
Moody's Investors Service has identified states that rely on the debt markets to fund their deficits and current operations, and thus will likely have to venture into the bond market even if it's inhospitable. It was an urgent need for short-term borrowing that fueled the European debt crisis last year, when countries such as Greece found investors would lend to them only at exorbitant interest.
California typically borrows billions each year to cover seasonal shortfalls in its cash flows. Illinois is proposing this year to issue an $8.75 billion "debt restructuring bond" to pay past-due bills to suppliers and a $3.75 billion bond to make required contributions to its pension system.
A spokesman for the California Treasurer's office said the state "will deal with market conditions as they come and we will get the best deal possible for taxpayers." In Illinois, a spokeswoman for the governor said, "we do not see a loss of muni-market access" because the state is working to close its budget deficit.
Ms. Whitney, the analyst who has forecast many defaults, has drawn criticism from others in the muni-bond world for that dire prediction. The analyst, who correctly predicted future bank troubles in 2007, hasn't widely disclosed the research on which she bases her outlook.
Ms. Whitney declined to comment. She declined an invitation to appear at Wednesday's congressional hearing, which is before a subcommittee of the House Committee on Oversight and Government Reform, because of a scheduling conflict, a committee spokesman said.
A default by a major borrower could ripple out in hard-to-predict ways.
"In the highly unlikely event of a state default, you could have major macro-economic dislocations—teachers not getting paid, roads going unplowed,'' says Mr. Powell, the former Treasury official. "Once that tree comes down, look out—it is falling on everyone, both the innocent and the guilty."
A major default "would rock credit markets,'' agrees Harvard economics professor Kenneth Rogoff, co-author of a history of financial catastrophes. He says it would likely affect financially stressed national governments: "If I were Spain, I wouldn't be too happy if New Jersey defaulted.'' He adds, "Clearly, we are in situation where markets are very skittish and there is uncertainty about how much risky debt there really is out there."
Yet some factors would tend to limit the impact even of a big default.
Banks, while they do a brisk business underwriting muni-bonds, are less active as owners of the securities. Banks have a total of 1.3% of their assets, or about $175 billion, invested in muni-bonds, according to Federal Deposit Insurance Corp. data.
Mortgage-backed securities, by comparison, made up about 10% of federally insured banks' assets when the mortgage market began its slump in 2007, according to the FDIC.
Banks' relatively modest position in muni-bonds means that further price declines wouldn't likely crimp their ability to lend to businesses and homeowners, as occurred during the mortgage crisis.
The next-largest muni-bond holders after individuals are insurance companies, mainly property-and-casualty insurers, with about 15%. But muni-bond price fluctuations don't hamper insurers' income statements because the insurers tend to hold bonds to maturity; bond losses on paper generally remain unrealized. In an extreme case, state insurance regulators could force a firm to set aside more capital to guard against losses.
There are a few small muni-bond defaults every year, but the default rate on a broad index of municipal bonds rated by Standard & Poor's was just 0.21% in 2010. Many investors and economists maintain that a default by a state or large city is unlikely for several reasons.
Politically fraught as bailouts are, many investors and economists think Washington would ultimately come through with some kind of help before a state or large city defaulted. "It would be difficult for the federal government to say yes to AIG and no to Illinois,'' says Hugh McGuirk, a portfolio manager at mutual-fund firm T. Rowe Price, referring to insurer American International Group Inc.
Most states must balance their budgets, and governors are now proposing spending cuts to do so. Illinois imposed sharp income-tax increases last month and is preserving cash by putting off paying vendors.
"What we are seeing on the ground is that states are taking actions that are good for bondholders,'' says Daniel Loughran, a senior portfolio manager at OppenheimerFunds.
The higher yields and lower prices on muni-bonds are luring some investors. An especially prominent one stepped up in December.
Bill Gross, co-chief investment officer at Pimco—the Pacific Investment Management Co. unit of Allianz SE—put money into five of its muni-bond funds, federal filings showed. Pimco said Mr. Gross wasn't available to discuss his investments.
One muni-bond issuer that didn't manage to sort out its problems is Vallejo, Calif., which more than two years ago filed for bankruptcy reorganization. (Many cities can do that, though states can't.) Vallejo Mayor Osby Davis says the likelihood his government won't be able to borrow for many years has a silver lining.
"We ought to stop living on credit and find ways to offer the same level of service for less money,'' he says.
—Jeannette Neumann contributed to his article. Write to Michael Corkery at michael.corkery@wsj.com
No comments:
Post a Comment