Last week, I met a CPA who works for a client of ours. During the meeting, she expounded over and over again on what a great investment municipal bonds represent. She repeatedly asserted, “as long as you hold them to maturity, you will never lose money, and you would have been far better off in the last ten years to make 5% tax free than risking your money in the stock market.” I have also heard this same type of “analysis” from numerous wealthy investors … has it worked? Up until now, it has … but it may be time to sell your municipals and look for safer investments. Yes, safer … it may seem like blasphemy, but many, if not most, municipal bonds are very speculative at this point. Losses may exceed 40% in the coming years… regardless of the economic expansion.
There has been a gradual, but steady deterioration of municipal finances for decades, and had not billions of Dollars been given to municipalities in the 2009 Stimulus Bill, there would have been numerous defaults last year. And, again in the latest “jobs” bill, there is money to help failing municipalities pay their bond interest.
The problems are the result of continuously rising spending, collapsing revenues, accounting gimmicks and a coming tidal wave of retiree healthcare expenses and retirement mandates. The key problems are highlighted in a September research piece by Weeden & Co, authored by Frederick J. Sheehan, who projects a collapse in the municipal market:
- Losses in retirement portfolios that will require large increases in pension funding.
- Spending has exploded, largely because of wage and salary increases to employees.
- Accounting gimmicks like selling assets to fund current spending.
- Totally inadequate financial disclosures by municipalities.
Take a few minutes to search the Internet using “city employee salary” or “state employee wages” or “municipal worker earnings” and you will just begin to see the absolute insanity of municipal payrolls. We have heard estimates that municipal workers overall earn $30,000 per year more than those in comparable private sector jobs. Frankly, our unscientific research seems to demonstrate that this is an underestimate. Further, public sector benefits packages are far richer than anything in the private sector … fully paid retiree healthcare for the worker AND spouse… pensions that equal 60% to 80% of the three highest years earnings (including overtime)… etc. And, any raise in compensation increases the benefits expenditure permanently. Additionally, lifetime healthcare for both the employee and his spouse is a major part of the typical state and municipal workers package.
The answer seems simple, municipalities have to cut spending, but it is not as easy as it might seem and may be impossible without a major crisis.
- Municipal bonds interest is scheduled to rise dramatically as total municipal debt has increased to an estimated $2.9 trillion at the end of 2009 up from $1.9 trillion in 2003. An increase in coupon payments to nearly $85 billion out of an estimated $1.9 trillion in tax receipts.
- There are numerous unfunded mandates by the Federal Government, Clean Air Act, Clean Water Act, Homeland Security, etc.
- And then there is the gap in Medicare left by inadequate Federal funding, and Medicaid. The increase between 2000 and 2008 was $79 billion ($158 billion up from $79 billion).
- Based on Federal Reserve statistics, in 1955 4 million Americans (2.4%) of our population worked for municipalities – by 2008 it had grown to 20 million (6.6%) of our population. And municipal wages and benefits have grown to become 43% higher than comparable private sector workers.
The result of these factors is that states are going to experience enormous budget gaps. According to the Center on Budget and Policy Priorities, California is already past the tipping point as its projected 2009 budget gap is nearly 36%, Illinios at 21.5%, New Jersey at 18.8%, and six states over 10%. This does not even begin to deal with the cities, counties and school districts.
Who is going to get paid?
Clearly, if it is up to the politicians, it will not be the bondholders. In the Chrysler bankruptcy, the secured creditors got 29 cents on the Dollar, while the UAW was kept whole. Those whose tax bracket make municipals attractive, are easy targets, especially considering the new populism that seems to be made popular by the behavior of the big banks and Wall Street in the current crisis.
What about the courts? The precedent for court supervised bankruptcy has often been to keep the companies alive to keep the employees working … until all of the assets belonged to the DIP (debtor in possession) lender, then wipe out the equity and bondholders before bringing it out or liquidating it. The secured bondholders of Eastern Airlines and others met with that fate.
There are some who believe that the Federal Government will step in and subsidize the municipal deficits or act as lender of last resort. First of all, if that did happen, effectively the municipalities would lose all of their original Constitutional rights. Once a state or municipality accepts money from the Federal Government, the Federal Government gains the right to make demands upon that entity. Perhaps the greatest concern is that the Federal Government deficits are already so large that assuming any state debt obligations is simply not practical or feasible.
In Summary
The path toward impairing the bondholders has already been staked out. All states have legal loopholes to protect their employee benefits such as the “California Rule:” When a state retirement system is financially threatened the state can make changes that are “reasonable and necessary” to support the state’s immutable guarantees to their employees. And if it involves breaking the municipalities “contract” with the bondholder, that precedence has also been set.
Tags: Bond Defaults, Municipal Bonds