Son of Subprime

In 2007, the writing was on the wall. The famous “perfect storm” had gathered above the US housing market, its eye hovering over subprime loans. As you know, the storm came…and it rained, and rained, and rained… Ultimately, it washed away trillions of dollars in investor wealth.

Now in an entirely different sector – probably the last place you’d look – the clouds are turning black once again. Strip out the finer details, and you’ll find the very same mechanics that brought the subprime market from boom to bust:

  • Widespread investor acceptance
  • Complicated derivatives
  • Intense incentives for banks to make deals
  • Boneheaded assumptions of endless return on investment
  • Underqualified borrowers
  • Stunning amounts of leverage and debt
  • A loosely regulated multitrillion-dollar market
  • Overstated credit ratings from Wall Street
  • Social and political pressures to maintain growth

This crisis-yet-to-be is…municipal bonds

Munis have been a long-standing pillar of stable return. Only bonds from sovereign governments and blue chip corporations have a better reputation for credit-worthiness than munis. So when a city or state sells bonds to build a new school, sewer or stadium, investors form a line around the block. In the history of the union, only one US state has ever defaulted on its debt (Arkansas 1934). A few cities here and there have also done so. In other words, munis have performed admirably over the years.

But reputations, as this credit crisis has taught the world, no longer mean jack. Ask debt holders of “blue chip companies” like GM, or “sovereign” states like Greece. Investors are learning an old lesson the hard way: No asset class – not one in the history of the world – is a sure thing.

Though vast and complicated, the root of American municipalities is like any business or household: Money goes in, money goes out. Done right, a municipality takes in more money than it pays out. Money comes in mostly from taxes and revenue streams such as utilities and tolls. Money goes out to finance municipal government payrolls and public works programs. Cities and states sell bonds when they either can’t pay upfront for such needs. No big deal…at least, it wasn’t a big deal until recently.

In this era of high unemployment and shrinking economies, municipal revenues are hurting. Tax revenue tends to be lower with 15 million Americans out of work. Just the same, they use less power, drive through fewer tolls. Pay that parking ticket? I don’t think so…not this year.

Not surprisingly, municipalities are struggling to cut spending in line with lost revenue. But their biggest expense of all is untouchable – pension plans. California offers a telling example. A recent Stanford study concluded that the state pension fund program is underfunded by roughly $500 billion. The researchers urged Gov. Schwarzenegger to inject $360 billion into its public benefit systems – right now – to have an 80% chance of meeting 80% of obligations over the next 16 years.

Facing a $20 billion state budget gap, what can he possibly do?

It’s precisely this pickle that undid Vallejo. The San Francisco suburb declared bankruptcy in 2008. Tax revenue had collapsed, a major shipyard closed and all of a sudden the city found itself paying 90% of its annual budget to retired public employee pensions. 90%!

The problem, just like with subprime, is an irrational form of leverage. In essence, municipalities borrow current earnings of public employees in exchange for some of the most favorable retirement plans in the world. That borrowed money is invested aggressively, just like a private-sector employee would in his 401(k).

Except if the fund loses money, which they all have over the last 10 years, pension funds don’t adjust payouts. The social and political pressure to maintain the status quo – keeping our public employees comfortably retired – is just too strong.

So municipalities kick the can down the road. New employees buy into the funds. Fund managers maintain their projections of endless 8% annual returns. Retirees keep taking out the funds they were promised…and no one pays the tab.

And it’s not just California. Orin Cramer, chairman of New Jersey’s pension program, estimates a national funding gap around $2 trillion.

The municipal bond market is roughly $2.7 trillion. If Cramer is on target, that’s a total liability about the size of France and Britain’s annual GDP – combined.

Therefore, in yet another subprime redux, Wall Street has found a way to make the muni bond problem even worse. Like the mortgage market, the municipal bond market has morphed into its own new era of highflying finance, adjustable-rate loans and complex securities.

For proof, read “Looting Main Street,” a recent Matt Taibbi expose in Rolling Stone. How could a $250 million sewer project leave taxpayers on the hook for $5 billion? Easy – if you’re a Wall Street bank and you engineer a “synthetic rate swap” deal. It brought Jefferson County, Alabama, to its knees:

The county got the stability of a fixed rate, while paying Wall Street to assume the risk of the variable rates on its bonds. That’s the synthetic part. The trouble lies in the rate swap. The deal only works if the two variable rates – the one you get from the bank, and the one you owe to bondholders – actually match. It’s like gambling on the weather. If your bondholders are expecting you to pay an interest rate based on the average temperature in Alabama, you don’t do a rate swap with a bank that gives you back a rate pegged to the temperature in Nome, Alaska.

That’s the “beauty” of modern lending. This deal, struck by JP Morgan, allows a cash-strapped county to upgrade to a world-class sewage system it could otherwise never afford. The extra costs – the fees, adjustable rates and superfluous debts… That’s a problem for the next generation. Just like the state pension fund.

And as Taibbi also observed, banks pull in millions upon millions in fees for structuring these loans and swaps. Bonuses live and die by such deals. Just like the 2005 mortgage market, there is both intense demand for new age municipal financing – and remarkable incentive for Wall Street to “help out.”

Of course, what modern catastrophe is complete without a credit ratings debacle? According to the National Conference of State Legislatures, 34 states are projecting budget gaps for 2010. The total shortfall will likely exceed $84 billion. Yet only two US states, California and Illinois, are currently rated lower than AA by Standard & Poor’s. Only four states have fully funded pension programs. Yet 11 have S&P’s coveted AAA credit rating.

Given all that we’ve explored above, and the ratings agencies’ track record over the last 10 years, those AA and AAA ratings seem woefully optimistic. Insolvent is insolvent, not matter what the rating agency’s say.

For the conservative investor, therefore, our advice is straightforward: Avoid municipal bonds. For the speculating investor, check back in tomorrow to learn about a risky way to bet against the municipal bond market.

Addison Wiggin and Ian Mathias
for The Daily Reckoning

The Daily Reckoning