The Muni Minefield

Following are some of my remarks prepared for Allen & Company’s Fifteenth Annual Arizona Conference. The discussion, “Munis and the Euro: Crises or Opportunities?”, took place on March 8, 2011. The moderator was Senator Bill Bradley, Allen & Co., New York. Participants were Dick Ravitch, Ravitch, Rice & Company, New York; David Kotok, Cumberland Advisors, Sarasota, Florida; Uri Dadash, The Carnegie Endowment, Washington, DC.; and Frederick J. Sheehan.

I will discuss four topics:

First, some background to current problems;

Second, why it is not wise to make predictions about the amount and size of defaults;

Third, some areas where municipal solvency and bonds are most vulnerable;

Fourth, the opportunities.

Okay, so let’s begin…

#1 – The background for today’s municipal funding crisis. The story, in essence, is very simple: There is a link between real estate bubbles and municipal finance bubbles.

A.M. Hillhouse, author of a splendid study of municipal bonds – Municipal Bonds: A Century of Experience, 1836-1936, analyzed the US municipal bond market across that century. He concluded: “[T]he major portion of overbonding by municipalities arises out of real estate booms… There will be no justification for a city’s coming forward [in the future] with the excuse that…its revenue has dried up in times of falling property values… [T]he cause of the debt trouble [must be regarded] as an unwarranted failure of the city to adjust its borrowing program to certain known facts.”

I wrote a study, “The Coming Collapse of the Municipal Bond Market” in 2009. The title may or may not turn out to be accurate, but there was and is no doubt municipal extravagance had left us with a grave problem. This extravagance was born of a massive real estate boom. A nearly identical scenario unfolded during the 1920s.

In a March, 1933 lecture before the American Economic Association, Professor Herbert D. Simpson, explained the link between the booming real estate market of the 1920s and municipal spending excesses:

During this period of prosperity, real estate taxes were paid with little complaint… [U]nder these conditions, public expenditures expanded and taxes were increased without protest; and public officials exploited the real estate groups as systematically and thoroughly as the real estate groups had exploited the rest of the public. The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale…

Throughout this period, there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate “speculation” carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29.

Inflated civic conceit hired construction crews to build houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury “Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program….”

The spending did not stop until the real estate taxes dried up. Sound familiar?

Simpson concluded:

The financial difficulties of local governments in consequence of both the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate…

But no one listened.

#2 – It’s not wise to make predictions about the amount and size of defaults because there are too many “don’t knows.”

  • We don’t know if unions and municipalities will reach agreements over benefit reductions.
  • If they do not reach an agreement, and the decision goes to a court, we don’t know how courts will rule. Union pension plans are legal contracts. Yet, pensions and benefits are unsustainable. How will judges rule? It is worth keeping in mind that most, if not all, states have legal recourse to amend pensions under certain conditions. In California – I quote: “an employee does not have the right to any fixed or definite retirement benefits but only to a substantial or reasonable pension.”
  • We don’t know what the federal government – including the Federal Reserve – will do if states and cities go into default. Treasury Secretary Geithner may copy Hank Paulson’s bazooka maneuver with Congress. The Fed may, or may not, buy a trillion dollars worth of municipal bonds before the Senate Banking Committee puts Chairman Bernanke in the witness box.
  • We don’t know what cities and towns that rely on a certain level of state aid to pay the bills will do. This, of course, is a don’t know only after we do know that a state has stopped or reduced local aid payments.
  • We don’t know if states and municipalities will tell the feds to fund their own mandates. That is, regarding state and local costs that were either signed into law or regulations imposed at the federal level, but were not funded by the federal government. We are seeing some opening salvos, here, in Arizona, which is making cuts to Medicaid. I think cities and towns will test the waters, for example, in schools – where, instead of laying off teachers, they may drop federally mandated requirements.
  • We don’t know, once this step is taken, the response of the federal government and the courts.
  • We don’t know if states and municipalities will raise taxes if they are unable to meet municipal bond payments. Rating-agency and brokerage-firm literature publish statements such as the following:

“What makes general obligation bonds…unique is that they are backed by the full faith and credit of the issuing municipality. This means that the municipality commits its full resources to paying bondholders, including general taxation and the ability to raise more funds through credit.”

But this is only true on occasion. A good place to study the variety of decisions is with a paper written by Kevin A. Kordana, an Associate Professor of Law at the University of Virginia. [“Tax Increases in Municipal Bankruptcies,” Virginia Law Review, September 1997, Volume 83, Number 6.]

  • Another don’t know is the level of ignorance in cities and towns, where it is too often the case that nobody understands the financial situation. An outsider who drops by city hall can be amazed at how little anyone knows.
  • Finally, and most importantly, the decision – or indecision, as it may be – to break the cities’ or towns’ contractual obligation to pay its lenders includes a lack of will among the parties. Here, we will have to wait and see.

#3 – Some areas where municipal solvency and municipal bonds are most vulnerable:

Disagreements about public employee benefits and payments are in the headlines, so I will start there….

I used to work with investment committees of corporate, union, and municipal pension plans, to design pension policies. This included analyzing assets and liabilities. Understanding future, annual cash flows – outflows to retirees – was important for duration- and cash-matching of assets to payments. I said to the pension committee of a town in 1989: “There will come a point when you won’t be able to pay these benefits.”

This was not a surprise at all. They knew that. They had no say in negotiations between the different union groups in the town and the selectmen who approved the benefits. There had been an increase in future benefits through improvements to the benefit formula almost every year for several years. And, there was a boost to the formula almost every year during the next decade.

The proportion of retirees to current workers was small back then. Plus, discounting the much higher future payments 20 or 30 years out produced tiny numbers that, over time, have blossomed. Now, we have reached the point when the benefit payments are exploding as a percentage of costs for many municipalities.

A second problem is maintenance expenses for municipalities that went on a building spree. A rule of thumb is they are about 30% higher than the prior trend.

A third potential problem is that many cities and towns are dependent on continual access to the bond market. If Treasury rates jump 3% or 4% in a failed auction, the light bill may not be paid.

A fourth means by which municipalities have telescoped the future into the present is by raising money through General Obligation bonds that is supposed to be used for a specific purpose but, the money is instead used to cover current expenses.

A fifth problem is the next step in the misuse of General Obligation proceeds. There are cities and towns that raise enough additional money in the bond market to cover the projected rise in next year’s operating expenses.

#4 – Are there any investment opportunities in the municipal bond sector?

Opportunities in municipal bonds will spring from ignorance. They already have. There may be a panic of indiscriminate selling when owners of munis understand a municipal bond is not simply “money good.” Such ignorance has produced great buying opportunities in the past.

For instance, in May 1933, all City of Miami bonds (with yields ranging from 4-3/4% to 5-1/2%, and maturities from 1935 to 1955) were quoted at $26. In the mid-1970s, the same combination of ignorance and fear created great buying opportunities for New York City bonds. All bonds traded for $25.

It will be awhile before buyers should pile in, but it’s no too early to begin paying close attention to the sector.


Frederick J. Sheehan
for The Daily Reckoning

The Daily Reckoning