Thursday, January 28, 2010

The Bubble Keeps on Bursting: Municipal Debt

The Big Asset Bubble of the early and mid-2000s continues to burst. The next big splatter may come from municipal debt, especially state government debt.

As we know, the Big Bubble puffed up real estate, stocks and other assets, and increased economic activity. That gave states more income and transactions to tax. State budgets bubbled up, and residents grew accustomed higher levels of service. When real estate and stocks nosedived, and the economy slid into recession, state revenues fell. But state debt holders continue to demand payment in full. California's problems have been well-publicized; its rating was cut a couple of weeks ago, although it's still somewhat above junk level. Other troubled states include Illinois, Arizona, Kentucky and Virginia.

All of these states are struggling to close their deficits. Unlike the federal government, states and municipalities are generally required by law not to have deficits. So cuts have to be made and/or taxes and fees have to be raised. At least that's what's prescribed by law. But state legislators and governors sometimes answer to a higher authority than the law--namely, their political futures. The governmental dysfunction in California is Rabelaisian in its grotesqueness and satire-worthiness. A default was narrowly avoided last fall, but could loom again this spring. Would the federal government bail out California? Given today's politics, with the Obama administration having today survived a second populist insurgent strike with the Senate's confirmation of Ben Bernanke for a second term as Fed Chairman, one would say no. But then again, that's what Gerald Ford said when New York City was on the verge of default in 1975, only to extend the city a loan that he adamantly refused against all the evidence to characterize as a bailout.

The problem with a major default in the muni bond markets, by California for example, is that it could chill the entire sector. That's what happened with money market funds right after the Lehman Brothers bankruptcy filing in September 2008. A well-known money market fund called Reserve Primary had to break the buck (i.e., reduce the valuation of its shares to below $1 each) because it held Lehman securities that had suddenly gotten very stinky. Investors across the entire multi trillion dollar money market fund sector freaked out. Only the announcement of an ad hoc temporary Treasury Department program insuring money market funds kept the entire sector from blowing up.

Sector-wide panic in the muni bond markets could shut down many state and local governments. They often borrow early in a year to pay employees and other operating expenses, and repay those borrowings later in the year after collecting enough taxes. A freeze-up in the muni bond markets might greatly reduce their liquidity, and leave them unable to cover operating expenses. Even if they could continue to operate, drastic cutbacks in employment levels and spending would exacerbate the slowness of the economic recovery--or even turn the economy back toward recession. If the administration and Congress have to choose between fiscal rectitude and facing a host of additional unemployed, angry voters in the fall, it isn't hard to foresee that expediency will be the better part of valor.

The federal government has already provided assistance to the municipal bond market. Last spring's stimulus package included a provision whereby the federal government would subsidize states' issuance of taxable bonds, so-called Build America Bonds. The federal government reimburses states for 35% of the interest expense of Build America Bonds, which effectively makes them about equally as expensive to states as regular nontaxable bonds. But the higher interest rate paid on Build America Bonds appeals to pension funds and other institutional investors that don't pay income taxes. So a potentially broader pool of investors than traditional high-income individual buyers of municipal bonds is available to invest in Build America Bonds.

These bonds have proven popular: close to $100 billion worth have been issued in less than a year. The federal government's potential interest costs are in the tens of billions. But the scarier thought is that bond holders may look to the federal government for a bailout if the states default on their Build America Bonds. After all, the federal subsidy drew many of them to these bonds in the first place. Of course, the federal government has no legal obligation to repay Build America Bonds. Then again, it had no legal obligation to pay the debts of Fannie Mae and Freddie Mac, or AIG, or . . . well, you see the point.

The U.S. Supreme Court just ruled that corporations and unions are no longer restricted in their campaign contributions. Unions, a bedrock Democratic constituency, are increasingly comprised of state and local government employees. After all, government employment levels have grown as industrial employment levels have fallen, and unions, like corporations, are driven by Darwinian imperative. In the acidic, 60/40, partisan atmosphere of today's national politics, expect unions to demand their due from the Democrats. With corporate America now ordering extra checks for all the additional campaign contributions it plans to make (and not to Democrats), a direct or indirect, one way or another federal bailout of state governments is all but inevitable.

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