Fool’s Gold 4: Death of the Empire

In the last two months, there has been a lot of hoopla in the media over municipal bonds.  If you have followed the Fool’s Gold series of articles that we published beginning in January, 2010, then the recent turmoil is not news to you (see www.ancorawest.wordpress.com, Fool’s Gold, 1/28/10, Fool’s Gold 2: Los Angeles, 4/22/10, Will Build America Bonds Save the States from Default, 6/4/10, and Fool’s Gold 3: The Empire Strikes Deals, 10/20/10).  On a recent 60 Minutes show, Meredith Whitney, the analyst famed for her calls on the impending implosion of the banking sector in 2008, predicted that the Municipal Bond Market could see 50 to 100 defaults amounting to more than $100 billion this year.   Needless to say, the municipal market has been reeling ever since.  In fact municipal mutual funds have seen more than $25 billion in outflows since Whitney’s TV appearance, according to the Investment Company Institute.  For her  prediction to have a chance of becoming reality, it appears to us that a large state would have to declare bankruptcy.  The most logical candidate for this would be California.

When we wrote the first Fool’s Gold article in January, 2010, California’s Long Term debt was about $59 billion.  Today, according to State Treasurer Bill Lockyer’s website, that long term debt is now $62.9 billion, about  7% higher.  But, that is only part of the story, as short term debt rose 30.5% over its 2009 level ($19.9 billion) to $25.9 billion.  Thus, total debt for California is $88.8 billion.   Furthermore, California currently faces a structural deficit of $25.4 billion, which newly elected Governor Jerry Brown proposes to close with $12.5 billion in spending cuts, and the rest ($12.9 billion) in tax increases. On January 20^th, California declared another fiscal emergency, as Jerry Brown’s budget hit snags from t special interests.

With this budget process looking like a repeat of last year’s when the budget deadline was missed by more than 100 days, it looks likes California will have to issues IOUs again.  This explains the strong language from State Treasurer Bill Lockyer in a recent Wall Street Journal article.  “We’ve never defaulted, not once in our entire history, including the Great Depression,”  he wrote and then goes on to affirm that making the debt service payment on the State bonds is the Treasurer’s second-highest priority, after debt service on school bonds.

The same day Governor Brown, announced his budget, the Illinois legislature, in a secret closed door session, raised its state income tax to 5% from 3% to plug its budget short fall.  Four days later Standards & Poor’s announced that there could be a surge in downgrades of bonds issued by state and local governments.  “We believe that continued revenue decreases for state and local government may increase fiscal strain on budgets, and monitoring of liquidity will be especially important in 2011,” said S&P’s credit analyst Gabriel Petek.  Mr. Petek could also be referring to Congress’s decision not to renew the Build America Bond (BABs) program that traders and analysts believed would save many states and municipalities when it was first introduced.  (See Will Build America Bonds Save the States from Default, 6/2/10)

With the ending of the back door BABs bailout of the States, it’s no wonder that there have been rumblings within Congress over legislation that will allow a state to file bankruptcy.  A recent New York Times article entitled State Bankruptcy Option is Sought (January 21, 2011) states, “Policy makers are working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts, including the pensions they have promised to retired public workers.”  While there is no draft legislation at the moment for fear of a constituent backlash and/or a destabilizing impact on the municipal market, in a recent meeting on Capitol Hill, Senator John Cornyn (R TX) broached the subject of the impact of such bankruptcies with Federal Reserve Chairman, Ben Bernanke.

Bankruptcy could be a the best option for a state like California, as it could permit it to alter its contractual promises to its current pensioners, and break current union contracts.  David A. Skeel, a law professor at the University of Pennsylvania, said in an article in The Weekly Standard (“Give States a Way to Go Bankrupt“), that it was possible to envision how bankruptcy for states might work by looking at the existing law for local governments.  Called Chapter 9, it gives distressed municipalities a period of debt-collection relief which they can use to restructure their obligations with the help of a bankruptcy judge. Unfunded pensions would become unsecured debts in municipal bankruptcy and may be reduced. However the biggest surprise may await the holders of a state’s general obligation bonds.  Through widely considered the strongest credit of any government, they can be treated as unsecured credits, subject to reduction, under Chapter 9.  While this is one way Congress could go, another would be modeled on the Municipal Assistance Corporation, which dealt with New York City in 1975.  That entity acted as an oversight agency in the restructuring of New York City’s debt.

In our opinion, in California’s case, there are really only two options: the state could go bankrupt, or seek a bailout from the Federal government, a move that will be resisted by House GOP members.  In bankruptcy, the losers are the bondholders, a group that has, so far in this economic crisis, escaped nearly unscathed (except in the Chrysler bailout), while a general bailout falls on all of the taxpayers and would likely be financed with yet more federal debt. While bankruptcy would allow the state to fully fund public services like education, police and firefighters, and health care, it could cost the state more in the long-run as new investors, sensitive to the fact that their preferred status had been removed, would require higher rates of return on newly issued debt.

Both of these alternatives will result in significant pain in the municipal bond market.  Bankruptcy, where bondholders take a discount, would be more disruptive to the markets than a general federal bailout, and if one state uses it, it is likely that others would follow.  But, in our view, bankruptcy would be preferable, as it establishes the fact to investors that there is risk in these investments and spells out to politicians that the ‘free lunch” of taxpayer bailouts has ended.

Robert Barone, Ph.D.

Joshua Barone

January 27, 2011