Fool’s Gold

The Golden State is looking a little lackluster.  Mired in debt, $59 billion in General Obligations and growing, California has ask and been rejected by the Obama administration for relief.  As a result, its debt rating was downgraded by S&P, Moody’s, and Fitch. And it appears that California is about to issue more IOUs, like it did last year, to bridge the massive amount of its budget short fall, some $26.3 billion dollars.  The State’s borrowing costs have risen 24% over the last three months, and look to go even higher with the recent debt rating downgrade. With the State flooding the market with new issues, older fixed rate issues have seen their value erode.

Some are saying that California is more than likely to default.  Martin Weiss of Weiss Research has been sounding the alarm since early June. You may remember him from his accurate predictions of defaults in Bear Stearns and Lehman Brothers.  Weiss says that without massive relief funding from the federal government, California’s only choice will be draconian cuts in state services and payroll, which will only deepen the dire economic conditions there.  In Weiss’ opinion, default is unavoidable.

To deal with its financial crisis, California has taken some unusual and controversial actions.  In July, 2008, California borrowed cash from its local governments to close its budget gap.  Then, in November, paid them back with newly issued general obligation debt, issues with below par market values from the moment of their issuance.  California has also been borrowing from all citizens employed in the State by increasing the State withholding Tax by 10%.  This is effectively a coerced short-term interest-free loan from its citizens.

California, the world’s 8^th largest economy, is also suffering from high unemployment (12.3%), the nations third highest foreclosure rate, and decreasing property taxes.  I found an interesting website that lets you try to craft a way out for California – its address is http://www.latimes.com/news/local/la-statebudget-fl,0,95571.htmlstory

Clearly, the holders of California General Obligation Bonds should be concerned.  But, what about other local government muni issuers?  If history is any guide, then we should see defaults increase across the board.  Especially vulnerable are issues that are sales tax dependent, and/or issues that depend on private or public usage.  According to Public Bond.org, a study done in 1998 by Enhance Reinsurance Company looked at historical patterns of municipal defaults from the 1800s to the 1980s and concluded that municipal defaults usually follow downswings in business cycles and are also more likely to occur in high growth areas that borrow heavily.

Seniors among us remember the New York City and Cleveland defaults in the 1970s.  Since then, large scale defaults have been rare, that is until May 23, 2008 when we were all shocked by the bankruptcy petition filed by the City of Vallejo.  Sixteen months after Vallejo, Jefferson County, Alabama defaulted on $3.8 billion in sewer bonds.  Other notable defaults in this cycle have been the Las Vegas monorail issue for $451 million, and a $709 million issue only collateralized with a gas supply agreement with the now defunct Lehman Brothers.

Because of the sudden and violent U.S. economic contraction, defaults on municipal debt increased dramatically from $329 million in 2007 to nearly $7.8 billion in 2008, according to Richard Lehmann, publisher of a newsletter that tracks defaults.  Part of the blame for the rise in such defaults clearly lies with the rating agencies whose ratings often reflected what the paying municipalities desired rather than reality, and also with the monoline insurers (MBIA, AMBAC, …) whose insurance reserves proved to be inadequate or worthless.  As a result, when the financial crisis first hit, some municipal bond mutual funds fell as much as 30% (in a market of rapidly falling interest rates) as the underlying credit quality and rating agency practices came under scrutiny.

Because I expect the number of defaults to increase dramatically in 2010 and 2011, the municipal bond buyer should be very careful.  Each individual issue should be examined for its solvency and cash flow.  Buyers should not take the ratings on such issues at face value.  Geographic area growth rates and borrowing levels should be key ingredients in purchase decisions with issues in low growth and low debt areas being favored.  But, be careful and stay on short end of the yield curve –  the landscape is rapidly changing.

Joshua Barone, Managing Partner

January 28, 2010