By Robert Brannum
For the past several months, the municipal bond markets have been roiled by predictions and prognostications that the markets may be teetering on the brink of major defaults. After witnessing the severe impacts to other markets, including the mortgage and credit markets, any dire forecasts can make investors jittery. Such has been the case facing muni bonds.
Muni bonds are issued by the state and federal governments to finance large scale projects, including highways and airports. They generate interest yields that are free from federal and often state income taxes, making them a preferred investment vehicle for wealthy investors as well as for those in retirement. Many investors hold muni bonds directly, or through the ownership of mutual funds.
Reasons for Concern
In sharp contrast to the boom investment years, when investors pledged blind faith to any over-hyped stock opportunity, today’s savvy investors question everything –
even traditionally secure muni bonds. Certainly the size of the muni bond market itself may be cause for concern: currently, combined municipal obligations in the US have reached $2.9 trillion, which is almost a quarter of the country’s gross domestic product. Outstandings grew $85 billion in the past year, and has increased by $1 trillion since 2006.
News articles have reported a flurry of negative facts and statistics which have raised market concerns: the Center on Budget and Policy Priorities reports that states must cope with a combined budget gap of $125 billion as they head into their current fiscal years; the widespread under-funding of public pensions are better understood; the 2009 stimulus support from the federal government has ended.
Respected analysts and investors have also claimed concern with the markets. Standard & Poor’s issued a report in January that warns of a surge in potential downgrades in state and local government bonds, stating “We believe that continued revenue decreases for state and local governments may increase fiscal strain on budgets, and monitoring of liquidity will be especially important in 2011,” raising worries that governments could run low on the cash needed to make their muni bond payment obligations. In December, Wall Street analyst Meredith Whitney announced on “60 Minutes” her projection that the market might see hundreds of billions in defaults in 2011, stemming from as many as 50 to 100 muni bond defaults and restructurings. JP Morgan Chase CEO Jamie Dimon warned muni bond investors to be “very, very careful” at a January conference, and in mid-2010, investor Warren Buffett added his observation that muni bonds were facing a “terrible problem.”
The accumulated results of these forecasts have been significant on the municipal bond market: municipal bond investors have been leaving the market in large numbers since November – almost $13 billion in net outflows in January alone from bond-based mutual funds during a time when other fund categories have had large inflows. And when investors fear larger risks from holding bonds and withdraw capital, they demand larger yields, raising the borrowing costs to states and local government issuers.
Reasons to Believe
How close to “teetering” are we? How concerned should investors be about the $2.9 trillion in current outstanding municipal obligations? And how is New York State positioned in this current climate of uncertainly and concern?
First of all, not all experts agree about the dire warnings.
To start, the $2.9 trillion in outstanding obligations, analysts say, is merely the aggregation of thousands of smaller, separate and independent obligations, which exist without support or reliance on others. Of that total, for example, only $1.2 trillion is state-related – the rest are owned by local municipalities. And nearly $500 billion of the state liability is tax supported, meaning that the obligations are underwritten by state tax revenues, making them highly secure. Of the remaining state-level debt, each state’s obligations are unrelated to the others’ – meaning that there may not be an “aggregation problem” at all.
Other industry observers believe states are taking the necessary fiscal steps needed to avoid an implosion. Jay Powell, a visiting scholar at the Bipartisan Policy Center, was quoted in a recent article in The Wall Street Journal saying, “The near-term budget problems of states are difficult, painful, but survivable. Yes, this is the worst stress the system has been under for many, many years, but predictions of widespread defaults are overblown.”
Hugh McGuirk, the head of municipal investments at T. Rowe Price, told CNN, “Governments are under financial stress and undoubtedly have long term liability problems related to pensions and health care costs, but they have been making substantive cuts in their budgets, and will continue to cut more meat to balance their budgets. All the stories about the demise of the bond market are grossly exaggerated.”
Others note the difference between “downgrades” and “defaults.” An S&P spokesperson commented that downgrades are likely, but that they shouldn’t lead to a “notable increase” in defaults.
In fact, some good might be coming out of all the dire gloom-and-doom commentary. Todd Snyder, a senior managing director at Rothschild, recently wrote in The New York Times that he believes many state leaders are using these forecasts, while not fully believing in them, to advance their own causes for austerity during current budget debates. He argues that the crescendo of discussion around state defaults and bankruptcies are being used as “Kabuki theater” in posturing the participants’ budget positions.
What of New York State?
New York is often mentioned as a state in trouble whenever state fiscal issues are raised (along with California, New Jersey and Illinois). As far back as 2009, then-Lt. Gov. Richard Ravitch warned about “cracks in the municipal bond market.” And as recently as mid-February, WGME television reported that Maine Gov. Paul LePage used New York as an example of a state in turmoil to warn against his own state following suit, by stating, “There are several states that I was reading this week that are teetering on default with municipal bonds. They are Texas, New Jersey and New York. And folks, we’re only a few numbers behind them.”
Is New York teetering?
By most professional accounts, the rumors of the state’s impending defaults are greatly exaggerated. True, New York has $78 billion currently in outstanding debt, with another $81 billion in unfunded obligations to state-employee pensions and retiree health care. According to the Manhattan Institute, the state owes $78 billion in the same way the nation owes $2.9 trillion – as an amalgamation of tens of thousands of smaller bonds that are issued by completely separate legal entities, each of which has independent boards, regulations, funding mechanisms and agreements with bond holders. The state itself only holds $3.5 billion of its own obligations.
One of the governors who appears to be using the pontificators’ muni bond warnings to advantage is New York’s own Gov. Andrew Cuomo. Cuomo has been pushing for more fiscal restraint by seeking both a reduction in spending growth for several statutory items including Medicare and education, as well as spending cuts in others by combining agencies and laying off state employees.
Cuomo has also rejected using tax hikes to attack the deficit, in addition to offering spending reductions, tax cuts in some areas, and emphasis on job creation initiatives. His 2011-2012 budget calls for reduced spending by $3.7 billion, and has raised support from many outspoken Republicans, including Assemblyman Mark Johns, who commented, “This year’s budget could be one of the most astounding in a generation, and will hopefully alter how our government operates for years to come.”
For the time being, crisis averted.
Robert Brannum is a freelance writer.