Certain states, like Texas and Virginia, appear to be in fine shape and are resonable credits (though you aren't getting paid enough to care, in our opinion). We'll call citizens of these states Future Subsidizors. Other municipalities - like California, New Jersey and Illinois (aka Future Subsidizor Supplicants) - will go through stress or outright distress.
Many of these Future Subsidizor Supplicants may at some point be great investments, if you know what you're doing. But the vast majority of the muni-market lender base (which is largely doctors and lawyers retail investors) have no idea what they are doing - nor do their advisors (e.g., muni mutual funds or private wealth advisors).
In the last few days the muni-market has become spooky. Examples - a small town outside Detroit, Michigan called Hamtramck has begun the process of seeking state permission to file for bankruptcy (link here). Additionally, some much bigger munis (like the state of California - which would be one of the largest sovereign issuers in the world if it were a standalone country) have pulled some offerings due to "tepid demand". At some point these municipalities are going to have to start issuing again in order to fund their deficits and - TILB supposes - many will have to fund at rates that far exceed their budgeted cost. This of course will lead to further strain on those government budgets, leading to higher interest rates, further budget cuts, more local economic straing, yet further strain on those government budgets, leading to higher still interest rates, etc., etc. ad nauseum...default (or restructure).
Beware. Skillful investors willing to take an active role in helping these munis "solve" their debt problems will be able to make money (Jenny Hedge Fund Manager will buy California's debt at 40c and selling back to Cali at 60c, thus making itself a quick 50% while helping Cali reduce that issuance by 40%), but Johnny Retail is about to get rolled.
Caveat Emptor - get ready for more Schwarzies.
Below are some excerpts from today's Wall Street Journal A1 page (all emphasis added):
America's strapped states and cities took another hit Wednesday, with California seeing tepid demand for its latest bond sale and other governments pulling about $700 million worth of borrowing deals this week as investors continued stepping away from the municipal bond market.
The normally staid market has grown volatile the past week, posting its sharpest selloff in nearly two years, as investors demand higher interest rates to buy paper issued by states, cities and counties to finance their operations. Localities have been hammered by a drop in tax revenue amid the downturn—and unlike the federal government, most are barred constitutionally from running deficits.
"The tax-exempt municipal bond market is a cold, cold world right now for issuers and taxpayers," Tom Dresslar, a spokesman for the California State Treasurer, said late Wednesday. He added that the state decided to cancel another $267.3 million bond sale it planned to price next week "in light of market conditions."
California's $10 billion bond sale this week was seen as a test of access for governments to the bond markets, and the middling interest signaled that municipalities could have to pay more to attract investors. The state further jolted the market by delaying the close of the bond sale, citing a lawsuit filed Tuesday that challenges a separate tactic the state is using to raise funds.
"California's timing unfortunately couldn't be worse," said Gary Pollack, head of fixed-income trading and research at Deutsche Bank Private Wealth Management. "This creates a fear among individual investors and probably could hurt the state in terms of paying a higher borrowing cost than if they'd done a deal at a different time."
After pouring billions into municipal bond funds most of the year, investors pulled $115 million out of the funds last week, the Investment Company Institute said Wednesday. That was the first weekly outflow in seven months, ICI said.
The fragility of government finances was also evident in a move by Moody's Investors Service to downgrade the city and county of San Francisco, as well as the city of Philadelphia, and by a request by Hamtramck, a small Michigan city, for permission to file for bankruptcy.
California, facing a projected $25 billion shortfall through June 2012, aimed this week to sell $10 billion in so-called "revenue anticipation" notes. Over three days, it reported total orders of about 60% of that amount, or $6.06 billion, for the securities, according to the Treasurer's office. In September 2009, California sold 75% of a similar offering to retail investors. The remainder of an offering is typically bought by big institutional investors.
The short-term notes mature next May and June and yield 1.25% and 1.5%, roughly what California paid a year ago, though higher than other states. "It's still an incredibly low rate, and it's an awful lot of bonds," said Matt Fabian, senior analyst at Municipal Market Advisors. [TILB note: Basically commercial paper for California - keep not extending maturities and rolling it short Cali, it will work out just fine...]
At the same time, concerns have been mounting over whether, after the double whammy of 2008 market losses and the economic downturn, municipalities will be able to maintain their reputation for always paying their bondholders.
Average yields on 30-year municipal bonds rose 0.13 percentage point Wednesday to 4.77% and are up roughly 0.5 percentage point in recent weeks. Yields on 5-year bonds rose 0.06 percentage point to 1.58% on Wednesday.
About $700 million worth of bond sales were pulled this week, according to Thomson Reuters. That is roughly 3% of the week's planned sales, according to data from Ipreo. Many of the bond sales were to refinance outstanding debt at lower rates, meaning the governments didn't need the money.
But postponed deals are atypical, market watchers say, and they attribute them to investor demand for higher interest rates amid a glut of bonds as well as the impact of the move in 30-year Treasurys.
Moody's cited "continued weakness of the city's finances" in its downgrade of Philadelphia, affecting $3.85 billion in outstanding debt. Rob Dubow, the city's finance director, said, "We understand we face fiscal challenges, and we have, but for us the timing is odd, because we feel like we have stabilized." As for San Francisco, the bond rater said the "city ended fiscal 2009 with a balance sheet that was weaker than at any time in the prior ten years."
A spokesman for San Francisco's mayor said the ratings downgrade was "not unexpected" given the challenging economy, and that the city still had a better rating than many other local governments.
As a brief aside, this whole thing is very sad. Most municipalities could handle their debt if they were willing to make hard choices. However, in a culture where homeowners now making "strategic defaults" on their mortgages, it does not surprise us that rather than cut back on trash service or government size, our municipalities are choosing to renig on their contractual and moral obligations to their lenders.
We think lenders - broadly - are not requiring enough compensation for this sea-change in risk.