Sunday, April 4, 2010

The Municipal Market

This represents my personal opinion, not the views of the SEC or its staff.

My first blog post was in June, 2007. It was titled “What sorts of crises am I worried about now”. My answer was housing and credit. With the benefit of hindsight, this might be considered a no-brainer, although at the time it was not so clear where things would go.

Now as the dust settles from the crisis that emerged in 2008, we can start to think about what might come next. And yes, the crisis really is settling down, despite the alarmists who, thinking we were in a 1930’s style depression, pushed the panic button and stuffed their mattresses (or portfolios) with cash. For whatever reason, be it astute government intervention or the natural healing process, we are looking back at something along the lines of a bad, credit-driven recession.

I don’t think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.

So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:

  1. Problems occur when things get leveraged and complex (and thus opaque).
  2. If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
  3. The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.
  4. A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
  5. Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
  6. Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages). .
Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?

Answer: The municipal market.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky -- the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the under funded portion of the portfolio.

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.

Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt – democracy at work.

I appreciate comments, but will not be able to respond to them. Also, because this is a personal blog unrelated to my work, I will not be posting comments that do not respect that separation.


  1. Thank you for this great analysis. If I had to add one thing, it's the potential systemic risks caused by the municipal bond insurers. A lot of these companies (the monolines, most famously) have already blown up in 2008, but I believe a municipal blow up would be even bigger, as the muni insurance market is older and deeper than the private mortgage insurance market ever was.

    I would also suggest to look at Matt Taibbi's new article in Rolling Stone, whatever you think of his style. There is an untold number of municipalities in the US that entered into Greek-style swap deals that may or may not be fraudulent but that are bound to explode. It is certainly worrying to think how much liabilities have been hidden in the past decade...

  2. Rick, I enjoyed the article. If you take out CDS's to try and capitalize you will also be blamed for using derivatives to hurt state and local governments.

    I think you could add this note to your point on leverage (this affects federal debt as well):

    When we increase our entitlements we increase leverage--see healthcare reform, which effects federal, and state through Medicaid expansion--even if we increase taxes enough to pay for the new entitlements, as the CBO suggests. These new taxes reduce our ability to raise taxes in the future to service our debts. For corporations, no one would lend to a firm without enough cash flow to service its debt. One of the reasons the United States can continue borrowing when it is in this situation is its untapped ability to raise taxes in the future. However, any increase in taxes that does not go to service debt, will reduce this untapped ability and weaken our financial position.


  3. Interesting analysis on systemic risk and the muni market.

    More on muni bankruptcy at Riski, the open source platform for financial reform:

  4. co-incident defaults are a classic case of non-linear impact amplification. Most mean variance risk scenarios and models rarely model co-incident event thresholds being crossed. These co-incident triggers or phase changes in behaviour are the crux of systemic inflections in economics. they are next to impossible to model and yet most risk system focus on them all the same. Low debt recovery and high debt defaults get triggered past a certain threshold in a market when sentiment changes. Sentiment prediction is a very NP tough problem :)

  5. Well now I'm scared. But is it clear who wins when a municipality has to default -- taxpayers, bondholders, or union employees and pensioners?

    Also a lot of municipal bonds are reinsured. Does a systemic crisis imply that the reinsurers will quickly get wiped out?

    And do you believe the federal government and federal reserve will not intervene ("bail out") during a municipal credit crisis after its actions during the last credit crisis?

  6. How much of the municipal debts are wrapped up in CDO's?

  7. The real question is, how do we profit from this, like folks that made millions during housing crisis.

  8. Excellent analysis. Thanks for your troubles.

    Any guesstimate in time frame?


  9. Should we only invest in GO bonds from municipal issuers that are considered too-big-to-fail?

  10. Much in this article is good - however, ultimately it falls prey to the same blind spots and empty academics many had before the last collapse - dominated by misguided faith in the false altruism of so-called finance reform, the rating agencies, the regulators,and all the other bad actors, as well as the fact that not a single person involved has had any accountability, nearly all of the criminals still have their jobs, and the entire manipulated and cancer-ridden system is unchanged.This wasn't a few rogue bad apples - it is an entire unsustainable casino system for a handful of power players and their faithful rodent minions who are happy to get the crumbs that fall off of Goldman Sachs table.Sure - it may stumble along for a few more months or even years...but it is and will be over and those who believe that, although easily marginalized by pompous academicians and corporate shills, will be reading posts like this to point out who the cheerleaders were who led taxpayers down another dark alley.

  11. I agree with the risk in the municipals, Rick, but don't you think you're being a little bit coy about the severity of the economic downturn? I mean, do you really think if we had job lines and food lines instead of emergency federal unemployment checks and food stamps, that it wouldn't look almost exactly like the 1930s? (Not to mention section 8 etc.)

  12. "Now as the dust settles from the crisis that emerged in 2008, we can start to think about what might come next. And yes, the crisis really is settling down..."

    Quid? The balance sheet of banks has been repaired? We do have a reasonable assessment of the amount of toxic debt that is still on their books? Must we conclude that mark-to-market can be reinstated subito presto without problems?

    Who knew?

  13. The muni market cannot be painted with a broad brush. There are many municipalities who exercise sound fiscal responsiblity. I have been a secondary market participant for 27 years. I only buy Texas bonds, I do my homework on each item, and bid quality. The muni market does not, and never has paid to take on risk.
    Stick with the best and you will not be dissapointed.

  14. Having reviewed our city investment portfolio and seeing millions in Fannie and Freddie senior debt, any non-support by the federal government of those two entities could create problems for our municipality.

  15. The complexity and connectedness of the entire "system" will be it's undoing. In the long run, we're all dead if we don't remain as outliers.

  16. Interesting post, Rick. I am in awe of the degree to which you have thought this one through. I also agree with one of the earlier commenters who accuses you of ever so slightly pulling your punches on what the likely aftermath of a muni crisis would be. You are basically talking about people taking to the streets and a severe crisis as it relates to the provision of police, fire and social services across the United States.

    Good work.

  17. Rick, can you tell us how exactly unfunded pension liabilities trigger defaults? I'm having a hard time with the exact mechanism here. Do the states and cities choose not to pay bondholders in favor of making what are really voluntary pension pre-funding payments, or will there be a wave of court decisions forcing them not to pay? I'm just curious how this would work.

  18. This is going to be similar to the way they have tried to recover the housing market but there will be an avoidance before things go into default instead. What I can see happening is any potential losses will be inflated away, and why the great play was buying non US-dollar linked assets and ncommodities. This does introduce the fact that people will now have to take on risk to maintain wealth as cash will be destoyed. Good luck.

  19. Rick, thank you for raising these important issues. See my response:

  20. I agree the municipalities are huge risk…..the only difference between them and the Feds is the timing of inability to issue debt and the ability to print money. Mark my word there is no settling down of risks. There is a pause…..there is just too much debt in the system with no where near the income earning power to even service the debt let alone even pay a nickel of it down.

    I don’t believe the banks are sound either. They have been saved by accounting relief only not of bad debt. And what we have learned recently of banks being able to game their debt levels for quarter end leads to more opacity not less. Can you ever really trust them….I won’t. Yes, municipalities, states and even the Federal government have mismanaged there finances… it has taken more and more debt just to achieve the meager “real” growth this country has been able to achieve (which we all know was false growth). This won’t look exactly like Japan but it will end up being close enough to scare generations…..having recency biases won’t help in navigating what will end up in a multi-decade storm.

  21. I too see problems on the horizon, problems so big that only a Federal bailout cold satisfy it. But (other than in a very few limited circumstances)) do I see the Feds coming to the rescue...... think Texas taxpayers bailing out California.

    Clearly, the root cause of our dire financial straights (exacerbated by the recent market decline of course) is the excessive pensions & benefits promised to Civil Servants at all levels (State, County, City, municipal).

    The VERY necessary "fix" is more than the usual "tinkering" around the edges or even reduced pensions for NEW employees (as savings from such reductions generally will not materialize until they retire in 20-30 years), but significant reductions (not for PAST) but for FUTURE years of service for CURRENT (yes (CURRENT) Civil Servants.

    While such reductions are ROUTINE in Private Sector pension plans, somehow, our legislators and politicians always treat such reductions as "impossible" in the public sector ...... perhaps because THEY belong to the same or similar plans.

    Well, that "impossible" better become "possible" or we're heading for a Public vs Private Sector Civil War.

  22. You have vastly overstated the risks of municipal bonds, without differentiating between the types of bonds in the market. For example, regardless of pension liabilities, overspending or overborrowing, it is virtually impossible (including in bankruptcy), short of a tornado that wipes out an entire town, for an unlimited tax general obligation bond or a bond supported by revenues of a well-established governmental enterprise (such as a water or wastewater system) to default. It requires a knowledge of municipal credit structures to understand this. Other structures are at greater risk, but with certain notable exceptions, so far, not intolerable. That is where people need to focus, not to use such discrete examples for overgeneralization. In any case generally also not subject to pension, etc. issues--land-based bonds are a prime example, as are new or vastly expanded governmental enterprises (a form of project financing), and other bonds for housing, health care, charter schools, nonprofit corporations, industrial development bonds, and the like. Again, pensions, etc. are not part of these credits.

    The securities that could be affected by pension and overspending issues are lease-purchase securities payable from governmental general funds without special revenues or designated tax support. These securities are now more important than in, say, 2007 due to the Vallejo, California, bankruptcy proceeds in which the City is avopiding some debt service. Even so, bankrupcy is not available to states or, in many states, to localities.

    I will be citing and quoting your remarks, however, in my upcoming book, as I seek to provide a diversity of opinions, even those that disagree with my own.

    Robert Doty

  23. Something everyone else knows is something not worth knowing. These insights are not unique.

  24. We have learn lessons from the financial crisis during recession, but many of us still are careless about managing the finances in right manner.

  25. Ah, yes, those darn "equally irrational...taxpayers".

    So darn irrational as to dare to suggest that a retired firefighter should not be entitled to $300k/yr and "free" health-care for the next 40 years or so? So irrational as to suggest that a failed takings project in New London, CT was a scam? So irrational as to be...a resident of Good 'Ol Bell, California?

    So d**n irrational as to actually want non-fraudulent practices in RMBS?

    So completely irrational that I think a pension fund's "proposed" return of over 8% is, itself, irrational?

    That's ME, dude!!!