While the low interest rates have allowed many financially stressed municipalities to save money for new projects, they have created their own stresses in other ways. Many of them made generous retirement promises to civil servants, but what they never provided for were the actual funds to pay for the plans
In the fall of 2011 banking analyst Meredith Whitney caused quite a stir in the normally placid world of the US municipal bond market. These bonds or Munis as they are known are usually issued by local governments in the US. They can be issued by all sorts of lower political subdivisions including states, counties, and municipalities. They are also used for raising money for other infrastructure projects like sewers and roads. Some states also allow non-profit organizations like universities and hospitals to issue these bonds. The bonds are considered unusually safe. So when Ms Whitney predicted hundreds of billions of dollars of defaults in 2012, $19.1 billion funds flowed out of the $3.7 trillion market.
But then nothing happened. Instead of a massive meltdown, there were only $2.8 billion worth of defaults in 2011 and only another billion of defaults were added in 2012. Presently out of tens of thousands of projects only 204 deals are in default or about 0.55% of the total. So Ms Whitney’s prediction was way, way off. Or was it?
For several years now the Federal Reserve has suppressed interest rates. The result is that investors, especially institutional investors including pension fund managers have been searching the globe for any investment that pays a decent yield. The outflow of funds prompted by Ms Whitney’s prediction reversed with a vengeance. Over $50 billion flowed into mutual funds and ETFs specializing in Munis. The demand for the bonds was so high that yields for 20-year general obligation bonds were forced to a low of 3.29%, a yield not seen since 1967. The riskiest of these bonds were the most favoured. These high-yield bond funds account for only 11% of the funds but attracted 20% of the money.
It may be that Ms Whitney’s prediction may have been exaggerated and a little premature. In December ratings agency Fitch also warned about the safety of these bonds. Fitch expects to downgrade dozens or even hundreds of municipalities in 2013.
What is most interesting about the Muni market is that its problems are very similar to problems of bonds in other countries especially those in emerging markets. They are lightly regulated. They are subject to political influence and they lack transparency.
While most stocks and corporate bonds are subject to stringent listing and reporting requirements from the US investment watchdog, the Securities and Exchange Commission (SEC), the Muni market is exempt. Unlike stocks, Munis are not required to provide audited financial statements. Disclosures like a potential bankruptcy or a criminal investigation are immediately required for other investments, but are often delayed by issuers of Munis. Until recently rating agencies did not consider unfunded pension liabilities. A recent SEC report described the Muni market as illiquid and opaque.
While the low interest rates have allowed many financially stressed municipalities to save money for new projects, they have created their own stresses in other ways. Like their European counterparts, many municipalities made generous retirement promises to civil servants, especially to their politically powerful and connected unions. What they never provided for were the actual funds to pay for the plans.
Two examples stand out. Puerto Rico is part of the US but has a special status as a Commonwealth and has never asked for or received statehood status. It has problems that are similar to Greece—poor tax compliance, a shrinking population, political stalemate and a stagnant economy. Its main pension fund serving about 250,000 past and present government workers is only 6% funded and could run out of money as soon as next year. A fund for 80,000 teachers is only 20% funded. Nevertheless its bonds are widely held. They pay interest that is 2.5% higher than other issuers, because they are rated just one or two levels above junk. According to Standard & Poor’s there was a one in three chance of a downgrade in 2013. A downgrade could provoke widespread selling by institutions required to hold only investment grade bonds.
Puerto Rico’s case may be severe but it is hardly unique. The state of Illinois has an unfunded pension liability of $96 billion with problems that date back as long as 70 years. Rather than raise taxes it was simply easier to not fund the pension liabilities. Other states with similar problems include Connecticut, Hawaii, Illinois, Kentucky, Massachusetts, Mississippi, New Jersey and Rhode Island.
The irony of the pension mess and its effect on Munis is that it has been made worse by the actions of the Federal Reserve. By lowering interest rates it has made it all but impossible for pension fund managers to get decent returns. The Fed has always maintained that a recession would be worse. By manipulating the market they may well cause what they sought to avoid.
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(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)