Wolf Richter: Fear And Trembling In Muni Land

Yves here. While Wolf offers a useful, and dour, assessment of the outlook for municipal bonds, a few quibbles are in order. There is no question that a lot of states and municipalities have funding problems underway or probable in the not-too-distant future. But their sorry condition is a direct reflection of the deteriorating finances of ordinary Americans.

The biggest cause of stress for many government bodies has been the global financial crisis. The meltdown and resulting hit to the economy devastated state and local budgets, since tax revenues collapsed. And some entities, Jefferson County being the poster child, had entered into complicated swaps as part of fundraisings and their costs blew out when they were downgraded. Another bit of Wall Street inflicted damage on local entities was the collapse of the auction rate securities market (most of the major brokers in this market were fined for their misconduct). And yet another type of swap-inflicted damage took place via Libor manipulation. Transit authorities like Boston’s MTA were big targets for floating-to-fixed rate swaps, and the effect of the protracted understatement of three month Libor during the worst of the crisis resulted in them paying excessive swap costs. An overview from the Fiscal Times:

In the two decades before the 2008 financial collapse, the investment banking industry sidled up to state and local finance officials with an offer they couldn’t refuse. Instead of issuing plain vanilla 30-year fixed-rate bonds to build roads, schools and parking garages, why not sell variable rate bonds at lower rates and buy a swap that would fix the total payment at something lower than what they’d pay in the fixed-rate market?…

There was a slight problem with the formula, though – one that would cause tremendous grief later on. Changes in the variable rate bonds were almost always tied to an index of actual municipal bond transactions compiled by the U.S.-based Securities Industry and Financial Markets Association (SIFMA). Changes in the swaps, on the other hand, were tied to the London Interbank Offered Rate (Libor), which is set by the British Bankers Association based on reported rates from global banks. If Libor moved lower at a faster pace than SIFMA, government agencies’ hedge would come up short…

The revelations sparked a major class action lawsuit filed earlier this year by the city of Baltimore, which entered into dozens of swap-based municipal bond contracts in the past decade that were tied to Libor. The suit accused more than a dozen financial institutions involved in setting Libor rates of engaging in a systematic conspiracy that resulted in “hundreds of millions, if not billions, of dollars in ill-gotten gains.”

“Just about every jurisdiction in the U.S. was affected,” said Michael Hausfeld, one of the attorneys representing Baltimore. “It affected hedge funds, money market investors, institutional investors. The total losses could exceed tens of billions of dollars.”

The additional losses from misreported Libor rates only exacerbated what had already become an exceedingly bad deal for public agencies. Most swaps contracts included large cancellation fees. In a falling interest rate environment where long-term tax-exempt bond rates have fallen to well below 4 percent, it became prohibitively expensive for governments to refinance floating rate debt that had been fixed via the swaps contracts at 5 percent or more.

So just bear in mind that the efforts to depict state and local governments as profligate are in some cases an effort to divert attention from Wall Street’s hand in their financial distress.

By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Testosterone Pit.

Municipal bond investors, a conservative bunch who want to avoid rollercoaster rides and cliffhangers, are getting frazzled. And they’re bailing out of muni bond funds at record rate, while they still can without losing their shirts. So far this year, they have yanked out $52.8 billion. In the third quarter alone, as yields were soaring on the Fed’s taper cacophony and as bond values were swooning, net outflows from muni funds reached $32 billion, which according to Thomson Reuters, was more than during any whole year.

Muni investors have a lot to be frazzled about. Municipal bonds used to be considered a safe investment – though that may have been propaganda more than anything else. Munis are exempt from federal income taxes, hence their attractiveness to conservative investors in high tax brackets. Munis packaged into bond funds appealed to those looking for a convenient way to spread the risk over numerous municipalities and states. While the Fed was repressing rates, muni bond funds were great deals.

Then came the bankruptcies.

The precursor was Vallejo, CA, a Bay Area city of 115,000 that filed for Chapter 9 bankruptcy protection in 2008 and emerged two years ago. But it’s already struggling again with soaring pension costs that had been left untouched. Jefferson County, which includes Alabama’s largest city, Birmingham, filed in 2011 when it defaulted on $3.1 billion in sewer bonds, the largest municipal bankruptcy at the time [but it’s already issuing new bonds; read….. Municipal Bankruptcy? Why Not! And so The Floodgates Open].

Stockton, CA, filed in June 2012. Mammoth Lakes, CA, filed in July 2012. San Bernardino, CA, filed in August 2012. They were dropping like flies in the “Golden State.” Detroit filed in July this year, crushing all prior records with its debt of up to $20 billion. That’s $28,000 per person for its population of 700,000.

But Detroit is just a fraction of what is skittering toward muni investors: the Commonwealth of Puerto Rico. The poverty rate is 45.6%. Unemployment is 14.7%. The economy has been in recession since 2006. The labor force has shrunk 16% from 1.42 million in 2007 to 1.19 million in October. The number of working people, over the same period, has plunged from 1.8 million to 1.1 million, a breathtaking 39%.

Puerto Rico had a good run for decades as federal tax breaks lured Corporate America to set up shop there. But when these tax breaks were phased out by 2005, the companies went in search for the greener grass elsewhere. To keep splurging, the government embarked on a borrowing binge that left the now lovingly named “Greece of the Caribbean” with nearly $70 billion in debt.

That’s 70% of GDP, and for its population of 3.67 million, about $19,000 per capita, or about $64,000 per working person. And then there is the underfunded pension system. But unlike Detroit, Puerto Rico is struggling to address its problems with unpopular measures, raising all manner of taxes and cutting outlays. Not even the bloated government payrolls have been spared. Too little, too late? Given the enormous poverty rate and long-term shrinking employment, what are the chances that this debt will blow up?

Pretty good, according to Moody’s Investors Service. Last week, it put $52 billion of Puerto Rico’s debt under review for a downgrade – to junk. Moody’s litany of factors: “Failure to access the public debt market with a long-term borrowing, declines in liquidity, financial underperformance in coming months, economic indicators in coming months that point to a further downturn in the economy, inability of government to achieve needed reform of the Teachers’ Retirement System.” This followed a similar move by Fitch Ratings in November.

Alas, Puerto Rico has swaps and debt covenants with collateral and acceleration provisions that kick in when one of the three major credit ratings agencies issues the threatened downgrade. Which “could result in liquidity demands of up to $1 billion,” explained Moody’s analyst Lisa Heller. It would “significantly narrow remaining net liquid assets.”

Now Puerto Rico is under pressure to show that over the next three months or so it can still access the bond markets at a reasonable rate. If not….

Puerto Rico’s debt was a muni bond fund favorite because it’s exempt from state and federal taxes. Now fears of a default on $52 billion or more in debt are cascading through the $3.7 trillion muni market. But Puerto Rico isn’t alone. Numerous municipalities and some states have ventured out on thinner and thinner ice.

Default risks are dark clouds on the distant horizon or remain unimaginable beyond the horizon. And hopes that disaster can be averted by a miracle still rule the day. However, the Fed’s taper cacophony is here and now, and though the Fed is still printing money and buying paper at full speed, the possibility that it might not always do so hangs like a malodorous emanation in the air.

Taper talk and bankruptcies are a toxic mix for munis. Now add the lure of stocks that have become the official risk-free investment vehicle with guaranteed double-digit rates of return for all years to come. So muni-fund investors, tired of losing money, are seeking refuge in stocks. This has pressured munis further. The Bank of America Merrill Lynch master municipal index has dropped 2.8% and, unless a miracle happens, will end the year in the red. A first since 2008. Its index of bonds with maturities of at least 22 years has skidded almost 6% – though the Fed hasn’t even begun to taper.

The Fed’s easy money policies over the decades encouraged borrowing binges by municipalities and states. When the hot air hissed out of history’s greatest credit bubble in 2008, the Fed’s remedy, its ingenious QE and zero-interest-rate policies, blew an even greater credit bubble – kudos! As that credit bubble transitions from full bloom to whatever comes afterwards, the plight of muni bond funds is just the beginning.

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  1. Jon Paul

    2 tangential thoughts

    First, I was just reading an analysis on another site about how muni CEFs are really beaten down and maybe overly so; what bothered me in the piece is how it hinted that the way the courts re Detroit seem to be screwing retirees might be good for bondholders. Sometimes I’m not so sure that any profit is good profit.

    Second, if the municipalities were hosed in any way, shape, or form by swaps in any way based on LIBOR, do they have a reasonable case for relief given the breadth of LIBOR manipulation?

  2. from Mexico

    Yves Smith said:

    “But their [states and municipalities] sorry condition is a direct reflection of the deteriorating finances of ordinary Americans.”

    But what is causing “the deteriorating finances of ordinary Americans”?

    1) Over indebtedness, and
    2) Stagnant wages and unemployment.

    How does one fix these? It seems to me it’s going to require a complete reversal of existing social power relationships.

    1. vlade

      It’s really the second. I’d write “the first cannot happen unless the second is true”, but there are still people willing to pay 20% interest on buying trivialities so it can.

      The problem is that when people have to pay 20% interest on the stuff they need to survive, because their take-home cash was in real decline for a long time.

  3. Moneta

    Here in Canada where real estate is bubblicious, I can only imagine the impact on muni budgets when this house of cards collapses.

    The Montreal admin is under invstigation… with only a few mouse clicks I could help then with a few frauds. LOL! Toronto is stuck with a clown. These are symptoms of the gross mismanagement which ballooned after the forced mergers. Thanks to soaring real estate prices, munis have been able to keep the game going. But the signs are everywhere and people are blind to them.

    For example, I went for a bike ride along the Ottawa river, stopped along the side to admire the only to find a coast littered with plastic tampon applicators… I guess everything else was diluted! Told my daughter to NOT put one finger in there. This is amid waterfront 2 million + luxury homes. One woman was walking her dog and only when I made a comment about the detritus did she seem to actually notice it… The mantra seems to be that we are lucky to be in Canada vs. the US and Greece so we should stop complaining…. the level of complacency is mind boggling.

    That is why I keep on saying that we are living above our means. We have built ourselves a lifestyle that is not maintainable while still paying pensions. Something will break. Had we properly maintained our infra, houses probably would not have gotten so big, we would have owned less cars and we would not have built so far out.

  4. Ignim Brites

    One more reason why it is unlikely the FED will ever taper. More likely that QEternity will embrace municipal and state debt.

  5. McMike

    Interesting that the arguments that advocate in favor of sky-high Executive pay are all turned on their head – often by the same people – when it comes to teachers and public employees.

    It’s okay to break contracts with teachers? It’s okay for pay to go exponential in pay even as evidence of a CEO pay/performance link is thoroughly disproven? We don’t have to worry about attracting good talent to education through a good pay system?


    Closer on-topic, I would love to see an analysis that correlates the municipalities in trouble now with the ones who a decade or so ago adopted the financial sector ethos, and hired a bunch of MBA wankoids and privatizer hacks who got them into the trouble in the first place. I suspect we would see a highly direct relationship between those who are sucking fumes now, and those who participated in the revolving door incestuous sell-out/sell-off then.

    Also, it is interesting to me that the Libor scandal and bid rigging revelations has not led to a tsunami of lawsuits. Maybe they are waiting to see how the early suits go. But this ought to roll out like the mortgage processing story. Eventually the Feds will have to step in and settle for everyone, because it will become clear that the banks ripped off every single customer they had, in ways so thorough and fundamental, that the only exit plan aside dissolution of the banks is for Obama to waive his magic get out of jail wand. Again.

  6. DakotabornKansan

    Yves said, “bear in mind that the efforts to depict state and local governments as profligate are in some cases an effort to divert attention from Wall Street’s hand in their financial distress.

    2012 Securities and Exchange Commission’s Report on the Municipal Securities Market:


    “The word “taxpayer” appears only 14 times in 165 pages of the Securities and Exchange Commission’s Report on the Municipal Securities Market…Only two of those mentions in the body of the report refer to looking out for our interests.”

    “Just the need for this report reveals that this prudent fiscal instrument of safe investment for the greater public good through building of schools, roads, bridges, utilities and other good and essential structures of government has been turned into an insidious machine to enrich a few at the expense of the many.”


    “The mission of the SEC does not explicitly include protecting taxpayers from unscrupulous politicians, bureaucrats, bond dealers, financial advisors, consultants or any other of the predators who have turned a solid house of prudent public finance into a den of thieves.

    From the mass of regulatory and legislative reforms proposed in this report, it looks as if that house is so rotten at the foundation it could fall any time.

    Complicating this bond ruin beneath a façade of safety are chilling acknowledgments of abuses such as “negotiated offerings” that “create opportunities for municipalities to allocate underwriting business on the basis of political contributions rather than on the price and quality of underwriting services.”

    Those “conduit” entities and “derivatives” secretly put taxpayers on the hook for billions and let politicians slip around legal borrowing limits…conduit bonds have represented approximately 70% of all municipal bond defaults despite representing a relatively small percentage of municipal bonds issued…

    As for derivatives, “The special and significant risks posed by derivative instruments to municipal issuers has underscored the need to consider enhanced disclosure …Considering just one common type of derivative, the report said, “there currently is no comprehensive data on how many municipal issuers are active in the $162 trillion U.S. dollar-denominated interest rate swap market, although anecdotal evidence suggests a relatively wide use.”

    That is $162 TRILLION, in notional value, putting taxpayers at risk for incalculable billions in losses.

    Anyone who believes current regulation is enough to protect taxpayers from these deals, take a look at the State Attorneys General Muni Bond Derivatives Settlement Website:


    Those are just the ones who got caught, so far.

    However the most tragic scam acknowledged by this report is politicians looting of municipal and state worker retirement funds to bypass legal debt restrictions. Public pension funds are at least $4.6 trillion short as of 2011, and falling fast…according to state constitutions, statutes and case law, public pensioners generally are first in line when it comes to taking taxpayer money. That puts them ahead of municipal bondholders, who invested under the delusion they get paid first.”

    Are taxpayers and dedicated public workers among the first to be protected?

    Hell no!!! They are being sacrificed on the massive tax hikes and crippling service cuts required to pay for the corrupt follies of politicians and their cronies. And they are blamed for the profligacy!

    1. McMike

      And in the end, taxpayers and teachers are worse off, the politicians have moved on to higher office or revolving door rewards, and the banks have all the money.

    2. James Levy

      Structurally, this is the end product of 40 years of relative economic decline. When the United States lost its ability to dominate global manufacturing (key word there is dominate), money started getting shunted, as it was in Venice, Holland, and Britain, from accumulated profits to financial investment and speculation. Institutions like the Fed and the SEC no longer were there to guarantee that industries and markets were honest; they were now there to make sure these vital sectors were profitable. The more America’s wealth and power depended on FIRE, the more these sectors were protected and the rules re-written to make them profitable. Reserve and collateral rules, usury laws, oversight, and finally Glass-Steagal all had to be manipulated or destroyed to keep up FIRE profitability. Now it will be state and local government, healthcare, education, and pension funds that will be sacrificed to FIRE profitability.

      To the people who own and operate this nation, FIRE is the economy. That’s why an insider like Podesta rambles on about a “return to robust growth” despite stagnant purchasing power, ecological devastation, and massive indebtedness. We’ve got to go back to clearing land, building McMansions, selling them, and then turning the mortgages into securities for the Fed to buy up at 100 cents on the dollar, while selling new cars and expanding old highways. It’s insane, but it’s all they’ve got, because it is the only way to keep the titans in First Class and the schmucks in steerage. They aren’t even interested in rearranging the deck chairs on our national Titanic. In fact, this is all happening just to make sure those seats stay bolted in place. Question is: will we seize the ship before it hits the iceberg? My guess is, no, we won’t.

      1. posa

        Superb and witty summary James of a grim scenario… I agree that the end of FIRE will occur as an unplanned death spiral … just what would be expected from a highly unstable, corrupt system. The Masters of FIRE however are not entirely oblivious to this fate. That’s why an Orwellian surveillance- Police State apparatus has been constructed to impose a complete lock down dictatorship over the population. Then the culling will begin in earnest.

  7. Otter

    It is the nature of predators to predate.

    When they run out of brown people and poor white people, they will prey upon middle class white people. The predators see no difference. Only lunch.

  8. Wells Fargo Must Die

    Wolf Richter is a bit of a right-winger and can hardly wait for municipalities to blow up. However, like most who make these predictions, I suspect he is completely ignorant of muni bankruptcy law. The ability for municipalities to pay their debts is not an issue. Pensioners may get fleeced but muni bondholders will always be protected. Bond holders rule the world.

  9. Min

    Why doesn’t the Fed buy municipal bonds? Why hasn’t it? (I asked a few years ago, and, IIUC, it is legal for it to do so.)

    1. Huxley

      Keep in mind that these debacles are engineered to profit insiders, each with the morals of a famished barracuda.

      The Fed doesn’t buy municipal bonds because their member banks stand to make a killing when they fail. Think of it as a predator whose role is to flush prey into jaws of the waiting pack. Conversely, banksters think of you as an eland with a slight limp.

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