Militant Unions Raise Muni Risk

It was not the kind of headline to which investors typically pay attention, but perhaps they should. It said: “Teachers start hunger strike to protest layoffs” atop a story about a nasty battle between the board of education and teachers in Los Angeles over efforts to close a $600 million budget deficit.

Hunger strikes are extreme, but they are just one weapon in an increasingly formidable union arsenal that includes lawsuits and brutal advertising campaigns aimed against budget-cutting politicians. Such tactics are only likely to become more common because states and localities around the country face, by one estimate, more than $350 billion in budget deficits in the next few years, and much of that is concentrated in employee costs. In the lofty world of municipal bond analysis the answer to these problems would be simple: raise taxes, cut costs and keep making those debt payments.

But today’s world is very different. Public employee groups have accumulated so much power in recent years that governments are having trouble trimming budgets, especially burgeoning employee costs, while tax increases on an already-shrinking economy aren’t producing the revenues needed to close budget gaps. That’s created budgetary gridlock in places like California and is one reason why imposing figures like Warren Buffett have started to worry whether the old, reliable municipal bond market isn’t heading for turmoil. “Insuring tax-exempts…has the look of a dangerous business,” Buffett wrote to shareholders earlier this year.

Buffett isn’t alone in worrying about munis. Although the municipal business has always been considered a plain-vanilla market— dependable bonds issued to conservative investors—it has also had its troubling, controversial side. As former Securities and Exchange Commission head Arthur Levitt recently observed in a Wall Street Journal opinion piece, the muni market has long been plagued by allegations of ‘pay-to-play’ in which firms win business not based on expertise but after making contributions to politicians. Legislative efforts to limit the role of political influence in the business have been halfhearted, perhaps because it’s such a gravy train for both politicians and investment bankers.

This intersection of finance and politics has resulted in a steady increase in local debt and, more disturbing, an increase in offerings that circumvent state and local legislative debt limits. States and cities have created a bevy of public authorities and other bodies that they use to issue debt that’s officially off-the-books but still leaves taxpayers on the hook. Several years ago an audit in New York State found that public authorities there had issued some $43 billion in so-called ‘backdoor debt,’ that is, debt not approved by voters--one reason why the state will spend nearly $5 billion this year just to service its debt.

These growing liabilities wouldn’t be half so troublesome except that, as Levitt pointed out, the market isn’t very transparent and reliably produces some controversial “Enron moment” every decade or so. In the 1970s, that moment belonged to New York City, which nearly reneged on its debt obligations under the weight of an unprecedented social welfare spending spree, until the state and the feds bailed out the city. In the 1980s the Washington Public Power Supply System, a municipal corporation created to build power plants in the Northwest, defaulted on $2.25 billion in bonds used to build nuclear plants that never operated (the debt vehicles became known as “Whoops bonds”). In 1994, Orange County in California filed for bankruptcy after it invested some $2 billion of borrowed money in risky derivative instruments that wracked up big losses. In 2006 the city of San Diego settled fraud charges with the SEC after admitting it hid growing pension shortfalls and misled investors about the extent of benefits it had promised to city employees. Tellingly, the city had granted rich benefits enhancements to city employees under the belief that a rising stock market, not taxpayers, would finance the new obligations, and eventually under the weight of those obligations the city declared bankruptcy.

Defenders of the muni market point out that such incidents are rare and that tax-exempt bonds have a far greater repayment rate than corporate bonds.

But if ever there were a market that seemed ready for what Nassim Nicholas Taleb calls a ‘black swan” moment, that is, a big, rare event outside the scope of past experience, it may be the muni market. Levitt observes that the market is far more opaque than investors believe, with inconsistent accounting standards and no central regulator watching over it, which raises the question of whether more San Diego-style surprises will emerge as budget woes intensify.

Meanwhile, Buffett worries that growing political pressure on elected officials—who are getting squeezed between irate taxpayers on the one hand and powerful public employee groups on the other—might prompt a few places to test the idea of reneging on their debt. That, he fears, could lead to a cascade of defaults that would overwhelm insurers who back these bonds: “If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow.”

Concerned about just such a gusher of bankruptcy filings, California’s state legislature is now considering controversial legislation that would require a municipality to get approval from a state commission to file Chapter 9, which is how governments go bankrupt. Muni investors can’t be heartened by the prospect of a rash of such municipal bankruptcies considering the way bondholders have been treated by government in the Chrysler and General Motors filings. I can just hear some politician browbeating muni holders about how they must do their part to help troubled cities out of their fiscal woes by taking 30 cents on the dollar.

For decades the claims of municipal bondholders have been considered the immovable obligations of government finance. But now their interests are in conflict with the new irresistible force of local politics, the public employee unions.