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Hundreds of birds fell from the sky over Arkansas on New Year's Eve, which some folks are taking as a sign of the impending apocalypse.
On Jan. 1, Chowchilla, a small, rural town in California, failed to make a scheduled interest payment on in its debt. This, to some observers, is the beginning of a wave of defaults that is about to rain down upon the municipal bond market.
According to National Geographic News, of the estimated 10-20-billion birds in North America, about half die each year. But the recent wave of reports of the birds' death is yet another example of media hype.
The hysteria about a potential similar wave of municipal bond defaults would seem to fall into the same category, especially after the CBS news magazine, 60 Minutes, last month ran a segment about the crisis in states' budgets.
Make no mistake: some big states face huge fiscal gaps, notably Illinois, California, New York, Texas and Arizona. And the crisis reaches down into other governmental units, including Nassau County, N.Y., where I live, which faces imposition of financial oversight by a state monitoring board if it can't close its budget gap despite being one of the richest counties in the nation.
That, however, doesn't mean a wave of huge defaults by state and local governments similar to the collapse in the mortgage market that threatened the very solvency of the banking system, as some critics have asserted.
Neither does it mean that the bonds of American state and municipal governments represent a risk to the financial system despite superficial similarities to the European debt crisis.
Finally, because the ratings agencies completely failed in assessing the credit risks posed by the mortgage-backed securities, nor does that mean their assessment of state and municipal credits should be disregarded.
While propeller-heads conjured triple-A mortgage securities out of garbage home loans, the green-eye shade types who analyze municipal bonds have been tough graders of risk.
The dimensions of the problem are enormous, not the least because states won't be receiving largesse from Washington in the form of stimulus funds starting in a few months. Citigroup Capital Markets reports that state budget shortfalls are estimated by the Center on Budget and Policy Priorities to hit $130 billion in fiscal 2011 and $113 billion in fiscal 2012.
But four states -- California, Illinois, New Jersey and Texas -- account for 50% of the total shortfall. Add in New York, these five states comprise 58% of the 2012 deficit.
So, while the problem is huge, it is concentrated. Moreover, Texas has a rainy-day fund it can tap, Citi notes. The budget woes in the other states are widely known; but the chances of default is virtually nil.
As bad as the budget situation is, it's getting better. Morgan Stanley Smith Barney points out that revenues actually have been increasing for three consecutive quarters owing to tax increases and an improving economy, with many key states seeing revenues exceed budget projections.
Moreover, what distinguishes state and municipal borrowers from sovereign credits such as Greece is the former are far less dependent on access to the bond market to roll over their debts, Citi's muni analysts point out.
Perhaps (unlike me) they're too young to recall that's what precipitated the biggest modern crisis in the municipal bond market in modern times, the New York City fiscal crisis. The Big Apple relied on repeated issues of short-term notes to paper over its budget woes until it couldn't refinance its debts. Then came the famous New York Daily News headline, "Ford to City: Drop Dead" after the Treasury refused loan guarantees. Only after turning over financial sovereignty to a state agency, the Municipal Assistance Corp., was New York able again to tap the muni bond market and refinance its debts.
Here is a major difference between the muni market and mortgages. For homeowners who owe more than their property is worth, "strategic" defaults have become a favored tack. In many states, they can hand back the property and go on their merry way. For municipalities, the penalty for failure to meet debt obligations is steep; they are pariahs who are shut out from credit until they regain the good graces of the market.
Another big contrast between mortgages and munis: To assess pools of disparate mortgages, the ratings agencies had to make assumptions about the ability of borrowers to pay and the value of the collateral. By making further assumptions, the rating agencies figured they could divvy up the pool so that a certain number of defaults could be absorbed by lower tranches and leaving the upper levels unscathed. All that was done on the basis of modeling and forecasts.
Municipal credits are assessed on the basis of actual financials. To be sure, in many cases those financial statements are not nearly as current or clear as for corporate borrowers; but at least credit analysts are going on some actual data rather than nebulous projections.
Finally, there's the matter of pricing. The supposed triple-A mortgage derivatives yielded a small increment over the London interbank offered rate, or Libor, the money-market benchmark, currently around 0.3%. In reality, they were junk credits, as their subsequent collapse shows, selling at top-quality yields.
Long-term municipal bonds, for the most part, provide after-tax yields comparable to junk bonds while having vastly higher credit quality than similarly rated corporate bonds. A 5% single-A bond free from federal and state taxes beats an 8%, fully taxable junk bond for an investor facing a combined 40% tax rate.
The massive budget deficits and even bigger pension-fund shortfalls are huge public-policy problems that will likely mean further cuts in state and local employment and concessions on pay and benefits. "Public Workers Face Outrage as Budget Crises Grow," the New York Times reported on Jan. 1. Taxpayers who work in the private sector don't see why they should pay so public-sector employees avoid the concessions they've made -- paying more for their health care and having a defined-contribution retirement plan rather than gold-plated benefits and pensions.
The result from all this bad news likely is a temporary widening of muni-bond yield spreads -- leading to price declines -- but not defaults. Investors in tax-exempt bond funds have seen such price drops (which also have been because of technical factors such as the sunset of the Build America Bonds program) and have withdrawn funds. Investors who buy and hold muni bonds have ridden out the turbulence.
Despite the high-profile budget problems in these aforementioned states, Howard J. Cure of Evercore Wealth Management sees plenty of opportunities. "Essential-purpose revenue systems with monopolistic control over the customer base and an independent rate-setting authority still provide the best security in troubled, contentious times," he writes.
Revenue bonds -- those that are backed by cash flows from certain authorities or projects such as bridges, toll roads or public-power systems -- once were considered the lesser part of muni market, subordinate to general-obligation bonds backed by taxes. But revenue bonds comprise 65% of all municipal debt, up from 40% in 1975 and virtually nil in the 1930s, according to Citi. So, most of the market should be immune from the headlines.
The risk lies in a handful of weaker credits or badly managed localities, Citi adds. In the case of Chowchilla, Calif., its former finance chief erroneously transferred $788,000 from a bond repayment fund for city infrastructure expenses in 2006, which had to be reversed in 2009, the Merced Sun Star reported. Now, the town is broke.
That's an example of birds falling from the sky. But in the muni market, the sky isn't falling.
Comments: E-mail randall.forsyth@barrons.com
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