Munis: Another Bailout Waiting to Happen?
One sign of a potential bubble is that market makers come to believe that they are insulated from risk. The housing market, for instance, inflated as banks made increasingly riskier loans which Fannie Mae, Freddie Mac and private investors snapped up in mortgage-backed securities, which took the loans off lender balance sheets.
Another sign of a bubble is that the market froth inevitably produces a significant upswing in fraud as new players race to get in on the action at any cost. As investors who were short the mortgage market will tell you, the rampant cheating which came to characterize mortgages from 2001 through 2007 helped convinced them that housing was ripe for a fall.
Which brings us to municipal bonds. In a widely reported move last week, the Securities and Exchange Commission cited New Jersey for misleading investors by excluding significant negative news from its bond offering statements. Among other things, the SEC accused Jersey officials of suggesting in offerings that the state was addressing its steep pension obligations when in fact Jersey has been skipping contributions to the system for years. Those missed payments are significant. Earlier this year Jersey's own actuaries said that individual funds within Jersey's public pension system could start running out of money as early as 2014, which shouldn't exactly reassure bondholders, given that pension obligations are among the biggest financial guarantees a state makes.
Yet the day after the SEC action, Jersey easily sold a big offering of short-term notes to banks without even having to pay a significant premium to get investors to dive back in. Anyone who studies Jersey's fiscal condition had to wonder what was going on, considering that it remains an open question how the state will come up with the money it needs to solve its multiple fiscal woes. Indeed, in a recent study, Northwestern University finance professor Joshua Rauh suggested the pension problems of Jersey (and a few other states) are so steep that a federal bailout might be the only way to fix the problem.
What, then, is the attraction of Jersey's muni bonds? Well, for one thing, Jersey and a host of other states have been raising taxes robustly, especially taxes on the wealthy. Jersey, which used to have modest tax rates, now imposes among the highest rates on top earners. Put Jersey's high personal income tax rates together with talk in Washington of letting the Bush federal tax cuts expire and it's not surprising that well-to-do state residents are rushing to find a tax-free haven via munis for some of their money, even in the face of greater risk.
This is part of the tension in the muni market today. States have engaged in increasingly opaque and gimmicky budgeting in recent years to hide the true nature of their obligations from taxpayers and bondholders, as I outlined in the Wall Street Journal earlier this week. Those gimmicks include using debt to close operating deficits, making unrealistically optimistic projections about investment returns on pension funds, and hijacking money from taxes dedicated to specific tasks like highway maintenance and putting into the general budget. Jersey isn't alone in such gimmicks. Illinois has used borrowing similar to Jersey's to make its pension system seem well-funded. New York, meanwhile, in the words of its own state comptroller employs "fiscal manipulations" to present a "distorted view of the State's finances," which the comptroller describes as a "fiscal shell game" meant to "mask the true magnitude of the State's structural budget deficit."
All of these techniques, piled on top of each other over successive years, have produced a fiscal house of cards in some states that has clearly raised the risk for municipal bondholders. Yet the prospect of significantly higher tax bills is keeping the muni market frothy, in the process rewarding politicians (or at least not punishing them) for their bad budgetary behavior. The lack of market discipline was apparent in the SEC's action against Jersey, which included no fines and no sanctions against any individuals responsible for misleading investors. Defenders of this approach suggested it would be unfair to fine the state because taxpayers would pay the levy, not the officials whose bad behavior created Jersey's mess in the first place.
But you have to wonder what kind of message that reasoning sent to politicians in places like California and Illinois, who so far have lacked the will to make tough choices on their budgets. The cynic must even wonder if politicians in those places prefer budgetary paralysis to enacting tough solutions in the hopes that the feds will step in and rescue them when a crisis develops, as Washington did in 2009 when it created the federally subsidized Build America Bond to unlock the muni market, which had closed down late the previous year.
Today, the muni market is exacting only a small price for the big risks and budgetary manipulations of some states, as the Jersey auction showed. You have to wonder if bond buyers don't believe the same thing as politicians, namely that the prospect of a failure by a state like California or Illinois or New Jersey is simply unthinkable. Are buyers of bonds in these places banking on one more federal bailout?