Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
Investing in the Tulip Crypto Mania 2021 - 19th Jun 21
Here’s Why Historic US Housing Market Boom Can Continue - 19th Jun 21
Cryptos: What the "Bizarre" World of Non-Fungible Tokens May Be Signaling - 19th Jun 21
Hyperinflationary Expectations: Reflections on Cryptocurrency and the Markets - 19th Jun 21
Gold Prices Investors beat Central Banks and Jewelry, as having the most Impact - 18th Jun 21
Has the Dust Settled After Fed Day? Not Just Yet - 18th Jun 21
Gold Asks: Will the Economic Boom Continue? - 18th Jun 21
STABLE COINS PONZI Crypto SCAM WARNING! Iron Titan CRASH to ZERO! Exit USDT While You Can! - 18th Jun 21
FOMC Surprise Takeaways - 18th Jun 21
Youtube Upload Stuck at 0% QUICK FIXES Solutions Tutorial - 18th Jun 21
AI Stock Buying Levels, Ratings, Valuations Video - 18th Jun 21
AI Stock Buying Levels, Ratings, Valuations and Trend Analysis into Market Correction - 17th Jun 21
Stocks, Gold, Silver Markets Inflation Tipping Point - 17th Jun 21
Letting Yourself Relax with Activities That You Might Not Have Considered - 17th Jun 21
RAMPANT MONEY PRINTING INFLATION BIG PICTURE! - 16th Jun 21
The Federal Reserve and Inflation - 16th Jun 21
Inflation Soars 5%! Will Gold Skyrocket? - 16th Jun 21
Stock Market Sentiment Speaks: Inflation Is For Fools - 16th Jun 21
Four News Events That Could Drive Gold Bullion Demand - 16th Jun 21
5 ways that crypto is changing the face of online casinos - 16th Jun 21
Transitory Inflation Debate - 15th Jun 21
USDX: The Cleanest Shirt Among the Dirty Laundry - 15th Jun 21
Inflation and Stock Market SPX Record Highs. PPI, FOMC Meeting in Focus - 15th Jun 21
Stock Market SPX 4310 Right Around the Corner! - 15th Jun 21
AI Stocks Strength vs Weakness - Why Selling Google or Facebook is a Big Mistake! - 14th Jun 21
The Bitcoin Crime Wave Hits - 14th Jun 21
Gold Time for Consolidation and Lower Volatility - 14th Jun 21
More Banks & Investors Are NOT Believing Fed Propaganda - 14th Jun 21
Market Inflation Bets – Squaring or Not - 14th Jun 21
Is Gold Really an Inflation Hedge? - 14th Jun 21
The FED Holds the Market. How Long Will It Last? - 14th Jun 21
Coinbase vs Binance for Bitcoin, Ethereum Crypto Trading & Investing During Bear Market 2021 - 11th Jun 21
Gold Price $4000 – Insurance, A Hedge, An Investment - 11th Jun 21
What Drives Gold Prices? (Don't Say "the Fed!") - 11th Jun 21
Why You Need to Buy and Hold Gold Now - 11th Jun 21
Big Pharma Is Back! Biotech Skyrockets On Biogen’s New Alzheimer Drug Approval - 11th Jun 21
Top 5 AI Tech Stocks Trend Analysis, Buying Levels, Ratings and Valuations - 10th Jun 21
Gold’s Inflation Utility - 10th Jun 21
The Fuel Of The Future That’s 9 Times More Efficient Than Lithium - 10th Jun 21
Challenges facing the law industry in 2021 - 10th Jun 21
SELL USDT Tether Before Ponzi Scheme Implodes Triggering 90% Bitcoin CRASH in Cryptos Lehman Bros - 9th Jun 21
Stock Market Sentiment Speaks: Prepare For Volatility - 9th Jun 21
Gold Mining Stocks: Which Door Will Investors Choose? - 9th Jun 21
Fed ‘Taper’ Talk Is Back: Will a Tantrum Follow? - 9th Jun 21
Scientists Discover New Renewable Fuel 3 Times More Powerful Than Gasoline - 9th Jun 21
How do I Choose an Online Trading Broker? - 9th Jun 21
Fed’s Tools are Broken - 8th Jun 21
Stock Market Approaching an Intermediate peak! - 8th Jun 21
Could This Household Chemical Become The Superfuel Of The Future? - 8th Jun 21
The Return of Inflation. Can Gold Withstand the Dark Side? - 7th Jun 21
Why "Trouble is Brewing" for the U.S. Housing Market - 7th Jun 21
Stock Market Volatility Crash Course (VIX vs VVIX) – Learn How to Profit From Volatility - 7th Jun 21
Computer Vision Is Like Investing in the Internet in the ‘90s - 7th Jun 21
MAPLINS - Sheffield Down Memory Lane, Before the Shop Closed its Doors for the Last Time - 7th Jun 21
Wire Brush vs Block Paving Driveway Weeds - How Much Work, Nest Way to Kill Weeds? - 7th Jun 21
When Markets Get Scared and Reverse - 7th Jun 21
Is A New Superfuel About To Take Over Energy Markets? - 7th Jun 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Possible Misunderstandings about Municipalities and their Bonds

Interest-Rates / Global Debt Crisis Apr 27, 2010 - 06:26 AM GMT

By: Fred_Sheehan

Interest-Rates

Best Financial Markets Analysis ArticleProblems of state and municipal finance worsen. Governors announce new spending cuts at press conferences but inspire little confidence. The fury of emergency announcements leaves the listener (as well as the governors) in a daze. Research reports offer broad explanations but have left bondholders, as well as employees and local residents, unprepared for discontinuities. In other words, there will be instances when these constituencies will find themselves marched to the slaughterhouse without warning.


Following are corrections to the more common misunderstandings.

Claim #1: "General Obligation bonds do not default." Financial planners sometimes reassure retail clients with this claim. Following is a case study that shows how a truth may stumble into a half-truth. A half-truth is often more dangerous than a lie.

From a credit agency report: "Even in the event of default on [General Obligation] bonds, investors are likely to enjoy a full recovery of principal and interest because municipalities are required to levy additional taxes to repay debt backed by the general obligation pledge." The most significant word in that sentence is "likely." [Note: General obligation (GO) bonds are debt instruments issued by states and local governments to raise funds for public works. In contrast, revenue bonds are repaid from the revenue generated by the specific project that the bonds are issued to fund. Only GO bonds are addressed here.]

From a brokerage firm report: "General obligation debt is backed by a state municipal pledge to raise taxes to service debt if necessary." This is also true, but not the whole truth.

Courts have rebutted this pledge. A 1990 Missouri court ruled that "tax caps in effect when municipal debt was incurred cannot be overridden even if necessary to pay off the debt." (Kevin A. Kordana, "Tax Increases in Municipal Bankruptcy," Virginia Law Review) The court admonished the litigating bondholders: "[E]very purchaser of a municipal bond is chargeable with notice of the statute under which the bond is issued." (Missouri had a statutory tax rate cap.) In words the judge might have used: "Stop whining and wasting my time. Next time, read the bond offering."

Aside from a legal interpretation, raising taxes is often impractical. "At a certain point, raising taxes ceases to raise tax revenues." (McConnell and Picker, "When Cities Go Broke," University of Chicago Law Review).

The City of Vallejo, California may be an important precedent. It filed for bankruptcy in 2008. Both bondholders and city employees agreed to receive less money. The decision is before an appeals court.

Claim #2: "General Obligation default rate is 0.01%." This calculation is used to prove Claim #1. From a brokerage firm report: "The default rate on general obligation municipal bonds since 1970 is 0.01%." The calculation is correct. The brokerage firm used the default rate of Moodys-rated GO bonds since 1970.

Although true, this is misleading. It seems like yesterday when all - and it was all - the certified experts bellowed: "House prices never go down nationally." Just as mortgage payments had risen to uncollectible heights, municipal costs have risen to unsustainable levels. This is a different world than the period addressed by the Moodys study.

Even though money rained on municipalities during the salad days (sales tax revenue increased 46% between 2003 and 2007), it was only by playing games with the books and issuing a record amount of bonds that municipal spending grew so extravagantly over the past decade. States and municipalities issued $442 billion of bonds over the five years from 1998-2002. They issued $804 billion over the next five years, 2003-2007. The growth rate was not quite as steep, but, not dissimilar to mortgage securitizations and private-equity LBOs. The downward slope may not look that different, either.

Claim #3: "Most states are required by law to balance their budgets." This implies the restriction on revenues diverging from spending reduces the possibility of default. Municipal finance is often a shell game, shifting capital-project funds to meet today's burgeoning payrolls and benefits. [See Miami's Municipal Woes (Again): Exiting Before the Tide Goes Out].

Claim #4: "States cannot declare bankruptcy." This is a conclusion drawn by statements such as the following from a brokerage firm report: "The state is not permitted to file for Chapter 9 bankruptcy. Such filings are permitted only for 'municipalities' (e.g., levels of government below the state) under certain conditions." This is true. Bankruptcy law in the United States does not address the states. This does not mean states will not default. They might be in limbo according to the bankruptcy code, but still bankrupt according to the dictionary: "Any person unable to pay his creditors in full." Bondholders should take heed of the dictionary instead of waiting for the law to codify state bankruptcy.

Claim #5: "There has never been greater demand for municipal bonds." This is a sales pitch that implies "buy now, or you'll regret it later." Evidence for this claim is the willingness of retail investors to buy California municipal debt that yields 2% (for debt maturing in 2012; 5.8% for debt maturing in 2030). Another "get 'em while they're hot" argument is an initiative in Congress that would end the tax deductibility on interest from municipal bonds issued in 2011 and after.

First, the possibility of Congress passing such legislation is remote. Second, the "safe" asset classification by financial advisers is the real energy propelling retail investors into municipal issues. It was only two years ago when money market funds were thought of as "safe." They were often classified as "risk-free." (Beware of investment categories and classifications. Labels are often applied after their characteristics have been deemed predictable. By the time the predictable has been awarded a classification, the category has probably attracted too much attention and mindless buying.) After panic selling in September 2008, the federal government guaranteed the net asset value of money market funds.

Municipal appetite is also strong because Federal Reserve Chairman Ben Bernanke has chased savers out of short-term investments. His monetary policy (zero percent fed funds rate) is designed to refloat too-big-to-fail banks (that invest at zero percent and buy 3% Treasury notes) while leaving savers in the poor house. Municipal bonds produce some income, so are the new "cash" option.

Individuals are the only remaining net buyers. In 1975, commercial banks, savings banks, life insurers, and casualty insurers were municipal bond buyers. Only the individual is left today. This is a lonely outpost.

By Frederick Sheehan

See his blog at www.aucontrarian.com

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, November 2009).

© 2010 Copyright Frederick Sheehan - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in