Back in December of 2010, banking analyst Meredith Whitney went on 60 Minutes and famously declared that a wave of municipal defaults was set to strike the U.S. in 2011. Alas, her prediction did not come to pass as municipal bonds have actually performed very well over the past two years. At the time, her warning made sense since most municipal governments are reliant on property taxes for revenue. With the housing bubble popped and a large inventory of foreclosed homes being left in the wreckage, the perfect storm really did appear to be on the horizon. But with a string of California cities defaulting recently, at least one prominent financial commentator has fallen into Whitney’s camp. As Zerohedge reported, last month Warren Buffet terminated his position in muni bonds five years early for a loss of a few hundred million. Given how highly connected Buffet is in the elitist establishment of politicians, financiers, and central bankers, it’s a safe bet that he knows something the average guy doesn’t.
Nevertheless, the municipal bond market has still found plenty of buyers so far in 2012. According to the latest BlackRock analysis, the market saw a .23% gain in the month of August. Issuances totaled $31.8 billion which was a 33.6% increase compared to August of 2011. The New York Times recently reported the junk bond sector is booming as investors are scrambling for higher yields amidst the low interest rate environment.
“In a yield-starved world, high-yield bonds are right now the only game in town,” said Les Levi, a managing director at the investment bank North Sea Partners. “The market is giddy.”
Investor legend Jim Grant once suggested that if he were Fed chairman, he would open the central bank’s first Office of Unintended Consequences. The flight into municipal bonds could be due to different reasons but in all likelihood it has been a consequence of the Fed’s policies. If and when Bernanke decides to hike interest rates, this will burst the bubble in muni bonds and send the market spiraling. Why? The logic is simple: because rates are so low, bond yields are also at historic lows. When rates rise, as they will inevitably do, so will yields and value of current bonds will plummet.
As Senior Editor of Agora Financial and the Laissez Faire Club Doug French explains,
However, bond and yield mathematics are set to deliver a cruel lesson. When interest rates go up, bond prices go down. Suddenly, what was supposed to be a safe bet looks like 2009 all over again.
The math works this way: Say the coupon (annual payment) on a particular bond is $100. Your broker says the bond you’re contemplating for purchase is yielding 6%. $100/.06=$1,666.67 bond price. Easy enough so far. But when interest rates increase — and they have nowhere to go but up from here — or if your bond issuer runs into financial trouble, bond buyers will insist on a higher yield.
The $100 coupon doesn’t change (except for a default), but if the market demands a yield of 8%, that bond’s principal value will now fall to $1,250 ($100/.08). That 2% interest rate change whacked 25% off the principal value of the bond.
For example, Moody’s Investors Service has reported that from 1970 to 2011, there were only 71 municipal bond defaults. But the Fed report counted 2,521 defaults in that time.
For some cities however, it has not been enough. The California cities of Stockton, San Bernardino, and Mammoth Lakes all declared bankruptcy last July. According to Moody’s, more are to be expected as slow economic growth continues to deplete tax revenue and increase strain on the pocketbooks of municipalities.
The thing is, this increased fiscal pressure on local governments was entirely predictable. There is a misconception out there that municipal governments are more trustworthy than those at the state and federal level. A recent survey conducted by Rasmussen showed that 40% of Americans trust their local government more than any other. Only 23% answered that they trust the federal government the most while just 12% put their faith in state government. Because city councils and school boards are typically made up of residents of the community, it is believed they are more responsive to the needs of the people. This may be true to some extent but local governments are still governments in the end. Those who reside in their offices claim the authority to tax, regulate, enforce land zoning, educate children, and provide utilities. In other words, they claim the right to steal and centrally plan the lives of residents through the use of force. Geographic proximity doesn’t negate the moral condemnation the state deserves. The coercive taking of income tends to give its custodians the incentive to make expensive promises. It leads to the money being spent fast and loose to buy votes and appease special interests.
For local governments, it has meant bowing down to the demands of unions. These public sector unions use their government-granted privilege of extortion to receive above-market wages for their members. They use the threat of violence to suppress any potential workers who would voluntary work for a lower wage. This, above all else, has made it difficult for local politicians to be flexible with changing economic conditions. Change is a constant in the private marketplace. Unions act against natural change to benefit their members and make society as a whole poorer as a result. When recessions strike, public sector unions fight tooth and nail against pay decreases or increased contributions toward benefits. In protecting their pay packages that private industry couldn’t afford, unions, in Murray Rothbard’s words, gladly stick “a knife into the ribs of John Q. Public.”
The ongoing strike by Chicago school teachers over a new evaluative process and job security is a perfect demonstration of the rigidness unions promote. Instances such as these are even more reason to believe that municipal finances are unsustainable in the long run. Combined with the Fed’s low interest rates policies, default is inevitable at this point. Unionized public sector employees have no reason to stop gorging at the taxpayer trough. As the old adage goes, something that can’t go on forever won’t. When the bubble pops, we can only hope that Bernanke’s reputation as the brilliant and heroic money printer will deflate along with it.