CNBC's John Carney has written an interesting series of posts this week, challenging the conventional wisdom that municipal bonds are low-risk investments. He argues that municipal bonds must be analyzed differently than corporate bonds, because municipal defaults are highly likely to be essentially voluntary, while corporate defaults come only when they are forced by economic or business plan circumstances. Essentially, he contends, municipal default should be viewed through the lens of political risk, rather than economic risk.
I think he overstates his case here, when he argues that political factors are likely to make voluntary defaults attractive to municipal issuers:
Think about it this way. The muni bond optimists claim that typically issuers will implement a combination of aggressive spending cuts and tax hikes if they encounter financial distress. But this is unrealistic. It's far more likely, in the current political environment, that many governments will find themselves between the Tea Party Scylla resisting tax-hikes and the public worker Charybdis resisting spending cuts. It should be at least acknowledged that there is a strong possibility that bond holders will not emerge unscathed between these forces.
Corporations almost never chose to lower their revenues, especially if doing so would interfere with debt payments. State and local government frequently cut taxes and lower revenues. The projected revenue stream of state and local governments is not just a function of the market--it is subject to strong political decisions.
The equity of shareholders is often wiped out when a corporation goes into bankruptcy. Nothing that belongs to citizens is wiped out when their city or state defaults on debt. This means that citizens do not have the same comity of interests with bondholders. They can choose to default without suffering a direct penalty.
There are two problems with this case. One is that state governments are the only issuers that may be able to engage in truly voluntary defaults. Municipal governments and authorities, which back a large majority of muni bond debt, can only default on their debts if their parent states permit them to do so. Some states forbid municipal bankruptcy, imposing state control boards over municipalities that fail to meet their obligations; others allow bankruptcy, but only subject to financial tests.
So, the scenario Carney describes--taxpayers and public
workers colluding to enrich themselves by throwing bondholders under the bus--would
in most cases require the approval of a state authority that isn't likely to
look kindly on frivolous default. States wouldn't stand for voluntary defaults because they
would increase borrowing costs for the state itself and other non-defaulting
municipal issuers, and because many of the bondholders facing losses would be residents of the state but not the defaulting municipality.
The other problem with Carney's argument applies to sub-state issuers and also to states themselves: a default on bond debt brings limited upside and significant downside for taxpayers and public workers. True, taxpayers don't see their financial interests wiped out after a bond default, like corporate shareholders can expect. But a government that defaults on its bonds will lose bond market access at least for a time. This imposes significant costs on taxpayers.
Furthermore, the governments dealing with the largest debt loads tend also to be dependent on borrowing to finance current-year operations, especially state governments. While every state except Vermont has some sort of balanced budget requirement, many of these requirements are full of loopholes that allow states to run budget deficits. A state that defaulted on its bonds would no longer be able to borrow, and therefore would have to move its budget into primary balance--causing exactly the sort of painful fiscal adjustments that taxpayers and state workers would be hoping to avoid by defaulting in the first place.
Governments are also heavily dependent on access to the short-term debt markets to manage their finances--for example, floating revenue anticipation notes months in advance of expected tax receipts. Losing this access would force governments to take cash-management actions not very congenial to taxpayers or public workers--moving tax payment dates forward, withholding tax refunds, paying employees with IOUs, and the like.
States would also likely respond to their loss of bond market access by withholding aid payments to independent agencies and municipalities, as has been a key part of Illinois's cash-management strategy while that state's legislature delays its approval for issuance of more bonds. That would likely lead to tax increases and service cuts at the local level--and would lead bond investors to demand higher yields from municipal issuers or withdraw their market access altogether. This would again increase costs for the same set of taxpayers hoping to save money through the state's bond default--and/or force spending cuts unfavorable to public employees.
All of these troubles would be incurred to achieve relatively little in the way of savings. For example, California's total state-level debt service (interest plus principal) is in the range of $6 billion per year in each of the next several years. Defaulting on these obligations would save roughly $162 per resident, compared to roughly $5,100 in tax collections per capita. In that light, the payoff for accepting a loss of access to the bond markets looks rather small.
In summary, municipalities and authorities do not have ability to default voluntarily in the way Carney describes. State governments may have that ability, but they are not likely to find it an appealing option. So, while there is a theoretical path for fundamentally voluntary municipal bond defaults, I think the more likely models for municipal bankruptcy are two that we have seen historically.
One, exemplified by Vallejo, California, is the case of a municipality that has hit either legal or economic maximums on its ability to levy tax revenue, and has incurred pension and contractual obligations that it cannot service with that amount of revenue. Other California municipalities such as Benicia, Bell and Maywood are in danger of suffering this fate--and possibly larger ones, like San Diego, which have particularly mismanaged their pension systems.
The other category consists of what I would call "freak accident" defaults. Classic examples include Orange County, which went under because of its treasurer's misadventures in investing the county's money in the derivatives market, and Harrisburg, Pennsylvania, which is on the brink of bankruptcy because of a trash-to-energy plant project that the city backed with its General Obligation guarantee and which has become a money sink.
If there is a wave of municipal bond defaults, it will be because a confluence of factors--weak tax receipts, poor performing pension fund assets, rising health care costs, and unaffordable union contracts--makes the former kind of default much more likely. But I'm not sure that should be described as a political risk rather than an economic one.