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The Hard Truths Of Facing Muni-Bond Reality

  • Written by Syndicated Publisher No Comments Comments
    July 30, 2013

    Following up on my timely post ‘Here Come Those Municipal Defaults That Everyone Said Couldn’t Happen, Pt 2‘, I comment on Meredith Whitney’s OpEd in the Financial Times.  If you remember, she – like I – warned of municipal defaults years ago and was ridiculed for such.  Ms. Whitney is quoted as saying:

    “As jarring as the reality may be to accept, Detroit’s decision last week to declare bankruptcy should not be regarded as a one-off in the U.S. municipal market.” she said.

    “There are five more towns like Detroit in Michigan alone. There are many more municipalities across the country in similar positions.”

    “The bill for promises past is now so large for some cities and towns that it is crowding out money for the most basic of services – in the case of Detroit, it could not even afford to run its traffic lights,” she said.

    “Will [lawmakers] side with taxpayers, unions or the municipal bondholders? If they back residents, money will be directed to underfunded public services at the expense of pensions and bondholders. If they side with the unions, social services will continue to be cut and the risk to bondholders will increase considerably. If they side with bondholders, social services and pensions are at risk.”

    In the case of Detroit, elected officials, for the first time in a very long time, are siding with residents, Whitney said. This is a new precedent that boils down to the straightforward reality of the survival and sustainability of a town or city, she said.

    “After decades of near-third-world conditions in the richest country in the world, the city finally stood up and said enough was enough,”

    Well, this is the problem. Defaulting on revenue bonds where the underlying asset (ex. a housing project, utility, or infrastructure project) is not generating the sufficient cash flows is part and parcel of the risk of investing in said class of bonds. This is widely accepted and understood, which is likely why those bonds have a slightly higher yield.

    For some obscene reason, defaulting on the general obligation bonds which purportedly carry the “full faith and credit’ of the municipality as a back stop is deemed as wholly different affair. The reason? Who the hell knows? This is a point I tried to drive home in the original  Here Come Those Municipal Defaults That Everyone Said Couldn’t Happen article in 2011. Backing by the full faith and credit of a public entity does not make an investment risk free. To the contrary, if said entity is fundamentally insolvent, the investment is actually “riskful”as opposed to risk free.

    Treating these bonds as unsecured in the bankruptcy is essentially the way to go. If you don’t want to do that, well you can still consider them backed by the full faith and credit of the insolvent municipality, which is essentially unsecured – and move on anyway – particularly as many potential collateral assets of value would have likely been encumbered by agreements with a little more prejudicial foresight.

    A GO default from a city the size of Detroit will dramatically change the face of GO bonds going forward. Now that the hoi polloi and tax free investing masses have been awakened, a true accounting of the risks involved will cause a much more realistic risk premium to be placed on GO bonds everywhere.  This wll be in addition to the natural increase of rates coming from the end of a 28 year natural bull market in bonds, in addition to the economic and market snapback borne from the end of the artificial eztension of said bull makret through ZIRP and direct credit market maniputlation by the Fed.

     

    Yes, a triple whammy coming to a bankrupt (or soon to be) state, city, town, or political subdivsion near you!

    The good news? Those pension funds that hold municipal assets (due to the uneccesary tax shielding from muni’s in a qualified account, not many) will get a higher yield on their bonds. The bad news? That yeild likey will not get paid!

    This may push rates higher in general, after all they’re artificially low to begin with. ZIRP has done it’s fair share of damage, and a snap back to market rates will hurt all the more…

     

    And then there’s those monolines who’re just working out that 90x leverage problem from the housing crisis (reference A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton)…

    And then…

    Of course, we can’t leave out those rating agencies who warned us all about the impending doom…

     

    And from the must read post, Banks, Monolines, and Ratings Agencies As The Three Card Monte (Wall)Street Hustlers! Its a Sucker’s Bet, Who’s Going to Fall for it in QE2?

    Three Card Monte is a scam designed to separate a fool from his/her money. It is quite efficient, particularly when fools are involved!
    The Boogie Down BronxThe big secret to the Morgan Monte Scam is that it is 10% sleight of hand and 90% teamwork. Even if you are not deft enough to capture the sleight of hand, the key in avoiding it is to recognize the team players, whose key player is often YOU – The Mark!The retail/typical qualified fund investor = “The Mark”

    Monolines/FIRE sector= The Operator/Hustler!

    Sell Side analysts = “Jess”

    Rating agencies = “Paul”

    How its done in the UK

     

    Reenactment of 2009’s entire year of Wall Street earnings

     

    How its done on Wall Street, see outset…

    Next, up we let the late Biggie school you on how Wall Street banks follow the Ten Crack Commandments!

    Images: Flickr (licence/attribution)

    About The Author

    Reggie Middleton is an entrepreneurial investor who guides a small team of independent analysts to uncover truths, seldom if, ever published in the mainstream media or Wall Street analysts reports. Since the inception of his BoomBustBlog, he has established an outstanding track record

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