Another Take on Munis as the Next Big Short
Here's a piece on municipal bonds by Rich Bookstaber, an SEC adviser and author of Demon of Our Own Design, a well-received book on derivatives. The article is a few months old, but -- since the muni market has yet to blow up -- it's still timely. See the last paragraph for a succinct explanation of the main risk to muni holders in particular and the economy in general.
The Municipal Market
This represents my personal opinion, not the views of the SEC or its staff.
My first blog post was in June, 2007. It was titled "What sorts of crises am I worried about now." My answer was housing and credit. With the benefit of hindsight, this might be considered a no-brainer, although at the time it was not so clear where things would go.
Now as the dust settles from the crisis that emerged in 2008, we can start to think about what might come next. And yes, the crisis really is settling down, despite the alarmists who, thinking we were in a 1930's style depression, pushed the panic button and stuffed their mattresses (or portfolios) with cash. For whatever reason, be it astute government intervention or the natural healing process, we are looking back at something along the lines of a bad, credit-driven recession.
I don't think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don't come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.
So, where to look next. To see other potential sources of crisis, let's first recount the lessons learned from this crisis:
- Problems occur when things get leveraged and complex (and thus opaque).
- If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
- The notion that you can diversify by holding a geographically broad-based portfolio, ("there has never been a nation-wide housing recession"), works fine - until it doesn't.
- A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
- Don't bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
- Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn't. Income that was supposed to be there to finance the mortgages - even when that income was fairly stated - became committed to other areas (like second mortgages).
Well, guess where we have a market that is (1) leveraged and opaque, that is (2) very big and tied to the credit markets; and is (3) viewed by investors as being diversifiable by holding a geographically broad-based portfolio; with (4) huge portfolios where assets and liabilities are apparently matched; and with (5) questionable analysis by rating agencies; and where (6) there are many entities, entities that may not approach default with business-like dispatch, and that have already mortgaged sources of revenue that are thought to support their liabilities?
Answer: The municipal market.
Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.
Size and potential systemic effects. That this is a big market in the credit space goes without saying.
Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn't just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?
Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky -- the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.
Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net - the under funded portion of the portfolio.
Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group - the local taxpayers - to deal with.
Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.
Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt - democracy at work.