Local and State Government

States’ Troubles Are Not the Real Risk for Muni Bonds

Posted on Friday, February 4, 2011

Huge state budget shortfalls make for easy headlines about the $3 trillion municipal bond market. But old woes like abysmal disclosure and more recent wounds like damage to the safety net should worry the sector’s tax-wary investors more.
Muni bonds, which pay interest that is generally exempt from federal and state tax, have long been a safe, as well as tax-efficient, place for wealthy Americans to park their cash. But given the recent downturn in the economy, defaults are sure to rise above the minuscule historical average of less than 1 percent a year.
And investors can no longer count on bond insurance to protect them from potential losses. Credit downgrades — or worse — during the recent financial crisis exposed the business of “wrapping” bonds as unsustainable for integral players like Ambac and MBIA, which provide financial guaranty insurance. As a result, less than a tenth of new municipal bonds carry insurance, compared with around half five years ago.
With this safety net much reduced, disclosure matters more. Last year’s financial reform legislation made some improvements like regulating the financial advisers used by municipalities, but did little to shine light onto the sometimes murky debt that comes to market.
For instance, state and local governments, and individual projects they support, don’t have to hand over any financial information to regulators before they raise funds in the muni market, even though they are often aimed at retail investors.
Unrated debt is the worst offender. There isn’t even the comfort of a rating agency assessing it before it’s sold. While this is a small part of the municipal bond market, accounting for 5 to 10 percent of total municipal debt sales in recent years, the total could still be significant — perhaps as much as $300 billion. This has nothing to do with the borrowing of struggling big states; it is smaller cities and towns, nursing homes and other projects backed by municipalities that depend on such financing.
But it’s the steady drumbeat of news about state shortfalls that may be causing investors to vote with their feet and withdraw cash from municipal bond funds. Despite the budget-balancing difficulties states may be having, they are not overburdened with debt. Over all, only 5 percent of state and local government expenditures are dedicated to interest payments, according to the Center on Budget and Policy Priorities. The proportion is nearly unchanged since the late 1970s.
So it’s more likely that smaller, murkier entities — municipalities and projects that did borrow beyond their ability to repay, helped by the absence of disclosure rules — that will default in the fragmented muni market.
But perception is critical in a market where individual investors run the show, holding roughly two-thirds of all munis. And some among the crowd that has flocked into the market over the last two years are now running scared. Investors in mutual funds have withdrawn $20 billion in the last 10 weeks, more than they poured into the market in 2010.
It shouldn’t be an insoluble problem. Unlike the subprime mortgage debt that fed the recent crisis, municipal debt has not been repackaged into exotic securities that obfuscate what underlies them. And for most muni borrowers, debt loads are not crippling.
One answer is to put money where there is disclosure. That would mean investors and their fund managers avoid bonds that come with little or no information, especially those without even a rating firm’s review, and look more favorably on general obligation bonds from states. These come with much more information and are arguably among the least likely issues to default because they are backed by the taxation power of states.
Other responses could involve Congress. Lawmakers might decide to repeal the so-called Tower Amendment. Sponsored by John Tower, the former Republican senator Texas, and enacted more than three decades ago, it exempts muni issuers from disclosure to federal regulators. They might also rethink the rationale for giving investors a federal tax break on muni debt in the first place. After all, subsidized debt invites inefficient spending.
Those moves would do more to bring sanity to municipal finance than the current effort to introduce legislation that would allow states to file for bankruptcy protection.

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