Thursday, August 16, 2012

Municipal Governments: Default Rates Higher Than Thought

“Moody’s Investment Service has reported that from 1970 to 2011, there were only 71 municipal bond defaults.  But (a Federal Reserve Bank of New York) report counted 2,521 defaults.”

“The report found a similarly vast gap in the raw numbers of defaults when it looked at data from Standard & Poor’s.  The Fed’s combined database indicated 2,366 defaults from 1986 to 2011, compared with S & P’s 47 defaults during this same period.”

These quotes are taken from the New York Times article, "Muni Bonds Not as Safe As Thought".

The difference in the figures is that Moody’s and Standard & Poor’s just report on rated bonds whereas the report of the Federal Reserve Bank of New York considers both rated and nonrated bonds.

Now most investors and investment funds just invest in rated bonds so that the report of the rating agencies represents what most of these investors face.  And, the default rate of the rated municipal bonds rests slightly below one percent.

However, if we are looking at the state of the economy and the state of municipal finances we need to look at all defaults and not just the defaults of the rated issues. 

But, we need to look deeper into the whole municipal financial to really understand what it going on in the municipal area.  “The Fed researchers said that debt backed by a city’s own general obligation pledge seldom defaults, while debts backed by revenues generated by individual projects were more uncertain.”

Bonds related to housing projects contributed 17 percent of the defaults; nursing homes accounted for 12 percent; and health care projects provided 11 percent.  But, the largest contributor was industrial development bonds, which made up 28 percent of the defaults.

And, it seems that municipalities are taking more and more risks on bonds, some of them related to educational efforts.  See the reference to the issue by the San Diego educational authorities mentioned in my August 11 blogpost, "Sour Time for Cities".  In this case, Poway Unified, one San Diego educational district, issued 7 percent “capital appreciation” bonds.  There is no need for Poway Unified to pay back interest or capital until 2033, and when the bond is repaid in 2051, the district will have paid back to investors 10 times the amount initially borrowed.

The total default rate on municipal bonds, both rated and non-rated appears to be about 4.5 percent.  This in not a huge number, but it is certainly not as low as most of us perceived the default rate on municipal bonds to be. 

Also, the Fed researchers noted that municipal defaults are not as closely tied to economic downturns, as are corporate issues.

The trend in municipal defaults seem to be tied to longer, more secular movements in the economy and not just business activity.

For example, at the start of the period covered by the research, 1970, public labor union membership was a very small of the labor union movement and not particularly strong.  Currently, public labor unions make up over 50 percent of the membership of labor unions in the United States.

Furthermore, in 1970, homes in the United States had not become the “piggy bank” of the middle class.  The inflation of home prices really began in the late 1960s and early 1970s and the almost continuous rise in the price of housing became the “go to” source of revenue for governments to raise the salaries, pensions, and other benefits of rapidly growing municipal employment roles.

According to the Federal Reserve figures, only 155 municipal defaults took place between 1970 and 1986…sixteen years.  This meant that about 10 defaults took place every year during this time period. 

From 1986 through 2011, 2,366 defaults took place.  Over this latter 25 years, the country averaged almost 95 defaults per year. 

And, the number of defaults was much greater during the latter part of the period than it was in the late 1980s and early 1990s.

Bottom line: municipal bond defaults are much more of a problem than many people have believed to be the case.  And, from all indications we are not out of the woods yet in terms of turning this situation around!

I have written a lot over the past year or so about the problems facing state and local governments.  Unfortunately, many state and local governments are not unlike the Greek government in under-reporting their fiscal situations.  And, in many cases we are just learning about them now.

I believe that we are still facing many problems in the state and local government realm due to unreliable accounting practices, declining tax base, promises to constituents relating to social services and education, and militant public labor unions.  Working out these problems is not going to be pretty…but, state and local governments cannot return to a prudent operating condition until they are worked out.

As a consequence, there will be many more bond defaults in the future, especially municipal bond defaults.  They may be non-rated bonds, but they are municipal bonds, but they are municipal bonds none-the-less.  These defaults will continue until these institutions get their act together and their budgets and accounting by in line. 

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