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. 

Structural Economic Problems Connected with State and Local Governments

Many things are contributing to the slow economic recovery taking place and fiscal or monetary stimulus is not going to overcome them.  One reason for this is that some of the things that must be overcome are structural and will require time and patience to correct.

More specifically, one of the economic sectors in need of a major restructuring is the state and local government sector.  The need for such restructuring has been written up in the New York Times, which had a front page article on the subject Wednesday morning, while the Financial Times also contained a similar report. 

The Financial Times summed up the news: “US state governments are in desperate need of reform to solve structural challenges that extend well beyond the cyclical woes of the financial crisis and the recession, including $4 trillion in unfunded pension and healthcare liabilities.”

The difficulties of state governments have grown as the economy slowed and failed to strongly rebound although some states have recently experienced rising revenues.  However, people are being cautioned about becoming too optimistic that the worst is over.

In addition, local governments, as we know given the recent municipal bankruptcies, are also facing continued dark times.  Local governments depend upon property taxes for about 74 percent of their revenue.  These governments have been starving over the past couple of years as the “middle class piggybank”…home prices…have fallen.  And, although there appears to be some leveling out of housing prices, any major recovery of property prices seems somewhere out in the future. 

Furthermore, Washington, D. C. is also contributing to the concern over the state and local government budget situation.  Given the fiscal problems in Washington, D. C., there has been talk of removing the tax exemption of municipal bonds.  This possibility of this occurring could certainly cause uncertainty to rise about what yields investors might receive on their investments in “munis”. 

The basic problem has been that the residents of these areas have demanded more and more services, like education, health, prisons, courts, and other agencies, and the governments have been able to supply these wishes by tapping more and more into the middle class “piggy bank”…home prices…and have been able to underwrite the increases. 

But, another factor has been at work as well, helping state and local government to swell their budgets.  Public unions have grown from a relatively insignificant part of the labor movement to the point where, at present, more than 50 percent of all unionized workers are employed by the government.  State and local governments have been able to pad their payrolls, increase salaries and wages, raise health and pension benefits, and create better and better working conditions during the past fifty years as credit inflation and housing price bubbles have inflated the revenues of these governments.

However, most state and local governments have some kind of “balanced budget” constraint placed upon them.  Yet, in truth, many of these organizations have run "deficits" for years and years. The revenue increases have not kept up with all of these expenses.  As a consequence, state and local governments went to the well…they found out how to use “create accounting” techniques.  This is why these state governments find themselves with $3 trillion of unfunded pension plans and $1 trillion of unfunded health care plans.

And these states must take care of building the new infrastructure of America, of providing a new health care program for America, and of dealing with cries for better schools, a better social net, and a fully staffed organization.   

In addition, this whole state and local government mess is going to get caught up in the next “big” fight about the existence of labor unions!

The health of the labor unions in the Unites States is tenuous, at best.  “The number of workers who belong to a union has plummeted about 20 percent over the last decade.  Only 8 percent of all workers are unionized.”  This from a recent New York Times article, which discusses the future of unions. 

Unions in the private sector have declined dramatically over the past forty years, and, the only real source of strength in the union movement has been in the public sector.  But, now with the sour economy and with a depressed housing market, state and local government budgets are being stretched to the limit and the “creative accounting” is coming back to haunt them.  The resolution of these budget difficulties is not going to take place in the near term and this will lead to more and more fights between governments and public labor unions.

Evidence of this was seen in the tussle that recently went on in Wisconsin between pro-union supporters and Wisconsin Governor Scott Walker. Furthermore, as the New York Times article states “nonunion workers tend to resent rather than applaud the better pay and benefits of their unionized brethren,” adding to the pressure against unions trying to achieve their goals.

But, there will be a fight in the public sector because public sector unions grew up on little resistance from public sector officials.  This was because the public sector officials could always tap into, without much complaint, the rising value of property values and pass-off these rising costs.  If not that, then there was always the deep pockets found in Washington, D. C.  Now, however, the “free lunch” is over.

So, expect a lot of turmoil in state and local government sector over the next five years or so.  Budget realities are setting in at all levels. Pensions cannot go unfunded indefinitely.  Health care costs cannot go unfunded indefinitely.  And, public sector jobs need to be filed in order to cover ordinary, day-by-day operation.

Moreover, the federal government is looking for ways to tap into more revenues, like the taxe on municipal bonds interest mentioned above, or more cuts in expenses, like less funding of state prisons along with their call for more state and local participation in health care and law enforcement.   

 

There are massive structural problems that must be dealt with in the United States before economic growth can really pick up more speed.  Correcting these structural problems is a part of what must be done to help get the US economy growing again at a more rapid pace. However, structural change takes time and patience.   

Problems to Economic Recovery: State and Local Governments

In my post yesterday, I wrote about the slow economic recovery taking place and the need for the economy to achieve some structural reforms for economic growth to return to a level more consistent with that achieved over the past fifty years or so: a 3.2 percent year-over-year rate of growth.

I argued that one of the economic sectors in need of a major restructuring was the state and local government sector.  Well, this post has been followed by several reports in major newspapers concerning the problems that specifically plague the states.  For example, the New York Times had a front page article on Wednesday morning while the Financial Times contained a similar report. 

The Financial Times summed up the news: “US state governments are in desperate need of reform to solve structural challenges that extend well beyond the cyclical woes of the financial crisis and the recession, including $4 trillion in unfunded pension and healthcare liabilities.”

The difficulties of state governments have grown as the economy slowed and failed to strongly rebound although some states have recently experienced rising revenues.  However, people are being cautioned about becoming too optimistic that the worst is over.

In addition, local governments, as we know given the recent municipal bankruptcies, are also facing continued dark times.  Local governments depend upon property taxes for about 74 percent of their revenue.  These governments have been starving over the past couple of years as the “middle class piggybank”…home prices…have fallen.  And, although there appears to be some leveling out of housing prices, any major recovery of property prices seems somewhere out in the future. 

Furthermore, given the fiscal problems in Washington, D. C., there has been talk of removing the tax exemption of municipal bonds.  This possibility of this occurring could certainly cause uncertainty to rise about what yields investors might receive on their investments in “munis”. 

States and local governments, although most of them have some kind of “balanced budget” constraint placed upon them, have run deficits for years and years.  Residents of these areas have constantly demanded more and more services, education, health, prisons, courts, and other agencies as the middle class has grown and as the middle class “piggy bank”…home prices…have been able to underwrite the increases. 

Furthermore, there has been another factor at work as well, swelling state and local government budgets.  Public unions have grown from a relatively insignificant part of the labor movement to the point where, at present, more than 50 percent of all unionized workers are employed by the government.  State and local governments have been able to pad their payrolls, increase salaries and wages, raise health and pension benefits, and create better and better working conditions during the past fifty years as credit inflation and housing price bubbles have inflated the revenues of these governments.

Still, the revenue increases have not kept up with all of these expenses.  As a consequence, state and local governments went to the well…they found out how to use “create accounting” techniques.  This is why these state governments find themselves with $3 trillion of unfunded pension plans and $1 trillion of unfunded health care plans.

And these states must take care of building the new infrastructure of America, of providing a new health care program for America, and of dealing with cries for better schools, a better social net, and a fully staffed organization.   

In addition, this whole state and local government mess is going to get caught up in the next “big” fight about the existence of labor unions!

The health of the labor unions is tenuous.  “The number of workers who belong to a union has plummeted about 20 percent over the last decade.  Only 8 percent of all workers are unionized.”  This from a recent New York Times article, which discusses the future of unions. 

Unions in the private sector have declined dramatically over the past forty years, and, the only real source of strength in the union movement has been in the public sector.  But, now with the sour economy and with a depressed housing market, government budgets are being stretched to the limit and the “creative accounting” is coming back to haunt the state and local governments.  The resolution of these difficulties is not going to take place in the near term and this will lead to more and more fights between governments and public labor unions.

Evidence of this was seen in the tussle that recently went on in Wisconsin between pro-union supporters and Wisconsin Governor Scott Walker. Furthermore, as the New York Times article states “nonunion workers tend to resent rather than applaud the better pay and benefits of their unionized brethren,” adding to the pressure against unions trying to achieve their goals.

But, there will be a fight in the public sector because public sector unions grew up on little resistance from public sector officials.  This was because the public sector officials could always tap into, without much complaint, the rising value of property values and pass-off these rising costs.  If not that, then there was always the deep pockets found in Washington, D. C.  Now, however, the “free lunch” is over.

So, expect a lot of turmoil in state and local governments over the next five years or so.  Budget realities are setting in at all levels. Pensions cannot go unfunded indefinitely.  Health care costs cannot go unfunded indefinitely.  And, public sector jobs need to be filed in order to cover ordinary, day-by-day operation.

Moreover, the federal government is looking for ways to tap into more revenues, like taxes on municipal bonds, or more cuts in expenses, like less funding of state prisons along with their call for more state and local participation in health care and law enforcement.   

 

There are massive structural problems that must be dealt with in the United States.  Correcting these structural problems is a part of what must be done to help get the US economy growing at a more rapid pace. At the end of this time, it is likely that labor unions in general, and more, specifically, public labor unions, will be an even weaker part of the United States economic scene than they are now.