Who will pay if there are municipal bond defaults?

I have written quite often saying that rising oil prices can be expect to lead to debt defaults. For a while, some of this was hidden through lower oil prices and stimulus programs, but we are now beginning to see problems arise again, this time in the area of municipal bonds. The question is, “Who ends up holding the bag, if major municipal bond defaults take place?”

“Municipal” bonds include bonds issued by states, as well as bonds issued by cities and by many types of smaller entities, such as hospitals and toll roads. To date, everyone has assumed that there is not much risk of default, and even if there is, someone else will handle it. But if one looks at the long term oil situation, and the problems states and cities are having already, it is pretty clear that the debt default problem is likely to get worse over time, and there is really no one set up to handle the default risk.

There are many ways debt default problems arise from higher oil prices. One path is

Higher oil prices -> less money to spend on discretionary items -> less demand for new homes -> lower home prices -> more debt defaults

Another is

Higher oil prices -> business layoffs -> unemployed unable to make debt payments->defaults on loans.

Some of these debt default problems fall through to cities that try to collect taxes on the value of homes. States find themselves in poorer financial condition, in part because they have to pay more benefits to the unemployed (without an increase in tax revenue), and in part because road repairs cost more.

Now municipal bonds seem to be having some of the problems that have been expected.

Wall Street Journal illustration

We read yesterday that New Jersey scaled back its offering by 47% yesterday, when it found required interest rates were higher than expected. Interest rates seem to be rising, especially on longer-term debt. Higher interest rates are themselves a problem, because if makes it more difficult to afford the current level of debt.

An even bigger part of the problem has to do with defaults. I wrote back in early 2008 that “monoline” bond insurers–the ones insuring municipal bonds were likely to encounter financial difficulties.  And I was right. Several municipal bond insurers did run into difficulty.

One of the big ones, MBIA, is in the news again now. It restructured in such a way as to provide less protection in the case of default, because of its financial difficulties. If insurance companies cannot provide coverage in the case of a municipal bond default, banks who have issued letters of credit guaranteeing these loans are next in line to pay. Banks sued to challenge MBIA’s restructuring plan, and initially a lower court ruled in favor of the banks.  Now, this week, a New York appeals court overturned the lower court’s ruling, leaving the banks with less protection.

In an article this morning, the Wall Street Journal tells us that bank letters of credit, which would also insure against the risk of default, is becoming less available and more expensive. We don’t know that this is a direct result of the MBIA ruling, but it no doubt didn’t help. The WSJ indicates that there are many municipalities in need of new letters of credit, but are having difficulty getting them. Without the letters of credit, they are in danger of losing their financing. An unusual number of letters of credit are rolling over now, because many municipalities were forced to arrange new financing in 2008, and the letters of credit written then were written to last for only two or three years.

It is certain that someone will left “holding the bag” on municipal bonds that likely will default in the next few years, but there is no program set up to handle this risk, that is “strong” enough to actually shoulder the risk.

Insurance companies do not charge much for insurance coverage for this risk, so they do not have much in the way of funds backing the coverage. If the insurers fail, there is no federal program guaranteeing the programs if they go under.

Banks offer backup default coverage (or full coverage, if there is no insurance available) through their letters of credit. But until recently, they seem to have paid little attention to this risk. They are not required to report this risk in their financial statements, so no one knows how much coverage is offered by banks.

Ultimately, if there is no coverage from banks or insurance companies, the risk of default goes to those holding the municipal bonds. There are obviously many different types of bond holders, but insurance companies tend to be big buyers of municipal bonds. Because of this, I would expect that insurance companies would be affected more than most businesses. Defaults would  first act to reduce the “equity” cushion of insurance companies, but eventually would reduce the funds they have available to pay claims to policyholders.

If the funds insurers have available to pay claim are reduced, the effect of municipal bond defaults may come back to those with insurance policies. While there are programs set up to handle many types of insurance company failures, they generally assume that solvent insurers will be assessed to pay the costs of insolvent companies. Such a scheme works for a while, but not if there are huge numbers of claims.

Ultimately, I am afraid we all may pay for municipal bond defaults. The federal government will try to bail out municipalities, banks, and insurers, but it won’t really be able to. Interest rates will rise. The result will be increased financial difficulties all around.

About Gail Tverberg

My name is Gail Tverberg. I am an actuary interested in finite world issues - oil depletion, natural gas depletion, water shortages, and climate change. Oil limits look very different from what most expect, with high prices leading to recession, and low prices leading to inadequate supply.
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10 Responses to Who will pay if there are municipal bond defaults?

  1. marty schoffstall says:

    many if not most municipalities in PA make a much larger amount of money from earned income taxes over real estate taxes, as such, they have already seen a decrease
    in their revenues and it has pared their budgets, or led to increased taxes, or both.
    The cycle for valuation of houses is I believe 10 years in PA by law, with the ability to challenge the valuation by the owner, these challenges are now at a record level, but realistically downward valuation and downward revenues are a trailing situation.

    The socialized & subsidized Build America Bond (BAB) program (built on a very obvious false premise) is now gone and we are now back to the original quasi-free muni market that we had before. The opportunity in the market is to price the real risk of various offerings by the tens of thousands of eligible entities, making the assumption that 1) undistorted info is available (in DC this is called real truth), 2) the rating services can actually do their job, 3) the insurers are available. The letter of credit piece is not intrinsic but it has been significant to some and of late.

    While you are dealing with the default of past issuance (which is important), the next months will be focused on continuing issuance, either for “projects” or “revenue bonds”. And they are two different worlds of hurt moving forward. Making the assumption that a muni was to build a project that had revenue (like gas, water, sewer, electricity), then things are easier, even in default the possability of a court settling this through a “lockbox” arrangement is possible. The problem is projects that are based on tax, ie my free highway that my local/state tax will pay for, there is a lot of difficulty there. The naked guy at the party are the revenue bonds that are needed for “operating cash flow”, they can be (and my opinion essentially are
    for states like California) the equivalent of financing your lifestyle from a stack of credit cards.

    It would be great if the above 3 requirements were met, and lenders could start thinking about both what and to whom they are lending too. It is hard to believe that Illinois/California aren’t Greece equivalents (11% bonds), and say Vermont isn’t a Germany equivalent (3%). The last two years under BAB socialized muni’s under the implicit guarantee of the federal government, and risk really wasn’t priced in my mind. Throughout the 90’s as the GIC’s grew, the whole debate as to whether Ginnie was or was not guaranteed by the government was eventually settled in the last 36 months. Much to the detriment of the US taxpayer.

    Given the state of this administration and the state of our culture any additional socialized risk appears to me to be dangerous. Much of the historically acceptable socialized risk from pensions, to health insurance, etc. seems to be either not working or completely ill-understood in our current political economy of “yes to everything”.

    • Interesting points. As you dig into this, there are more and more working parts, and more and more special situations. But it is hard to see many of them will work out very well.

      As long as there is a possibility of borrowing money now to pay for a program later (and lax lending standards) there is going to be someone who wants to take up the offer. The hope is that someone else in the future will pay the costs. This only works well when the economy is growing.

  2. Owen says:

    An oddball reality is that foreign banks are getting heavily involved in swaps. US munis are swapped every which way to Sunday and if UBS and Credit Suisse pour some notional billions into rate derivatives or outright default swaps, we could see a transformation of Illinois into a bona fide global Too Big To Fail entity.

    In which case the obvious thing starts to happen. US states get lines of credit from the ECB, given that Bernanke told us last week he is legally constrained from buying munis with maturities longer than 6 mos.

    Let’s just look at that situation and lean back and simply recognize that the world has gone insane.

    • Jb says:

      Or, as this article suggests, Congress changes the rules and expands the role of the Federal Reserve: http://www.huffingtonpost.com/ellen-brown/the-fed-has-spoken-no-bai_b_808094.html?ref=fb&src=sp

      As insane as that sounds, it might be the path of least resistence.

      I met with two city employees last week working on the city’s carbon footprint. In the course of the conversation, they told me that about 40% of our local city residents live below the proverty line. I was stunned. Where are they going to get the money to keep things running?

      • The Ellen Brown article is interesting. She talks about $140 billion needed to bail out the states. I wonder what that includes. Is that just state budget shortfalls? There are a huge number of state pensions that are badly underfunded. I doubt that they are included.

        There are city governments that are struggling. These also often have pension plans. And there are a lot of separate entities like toll roads and college dormitories that we financed by bonds. Most of these are doing all right now, but a person wonders about the long term.

        • Owen says:

          I am a bit annoyed at the direction the discussion goes in that article.

          The states need a bailout is the starting point. If they don’t get a bailout they will default . . . is the continuation.

          How is this valid? If the states instantaneously reduce their deficit to zero via spending cuts and tax increases, there is no need for a bailout.

          What the position seems to be is this:

          These states must be allowed to spend beyond their means because . . . nevermind because. They simply are *entitled* to have things and lifestyle/services they cannot pay for and no one is allowed to challenge this — and thus, given that lenders will no longer lend money to spend beyond their means, some magical new lender must be found who will provide that money for . . . let’s use the word . . . extravagant . . . services and indeed, perhaps it will be a form of magic that will never require repayment.

          Let’s also note another premise that is bogus . . . that these states and local governments are in difficult times solely because of the economic Apocalypse. Not so. These states were running worsening deficits before 2007.

          They Live Beyond Their Means. When their means decline, so must their expenditures. They played the borrow until things are better card already. No more such cards are in the deck so it is time to fire people and shut off departments. Period. Increasing taxes won’t work — not in the context of right wing ideology but in the context of Peak Oil. It’s Not Going To Get Any Better. Cut Now. You can help more people if you cut now.

          There are similar games being played in the re-definition of the word “default” as is transpiring in the Federal debt ceiling discussions. “Default” refers to and only to debt interest. Fail to pay interest on debt and you have defaulted. If a contract is signed and reneged on, that is a cancellation (with cancellation fees), not a default. If employees are fired for lack of salary funding, that is a layoff, not a default.

          Failure to raise the debt ceiling does not equate to default, but that’s the verbage du jour. There is ample tax revenue to fund interest on the national debt. One helluva lot of other things would get cut (including DoD), but it would NOT be a default with global swap triggering consequences.

          There would be a smash of GDP growth, and tax revenue the next year, requiring even more cuts, but the sensitivity of GDP growth to fiscal balances would be hit far less severely in year 2, and then even less in year 3 etc. The point being, again, Peak Oil doesn’t provide us years and years and years to work through these debacles. Cuts have to be NOW. More can be served / saved as the post Peak world asserts itself if the smash is endured now rather than when the trucks stop bringing food to shelves.

          • My impression is that Ellen Brown does not understand peak oil and its implications. I expect Ellen Brown, like most people today, has the mindset that things will keep getting better and better, so that funding prior obligations will not be much of a problem and paying off debt will not be a problem. In that context, living beyond ones means today is not a huge problem. All one needs to do is to pay for it tomorrow.

  3. Hi Gail,

    Thanks for your feedback on my last Maine degrowth planning blog post. I’ve just posted my second installment in the series, which recapitulates a good bit of your excellent article on Oil and the Economy on the way to a more politically doable (?) GDP degrowth projection for Maine.

    Your analysis here is constructively provocative. I think we’re going to face a major and justified collapse of confidence in the existing system of money, credit, and banking, which will only be resolvable through reform of the Federal Reserve (following Zarlenga’s model) and a new system of state and local banks (following Brown). Most of the big banks and a lot of households will go bankrupt, and many “banksters” (banker gangsters) will lose more than their assets, as should be the case, given the extent of the injustices they have perpetrated. Interests rates will rise as investors scour the world for “real credit,” i.e., something to really bank on, to invest in, to lend to, and that will be state and local units of government that are systematically planning for degrowth to a steady-state economy, including a post-petroleum agrarian foundation and the safety nets that will maintain public health, civil order, and workforce redevelopment. These state and local governments will also emerge as the most attractive locations for those eco-savvy business and nonprofit entrepreneurs who want to grow their organizations in the context of the most proactive steady-state infrastructure available. So I think we could see a flocking of capital, talent, and credit to those pilot and pioneer communities that figure out how to engineer whole systems degrowth.

    An American Renaissance may diffuse outward from these state and local communities.

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