A money manager friend showed me an interesting research report by Frederick J. Sheehan titled “Dark Vision: The Coming Collapse of the Municipal Bond Market. This is a product of weedenco.com and available only to subscribers, but I will summarize it here.

Sheehan starts off by noting that a lack of panic by the ratings and government agencies does not indicate health for a financial market. He cites the fact that the Fed did not anticipate how bad the subprime collapse was likely to be and obviously the Moody’s and Standard and Poor’s ratings were ridiculous.

Sheehan notes that “spending is rising and revenue is collapsing” for all levels of government. Pension fund losses will require governments to double their contributions to pension plans (see my blog posting on public employee pensions). Spending is rising, e.g., in New York City from an average of $65,401 in compensation per public employee in 2000 to $106,743 in 2009. The number of full-time employees in NYC grew as well, despite falling school enrollment. The number of state and local government workers grew from 4 million in 1955 to 20 million in 2008 (5x growth, against less than 2X growth in U.S. population). Those workers receive an average of 43 percent more pay and benefits than a private sector worker.

Municipalities dealt with the separation between taxes and expenses by borrowing. In the mid-1990s, states and cities were retiring as much debt as they were incurring. During the 2000s, though, they borrowed about $150 billion per year in aggregate, peaking at $215 billion in 2007 by which time $2.7 trillion in debt was outstanding, more than two years’ worth of tax receipts.

Barring some sort of miraculous boom in the economy and pension fund investment returns, state and local governments are headed for insolvency and default. This means that valuing a municipal bond becomes a matter for a legal expert rather than an accountant. Even for the legal expert, it is apparently tough to predict what will happen. Let’s start with the Wikipedia article on Chapter 9 bankruptcy: “Previous to the creation of Chapter 9 bankruptcy the only remedy when a municipality was unable to pay its creditors was for the creditors to pursue an action of mandamus, and compel the municipality to raise taxes. During the Great Depression this approach proved impossible so in 1934 the Bankruptcy Act was amended to extend to municipalities.”

Without bankruptcy protection, a city that couldn’t pay bondholders would be forced to raise taxes until it could. This happened to West Palm Beach, Florida in the Depression and property tax rates rose to 42.5 percent of assessed value. Potentially bondholders might demand that the city hand over real estate to satisfy its debts. With bankruptcy protection, it is unclear what happens. Vallejo, California went bankrupt 18 months ago and their obligations have not yet been resolved (story). If courts allow municipalities to walk away from debt they’ll have every incentive to declare bankruptcy and start afresh. There are no shareholders in a municipality to wipe out and therefore the only negative consequence of a bankruptcy filing would possibly be having to pay higher interest rates for future borrowing. If on the other hand, governments are not allowed to walk away from many of their obligations, they will simply run out of cash. Are bondholders senior to pension obligations or not? It may be up to the individual judge. This is “uncharted territory for investors” as my money manager put it (he does not buy U.S. muni bonds).

Municipal bonds are still perceived as almost risk-free by most investors and consequently offer a low yield, according to Sheehan. He points out that if the municipalities don’t default, the investor gets only a slightly better return than in Treasuries. Why take the risk if you’re not getting paid for it?

This ends my summary of Sheehan’s report. My own opinion is that the main lesson of subprime is that an investor cannot rely on the ratings agencies or the government to protect his or her interests. The never-employed guy in Cleveland with the house in a crummy neighborhood and no down payment? The risk that he would never make a payment should have been apparent to any investor who dug underneath the asset-backed security. Similarly, an investor in muni bonds can look at the municipality. Does the state have a shrinking population, high public employee salaries, and a big pension obligation overhang from when the population was larger? They probably will eventually default. And if an insurance company was dumb enough to insure the bonds, they’ll probably be bankrupt too.

http://www.taxfoundation.org/research/show/268.html gives a table of per-capita debt in each state and also the ratio of that debt to GDP. Massachusetts comes in at #1, with more than $10,000 of debt for each citizen and 20 percent of GDP. Each Texan owes about $1,000, by contrast, or 2 percent of GDP. The difference in yield between a Massachusetts bond and a Texas bond is probably not large enough to compensate for the increased risk of Massachusetts defaulting. This LA Times article contrasts California’s spending versus Texas’s.

[Separately, this table should be looked at whenever you’re reading about an economist who says that the U.S. should borrow and spend more on “stimulus”. They’ll tell you that we can afford to borrow another 20 percent of GDP, citing the current federal debt-to-GDP ratio. What they don’t tell you is that your state and local government may already have borrowed an additional 20 percent of GDP!]

The most serious weakness in the article is that Sheehan does not identify the mostly likely candidates to default. Surely Greenwich, Connecticut, whose residents were recently showered with billions of dollars in federally-funded bonus payments, is not going to have trouble repaying obligations incurred when investment bank salaries were much lower. But what about the Rust Belt? There must be cities whose factories have closed, residents have moved on, yet whose bond obligations remain. If so, let’s have the names! If not, how bad can the “crisis” really be?

More: A discussion of Sheehan’s report is available at the Daily Kos.