Federal Reserve warns, Calif., other municipal bonds very risky

Aug. 20, 2012

By Chriss Street

Last week, we first reported first that “Permanent Link to Calif. sales tax revenue nosedives 33.5%,” then that “Moody’s warns of mass Calif. municipal bankruptcies.”

During the Great Recession of the last four years, the California private sector was forced to slash employment and infrastructure spending, but the public sector made only modest cutbacks. Much of this state and local spending was funded by selling municipal bonds to elderly investors who were told the “muni market” was safe because the default rate is very low.

Now a new Federal Reserve Board study, “The Untold Story of Municipal Bond Defaults,” debunks the belief that municipal bonds are safe investments and blames the Moody’s and S&P credit rating agencies for deceiving the public. This is sure to fan the flames of the growing panic among holders of California municipal debt. According to the August 15 report:

“The $3.7 trillion U.S. municipal bond market is perhaps best known for its federal tax exemption on individuals and its low default rate relative to other fixed-income securities. These two features have resulted in household investors dominating the ranks of municipal bond holders.”

Individuals own three quarters of all municipal bonds; with $1.879 billion held directly and another $930 billion through investments in mutual funds.  The Fed report emphasized that the perception of a low historical default history of municipal bonds has played a key role in “luring investors” to buy huge amount of municipal debt.

The Fed specifically points out that the perception of low default rates is due to widely advertised reports of low default rates by credit-rating agencies.  But the Fed determined the credit-rating agencies have not told the whole story about the level of municipal bond defaults.

Default records

Moody’s Investors Service and Standard and Poor’s (S&P), the two largest bond rating agencies, provide annual default statistics for the municipal bonds.  S&P reported that its “rated” municipal bonds defaulted only 47 times from 1986 to 2011.  Similarly, Moody’s indicated that its “rated” municipal bonds defaulted only 71 times from 1970 to 2011.  This compares much more favorably to the record of thousands corporate bond defaults during the same period:

But when the Fed tracked default listings from 1970 to 2011 through the Mergent and S&P Capital IQ data bases available to institutional investors, the municipal default rates during the same periods skyrocketed from 71 to 2,521 for Moody’s and 47 to 2,366 for S&P.  The Fed calculated that there were a total of 2,527 municipal bonds that defaulted from the late 1950s through 2011 — confirming that the real rate of municipal bond defaults was 36 times higher than Moody’s and S&P reported to the public.

The Fed warned that information regarding municipal bonds tends to be “self-selected.”  Issuers stop seeking an annual rating from Moody’s and/or S&P, if their bonds are likely to not receive an “investment grade” rating.

The Fed also determined that “the municipal market is bifurcated into general obligation (GO) bonds and revenue bonds.”  GO bonds carry a full faith and credit pledge of a state or local government, but revenue bonds are backed by a pledge of revenues raised from a specific enterprise, such as an airport, hospital, or school.  According to the Fed, over the past 16 years, 60 percent to 70 percent of newly issued municipal bonds were revenue bonds.  Many of these projects appear to be politically justified to bankroll crony capitalist “sustainable” investments as industrial development bonds.  IDB financings often involved new technologies or projects with no historical track record. The Fed wrote:

“the services offered by an alternative energy plant, pollution control facility, or other corporate-like entity may not be considered essential, because of the availability of other energy sources. Thus, these enterprises may have less potential to generate revenue.”

Culpable

The bottom line of the Fed report is Moody’s and S&P are culpable for understating the risks to investing in the municipal bond market.  Within 48 hours of the release of the Fed report, Moody’s acknowledged 10 percent of California cities have declared fiscal crises and disclosed that “across-the-board rating revisions are possible following a review of our ratings on California cities over the next month or two.” Based on the Fed report and Moody’s reaction, California and other municipal bondholders should be panicked.

Chriss Street and Paul Preston Co-Host
“The American Exceptionalism Radio Talk Show”
Streaming Live Monday Through Friday at 7-10 PM
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15 comments

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  1. Ulysses Uhaul
    Ulysses Uhaul 20 August, 2012, 09:17

    PACK AND SHIP!

    -reserve early-

    Reply this comment
  2. Wayne Lusvardi
    Wayne Lusvardi 20 August, 2012, 09:59

    Hmmmm?

    Letter in Wall Street Journal Aug. 19:

    Peggy Noonan assumes the role of Chicken Little in her assessment of California, but the facts contradict her gloom and doom (“A Nation That Believes Nothing,” Declarations, Aug. 11).

    The Golden State is leading the nation in job growth, according to the Bureau of Labor Statistics. California attracts more venture capital investment than all other 49 states combined, according to Standard & Poor’s, and California’s exports are at historic highs after 31 months of steady growth. The state’s bond rating outlook shifted from negative to positive under Gov. Jerry Brown’s watch.

    California’s unemployment rate is the result of job losses that occurred when Republicans occupied the White House and the statehouse. Under Democratic leadership, jobs are coming back. That’s great news for California but “grim salad” indeed for conservative parroters.

    Gil Duran
    Press Secretary
    Office of the Governor
    Sacramento, Calif.

    LINK
    http://online.wsj.com/article/SB10000872396390444508504577594113256762558.html?mod=WSJ_Opinion_MIDDLEThirdBucket

    Reply this comment
  3. Frank
    Frank 20 August, 2012, 11:13

    Uh… maybe somebody should let Duran in on today’s news?

    Bloomberg: California Cities Face Default, Bankruptcy

    August 20, 2012

    “The risk of default on municipal bonds in California is rising,’’
    according to Moody’s Managing Director Robert Kurtter, lead
    author of a report on the subject released Friday. “Across-the board
    rating revisions are possible.’’

    The situation is worsened by the state’s boom-bust real-estate economy and “hands-off’’ policy on the finances of local governments, the rating company said.

    At particular risk are cities in the Inland Empire, east of Los Angeles,
    and Central Valley localities, which run through the middle of
    the state. “We expect more bankruptcy filings and bond defaults
    among California cities reflecting the increased risk to bondholders
    as investors are asked to contribute to plans for closing
    budget gaps,’’ the report said, adding, “however, we expect the
    number of filings will be low relative to the 93 Moody’s rated and
    389 un-rated city credits in California.’’
    — Michelle Kaske and Will Daley, Bloomberg

    Reply this comment
  4. Rex the Wonder Dog!
    Rex the Wonder Dog! 20 August, 2012, 11:49

    Gil is a paid mouthpiece, has a little bit of bias-no one will take anything he says as the truth and he knows that.

    Reply this comment
  5. us citizen
    us citizen 20 August, 2012, 11:53

    bahahahahha Duran is a shill for the dems or he is living in an alternate CA universe. What a load. Im actually surprised that he could say that with a straight face.

    Reply this comment
  6. Rex the Wonder Dog!
    Rex the Wonder Dog! 20 August, 2012, 13:31

    He was biting his tongue to stop from LOL!

    Reply this comment
  7. Chriss Street
    Chriss Street 20 August, 2012, 15:05

    Wayne: Memo to Governor’s staff: NO MORE MEMOS !!!!!!!!!!!!!!!!!!!

    This is really a big deal, because the FRNY used the term “luring”. This is the type of volcanic language used regarding child molesters. The FRNY is delegated all securities and derivatives regulation of banks. This “research report” must have been vetted by the most senior Fed staff appears to reflect the Fed’s intention to pull the plug on the muni market.

    Reply this comment
  8. Tax Target
    Tax Target 21 August, 2012, 06:24

    Can you say Kalifornsky Junk Bond? “California here we come….”

    The State is praying that the meat cleaver doesn’t come down on their credit card. They know damn well that the voters will not pass their tax measures if the credit cards get cut up…

    Reply this comment
  9. BobA
    BobA 21 August, 2012, 15:25

    Wayne Lusvardi:

    I read that article in the WSJ and let me summarize what the author is essentially saying:

    Don’t believe what you hear or see. They’re all lies put out by the Wall Street, the Feds and the republican party.

    There is no budget deficit in the state of California;

    There is no unemployment problem in California;

    there’s no truth to the rumors that California cities are going bankrupt; California bonds are the safest investment in the world;

    jobs are plentiful in the state of California;

    California doesn’t have a spending problem;

    California has some of the lowest taxes in the nation and lastly, California would be better of as a one party state controlled by the democrats.

    Legislation is pending to finance the building of crematoriums to take care of the state’s republican problem but until then, it’s all Bush’s fault!!

    Reply this comment
  10. econprof
    econprof 21 August, 2012, 20:50

    About one year ago as Spain’s fiscal problems were worsening, the government and banks massively sold debt instruments to their public, especially bank customers. Conned them into shifting their savings into this toxic paper. Now that Spain’s problems (resulting from overbuilding real estate) have been uncovered, those Spanish citizen’s have lost billions in the market value of their instruments. They feel betrayed for listening to their authorities, just as today’s holders of CA municipal bonds may soon be feeling for listening to CA politicians and investment advisors.

    Reply this comment
  11. BobA
    BobA 22 August, 2012, 09:40

    econprof:

    I was all set to buy California muni-bonds in late August 2008 through my investment advisor at the time but after amply research on my own into California’s debt situation and the yield on California muni-bonds, I thought better of it and backed out at the last minute.

    Safe to say, I have no regrets. Investing in California muni-bonds is a risky proposition and to the unsophisticated investor, the yield on California muni-bonds seems very attractive. Blinded by the high yield rates,they never bother to understand the caveats attached to buying muni-bonds and especially California bonds.

    Financial planners, investment advisors and the lot do a poor job of explaining the details of muni-bonds and all the little gotchas. They will sell you garbage as long as they get a commission on the sale.

    Reply this comment
  12. Thomas Hickman
    Thomas Hickman 23 August, 2012, 10:40

    This article is missing some key facts that “The Untold Story of Municipal Bond Defaults” was trying to get across. The main point in the article released by the Fed was that non-rated bonds have a higher default rate. And more specifically, non-rated revenue bonds, specifically Industrial Development, Housing, and Nursing Homes, have a much higher default rate. The bankruptcies we’ve seen in Califronia were on the City level. When a city, county, or school district issue debt it is typically a G.O. bond secured by tax revenues.
    While credit risk of California cities and counties are at an all time highm, it’s the way bonds are structured that warrant the most risk.

    Reply this comment
  13. Chriss Street
    Chriss Street 24 August, 2012, 07:43

    Thomas: Very fair comments, below are my comments.

    I try to shrink complicated technical issues down to 750 word reports. Although the Fed’s report did make clear that not all bonds are created equal, the focus was on Moody’s and S&P fraudulently “luring” the public to buy risky debt based on phony default statistics.

    Luring is a word normally associated with child molesters. This is a road map for litigation against the rating agencies if these are large numbers of muni defaults.

    Reply this comment
  14. John
    John 19 January, 2013, 01:05

    Laughable!! I have been hearing that the sky is falling ever since I bought a little over $9M in California GO bonds back in 2007. Since that time I have enjoyed an average of 5.3% double tax free on those bonds and their capital value is up 12.5% over what I paid for them. As I have re-invested the excess dividends back into more bonds, my portfolio now stands in the mid $11M range and my NET income from the bonds is $503,000 which for me is the equivalent of around $900,000 taxable. Show me any investment that is close to returning that with as little risk and I will start to listen.
    Why do you suppose that these bonds are trading at 12% plus over the face value? Do you really think that there are so many dumb people out there that would pay a premium to get into a high risk investment? I seriously doubt it.
    The real risk to these bonds is inflation and higher interest rates. We will not see a meaningful increase in rates until at least 2015. By then I will have earned more than $1M double tax free and will consider shifting some of my portfolio.

    Reply this comment

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