Back in December of 2010, banking analyst Meredith Whitney went on 60 Minutes and famously declared that a wave of municipal defaults was set to strike the U.S. in 2011.Â Alas, her prediction did not come to pass as municipal bonds have actually performed very well over the past two years.Â At the time, her warning made sense since most municipal governments are reliant on property taxes for revenue.Â With the housing bubble popped and a large inventory of foreclosed homes being left in the wreckage, the perfect storm really did appear to be on the horizon. But with a string of California cities defaulting recently, at least one prominent financial commentator has fallen into Whitneyâ€™s camp.Â As Zerohedge reported, last month Warren Buffet terminated his position in muni bonds five years early for a loss of a few hundred million.Â Given how highly connected Buffet is in the elitist establishment of politicians, financiers, and central bankers, itâ€™s a safe bet that he knows something the average guy doesnâ€™t.
Nevertheless, the municipal bond market has still found plenty of buyers so far in 2012.Â According to the latest BlackRock analysis, the market saw a .23% gain in the month of August.Â Issuances totaled $31.8 billion which was a 33.6% increase compared to August of 2011.Â The New York Times recently reported the junk bond sector is booming as investors are scrambling for higher yields amidst the low interest rate environment.
â€œIn a yield-starved world, high-yield bonds are right now the only game in town,â€ said Les Levi, a managing director at the investment bank North Sea Partners. â€œThe market is giddy.â€
The primary cause of this rush into bonds is Federal Reserve chairman Ben Bernankeâ€™s efforts to keep interest rates at historic lows through the liberal use of the printing press.Â Just this week, Bernanke placated Wall Street once again and announced that the Fed was going to embark on another round of quantitative easing to lower long term interest rates.Â This new open-ended buying spree of $40 billion worth of securities a month came with a pledge to ensure low rates till at least the summer of 2015.Â That means all the corporate pensions and insurance funds that were struggling to find relatively safe yields over the past four years arenâ€™t going to see a light at the end of the tunnel anytime soon.
Investor legend Jim Grant once suggested that if he were Fed chairman, he would open the central bankâ€™s first Office of Unintended Consequences.Â The flight into municipal bonds could be due to different reasons but in all likelihood it has been a consequence of the Fedâ€™s policies.Â If and when Bernanke decides to hike interest rates, this will burst the bubble in muni bonds and send the market spiraling.Â Why?Â The logic is simple: because rates are so low, bond yields are also at historic lows.Â When rates rise, as they will inevitably do, so will yields and value of current bonds will plummet.
As Senior Editor of Agora Financial and the Laissez Faire Club Doug French explains,
However, bond and yield mathematics are set to deliver a cruel lesson. When interest rates go up, bond prices go down. Suddenly, what was supposed to be a safe bet looks like 2009 all over again.
The math works this way: Say the coupon (annual payment) on a particular bond is $100. Your broker says the bond youâ€™re contemplating for purchase is yielding 6%. $100/.06=$1,666.67 bond price. Easy enough so far. But when interest rates increase â€” and they have nowhere to go but up from here â€” or if your bond issuer runs into financial trouble, bond buyers will insist on a higher yield.
The $100 coupon doesnâ€™t change (except for a default), but if the market demands a yield of 8%, that bondâ€™s principal value will now fall to $1,250 ($100/.08). That 2% interest rate change whacked 25% off the principal value of the bond.
Municipal bonds are generally looked to as safe investments because historically, the number of defaults has been tame.Â But as a study by the Federal Reserve Bank of New York recently uncovered, there have been thirty six times more municipal defaults than the number reported by major rating agencies.Â As the New York Times reports
For example, Moodyâ€™s Investors Service has reported that from 1970 to 2011, there were only 71 municipal bond defaults. But the Fed report counted 2,521 defaults in that time.
The case for a bubble in municipal bonds is straightforward.Â Rates must rise eventually and so too must the yield investors demand.Â Meredith Whitney may have had this scenario in mind when she made her call.Â Yet this isnâ€™t the only obstacle the muni market faces in the near future.Â The Great Recession is still raging even with Bernankeâ€™s printing orgy.Â State and local governments have shed workers (great!), hiked taxes, and raised fees to offset the decline in revenue.Â In the city of Scranton, Pennsylvania, the mayor cut the pay of all city workers to the minimum wage last July.Â While many municipalities were kept afloat with funding from the federal government after the passage of the American Recovery and Reinvestment Act, that money is long gone.Â City councils all around the country now have to face the music and have done so with a mix of austerity measures and accounting gimmicks.Â Some have opted for property tax increases while others have furloughed teaching positions.
For some cities however, it has not been enough.Â The California cities of Stockton, San Bernardino, and Mammoth Lakes all declared bankruptcy last July.Â According to Moodyâ€™s, more are to be expected as slow economic growth continues to deplete tax revenue and increase strain on the pocketbooks of municipalities.
The thing is, this increased fiscal pressure on local governments was entirely predictable. Â There is a misconception out there that municipal governments are more trustworthy than those at the state and federal level.Â A recent survey conducted by Rasmussen showed that 40% of Americans trust their local government more than any other.Â Only 23% answered that they trust the federal government the most while just 12% put their faith in state government.Â Because city councils and school boards are typically made up of residents of the community, it is believed they are more responsive to the needs of the people.Â This may be true to some extent but local governments are still governments in the end.Â Those who reside in their offices claim the authority to tax, regulate, enforce land zoning, educate children, and provide utilities.Â In other words, they claim the right to steal and centrally plan the lives of residents through the use of force.Â Geographic proximity doesnâ€™t negate the moral condemnation the state deserves.Â The coercive taking of income tends to give its custodians the incentive to make expensive promises.Â It leads to the money being spent fast and loose to buy votes and appease special interests.
For local governments, it has meant bowing down to the demands of unions.Â These public sector unions use their government-granted privilege of extortion to receive above-market wages for their members.Â They use the threat of violence to suppress any potential workers who would voluntary work for a lower wage.Â This, above all else, has made it difficult for local politicians to be flexible with changing economic conditions. Â Change is a constant in the private marketplace.Â Unions act against natural change to benefit their members and make society as a whole poorer as a result.Â When recessions strike, public sector unions fight tooth and nail against pay decreases or increased contributions toward benefits.Â In protecting their pay packages that private industry couldnâ€™t afford, unions, in Murray Rothbardâ€™s words, gladly stick â€œa knife into the ribs of John Q. Public.â€
The ongoing strike by Chicago school teachers over a new evaluative process and job security is a perfect demonstration of the rigidness unions promote.Â Instances such as these are even more reason to believe that municipal finances are unsustainable in the long run.Â Combined with the Fedâ€™s low interest rates policies, default is inevitable at this point.Â Unionized public sector employees have no reason to stop gorging at the taxpayer trough.Â As the old adage goes, something that canâ€™t go on forever wonâ€™t.Â When the bubble pops, we can only hope that Bernankeâ€™s reputation as the brilliant and heroic money printer will deflate along with it.