California is issuing more munis to bridge the state through a huge $20B deficit (on a $87B budget, which used to be an astounding $110B). The credit default swap rate of California has grown towards Greek levels - yet the offering sold out 25% more than expected. Floating $2B, Cal sold $2.5B at 5.65% for 30 year bonds. That interest rate is 1.2% higher than comparable munis elsewhere, a bigger spread than last time Cal did this (in Nov) where the spread was 'only' 90 bp. As the deficit in Cal has widened, the spreads have increased, but does this really indicate a risk of default?
My view is no. The last thing Cal will do is stop paying on these bonds. It needs them to manage through the ups and downs of tax revenues.
An analogy for muni bonds is to the dot-com era, where the dot-coms threw everything overboard to stay afloat - except their web hosting. Their web sites were their lifeblood. The leading hosting service, Exodus, was a huge short waiting to happen, since its stock held up past the bubble bursting, until finally the dot-coms had to shut their sites down.
You can see the behavior of the issuer in this over-subscribed issuance: rather than worry over the high interest rate (120 bp higher than other States), California issues even more, fearful of buyers at all. Hence the rates rise due to market noise, not the underlying risk. (Also note that the higher muni rates of Cal are still not anything like a junk bond rate - as long as Treasuries are still below historical norms, the bond market will keep munis relatively lowish). Don't believe an efficient market hypothesis for California Munis right now - rates are driven by fear and greed. Fear by the issuer, greed by the happy buyers of relatively high tax-free rates.
Historical Default Rates
Muni's historically have had low default rates, even when the issuer itself went bankrupt. In the Great Depression about 2000 cities defaulted, which led to Chapter 9 of the bankruptcy code, allowing them to go into restructuring - and save their bonds. Since this was passed in 1934, around 600 cities have had to file for Ch 9 - out of well over 40,000 municipal entities. A very low rate.
The big one to fall in 1994 was Orange County, California, which initially defaulted on part of its debt, but eventually the bondholders were made whole. Orange County led to a series of reviews of muni default risk. The studies concluded that general obligation bonds have a very low default rate of about 1/4 of 1%, especially if Orange County is taken out as an an outlier due to unusual circumstances. Much riskier are special districts and industrial-development finance that issue under the name of a municipality.
The lessons learned for munis are twofold:
- diversify, so one Orange Count does not hammer the whole portfolio (obvious)
- look inside the issuance to the real party at risk, and avoid special project finance
On the last item, there were higher electric-power project defaults in 1982 coming from a court ruling, but very low since, especially after changes in the 1986 Tax Reform Act. This suggests two risks in buying industrial development bonds: the underlying project may fail, and laws may change.
Consequently, be wary of muni bonds fronting:
- industrial development
- green projects/renewable energy
- hospitals and education projects
The Inapt Comparison to Sovereign Debt
Worries over the rising CDS spreads in California and Illinois bonds are misplaced. Illinois is in deep trouble, but it is not the next Greece, nor is California about to join Club Med. The Big Picture does a nice treatment on why muni's are not in as much risk as sovereign debt despite scary charts like this one:
Simply put, a State cannot go bankrupt. They can run out of money, as California is wont to do every year, but then they scale back their commitments: first education (50% of budget), then interest on muni's (7%). The shortfall has to be 43% before muni's get at risk of default.
To top it off, the Stimulus has provided a large bridge to the States: $135B of the $150B estimated State shortfall will be covered by Stimulus. A lot remains to be drawn down, particularly for education, giving the debt service segment even more leeway. See next chart. So instead of dragging down muni's, State problems will drag down the Federal taxpayer.
It seems inevitable that Greece and other PIIGS in Poo will default. It turns out sovereign nations tend to default much more frequently than muni's. They have armies and can get away with it. Here is what I wrote as the Greek Tragedy began to erupt and gold began to be hoarded:
What happens when the debts of the issuer are vastly beyond their productive capacity? Well, the country defaults, and the fiat currency is forcibly exchanged for scratch. A 2008 paper by Harvard Professor Rogoff and Prof. Reinhart, both members of the NBER (which calls recessions and recoveries) entitled This Time Is Different demonstrates that instead of fiat regimes making good, they have defaulted over and over throughout eight centuries of financial crises:
We find that serial default [repeated sovereign default] is nearly a universal phenomenon as countries struggle to transform themselves from emerging markets to advanced economies.
Before we take comfort in the US being already an advanced economy, the imperial power of its day has typically defaulted after over-extending. Rich European countries have defaulted, including Austria, France, Portugal Spain and Germany. The reunified German defaulted in 1873, bringing the whole world into a long depression, including the United States. In the last century, Germany defaulted twice: 1932 and 1939. Russia three times, beginning in 1918. England in effect defaulted in 1931.
The interesting conclusion: Treasuries, gold and Muni's stack up as the safer places to be. Even corporate debt from quality issuers may prove safer than sovereign debt.
The Union Stranglehold
Could it be different this time around? Despite the low historical default rate, even back in the Great Depression, there is a new factor to consider: the self-destructive politics from State unions.
Bloomberg issues a "bankruptcy bloodbath" story about Vallejo, Calif, the most recent major city to go into Ch 9. Vallejo is in trouble due to excessive demands of city unions, and the worry is that bondholders may have a partial default as part of a packaged deal.
The new factor in munis is how laws have changed to advantage State unions. Still, Ch 9 would allow excessive union contracts and benefits to be voided. About half the States, however, prohibit by law their municipalities from using Ch 9, presumably to further entrench union contracts. Fortunately for California, it is not one of those States. (The list is in the Bloomberg story.)
A recent article, Plundering California: How Public-Sector Unions Brought The State To Its Knees, has now become the book Plunder!, discussing how public sector unions like Visigoths have sacked States across the nation. The author posted the Readers Digest version in the WSJ. Memorable anecdotes include:
- the average pay in Orange County for a fireman is $175k, and allows retirement at 90% of the final year's pay for life, including the life of his/her spouse
- 82% of chief-level Highway Patrol employees discover a disabling injury about a year before they retire, which gives them extra benefits; very few seem job-related
- teachers and police get shielded from dismissal, to the point that school districts don't even try to remove misbehaving teachers
It used to be public workers took lower pay but had better retirement. Now they get higher pay and much better retirement. Such a deal!
This picture is interesting because we grew up thinking the blue collar jobs were union - does that mean Jose in the picture is pulling $175k/yr? Nope. With the advent of public worker unions, a huge number of white collar jobs are now unionized - and padded. All those supervisors above would pull down big bucks with cozy retirement packages; Jose is probably an illegal alien hired by a private contractor off union pay.
We have long passed the point where union workers were largely assembly-line, truck-drivers, dock-workers or miners. Worse, we have recently passed a chilling moment: government workers (heavily unionized) now exceed manufacturing workers (lightly unionized):
Take one unionized sector: education. It used to be most of the spending on K12 education went to teachers, principals, buses and schools. Cal actually ranks low on support people at the school level, but I recall that by the '90s California spent only 60% of its education budget on actual education (teachers, principals, buses, schools) and the rest on an over-paid bureaucracy in Sacramento, the State capital. A decade later and that 60% is down to 50%, meaning half of the education budget now flowing into those nefarious bureaucrats.
These percents come from politicians and are probably overblown for effect, but the impact is clear: unions and administration are bleeding the State budget dry while letting the vaunted California K12 system fall to the bottom of the heap. Something has to change.
What Happened to the Golden State?
Californians sigh thinking of how golden the State was in the '60s. On lower taxes and spending per capita, it had the best public schools in the country, new freeways that flowed, cheap housing, almost-free universities, cheap energy, heavy industry, and seemingly unlimited growth. Today on higher taxes, more than 2x higher real spending per capita on education, and very high energy costs, it has the second worst K12 public schools in the country (thanks, Mississippi!), crumbling roads, riots over tuition in colleges, loss of heavy industry (auto, aerospace, shipbuilding) and a list of woes that overwhelms.
I went to a rally for Meg Whitman for Governor, and the first question she was asked was, why would you want such a hopeless job?Most Californians can point to the key forks on the road to perdition:
- 1977: Jerry Brown as governor allows State employees to unionize
- 1978: Prop 13 freezes local taxes & pushes education funding to the State level
- 1985: Cal Supreme Court allows strikes by public unions
- 1988: Prop 98 fixed the percent of spending on education at 40%
- 1999: Gray Davis, elected by unions, pushes wild increase in public pensions
- 2000: Gray Davis shifts budget surplus to education, increasing Prop 98 baseline
Jerry Brown is running against Meg Whitman. He admits that his biggest mistake was the 1977 law which allowed State workers to unionize. This, not Prop 13, has busted the budget and put California into chronic financial crises. Prop 13 combined with Prop 98 created a great flow of power to the State level, and with that power the giant sucking of "education" funds out of education and into administration. The State has been plundered by a trifecta of unions:
Aware that Proposition 13 had shifted political action to the state capital, three major blocs—teachers’ unions, public-safety unions, and the Service Employees International Union, which now represents 350,000 assorted government workers—began amassing colossal power in Sacramento. Over the last 30 years, they have become elite political givers and the state’s most powerful lobbying factions, replacing traditional interest groups and changing the balance of power. Today, they vie for the title of mightiest political force in California.
The pattern in California is for the surpluses in good years to be doled out to political favorites. In 1999 the huge dot-com surpluses went to public-sector union benefits. In 1996 surpluses went to K12 by reducing class size. And so forth time and again. During the bad times, these constituencies buckle down in a fight to hold their benefits, and the State in desperation issues more bonds to bridge the difference. The legislature remains eternally in deadlock.
It is a terrible political situation when State unions can use campaign finance and other muscle to shake-down the taxpayer for benefits. This is a whole different dynamic than normal bribery lobbying of the legislature, since the State pays for the union benefits, State laws make it hard to remove the benefits, and the taxpayer is stiffed without apparent recourse. The plunder is constantly misrepresented factually and emotionally.
Taxation without representation? Perhaps better put as: taxation with misrepresentation.
Clearly reform is necessary, but it is not clear the crisis is yet bad enough to cause the change that is required: to repeal Jerry Brown's 1977 law.
The potential risk to muni's is that attempts to fix the budget run into a rock and a hard place: education has to remain at that 40% level (which has crept higher than that under the Prop 98 rules) while unions fight to maintain their inflated benefits. Are bond payments now a weaker political constituency than schools (by law) or unions (by force)? This will be tested in the Ch 9 settlement in Vallejo.
The Need for Tax Reform
The underlying cause of the boom/bust cycle is the highly progressive tax system in California. It in a sense is more profit based than income based. During good times, it provides too much revenue to the State, which spends it and ratchets up the budget. During bad times it provides too little, and as unions fight to maintain their politically-gotten benefits, the muni bond market fills the gap, putting the muni market through its periodic conniptions of fear and greed.
This is good for muni's, since it drives rates up without materially affecting the risk of default. It is NOT good for the State.
There is a tax reform proposal floating through the halls of Sacramento which makes sense: flatten the tax rates by broadening the tax base, and change to a more stable system that collects about the same in good and bad times. Simplified, it changes the sales tax to a business gross receipts tax, and the income tax to a flat rate. The plundering would continue, but with less of a pool of excessive tax revenues to feed off of in good times.
My take is that the tax reform is more likely than the repeal of the 1977 union law. It would improve the climate for muni bonds, since it would make tax revenues more reliable. Also, after the Orange County default, the muni market recovered quickly. Any mistake in Vallejo that partially effects bonds is likely to be met by even stronger support for avoiding bond default elsewhere - and momentarily higher rates, a great buying opportunity.
There still is gold in the Golden State, in muni bonds.
----note: this is the second in a multi-part series on bonds