The Logic For Bonds: California Munis

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-subcribed 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

Despite the desire to see reneweable energy get built, if the project relies on subsidies and coercion to survive, rather than underlying economics, laws can change and subsidies can evaporate, especially in a streesed financial climate - as in California! A similar risk may be there for hospital and school projects, given the likely changes in healthcare and education.

The Union Stranglehold

Make no mistake of fear despite the low historical default rate, even back in the Great Depression. 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! 

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 in 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%, with half of the education budget now flowing into those nefarious bureaucrats. These percents 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, something like 2x the 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, 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:

1. 1977: Jerry Brown as governor allows State employees to unionize
2. 1978: Prop 13 freezes local taxes & pushes education funding to the State level
3. 1988: Prop 98 fixed the percent of spending on education at 40% (it is now above that)
4. 1999: Calpers (public employee retirement) sharply increases pensions

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 funds out of education and into administration.

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 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. 

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 munis 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 ill-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 munis, 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 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. 

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note: this is the second in a multi-part series on bonds

Comments

[nspolar]

Yelnick, that picture has been posted around quite a bit, and yes it is apt for many companies and organizations in business today.

Yet I would dare say it does not truly jive with what you communicated. Why might that be?

Well I would suspect Jose is union, the rest would be white collar. If Jose is making $175 K per annum, I would say that compared to the rest he deserves it.

ns

[yelnick]

ns, have you any experience with California unions? It isn't about blue collar vs white collar anymore. The dudes standing around with glorious titles are all public sector, and they are supervising / auditing / investigating / counting / administering / teaching / PRing / marketing / unionizing / politicizing an illegal alien who is actually doing trying to do the work.

[nspolar]

Yelnick, well I do not know about CA I have to admit.

We use contract union labor in my company, but they are not the source of the problem. No union labor person, regardless of position, that we use would have the title of manager. All of our managers, and your picture fits, are company employees and non union.

Internally many within the company I work for are imo parasites, no more no less, and 80 % or so of the work they do is totally non value added.

The only impetus imo to route this out (in my company anyway) is related to economics ... i.e. if the economy goes into the real shitter, massive layoffs in the white collar ranks will occur.

ns

[yelnick]

NS, the problem in CA is the public sector union worker is nothing like the traditional blue collar assembly line worker. They include first responders, but go well beyond. And they are largely white collar and very well paid, and very protected.

Recently we hit a milestone the majority of union jobs in the US were in government, not the private sector. http://blog.heritage.org/2009/11/17/in-pictures-the-big-labor-takeover-of-big-government/

[nspolar]

W/r to this coming week in the markets I think we are about down to two choices, we bust through and the bulls celebrate; or we start down. I am looking for an interesting week.

My fav timing model for a 'B' top is/was from last Friday to about this Wednesday.

The dollar is already up this evening. I don't personally believe it is because of a strong US economy or a smell of a rise in rates anytime soon. Rather if it continues up it will likely be the result of a global flight to safety.

Maybe the speculators are going to give the Euro a hard time. Curriency issues as I see it are all relative, and the dollar is still the safest of the lot. The Euro may stink up the joint good, more than all the rest.

My models ultimately can allow the dollar to push 100 again. Following that the dollar could get wiped out in its a final leg down.

ns

[Hockthefarm]

Yelnick:

What a sickening post. I lived in Long Beach for 12 years, and while we loved it, we have no desire to return. Close friends are leaving in droves.

I guess the radicals with their white pony tails, matching sneakers and 400$ ties at UC Berkeley were full of chit afer all.

I doubt Arnie knows his times tables beyond 4 or 5. The only solution imo is to let state governments implode. Then change will come. Voters in CA seem to understand this.

I understand that Obama's budget deficit for February was 220+ billion dollars. What would a guy like that do with increased tax revenues? Increase deficit spending is surely the only answer. Candidates that will cut government and reduce taxes get my vote from here on out. I don't want to know their positions on any thing else.

The precursor was Bush(how could the republican party have put that guy forward) and deficits don't matter Cheney. They opened the door for an Obama to borrow us into oblivion. That is exactly what he is going to do.

I've been pushing for an international assignment for over a year now. I work for a large multinational and if all goes well, should be ex-pat by Q4 of this year on a 2 year assignment. We have no intention of returning, at least until I retire (10 years). And at that time, we plan to take a long hard look at things.

Hock

[Anon]

Housing was oversubscribed at one point as well.

[marketman]

Yelnick, as a 4th generation Californian . . . you hit the nail on the head in regards to the public sector and their labor unions. I believe that Meg Whitman wants to start by cutting 40,000 state government jobs, which would take us back to the level that the State operated "comfortably" back in 2004. I'd say that's a pretty good start!

[Steve P]

Very interesting post Yelnick. I believe the next economic downturn may deliver a good dose of economic justice to those who have benefitted from the debt fueled spending binge here in Kalifornia. Public pension funds are big buyers of municipal bonds. When things really implode I think many of those generous union jobs and retirement benefits will evaporate. Sure they'll be ranting and raving, but the money simply won't exist anymore. Politicians won't be able to raise taxes to make up the shortfalls because the private sector will already have been in depression for a while and the money won't exist there either. I've got plenty of popcorn and a front oow seat. It should be quite a show here.

[Mr. P]

California is done. California exemplifies the reckless spending that has been occurring for the past 30 years and the delusional thinking that it can continue endlessly. Every election brings out the myriad of bond proposals that get apporoved by the electorate with Arnie supporting every one while desperately pleading with the federal government to cover California's budget shortfall. It's amusing how many budget reconciliations there have been the past two years yet a few months down the road the state is $20billion in the hole again.
California is due for a karmic reckoning and its going to get it. States defaulted on their bonds in 1840/1841 and I have no doubt California will be leading the way during the next few years because the politicians and the electorate don't have the will to alter anything.
There is an individual who has written on the constitutional crises in California's history which has led to California overhauling its constitution in 1879,1907(?) and another time I believe. He teaches at USC now and he has some title like California's Historical Laureate.

[Dave B.]

California has the THIRD oldest Constitution in the world, next to India and Alabama.

The "super-majority" vote that is necessary to get legislation passed is one big reason why nothing ever gets done in the Legislature, and why they (and Schwarzenegger) wind-up flooding the ballot with Propositions.

Arnie has shown absolutely ZERO leadership, and ironically many of the things that (he complained about) which got Gray Davis removed from office, are the exact same things that Arnie has done.

Incredibly irony.

Just as in the case of GM and Chrysler, the pension liability and healthcare retirement benefits are killing the State.

We actually have a retired Fire District Captain from a town of 58,000 (San Ramon) that is making more money in retirement (due to his ability to "spike" his pension with overtime)from a salary of $221,000 per year to the tune of $284,000.

Some of these police and fire (first responders) are the BIGGEST culprits of this pension game. It's gotta come to a stop if the State is gonna get "healthy" again!