Friday, August 17, 2012

The well-known story of municipal bond defaults

It is one thing to read intellectually dishonest drivel about the municipal bond market in the mainstream media (which investors appear to be ignoring anyway), but it is another thing entirely to see it promoted as research by the Federal Reserve Bank of New York. Such is the case with this post on The Untold Story of Municipal Defaults on Liberty Street Economics.
The basic argument of the post is that there are significantly more municipal defaults than are commonly cited because the default statistics many people cite come from the rating agencies, and the rating agencies only cite defaults that occur within the universe of credits they rate. The post then mentions default studies published by Moody’s and Standard and Poor’s, which note that of the over 50,000 “municipal” issuers they rate, there have been 71 and 47 defaults, respectively, since the 1970s. The Fed researchers then contrast these figures with a database that includes unrated debt, and “discover” that there have been 2,521 defaults over the same time period.
This will obviously be very distressing news to anyone who gets their market research from Seeking Alpha. But default statistics that include unrated debt are not difficult to come by, and these data are widely cited in research notes from investment banks and independent advisory firms. (They are also regularly cited in Bloomberg and the Bond Buyer.) The Fed did not come by its data for this post any differently than any other market participant does. As I mentioned at the end of my post on California bankruptcies (quoting JP Morgan research), there have been 47 first-time monetary defaults totaling $889 million YTD (with Stockton expected to default on $230 million of debt next month), of which 58% is unrated. If you exclude insured bonds, the total amount is $725 million across 42 issuers. If you exclude a handful of cases where debt service payments were late due to administrative errors and oversights, the total is $549 million across 33 issuers. This is for a $3.7 trillion market. Of course, the folks at the Fed did not find it necessary to include a detail as trivial as the par amount of defaulted bonds (or recoveries or defaults due to administrative errors that were rectified) in their post.
I think a lot of the problems that the uninitiated encounter in trying to understand credit risk in the municipal bond market relate to the facile distinction between general obligation and revenue pledges rather than an emphasis on the differences between the actual borrowers in the “municipal” bond market – by which we really mean the “tax-exempt” bond market.  Governments issue both general obligation and revenue debt and they create a lot of special districts and independent issuers that complicate analysis. But there is also revenue debt that is issued on behalf of non-governmental entities that is not even remotely similar in nature. The federal tax code allows states to issue a limited number of tax-exempt bonds for private business use every year. These bonds are issued on behalf of private (corporate) borrowers and are repaid from private resources. There are also a host of bonds issued on a tax-exempt basis on behalf of non-profit entities, like hospitals and colleges (although you would probably be surprised by the types of enterprises that count as charitable organizations under the federal tax code these days). This is not government debt. It is often not even a question of whether they serve an inessential or essential purpose vis-à-vis a governmental entity, as the post suggested – they are simply getting a government subsidy for economic development or other purposes. Literally the only thing these bonds have in common with government debt is their tax status, and yet they are lumped in with “municipal” bonds for statistical purposes. This is where the vast majority of defaults occur, and it is why aggregate default statistics are mainly only useful for making fun of Meredith Whitney. Most of the “idiosyncratic events” that cause defaults among specific sectors do, in fact, have well-documented narratives (e.g., dirt bonds).
I also thought the remarks at the end about how the near-demise of the bond insurance industry has only complicated matters for investors were rather humorous … in a post about unrated bonds. Perhaps someone should explain to the NY Fed what types of bonds are insurable?
It is frustrating reading posts such as this because I know that an uninitiated person will not read it and think, “bonds that are issued without ratings, generally for private and not public purposes, generally not by an issuer with the authority to levy taxes, and generally sold to institutional investors may involve credit risk.” They will instead think, “wow, municipal bonds are really risky, look at all of these defaults that the so-called experts have missed,” because heaven knows investors lose millions of dollars silently. And of course, the fuckwits in the mainstream media and on blogs will talk about this report non-stop as a vindication of their own misguided commentary, even though they can’t even name a single default besides Jefferson County and tend to get default and bankruptcy confused anyway.
By and large, it is not difficult to identify where credit risk exists in the municipal bond market. If bonds are being sold unrated, and it is not because the issuer is a small and inactive borrower, and if there is a large private participation element, you might want to do some more digging. One might argue that investors need to be exposed to this information because they may be holding such risky, unrated paper through funds. If that worries you, there are investments out there besides high-yield funds.
The Fed really ought to be embarrassed that it published something like this.

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Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.