Municipals Bond Defaults: Oh, switch off!

Let's compare two companies, thinking in terms of credit-worthiness. Note that on May 1, 2008, credit-default swaps (CDS) on both companies were around 55bps. By way of comparison, CDS on the United States of America current trade at 67bps.

Company A:

• Is heavily exposed to residential and commercial real estate
• Has experienced an 18% decline in revenue over the last year
• Has announced massive layoffs
• However, is widely viewed as one of, if not the strongest within its industry
• CDS for Company A are currently quoted at 121bps

Company B:

• Is heavily exposed to residential and commercial real estate
• Has experienced a 1% increase in revenue over the last year, although previous revenue forecasts had been for an increase of 6-8%.
• Continued economic deterioration will likely cause revenue to fall about 5% short of previous guidance in 2009
• Company executives have proposed a 1.5% price increase on their second largest revenue item to close this gap
• CDS for Company B are currently quoted around 400bps

Company A is J.P. Morgan. Company B is the State of California.

I bring this up in response to Doug Kass' piece on "20 Surprises for 2009" and specifically #11: "State and municipal imbalances and deficits mushroom." (Actually its largely Roger Nusbaum's comment here that inspired this post.) Doug and Roger) are right. State and local governments tend to spend all they have every year. Few build up any kind of meaningful reserve during times when tax collections rise due to strong economic conditions. So when economic conditions turn, budgets become highly strained. This period is going to worse than past periods for a variety of reasons, primarily because it is hitting real estate values directly, which is a key revenue item for most local governments.

But the market is making a huge misjudgement in comparing the actual risks of large municipal issuers versus corporate issuers. Right now, the State of California CDS are trading wider than all but 28 of the 125 member Investment-Grade CDX index, indicating that most investment-grade corporations are less risky in terms of credit losses than the State of California.

Currently CDS on the Golden State trade similarly to CBS Corp, Southwest Airlines, and Rio Tinto. Yes, California is exposed to a bad economy, but the state has the power to forcibly collect revenue from its citizens! At 400bps, California CDS are wider than Carnival Cruiselines (358bps), Kohl's (293bps), Darden Restaurants (275bps) and Toll Brothers (206bps). Aren't all these companies just as exposed to weak economics? And aren't their revenue streams less diversified than America's most populous state?

Remember that the CDS should reflect the expected loss for all these companies. When a corporation goes bankrupt, debt holders usually wind up either selling off the pieces of the company for cash or becoming the new equity holders of the company in a reorganization. In bankruptcy, a firm's best asset is usually their real estate, but in today's market, commercial real estate certainly won't fetch top value in a liquidation. So corporate debt holders, generally speaking, are looking at historically weak recovery in a liquidation.

What could a municipal bankruptcy look like? Municipal debt holders would obviously not be foreclosing on the Governors Mansion. Instead, the bankrupt municipality would likely issue new debt to replace the old, defaulted debt. This might take the form of replacing existing debt at 5% with new notes with a 4% coupon. Even on a 30-year bond, an exchange of this type would only result in around a 18% present value loss. Even more benign would be to pledge a particular revenue source, such as a new sales tax, to a new debt series, then use the new debt to pay off the old debt. This is essentially what New York City did in the 1970's to avoid a default.

Note that California, like 48 other states (all but Vermont) are constitutionally required to pass a balanced budget. There is no option to just throw up their legislative hands and conclude that the citizenry won't accept more taxes. There is no option to say they'd rather pay the teachers and police than bond holders. Even if budget cuts and tax hikes become severe, governments will have no choice but to use all their resources to pay bond holders.

This isn't to gloss over the problems municipal issuers face. But it is far more likely that municipal bond holders will take losses on smaller, local issuers than states and (most) big cities. Take Vallejo, CA for example. That city of 117,000 filed for Chapter 9 in May. A small city like Vallejo is much more dependent on property taxes than larger governments, which tend to have a more diverse revenue streams. Plus smaller municipalities have less budget flexibility. Their budgets are usually dominated by education and law enforcement, where as larger issuers tend to have more fat to cut.

So here is my own surprising prediction for 2009: while municipal defaults will likely rise to a record number, losses to bond holders will still be relatively small. On top of that, muni bond holder losses will be dwarfed by those suffered in corporate debt.

(I own debt securities for J.P. Morgan and the State of California. No holdings in any of the other companies mentioned.)