The Municipal Bond Crisis: Why Stock Market Investors Should Pay Attention
Purchasing municipal bonds is just a bit like being kissed by your grandmother; it's comforting, however not particularly exciting. Lately, however, thanks to extraordinary media attention, the subject of municipal bonds has turned into a decidedly uncomfortable subject for several investors. Recent headlines in prominent national newspapers include such dire headlines as "Mourn the Muni Market," "Dire Headlines Unsettle Muni Bond Investors," and "Mounting Debts by States Stoke Fears of Crisis." And the list goes on.
Could be the municipal bond market facing a true crisis here, or is this really a case of journalistic sensationalism? Perhaps a far more important question: what're the consequences if you should be an investor in municipal bonds, or an investor in the stock market? For reasons which I discuss shortly, I think that investors in stock markets may be missing the big picture, and might actually stand to get rid of more from the municipal bond crisis than the particular bondholders stand to lose. In 2008, many stock market investors suffered huge losses simply because they focused solely on stocks themselves, and generally failed to pay attention to the unfolding problems in the markets for overnight bank lending. Similarly, the ongoing problems in the municipal bond markets must certanly be closely watched by stock market investors, because of the anti-growth taxation and spending policies which are being implemented all over the country.
Let's start with the municipal bond market itself, and then turn our attention to the broader financial implications for the stock market. Recent media reports suggest there might be 50 to 100 municipal defaults in the coming year. Although this would have been a historically large number, even though true this is a very small percentage of the total. Specifically, the state and municipal bond market is approximately $2.8 trillion in dimensions with about 60,000 different bond issues. So, even though 100 issues default next season, this would only represent 0.2% of the total. Furthermore, based on a current article in the Wall Street Journal, before 40 years there have only been 54 cases of Moody's-rated municipal debt default. Of them, 78% were in stand-alone housing and health-care projects. (Wall Street Journal: "New Risks Emerge in Muni's" Nov. 10th, 2010). Considering the sheer quantity of individual bond issues in existence, this really is an exceptionally low rate of historical default, and implies that cases of true default at the town, county, and even state level is exceedingly rare.
The media is keen on mentioning Vallejo, California, and Harrisburg, Pennsylvania - two cities with severe fiscal problems - but nothing is said of the thousands of cities, counties, and various government agencies that never miss a single payment for their bondholders. As alluded to in the Moody's data, most municipal bond defaults originate from project-specific revenue bonds. They are not general obligation bonds, which are secured by the full faith and taxing powers of the issuing municipality. Without question, a large proportion of general obligation municipal bonds will remain highly credit-worthy and will remain an audio investment for tax-sensitive investors with a dependence on income.
However, as suggested previously, even though our worst fears show to be true, investors in municipal bonds probably aren't those with at an increased risk - stock market investors may stand to get rid of more in this crisis. Why? First, we need to realize that 1 of every 7 workers in the entire United States is proven to work for a municipality, including state, county, and city governments, transportation authorities, law enforcement agencies, school districts, and so forth.
That's right, 15% of all workers in this country work for a municipal government or state agency of some sort. Collectively, which means that "Municipal America" is undoubtedly the biggest employer in the united kingdom, and the employer is facing a dire financial situation. Furthermore, 13% of total U.S. economic output (i.e., gross domestic product) originates from municipal spending. Which means municipal expenditures represent the second-largest part of the entire U.S. economy; consumer spending is the largest. Consequently, the actual risk to your financial system isn't the possibility of dozens of municipal Bond View defaults, the actual risk is that thousands of municipalities are forced to lay-off or furlough hundreds of thousands of employees and substantially curtail spending and benefits, thereby tilting the fragile U.S. economy back toward recession. In ends up that such developments have begun.
Indeed, state and local governments have now been cutting their payrolls at an accelerating pace in the past 12 months with about 250,000 jobs lost in 2010 alone, together with 130,000 jobs lost in 2009. Even more interesting: since January of 2008 the U.S. economy has lost 7.2 million jobs, yet total state and municipal employment rolls have only declined by 225,000, cumulatively, before 3 years. Given that this latter group represents 15% of total employment, one might expect that the proportionate share of those jobs to have been lost here, but that hasn't been the case. When it were, state and municipal agencies could have lost about 1.1m jobs by now. Because the municipalities didn't start cutting payrolls in large numbers until a complete year following the recession began, it's reasonable to think that substantial losses are actually hard upon us, and we might have up to 1 million more jobs to be cut from state and local government payrolls in the coming years.
Yet even this understates the full total economic impact of municipal austerity since it only counts jobs lost, excluding employees who've merely experienced furloughs, pay freezes, benefit cuts, and so forth. A recently available NY Times editorial, titled "The Looming Crisis in the States," stated that, "State spending fell 3.8 percent in the 2009 fiscal year and 7.3 percent more in the 2010 fiscal year."
In the event that you eventually work for a municipal agency, chances are you currently have recently seen a hiring freeze, a pay freeze, restrictions on work hours, and so on. Also, most of the projects funded by the American Recovery and Reinvestment Act of 2009 is going to be ending soon, and municipalities are not participating in large outlays for new infrastructure projects. This can result in a substantial decrease in construction-related spending. Finally, in the event that you eventually reside in one of many fiscally hapless states, such as for instance Illinois, you will undoubtedly be paying much higher tax rates and receiving reduced services.
Illinois recently raised its state income tax from 3% to 5%, that will cost the typical family of 4 about $1,000 more per year. Similarly, the newly-elected governor of California is proposing $12 billion in tax increases plus $12.5 billion in spending cuts for the coming year, with cuts being produced in healthcare, welfare, community colleges, universities, services for the disabled, purchase state employees, and so on. This is all good news for holders of Illinois and California bonds, but bad news for just about every resident, worker, and business in the state, along with companies that business with the state.
Municipal governments will continue to handle painful choices in 2011 and 2012, but most are confronting their problems in the only real logical way: financial austerity. This is good news for municipal bond investors. However if the trend continues, as it probably will, it further diminishes the prospects for a wide economic recovery in 2011 and 2012, and thus the municipal bond crisis may become more troubling for stock markets than most investors realize. Certain types of companies will obviously be hard hit, including construction firms, information technology and services, among others. Municipalities will cut back on new construction projects, and they will defer upgrades to systems and technology for another year, or longer. Service firms that be determined by contracts with the state and local agencies is going to be hurt as well.