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Munis In The Crosshairs
When it comes to budget finance, a municipality more or less works the
same as the federal government. It carries a surplus, deficit, or
balanced budget. If a muni has a budget shortfall, it needs to finance
it through the sale of bonds. That is how a federal budget deficit is
managed as well.
The difference lies in the price to finance. The U.S. government can
sell treasury notes at a high price with a low yield. This is not always
the case for the muni, and recently yields have gone through the roof.
Obviously many of the factors that affect the two debt markets differ,
but all in all the yield is supposed to represents the risk to default.
Recently the credit spreads between muni and federal debt have gotten
extremely wide. In fact, the tightness in credit markets has resulted in
a massive default and potentially the largest municipality to go
bankrupt since Orange County, California went broke in 1994.
Jefferson County, Alabama
Before going on, I must say I told you so. Like many of the other shoes
to drop in the credit market, I have been calling for the munis to be
the next victim of tight credit markets. We must understand that this is
a systemic failure that still has many unclaimed victims. Moving on...
Jefferson County, Alabama, home of Birmingham, defaulted on an $83.5
million interest payment on its $3.2 trillion in outstanding debt. More
specifically, Jefferson County had agreements with creditors to forego
the due payment on its $850 million sewer project resulting in the
interest payment that was defaulted on. Jefferson County Commissioner
Bettye Fine Collins stated, "we just don't have the funds to cover these
interest payments." Currently, the county is set to vote tomorrow
morning in an attempt to obtain a 10-day grace period on the debt.
This is a benefited case of pure exotic debt instruments blowing up.
Jefferson County was using variable-rate bonds paired up with paired
with interest rate swaps. By the way, these are the exact instruments
that the investment banks are being sued for selling.
Variable-rate bonds paired with interest rate swaps...say that ten times
over. These debt instruments, paired with tunnel vision budgeting based
on absurd prediction of projected tax revenue, is a nasty combination
for any muni.
Let's first touch on the tax revenue issue. I've discussed this in prior
issues of B&B, but I want to reiterate them here. It is a very simple
ripple effect of the housing recession. When an individual forecloses on
their home, they no longer pay property tax. When the value of a home
declines, the owner will pay a smaller property tax. There's your first
ripple. The second ripple effects consumer spending. As the economy
slides into recession, unemployment rises, wages fall, and consumers
spend less. This means less sales tax. The third ripple which is
starting to show is the lack of available credit to finance corporate
projects. Again, this will result in less corporate tax revenue for the
state.
Then there's the issue of these exotic debt instruments. Both Jefferson
County and the company that insured the county's bonds have had their
credit ratings reduced. A long story short, the reduction of credit
worthiness resulted in the County having to pay unanticipated
installments on their swaps.
On the other side of the debt casserole, we had the variable-rate, or
auction-rate bonds. This is debt that is regularly reprised. It is
reported that in attempts to refinance this debt, the county was facing
bids as high as 10% on the yield.
Future for Muni Debt
As far as Jefferson County goes, I believe their lesson learned in
fiscal/financial responsibility will end in bankruptcy. Jefferson County
still has $2.2 billion in auction-rate debt to roll over, and at 10%
yields, that's all but impossible. It appears that the Jefferson County
Commission is about to wave the white flag soon. Two of its 5 members
have already approved a declaration of bankruptcy. Just to note, it
would be the largest default on municipal bond history according to the
county's debt load.
What about the rest of the municipalities? We can expect more of the
same, and definitely on a larger scale. Jefferson County was not the
only muni to finance deficits with exotic debt instruments. They also
weren't the only ones to misproject tax revenues. There are $2.6
trillion dollars of stressed muni debt facing extreme prices to
refinance. Then there's the credit default swaps on the $2.6 trillion.
We are again talking numbers in the neighborhood of tens of trillions of
dollars here.
Nicholas Jones
Analyst, Oxbury Research
www.oxburyresearch.com
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