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The Untold Muni Story: Default Frequency Is Far Greater Than Reported
Via The Federal Reserve Bank of New York,
In our recent post on the state and local sector, we argued that structural problems in state and local budgets were exacerbated by the recession and would likely restrain the sector’s growth for years to come. The last couple of years have witnessed threatened or actual defaults in a diversity of places, ranging from Jefferson County, Alabama, to Harrisburg, Pennsylvania, to Stockton, California. But do these events point to a wave of future defaults by municipal borrowers? History—at least the history that most of us know—would seem to say no. But the municipal bond market is complex and defaults happen much more frequently than most casual observers are aware. This post describes the market and its risks.
The $3.7 trillion U.S. municipal bond market is perhaps best known for its federal tax exemption on individuals and its low default rate relative to other fixed-income securities. These two features have resulted in household investors dominating the ranks of municipal bond holders. As shown below, individuals directly hold more than half, or $1.879 billion, of U.S. municipal debt; when $930 billion in mutual fund holdings is included, the household share rises to three-quarters. Although the low default history of municipal bonds has played a key role in luring investors to the market, frequently cited default rates published by the rating agencies do not tell the whole story about municipal bond defaults.
Two large bond rating agencies, Moody’s Investors Service (Moody’s) and Standard and Poor’s (S&P) provide annual default statistics for the municipal bonds that they rate. S&P reports that its rated municipal bonds defaulted only 47 times from 1986 to 2011. Similarly, Moody’s indicates that its rated municipal bonds defaulted only 71 times from 1970 to 2011. As shown in the table below, this record of defaults compares very favorably with the corporate bond market, especially given the larger number of issuers in the municipal bond market.
However, not all municipal bonds are rated and the market’s rated universe only tells part of the story. We have developed a more comprehensive municipal default database by merging the default listings of three rating agencies (S&P, Moody’s, and Fitch) with unrated default listings as tracked by Mergent and S&P Capital IQ. Rather than confirming Moody’s 71 listed defaults from 1970 to 2011, our database shows 2,521 defaults during this same period. Similarly, our database indicates 2,366 defaults from 1986 to 2011 versus S&P’s 47 defaults during this same period. In total, we find 2,527 defaults from the period beginning in the late 1950s through 2011. (We don’t have complete information on the number of issues, so we can’t compare default rates.)
Our findings raise the question, What causes such markedly different default frequencies between rated and unrated municipal bonds? Our answer: Not all municipal bonds are created equal. Different types of municipal bonds are secured by very different revenue sources with varying levels of predictability and stability. Furthermore, we believe that rated municipal bonds tend to be self-selected: issuers are less likely to seek ratings if their municipal bonds are not likely to achieve investment grade ratings.
To provide some background, we note that the municipal market is bifurcated into general obligation (GO) bonds and revenue bonds. GO bonds carry the broad full faith and credit pledge of a state or local government.; GO pledges are considered among the strongest type of security because municipalities have the authority to levy taxes; GO defaults like those in Jefferson County and Harrisburg are relatively rare. Revenue bonds, on the other hand, are backed only by a pledge of revenues raised from a specific enterprise, such as an airport, toll road, hospital, or school. GO bonds are therefore stronger than revenue bonds, because the revenue base for general obligations is much broader (for example, the ability to levy taxes on property or citizens within a specific geographic area) than the typical revenue bond revenue base (for example, a specified stream of revenue or enterprise).
The default risk of a revenue bond varies with the essentiality of the service provided by the enterprise. For example, water and sewer utilities provide essential services and thus have a strong ability to generate revenue. By contrast, the services offered by an alternative energy plant, pollution control facility, or other corporate-like entity may not be considered essential, because of the availability of other energy sources. Thus, these enterprises may have less potential to generate revenue. Alternative energy plants, pollution control facilities, and other corporate-like enterprises are all examples of industrial development bonds (IDBs). IDB financing projects using new technologies or projects with no historical track record tend to make up a majority of unrated IDB defaults.
It is also not surprising that revenue bond sectors, such as IDBs, experienced more defaults than GO bonds because they have made up almost two-thirds of municipal new issuance since the mid-1990s. While total municipal issuance has bounced around over the past sixteen years, revenue bonds have remained between 60 percent and 70 percent of new issuance.
To clarify how the number and behavior of municipal bond defaults compare with those of corporate bond defaults, the graphs below plot each series against the Philadelphia Fed’s national coincident index, a proxy for GDP. In the case of corporate bonds, defaults occur at a higher frequency during recessionary periods. In contrast, the pattern of municipal bond defaults appears less tied to recessionary periods. The absence of a clear pattern leads us to believe that municipal bond defaults may be more a function of idiosyncratic factors associated with individual sectors or issues than the result of broad macroeconomic developments.
The second graph also illustrates one of the main points of our post: the untold story of municipal bonds is that default frequencies are far greater than reported by the major rating agencies. Again, this is partly because the rating agencies’ default numbers only cover bonds that they rate, and the unrated portion of the market can be home to municipal bonds of lower credit quality, exhibiting a higher frequency of defaults. Until recently, investors could take some comfort from the fact that many municipal bonds—both rated and unrated—carried insurance that paid investors in the event of a default. But now that bond insurers have lost their AAA ratings, they no longer play a significant role in the municipal bond market, increasing the risks associated with certain classes and certain issuers of municipal debt.
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Meredith Whitney=early
If she were a President she's be "Baberaham Lincoln"...
An entirely obvious trade that nobody is talking about is the Muni-Treasury Arbitrage compression trade. For example the yields on 10 year California notes average at around 2.5%, whereas the UST 10 year yield is around 1.77% - that’s a 73 basis point arbitrage! Our congress and Federal Reserve are willing to assume the liabilities of state governments and thus our muni debt has a safe haven status equivalent to that of US Treasury debt. Of course, you could make the case that both muni and treasury yields are headed much lower, in which case you could make more money just buying the notes – and personally I would not argue with that.
You still averaging down your cost basis on FB?
"...muni debt has a safe haven status.."
Best pile in MDB, nobody here will hold you back
...er, you have read this article yes?
"...muni debt has a safe haven status equivalent to that of US Treasury debt.."
pile into US Treasury debt too MDB, got a crash helmet?
"..personally I would not argue with that..."
who could argue with a Progressive, it's a belief system like religion afterall, don't let truck loads of reality awaken you. Ok every Progressive Project around the country is bankrupt but if you keep buying California et al's debt you'll keep your believers alive a few minutes more
Go For It MDB, buy all the Muni and US Govt debt you can, you can even use the debt as leverage for more credit it's considered such a 'safe haven'. That's how Progressives build their castles in the sky isn't it, on the solid foundations of ever expanding debt piled onto more debt.
Don't let the reality Progressive politicans suicide spending orgy's are conducted with no plan ever to repay the debt worry ya
Yeah, and the conservatives have been so much more responsible with their borrow and spending. ''Reagan proved the deficits don't matter'' - Dick Cheney. And no one on the right so much as flinched.
and the xxx did so much better blablabla. Your response is so sheeplish.
Remember, they (them parties) are all evil. You don't have a choice. It's a two headed dragon.
So you don't vote any more either? Me too.
Party on Wayne!
Sorry, I forgot where I put my shocked face.
Last report on NY fed site on repo intervention dated 8/10.
Repos have 3 day duration.
What are they hiding ?
Defcon 1.
"What are they hiding ?"
that's easy - "default"
gonna raise your property taxes next year for sure.
Like they do every other year anyway.
It's galling to see the $400+ (over 10%) increase. Then at the bottom of the bill there is a $100 "Homestead Exclusion" - which I tried not to apply for, since I figured I wouldn't qualify or it wouldn't amount to much. Nuh-uh, had to file the application - it is the law! So, woo-hoo my county excludes 100 bucks of the taxes, but raises the millage or rate every year anyhow. Claim is my county makes lots of money on their new prison by housing overflow from nearby counties. Guess that's the new growth industry around these parts.
So, yer county is making munny from prisons, yet they still have to raise yer taxes -- what, so they can hire more county clerks to count all the moola?? WTF?
There is a cancer on our Monetary system........... and it is growing
Isn't there a mmandate that any of these bonds require either the revenue generating entity or tax entity to restructure (ie raise rates / taxes) in order to make the defaulting bond hold whole?
In addition to the public pensions you have moron's who do things like this
Where Borrowing $105 Million Will Cost $1 Billion: Poway Schools
snip
Last year the Poway Unified School District made a deal: It borrowed $105 million from investors to fund a final push in its decade-long effort to revamp aging schools.
In many ways, the deal was unspectacular. Some of the money was used to pay off previous debts from delayed and over-budget construction projects. The rest went towards finishing upgrades that Poway taxpayers had been promised as far back as 2002. To a casual observer, it was just another school bond.
But Poway Unified’s deal was far from normal.
In 2008, voters had given the district permission to borrow more money to finish its modernization, and they had received a big promise from the elected school board in return: No tax increases.
Without increasing taxes, the district couldn’t afford to borrow money in the conventional way. So, instead of borrowing from investors over 20 or 30 years and paying the debt down each year, like a mortgage, the district got creative.
and this
The California Conundrum: New, Costly High-Speed Rail vs. Massive Budget Deficit
That's lovely--a timebomb.
Between HEALTHCARE COSTS and PENSION costs....THERE IS NO WAY THEY CAN GO ON SOLVENT. NO WAY.
I love pensions as much as the next person, especially if I get one that is 3 or 4 times my base salary. However, do the math.
If you start with 5 cops in your muni....that is 5 salaries that are paid for by tax payers since they are not a revenue job.
They retire.....HIRE 5 MORE COPS.....WHILE PAYING THE OLD COPS.....
NOW WE HAVE 10 COPS ON THE SALARY......They next 5 retire or are hurt at 42 yrs old and get their pension.......
Hire 5 more....Now we have exponential growth in liabilities.....
EXPONENTIAL.....and we wonder why it doesnt work!!!
most people can't balance their checkbook, much less understand exponential equations.
Law,
I kinda wish you were not right but I know you are spot on.....common sense is an oxymoron of the first order. Top of the list really.....
This girl, going to grad school I think since she cant find a job, worked with my wife this summer......SHE DIDNT KNOW WHICH DIRECTION THE SUN SET!! And I am not asking for exact degrees......just 1 out of the 4 major directions and she didn't know....
Bottom line, if you want to pay these useless civil servants a pension, have them fund it personally like a 401k.
That is the fly in the pudding.....pensions....
In regard to your "useless civil servants" comment,
Be careful what you wish for there are many good folks who are leaving civil service because they can find much better compensation in the private sector. Common sense tells you that you do get what you pay for.
The problem is in the moral hazard and the lack of accountability and oversight (not to be confused with regulation).
In essence, fraud is the fucking status quo, and at ALL levels of society.
Restore real consequences for bad behavior at all levels and most of the world's problems take care of themselves.
Another common sense issue is that of income and the real value of a persons labor. Does it really make sense that my capital gains (the result of pushing paper) should be taxed at 15% while the salaries of my employees (who plant, grow, harvest, and deliver real agricultural products and face numerous challenges in doing so) pay 35%.
Income that you can use to enrich your life is fucking income, tax it all at the same god damn rate (preferrible lower) already.
Is this the "adult conversation" the Romney and Ryan want to have? I hope so, because if they did and had a strictly no bailout policy, that would be a game-changer. Ryan's voting record as a career politicain is very clear, we have no "choice".
I'll write in Ron Paul, sleep well, and support my employees (who are my business) as best I can.
How true.
Fraud and Govt. have been and will always be synonymous. Like Lincoln knew from the start that the boats the Govt needed for the war (Civil) were not only priced 5x more than a boat we could get but it had holes in them to boot!!!
That is for starters, the companies that service the govt.
Then there is the constant skimming from everybody near the honey jar....
bottom line: if it were their own company, private, THEY WOULD NOT LEVERAGE 40, 50, 60 TO 1.......
I would do anything WITH YOUR MONEY TOO!!!
Bailed out with a windfall payment to get lost.....that is a sore dick....you cant beat it! (if it's you!! the ohter 99.999% think it sucks!).
There is no punishment; therefore, do it again
You must pay very well. I don't know of many labor jobs that pay enough for someone to be taxed at 35% even if you count federal & state taxes.
To be fair: what does this one girl have to do with civil servants? Since she doesn't have a job, I guess not.
Seems more geometric to me than exponential.
and don't forget to extend that formula to any of the multitude of National Agencies...
Uuuhhhh, heh heh. He said exponential.
All economies are local, especially muni markets (individuals holding their own debt). If you want to know how yours is doing, get off your ass and take a walk around your community. What's that saying in real estate again? location, location, location.
Any muni you buy should be rated, wheteher Moodys, S&P or Fitch. Due to the debacle of 2008, less faith is given to insured muni's. Trying to keep this short......know the underlying credit of the municipality or entity issuing the debt and the call features.
Pigs get slaughtered.
Hippocratic Oaf
Are those ratings any good remember Warren Buffoon's Moody's (Wells Fargo & at the time majority owner of Moody's sweet)
Negative Reviews for Warren Buffett's Defense of Moody's to Crisis Commission
Wells Fargo Fined $6.5 Million Over Risky Mortgage Securities
Some other dirty secrets
Money Market Funds Can Lose Money, Just NotYour Money
Breaking a Buck, Maybe, but Not Taxpayers’ Backs
Municipal bonds are the first in line to get paid under bankruptcy, so investors should want cities to file for bankruptcy rather than just default, right?
Lost Wages
Looks like that depends on where you live
California Bankruptcies Shield Retirees, Not Bondholders
U.S. Pension Crisis: States Choose Bondholders Over Public Employees
Teachers, SEIU own the democratic party in SF. Cops and Fire own everybody.
My retired parents are "bondholders" because their adviser has all their money in ACTFX and ORNCX, so I have to wonder how it is going to turn out. (They won't listen to me about silver & gold. Won't get a single ounce.)
"Lost Wages My retired parents are "bondholders" because their adviser has all their money in ACTFX and ORNCX, so I have to wonder how it is going to turn out."
You know Lost Wages your parents are the other side of a story that a lot of people who use class warfare leave out. Investing is not exclusive to the 1%.
Lost Wages .... we're more alarmed about all the leftist baggage in your head !
One thing leftover from being a Democrat is that I still enjoy trolling Republicans.
I think he meant to write: "As shown below, individuals directly hold more than half, or $1,879 billion, of U.S. municipal debt" instead of $1.879 billion. Very large disparity!!!!
Europeons swap the usage of commas and periods in monetary numbers.
bond insurance, what a scam.
Muni bond insurance is pure brilliance. Premiums for the life of a 30-year bond are paid entirely upfront based on IRS approval of "bond insurance" as an eligible use of tax-exempt bond proceeds. Premiums averaged 3% of a bond issue (thats $3mm upfront cash on a $100mm bond deal). As bonds roll down the yield curve, that 30-year bond issue will be refinanced over and over and over again. On each refinancing, the bond insurer simply pockets those old $3mm premiums as "profit" since holding reserves isn't necessary for retired bonds. Even better, the insurer collects new upfront premiums (ie, another $3mm) for the life of the refunding bonds (which will also be refinanced before stated maturity).
Assuming four refinancings by the time the original 30-year bond would have matured, the original $3mm insurance "premium" becomes $12mm of bond insurer "profit" financed directly from the proceeds of taxpayer debt. With each new deal... everybody wins! Bond insurer gets paid, rating agencies get paid, financial advisors get paid, wall street earns fees, investors feel safer, municipalities pay less interest (on more principal), and the IRS exempts less interest (more tax revenue). The only downside is that individuals earn less tax-exempt income, and the taxpayers will have financed the same "lifetime" bond insurance fees multiple times with the blessing of the IRS!
It really does pay to have friends in Washington!
That's some pretty charts and graphs and some time was obviously spent putting this article together. I would offer a much more simple explanition as to why rating agency default rates differ from the finding of the article: The rating agencies will keep their rating on a bond right up until the event of default and pull the rating(s) at the very last second. By doing this the rating agency can say that they didn't have a rating on a bond that defaulted.
Correct, another scam. The mis-allocation and malinvestment of capital and resources continues.
I read somewhere that the Governments with the lowest tax rate have the lowest default rate. Don't buy Munis in States/Cities with high tax rate.
Here is another interesting observation: the states with the weakest credit ratings typically vote democrat.
Oooooops.
Muni bond insurance is a pretty thin (and not free) film of security anyway. Unless a default happens as a stand-alone, isolated event (hardly the case these days), the risk of your claim not getting paid shoots up as each muni fails.
Remember what happened to the RE monolines in 2008?
So they are allowed to default by their state after all? That's good news!
Yes, of course all of these shit unrated munis default frequency is greater. . .
It should be remembererd that bond insurers all went down because they participated in the subprime fraud, credit wrapping mortgage turds to tripple A: shit to shinola magic. If they had stuck to their core business they'd still be AAA. Clearly, enough muni failures would take them down, but what has happended so far is virtually nothing vs what their reserves were.
Ironically, bond insurers expanded into mortgage-backeds and structured credit because the rating agencies told them to diversify their revenue streams to maintain their AAA ratings. Oh, Karma. I guess the rating agencies wanted to expand their own revenue stream in crap asset-backed ratings. Mission accomplished.
This is the kind of article that I like to see in ZH; providing the facts that should be well known, but that you just don't see in mainstream media.
A continuing education, in a field of interest to me.
Atta-boy.
How much municipal debt is owned by solvent municipalities .... taking advantage of a good deal ? Monedas 1929 That is the question !
Sudden surge in bond issues-
http://blogs.marketwatch.com/thetell/2012/08/15/companies-stampede-to-issue-bonds-in-august-informa/