Something strange is happening in the short end of the Treasury securities market. Treasuries maturing in about 1 month are yielding around 0.01%. Just a couple of weeks ago, yields were above 0.10%. Perhaps this may all seem like peanuts (and it is, if you have, say, $10,000 invested). But a yield of 0.01% was last seen during the dark days of the credit crunch in late 2008 and in 2009, when the world's banking system faced a funding crisis. Such a low yield signified that no one trusted anything except the obligations of the U.S. government; that investors didn't care about getting a return. They just want to keep their money safe. The recent 90% plus drop in the short end of the Treasury yield curve in less than two weeks may be a sign that something is rotten somewhere.
Economists and other fortune tellers are raising their estimates for growth next year. Stock prognosticators are full of holiday cheer, predicting rosy returns for stocks in 2011. Consumers may be loosening their purse strings a bit for this year's holiday season. Recent tax legislation will widen the deficit for next year, ensuring that the federal spending spigot won't slow down. All systems are go, it would seem. What's to get stressed about?
Euro Mess. The European response to the Euro bloc sovereign debt crisis, generously assessed, has been tentative and muddled. The only clear impact has been to transfer risk of loss to European taxpayers and give the can a hard kick down the road. The continued uncertainty makes the U.S. greenback look good by comparison (once again demonstrating that it's easy to lose faith in America, until you look at the rest of the world). If you're going to dump Euros for dollars, it makes sense to buy the short end of the Treasury yield curve, where you're not competing against the Fed's quantitative easing program.
One group of potentially nervous investors would be money market funds that hold commercial paper of banks in shaky Euro bloc nations, like Greece and Portugal. Amazingly, in spite of the money market fund credit crunch in 2008, many money market funds bought this foreign issued commercial paper. (One wonders what happened to prudence, but then again prudence is something isn't brought up in polite company.) Those money market funds now may be quietly easing out of Euro bloc bank commercial paper and shifting into Treasuries before year end, when they'd have to disclose their holdings to investors.
Muni Mess. The muni market has fallen, about 5% in the past month. That may not sound like much, but if you held munis and it was your 5%, you'd be peeved. The future for munis isn't pretty. The federally subsidized Build America Bonds program turns into a pumpkin at the end of this year, and there won't be a fairy godmother for it next year. That means states and municipalities will face the harsh winds of the muni market without a quick fix from Uncle Sam. Many financially troubled states are still struggling with their budget problems. To make things worse, questions over states' pension accounting could compel larger state contributions to employee pension funds. Muni investors with battered portfolio syndrome may be seeking a port in the growing storm and heading for the safety of Treasuries.
Bond Mess. The bond market has fallen since early November, when the Fed formally announced its quantitative easing program. Investors who bet that QE would extend the 30 year bull market in bonds may now suspect that this time, things really are different. Those that aren't ready for the quicksands of the stock market may be parking at the short end of the Treasury curve, waiting to see whither the winds blow.
It's unclear that any of this will push the financial system back into the septic tank. Any analysis of that question would require information about who's holding what exposures in the derivatives markets. (Query: are major banks holding the hot tamale because they took the wrong end of the wrong credit default swaps?) But those markets are as opaque as ever, notwithstanding the enactment of the Dodd-Frank financial reform legislation this past summer. All we know is that the short end of the Treasury yield curve is at 0.01%, and the last time that happened, canaries in the mine were gasping.
Showing posts with label municipal bonds. Show all posts
Showing posts with label municipal bonds. Show all posts
Monday, December 20, 2010
Thursday, January 28, 2010
The Bubble Keeps on Bursting: Municipal Debt
The Big Asset Bubble of the early and mid-2000s continues to burst. The next big splatter may come from municipal debt, especially state government debt.
As we know, the Big Bubble puffed up real estate, stocks and other assets, and increased economic activity. That gave states more income and transactions to tax. State budgets bubbled up, and residents grew accustomed higher levels of service. When real estate and stocks nosedived, and the economy slid into recession, state revenues fell. But state debt holders continue to demand payment in full. California's problems have been well-publicized; its rating was cut a couple of weeks ago, although it's still somewhat above junk level. Other troubled states include Illinois, Arizona, Kentucky and Virginia.
All of these states are struggling to close their deficits. Unlike the federal government, states and municipalities are generally required by law not to have deficits. So cuts have to be made and/or taxes and fees have to be raised. At least that's what's prescribed by law. But state legislators and governors sometimes answer to a higher authority than the law--namely, their political futures. The governmental dysfunction in California is Rabelaisian in its grotesqueness and satire-worthiness. A default was narrowly avoided last fall, but could loom again this spring. Would the federal government bail out California? Given today's politics, with the Obama administration having today survived a second populist insurgent strike with the Senate's confirmation of Ben Bernanke for a second term as Fed Chairman, one would say no. But then again, that's what Gerald Ford said when New York City was on the verge of default in 1975, only to extend the city a loan that he adamantly refused against all the evidence to characterize as a bailout.
The problem with a major default in the muni bond markets, by California for example, is that it could chill the entire sector. That's what happened with money market funds right after the Lehman Brothers bankruptcy filing in September 2008. A well-known money market fund called Reserve Primary had to break the buck (i.e., reduce the valuation of its shares to below $1 each) because it held Lehman securities that had suddenly gotten very stinky. Investors across the entire multi trillion dollar money market fund sector freaked out. Only the announcement of an ad hoc temporary Treasury Department program insuring money market funds kept the entire sector from blowing up.
Sector-wide panic in the muni bond markets could shut down many state and local governments. They often borrow early in a year to pay employees and other operating expenses, and repay those borrowings later in the year after collecting enough taxes. A freeze-up in the muni bond markets might greatly reduce their liquidity, and leave them unable to cover operating expenses. Even if they could continue to operate, drastic cutbacks in employment levels and spending would exacerbate the slowness of the economic recovery--or even turn the economy back toward recession. If the administration and Congress have to choose between fiscal rectitude and facing a host of additional unemployed, angry voters in the fall, it isn't hard to foresee that expediency will be the better part of valor.
The federal government has already provided assistance to the municipal bond market. Last spring's stimulus package included a provision whereby the federal government would subsidize states' issuance of taxable bonds, so-called Build America Bonds. The federal government reimburses states for 35% of the interest expense of Build America Bonds, which effectively makes them about equally as expensive to states as regular nontaxable bonds. But the higher interest rate paid on Build America Bonds appeals to pension funds and other institutional investors that don't pay income taxes. So a potentially broader pool of investors than traditional high-income individual buyers of municipal bonds is available to invest in Build America Bonds.
These bonds have proven popular: close to $100 billion worth have been issued in less than a year. The federal government's potential interest costs are in the tens of billions. But the scarier thought is that bond holders may look to the federal government for a bailout if the states default on their Build America Bonds. After all, the federal subsidy drew many of them to these bonds in the first place. Of course, the federal government has no legal obligation to repay Build America Bonds. Then again, it had no legal obligation to pay the debts of Fannie Mae and Freddie Mac, or AIG, or . . . well, you see the point.
The U.S. Supreme Court just ruled that corporations and unions are no longer restricted in their campaign contributions. Unions, a bedrock Democratic constituency, are increasingly comprised of state and local government employees. After all, government employment levels have grown as industrial employment levels have fallen, and unions, like corporations, are driven by Darwinian imperative. In the acidic, 60/40, partisan atmosphere of today's national politics, expect unions to demand their due from the Democrats. With corporate America now ordering extra checks for all the additional campaign contributions it plans to make (and not to Democrats), a direct or indirect, one way or another federal bailout of state governments is all but inevitable.
As we know, the Big Bubble puffed up real estate, stocks and other assets, and increased economic activity. That gave states more income and transactions to tax. State budgets bubbled up, and residents grew accustomed higher levels of service. When real estate and stocks nosedived, and the economy slid into recession, state revenues fell. But state debt holders continue to demand payment in full. California's problems have been well-publicized; its rating was cut a couple of weeks ago, although it's still somewhat above junk level. Other troubled states include Illinois, Arizona, Kentucky and Virginia.
All of these states are struggling to close their deficits. Unlike the federal government, states and municipalities are generally required by law not to have deficits. So cuts have to be made and/or taxes and fees have to be raised. At least that's what's prescribed by law. But state legislators and governors sometimes answer to a higher authority than the law--namely, their political futures. The governmental dysfunction in California is Rabelaisian in its grotesqueness and satire-worthiness. A default was narrowly avoided last fall, but could loom again this spring. Would the federal government bail out California? Given today's politics, with the Obama administration having today survived a second populist insurgent strike with the Senate's confirmation of Ben Bernanke for a second term as Fed Chairman, one would say no. But then again, that's what Gerald Ford said when New York City was on the verge of default in 1975, only to extend the city a loan that he adamantly refused against all the evidence to characterize as a bailout.
The problem with a major default in the muni bond markets, by California for example, is that it could chill the entire sector. That's what happened with money market funds right after the Lehman Brothers bankruptcy filing in September 2008. A well-known money market fund called Reserve Primary had to break the buck (i.e., reduce the valuation of its shares to below $1 each) because it held Lehman securities that had suddenly gotten very stinky. Investors across the entire multi trillion dollar money market fund sector freaked out. Only the announcement of an ad hoc temporary Treasury Department program insuring money market funds kept the entire sector from blowing up.
Sector-wide panic in the muni bond markets could shut down many state and local governments. They often borrow early in a year to pay employees and other operating expenses, and repay those borrowings later in the year after collecting enough taxes. A freeze-up in the muni bond markets might greatly reduce their liquidity, and leave them unable to cover operating expenses. Even if they could continue to operate, drastic cutbacks in employment levels and spending would exacerbate the slowness of the economic recovery--or even turn the economy back toward recession. If the administration and Congress have to choose between fiscal rectitude and facing a host of additional unemployed, angry voters in the fall, it isn't hard to foresee that expediency will be the better part of valor.
The federal government has already provided assistance to the municipal bond market. Last spring's stimulus package included a provision whereby the federal government would subsidize states' issuance of taxable bonds, so-called Build America Bonds. The federal government reimburses states for 35% of the interest expense of Build America Bonds, which effectively makes them about equally as expensive to states as regular nontaxable bonds. But the higher interest rate paid on Build America Bonds appeals to pension funds and other institutional investors that don't pay income taxes. So a potentially broader pool of investors than traditional high-income individual buyers of municipal bonds is available to invest in Build America Bonds.
These bonds have proven popular: close to $100 billion worth have been issued in less than a year. The federal government's potential interest costs are in the tens of billions. But the scarier thought is that bond holders may look to the federal government for a bailout if the states default on their Build America Bonds. After all, the federal subsidy drew many of them to these bonds in the first place. Of course, the federal government has no legal obligation to repay Build America Bonds. Then again, it had no legal obligation to pay the debts of Fannie Mae and Freddie Mac, or AIG, or . . . well, you see the point.
The U.S. Supreme Court just ruled that corporations and unions are no longer restricted in their campaign contributions. Unions, a bedrock Democratic constituency, are increasingly comprised of state and local government employees. After all, government employment levels have grown as industrial employment levels have fallen, and unions, like corporations, are driven by Darwinian imperative. In the acidic, 60/40, partisan atmosphere of today's national politics, expect unions to demand their due from the Democrats. With corporate America now ordering extra checks for all the additional campaign contributions it plans to make (and not to Democrats), a direct or indirect, one way or another federal bailout of state governments is all but inevitable.
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