Let the States Go Bankrupt?

As I work for my own state's budget office, this headline got my attention: http://www.msnbc.msn.com/id/41188877/ns/business-the_new_york_times/

I think that those pushing this have a hidden agenda and are not as "concerned" about the fiscal health of the states as one might think. At the end of the day, very few states are in what I would call real fiscal stress in that very few sit around and wonder on a regular basis whether or not they can pay their upcoming obligations. Illinois and California are probably the only two.

The argument is, mostly, predicated around the discussion of future pension and healthcare obligations. Some studies have greatly exaggerated the level of underfunding for pensions and this is something I was hoping to address in a post this weekend and I still might.  However, if you believe those studies, then you might say that we have to let the states have a mechanism to jettison these obligations.

I will address this in further detail this weekend. Understand that anything I say is not the official position of the State of Wisconsin, but rather my own view of the larger issues here.

Illinois and the state of local government debt

http://www.washingtonpost.com/wp-dyn/content/article/2011/01/12/AR2011011206436.html

I think that Illinois' dramatic tax increase (which is larger than I have ever seen a state do) is evidence that state and local governments that face insolvency have the willingness and the means necessary to address their problems. Among major state and municipal governments, I really haven't found any that have so overexerted themselves to the point that they cannot reasonably increase their tax burdens or decrease spending by enough to make up the gap. As such, Meredith Whitney's assertion that there will be between 50 and 100 major municipal defaults is a little questionable.

The Municipal Bond Rout

One thing I've always marveled at is just how quickly a bond market panic can materialize. Case in point, the municipal bond market rout over the past several trading days.

My favorite proxy for munis, MUB, has sold off in spectacular fashion, but this rout has not been entirely confined to munis. Treasuries have sold off too, as shown in this comparison with TLT.

Still, when you consider the generally narrower bounds in which MUB trades due to not only being long term securities, it is clear that this sell-off is more than just a turn away from government bonds generally. Now, as to the proximate cause of this panic, it is hard to say. There isn't a general financial panic like there was when muni bonds did this back in 2008.

That sell-off was caused by hedge funds desperately raising cash from whatever they could and they liquidated municipal bonds without mercy. This sell-off has been partially blamed on a large issue by California  coming to the market. I'm not so sure about that. I have a hard time buying that a $12 billion issue by California is enough to cause this mayhem. It is true that with Republicans now controlling one house of Congress that federal aid to state and local governments is unlikely to aid them as they attempt to bridge their budget gaps. Still, the election outcome was not a surprise and usually bond markets price things like that in.

The PIMCO California Municipal Income Fund (PCQ) might be making a bit of a fool of me, though. It has shown a sharper rout than munis in general and because California is such a large segment of the muni market this may make sense. However, with California now having the ability to pass budgets more easily, I'm not sure that questions about California's solvency are quite as pertinent as they used to be. Regardless, California munis have been obliterated.

Very oddly, this has been accompanied by a sell-off, not a rally, in gold. If there's one asset I would expect would do well in a rout of safe assets, it would be gold.

This bears watching and there's easy money to be made in munis if the sell-off gets out of control. Don't be so foolish as to pick up individual issues since if you happen to buy a special district's issues without understanding what revenue stream backs its payments, you can end up in a world of hurt. Those can and do default.

The crazy(?) bond rally

Over the past four weeks or so, the bond rally has become truly epic. I have been truly stunned by the magnitude of it.

Here is the oft-mentioned TLT, which tracks the 20 and 30 year US Treasuries.

It's charted against SPY (the S&P 500 proxy) and EEM (the emerging markets proxy). To show that the bond rally has some breadth, let's look at municipal bonds as well. Now, the MUB is not just a long maturity municipal bond fund but rather a larger aggregate so its moves aren't as dramatic, but it tells a similar tale.

The same had also held with corporates, as represented by LQD, which tracks long term investment grade corporate debt.

Now, the question that many are asking is "Is this a bond market bubble?" Well, current interest rates do seem absurdly low. In terms of the stock market, it would be the equivalent of paying 40x earnings for a company's stock (the equivalent of a 2.5% earnings yield). However, with inflation also at historic lows, the bubble might not be as big as some are claiming. If you are of the view that inflation will soon accelerate to 4%+, then yes, bonds are dramatically overvalued. If you believe instead that inflation will be between 0% and 1.5%, the overvaluation of bonds ranges between not much and only marginally overvalued. I do happen to think that, when you look at comparative stock market measures, bonds are at least moderately overpriced. That holds true so long as corporations will be increasing their earnings even at a moderate pace over the next several years.

With the Fed possibly embarking on more quantitative easing (the direct purchase of treasuries to increase the money supply), one might wonder if interest rates will be capped at these low levels or even drop further. The last time the Fed did a similar action, interest rates rose anyway because market expectations of an economic recovery picked up. At this juncture, it's hard to say which way they will go, but I think that past performance might be a decent indication. Quantitative easing is a powerful stimulative tool and if the Fed is zealous in its application, it actually might actually have the net effect of increasing interest rates through market expectations of higher growth. All of this remains to be seen, however.

Municipal Debt Worries Overblown

Now, this is outside of any official capacity I have with the State of Wisconsin and I personally own no municipal bonds, but I do think it is important not to fall victim to scare tactics. For weeks and even months, there have been numerous attempts to prompt a run on the municipal bond market. The simple truth is that worried are far overblown. This article from last week expresses the view of one firm, but I think it is correct: http://www.businessweek.com/news/2010-07-20/insurers-risk-of-municipal-debt-defaults-overblown-fbr-says.html

Neither I nor most readers of this blog have much use for municipal bonds since the tax-free status of the interest on most issues means very little to us. There are online calculators all over the place that help assess at what rates tax-free versus taxable bonds make sense at given income levels and I won't get into that now except to say that if you don't know if buying municipal bonds makes sense to you, the odds are that it doesn't. However, the issue as to whether or not there will be hundreds of billions in defaults that will cripple the balance sheets of insurance companies like Aetna (AET) and WellPoint (WLP) or possibly bank balance sheets is worth mentioning.

The simple truth is that most municipal and all state governments have very robust provisions to insure the timely payment of debt service. California proved that in spades recently. Some special districts with limited taxing authority have defaulted and many more probably will, but in terms of large scale general obligation bond defaults, that's a very unlikely scenario indeed. If you are looking for the "next shoe to drop", this is not it.