“Beware Of Greeks Baring Lips”

Dolors & Sense

by Sanford Rose

KISSIMMEE, FL—(Weekly Hubris)—6/28/10—I guess finance is not hip. (Do people still use that expression?)

Hips are hip. I got no response to my previous half dozen or so columns. But I got some reaction to the last one—on hips.

Nonetheless, back to municipals, because they’re supposed to default and, if that happens, there is little doubt that we will double-dip (which would be hard not only on the hips but on everything).

A major hedge fund operator, a Greek-American named Jim Chanos, has been talking down municipals, probably because he wants to buy them cheap. And he is quite articulate, with a knack for getting on TV. But such talk is worse than irresponsible since it could lead, among other things, to higher borrowing costs for municipalities at a time they can least afford it.

Municipals are weakening anyway for the oddest reason: the IRS is investigating issuers of the taxable type of municipal that is dubbed the Build America Bond. That’s the child of the 2009 law that provides for a Federal subsidy to the issuing local government of 35 percent of the bond coupon.

The IRS thinks that some hanky-panky is taking place. Issuers are putting out high-coupon bonds that are promptly marked up in price by distributors. This means that the issuer can pocket 35 percent of a higher yield than is immediately available to the investor.

Fear that the IRS investigation will curb the issuance of taxable bonds and therefore stimulate the issuance of the old-fashioned tax-exempt variety, which are currently rather scarce, is pushing down prices in the tax-exempt part of the market.

As yet, however, prices are not terribly soft. Nor will they get soft unless there are widespread defaults or at least one really big default.

Thus far, most of the defaults have involved what are termed “dirt bonds”—relatively small housing development bonds, mostly in Florida.

These are routine, non-rated bonds the demise of which does not move markets. Aside from a few more prominent names, including two cities, there is little default activity—surprisingly, almost shockingly little.

The absence of defaults reflects the following factors:

1) Tax revenues in some states and localities have improved.

2) Expenses are being cut.

3) There are tentative signs that the problem of overgenerous pensions for public employees is being addressed.

4) The proportion of tax revenues needed to service bond debt is smaller than people think—typically, only between 3 and 8 percent.

5) Some states and localities can’t get between tax revenues and bondholders. By law or constitution, the bondholders get first or second crack at all available monies.

6) Many states and localities don’t want to get between them. They value their capacity to borrow too highly to monkey with it.

So, the loose-lipped Mr. Chanos notwithstanding, as yet, municipals do not appear fated to default in appreciable quantities. Investments in so-called safe-sector tax-exempts—general obligations of major cities and nearly all states as well as bonds secured by revenues for essential services like water and sewerage—should continue to pay off.