“Real Deal Or Raw Deal”

Dolors & Sense

by Sanford Rose

KISSIMMEE, FL—(Weekly Hubris)—3/15/10—Main Street says it’s the next financial disaster; Wall Street says it’s a rich lode that can still be mined.

The “it” is the municipal bond market, a nearly $3 trillion, formerly somnolent souk that has cratered and then revived spectacularly in the last two years.

The electronic and print media have been waxing eschatological over the future of this traditional tax haven. State and local governments face their most daunting fiscal crisis in history; multiyear deficits of a cavernous depth impend. Budgets have been cut and taxes raised, but on nothing like the scale needed to plug the gap.

Only the much-touted and thus far elusive “V-shaped” economic recovery would suffice, but the very actions that the states have taken to palliate their problems impede rapid national economic recovery. Cutting appropriations erases jobs; raising taxes reduces spending. While the Federal Government pursues contra-cyclical policies, the states and localities, in their immediate self-interest, pursue pro-cyclical ones. What Washington gives, Sacramento, Albany and Springfield help to take away.

Since states can’t monetize their deficits (print money), they must find ways to balance budgets while borrowing to meet allegedly temporary shortfalls. But, given the magnitude of their problems, who would continue to lend them money? Who is not spooked by the specter of default, which, according to many experts and those who echo their pontifications in the daily media, will envelop California imminently and Illinois, New Jersey and New York soon thereafter.

The answer is that thus far (and bear in mind that most financial analyses have a half-life of about 30 milliseconds) few if any who are possessed of financial wherewithal are frightened. Fearing higher taxes, investors have been scrambling to buy tax-exempt paper. At the same time, the supply of that paper (at least the so-called high-quality variety) is more limited than the investor would like. That’s because Congress has created a taxable bond, dubbed the Build America Bond, that provides a direct 35 percent rebate to the issuing state.

This rebate has been attractive enough to states to elicit a torrent of bond offerings. With states issuing relatively more taxable and relatively fewer tax-exempt bonds, the prices of the traditional tax-exempts have risen to vertiginous levels. Otherwise put, many states with, to say the least, precarious budget positions are nevertheless able to sell bonds at some of the lowest investor yields in history. Even California, reduced to issuing scrip for a part of last year, has been able to market its bonds at a penalty of only about 1.5 percent above market.

Greece should be so lucky.

Will it all blow up? Will the market collapse, as it did when the bond insurers in effect imploded in 2007 and 2008? Will states, or more likely cities, begin defaulting and thus provide the “event risk” that leads to another degringolade of values?

The standard argument is that only one state has ever defaulted–Arkansas in the 1930s—and none is likely to do so now. Arguments based on history are singularly weak, however, since the unprecedented has virtually become the expected in this the most troubled time since the 1930’s.

California could default but, if it does suspend debt payments, which, incidentally, account for only 7 percent of state revenues, the interruption is likely to short-lived. Still, the interruption would be calamitous. To forestall such a calamity depends, once again, on more forthright Federal action on housing (mentioned in my last column). Buying California bonds is in reality a speculation on the recovery of the housing market. And, thus far, while some sectors of the US economy show signs of recovering, housing is not one of them.

The government is trying a new approach, that of preventing foreclosures from weighing down the property market by encouraging “short sales” through cash incentives. The approach isn’t likely to work, in part because it is, despite some implied coercion of banks, a voluntary undertaking. Banks would be permitted to reject any short sale, the proceeds of which fell short of an outside appraisal. Since most short sales are made at prices much lower than appraised values, banks would end up having to accept very few of these transactions.

Unless we get serious about remediating the root causes of our difficulties, ancillary problems that result from and in turn serve to compound these causes (positive feedback of a negative kind) will not be solved. We will not exit this crisis. California may well default on its debt (one of its smallish towns, Vallejo, has already gone into bankruptcy). The high-flying municipal bond market could well come crashing down, despite investor yearning for that evanescent tax exemption.