Thursday, September 17, 2020

Muni haircuts

"Municipal bond investors have to share the burden in state bailouts" writes my colleague Josh Rauh, and he is exactly right.

Background: State and local governments borrowed a lot of money and blew it. They borrowed further by not funding their pensions. Now covid comes along, people are fleeing cities, and they don't have tax revenue to fund ongoing expenses. 

The big question hanging over Washington: If we are going to help state and local governments weather the storm of their current expenses, does that mean federal taxpayers bail out the bondholders who lent state and local governments all this money? 

As in the Greek crisis, bond investors and their allies like to clam "contagion," that any losses will spark a financial crisis.  

Whether that argument has any merit in other cases, as Josh points out it does not hold for municipal bonds in the current financial environment. Municipal bonds are illiquid and tax-exempt and thus well targeted at very wealthy high-income individuals who face high tax rates, and whose saving is thus beyond IRA, 401(k) and other tax-free investment possibilities. And we are not in a systemic financial crisis. of this spring, around 12 percent of municipal bonds were owned by banks. This implies only about $130 billion of total exposure to all general obligation municipal debt by the banking sector, compared to well above $1 trillion of tier one bank capital. Similar amounts of general obligation municipal debt reside on the balance sheets of the insurance companies, where municipal bonds are 7 percent of assets.

The remaining municipal bonds are directly owned by individuals, or in mutual funds and exchange traded funds largely owned by individuals. Municipal bond defaults would primarily affect individual investors, and especially individuals who buy tax exempt municipal debt because they are looking for tax free income.

Of a piece with the effort to restore the state and local tax deduction, the effort to bail largely blue states and cities out of their debts to largely blue high income taxpayers is just a little bit inconsistent with tax the rich and tax their wealth rhetoric.  

Daniel Bergstresser and Randolph Cohen presented a paper a while ago at a Brookings conference, measuring that 42% of municipal bond value was held by the top 0.5% of the income distribution. Now that so many including the Fed are interested in racial justice, similar breakdowns of who holds municipal bonds would be interesting. Given the racial disparity in wealth, it would be astounding if the disparity in municipal bond holding were not very large as well.   

Josh's solution is straightforward: 

Congress has to therefore condition any further bailout funds on shared losses by municipal bond investors. For instance, the law can mandate that state governments pass legislation that would write off a dollar of municipal bond debt for every dollar of additional grants given to a state or local government.

If we ever are to have any sort of market discipline, if a Fed put is not going to protect all large and politically potent issuers and all large and politically potent investors, who got outsized returns for many years by holding risky assets,  from actually taking those losses when it counts, rather than one more taxpayer bailout, this seems like the time and place. 

Municipal bonds are already highly subsidized, by their tax deduction. State and local governments have responded predictably by borrowing a lot. (Universities also get to borrow at municipal bond rates, and effectively use the money to invest in their hedge-fund endowments.) If municipal bonds now enter the too big to fail regime, the subsidy and incentive to over borrow explodes. 

This situation is part of a general conundrum. The government and the Fed has taken on forestalling bankruptcies of large businesses and governments in the covid recession. (Restaurants, small landlords, and other small businesses no. But AAA bond issuers, and municipal bond issuers yes.) 

To forestall a bankruptcy, you do not just lend money for current operations -- you end up taking on past debts.  

Fortunately the recession seems to be ending quickly, because the magnitude of debt that might end up in federal hands under the no-bondholder-may-lose-money regime is pretty frightening. 


French Translation at Vox-fi


  1. The case for the municipal bondholders to get a haircut in any kind of bailout is very straightforward. Which is frightening is being in a position in which this principle has to be discussed. You take a risk, you bear the consequences: do your homework before investing! There is not (or at least there should not be) such a thing as a free lunch.

    What I don’t get is why you say investors are subsidized when they buy muni bonds because they are tax free. This feature of the muni bonds is there to allow municipalities to borrow at a lower interest rate.

    It is the federal and state government subsidizing the municipalities. The former foregone some of their income to allowing the later to pay less interests in their debts. The feature is more attractive the higher your tax bracket, but, still, investors are analyzing investment opportunities based on their after-tax returns. In the absence of the "tax free" feature of the munis, the municipal debt will just be more expensive.

    So, who is the one been subsidized here is not so clear to me.

    1. I read the post to make the same point that you are: "Municipal bonds are already highly subsidized, by their tax deduction. State and local governments have responded predictably by borrowing a lot ... If municipal bonds now enter the too big to fail regime, the subsidy and incentive to over borrow explodes."

      That's saying that the subsidy goes to the borrower, not the bondholder. Hence, the incentive to over borrow, because of lower interest rates.

  2. The Federal Government is the ultimate "commons." All of the representatives in the House and Senate represent states, not the country as a whole. So, over time, the shared commons that is the Federal Government has its financial state eroded for the states. There's a reason why almost every democratic country runs persistent deficits, and this is it.

  3. If you remember the bankruptcy of Orange County (1994) [ ], you will recall that Orange County leans Republican, by and large. The bankruptcy was caused by a leveraged investment fund owned by Orange County that made one-way bets on the direction of interest rates. They chose the wrong side of the bet and lost big--hence the bankruptcy when Wall Street lenders refused to provide further liquidity to the investment fund.

    How did it go? The county made an arrangement with creditors. By 2017, 23 years later, the county made its final repayment on $1 billion of indebtedness to Wall Street creditors. On July 1, 2017, only $20 million was outstanding, and unpaid. In the interim services were cut, but property taxes were not raised. [ ]

    A general obligation municipal bond is secured by municipal revenues and property taxes. Bond holders would be second, or third, in line after the federal government, and the state goverment. This makes it less likely that municipalities will default on their obligations to bond holders. Is it probable that municipalities will default on their promises to pay/redeem the debt when it comes due? It seems unlikely, unless there is no other recourse. But, even then, default is an unlikely outcome, compared to reduced services and employee head-count cuts.

    Another tempest in a tea-cup; or the real McCoy?

  4. The best time to avoid moral hazard is before you start advocating for bailouts or haircuts. If the private property within a city is still worth several times more than a city's outstanding debt, why should the city be allowed to haircut bonds or be given a bailout? Why aren't the property owners in the city on the hook for bonds that they could actually repay? Of course anyone facing a tax bill that forces them to sell their house is politically unpalatable, but isn't that what these property owners signed up for? I understand why a city or US state would want to avoid this, like a sovereign nation does, but let's be clear what this comes down to is that people who could pay don't want to honor their debts. US courts should enforce the terms of municipal bonds to the letter.

  5. I searched a little to verify "Now covid comes along, people are fleeing the cities..." I only found so far data.

    August 12, 2020: "Are people fleeing the cities for greener suburban pastures? Some faint signals may have emerged in certain places, but by and large, the data show that suburban housing markets have not strengthened at a disproportionately rapid pace compared to urban markets." - Executive summary, sorry no time to wade through the report.

    September 5, 2020: "Freedom to Telecommute Could Add Almost 2 Million Potential Buyers to the Market". So from that title I take that there's a trend to move out but not directly from COVID but indirectly by the increase from telecommuting.

    Is reliable? Hard to tell but the Feds have referenced it ( Not sure if the Office of the Chief Economist is respected here.

  6. TBTF comes in so many forms. NJ Gov Murphy will tax the wealthy to cover the states budget shortfall. Inept public officials bankrupt cities, states and countries. October 19, 1987, several large brokerage houses, as an income strategy, opened short put and call positions for investors. The investors lost millions and threatened legal action. Subsequently, those firms asked traders who made fortunes that day, if they would "disgorge" some of those profits so as to reconstitute the accounts of those customers. Being private agents we had the option of saying no. We did, UNANIMOUSLY!

  7. The moral equation should include [1] venal politicians who have a conflict of interest due to their own anticipated pensions; [2] actuaries who have a guardian role but sidestep that role by allowing politicians or unions to set actuarial assumptions; [3] CPAs (guardians) who sign financial statements using reliance on those actuaries; [4] unions who trade votes for pay raises when they should be negotiating for pension contributions; and [5] rating agencies, bond lawyers and consultants (also guardians) who cajole local officials to finance operations and refinance debt through the bond market. Most institutional investors are tax exempt. Most muni-bond investors are wealthy. Most of the foregoing [1-5] have exculpatory clauses in their engagement letters ... which ought to be void as a matter public policy. They also get paid "in front" and charge exorbitant fees. Official Statements are laboriously drafted to eliminate liability on the part of the supposed guardians.

    NOW, the politicians are mostly "immune" under state law; retirees, bondholders and other victims may or may not deserve sympathy although the "system" is unable to adjudicate individual circumstances. Meanwhile, the expectations are like water allotments from the Colorado River. No water, no tax revenue, demographic issues, etc.

    We can either treat government responsibility as some sort of welfare program to avoid poverty among the retirees or we can adopt some sort of federal insurance or bailout which ignores the moral culpability of all the players. In any event, a bailout should have caps on what's bailed out and should be tied to reforms such as benefit reduction through bankruptcy.

    Notwithstanding what logic and pragmatism may suggest, the emotional component and partisan outrage can't be wholly neglected. Train wrecks loom and as of today the only remedy is bankruptcy [states excepted for the time being] and even with the spore of disorder in the wind bankruptcy provides the only moderately orderly approach. State courts as well as legislatures and executives are so-far conflicted that little that is fair can be expected from those institutions.

    Now the pension beneficiaries and bondholders are not "innocents." Pension beneficiaries "rely" on their pension but they also elect union leaders and vote for politicians as instructed. Bondholders believe salespersons and rating agencies and don't read or even understand official statements.

    I admit to being both old and grumpy. I am no economist but worry whether all the bailouts on the horizon, including both federal and state entitlement programs and federal and state pension promises will destroy the economy through some Weimar inflation. On that point, I'd welcome feedback from those who enable us to ventilate here.

  8. Observation of the day at the WSJ, "Markets" newsletter:
    "On this day in 1998, Wall Street’s top investment banks, encouraged by the Federal Reserve, completed marathon negotiations for a $3.65 billion bailout of the giant hedge fund Long-Term Capital Management, which lost nearly $2 billion in a single month when the mathematical models designed by two Nobel laureates failed."

    "...when the mathematical models designed by two Nobel laureates failed."

    Makes one wonder... .


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