The Municipal Bond Market is Imploding

Moody’s Credit Rating Service just announced the ominous trend that credit quality in the municipal bond market is falling at the fastest rate since the collapse of Lehman Brothers in 2008. Data released showed that 5.3 times as many municipal bonds were credit downgraded over the three last months than were upgraded. Moody’s emphasized that: “Downgrades dominated rating revisions across all public finance sectors except for healthcare,” said Assistant Vice President-Analyst Dan Steed, author of the report. “A rapid deterioration in credit metrics led to a higher-than-average 14 multi-notch downgrades.” Often sold to individuals as “conservative investments with tax free income”, munis in states like California, Illinois, New Jersey, and Pennsylvania are increasingly looking like high risk rolls of the dice.

This credit implosion comes after a sustained period when muni bonds were performing much better than corporate bonds. During the credit crisis; corporate bonds prices dropped by 30%, while muni bonds suffered very modest losses. The main reason for this stability was bail-out money showered on state and local governments by the Obama Administration. But fed money has dried up and property reassessments are falling for the first time since the 1970s. Strains on core operating expenses and revenue sources will likely persist, according to Moody’s: “This will be mostly due to economic stagnation, high unemployment, declining home values, and low consumer confidence,” said Steed. “We expect downgrades to continue exceeding upgrades in upcoming quarters.” This is polite ratings speak for: “duck and cover”.

The state revenues fell by $14.3 billion, even as the national economy has seemed to stabilize. The quarter ending September 30th saw 163 ratings reductions, the second highest 90 total in history. Over 100 of those downgrades were cities and school districts where falling property-tax collection is playing catch-up on the downside to the 30% fall in real estate values.

John Dillon, chief municipal-bond strategist at Morgan Stanley, said after a downgrade: “Usually management snaps to attention.” To stay solvent states and localities have tried to cut costs and raise revenues. Most have delayed infrastructure projects, increased garbage collection fees, and even closed parks. But raising property taxes awakens taxpayer vengeance and threats of recalling local politicians. Anne Van Praagh, managing director at Moody’s, said fiscal conditions of some local governments can deteriorate more quickly now than in previous recessions. Moody’s recently cut seven states or localities by three grades or more.
Fresno, California’s fifth-most-populous city, two weeks ago had $477 million of their debt “super-downgraded” three levels by Moody’s and is under a “negative” outlook for the risk of further downgrades. Moody’s emphasized city’s budget gap is so large due to a “weak economic base, with unfavorable demographic and economic trends,” and the city lacks “ability to absorb additional budgetary pressure.” Furthermore: “Like all California cities, Fresno’s ability to raise revenues is highly constrained; its primary budget balancing option is cost reduction”. This is ratings speak for: property collection may fall 20% and the city must fire police and firemen.

The neighboring City of Stockton looks even worse. Following a Securities & Exchange Commission filing; the city admitted they will probably be the first in California to default on redevelopment agency bonds. Long criticized as crony capitalist honey-buckets; developers lavished huge donations across the state to gain access to tax free city financing of mega-projects with no-money-down. After the agency debt was downgrade to “junk”, Stockton optimistically stated they only expect a 3.17% drop in property values for 2012. Good Luck on that number!

With muni bonds generally in the hands of older citizens, there has not been the panic selling by institutions when bonds are downgraded. But many individuals have their entire life savings in municipal bonds. When defaults become a reality, the press will run endless stories of tearful traumatized seniors and cringing corrupted politicians. Then there will be panic!