A Quick Thought on Municipal Bankruptcy
On CNBC today, analyst Meredith Whitney commented that “everybody loses” from the Detroit declaration of bankruptcy.
If that is the case, then why in the world are they seeking bankruptcy? If everybody loses, then it means nobody wins from declaring bankruptcy, and if that’s the case then it would be truly idiotic to seek it.
But of course, this is nonsense. There is no wealth being either created or destroyed in a bankruptcy proceeding; it is merely being forcibly reallocated. In this case, the winners are the taxpayers of Detroit. More to the point, it is the future taxpayers of Detroit, who were on the hook for a bunch of liabilities that they were going to have to figure out how to pay someday, but are not now going to have to pay. Those folks win big. And it’s a good thing, too, because Detroit needs more of these future taxpayers to move to Detroit.
The losers are many in number. Bondholders will lose a lot. Pensioners will, unfortunately, lose a lot. Many of the public service unions will lose a lot as their contracts are rolled back. But their losses are equal in magnitude to the gains of the future taxpayers.
Another prediction that Whitney made is on firmer ground. She said that this bankruptcy would touch off a wave of other municipal bankruptcies. I think there is a very good chance of that. I am not saying that because I have analyzed the balance sheets of many municipalities in great detail, as Whitney have (although I have seen enough, in trying to persuade some of them to hedge their post-employment medical liabilities, to be concerned). I say it because we have seen such phenomena before in industries which were overburdened. Consider telecommunications in the early 2000s. Once one big telecom company declared bankruptcy, it suddenly had a big cost advantage over its rivals, and could underprice them until its rivals followed the same path. We’ve also seen this in airlines. It seems to me that it is entirely possible that, if Detroit is able to lower taxes and reinvigorate the economy once it no longer needs to service these overwhelming liabilities, and begins to attract migrants from high-tax neighboring cities and states, then it makes the finances of places like, say, Chicago that much worse as their taxpayers leave.
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Hi Michael,
I expect that other cities may also face increasing costs to finance debt when credit risk is priced in. This may also create a negative convexity event?
My thanks to you for clearly explaining the risks and event characteristics of negative convexity in previous articles!
Bart
my pleasure! That’s hard-earned and expensive experience talking about negative convexity! ๐
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The important precedent here, if it happens, is the reduction of pensions in bankruptcy, even if it is in apparent violation of the Michigan state constitution. It never made sense for municipal employees to be able to work 20 years, say from 20 – 40 (as with many cops and firefighters), then live in retirement on a full pension until their 80s. If I were to pity anyone, it would be the bondholders, who were merely negligent. The city employees of Detroit and their unions have been a driving force behind the financial disintegration of a major American city.
“The city employees of Detroit and their unions have been a driving force behind the financial disintegration of a major American city.”
Not just one. I live in San Francisco. Until recently, their policy was that after working there for *five years*, upon retirement you would get fully-paid health care for life – in addition to your pension, of course.
I worked for the city government for a year. Theoretically I could have gamed the system by working there for five and then gone elsewhere, secure in the knowledge that my retirement was supplied by future taxpayers. Many current consultants do just that. I couldn’t stand it, though.
I think I like munis here, and I’m curious what you think of the following argument: historically, munis have paid about 100bps less than treasuries, but now they are paying about 100bps more. That reflects are level of default risk, which, if it were realized, would not “be contained.” In other words, either munis are a good buy here, or else everything other than non-TIP treasuries is a massive sell. Thoughts?
I am not sure. Munis have traded above Treasuries for quite a while now. I am not sure I can fairly evaluate what the fair credit spread is. What is the recovery rate in a muni bankruptcy?
Having said that, I think that most credit is a massive sell here. ๐
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Let’s say the recovery rate is 50%. And let’s say the 200bp swing is reflective of 5-7 year bonds. Crude approximation: doesn’t that mean the market is pricing in 15-20% default rate over the next 5-7 years? And wouldn’t that be a credit crisis that would make subprime look like a walk in the park? And wouldn’t that, in turn, be bad for, for example, breakevens and commodities. (look at what they did in 2008-9). In other words, if one is, just for random example (not that I know anyone like this) bullish on breakevens and commodities, doesn’t that imply that one thinks the muni market is overpricing default risk. That, anyway, is the argument.
Well, I think that recovery rate is really high. I think in Detroit they’re thinking 10-15 cents (although I’m not sure…just seems I saw that number bandied about). This isn’t corporate bankruptcy…there’s nothing to sell off!
I think the argument for a while has been that munis were overpricing default risk. As I said, I think they’ve been above Treasuries for quite some time (although some of that is also pricing the possibility that their tax deductibility could end as well). Do you think the spread is 200bps on 5-7y paper? Again, I don’t have any data but I think the average muni is much longer than that, too.
I do think you’re right that there will be an opportunity, but I would be suspect that it has happened when you just have a single big bankruptcy. That would be like jumping into real estate early in the 2007-2008 crisis. In that case you wanted to wait until there were NO buyers. The first loss was the best loss, but the converse of that is that the first buyer was the worst buyer.
You might well be right. I’d just be sure to average in.
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The recovery rate is kind of moot. It makes no difference to my point whether its a 50% recovery rate with a 20% default rate or a 0% recovery rates with a 10% default rate. What matters is that 10% of a multi-trillion dollar market is being priced in to evaporating. I have a hard time seeing that happening without the whole economy going nuclear.
I also don’t think we will see any more Detroit-sized defaults anytime soon. Detroit is unique in many respects. And we have already had stockton and few others of that size.
But I definitely take your point about being early and averaging in. The problem is once there are “no buyers” that sometimes applies to one’s own self. That happened to me with real estate. I waited and waited and by the time the bottom was in I thought for sure Florida real estate was all going to end up over-run by wild cats and I gave up. ๐
You’re right about the spread too, I was remembering the data wrong. Its comparing 20 year munis to 20-year treasuries. And the claim wasn’t that the spread is 200bps. The claim is that the spread is 100bps but that, because of the tax advantages, its usually, 100bps in the opposite direction, so the “effective spread” is 200bps. And really, that’s not telling you the gross default risk. That’s telling you the default risk over and above what it used to be considered to be. (although one might argue that that was zero).
Don’t let me talk you out of a good trade! But wait until Chicago or California declares, first. ๐
Actually, that’s one possible explanation of the spread. It MAY be that there are a few very large issuers who are so big (and so weak) that their possible default is way overrepresented in the indices. So, maybe the default rate is 1% for munis, but if California is 30% then it pushes the issuance-weighted average quite a bit higher.
Again, I don’t know too much (at least, that is current) about the muni market.
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