Sunday, April 4, 2010

States Aren't About To Default

¹²States Aren't About To Default On Debt

By James Altucher | 29 March 2010

Everybody thinks municipal debt is "the next shoe to drop". That's the phrase I keep hearing. We're all holding these mysterious "shoes" (why we aren't wearing them is not clear) and we've dropped one shoe already: subprime debt. And now our other shoe will drop.

It's not commercial real estate or credit-card debt or Greece. It's the wave of municipal defaults that are expected to hit as tax revenues slow down and cities will be forced to declare bankruptcy. And now that we are a country of debt experts (people are coming out of the woodwork to say they could have easily predicted the subprime fiasco), everyone has an opinion.

There are big differences, however, between municipal debt and subprime debt. Subprime debt in the later vintages (2004-2007) was often lent out fraudulently and with few assets to back up the debt. Municipalities have assets and the ability to collect taxes to create revenue. Homeowners don't.

Also, states legally cannot declare bankruptcy. There are bankruptcy laws for cities but not states. When a state can't pay its bondholders it has only two choices: sell assets or increase taxes. It has no other choice.

Let's take my friend's example of California as a case study.

The California constitution mandates that education costs be paid first out of any revenue coming in. California has about $90 billion in revenue. About 40% of that goes to education. After that, as per the California constitution, all debt payments have to be made. Only after that, can California spend on whatever it wants: police, landscaping, random buildings, etc. Debt service payments come to about $5.5 billion per year.

In other words, each year California makes its debt payments, with an extra $50 billion to spare. This is why it has no problems refinancing and why municipal bond yields are at record lows. Most states have similar clauses in their state constitutions: debt service payments come before anything else.

Well, what about cities? Cities can go bankrupt, can't they? Yes, cities can file for Chapter 9 bankruptcy. But even then, cities are different from corporations. Cities don't get liquidated. They still have to figure out how to pay off their debts (so they can borrow again in the future) and raise revenue.

Let's look at the worst municipal bankruptcy in U.S. history: the 1994 bankruptcy of Orange County. The county made a disastrous bet on derivatives (sound familiar?) and lost $1.6 billion. It filed Chapter 9 bankruptcy [[which, I believe, has the usual result of cancelling union contracts, etc.: normxxx]]. In 1995 and 1996 it drastically cut back on spending. It then issued long-term 'recovery' bonds and paid back the municipal-bond holders 100 cents on the dollar.

Before a municipality will default on its debts it will cut salaries (as happened in the Vallejo, Calif., bankruptcy in 2008 where it paid out less than contacted salaries to police officers and union workers), cut other spending, raise taxes, and do whatever it can to pay down debt. Its also not easy, legally, for a city to declare bankruptcy. It has to obtain permission from the state, for instance, and only 24 states have laws describing how the Chapter 9 process can occur.

Georgia specifically prohibits Chapter 9. This is why more than 15,000 corporations have been able to declare bankruptcy but only 614 municipalities have filed for Chapter 9 since 1937. Even Harrisburg, Penn., which has become perilously close to not paying its debts, has tapped into a 'reserve' fund it had for this purpose and has called talk of bankruptcy "premature".

Unlike for corporations, a trip to bankruptcy court is no panacea to eliminate or reduce debt. A municipal issuer that files for bankruptcy simply hinders its access to the capital markets. Since issuing new debt is often part of the resolution, defaulting is generally ill-advised and contraindicated.

One may certainly question the wisdom of papering over every shortfall with ever more debt, but it will be some time before debt service itself is the problem, especially in this low interest rate environment. Municipal defaults right now are at about 0.1%. At worst they double to 0.2%, but even this is unlikely due to all the mechanisms in place that municipalities have to cover their debt service.

How to take advantage of this? There are two major players in the space. The smaller player is a little company called Berkshire Hathaway (BRKA, BRKB), run by a curmudgeonly speculator named Warren Buffett. He entered the space when the two biggest players, MBIA and Ambac, ran into trouble by dabbling too much in subprime debt.

The other player is Assured Guaranty (disclosure: I own the stock) which counts as its largest investor, the very successful investor Wilbur Ross. These super investors, plus the fact that municipal bond yields are trading at a meager 3.89%, suggest that the smart money is completely aware of the potential for municipal defaults and they are eagerly letting panicked investors insure municipal bonds.

Will more municipalities default? Maybe. Maybe it goes up from a 0.1% rate to a 0.2% rate. But if the bears are looking for something to point at as the "next shoe" to drop then they will have to look elsewhere. States have the assets, the tax-raising ability, and the incentive to meet their debt obligations so they can survive and thrive in the future. And the companies that are right now taking advantage of this will prosper.

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