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Why Municipal Bonds are Bad Investments

San Francisco, Golden gate Park, windmill

Municipal Bonds is dedicated to helping investors demystified the municipal bond market place, so what better than to have an article describing reasons why municipal bonds are a bad investment.  We need to understand the dark side of municipal bond investing to realize areas we need to avoid.

Revenue Challenge

Revenue from sales tax, income tax, and property taxes are falling, so municipalities are encountering hard times and may default more often than the past. Towns and cities often rely on one fourth of their revenue from property taxes. One third of their revenue typically comes from state aid, according to the Congressional Budget Office. The credit crisis, unemployment, foreclosures, and the like are impacting the ability to meet obligations. Many local governments have major financial problems, and need to work out their problems without borrowing more money. Analyst Meredith Whitney explains the situation in this video. Stimulus funds run out in June 2011, so a day of reckoning is close at hand.

States have increasingly relied on issuing new debt to pay their bills, rather than increasing taxes or cutting spending.

Tobacco Issues

Tobacco bonds are backed by payments made to the state government by tobacco companies. These statements are based on projected cigarette sales. The problem is that cigarette consumption keeps dropping, making the original projections way out of whack. This leads to fears that defaults could occur.

Failed projects leads to bond Defaults

Revenue bonds on projects with an ample amount of risk are failing. Key examples of failed projects include Wisconsin‘s steam plants, Las Vegas monorail, and non-hospital healthcare facilities. If you go back and look at the Official Documents, you can see that there projections a.k.a. guesses were way off, and bond insurance has amounted to little insurance.

Underfunded Pension Liability

There are many states with massively underfunded pensions. These long-term liabilities are usually not on the balance sheet and hidden away from most investors. It is estimated that $11 trillion is the amount nationwide that is underfunded. But, 84% of state pensions were funded, in aggregate. This is a serious long-term issue that needs to get addressed. Official Statement‘s need to get beefed-up to acknowledge these liabilities. Municipalities have to raise taxes, increase retirement age, and cut services to bridge the pension liability gap. At least this liability is not a near term causer of default risk.

Additionally some states have underfunded Unemployment Funds.

No AAA Rated Insurers

Municipal bond insurance used to be incredibly important, but now that there are no more AAA-Rated insurance companies, fewer than 10% of bonds get insured. Credit ratings of the underlying security are much more important now.

City/State Budget Gaps

Many large states and cities are running huge budget gaps. Expenditures far exceed revenues, something that doesn’t work very long. $350 billion is the projected gap for 2010 and 2011. Illinois has a 42% gap, while California has a 22% gap. Something needs to be done to stop the hemorrhaging. The health of local governments usually lags the national economy by a year or two.

Desperate Municipalities Selling Assets

To plug huge deficits, municipalities are starting to sell off physical assets like real estate. Many cities are exploring selling buildings and then leasing them back. The key is to make sure that the lease service funds have been appropriated, or else a bigger hole will emerge for them.

Substandard Disclosure

There have been several cases of lawsuits against local governments claiming that the government misled investors when making a bond offering. New Jersey and San Diego, in 2010, got sued for failing to fully disclose their pension liability. The SEC is investigating the area and will hopefully add more disclosure requirements to municipal bonds. A municipal bond unit was set up by the SEC in 2010 tasked with ensuring that information was disclosed to bondholders in a timely fashion.

In the middle of 2012, the SEC asked Congress for the authority to fix the problems with municipalities who issue bonds but don’t keep the public up to date on their financial situation. They would like to allow intermediaries to sue the municipality when disclosures are breached.

Audited financial statements could be wrong. Municipal auditors engage in peer review process, something that was used during Enron’s era. Accounting standards differ in need to be standardized. Random Federal Audits in 2007 no problems relating to internal controls in many municipalities.

Investors must wait a year or more to see updated financial statements for cities, states, and others. By that time the financial condition may have changed drastically. A recent study showed that 56% of bond issues from 2005 through 2009 filed no financial statements in any given year. This means that more than $2 trillion of the $3 trillion in outstanding municipal bonds had insufficient ongoing disclosure.  There some instances where municipal bond investors have gotten little or no disclosure prior to a default.

Conduit Financing

Conduit Financing is where private or nonprofits use the municipal bond market for funding. The public issuer gets fees for helping the firm do it, but incurs no legal or financial liability. These are typically unrated municipal bonds that make up approximately 30% of the marketplace, but produce 35% of municipal bond defaults. Another Problem Is That the Government loses out of tax revenue.

Letters of credit

Does the state or local government have a letter of credit with a bank? When does it expire, how likely is it to be renewed by the bank. If a bank failed to renew letters of credit, then the municipal bond would need to be refinanced, causing problems.

Adjustable Rate debt

Some cities and towns in 2011 have been affected by the Greek debt crisis. They took part in municipal bond deals backed by Dexia, a Belgian French bank with large exposure to  Greek government debt. The bank had previously offered cheap financing by agreeing to backstop their municipal bonds, but the bank is now forced to increase the interest rate the cities pay, causing substantial problems.

Interest Rate Swaps

Does the state or local government have any interest rate swap agreements that they set up to try to limit interest rate risk? It is possible that interest rates will move against the swaps, causing possible problems.

Poor Regulatory Framework

The SEC can pursue violations of security law, regulate underwriters, and regulate sellers of municipal bonds. It can require them to demand financial disclosure from issuers. It cannot do this today to issuers directly. The Tower Amendment, adopted in 1975, forbids the SEC from requiring states or local governments to file information with it. This amendment arose to prevent Federal government from impinging on state sovereignty. Considering any major problem in the municipal bond market would eventually fall on the Federal government anyway, this law is out of date. The SEC can only go after broker dealers that commit fraud. Clearly the SEC’s power needs to be extended.

Bond Rating Agencies

Moody’s, the rating agency, has 120 people analyzing 29,000 issuers. Clearly they only can do so much work every day. The issuers need far more scrutiny on a continual basis. Also recall how many failing securities had AAA ratings right before the credit crisis.

Doomsday scenario

A default by a state or major municipality could have unforeseen effects to the credit markets.  It is possible that the ripple effect could cause another credit crisis.

Federal Reserve bailout

Keep in mind that the Federal Reserve is limited by law to only buying certain kinds of very short term Muni debt with maturities no more than six months, so bailouts are limited. They could possibly use emergency powers to buy longer maturity municipal bonds,  if there is enough political will.

State Bankruptcies

Currently, states cannot file for chapter 9 bankruptcy, making it difficult for states to terminate costly contracts, restructure bond debt, and to redo expensive Cadillac pension benefits promised to state workers. Some cities and counties can file for bankruptcy although 26 states prevented. Keep in mind that when municipalities file for bankruptcy, only elements like interest payments can see some relief, making it not a foolproof way to solve larger problems.

Related Municipal Bond articles:

Analyzing Municipal Bond Defaults

Are we in a bond bubble?

Municipal Bonds are Bad Investments

Municipal Bonds Are a Good Investment

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