In the vast market of municipal bonds with over 40,000 issuers, there have been some hiccups recently: Detroit, MI; Vallejo, San Bernardino, Stockton, and Mammoth Lakes, CA; Jefferson County, AL. Harrisburg, PA; Central Falls, RI; Boise County, ID. They all went bankrupt.

Others are lining up to join that elite list, not counting Puerto Rico, which for all practical purposes is already bankrupt but doesn’t have a legal framework for it.

Unfunded pension obligations are dogging a lot of these entities and have triggered a wave of multiple downgrades over the last two years: Illinois, Connecticut, Kentucky, New Jersey, Hawaii, Pennsylvania…. and of course, Chicago to junk.

People who buy munis are looking for low-risk investments that come with some tax benefits. In return, they accept low yields. They don’t want to ride a rollercoaster, and they don’t want to speculate with these securities. When news of downgrades, defaults, and bankruptcies hail down on them, their nerves begin to fray in an otherwise self-satisfied sleepy market.

And so Schwab, whose clients own a lot of munis, warned about the fiasco in Chicago, and munis in general. It’s not like we haven’t heard this before.

“There’s not a doubt in my mind that you will see a spate of municipal-bond defaults,” predicted Meredith Whitney in December 2010, on 60 Minutes. She’d ridden to fame on a gloomy research report about Citigroup in October 2007. There’d be “50 to 100 sizable defaults, or more,” she told Steve Kroft. “This will amount to hundreds of billions of dollars’ worth of defaults.”

She was right, of course. But that “spate of defaults” wouldn’t play out in the timeframe the media likes to look at and that speculators have the patience to bet on. These things aren’t going to happen suddenly, or even by the end of the year. They play out in small messy increments, one by one, year after year. Had she said that this “spate of defaults” would occur over the next decade, no one would have paid attention.

But that’s how they’re going to occur. The initial batch is already on the books. More agencies, cities, counties, even states are running out of road to kick the can around. It’s getting to the point where the New York Fed saw it necessary to hold a workshop on municipal bankruptcies.

So Schwab now released a report to address what is slowly growing into Whitney’s “spate” of muni fiascos, particularly Moody’s 2-notch downgrade of Chicago’s general obligation bonds (GOs) to “junk.”

Illinois, which itself is getting in trouble, passed legislation two years ago to curtail pension payouts. But on May 8, the Illinois Supreme Court ruled that the law violates the state constitution. The ruling also constrains efforts by municipalities like Chicago to stay afloat by reducing retirement benefits for current employees.

A big problem, says Moody’s:

The cost of servicing Chicago’s unfunded liabilities will grow, placing significant strain on the city’s financial operations absent commensurate growth in revenue and/or reductions in other expenditures. The magnitude of the budget adjustments that will be required are significant. Furthermore, Chicago’s tax base is highly leveraged by the debt and unfunded pension obligations of the city, as well as those of overlapping governments.

The downgrade to junk has some nasty side effects. The counterparties in certain financial instruments the city is holding have, according to Moody’s, “the option to immediately demand up to $2.2 billion in accelerated principal and accrued interest and associated termination fees.” Money that Chicago doesn’t readily have.

So Schwab warns that the “downgrade to junk raises the cost of borrowing for Chicago and limits the market for the city’s bonds. Because of their below investment grade rating, we don’t currently recommend the bonds as holdings for individual investors.”

A massive sell. But Schwab tries to soothe the frazzled nerves of its clients. “Is Chicago the next Detroit?” it asks, before answering half-heartedly, “we think Chicago is better off.”

It outlines some of the differences between the two cities: size of population, some demographic details, Chicago’s “deep and diverse economy” that has a “broad mix of tax revenue” and isn’t haunted by the “the same demographic issues that plagued Detroit….”

Yet Chicago is drowning in debt and pension obligations, just like Detroit.

“The pursuit of bankruptcy is not on the near-term horizon for Chicago. If Chicago’s pension funds continue toward insolvency, however, our opinion may change,” Moody’s wrote, and Schwab cited nervously.

Near-term horizon? So not this year? Would next year, which is the beginning of medium-term, be the time for “the pursuit of bankruptcy?”

Moody’s didn’t say. But bankruptcies, such as San Bernardino’s, have shown that bondholders can get totally whacked when pension obligations come out on top.

So Schwab recommends dumping Chicago munis. Diversify the rest of the muni portfolio, “with no more than 10% exposure to a single issuer.” Get rid of munis “affected by pensions.” But wait. Even safe-sounding revenue-backed debt, though on first sight not affected by pensions, may be affected by pensions. Schwab:

In Chicago, Moody’s downgraded sales tax revenue debt and motor fuel tax revenue debt based on the “lack of full legal segregation of pledged revenue from the general operations of the city” and its outstanding water and sewer debt based on the system’s “status as an enterprise of the city.”

In other words, in a municipality like Chicago it may be hard to find any bonds that pension obligations can’t eviscerate.

But the process will be slow. Defaults won’t suddenly show up on the “near-term horizon.” Each municipality will struggle with its sins of the past in its own way. Some will manage. Others will end up defaulting, in line with Whitney’s prediction, but years behind her schedule.

New York Fed President Dudley cautioned that risks in munis were “more widespread” than implied by bond ratings. The situation was serious enough to where the New York Fed is now doing workshops on municipal bankruptcies. Read….  Fed’s Dudley Warns about Wave of Municipal Bankruptcies

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