Federal Reserve Warns Municipal Bonds Very Risky

By Chriss Street, Newport Beach, CA.

Last week we first reported that California Sales Tax Revenue Nose Dives by 33.5% for the month of July, and then Moody’s Warns of Mass California Municipal Bankruptcies.  During the “Great Recession” of the last four years, the California private sector was forced to slash employment and infrastructure spending, but the public sector made only modest cut backs. Much of this state and local spending was funded by selling municipal bonds to elderly investor who were told the “muni market” was safe, because the default rate is very low.

But a new Federal Reserve study, “The Untold Story of Municipal Bond Defaults”, debunks that municipal bonds are safe investments and blames the Moody’s and S&P credit rating agencies for deceiving the public.  This is sure to fan the flames of the growing panic among holders of California municipal debt.

According to the August 15th report the by the Federal Reserve of New York:

The $3.7 trillion U.S. municipal bond market is perhaps best known for its federal tax exemption on individuals and its low default rate relative to other fixed-income securities. These two features have resulted in household investors dominating the ranks of municipal bond holders.

Individuals own three quarters of all municipal bonds; with $1.879 billion held directly and another $930 billion through investments in mutual funds.  The Fed report emphasized that the perception of a low historical default history of municipal bonds has played a key role in “luring investors” to buy huge amount of municipal debt.  The Fed specifically points out the perception of low default rates is due to widely advertised reports of low default rates by credit rating agencies.  But the Fed determined the credit rating agencies have not told the whole story about the level of municipal bond defaults.

Moody’s Investors Service (Moody’s) and Standard and Poor’s (S&P), the two largest bond rating agencies, provide annual default statistics for the municipal bonds.  S&P reported that its “rated” municipal bonds defaulted only 47 times from 1986 to 2011.  Similarly, Moody’s indicates that its “rated” municipal bonds defaulted only 71 times from 1970 to 2011.  This compares much more favorably to the record of thousands corporate bond defaults during the same period:

Moodys lies about muni risk 300x120 FEDERAL RESERVE WARNS MUNICIPAL BONDS VERY RISKY

But when the Fed tracked default listings from 1970 to 2011 through the Mergent and S&P Capital IQ data bases available to institutional investors, the municipal default rates during the same periods sky-rocket from 71 to 2,521 for Moody’s and 47 to 2,366 for S&P.  The Fed calculated that there were a total of 2,527 municipal bonds that defaulted from the late 1950s through 2011; confirming that the real rate of municipal bond defaults was 36 times higher than Moody’s and S&P reported to the public.

Munis 36 times more risky 300x191 FEDERAL RESERVE WARNS MUNICIPAL BONDS VERY RISKY

The Fed warns that information regarding municipal bonds tends to be “self-selected”.  Issuers stop seeking an annual rating from Moody’s and/or S&P, if their bonds are likely to not receive an “investment grade” rating.

The Fed also determined “the municipal market is bifurcated into general obligation (GO) bonds and revenue bonds”.  GO bonds carry a full faith and credit pledge of a state or local government, but revenue bonds are backed by a pledge of revenues raised from a specific enterprise, such as an airport, hospital, or school.  According to the Fed, over the past sixteen years, 60% to 70% of newly issued municipal bonds were revenue bonds.  Many of these projects appear to be politically justified to bankroll crony capitalist “sustainable” investments as industrial development bonds (IDB).  IDB financings often involved new technologies or projects with no historical track record:

The services offered by an alternative energy plant, pollution control facility, or other corporate-like entity may not be considered essential, because of the availability of other energy sources. Thus, these enterprises may have less potential to generate revenue.

The bottom line of the Fed report is Moody’s and S&P are culpable for understating the risks to investing in the municipal bond market.  Within 48 hours of the release of the Fed report, Moody’s acknowledged 10% of California cities have declared fiscal crises and disclosed: “across-the-board rating revisions are possible following a review of our ratings on California cities over the next month or two”.  Based on the Fed report and Moody’s reaction, California and other municipal bondholders should be panicked. Cross-posted fromChriss Street’s blog.

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