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Hakuna matata: our best advertising

We thank a reader for bringing to our attention a newsy story on MarketWatch covering the municipal bond markets, Municipalities on the brink, but muni bonds hang in there. The article is worth a read if only for a bold market call.

We are given to understand that

All state governments "will pay principal and interest in a timely fashion, even the states that are most in the news." said Gary Pollack, head of fixed-income trading and research at Deutsche Bank Private Wealth Management...States in particular are generally safe because they can't really file for bankruptcy and most are required to pass a balanced budget every year..." (exerpted)

We beg to disagree with just about every dimension of this perspective. 

The viability of this view rests soley on the assumption that the federal & state governments will honor established rule of law & process with regard to budgetary procedures & taxing authority and, further, will have the political ability to do so. We think this assumption will not stand scrutiny, that the underlying binary approach to risk assessment is fundementally flawed and yeids capricious results.

But from this key assumption flows the conclusion that there are cumulatively no material risks associated with the timely payment of interest or principal for the entire state muni bond markets.  For this to be true there must be no material risks, either jointly or severally, induced by a long punch list of items:

  • economic risk -  the ability of the economy in question to generate adaquate tax revenues to meet all obligations in timely manner. We are of the view that some of the numbers don't work.
  • legal risk - documentation, statutory, administrative or regulatory
  • structural risk - GO, special purpose, or other (remember the good old variable rate demand bond market that simply stopped?)
  • enforcement risk - We have seen a dramatic increase in selective enforcement of the law. 
  • local entity political risk
  • soverign entity political risk - Seems to us that just about any entity within the United States can or could subsequently be named as Too Big To Fail and subject to an arbitrary restructuring. We have no reason to believe that threats to the financial viability of states such as New York, California, Ohio, Michigan, or New Jersey would be exempt from this phemomena, and we have no ability to predict future political or regulatory responses. 

The senior secured creditors of Chrysler believed that much established rule of law would sustain the value of their positions, and it didn't work out so well. The matter was resolved arbitrarily by political fiat. The government effectively instructed them to "Take a ticket and move to the back of the bus." The burden of proof is to show that muni investors are exempt from this risk.

The CBO in its recent report, Federal Debt and the Risk of a Fiscal Crisis, addresses the issue of fiscal viability from a federal perspective.  The CBO lists four possible solutions to the problem on a federal level: restructing debt, inducing inflation, increasing taxes, and reducing spending. States don't have the ability to induce inflation, so the list of possible solutions gets shorter: raise taxes, cut spending or restructure. 

To get on the board with Deutche Bank, you have to believe with respect to the debt of states, even the weak ones, general obligation or otherwise, that there is

  • a 100% probability to the timely payment of principal and interest and 
  • 0% probability to any restructuring of any selected state debt

We're not there, in fact we're way past that. We think it's imprudent. That's not to say that muni's do not offer value. Some clearly do, but one had better get the risk premia right and to do that requires the ability to forecast the key issues above. The only way to play this market, in our view, is through a broadly diversified, unconcentrated book of high quality GO credits.

Oh, and by the way, doesn't the value of the tax shield go down if a VAT is put in place and as part of the deal income tax rates go down?

Reader Comments (2)

August 6, 2010 | Unregistered Commenterbig jack

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