from
(snip)"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 periodsnip)
(snip)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."(snip)
(snip)"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 from Chriss Street's blog."(snip)
If you're not familiar with the role of municipal bonds, some additional explanation is in order. The appeal of muni bonds stems from the fact that, as debt issued by state agencies, interest earnings on muni bonds are exempt from federal, state and local income taxes. So in a state like California or New York which imposes a ~10% income tax on the 'ordinary income' earnings of its higher earning citizens, muni bonds have become very popular with 'rich' state residents. After all, if faced with a choice of earning 2% interest on a CD - plus paying 36% federal income tax plus 10% state income tax on the interest earnings, versus a choice of earning 5% interest on a muni bond - with zero federal or state income tax due on the interest earnings, muni bonds become a no-brainer. Well, that remains true providing that there is near zero risk that any of the money originally invested in the muni bond may be 'lost'.
Or put another way, rich residents of California or New York, when faced with the potential of state income tax rates being increased to ~10% and federal income tax rates being increased to 36%, really didn't need to worry since they could invest $50,000 in a state muni bond that would provide them 5% tax free earnings paid for by revenues from the alternative energy surcharge on customer electric bills, a surcharge on customer sewer bills, higher road and bridge tolls, etc. or whatever similar facility the muni bond money was used to finance. In the past this was a 'sweetheart deal' since the state agency could basically fix the amount of surcharges / price increases on 'users' of the investment property to assure that bondholder interest costs plus labor costs plus maintenance costs were met. But recently this has become less possible because the magnitude of surcharges / price increases necessary have become impossible to pass on to 'users' without risking 'torches and pitchforks.'
Very recently, the publicity of conspicuous 'failures' of such things as a large billion dollar municipal sewer system, some large alternative energy ventures etc. has raised questions in regard to the true risk of loss associated with these revenue bond financed projects. This of course translates into a real risk of ( partial ) loss of the $50,000 initial muni bond investments made by rich Californians or New Yorkers wishing to legally 'escape' higher tax rates. Moodys and S & P are now releasing information that the REAL rate of muni bond defaults is likely to be 36 times higher than the 'official' default rate. And from other sources we find out that, due to hard pressed state and local gov't budgets, many recently issued muni bonds have foregone the once standard 3rd party insurance protection against default ( since the premiums states and local gov'ts would have had to pay for such insurance have now risen to onerous levels ).
Thus rich Californians , rich New Yorkers etc. who are individually sitting on hundreds of thousands / millions of dollars worth of state muni bonds ... thinking that said muni bonds were a 'safe' way to receive comparatively high returns on their investment net of federal, state and local taxes ... now face a very real possibility that 10%-25%-90% on some of their original muni bond investment dollars may be lost. And without the option of 'loss' proof muni bonds, they now face the prospect of having to pay a 46%+ tax rate on interest earnings from non-tax favored conventional investments.
Beyond direct losses to rich California and New York muni bond owners, it remains to be seen what the other 'after-effects' of muni bond defaults / devaluations will turn out to be !!! One almost certain byproduct will be that state and local govt's will no longer readily find willing lenders i.e. more rich individual buyers of newly issued uninsured muni bonds at 'affordable' 5% interest rates which state and local gov'ts MUST sell in order to continue gov't spending at current levels. This in turn will mean that state and local gov'ts will have to pay major premiums to insure future bonds against default ( which may by itself be equivalent to 5% of the bond's value ), or that state and local gov'ts will have to offer much higher interest rates to future uninsured bond holders to compensate for the upcoming state / local credit rating downgrades, or both !!!
The above scenario of additional gov't borrowing becoming prohibitively expensive due to high default risk being publicly acknowledged, as well as the ability to find willing lenders becoming increasingly difficult, as well as overall costs of gov't borrowing rising to double digit interest rates ( or equivalent insurance premiums ), is exactly the situation which has been going on in Greece and Spain.



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