The Municipal Bond Pitch: “What You’re Giving Me is Pure Bulls**t”

Undaunted by falling municipal bond prices, rising yields, and withdrawal of funds, research reports by large brokerage firms still mollify the majority of clients and fund managers with numbers and assertions: “General obligation bonds do not default.” “The general obligation default rate is 0.01%.” “Most states are required by law to balance their budgets.” To these and other airtight arguments in the muni marketing kit, the proper articulation of doubt may be expressed as: “Yeah, Yeah, Yeah.” Or, one might read “Possible Misunderstandings by Municipalities and Their Bonds.”

This précis was written in April 2010. It is a sign of the times that market-making brokerage houses and fund companies still roll out the same phrases and avuncular charm, dismissing critics, but with nothing new to add. Meredith Whitney, an Oppenheimer bank analyst (at the time), told an uncomprehending world in 2007 that banks were going bust. In September 2010, she issued a 600-page report that projected the same for mendicant states and municipalities. One expert replied that he was “somewhat skeptical about Ms. Whitney’s sensational hypothesis and [felt] that she might be trying to hit a ‘home run’ like she did with the banking crisis.”

Of course she was trying to hit a homerun! Why else would she write a 600-page report on municipal finance? That has nothing to do with her argument that California, New Jersey, Illinois and Ohio may either default or need a federal bailout in the next twelve months. (Ten months from now, since she stated the warning on September 30, 2010, via Bloomberg TV.)

It has become clear that the states and municipalities facing the greatest financial difficulties will default. This applies to their general obligations and probably many revenue projects, too. This forecast is a synthesis of observation. Those in hock cannot tie their own shoelaces. For investors who hold the municipal bonds of localities where evening news coverage from state houses and town halls could be mistaken for an episode of the Bowery Boys, there is no reason to expose your net worth as an air-raid shelter over the pathologies of American excess.

During the course of nearly two decades setting investment policy and asset allocation with companies, municipalities, and unions, it became clear to me there were organizations (companies, municipalities, and unions) that understood what needed to be done and did it. There were also those that avoided any sort of unpleasantness by delaying, forgetting, or concentrating on minutiae. It was rare for a pension plan’s committee to hop from one of these categories to the other. Those that delayed turned manageable situations into quagmires. (A comparison to Washington is apt.)

And so we see, despite the extended period during which municipalities were granted to right their wrongs (the Federal government filled financial gaps), the general tendency among the damned and the dead is, still, to borrow more money. Nearly $42 billion of municipal bonds were issued in November 2010, according to the December 1, 2010; issue of the Bond Buyer. That is nearly one-quarter of the $177 billion municipal volume for all of 2006, a year when property taxes were rising faster than money could be spent, at least among the more sober-minded. The dysfunctional cities and towns managed to build high school gymnasiums that could house the Baths of Caracalla while others started – but never completed – baseball stadiums, renewable energy incinerators, and “tunnels to nowhere.” The last is in Pittsburgh, a city apparently yearning for a Municipal Darwin Award. The city counsel is incapable of selling its parking garages for a bid of $423 million, money that is badly needed. The “tunnel to nowhere” is a $500 million public transit project, already $125 million over budget, a clogged artery symbolic of the minds that rule Pittsburgh and those in dozens of cities and states across the United States.

The commonly cited 0.01% default rate applies to general obligation bonds issued since 1970 that were rated by one of the agencies. The 1970s was a decade of great trouble for some municipalities, most of which maneuvered out of harm’s way. That was a different time. The level of debt, fixed costs, and corruption; the incapacity to manage, to act, to think logically has blossomed into a New Era. This New Era of concentrated madness, run amok among certain Nasdaq stocks in the late 1990s, was captured by James Burke, a science historian whose study for the Royal Society for the Arts, Opening Minds, was publicized in May of 1999: “Instead of judging people by their ability to memorize, to think sequentially and to write good prose, we might measure intelligence by the ability to pinball around through [sic] knowledge and make imaginative patterns on the web.” The weird mutterings of the current Federal Reserve chairman is an example that barely needs mentioning.

Felix Rohatyn, who played the lead role in saving New York City from bankruptcy in the 1970s, spoke recently at a Grant’s Interest Rate Observer conference at the Plaza Hotel in New York. His talk was distilled in a subsequent edition of Grant’s: “Asked if his experience with New York in the 1970s provided a template for solving the public-debt problems of today, Rohatyn could only lift his palms and shake his head. The numbers are staggering, the constitutional barriers formidable and the political will absent.”

The man who accomplished the impossible, the bailout of New York City in the 1970s, is at a loss: “I just don’t see where you go to restructure this.”

Rohatyn continued: “‘I think that if you have to go into some kind of dramatic, last-minute restructuring with these kinds of amounts that we’re dealing with, I would just shudder at that.’ That the city muddled through in the 1970s Rohatyn attributed to the good-faith efforts of radically different (and usually antagonistic) interests to effect a compromise. In recalling what worked then, Rohatyn found his gravest cause for concern today. Said the long-serving Lazard partner: ‘I don’t see this anywhere on the horizons today, whether it’s at the state or at the level of the city, where I could put together six people, eight people, or 10 people, that you could close the door with and say ‘how do we do this?'”

Rohatyn’s macro view complements the micro perspective of a veteran who has served on municipal committees and boards for the past forty years. As People magazine might say, what follows is from an exclusive, story-behind-the-story discussion with a man who knows where all the bodies are buried:

No one in the Town is worried about their rating or what others think of the balance sheet. [And, that the municipal bond market might shut down for rollover and new debt- FJS.] There is still a sense that they can pay to have their debt guaranteed and upgraded to save on interest. And rates are so low, what the hell.

All the Towns are in the process of rolling their debt while rates are attractive….The towns are not just rolling debt to lengthen maturities; they are in a sense taking equity out of the house. They are putting a bit of free cash (as it is called on budget) away for future needs, meaning that they are borrowing for next year’s budgets. I think we can conclude that there are some new sub prime munis being issued this year. [These are still rated as high-grade bonds by the agencies – FJS]

A town treasurer helped the veteran, who was already well acquainted with municipal finance accounting (and mis-accounting): [He] made sure that I did not stop with the Town’s latest “official Statement” dated Sep 1, 2010. “There are certain liabilities which are not on the balance sheet that you should know about. It says our total debt is $98 million, but that does not include our cost of closing the dump ($19 million), our interest due ($9mm), our health insurance liability ($35mm), and the cost of closing the Town’s Street and Bridge Lots ($5mm for hazardous waste).” When I asked about the unfunded pension liability, which I know to be in excess of $72mm, he nodded and said something like: “No one is quite sure how to calculate the pension liability, and it is above my pay grade, but it is at least as much as the total Town Debt outstanding; I would use that number.”

Felix Rohatyn just published his autobiography, Dealings: A Political and Financial Life. He remembers a meeting in 1975 with the then deputy mayor of New York, James Cavanaugh. The city’s finances had so deteriorated that it was not able to issue long-term bonds. (This is a timely reminder of what to expect in 2011: There will be states and cities unable to issue bonds or rollover debt. If the federal government, including the ever-expanding Federal Reserve, does not or cannot fill the gap, scrip will be issued to pay municipal bills and salaries.) Cavanaugh claimed that New York City was running a balanced budget. Rohatyn disagreed. Cavanaugh “breezily” patronized Rohatyn: “I see you don’t know much about municipal finance.”

The investment banker who had negotiated the largest merger in American corporate history (ITT and Hartford Insurance Company) shot back: “Mr. Cavanaugh, I may not know much about municipal finance. But I know about bulls**t. And what you’re giving me is pure bulls**t.”

Back to the 40-year veteran. He found the most illuminating document in Massachusetts is the Official Statement (OS). The municipalities are required to publish the OS whenever a new bond is sold to the highest bidder:

The OS is similar to a prospectus, but is far more interesting to read. You need all the schedules so that you can adjust the Town’s net worth, so to speak. None of this material is ever put on the web sites of the Town and though there is a law (I am told this) that the Commonwealth [of Massachusetts] should now be posting this information, it was decided by the State House that the cost of this action is not worth the result. They sited [Governor] Deval Patrick’s goal of grouping towns as a reason not to put this information on the state’s site.

Grouping the financial statements of towns in a consolidated statement, municipalities that already leave over half their liabilities off balance sheet, sounds like a combination of Enron’s dirty dealing tucked inside an impenetrable Collateralized Debt Obligation. I may not know much about Massachusetts state house budgeting. But I know about bulls**t. And what the 40-year veteran was told is pure bulls**t.”

About Frederick Sheehan 53 Articles

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009). He is the co-author of Greenspan's Bubbles: The Age of Ignorance at the Federal Reserve.

Mr. Sheehan was Director of Asset Allocation Services at John Hancock Financial Services in Boston. In this capacity, he set investment policy and asset allocation for institutional pension plans. For more than a decade, Mr. Sheehan wrote the monthly "Market Outlook" and quarterly "Market Review" for clients.

He is a frequent contributor to Marc Faber's "Gloom, Boom & Doom Report." He also has written articles for "Whiskey & Gunpowder" and the Prudent Bear website, among others. He currently serves as an advisor to an investment firm and a non-profit foundation.

A Chartered Financial Analyst, Mr. Sheehan is a graduate of Columbia Business School.

Visit: Frederick Sheehan's Website

6 Comments on The Municipal Bond Pitch: “What You’re Giving Me is Pure Bulls**t”

  1. Out-of-control financial fraud, yet another violation of our rights. Add it to the list of gov’t violations of our right:
    They violate the 1st Amendment by placing protesters in cages, banning books like “America Deceived II” and censoring the internet.
    They violate the 2nd Amendment by confiscating guns.
    They violate the 4th and 5th Amendment by molesting airline passengers.
    They violate the entire Constitution by starting undeclared wars for foreign countries.
    Impeach Obama and sweep out the Congress, except Ron Paul.
    (Last link of Banned Book):

  2. Hmmm

    The problem is not run away deficit spending. The problem is the FED has debased the dollar to the point it is now worth about 3 cents compared to when
    the FED took control in 1913. The American people and the world at large are being looted by a small group of very evil criminals using National Banks, state tresuries and bought off politicians to literally steal the worlds wealth. Of course in order to do so they have to literally enslave 99% of the worlds population. But there conscience is clear as they considern themselves the chosen few. Wake up people! Just start saying NO to the Banks. It really is that simple. Tell them NO you can’t have our money!

  3. The end of all this is close at hand. Our lives are ruined. Our country was taken from us in broad daylight. We trusted politicians who are committing treason. China has become our new owners of America.

    Learn Chinese for your survival. Freedom is gone. Your Rights are gone. Your future happiness is gone. Your jobs are gone. Your houses are gone. Your existence has become worthless.

    We are ALL embarrassments to the patriots who sacrificed their lives to keep our Constitution and Bill of Rights alive!

    Our families will now suffer from our laziness to defend our homeland.

    But, they have made you feel safer right?
    All the while they looked at you as the potential threat to your own safety!

  4. The problem is the jooz! The jooz are the frontmen and some of them are the banker cabal responsible for the crap going on! America will never recover until we get rid of the jooz in government, Wall Street and the media!

  5. It is not the jooz. Please. Not all jooz are zionists. The zionists are the dark ones who own our country and are buying out the world. A joo is not evil by virtue of the fact that s/he is joo. Please remember this distinction.

  6. Time for one and all to contact their city, county and state, and request a copy of the most current Comprehensive Annual Financial Report, and to spend an hour or two in private study, and then engage a discussion of all the paper (read ‘wall street’) investments held in the name of the corporate municipality, purchased with taxpayer money.
    These instruments could be offered to the market at large, and could in an
    emergency be sold at fire sale prices.
    Otherwise, they could be sold at market prices.
    I would suggest that all of the paper who that has poor returns be dumped, and the cash from the sales of these wall street instruments to be used to
    discharge bank debt, or to use the cash to retire bonds.
    A large share of the wall street market paper is held by municipalitys.
    Time to send that paper back to its makers.

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