Sing along with us:
From a wilderness of prairies, Illinois, Illinois,
Straight thy way and never varies, Illinois, Illinois,
Till upon the inland sea,
Stands thy great commerical tree, turning all the world to thee, Illinois, Illinois,
Turning all the world to thee, Illinois.
Turning to thee, then, Illinois, your fiscal lumberjacks have been chopping away at your commercial tree on Friday.
The Chicago Tribune reports that state lawmakers have reached a tentative agreement to raise personal income taxes to 5.25 per cent from 3 per cent and business rates to 8.4 per cent from 4.8 per cent. These rises were higher than muni market watchers were expecting, while the projected borrowing to finance the plan was lower than expected — $12bn rather than $15bn.
This has provided (very) slight relief for Illinois CDS levels (data from Markit; amateur Excel skills from FT Alphaville):
But as you can see, this comes on the back of a steady rise, driven in part by growing fears of difficulties and defaults in munis. The FT (in addition to others) has documented difficulties here, here and in-depth here. Concern was heightened following Meredith Whitney’s prediction of default doom in 2011.
However, others have commented these fears may be overblown due to the sheer variety of muni bonds and the legal particularities surrounding what defaults actually mean. For more on this, Bond Girl has an erudite double post, which we recommend checking out.
In a report released Thursday Moody’s also argues that default fears have been overblown. Nevertheless they describe the cases where stress on municipal issuers would occur (from the report):
1. Issuers that Use Debt to Fund Operating Deficits
… While only a few have explicitly issued deficit-funding bonds, more commonly they have paid for current debt service payments through refunding issuances that push debt payments into later years and produce budgetary savings in the current fiscal year. Many of these issuers have internal resources to cover budget deficits if they were to lose market access. The most vulnerable to a loss of market access are those issuers with structural budget imbalances that exceed internal sources of funding.
2. Issuers that Rely on Seasonal Cash Flow Borrowing
Loss of market access for seasonal cash flow borrowing would most severely hurt those governments who would run out of cash absent such borrowing. In this regard it is important to differentiate between those issuers of seasonal cash flow notes that have relatively small seasonal cash imbalances and could borrow from internal reserves as an alternative to issuing cash flow notes, and those that would run out of operating cash if they were shut out of the capital markets.
3. Issuers that Need to Roll Over Bond Anticipation Notes
Issuers of bond anticipation notes (BANs) are vulnerable to market risk at the time of note maturity, when they must issue new notes or long-term debt to repay the original note issuance.
4. Issuers of Variable Rate Demand Bonds with Commercial Bank Liquidity Agreements
Issuers of variable rate demand bonds that rely on commercial banks for liquidity (and sometimes credit) support are exposed to two sources of market access risk. First, in the event that bonds are tendered by investors and cannot be successfully remarketed, they are purchased by the bank and become “bank bonds” that usually mature on an accelerated schedule and carry a high interest rate. The second source of market access risk for variable rate demand bond issuers stems from the mismatch between the expiration of bank liquidity agreements and letters of credit, generally one to five years, and the 20 to 30 year stated maturity of those debt structures.
Unfortunately for the Prairie State these risks (in particular 1 and 2) are very much present, so don’t expect today’s fiscal moves to end woes any time soon. California is also of course in deep trouble, as today’s default by Chowchilla shows (a victim of risk 1). And expect to hear a lot more about muni problems alongside discussions of the federal deficit, particularly from Republicans.
Indeed, earlier on Friday, Ben Bernanke was grilled on muni debt by the Senate Budget Committee. His view: munis are in trouble but default is unlikely and don’t come to me for help — I can’t.
Excerpts from Reuters:
“Clearly the large cities are under a lot of financial stress. It’s something that we need to pay attention to because it would have spillover effects in other markets. But we don’t at this point see anything of that magnitude happening.
“That being said, I think cities and municipalities will need to take strong measures to avoid defaults. Default is only at best a short-term solution for local governments because what they find is that it would be very difficult to get back into the market and they’ll have to pay a higher interest rate so it would be much in their interest to take the difficult measures to avoid default. As I said earlier, while there’s no question there’s a lot of stress on state and local governments, at this point the municipal market seems to be operating fairly normally but we’ll watch that very, very carefully.
“They should not expect loans from the Fed. The numbers that the chairman referred to are prospective, they’re a measure of how much spending cuts or tax increases are going to be needed to achieve balance. It’s going to be difficult but on the other hand there is some improvement in the economy and tax revenues actually have picked up.”
That doesn’t mean that other parts of the government could not or would not intervene were disaster to strike. In fact, the Senate Budget Committee is already (as makes good, proactively reactive sense) preparing in case states were to come cap in hand to Congress (H/T The Bond Buyer).
In the meantime, though, expect to see some divergence between stimulus 2.0 at the national level and enforced tightening locally. Expect, too, to see disturbing human impacts like the closures of Detroit schools reported by Bloomberg.
For while the muni risk is more complicated and disparate than often thought, them $6trn of outstanding debts and pension liabilities in US states and cities ain’t going away any time soon.
Update (21:02 GMT): Tip of the hat to reader Steve Miriani for this update from the Chicago Tribune’s Clout St blog. Apparently that “tentative” deal was very tentative and has not yet been concluded at hometime Friday. Spreads still tighter but they likely won’t be for long if the deal is indeed jacked.
Related links:
A two-tiered municipal bond market? – FT Alphaville
Default and bankruptcy in the municipal bond market (part one) – Bond Girl
US municipal bonds – Lex
US states of emergency – FT