Disclosure: Our firm is short AGO.
Why The Fed can’t bailout the US Muni bond market
(i.e. why cities, counties and states are not like Greece and Puerto Rico.)
The Muni bond market is terribly fragmented. You have hundreds of large municipalities all with different financial situations. These public entities have issued bonds in every size, shape and color: collateralized and non-collateralized, taxable vs. non-taxable, short-term vs. long-term, revenue-backed or not revenue-backed, insured or not insured, ect. When the Eurozone bails out Greece, they have a single bond to bailout, that of the Greek federal government. It’s a large market, albeit smaller than 12 individual US states, but a single, straightforward market at that.
When the cracks in the Muni bond market begin to show, the Federal Reserve doesn’t have a single entity or a single type of bond to backstop, they have thousands of different ones. How will they decide which ones to bailout? What kind of moral hazard will they create? How much further can they expand their balance sheet without crashing the currency?
If a nation like Greece defaults and is subsequently booted from the Eurozone, Greeks will suffer hyperinflation as their new currency will certainly be steeply devalued compared to the Euro. In the US, inflation does not seem to concern us the way it does those in Europe. Over there, they are painfully aware of the fascist regimes that have been born out of the tyranny of inflation. Before the Nazi’s in Germany, there was the Communist Revolution in Russia and even earlier that that there was the inflation seeds that gave birth to the Spanish Inquisition.
It is easy to make the case that Greece and other hard hit nations are better off servicing their debts so they can stay in the Eurozone. But this is a case that cannot be made in the US because no city or county will be booted from the US for defaulting on their debts. When Greece fails, they will have to adopt a new currency, but when Jefferson County, AL failed, no one had to give up their US dollars. When Harrisburg, PA claimed bankruptcy, none of its citizens had to forfeit their US dollars either. And when Orange County went bankrupt way back in ’87, the US dollar continued being the medium of exchange.
The European Union can threaten to boot out whatever country that can’t make good on their debts and isn’t willing to play by the ever evolving rules and mandates of the Troika. But the US isn’t going to boot anyone out of the Union. The Feds can huff and puff all they want, but they won’t be able to make US cities play by their rules so they will have very little leverage over cities who deem it in their best interest to default.
Our nation is now so polarized along party lines, would one party running a large city, say Chicago, default out of pure spite or vengence? What better way to upset the policital apple-cart. For many local policiticians, default maybe one of the few ways for them to flex their muscles.
Local vs Federal (Micro vs. Macro)
Sooner or later, a politician in a distressed city or town is going to figure out that the bondholders do not have a vote. Austerity measures will impact his or her contingency but defaulting on the debt will not. As soon as the cash flows required to service the debt are greater than the cash flows required to provide services in the city, it makes economic sense to default. Put two and two together and you have a situation where it makes sense to strategically default on the debt.
Radical shifts in sentiment do not start from the top and filter down. They start on the street and work their way around. Only a few years ago, it was embarrassing and largely unthinkable to default on your home mortgage. Today, it is understandable and accepted by many. Tomorrow, it might just be deemed admirable. I’m waiting for the day when people start posting on their Facebook page, “Just mailed the keys back to those *^&%*$ bankers, I’m going to the beach!!!!”
The tipping point for the US Muni bond market will be the point when local elected officials deem it acceptable or inevitable to default. When this happens, the holders of Muni bond debt will envy those holding Greek sovereign bonds.
The Covid Crisis has resulted in perfect storm for local governments. Generational highs in unemployment, sales tax revenue falling off a cliff and bond portfolios near zero mean pension plans are now further in the red than ever before. The liabilities of local governments are just far too great to be overcome and raising taxes at a time like this will prove to be impossible. Sure, the FED can keep doling out bailouts but it is only to do so in a somewhat equitable fashion and too many cities are too bad off to be bailed out.