Beware Municipal Bond Buyers; This Situation Isn’t Getting Any Better

The municipal bond market is not a safe place these days. Municipal bankruptcies are becoming a norm in the current U.S. economy, and bankruptcy is the only way out for many municipalities.

Local governments have to control their budget deficit—and deficit cuts are much needed by municipalities in order to avoid any future disturbance with creditors. The after-effect of local governments taking the usual steps to stay alive will be on the municipal bond investors—a $3.7-trillion market.

Cities in California, like Vallejo, Mammoth Lakes, Stockton, and San Bernardino, have already defaulted on their municipal bonds. Compton is most likely to be the next to default. What do all these towns have in common? They are suffocating under big budget deficits.

When times are good, spending doesn’t seem to be a problem. For example, Bell—a city just outside of Los Angles—revealed in 2010 that it paid city managers $800,000 a year. (Source: Wall Street Journal, July 18, 2012.) This kind of behavior is what gets municipalities in trouble.

Cities that filed for bankruptcy were facing immense budget deficits. Property taxes are the main source from which municipal governments get their revenue. When that tap is turned off, cities must find other ways to earn revenue to pay their dues—or simply tell municipal bonds investors, “Sorry, we can’t afford to pay you.”

It may sound like a perfect plan: default on municipal bonds and start over. I must ask the question, is it working? The answer is simply, no.

The cities that have already defaulted on their municipal bonds are still scrambling. Stockton, California wants its municipal bond insurers to take a bigger hit because it has pensions to pay—$26.0 million each year. The insurer of the municipal bonds stands to lose more than $100 million. (Source: The Examiner, September 17, 2012.)

Similarly, Jefferson County in Alabama is showing distress, once again. This county filed for chapter-nine bankruptcy back in 2011. The municipal bond insurers are now feeling a bit skittish and could lose about $709 million. The city failed at financial planning and controlling the budget deficit.

The moral of the story is that the number of municipal bankruptcies is going to increase and the municipal bond investor will certainly be affected by it. The issue of cities defaulting on municipal bonds is not only in California. Municipal bond investors need to be very alert about what it is they are buying. Don’t let the temptation of tax-exempt bonds lure you in.

Wenatchee, Washington, Scranton, Pennsylvania, and Moberly, Missouri have already skipped on their municipal bonds payments due to a lack of cash. (Source: Bloomberg, September 10, 2012.) Who is next? There will certainly be more.

Where the Market Stands; Where it’s Headed:

There’s not much I can say about the stock market that I already haven’t said above except for this:

Since 2009, the government and the Federal Reserve have fought the bear market tooth-and-nail. The government has gone on a borrowing spree never before seen in history. The Fed has increased the money supply by trillions—money out of thin air. And interest rates have been kept artificially low for years.

In the end, I believe all the meddling by the government and the Fed will only act to delay the inevitable and natural forces of the bear market.

What He Said:

“For the economy the message from retail stocks is quite clear: Consumer spending, which accounts for roughly 70% of U.S. GDP, is in jeopardy. After having spent like ‘drunkards’ during the real estate boom years, consumer spending is taking the same trend as housing prices, slowing down faster than most analysts and economists had predicted. As news of the recession continues to make headlines in the popular media, the psychological spending mood of consumers will continue to deteriorate, lowering earnings at most high-end retailers and bringing their stock prices down even further.” Michael Lombardi in Profit Confidential, January 28, 2008. According to the Dow Jones Retail Index, retail stocks fell 39% from January 2008 through November 2008