Yields on top rated 10-year U.S. municipal debt rose steeply today, as investors were dumping municipal bonds and a flood of states and municipalities were seeking to raise money. California alone is planning $14 billion of debt sales before Thanksgiving.
Historically, the US experienced very few municipal defaults -- around a tenth of 1 percent over the last 40 years, and hence has been thought of as a safe place to invest. But that $2.8 trillion market is becoming more and more vulnerable.
A recent Northwestern University study found the funding gap for city pensions is $574 billion, on top of the much larger gap at the state level. A few weeks ago, the state of Pennsylvania gave an emergency cash allowance to stave Harrisburg, the state capital, from default. Jefferson County, Alabama, may file for the biggest municipal bankruptcy ever. New Jersey, Philadelphia and Los Angeles are in similar distress, and many more fare only a little better.
Lavish pensions and liberal healthcare plans created huge unfunded liabilities and a sense of entitlement. 89 California Highway Patrol officers earned more than $200K in 2009. That is just one example of the obligations California has taken on, thanks to the devastating collaboration between elected officials and unionized state and local workers.
With declining tax revenues, many municipalities can no longer afford those obligations. Politicians, long accustomed to freely spending taxpayers' money to win the affections of the electorate, will soon be facing a choice -- either default on the municipalities' obligations (and stick anonymous debt holders with the bill), or face their constituents, cut back essential services and raise taxes. What course do you think a typical politician will follow?
Based on the historical record, many municipalities still enjoy high debt ratings. But recall that some Lehman CMBS were still rated AAA the morning Lehman filed for bankruptcy. So was the case for AIG bonds, to name just two of many prominent examples.
The last time munis got in trouble was the Great Depression: 851 cities and 359 counties were in default in 1935. Yet in 1929, half of the defaulting issues carried a AAA credit rating.
Today, municipal bond yields are still near record lows. Investors like to extrapolate the recent past into the near future. But the potential for disaster is enormous, and it does not come close to being compensated for by the puny existing yields.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.