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The Next Sovereign Debt Crisis

Tuesday, August 3, 2010

Europe’s PIIGs are in a poke, but U.S. states and municipalities risk their own sovereign debt crisis.

Europe’s PIIGs are in a poke, but U.S. states and municipalities risk their own sovereign debt crisis, with a huge liquidity risk from short-term debt. According to the Federal Reserve, at the end of the first quarter of 2010, state and local governments had $2.8 trillion in outstanding debt. This massive figure doesn’t count unfunded pension liabilities (which, except for a few governments in immediate distress, face a longer-term solvency crisis), but does include $465 billion of debt issued on behalf of nonprofits and private industrial revenue bond borrowers, many of whom are politically connected. Of the $2.8 trillion, perhaps 25 percent effectively consists of short-term obligations, much of which was purchased based on questionable ratings resting on doubtful guarantees. Even if only a few financially stressed municipal debt issuers default, anxious short-term debt holders could suddenly demand cash and trigger a liquidity crunch.

Traditionally, municipal debt was long term and self-amortizing, so risks decreased over the life of the bonds. Today, much municipal debt is long term only in theory. According to the Fed, only $134 billion of municipal debt (or about 6 percent of the outstanding total) technically originated as short-term debt (having an original maturity of 13 months or less). But at the end of the first quarter of 2010, tax-exempt money market funds held $369 billion of assets. This means that almost 66 percent of tax-exempt money market fund assets are short-term debt dressed in long-term drag. These are better known as Variable Rate Demand Obligations (VRDOs) or Variable Rate Demand Notes (VRDNs)—two acronyms for the same instrument (I’ll use VRDNs here). In addition, VRDNs are presumably a significant portion of the $1.9 trillion in municipal securities held by households and entities such as property-casualty companies.

Municipal debt issuers are increasingly stressed, needing to place $435 billion in debt and fund an aggregate $200 billion deficit this year.

So how do VRDNs work? As T. Rowe Price, whose $844 million Tax-Exempt Money Fund was 45 percent in VRDNs as of February 28, 2010, explains it, a VRDN holder “has the right to sell the security to the issuer … at a predetermined price (generally par) on specified dates (generally daily or weekly)” [italics added].

In other words, the bond may technically mature in 20 years, but the interest rate resets weekly and the buyer can put it back to the issuer at any time. Based on a selective review of large tax-exempt money market funds, high VRDN allocations are typical.

Regulations generally limit money market funds to high-rated securities, so one might think VRDNs are safe. But the ratings agencies are subject to the same pressures from originators as in the subprime glory days: if the rating isn’t high enough to do the deal, the ratings agency doesn’t get paid. The agencies typically don’t re-rate securities for financial strength after origination unless they receive information on a change in condition. The result, as in the infamous Enron case, is that downgrades usually follow rather than lead the market’s valuation, and troubled securities can retain high ratings until just before default. In rating individual securities at origination, the agencies gave little weight to liquidity risk: whether the VRDN market has the capacity to handle a wave of redemptions.

Municipal money market fund portfolios contain many industrial development, hospital, and housing securities, suggesting a substantial amount of politically connected debt.

As with home mortgages, many high ratings are based on credit enhancement (a guarantor’s credit) rather than the quality of the revenue stream that is expected to pay off the security itself. Of the two major pre-bust municipal bond insurers, AMBAC is gradually liquidating under state supervision after functional insolvency, while MBIA is still in financial difficulty and is writing only limited new municipal bond insurance. Berkshire Hathaway Assurance Corp., a new entrant, was rapidly downgraded by the ratings agencies. VRDNs are often backstopped by bank letters of credit—often required in case the bond insurers are downgraded, and requiring municipal securities issuers to pay a high interest rate if drawn on—but this merely transfers the risk of nonpayment from municipal bondholders to the banking system.

As Manhattan Institute Senior Fellow Steven Malanga has noted, state and local politicians around the country have issued municipal debt to fund vanity projects and hide shortfalls. The New York Times recently reported that the New York City Housing Development Corporation lent political powerhouse pastor Floyd Flake $14 million for his no-bid, no-money-down acquisition of a federally funded housing complex from a nonprofit he controlled. The total financing package apparently exceeded 100 percent of the property value. Back in 2004, the Times reported that a senior South Jersey legislator forced cash-strapped NJ Transit to incur $1 billion in debt to build the River Line light rail, currently serving just 8,200 riders a day from Trenton to Camden at a huge deficit. While the maturity structure for these specific obligations is unclear, municipal money market fund portfolios contain many industrial development, hospital, and housing securities, suggesting a substantial amount of politically connected debt.

The 2008 meltdown was triggered by Lehman’s reliance on short-term debt for funding. When Lehman cratered, so did the commercial paper markets (led by the failure of the Reserve Funds), requiring rescue by a Fed commercial paper facility that has now closed. Municipal debt issuers are increasingly stressed, needing to place $435 billion in debt and fund an aggregate $200 billion deficit this year. Given all the poorly underwritten, politically connected municipal debt, it is hard to gauge whether any major issuers—like Christmas trees still in the living room in the dog days of August—require a single spark to explode in flames. With investors holding billions of dollars in short-term municipal debt at near-zero yields and almost no reward for bearing credit risk, we may find out.

Jay Weiser is an associate professor of law and real estate at Baruch College.

FURTHER READING: Veronique de Rugy has also warned of the United States’ impending sovereign debt crisis in “Athens on the Potomac,” while Arnold Kling explains “Why Our Current Budget Situation Is a Crisis.” Michael Barone says “Voters Want Supersized Government to Go on a Crash Diet,” and John Makin discusses why “We Do Not Have Liftoff” on the economy.

Image by Rob Green/Bergman Group.

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