Rep. Nunes and Sen. Burr Introduce PEPTA: Another Threat to Municipal Bonds

This is the first in a four part series on Public Employee Pension Transparency Act of 2013, also known as PEPTA.

More and more, Congress appears to be considering legislation that is based on anecdotal and inaccurate information and not on good public policy or the facts.

That certainly was the case when the House last month approved a bill to reauthorize the Workforce Investment Act (WIA).  Even though House leadership might tell you otherwise, the decision to move programmatic authority from local elected officials and local business leaders to governors had nothing to do with improving the governance structure of the workforce development system, nor did the decision to consolidate nearly 50 funding streams into one have anything to do with improving the delivery of services.  The proposed changes were made on ideological grounds, and information to support making those changes — a study of the Workforce Investment Act by the General Accountability Office – was taken out of context.

Now it appears to be happening again around public pensions and municipal bonds.  Numerous press reports, most notably in the New York Times, have suggested that public pensions are on the verge of collapse, and that their collapse will set off a wave of local bankruptcies that will seriously jeopardize the economic health of the United States.  Other reports have suggested that cities and towns are too heavily leveraged and are about to default in massive numbers on their tax exempt municipal bonds.  While the evidence is clearly otherwise – in 2011 only 13 municipalities filed for bankruptcy protection – members of Congress have latched onto these reports as an excuse to go after state and local public pensions and to link their sustainability to the issuance of municipal bonds.

Last week Reps. Devin Nunes (R-CA), Paul Ryan (R-WI) and Darrell Issa (R-CA) introduced H.R. 1628, the Public Employee Transparency Act of 2013 or PEPTA in the House and Sens. Richard Burr (R-NC), Tom Coburn (R-OK) and John Thune (R-SD) introduced S. 779, the Public Employee Transparency Act of 2013 or PEPTA in the Senate.

Like so many other bills introduced in Congress, this bill is based on fictitious notions that states and localities are about to declare bankruptcy, or come to the federal government for bailouts to prevent them from defaulting on their obligations.


Muni Default & Bankruptcy-Chasing Continues

Christopher Hoene

Christopher Hoene

For a moment I thought it was April Fool’s Day, not Leap Day.  Why? Former Kansas City Mayor Mark Funkhouser, now with Governing, blogged on February 29 that Stockton, California’s plan to declare default on $2 million in debt payments might be evidence that Meredith Whitney’s 2010 prediction of 50-100 sizeable muni defaults in the year to follow, could still come to pass.  Funkhouser noted Whitney’s prediction has been “roundly derided….But, I wonder if she might have just missed the timing by a little.” Later, he adds, “…Meredith Whitney might end up being right after all.”

I’m starting to think that in a media market where the rule is if you say it, it must be true, that crazy is becoming contagious.  Whitney’s projections were not just “roundly derided.” They were flat out wrong.  The muni market did not see a notable uptick in muni defaults – in numbers or scale – and has actually been improving.  Cases of muni defaults and bankruptcy have continued to be the exception, rather than the rule.  Funkhouser admits in his blog that these cases are usually characterized by idiosyncratic circumstances – “stupid or illegal” acts.  He argues, however, that Stockton’s case is different, and therefore a harbinger of trouble to come.  Here’s the problem – he then goes on to explain that Stockton’s case is one of three decades of incredibly bad fiscal management, happening “in a city with the second-highest foreclosure rate in the country and crime and unemployment rates that are among the highest.”  In other words, Stockton’s another special case.

Funkhouser gets it right when he notes that “the vast majority of average Americans are hurting economically. It’s not surprising that cities are hurting as well.”  Exactly.  As we’ve written previously in this space, the real story, distracted by misinformation from Whitney and others, continues to be about the services that are being cut and the implications of those service cuts for communities.  We should be worried about the implications of cuts for the quality of life in our communities and finding ways to help cities position themselves for economic recovery, rather than chasing and fueling a muni default scare.

Meredith Whitney’s Misinformation Campaign

Almost six months ago, Meredith Whitney – the controversial financial investor who made her name by predicting the recent troubles for Wall Street banks  – set off a firestorm in financial markets by claiming that “social unrest” was coming in the form of ”50-100 sizeable municipal defaults.” She’s back this week with an op-ed in the Wall Street Journal where she claims the fiscal pressures on states threaten the economy.

Mostly though, the op-ed is an attempt to sell her latest 77-page report and keep her name in the category of celebrated market analysts (or is it celebrity market analysts?).

In a piece that reads more like political commentary than market analysis, Whitney claims that fiscal pressures on states threaten economic recovery.  But, this is hardly news.  Over the last several years, NLC, a host of state-focused groups (CBPP, NGA, NASBO, SUNY-Rockefeller), and President Obama, among others, have been calling attention to state-local fiscal pressures requiring layoffs and service cuts, and the potential drag on the economic recovery.

Whitney’s op-ed focuses, in part, on unfunded state pension liabilities – also true, though in many cases the cause is an underperforming market in recent years.  While we don’t deny there is more work that needs to be done on this front, this work is already underway in state and local governments across the country.

But, fiscal pressure from cyclical revenue declines and pension liabilities does not add up to Whitney’s doomsday predictions of sizeable defaults and social unrest.  The latest version of Whitney’s misinformation campaign includes her note at the end of the WSJ piece that “Municipal bond holders will experience their own form of contract renegotiation in the form of debt restructurings at the local level.”  Yet, restructuring debt does not necessarily qualify as default, nor is it destabilizing to financial markets (since, in most instances, investors are kept whole).

Whitney’s op-ed is an example of the misinformation permeating the national dialogue about state and local finances. She’s in good company, as poorly constructed arguments about state-local insolvency have, in recent months, riddled airwaves and policy debates: confusion over structural deficits versus budget shortfalls, a lack of understanding of local municipal budgeting processes that place debt service payments above all else, and a near-total lack of understanding of the difference between municipalities with general obligation bonds as opposed to revenue bonds and conduit bonds.

Now Whitney seems to be suggesting that renegotiating labor contracts and restructuring debt are signs of a failing sector, when in fact, these actions occur all the time during both good and bad economic times.

Once again, Whitney’s “call” is a distraction from the real story, which is about the difficult choices local and state leaders are making about delivering services.  There are real implications when the wrong information is pushed and repeated over and over in the media for ratings, report-sales, and celebrity status.  Earlier this year retail investors fled the bond market over exaggerated concerns, followed by a series of poorly conceived policy proposals on state bankruptcy, federal intervention in state pensions, and public sector compensation.

All of this combines into one big pot of bad smelling soup because American taxpayers are on the hook for paying more for services like schools and infrastructure projects.  When Whitney and her supporters get it wrong on the corporate side, only her clients (and her clients’ shareholders) suffer.  When they get it wrong on the municipal bond side, communities and taxpayers pay the price.

Gross Exaggeration or Factually Ambiguous (or both?)

In recent media interviews, Whitney waffled on her earlier predictions.  First, on Bloomberg Radio she argued that the sequence leading to a run on the muni bond market would start with widespread downgrades of municipal issuers.  Exodus from the municipal market would be led by insurance companies whose portfolios are limited to holding only the highest-rated municipal securities.  From there, the run is on…Scary stuff, except Standard & Poor’s just published predictions that widespread downgrades are unlikely.

Add to this the fact that there has not been any real increase in sizeable municipal bankruptcies since Whitney made her now-infamous prediction in December.  Whitney’s latest backtracking on that prediction described her overreach as an “approximation for the current cycle”.  Huh?   In other words, it was a gross exaggeration (she also had a report to sell at the time) or factually ambiguous, or both.

At the same time this week, new reports show that revenue at the state level is up.  Concern over the finances of local governments started more than two years ago.  While localities still have a couple of tough years ahead of them, our own research (forthcoming) shows that local economic indicators are improving.

In the end, it’s useful to remember that cities and other local governments must balance their budgets.  For most, it’s required by state law and few cities could function if they did not balance their budgets every year. Cities also have the ability to raise taxes.  Unlike a company that is facing economic hardship, cities can compel revenue.  While this may not be politically popular, it insures fiscal solvency in the municipal sector.

The real story, hidden by misinformation provided by Whitney and others, continues to be about the services that are being cut and the implications of those service cuts for communities.  That’s the real risk.  Cities will survive, but we will see continued cuts to necessary services like schools, fire and police.  And the evidence shows city leaders will cut the services rather than destroy city credit ratings.  Investors should worry less about the risk of systematic collapse of the bond market and instead worry more about whether their local school, police department, or fire hall down the street needs a fundraiser to stay in service?

Crying Wolf on Municipal Defaults, Part 2

Here we go again.  Meredith Whitney, the Wall Street analyst who appeared on CBS’ 60 Minutes in December and predicted “50-100 sizeable municipal defaults” totaling “hundreds of billions of dollars,” appeared on CNBC this morning and claimed that there would be “indiscriminate selling” of municipal bonds because “local leaders want to default on debt investors and not on their constituents.”

NLC offered a rebuttal to Whitney’s 60 Minutes performance with Crying Wolf About Municipal Defaults.  We were in good company, including PIMCO’s Bill Gross and Federal Reserve Chairman Ben Bernanke.

Whitney’s comments reveal a stunning lack of understanding of the municipal sector and, unfortunately, seem based more on conjecture than facts.

Defaults or Cuts?

Whitney contends that local and state leaders do not have the political will to take policy actions to pay their debts, whether that is cutting services or raising revenues.

But, local governments have been and will continue to cut services.  NLC’s annual survey of City Fiscal Conditions found that 79% of cities cut personnel in 2010, 69% canceled or delayed infrastructure projects, 44% made cuts in services other than public safety, and 25% cut public safety or made across the board service cuts.  The latest U.S. jobs report revealed that state and local government employment levels were at a 4-year low.  In contrast, as of November 2010, there were 72 muni sector defaults, down from 204 in 2009 and 162 in 2008 (these numbers include technical defaults that do not result in losses to investors).

Furthermore, it is standard practice for many local governments to budget to pay their debt service before they fund other operational costs.

Just this week, state policy makers in Illinois, the poster child for state and local revenue shortfalls, moved to raise the state’s income tax rate in order to improve the state’s ability to pay its debts.  All Whitney had to say about Illinois was that the state is now “less favorable to business.”

The “Daisy Chain” of State & Local Finance

Whitney’s claims appear to be based on research that her consulting group has conducted over the last couple of years, analyzing the budgets of 15 states.  Yet, Whitney herself says it’s unlikely that states will default on their debt.

Instead, she says, her fears are for local governments – cities and counties.  Whitney predicts that states will cut aid to local governments – the “daisy chain” of state and local finance.  Whitney is right about the daisy chain.  States do provide aid to local governments, although there is considerable variation across the 50 states, and states are likely to cut aid to local governments as they continue to struggle with revenue shortfalls.

But, cutting aid doesn’t necessarily translate to defaults.  State cuts are common during economic downturns.  Yet, of the 54 municipal defaults (excluding technical defaults) that have occurred since 1970, only 4 came from cities and counties.  In other words, the overwhelming preponderance of local governments respond by cutting spending or raising other revenues, not by defaulting on debt.

When asked for details, such as naming the top three cities at risk of default, Whitney balked, saying “I don’t want to do that.”

Back Peddling

On 60 Minutes, Whitney remarked that defaults would total in the “hundreds of billions of dollars,” a claim that she back peddled from in her CNBC interview.  When presented with a critique of the magnitude of her prediction, Whitney responded “It’s not a severity issue. It’s a frequency issue.”  In other words, her prediction is that there will be an increase in the number of defaults, but the magnitude of the defaults may not be as significant as her earlier projection.

This is not a minor concession.  It’s the crux of the matter for investors.  It seems reasonable to suggest that we might see a few more defaults in the next couple of years.  But, a few more defaults, on top of a historical default rate of less than 1/3 of 1% hardly suggest investors should exit the market.  Bloomberg’s Joe Mysak recently cautioned that the defaults we might see in the next year would total between $5 billion and $10 billion – a small share of the total market of $2.7 trillion.

The Real Story

The bottom line is that sky-is-falling reports about the muni market are lacking in evidence, but are receiving a lot of airtime and print coverage because they make for attention-grabbing headlines.

The real story comes back to Whitney’s question about whether local leaders will default on investors or constituents.  It’s a false choice.  Defaulting on debt has dire ramifications for the shorter- and longer-term fiscal stability of local governments.  The overwhelming majority of local leaders will protect debt obligations and will, if necessary, make cuts in services and personnel or raise revenues via taxes and fees.  Those actions have ramifications for local economies and quality of life, issues which deserve considerably more attention.

We think Whitney finally got it right when she said “investors can still make money on munis, but need to be careful in how they proceed.”