Although we believe US muni defaults may happen this year, the outcome likely won’t be as bleak as many fear.
Historically, recovery rates on defaults have been very high.
Compared to the worst case historically, where municipal defaults might reach Great Depression levels, losses would still likely be manageable.
As the economy continues to expand, state and local governments’ tax receipts should rebound— helping close budget gaps and allay default fears.
On Tuesday, Idaho’s Boise County, filed for municipal bankruptcy protection. This was the first US municipal bankruptcy filing of 2011. A sign of more ominous things to come? Probably not. The small rural county must pay a property developer $5.4 million due to a lost lawsuit, and with an operating budget of only $9.4 million, the county opted to file for bankruptcy protection instead. (Ironically, Boise County has no bonded debt.)
As a result of the recession, fiscal mismanagement and entrenched financial obligations (e.g., pensions), many US states and local governments are facing steep budget deficits. But fears of a tsunami wave of municipal defaults have yet to be realized. Besides Boise County, there were six municipal bankruptcy filings in 2010—and while many states face big budget gaps, none seem poised to default at the moment.
First, it’s worth noting when most people think “default,” they think money is lost and never paid back. But a default is a breach of any covenant of a bond. A muni default is often only a timing issue—principal and interest payments might be delayed but are eventually paid. And even when all principal isn’t repaid, historical recovery rates have been high. (Even during the Great Depression, the recovery rate on defaulted debt was about 99.5%.1 Pretty good.) For example, in the last four years, only seven municipal governments filed for bankruptcy and all bondholders were paid in full.
Additionally, because municipal debt is tied to state income taxes and sales receipts (which fall during recessions and boost deficits, then recover with the economy to close gaps), the economic recovery and current expansion mean municipalities’ fiscal positions are already improving. The graph below shows the decline and rapid recovery of state and local government tax receipts in the last couple years.
State and Local Government Tax Receipts
Source: US Dept. of Commerce, Bureau of Economic Analysis, National Income and Product Accounts Table 3.3, State and Local Government Current Receipts and Expenditures (seasonally adjusted at annual rates).
Additionally, most state and local governments seem to be able to cover debt service costs adequately with current tax receipts. The aggregate tax receipts-to-interest payments ratio—a measure of governments’ ability to make debt service payments—stands at 11.9, lower than pre-recession highs, but above the 30-year average (the higher, the better). Put another way, municipal debt service is only about 3%-5% of state and local budgets. Plus, municipalities have every incentive to keep making payments—defaulting on these relatively minor payments would inhibit future ability to raise funds via debt issuance, and they know it.
Even in a scenario where defaults rival their worst period historically, consequences today likely wouldn’t be as dire as widely feared. During the worst Great Depression year (1933), muni bond issuers defaulted on 16% of total interest and principal payments. Today, a 16% default rate on the about $400 billion US muni issuers pay annually in interest and principal would mean $64 billion in losses—before recovery. Even a historically dreadful 80% recovery rate would mean about $12.8 billion in ultimate losses—not much at all relative to our $15 trillion economy. Plus, the likelihood of such a situation is remote—states typically support municipalities, and the federal government would likely support states if necessary. (A state hasn’t defaulted since 1933.)
Furthermore, the US economy is entering its sixth consecutive quarter of solid growth, further benefiting state and local budgets. Even in the worst of budget situations, gaps should at least narrow (overall—no doubt some states are in for a very rough ride—ahem, California, ahem) as incomes and therefore tax receipts continue bouncing back. Plus, states aren’t helpless to assist in closing gaps. They can in fact slash spending and, though we’re no fan of higher taxes, raise taxes and fees. That may prove politically unpopular, but sometimes fiscal responsibility isn’t for the faint-hearted. Our guess is in 2011, muni debt may replace (or rival) PIIGS debt jitters. But the actual fallout is likely much more manageable than feared.
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