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Changing Tides II: Could Municipal Bonds Become Risky?   (November 13, 2007)

It has long been gospel in the investment world that municipal (tax-free) bonds were extremely safe investments. How about in the future? Uh.... Knowledgeable reader and frequent contributor J.F.B. sent in this important story:

Municipal Bond Insurers: More Dangerous Than You Realize (Seeking Alpha blog, 11/5/07)

Meanwhile, back on Main Street, old-line businesses which supported city and county tax revenues for decades are failing left and right. Here is my previous entry on the erosion of the tax base even as municipal benefits and pension costs shoot through the roof:

Scale Invariance: Is Your Neighborhood Sliding into Recession? (February 6, 2007)

My local city's pension contributions have risen 384% in a few years. In fiscal year 2005, $15 million of Berkeley’s $115 million general fund will pay for contributions to the California Public Employees System (PERS). Last year, the city spent $8 million on retirement benefits. The year before, the city spent only $2.8 million.

This means 13% of the city's general fund is going to pensions, and it's slated to inexorably rise--and that's counting on the existing pension fund being able to generate 8% returns far into the future. What if the pension fund takes a string of 8% losses? Nobody even mentions that as a possibility.

Do you see a pattern here? Municipal unions secure much-richer pensions and medical benefits for life, while the source of all those tax revenues--old-line businesses--are failing left and right. These businesses are irreplaceable; a new ink cartidge refilling outlet (just about the only new retail operation in downtown) does not provide anywhere near the same payroll or sales tax revenues as the large, established retailers who have called it quits.

I have long predicted that a showdown between public employee unions and residents (taxpayers) is brewing and will explode once the recession drives down pension fund returns and city tax revenues.
For verification of these trends, let's turn to my long-recommended colleague Mish over at Mish's Global Economic Trend Analysis:

Healthcare costs soar-What are we getting for it? (5/26/07)

Drop in Revenue Growth at State and Federal Level (10/27/07)

And lastly, let's touch on a topic which remains largely verboten in the media: public employee greed: Public Employee Pension Greed and the Gutting of Downtowns (February 7, 2007)

I have no axe to grind with public employees--my cousins are firemen, police officers, librarians; almost all are publice employees--but the fact remains that a significant percentage of public employees "game the system" to maximize their benefits, even as the cost of those benefits is skyrocketing.

So let's line up the dominoes which could very well lead to a municipal bond default in recessionary states (i.e. eventually all 50):

1. Muni bond insurers may well go belly up, removing the guarantee that a default will not affect bond holders.

2. Old-line retailers are folding up, eroding the tax base. The addition of a big-box store or two and a giant mall of specialty retailers does nothing to forstall lower sales tax revenues; as high rents kill off the specialty retailers, the recession eats into the revenue of even the big-box outlets.

3. Public pension and medical benefits were increased during the dot-com boom, and now the bills are coming due right as yields on public pension funds are dropping along with the stock and bond markets. As a result, the general tax funds are having to pony up increasingly onerous chunks of cash to cover the city, county and state pension obligations.

Inevitably, cuts in current services and payrolls must be made to free up the money for pension obligations.

4. Medical costs are rising, especially for the "full service" plans promised to public retirees.

5. Tax revenues generated by the housing bubble are plummeting, pinching municipalities even before the full brunt of a retail-sales recession eats away at their sales tax revenues.

To summarize: expenses are rising fast even as revenues are falling fast. Something has to give.

When Orange County, California defaulted due to massive derivative losses in the early 1990s, general obligation funds were spared but some pension obligations were axed. But what happens if the above trends last a number of years? Won't a very large number of cities and counties be driven to default on some obligations to somebody?

It doesn't take much imagination to imagine the ruckus facing the poor judge in bankruptcy court (yes, cities and counties can go bankrupt, too): over here are the current city employees, demanding not to be fired to cut expenses; over there are the pensioners, demanding "whatever it takes" to preserve their pension and medical benefits, and over yonder, the muni bond holders, screaming about their right to "first dibs on any revenues."

Somewhere in the back, lost in the chaos, is the poor taxpayer, ignored except as subservient cash-cow, and the poor citizen, deprived of libraries and other municipal services as the greed-fest-frenzy swirls around the judge.

Official reaction is entirely predictable: let's raise taxes! Soak those "rich" business owners, and "rich" property owners. never mind if they've lost their jobs or seen their own incomes slashed by recession; "raise taxes to save our libraries" will be the clarion call.

What happens if the taxpayer rebels, and demands that all players take huge cuts? What if citizens demand police protection, and reckon any cuts should be taken out of the hides of muni bond holders and retirees' medical benefits?

Ugly battles ahead? Believe it. Once businesses and homeowners galore seek bankruptcy protection, there won't be enough docile cash-cow taxpayers left to fund the shortfalls. Municipal officials will be faced with only unsavory options, and the hue and cry from those who can no longer belly up to the public trough to feed will be stunned and angry.

But there simply won't be enough money to meet what was promised to everyone. If you find this premise too "doom-and-gloom" to be realistic, print this out and read it again in, say, four years, in November 2011, and then look around your city and county and state and see if it isn't even worse than what's described here.

Thank you, Dwight Rounds, ($100), fellow author and music buff, for your extremely generous contribution to this humble site. I am greatly honored by your readership and support. All contributors are listed below in acknowledgement of my gratitude.

For more on this subject and a wide array of other topics, please visit my weblog.


copyright © 2007 Charles Hugh Smith. All rights reserved in all media.

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