Money Sage (archive)

The latter, in our view.

The media has been making mucho hay with the supposed muni bond crisis. Media stories and reports have focussed upon the prospective downgrades of the credit ratings of the companies which insure municipal bonds. According to the media accounts we have seen, these downgrades will/may produce a litany of horrors:
--the insurers themselves may go bust;
--many tens of billions have already been "lost" because of the drop in muni bond prices caused by the deterioration in the viability of the insurers;
--the value, safety, and security of muni bonds will be substantially depreciated by the failure of the insurers, or by their loss of the coveted AAA ratings which enable them to remain in business;
--municipalities will have to pay much more for their borrowings since they will no longer be able to insure with AAA insurers, whose AAA rating automatically extends to any municipal issues they insure and thus reduces the interest rate said issuers must pay investors;
--financially hardpressed municipalities will take an additional and continuing hit to their finances as they must pay a higher rate of interest to buyers.

In fact, municipal bonds have historically been a very safe investment. States and most municipalities have typically paid a substantially lower rate of interest than even the highest-rated corporate issuers. Muni issuers have been aided, of course, by the exemption of muni bond interest from federal income taxes. The main source of the ability of muni issuers to find a ready and eager market for their bonds comes from another source, however. Municipal bonds have an outstanding record of dependability in paying interest due on time. Even more significant, the rate of default on municipals has been impressively low. The cumulative default rate on these securities over the latest 15-year period is WELL UNDER 1%. The ONLY TIME there was a significant problem with muni bond interest payments was during the GREAT DEPRESSION.

Many municipals are, of course, based upon the taxing power of the state or municipality that issues them. These are the GOs -- General Obligation Bonds. The other main category of munis -- Revenue bonds -- are funded by the revenues of the project or municipal/state authority that issues them.

Roughly half of muni bond issuance is backstopped by insurance, in addition to the basic funding source. Uninsured munis have historically been an extremely safe and reliable investment -- second only to Treasuries. (Here we would note that vastly more money was lost by bank depositors in the 1930s than by owners of municipal bonds). AAA rated mortgage-backeds have collapsed in value and are, in many cases, unsalable today, as we all know. This type of collapse has not occurred in the municipal bond market, with the possible exception of the unprecedented depression of the 1930s.

Municipal bond issuers have frequently "insured" their bonds as a result of simple arithmetical calculations: the difference between what they must pay the investor without the insurance guarantee as compared to what they would have to pay by issuing bonds without insurance EXCEEDS the cost of the insurance. Essentially, muni bond insurance is a frivolity on a highly secure investment. This is the reason the muni bond insurance business has been such a profitable, sure-fire way of making money. All would have been well had the insurers stuck to their highly profitable business, instead of being driven by GREED to insure less gilt-edged securities. If we had to make a guess, we would guess that new muni bond insurers, unencumbered by a mountain of unpayable obligations, will materialize. This business remains a golden goose.

In fact, one could make a good case for the thesis that both municipal issuers and investors would be better off without the existence of insurance. This would increase the prudence and care of both categories. The market's efficiency in pricing IS REDUCED by insurance, which obfuscates the underlying credit-worthiness of the issuer, and hence the appropriate, risk-adjusted price it would be prudent for investors to pay for any given bond issuance.

As for the many "billions" allegedly lost by muni investors, these "losses" are purely paper losses. As long as there has been no impairment of the timely flow of interest payments, and the continuing and future ability of the issuers to meet their interest and principal obligations, the value of the bonds remains unimpaired. (This in dramatic contrast to the pitiful circumstances of investors/speculators in mortgage-backeds). Typically, muni investors are individuals who do not sell their bonds. They purchase them for the reliable stream of tax-exempt interest payments, and they hold the bonds to maturity. Paper "losses" have no significance except to journalists and talking heads, who can derive copy via their fear-mongering. Moreover, as we have noted frequently, FEAR SELLS NEWSPAPERS AND TALKING-HEAD MEDIA. Hence the incentive for the media to exaggerate, overplay, and mislead in the unending effort to generate FEAR AND PANIC. If municipalities must, for a time, have to pay more interest to sell new bond issues, the source is NOT the need for insurance and the prospective failure of the insurers, BUT RATHER THE MEDIA-GENERATED HYSTERIA.

We believe that, in due course, municipal bond prices will return to normal valuation levels relative to Treasuries. For smart investors, the media-ginned hysteria constitutes a buying opportunity, we believe.