The prospective condition of state and municipal finances in this country gives cause for serious concern in the current contractionary environment. Obviously, income flows to states and, particularly, to cities and other municipalities are poised to decline significantly. The major source of this prospect is, of course, the housing depression. Each house which is abandoned by a mortgagee unable to meet his monthly payments constitutes a loss of tax revenue to the municipality. Each notch down for house prices in general translates ultimately into downward revisions of house value tax assessments, and a deterioration in the overall revenue stream for municipalities. Each step down in the quantity of new houses under construction translates into future real estate tax payments which will NOT materialize.
There are two additional factors pressuring municipal revenues. The first is the ripple effect of falling house prices on overall local economies, which produces further downward pressure on house prices, new home construction, and, consequently, lost tax revenue to the municipalities. The second is the RISING COST OF MUNICIPAL BORROWINGS.
We find this second factor to be the most intriguing. Certainly, it is most unusual. In past economic downturns, the concomitant, across-the-board decline in interest rates has relieved one source of negative pressure on municipal finances: municipalities with maturing debt were able to roll over this debt at a lower rate of interest. New debt could be incurred at a similarly reduced cost. Additionally, the flight to safety -- the reverse side of the coin of the flight FROM RISK -- benefited municipalities, as municipal securities were in the safe category, and were hence a prime destination for frightened money. This seems no longer to be the case.
It is hardly a secret that the price of municipal securities has DECLINED, even as TREASURY prices have SOARED. Moreover, there is less liquidity in the muni market than normal. The INTENSITY IN THE LEVEL OF FEAR is very elevated in the current environment. The reason, we think, is pretty clear: When AAA rated bonds are being downgraded several steps in one fell swoop -- with some moving directly from AAA ratings to junk (Do not pass GO; do NOT collect $200), anxiety over the safety of all but the safest securities (read: TREASURIES) has led to a flight to the one and only one financial asset of supreme safety, and an accompanying flight FROM all others. In addition, there is the recent de facto collapse of the muni bond insurers, whose greed led them to throw prudence to the winds and join the mortgage-backed frenzy, which has now brought them to the brink of insolvency (if not across it). A by-product of the collapse of the muni bond insurers has, of course, been a decline in the price and liquidity of munis. This, in large measure, constitutes a SERIOUS MISPRICING BY THE MARKET, we think. The rate of muni default has historically been extremely low -- with the notable exception of the 1930s. Municipal bond insurance has been a game of smoke and mirrors: a municipal issuer can purchase the insurance, and, with it, the AAA credit rating of the insurer, for LESS than it would cost the municipality to sell the bonds WITHOUT INSURANCE. The fact that the uninusred munis are very safe (with the occasional possible exception) and can reasonably be presumed to carry very little credit risk has not altered the optical illusion that a AAA rating borrowed from the insurer makes an A or A- or BBB muni safer. The municipalities benefited from this optical illusion in the past: now, they are paying for it. What goes around, comes around.
The weakening of municipal finances, with the fall in revenues being amplified in impact by the rise in borrowing costs, will certainly contribute to the weakening of the economy and the rise of deflationary pressure. Weaker municipal spending is inevitable: this translates into fewer jobs, contracts, and overall input to economy activity. With aggregate demand under pressure nationwide for all the familiar reasons, this additional blow is coming at precisely the wrong moment.
