Municipal bond default wonkery

By Fester:

Moderate municipal finance wonkery to commence in

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You have been warned. I am wondering if the recently cut but not yet approved California budget deal will lead to the anticipated implosion for municipal bond insurance. There may be a series of highly correlated defaults and credit events as California cities and towns will see massive amounts of anticipated revenue via state aid disappear and be replaced with an IOU. Here are the relevant details of the California budget deal:

The $4.4 billion plucked from local governments would come from three sources: nearly $2.1 billion in property and sales tax receipts; more than $1.3 billion in redevelopment money; and $1 billion in transfers from local gas taxes...

Under Proposition 1A, which voters passed in 2004, the property and sales tax money must be repaid with interest within three years. No such provisions exist for redevelopment funds and cash diverted from gas tax revenues, which voters have earmarked for road repairs.

The property and sales tax revenues are 'merely' a loan that the state of California is taking out against the cities.

The logic is that cities and other municipal spending/taxing units can then take the account receivable from the state and use that as collatoral for their own operating cost loans. The problem with this is simple. What would the yield be on the new municipal debt (if a distressed city government could actually issue debt at all) that is dependent on a significantly improving California economy, non-myopic state legislaturers, a functional and rational government process and no other raids on revenue in the near future despite all of the incentives for those raids. The debt would not be cheap even if it is very short term. There is significant political risk at the state level as well as correlated political risk at the federal level as one of the two parties thinks that the best way to deal with a massive output gap is to freeze spending or cut back despite not having a balanced budget constraint.

I think it will be difficult for California communities that are already seeing local revenues plummetted. Local governments are already at the point where revenues will not meet with baseline service costs. Additional shocks such as either the complete loss of state pass-through revenue or expensive bridge loans and increased pension pay-ins will change the political calculations. Municipal financial managers do not want to default as they fear losing access to credit.

However there is a collective action problem.  A few defaults among the thousands of California borrowing entities will cut off credit for everyone else. Once a few entities default, everyone is screwed.  If financial managers expect other managers to default, the smart thing to do is default first.   Defecting and defaulting quickly reduces the pain of being forced to choose between repairing a creaky bridge or paying interest on that variable rate debt that Goldman Sachs told your city council was such a great deal a few years ago but is now eating up a massive proportion of your discretionary budget. At that point, correlated and rolling defaults become far more likely as communities say fuck-it and tell the bond insurers to go after them or the state of California as no one has any money anyways.