It’s an overview of the escalating deterioration of municipal debt markets, and the concurrent increase in the likelihood that the Fed will again be called in for a bailout. There is also a link to an article on the topic from the New York Times that is worth reading.
Here’s a quote:
The problem is state debt. New York, California and Illinois look more like Greece to their bondholders every day. Since the November elections, investors have been dumping their bonds, and hedge funds are betting against them, perhaps realizing that a Republican House is not going to offer generous, condition free bailouts.
“It seems to me that crying wolf is probably a good thing to do at this point,” Felix Rohatyn told the Times. Rohatyn is the legendary investment banker called in to bring New York city back from the dead in the 1970s and he remains one of the most respected voices in American business life.
The Times story compares blue state debt to the subprime crisis and the Greek meltdown. A deeply disturbing graph shows a true panic underway as investors pull money out of mutual funds that invest in municipal bonds even faster than at the height of the market collapse in October 2008. With as much as $4 trillion in off-the-books pension and health care liabilities, the worst hit states may soon be unable to operate without massive federal support.
The crisis could come much faster than Washington thinks. States and municipalities sold more than $55.6 billion in debt this November even as individual investors reduced their holdings of mutual funds containing these funds by $5.37 billion in the two weeks ending November 24. If supply keeps rising while demand sinks, sooner or later prices are going to crash.
If things go wrong in the markets for blue state debt, watch out. If big blue states like New York, California and Illinois hit a point of market failure when private investors will no longer buy their bonds, Washington will have to decide what to do. Fast.
It will be ugly, and it will hurt.
Will GOP legislators bail out the public sector unions and shovel cash into the maw of improvident and badly managed blue states like so many steaming German taxpayers bailing out the lazy Greeks? Or will Congress sit on its hands while vital state services close down, unemployment spikes, and the financial markets panic? Will all parties turn to the Fed to buy up state bonds? If so, on what conditions and terms?
Here’s a link to the full article, which is worth a read.
The problem, of course, is that the only entity available to bail out the municipalities is the federal government – the world’s largest debtor – but it is bankrupt. There is the Federal Reserve, which could hypothetically begin buying state and even local debt. And why not? It has already bought hundreds of billions of dollars worth of toxic mortgages from banks and other lenders – including, of course, Freddie and Fannie.
Sure, why not? At this point we aren’t just in unchartered waters – we’re wandering around the dark side of the moon.
But how long, really, will the foreign holders of our debt – or those of the domestic variety, for that matter – go along with the money printing? While Bernanke has done a pretty good job of sliding the latest QE under the radar of bond buyers – and holders – the recent rise in U.S. yields is a clear sign that the light of day is beginning to dawn on the Fed’s scam.
Simply, the U.S. Treasury and the Fed are both running out of rope. And now, absent Ron Paul having an unfortunate “accident,” the Fed is going to have to run its operations under far greater scrutiny from Congress. That’s because, rumors to the contrary, Ron has just been given control over the House subcommittee charged with overseeing the Fed… no wonder Bernanke was looking so nervous on 60 Minutes.
This is all sliding to an inevitable conclusion, and maybe even an imminent one. If interest rates start to ratchet up on our many debts – and by “our” I mean we the people, as well as the state, local, and federal debts – the government and the Fed have no bullets remaining with which to fight.
So, what happens to bond prices if interest rates rise? FINRA (the Financial Industry Regulatory Authority) recently asked that question as part of a random survey of 28,000 folks around the country. They were hoping to get a sense of the average person’s level of financial acumen.
The results are in (thanks to Henrick for this):
“If interest rates rise, what will typically happen to bond prices?”
18% – They will rise
28% – They will fall
5% – They will stay the same
10% – There is no relationship between bond prices and the interest rate
37% – Don’t know
2% – Prefer not to say
And so, out of the entire sample, only 28% actually understand that rising interest rates are like arsenic tea to bonds. Anyone holding on to them – and the world owns dollar-denominated bonds in prodigious quantities – takes a direct hit to principal, effectively wiping out any thin yields they might have hoped to earn.
And anyone thinking about buying a dollar-denominated bond will insist on ever-higher yields in an attempt to assure that this won’t happen to them.
Throw in the very real default risk that is growing more acute by the day, especially in municipal bonds, as the article quoted above makes clear – and the demand for more yields, as the knock-on losses to principal, soars. Much as has happened in Greece and Ireland.
That this is not going to be a welcome development can be understood on many levels, not the least of which has been the surge of buying of municipal bonds over recent years. This snippet just in from steady correspondent Nitin in Nepal:
According to the Investment Company Institute, $84 billion went into long-term municipal bond mutual funds in 2010, up from $69 billion in 2009. And the 2009 level represents a 785 percent increase from the 2008 $7.8 billion.
Of course, the longer the term, the bigger the hit to capital in a rising rate environment. Recently, the tide has shifted and is beginning to go out of municipal bonds – which is only going to exacerbate things.
Don’t forget to duck (into the nearest precious metals shop, on corrections).
