Why All the Noise About Muni Bankruptcies?

The financial analyst Meredith Whitney is predicting a significant upsurge in municipal bond defaults. Jin Lee/Bloomberg News The financial analyst Meredith Whitney is predicting a significant upsurge in municipal bond defaults. But Bill Gross of Pimco disagrees.
Bill Gross of Pimco.Andrew Harrer/Bloomberg News

Todd R. Snyder is a senior managing director and co-head of restructuring and reorganization at Rothschild. He is also an adjunct professor at New York University Law School and Leonard N. Stern School of Business.

Governors across the nation are girding for budget retrenchment and an overdue visit from fiscal reality. The financial analyst Meredith Whitney made headlines recently with loose talk on “60 Minutes” predicting a significant upsurge in municipal bond defaults. Later, Ms. Whitney seemed to contradict her original view by agreeing with Bill Gross of Pimco, when he asserted that his firm does not see “states” defaulting.

Meanwhile, observing that Chapter 9 of the Federal Bankruptcy Code, while available to municipal debtors, excludes the states themselves, two Republican senators, John Cornyn of Texas and Mitch McConnell of Kentucky, as well as Representative Eric Cantor, the Virginia Republican who is the House’s economic guru, have openly debated the wisdom of extending bankruptcy protection to states.

With the municipal bond market approaching $3 trillion, institutional investors, mom and pop investors and high-income professionals seeking tax-advantaged savings are asking with increasing alarm: Is it time to be concerned? Will a wave of defaults turn state and municipal bonds into a trap for unwary investors?

This speculation, despite a market that has had historically low default rates, has resulted in significant capital outflows, falling bond prices and rising yields, already raising the cost of borrowing for issuers. Future market dynamics will reveal whether those increasing yields tempt investor capital back, stemming the outflow of investment dollars from municipal bond funds, or whether spooked credit markets will lead to an even greater sell-off and further increases in borrowing costs.

But visible public figures continue to engage in market-jarring musings about state bankruptcies. Why? Here are a few of my theories:

Another View
View all posts

Budget Cover

State governors are generally too well informed and advised to casually banter about credit default. After all, they know better than anyone that their states require an open and willing municipal bond market to finance government. Nonetheless, the dire predictions from market commentators provide state executives political cover for necessary budget austerity measures.

‘No’ Signal on Possibility of Federal Bailout

Congressional lawmakers, who are facing an enormous budget deficit of their own, do not wish to even contemplate a bailout of state finances. They are, however, hoping to signal all stakeholders at the state level that federal money is not and will not become available even at the extreme cost of a state default. Federal legislators, while hoping not to have their resolve tested, are seeking to soften the negotiating positions on all sides of state budget negotiations by engendering a modicum of overdue but salutary fear of the consequences of intransigence.

Framework for Consensual Restructuring

To the extent that negotiated modifications of state commitments are required, stakeholders on all sides will benefit from a clearly illustrated sense of what the alternatives to rational concessions might look like. Bankruptcy creates a clear picture of downside outcomes. Out-of-court restructurings occur when negotiating parties, acting in rational and informed self interest, can clearly determine that what will happen in the absence of agreement is materially worse than the cost of concessions required to achieve that agreement.

In short, it is the availability and clarity of a bankruptcy option that provides for the possibility of avoiding bankruptcy in fact. Perhaps the intent to provide a stark message to states and their creditors is motivating the talk of extending bankruptcy code protection beyond municipalities. But this kind of talk is not cheap; it is actually quite expensive. Just ask Chris Christie, the Republican governor of New Jersey.

Finally, the Political Fig Leaf

Many governors are certain their jobs require “entitlement” cutting, modification of service and payment promises and constituent-pinching fiscal discipline. No governor wants to be directly involved in a dialogue about potentially using the bankruptcy code to adjust state debts. Having one’s state tied to such a discussion would only increase borrowing costs and likely galvanize opponents. But state chief executives are secretly pleased by the idea that, in a hypothetical state bankruptcy, they will have political cover. They would prefer to be “forced” by a federal judge to modify pension benefits or to renegotiate collective bargaining agreements or even to extend, modify or reduce financed debt obligations as opposed to making such demands themselves in a rancorous test of political will.

In short, most of the dialogue about accelerating defaults and possible bankruptcies is Kabuki theater intended to signal participants all around the various municipal and state negotiating tables that the game is afoot. Each of the participants — the state executives, the federal government, the municipal unions, the bond investing, underwriting and rating communities and the taxpayers themselves — are communicating their initial negotiating postures using the tools of smoke signals and shadow puppets so that they can make their respective messages heard without exacerbating market dynamics and, importantly, without bearing direct political responsibility for an unpleasant message.