One of the things that's struck me about the two most recent bankruptcies — or almost-bankruptcies — in California, San Bernardino and now Compton, is that the bond markets aren't predicting a crisis. Reuters MuniLand columnist Cate Long has been following all the recent action in California's troubled cities and correlating it with what's going on in the $3.7-trillion municipal bond markets and she sees...no cascade of impending Chapter 9s:
American cities and states are enduring a lot of fiscal stress, and in some cases their municipal bonds are showing stress too. But overall the muni bond market feels comfortable with the debt of U.S. states and cities. The data does not suggest a broad meltdown.
In that context, she cites Guy Davidson of AllianceBernstein, a firm that according to Long has $3.3 billion in California muni exposure (and $31 billion under management in total) and that therefore might want to argue against a panic in MuniLand. This is from Davidson's blog post:
Both [Stockton and San Bernardino] went through a housing boom that generated strong revenue growth. Assuming the growth would continue, their governments quickly expanded budgets and services. Unfortunately, the housing boom was quickly followed by a deep local housing collapse, and the cities were unable or unwilling to cut expenses or raise revenues quickly enough. Diligent research and analysis of each issuer’s options and willingness to address problems is warranted.
Clearly, research on the impact of the housing cycle and municipalities’ fiscal response to it is critical to understanding today’s municipal market. And the housing crisis hit California particularly hard. One way to measure just how hard is to look at the percentage of home mortgages that are more than 90 days delinquent. When that percentage exceeds 10% of a county’s mortgages, a housing crisis has had a serious impact on that county’s economy. Of the 54 California counties tracked in the Federal Reserve database (four counties do not report the statistic at all), 10 have 90+ day delinquency rates exceeding that critical 10% level—including San Bernardino at 11.7%.
That means more filings are possible. However, the local government-related debt issued in these 10 counties is small, representing only about 1% of outstanding California municipal debt. In other words, the total amount of debt involved in potential filings should remain quite small—and does not mark the beginning of a significant trend.
That small percentage of muni debt in counties that are suffering the most from the housing downturn explains why the bond markets aren't flashing red signals. So it won't be debt exposure that sinks stressed-out cities in California, but the inability to issue new debt or roll over existing debt could be a factor — Compton for example saw S&P downgrade its revenue bonds to junk status last year (they were still considered investment grade in July of 2011). That meant that to issue new revenue bonds to make up for funds that haven't shown up yet, Compton would have to pay a higher price for the debt.
To get a fix on which California cities may be next in line at the Chapter 9 window, it makes sense to discount the bond markets, even though as Cate Long notes, Warren Buffett is currently wagering on muni defaults, by holding $16 billion in credit default swaps on muni debt, versus $3 billion in actual municipal bonds. (CDS are sort of like insurance against defaults, and in this case Buffett's $16 billion will pay out if defaults happen.)
We should look instead at how much it's costing to maintain police and fire services (as a percentage of the overal city budget); pension and benefits costs; and revenue losses, from reduced property taxes in particular.