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Federal Reserve Chairman Ben Bernanke. Will continued low interest rates lead to inflation? Some money managers don't think so.
The Federal Reserve's Open Market Committee announcement Wednesday wasn't a big surprise on the interest-rate front. The Fed has stated it intends to keep short-term rates low for the foreseeable future, in an effort to stimulate the economy and push investors into riskier assets, like stocks. A continued low-interest rate environment will also continue to bolster the housing market, where mortgage rates are at historic lows.
Fed Chairman Ben Bernanke and the rest of the FOMC annouced that they will keep rates low until unemployment falls to 6.5 percent. It will also continue to buy up mortgage-backed securities, at roughly the same rate it has been (so-called "Quantitive Easing," installment 3, or "QE3").
[UPDATE: I slightly misinterpreted what the Fed is doing on the bond-buying side. It's also worth noting that the Fed is now saying that it will keep interest rates low until unemployment hits a specified level. This is a policy departure from saying that rates will stay low until the economy improves. But anyway, bond-buying: the Fed is going to double what it's doing in the QE front and change "Operation Twist" into an extension of QE3. The older aspect of QE will still involve buying MBS. But the additions to QE3 will entail buying long-term U.S. Treasuries without selling short-term bonds. This is important as it means the Fed will be adding $85 billion per month to its balance sheet — under Operation Twist, it hadn't grown much, which was viewed as an way to "sterilize" against inflation. Former Dallas Fed President Bob McTeer has a good post about the FOMC decision at Forbes.]
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A sign stands in front of California Public Employees' Retirement System building. CalPERS is trying to prevent bankrupt cities from evading pension obligations.
Last week, Moody's, the rating agency, released a note about the ongoing San Bernardino bankruptcy and the city's pension obligations to CalPERS. According to Moody's, San Bernardino's total unfunded pension liability far outstrips it other municipal debt.
San Bernardino declared bankruptcy in July, after the city council revealed that it barely had enough money to keep the lights on. A big question in the bankruptcy has been whether the city will attempt to reduce or discharge its CalPERS liabilities. As Moody's pointed out, neither Vallejo, which went into Chapter 9 in 2008 and emerged in 2011, nor Stockton, which declared bankruptcy earlier this year, sought concessions from CalPERS. In Vallejo's case, other creditors took a substantial haircut.
CalPERS maintains that pension obligations can't legally be reduced in bankruptcy. That hasn't stopped San Bernardino from ceasing payments, to the tune of $6 million. CalPERS is now disputing San Bernardino's Chapter 9 eligibility, according to Moody's, and is threatening to do away with the city's pension plan. This would expose San Bernardino to a bigger pension payment, due immediately.
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San Bernardino City Hall. Was bankruptcy really the best move for this California municipality?
Moody's, the investment rating agency, has just released some commentary on "speculative" credit in the local-government sector. This is credit that has been downgraded to non-investment-grade status. It's basically junk — or, if you prefer, "high yield." The risk of default is higher, but the interest rate is also higher, making for a beefier return.
Moody's has been focusing for a while now on the worsening fiscal situation for the cities whose debt it rates, with special concentration on California. It recently placed a number of municipalities in the state on review. The agency says that there's a new factor it's watching carefully. From the report:
Some distressed governments have confronted the plethora of economic, financial, and managerial problems by choosing to discriminate among their outstanding obligations. Lack of willingness to pay debt service is emerging as a new theme in public finance. Although it’s not expected to become a widespread practice, even among speculative-grade issuers, there are several recent examples of this development.
The City of Stockton, CA has struggled for many years to control costs efficiently amid a severely weakened local economy, ineffective negotiations with its bargaining units, and management’s decision to take on the costs of dissolving its redevelopment agency. In June 2012, Stockton filed for Chapter 9 bankruptcy protection and adopted a budget that suspends payments on some lease and pension obligation bonds.
Another big rating agency, Standard & Poor's, is also keeping an eye on cities in California. I recently talked with Gabriel Petek, an S&P credit analyst. He indicated that S&P is also reviewing the California cities in its ratings universe and echoed Moody's concern about the "lack of willingness to pay" matter.
But he also tackled the question of whether it makes sense for financially distressed cities to enter bankruptcy, as three California cities — Stockton, San Bernardino, and Mammoth Lakes — have this year. (More may be on the horizon: Atwater, near Stockton, has declared a fiscal emergency, and things don't look too good in Compton.)
"In a case where an entity is genuinely insolvent, there may not be a lot of options," he said. This is effectively what happened in San Bernardino, where unlike Stockton, there was no pre-bankruptcy mediation process, now mandated by state law. The fiscal crisis in San Bernardino was so dire that the city proceeded directly to Chapter 9.
But as far as Petek is concerned, that was an extreme case. "Bankruptcy should be avoided at all costs," he said. "Most bankruptcies seem to exceed long-run and near-term benefits."
Case in point? Vallejo, the Northern California city that declared bankruptcy in 2008 and emerged in 2011, racking up tens of million in bankruptcy costs along the way. The Vallejo experience led to AB 506, the mediation legislation that created the process that was first tried, but that ultimately failed, in Stockton. Vallejo's dire financial straits have been much analyzed, perhaps most prominently by Michael Lewis last year in Vanity Fair.
"Other parts of Bay Area are in recovery, but Vallejo is languishing," Petek said. "They haven't had access to capital markets. Older cities need to make investment in infrastructure, and the only way to do that is via access to capital markets. So cities that may be in Vallejo [and Stockton's] position should be forewarned. It will be a costly drawn-out process."
So if bankruptcy is a bad move for California cities under financial stress, does mediation, even though it failed in Stockton, represent a vaible option?
"We haven't seen so far that it's functioned that way some policymakers had hoped for or envisioned," Petek said. "The problem starts with initial negotiations. Multi-year contracts with labor, securing compensation, don't enable management to deal with changing conditions."
These labor contracts have become a sticking point for numerous older, stressed-out California municipalities. Negotiated when city budgets were flush, they've become onerous since times have changed and revenue bases have collapsed due to the housing crisis and high unemployment cutting into sales taxes. Labor costs are gobbling up 80 percent of budgets, leaving city managers with extremely limited flexibility.
"Cities are service providers, but some are operating in an environment where you can't raise revenue due to Proposition 13, and some of these are cities that also locked in multi-year labor contracts," Petek said. "They removed the part of the budget they had discretion over."
Petek calls this "fiscal handcuffs." Because Proposition 13 prevents any latitude on raising property taxes and some city workers have been inflexible in renegotiating contracts, municipalities are staring down the difficult choice of declaring bankruptcy and ending up like Vallejo or muddling through and trying to slash everything but essential or non-negotiable services, degrading quality of life in their cities.
Petek doesn't let city managers off the hook, however. He said that many made decisions prior to the end of redevelopment and the loss of $6 billion painted cities into a corner. Redevelopment wasn't intended to plug budget gaps. But in San Bernardino, redevelopment money became a "lifeline," according to city officials, enabling the municipality to maintain it aging infrastructure.
The fiscal collapse of several cities in California caught the bond markets off guard. Over the past year, Moody's, S&P and others have been taking a much closer look at why cities that didn't outwardly look like major credit risks suddenly got on fast tracks to Chapter 9. For the most part, there's no reason to expect a deluge of bankruptcies. But for Petek and others, there are good reasons to drill deeper into what's really been going on with the finances of Golden State municipalities.
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The ratings agency announced that it's reviewing more than 30 California cities for bond-rating downgrades. However, Los Angeles could get an upgrade.
Moody's, the big ratings agency, announced last night that it's reviewing the bond ratings of 32 California cities including Santa Monica, Glendale, Huntington Beach, and Long Beach. The reviews are for downgrades, mostly, but two of California's biggest cities - Los Angeles and San Francisco - are under review for bond-rating upgrades. This is particularly good news in L.A.'s case, given the city's looming $200 million budget deficit.
This action didn't come out of nowhere. Back in August, Moody's emphasized that although municipal debt defaults are exceptionally rare, bankruptcies in Stockton, San Bernardino, and Mammoth Lakes — along with the general fiscal stress that California cities are under — compel the agency to review the 95 Golden State municipalities whose debts it rates.
Tuesday's announcement is the culmination of that exercise. All the cities Moody's is reviewing may not be downgraded, but the agency's examining one-third (the review process will take about 90 days). The pension-obligation bonds of eight cities were downgrades. That indicates how serious a problem funding legacy pensions has become for some cities in the state.
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Lehman Brothers headquarters in New York on September 15, 2008. The 158-year-old investment bank filed for bankruptcy four years ago.
Tomorrow, September 15, marks four years since Lehman Brothers declared bankruptcy and the financial crisis, complete with TARP and bailouts and more bankruptcies, shotgun mergers, "Too Big to Fail" (see below), and the end of a long, debt-fueled boom economy.
You could make the argument that we're still not recovered — and in fact some experts insist that there never was a recovery and that we're continuing to deal with the aftermath of the worst financial downturn since 1929.
There's little doubt that the U.S. economy is still in bad shape. Unemployment is high at 8.1 percent, fewer Americans are in the job market than at any time since the early 1980s, housing remains a mess in much of the country (especially California), and the national debt recently crossed the $16-trillion mark. The Federal Reserve just announced that it will once again put money into the economy to stimulate growth and hiring and provide a boost to consumption and the housing market.