Explaining Southern California's economy

The investors' view on the Federal Reserve's interest rate decision

Ben Bernanke

Alex Wong/Getty Images

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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The story behind Moody's review of California cities

US-FINANCE-ECONOMY-MOODY'S

EMMANUEL DUNAND/AFP/Getty Images

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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Things are getting tense in the municipal bond market

Residents make their way in and out of t

Frederic J. Brown/AFP/Getty Images

San Bernardino is the latest California city to declare bankruptcy. Is this the beginning of the end of the once-sleepy, rock-solid municipal bond market?

It's hard to tell if this is just general nervousness after a rally or a legitimate reason to worry about an impending wave of defaults on municipal bond debt — something that has basically never happened. But in the span of a few days, billionaire investor Warren Buffett has unloaded $8.25-billion in credit default swaps on muni debt.

Buffett's Berkshire Hathaway sold the CDS to Lehman Brothers prior to the investment bank's epic bankruptcy four years ago, a Chapter 11 for the ages considered by many to be the thing that kicked off the Great Recession. Buffett's CDS amounted to a bet that cities wouldn't default on their debts — a prediction that for the most part has turned out the be true.

However, over the past few months, three California cities — Stockton, Mammoth Lakes, and San Bernardino — have declared bankruptcy. The ratings agency Moody's has stressed that muni defaults are exceptionally rare (as long as the bonds are rated; the Federal Reserve Bank of New York recently noted that unrated defaults happen more frequently, although they're far from common). But Moody's has also announced that it's conducting a review of the debt of cities in California, in light of recent events.

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California city bankruptcies are raising questions about the municipal bond market

Muni-Defaults

Federal Reserve Bank of New York

Last month, I wrote about Moody's, one of the big ratings agencies, and its view that the municipal bond market was getting a bit riskier than everyone has conventionally thought, in the aftermath of the bankruptcies of Stockton and San Bernardino and other U.S. cities. 

At the time, I noted that between 1970 and 2011, Moody's could find only one city — Cicero, New York — "electing to default on debt not out of ability to pay but willingness to pay."

What that implies is that the now $3.7-trillion muni bond market has been a safe investment for decades. As long as you're investing in rated bonds. (And even if you haven't, but more on that in a sec.)

Now the Federal Reserve Bank of New York has offered its own take, at its Liberty Street Economics blog. It differs from Moody's in terms of the looking at the entire muni market, not just the part that's rated by Moody's and others. The conclusion is represented in the graphic above. Moody's found 71 defaults between 1970 and 2011 — and that's total defaults in its rating universe, so presumably 70 we due to inability to pay while only Cicero strategically defaulted due to an unwillingness to pay.

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Why Oakland vs. Goldman Sachs is an interest-rate mess

Earns Goldman Sachs

Richard Drew/AP

The price of Goldman Sachs stock is shown at a trading post on the floor of the New York Stock Exchange. The Wall Street bank is fighting with Oakland about a deal that goes back to the late 1990s.

If you want to engage in a nice, deep dive into the murky depths of municipal finance, investment banking, and the post-financial crisis world of rock-bottom interest rates, then you're going to want to spend some time getting to know a dispute that's been brewing between Oakland and the Wall Street investment bank that everyone loves to hate, Goldman Sachs. 

The Financial Times has been covering the fracas. But I'll break it down to a few bullet points:

•15 years ago, Oakland did a deal with Goldman to buy interest rate swaps, a type of financial derivative, as insurance against interest-rate volatility on bonds Oakland had issued.

•The bonds in question were commonly used before the Great Recession, but since then cities have gotten rid of them, refinancing the variable-rate debt into fixed-rate debt. But Oakland's swap deal with Goldman runs through 2021.

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