Fed Report: Threat of Municipalities Defaulting May Be 'Overblown'

Despite turbulent economic times and bigger anticipated payments to underfunded public pensions, a new study has indicated that few municipalities will default on debt.

(April 19, 2011) — A Federal Reserve economist is challenging the widespread assertions that municipalities are on the brink of disaster and heading for bankruptcy, claiming that the argument is overblown and lacks perspective of past recessions.

In the midst of a challenging fiscal environment, with underfunded public pensions demanding larger annual contributions to return to stability, a new study released by the Federal Reserve Banks of Chicago — titled “Local Governments on the Brink” by economist Richard H. Mattoon — asserts that few municipalities will default on their debt. While there is little disagreement that 2011 will be a tough year in terms of local government finance, the study claims that given the mounting challenges of the current environment and the perceived threat of a wave of local government bankruptcies and credit defaults, the concerns about bankruptcy and default may be overblown.

The reasoning: “For one, the fiscal resources of local governments are deeper than commonly believed. Also, local governments often can take intermediate corrective budgetary action (usually at the insistence of the state) to avoid bankruptcy. Finally, in most cases this corrective action is preferable to the stigma that bankruptcy creates, particularly with regard to the issuance and performance of municipal bonds,” the report asserts, noting that municipalities appear to have reserves that can be tapped in the short-run. The report argues that a potential default would severely limit a local government’s access to credit.

“There is clear statistical evidence that since 1999, local governments, in aggregate, have been increasing their debt. However, it is hard to make the case that this debt is reaching an unmanageable level,” the report says, noting that municipalities have been aided by infrastructure. “…Municipalities tend to issue debt for infrastructure projects, and evidence suggests that they tend to match the term of the debt to the life of the project.”

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The report echos findings of a previous paper released in March titled “Municipal Bond Woes,” authored by Atlanta Fed economist Gerald Dwyer, which stated that data on state and local governments “do not support a forecast of widespread defaults and losses on municipal bonds.”

To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742

Standard & Poor's credit rating of the US government's heightened debt level reflects an awareness that has long been understood by institutional investors, consultancy NEPC believes.

(April 19, 2011) — Institutional investors are relatively unfazed by Standard & Poor’s (S&P) warnings that the US government is in danger over its mounting debt, having understood the problem for years, NEPC’s Chief Investment Officer Erik Knutzen says.

Knutzen says while the S&P’s remarks may serve as a wakeup call about the risks associated with US Treasuries, the rating agency’s blunt warnings are a reflection of a reality that has long burdened institutional investors. “The numbers have been evident since the credit crisis pummeled the country’s fiscal deficit and expanded the United States’ projected debt level,” Knutzen tells aiCIO.

The ratings agency is monitoring fiscal policy, as it should, and its warnings about the US government’s debt level signals renewed urgency that institutional investors may be wise to flee US Treasuries — once perceived as a safe haven — Knutzen believes. “It’s a reminder to plan sponsors that there may be risk associated with government bonds,” Knutzen says. “Funds may move away from bonds toward a broader basket of securities, incorporating currencies or gold as a hedge against devaluation.”

Both fund managers and foreign governments are taking action in response to a potential downgrade. In response to the S&P’s debt warning, China — the largest holder of US government debt with $1 trillion of federal bonds — expressed hopes that the US would enact responsible deficit-cutting measures. “We hope that the US government will take practical measures under a responsible policy to protect the interests of investors,” China’s foreign ministry spokesman Hong Lei said in a statement on the ministry’s website. Fears over the impacts of debt have also been articulated by China’s sovereign wealth fund, the China Investment Corporation. With the continuing debt crisis in Europe and the US, CIC head Lou Jiwei has been pessimistic about the outlook for the developed world, noting that emerging economies have been increasingly concerned about the effects of the loose monetary policy in developed economies, the Wall Street Journal has reported.

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As for asset managers, the departure from bonds can be seen in Pacific Investment Management Co.’s (PIMCO) decision to stray away from the asset class in favor of other sectors. “Investors seeking to maximize total returns in this environment should break away from investing in bonds in the traditional way, since that provides an inadequate hedge against inflationary risks, and instead move toward ‘safe spread.’ By this we mean sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios, given the range of risks,” PIMCO’s Michael A. Gomez, portfolio manager and co-head of the emerging markets portfolio management team, said in a recent report.

Emerging market investments, with particular attention to Asian currencies, have been, and remain, at the forefront of PIMCO’s desire to diversify away from bonds. “As the asset class expands it provides portfolios with a wide range of instruments to diversify currency holdings, cushion against developed world rising rates through attractive spread opportunities, and hedge against downside risks through stronger balance sheets,” the report noted.

To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742