It's the other U.S. debt problem.
States are scrambling to close $114 billion in budget shortfalls over the next year and a half. For now, they can borrow at curiously low rates in the bond market — but they better hurry.
Lenders are still throwing money at the federal government despite its trillions of dollars of debt. But when it comes to states, cities and local governments deep in the red, their generosity appears to be running out.
Prices of municipal bonds, which are issued to build schools, lay water pipes and pave roads, dropped last month at one of the fastest clips since the credit crisis two years ago. Shares of mutual funds that hold the bonds have fallen hard, too.
Some experts worry that problems in the municipal bond market could spread to other markets. Their worst case: A plunge in muni prices triggers panic among investors and widespread selling of other financial assets. That happened during the 2008 credit crisis, when the market for mortgage-backed bonds collapsed. Credit markets froze and stock prices plunged worldwide. A recession that had begun nearly a year earlier became the worst downturn since the Depression.
"It's a Molotov cocktail," Envision Capital founder Marilyn Cohen says of the muni market. "It could explode."
The causes of turmoil in the $2.8 trillion muni market are myriad, but critics say one was misplaced investor enthusiasm.
State and local governments have rarely been in worse shape, but the average investor was convinced they would always pay back what they owed anyway. So bonds were scooped up, prices rose and yields, or the interest paid each quarter as a percentage of those prices, fell to the lowest in decades. New buyers of muni bonds earned less in interest even as the risk grew that a state or city or town couldn't pay it.
At this point after a recession, the economy typically would be growing strongly, raising the tax revenue needed to close budget gaps. And if the economy snaps back, city and state tax revenues will grow quickly, making the crisis a memory.
But so far, that isn't happening. As a result, local governments are turning to states for emergency funds to pay for services and salaries. Others are looking at plans to sell or lease public property to raise money fast. And some have taken the unusual step of using proceeds from muni bonds to meet payroll or other immediate expenses instead of funding big projects.
"It's like using your credit card to cover living expenses," says Richard Lehmann, an investment adviser and author of the Distressed Debt Securities Newsletter. "It's a quick path to ruin."
In Illinois, a pension plan for teachers that was short of money sold $1.3 billion in investments set aside for future retirees. The state budget deficit nearly tripled last year. Yet some investors have been accepting less and less interest on their bonds, just as they would if finances were improving.
There are plenty of other ominous signs. Some voters in San Diego are pushing the city to file for bankruptcy to get out from under $3.5 billion in unfunded pension and health care costs for workers. The possibility of bankruptcy has been looming over Detroit's school system for nearly two years. The city council of Harrisburg, the capital of Pennsylvania, recently voted to hire a bankruptcy adviser.
"Do we cut salaries or operate fewer buses — or do we pay all the interest" on our bonds? says Michael Aronstein, chief investment officer of Oscar Gruss & Sons Inc., a research and brokerage firm. "All these are possibilities when the numbers no longer work."
The numbers stopped working for Vallejo, Calif., 2½ years ago. Faced with rising bills for its public workers and falling property taxes, the city of 20,000 filed for bankruptcy. Though it has promised to make good on its debt eventually, it isn't paying full interest on all its bonds.
Whether there will be many more Vallejos is anyone's guess, but the history of munis is not completely reassuring. In the Great Depression, governments defaulted on 11 percent of munis, notes James Grant in a recent issue of Grant's Interest Rate Observer. The lesson: In times of crisis, moral compunctions about reneging on promises to investors are forgotten.
The $114 billion budget shortfall confronting U.S. states is down from $191 billion in fiscal 2010, according to the nonpartisan Center on Budget and Policy Priorities. States tapped special federal aid to plug one-third of last year's record gap. Most of that aid runs out this summer.
Another looming problem: woefully underfunded pensions. To make good on promises to current workers, state and local governments need to inject $3.6 trillion into the funds, according to a study by Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester.
For now, states are considering more spending cuts and tax hikes and tapping their rainy-day funds again. For investors in municipal bonds, meanwhile, there are other troubles to think about.
Half of municipal bonds are in mutual funds that buy and sell constantly. This means even if defaults remain low, investors can lose money if their fund managers overreact to the fear that defaults will rise.
Those who prefer to own individual bonds instead of investing in funds face risks, too. Many munis owned directly are barely traded, so sellers sometimes can find few or no buyers.
That's not the case with U.S. Treasury bonds or stocks of big companies like General Electric or Microsoft, which enjoy liquid markets and the services of deep-pocketed firms charged by regulators with buying if no one else will. Muni sellers are basically on their own, and prices can fall fast.
In 2008, investors pulled $15 billion out of muni funds in four months while prices were tumbling. To raise cash for investors wanting their money back, fund managers had to sell munis even if they didn't want to. The average fund lost 5.5 percent, according to Morningstar Inc. In 1994, a similar cycle sent bond prices down, too. The average muni fund lost 5.8 percent.
Something similar is happening now. In the two weeks that ended Nov. 24, investors pulled $7.8 billion more from muni funds than they put in, according to the Investment Company Institute. That helped push some mutual funds down 10 percent. It was a big change: For much of the past decade, investors were pouring money into munis, not taking it out.
"When people redeem, I have to sell," says Thomas Metzold, who manages Eaton Vance's National Municipal Income Fund. It's down 5.4 percent in a month. "What can I do?"
Despite the turmoil, Metzold dismisses the idea of munis as the source of the next systemic crisis. He thinks the worst has passed and notes bond prices have inched back up in recent days. He thinks the selling reflected not fear of defaults but an oversupply of new bond issues, which overwhelmed demand.
Other investors say that because there are tens of thousands of bond issues of various credit quality and with various dates on which they mature, it is difficult to say whether the market as a whole is overpriced.
And even if a town or city gets into trouble, muni experts say, it will do almost anything to avoid reneging on its debt. "Municipalities run on debt, and if they default and can't borrow, things will grind to a halt," says James Klotz, president of muni broker FMS Bonds Inc. "They can't allow themselves to get shut out of the market."
Still, some of the biggest names on Wall Street warned in the past year that the market was primed to fall. They include James Chanos, who bet against Enron before it collapsed, billionaire Warren Buffett and Meredith Whitney, a banking analyst who predicted that industry's crisis.
Municipalities use revenue from taxes, fees and other sources to make interest payments and repay principal when a bond matures. Muni bonds are attractive to investors because you don't have to pay federal income tax on the interest. That's not true for corporate bonds. So while top-rated munis maturing in 10 years yield 3.38 percent annually now, that's more like 5.2 percent for those in the highest tax bracket. If you buy bonds issued in your state, you often don't have to pay state or local income taxes, either.
Investors tend to buy munis based on the yield and take their chances that the price of their bonds or the price of their muni fund shares won't fall. Despite the recent drops, bond prices are still up this year. That rise plus interest payments translates into 5.5 percent gain for munis so far this year, according to Barclay's Capital.
The bullish case for munis is that they almost always make good on their payments. Only 54 of the 60,000 munis that Moody's Investors Service rated from 1970 through last year have defaulted. But history may not be a good indicator because the finances of local governments are in their worst shape since the Depression.
"Risk is inherent in the unprecedented, not the precedented," Aronstein says.
© Copyright 2015 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.