Municipal Bonds

If yields on U.S. Treasury bonds keep rising, things are going to get very messy. As I write this, the yield on 10 year U.S. Treasures has risen to 2.51 percent. If that keeps going up, it is going to be like a mile wide lawnmower blade devastating everything in its path. Ben Bernanke’s super low interest rate policies have systematically pushed investors into stocks and real estate over the past several years because there were few other places where they could get decent returns. As this trade unwinds (and it will likely not be in an orderly fashion), we are going to see unprecedented carnage. Stocks, ETFs, home prices and municipal bonds will all be devastated. And of course that will only be the beginning. What we are ultimately looking at is a sell off very similar to 2008, only this time we will have to deal with rising interest rates at the same time. The conditions for a “perfect storm” are rapidly developing, and if something is not done we could eventually have a credit crunch unlike anything that we have ever seen before in modern times.

At the moment, perhaps the most important number in the financial world is the yield on 10 year U.S. Treasuries. A lot of investors are really concerned about how rapidly it has been rising. For example, Patrick Adams, a portfolio manager at PVG Asset Management, was quoted in USA Today as saying the following on Friday…

“I am watching the 10-year U.S. bond,” says Adams. “It has to stabilize. If the yield goes significantly higher the market is going to freak out.”

If interest rates keep rising, it is going to have a dramatic effect throughout the economy. In an article that he just posted, Charles Hugh Smith explained some of the things that we might soon see…

The wheels fall off the entire financialized debtocracy wagon once yields rise. There’s nothing mysterious about this:

1. As interest rates/yields rise, all the existing bonds paying next to nothing plummet in market value

2. As mortgage rates rise, there’s nobody left who can afford Housing Bubble 2.0 prices, so home prices fall off a cliff

3. Once you can get 5+% yield on cash again, few people are willing to risk capital in the equities markets in the hopes that they can earn more than 5% yield before the next crash wipes out 40% of their equity

4. As asset classes decline, lenders are wary of loaning money against these assets; if the collateral for the loan (real estate, bonds, stocks, etc.) are in a waterfall decline, no sane lender will risk capital on a bet that the collateral will be sufficient to cover losses should the borrower default.

In addition, rapidly rising interest rates would throw the municipal bond market into absolute chaos. In fact, according to Reuters, nearly 2 billion dollars worth of municipal bond sales were postponed on Thursday because of rising rates…

The possibility of rising interest rates rocked the U.S. municipal bond market on Thursday, with prices plunging in secondary trade, investors selling off the debt, money pouring out of mutual funds and issuers postponing nearly $2 billion in new sales.

“The market got crushed,” said Daniel Berger, an analyst at Municipal Market Data, a unit of Thomson Reuters, about the widespread sell-off.

We are rapidly moving into unprecedented territory. Nobody is quite sure what comes next. One financial professional says that municipal bond investors “are in for the shock of their lives”…

“Muni bond investors are in for the shock of their lives,” said financial advisor Ric Edelman. “For the past 30 years there hasn’t been interest rate risk.”

That risk can be extreme. A one-point rise in the interest rate could cut 10 percent of the value of a municipal bond with a longer duration, he said.

Many retail buyers, though, are not ready for the change and “when it starts, it will be too late for them to react,” he said, adding that he was encouraging investors to look at their portfolio allocation and make changes to protect themselves from interest rate risks now.

Rising interest rates are playing havoc with other financial instruments as well. For example, it appears that the ETF market may already be broken. Just check out the chaos that we witnessed on Thursday…

The selling also caused disruptions in the plumbing behind several ETFs. Citigroup stopped accepting orders to redeem underlying assets from ETF issuers, after one trading desk reached its allocated risk limits. One Citi trader emailed other market participants to say: “We are unable to take any more redemptions today . . . a very rare occurrence due to capital requirements we are maxed out on the amount of collateral we have out.”

State Street said it would stop accepting cash redemption orders for municipal bond products from dealers. Tim Coyne, global head of ETF capital markets at State Street, said his company had contacted participants “to say we were not going to do any cash redemptions today”. But he added that redemptions “in kind” were still taking place.

These are the kinds of things that you would expect to see at the beginning of a financial panic.

And when there is fear in the marketplace, credit can dry up really quickly.

So are we headed for a major liquidity crisis? Well, that is what Chris Martenson believes is happening…

The early stage of any liquidity crisis is a mad dash for cash, especially by all of the leveraged speculators. Anything that can be sold is sold. As I scan the various markets, all I can find is selling. Stocks, commodities, and equities are all being shed at a rapid pace, and that’s the first clue that we are not experiencing sector rotation or other artful portfolio-dodging designed to move out of one asset class into another (say, from equities into bonds).

The bursting of the bond bubble has the potential to plunge our financial system into a crisis that would be even worse than we experienced back in 2008. Unfortunately, as Ambrose Evans-Pritchard recently noted, the bond market is dominated by just a few major players…

The Fed, the ECB, the Bank of England, the Bank of Japan, et al, own $10 trillion in bonds. China, the petro-powers, et al, own another $10 trillion. Between them they have locked up $20 trillion, equal to roughly 25pc of global GDP. They are the market. That is why Fed taper talk has become so neuralgic, and why we all watch Chinese regulators for every clue on policy.

This is one of the reasons why I write about China so much. China has a tremendous amount of leverage over the global financial system. If China starts selling bonds at about the same time that the Fed stops buying bonds we could see a shift of unprecedented proportions.

Sadly, most Americans have absolutely no idea how vulnerable the financial system is.

Most Americans have absolutely no idea that our system of finance is a house of cards built on a foundation of risk, debt and leverage.

Most Americans have complete and total faith that our leaders know what they are doing and are fully capable of keeping our financial system from collapsing.

In the end, most Americans are going to be bitterly, bitterly disappointed.

In the United States, it is not just the federal government that has a horrific debt problem. Today, state and local governments across America are collectively deeper in debt than they ever have been before. In fact, state and local government debt is now sitting at an all-time high of 22 percent of U.S. GDP. Once upon a time, municipal bonds (used to fund such things as roads, sewer systems and government buildings) were viewed as incredibly safe investments. They were considered to have virtually no risk. But now all of that has changed. Many analysts are now openly speaking of the possibility of a municipal bond market crash in 2011. The truth is that dozens upon dozens of city and county governments are teetering on the brink of bankruptcy. Even the debt of some of our biggest state governments, such as Illinois and California, is essentially considered to be “junk” at this point. There are literally hundreds of governmental financial implosions happening in slow motion from coast to coast, and up to this point not a lot of people in the mainstream media have been talking about it.

Fortunately, a recent report on 60 Minutes has brought these issues to light. If you have not seen it yet, do yourself a favor and click on the video below and spend a few minutes watching it. It is absolutely stunning.

In the piece, one of the people that 60 Minutes interviewed was Meredith Whitney – one of the most respected financial analysts in the United States. According to Whitney, the municipal bond crisis that we are facing is a massive threat to our financial system….

“It has tentacles as wide as anything I’ve seen. I think next to housing this is the single most important issue in the United States and certainly the largest threat to the U.S. economy.”

State and local governments across the United States are facing a complete and total financial nightmare. The 60 Minutes report posted below does a pretty good job of describing the problem but it doesn’t even pretend to come up with any solutions….

Unlike the federal government, state and local governments cannot just ask the Federal Reserve to print up endless amounts of cash. If state and local governments want to spend more than they bring in, they must borrow it from investors.

If the municipal bond market crashes, and investors around the world are no longer willing to hand over gigantic sacks of cash to state and local governments in the United States, then the game is over. Either state and local governments will have to raise taxes or they will have to start spending within their means.

Most Americans have no idea what this would mean. For decade after decade, state and local governments throughout the nation have been living way, way, way above their means. If the debt cycle gets cut off, it is going to mean that many local communities around the nation will start degenerating into rotting hellholes nearly overnight.

We are already seeing this happen in places such as Detroit, Michigan and Camden, New Jersey but if the municipal bond market totally collapses we are quickly going to have dozens of Detroits and Camdens from coast to coast.

Let’s take a closer look at some of the state and local governments that are in some of the biggest trouble….

California

California is facing a 19 billion dollar budget deficit next year, and incoming governor Jerry Brown is scrambling to find billions more to cut from the California state budget. At this point, investors are becoming increasingly wary about loaning any more money to the state. The following quote from Brown about the desperate condition of California state finances is not going to do much to inspire confidence in California’s financial situation around the globe….

“We’ve been living in fantasy land. It is much worse than I thought. I’m shocked.”

Unfortunately, the economic situation in California continues to degenerate. For example, 24.3 percent of the residents of El Centro, California are now unemployed. In fact, the number of people unemployed in the state of California is approximately equivalent to the populations of Nevada, New Hampshire and Vermont combined.

The housing market in the state is also a major drag on the economy there. For instance, the average home in Merced, California has declined in value by 63 percent over the past four years.

The state of California is swamped with so much debt that there literally appears to be no way out.

Arizona

The state government of Arizona is so incredibly starved for cash that it actually sold off the state capitol building, the state supreme court building and the legislative chambers. Now they are leasing those buildings back from the investors that they sold them to.

Arizona also recently announced that it has decided to stop paying for many types of organ transplants for people enrolled in its Medicaid program.

Illinois

Illinois is widely regarded to be in the worst financial condition of all the U.S. states. At this point, Illinois has approximately $5 billion in outstanding bills that have not been paid.

According to 60 Minutes, the state of Illinois is six months behind on bill payments. 60 Minutes correspondent Steve Croft asked Illinois state Comptroller Dan Hynes how many people and organizations are waiting to be paid by the state, and this is how Hynes responded….

“It’s fair to say that there are tens of thousands if not hundreds of thousands of people waiting to be paid by the state.”

The University of Illinois alone is owed 400 million dollars. There are approximately two thousand not-for-profit organizations that are collectively owed a billion dollars by the Illinois state government.

New Jersey

The New Jersey state budget has been slashed by 26 percent, a billion dollars have been cut from education and thousands of teachers have been laid off.

But even with all of those cuts, New Jersey is still facing a $10 billion budget deficit next year, and the state has $46 billion in unfunded pension liabilities and $65 billion in unfunded health care liabilities that it is somehow going to have to address in the future.

Detroit

Detroit Mayor Dave Bing has come up with a new way to save money. He wants to cut 20 percent of Detroit off from essential social services such as road repairs, police patrols, functioning street lights and garbage collection.

Miami

One Miami commissioner declared earlier this year that bankruptcy may be the city’s only financial hope.

Philadelphia, Baltimore and Sacramento

Major cities such as Philadelphia, Baltimore and Sacramento have instituted “rolling brownouts” in which various city fire stations are shut down on a rotating basis.

Camden

The second most dangerous city in the United States – Camden, New Jersey – is about to lay off about half its police in a desperate attempt to save money.

Oakland

Oakland, California Police Chief Anthony Batts has announced that due to severe budget cuts there are a number of crimes that his department will simply not be able to respond to any longer. The crimes that the Oakland police will no longer be responding to include grand theft, burglary, car wrecks, identity theft and vandalism.

Nassau County, New York

In New York, the country of Nassau (one of the wealthiest counties in the state) has a budget deficit that is approaching 350 million dollars.

America used to be viewed as the land of great economic progress, but that is no longer the case. Sadly, all over the United States there are signs that we are actually going backwards as a country.

All over the nation, asphalt roads are actually being ground up and are being replaced with gravel because it is cheaper to maintain. The state of South Dakota has transformed over 100 miles of asphalt road into gravel over the past year, and 38 out of the 83 counties in the state of Michigan have transformed at least some of their asphalt roads into gravel roads.

Just think about that – we are actually going back to gravel roads.

What’s next?

But this is what is going to happen all over America if dozens of state and local governments start defaulting and the municipal bond market crashes.

In fact, don’t look now, but there are signs that a “bloodbath” in the municipal bond market has already begun. The months of November and December have been incredibly rocky for municipal bonds.

The days when U.S. states and cities could borrow seemingly endless amounts of incredibly cheap money are officially over.

So where are state and local governments going to get the money that they need?

Well, they are going to come and try to get it from you of course. Over the past two years, 36 of the 50 U.S. states have jacked up taxes or fees.

Many local governments are trying to raise funds any way that they can. For example, from now on if you are caught jaywalking in Los Angeles you will be slapped with a $191 fine.

This kind of thing is happening all over America. Police departments are being turned into revenue raising operations. Police are so busy writing tickets that they barely have any time to investigate actual crimes anymore.

But it simply is not going to be enough. State and local governments across the U.S. are facing financial holes of legendary proportions.

The 60 Minutes report above stated that the combined unfunded pension and health care liabilities of the 50 states is $1 trillion. Unfortunately, that is an estimate that is probably way too conservative. In fact, two prominent university professors have calculated that the combined unfunded pension liability for all 50 U.S. states is approximately 3.2 trillion dollars.

So if the municipal bond market does crash will the federal government step in and bail everyone out?

Well, this upcoming spring the $160 billion in federal “stimulus money” runs out. At that point there will likely be a huge cry for even more “stimulus money” for state and local governments.

Unfortunately, as I wrote about yesterday, the federal government is also flat broke and swimming in an ocean of endless red ink. Congress could potentially step in and try to bail all the state and local governments out, but in the end it is the American people who are going to have to pay the bill.

We are on the verge of a horrific economic collapse which is going to change life in this country as we know it forever. All of this debt is absolutely going to swamp us. Our politicians can keep trying to kick the can down the road for as long as they can, but eventually the financial nightmare that so many of us have been dreading is going to overtake us.

“If The Yield Goes Significantly Higher The Market Is Going To Freak Out”

Municipal Bond Market Crash 2011: Are Dozens Of State And Local Governments About To Default On Their Debts?