Are States The Next Greece?

Recent Events
The recent downturn in our economy has created severe budgetary stress for states, as their revenues have fallen precipitously and the demand for services has increased. The State of California with it’s politically charged budgetary process, high foreclosure rate, and high unemployment rate has received much negative attention in the media. Some are saying “California is the next Greece”. While there is little doubt California is under financial stress we believe these concerns are overblown.

A Sovereign: Greece
Greece is an independent political and financial entity and enjoys “self rule”. It is responsible for it’s budget and has the ability to issue debt and print money. Much of their debt is sold to foreigners and foreign banks. Greece is part of the European Union (EU), and their currency is the euro. The EU requires certain fiscal disciplines for member nations, such as balanced budgets, in order to use the euro as their unit of currency. Recently, it was discovered that Greece created fictitious budgets in order to become part of the EU and their financial circumstances are much weaker than previously thought. The revelation of Greece’s weakened financial state has led to a lack of confidence in their ability to re-pay their debt which has created a “debt crisis” for the country and the EU. The EU has demonstrated a willingness to bail out Greece if certain austerity programs are implemented. Resistance to these austerity measures and violent demonstrations in Greece by it’s citizens have been shown on television. Other EU countries such as Portugal, Spain, and Italy are also experiencing financial problems. Many are questioning the viability of the euro as a currency, and it has been under severe pressure as holders of euro’s look to sell and trade into more secure currencies.

A State: California
The State of California is a political sub-division of the United States. It is responsible for it’s budget, but is required by law to have a balanced budget. It is not able to print money. The U.S. government has helped the States, including California, through various stimulus packages during the last 1.5 years. Most of the debt of the State is held domestically, and is not subject to additional volatility caused by currency risk, which makes them much less volatile than Greek bonds during the last couple of years. Though
the budgetary process is cumbersome and outdated, the financial reports issued by the State comply with legal reporting standards and offer a fair representation of the State’s financial circumstances. The State has the ability to cut expenses and raise revenues to balance the budget. The rapid decline in tax revenues for the last 2 years has caused a great deal of budgetary stress for the State. The ability to make difficult decisions shows the resiliency of the State. These decisions have been made without fiscal discipline being imposed from foreigners, and without rioting in the streets like Greece. The issue of unfunded pension liabilities and healthcare benefits for public employees has not been adequately resolved, and will likely become a major issue during the next 10 years.

Differences
One of the most important differences between Greece and the State of California is the legal framework and rules for reporting. California has had fiscal discipline imposed on it by existing state and federal statutes. These statutes require a balanced budget, and set priorities for paying bills. For example, the highest priority for the State when paying expenses is to first pay those for education, next is debt service on bonds. All other expenses are subordinate to these and are paid after these expenses have been paid. Since Greece is a sovereign, it has been easier for them to avoid fiscal discipline through false reporting and false promises to their citizens. However, this has come to an end as the EU and IMF are dictating austerity measures for Greece.

Another difference is that there is a closer relationship between a State and the U.S. government, than there is between a member nation and the rest of the EU. Imagine being a German citizen and watching reports on television of the rioting in the streets of Greece, while they are expecting you to bail them out. How would you feel when you aren’t even part of the same country?

Sovereigns are also responsible for the banking system and credit conditions within their borders. Many sovereign nations are still reeling from the extensive bailout programs which were required to bail out the banks during the last credit crisis, and to stimulate their economies. In the U.S. the Federal government is responsible for the banking system. This allows the States to focus on other issues, such as education.

Conclusion
There is little doubt that many Sovereigns are riskier credits than States in the U.S. During the last 10 years, the default rate for all Muni bonds has been only 0.1%. There has not been an instance of a State default for over 75 years. The default rate for all Sovereigns during the same time period was 6.0%, which is 60 times greater than the default rate for all Munis.

(Please see chart below for Muni vs. Sovereign comparison.)

Lessons From Vallejo

2008: Vallejo Under Financial Stress

In 2008 the City of Vallejo, CA was suffering from severe financial stress caused by recurring budget deficits in it's general fund. The city found it difficult to bring it's budget into balance because 74% of the budget consisted of expenses for police and firefighter salaries and pension obligations which had been growing out of control. City officials attempted to renegotiate labor contracts and benefits, but were unable to generate enough cuts to balance their budget. The deficit for 2008 was $4.3 million, with a projected deficit for 2009 of $16 million. According to a recent Wall St. Journal article which appeared on March 26, 2010 "salaries for police captains were over $300,000 per year, and firefighters averaged $171,000 a year. These same workers could retire at age 50 with a pension that guaranteed them 90% of their final year's pay."


Vallejo Enters Bankruptcy

On May 23, 2008 the City of Vallejo filed a petition for protection under Chapter 9 of the U.S. Bankruptcy Code. According to the law firm which represented Vallejo, Orrick, Herrington, & Sutcliffe, in order to file bankruptcy a municipality must meet the following criteria:

1. It must be a political subdivision of the state. A state is not allowed to file for bankruptcy.


2. State law must allow a municipality to file for bankruptcy. About half of the states in the U.S. do not allow municipalities to file bankruptcy.


3. The municipality must be insolvent which means they are not able to meet their current obligations or won't be able to meet them in the next year.


4. The municipality must desire to effect a plan to adjust it's debts.


5. The municipality must show it has tried to negotiate unsuccessfully with creditors.

In September 2008 the Bankruptcy Judge Michael McManus determined the City of Vallejo met these conditions, and the Bankruptcy Appellate Panel affirmed his decision on June 26, 2009.

Collective Bargaining Agreement Is Rejected

On March 13, 2009 the judge ruled the City could reject the Collective Bargaining Agreements it had with various city unions, and the City of Vallejo began to renegotiate it’s contracts with public employees including firefighter and police.

Vallejo’s Bankruptcy Workout Plan Affects Bondholders

On December 22, 2009 the City came up with a Bankruptcy Workout Plan which called for no principal or interest payments to be made for three full years beginning January 15, 2011 through January 15, 2014 on outstanding debt. This affects all bonds that are secured by the General Fund. Bonds with dedicated revenue streams are not affected by the moratorium on debt service payments. The bonds that are still paying interest are secured by water revenues, special assessments, and special taxes. Bonds for related entities are also not affected by the Workout Plan. These include Vallejo Sanitation and Flood Control District, Vallejo Redevelopment Agency, and Vallejo Housing Authority. These are all separate legal entities from the City of Vallejo.

Why Vallejo Is Important To Bondholders

During the last 40 years most Muni bond defaults have been for housing and healthcare bonds. There have only been 3 general obligation bonds which were rated by Moody’s that have defaulted during this period. Perhaps the best known case is for Orange Co., CA which defaulted on it’s debt, because of excessive exposure to derivative trades in it’s investment pools by rogue trading by the county treasurer. Bondholders were eventually able to recover 100% of both principal and interest. Jefferson Co., AL defaulted on it’s bonds in April 2008, because of excessive exposure to variable and auction rate securities swaps which caused a large liquidity deficiency for the county when their swaps didn’t work out.

The bankruptcy filing for Vallejo is quite different. It is the result of poor governmental planning with the City lacking the political will to negotiate affordable contracts with public workers, and also making them promises they are not able to keep. Public employees and bondholders alike are watching this case with interest. Numerous municipalities across the country have significant unfunded liabilities for both pensions and healthcare benefits. This case is, thus, important to see if bankruptcy for a municipality is a way to make these liabilities more affordable for it’s taxpayers.

Vallejo: Has Bankruptcy Paid Off?

It is clear bankruptcy has not been a silver bullet for Vallejo, and the costs have been significant. Since filing for bankruptcy, Vallejo’s tax revenues have fallen 20% with further expected declines likely in 2011-2012. The City has not had the political will to reduce existing pension costs. These costs will leave the City
facing projected annual deficits of $23-$27 million once retirement costs are fully recognized. There has been a stigma for residents which makes Vallejo a less desirable place to live. This is reflected in falling property values, reduced services, and a higher crime rate. The City has also been shut out of the credit markets, and will be unable to raise funds for an extended period. The City has made progress in renegotiating labor contracts, but the cost has been high.

We believe other municipalities will look at this case with mixed feelings, and will realize bankruptcy is an option of last resort. It is not a panacea for getting rid of unfunded pension liabilities. Most municipalities are not in the dire straits which Vallejo is in, which means they are not eligible to file for bankruptcy. Fears of widespread use of bankruptcy by municipalities to lower unfunded liabilities are overblown. On a positive note for taxpayers, this case sends a clear message to organized public workers. In a bankruptcy situation their existing contracts are all up for renegotiation. This should make them more willing to negotiate on more favorable terms with municipalities in the future.

Lessons To Be Learned For Bondholders

This case provides several lessons for investors. First, Muni bondholders should realize security selection has never been more important than it is now. Improper security selection can be very punishing to investors. Next, bond investors cannot assume general obligation bonds are more safe than revenue bonds. When a municipality experiences extreme stress and enters bankruptcy, bonds with dedicated revenue streams are superior to claims on the general fund. Also, some municipal entities may lack the political will to make sound financial decisions. Even though municipalities are required to balance their budgets, there may be some situations which make it extremely difficult for them to do so. Many budgetary problems need long term solutions, but politicians are only willing to provide short term fixes. In addition, since states are not able to declare bankruptcy, it is difficult for investors to know which type of bonds have priority over other general fund obligations such as payroll and vendors. Laws will vary from state to state. For example, in California payments for schools have priority over debt service, which has priority over all other general fund expenses. Finally, the Muni market is a fragmented market of over 50,000 different issuers. It is not possible to make general statements re
garding the creditworthiness of all Munis. Pundits which make generalizations about the Muni markets should be treated as suspect. Instead, investors should be more like loan officers who realize that each borrower has different abilities to service their debt. They should consider off balance sheet obligations, wealth levels, and debt per capita before purchasing the issuer’s general obligation securities.

Conclusion

The Muni market is not a good do-it-yourself market. Proper security selection is beyond the scope of most individual investors. We also believe the financial situation of the City of Vallejo shows the danger of blind reliance on default studies, which is not a good policy in today’s environment. These studies cover a time period where most municipalities did not experience the amount of financial stress which they will be facing during the next couple of years. This stress may be caused by declining tax revenues, higher costs of providing healthcare, or unfunded liabilities associated with public employees. Instead, we plan to place more emphasis on revenue bonds with secure revenue streams and less emphasis on some general obligation bonds. This strategy is similar to the one we have used for California Muni bond investors. We will continue to seek out general obligation bonds of high wealth areas, and issuers with low debt per capita levels, and a willingness to make difficult budget decisions. But, we will also place increasing emphasis on essential service revenue bonds where the issuer has a monopoly on the services they provide.

Shared Sacrifice

Turmoil In The Credit Markets
During the last 2 years there has been considerable turmoil in the credit markets due to the rapid decline in the credit quality of borrowers in the corporate, mortgage, and agency markets. The sub-prime mortgage crisis, collapse of Fannie and Freddie, banking and investment banking crises, stress on insurers and guarantors of debt, and collapse of 2 of the 3 largest auto makers are all examples of the deterioration in the credit quality which has taken place. Even the credit quality of the U.S. Government (the heretofore standard for a riskless borrower) has been called into question.

Fixed Income Credit Analysis and Risk
This decline in credit quality has made credit analysis more important than ever. Fixed Income money managers who were able to avoid major problems with credit issues have achieved superior performance to those who were unable to foresee potential credit problems. The penalty for being “wrong” on the credit of an issuer has been harsh as credit spreads blew out to very wide levels. A good credit analyst is able to identify and understand the risks in any given security. Most investors lose money because they grossly underestimate the amount of risk they are taking. The other mistake they make is “reaching for yield”. This leads to creating portfolios that consist of all the weakest credits, because they are the ones that yield the most. These portfolios do not perform well in stressful times for the markets. A good credit analyst is also able to determine what the “worst case” is for any security he owns. This is extremely important when things “go bad” for a credit. There are different layers of security for a bondholder. These include debt service coverage, the issuers ability to pay, and where the bondholder stands as a creditor in bankruptcy. In bankruptcy, there are long established rules that apply to secured and unsecured creditors, as well as to equity holders. These rules provide comfort to secured bondholders when things “go bad” for one of their borrowers. The current economic cycle has allowed the government to become involved in the economy to an unprecedented extent, which has revealed a new level of risk a good credit analyst needs to consider. We will call this ‘political risk”, which is the risk of confiscation of secured creditor assets for the benefit of a junior class of creditors. This is a risk that is more prevalent in unstable less developed countries, and was unthinkable in the U.S. until Chrysler.



The Chrysler Bankruptcy
The auto industry was particularly hard hit in the recent economic slide with both Chrysler and GM going into bankruptcy. The actions taken by the government in the Chrysler bankruptcy were unprecedented. The President introduced the concept of “Shared Sacrifice” in the media as he called upon secured creditors to take less than they were entitled to legally so that one of his political supporters, the UAW (a junior creditor), could get a larger share of the new firm. TARP participants who represented the majority of senior secured creditors were then coerced into voting for a government sponsored cram down which gave the secured creditors only 30% of the company while the junior class of creditors (UAW) received 50% of the firm. The secured creditors who did not vote for the plan were labeled as speculators and were portrayed as all around bad guys to the public. This creates an enormous amount of uncertainty for investors in fixed income securities in the U.S., because laws which were deemed sacrosanct have been rendered meaningless as assets are confiscated from one class of creditor and given to another class of creditor based on political whim instead of rule of law.

Bankruptcy Law
Existing bankruptcy law is designed to protect debtors from creditors seizing their assets without giving them time to come up with a plan to pay creditors in a fair and equitable manner. When bankruptcy is declared an estate is created, similar to when a person dies. The assets of the estate are then valued, and creditor claims are processed and organized into order of their priority. Some claims are secured, and have a priority over junior claims. A first mortgage claim is entitled to receive full payment before the second mortgage holder receives any funds. Priority of claims is a well established principle of bankruptcy law. Debtors are not allowed to pay some creditors to the detriment of others immediately prior to or during bankruptcy. The debtor in possession of the assets is allowed to form a plan which is equitable to it’s creditors, and the creditors can then vote on the plan. If a majority of the creditors vote for the plan, the dissenters will suffer what is caused a cram down, as the plan is approved over their objections. In the Chrysler case there are problems with the asset valuation process, priority of claims issues, and the nature of the government’s cram down. The concept of “shared sacrifice” violates bankruptcy law and discourages lending, particularly to weaker credits.


Conclusion
We believe the government has now re-written bankruptcy law in this country. Since the Chrysler case, GM has been put into bankruptcy. A similar approach to a rushed asset valuation process has been taken in GM as well. Virtually every secured creditor in the country has now found their position in bankruptcy lowered, as the government ignores the established rules of bankruptcy law. We were fortunate that we did not own any bonds for the auto companies, because our credit analysis deemed them too risky. We also avoid high yield bonds, because they are very highly correlated to equities, and don’t offer enough diversification to the investor’s overall portfolio. However, even though we dodged the Chrysler bullet, we are still very concerned by the government’s actions and our level of “trust” for our system has been shaken. Why would any investor want to invest in high yield fixed income with the additional risk of confiscation in bankruptcy? Without the established priority of claims in bankruptcy there is now no such thing as a secured or priority claim. “Shared sacrifice” does considerable harm to encouraging lending during these difficult times, because it makes it nearly impossible to determine the lender’s worse case. It makes more sense for the lender to avoid lending to riskier firms, because a secured loan to a struggling creditor suddenly has become much riskier.

Nominal GDP and Inflation

The Current View of Inflation
Investors have become increasingly concerned about future inflation due to massive governmental intervention and growth in the money supply. These investors argue that the large increase in money supply has to go somewhere, and it will cause inflation. They may also argue that this increase in money will cause the dollar to go down, which will in turn cause prices to rise even further. They frequently feel compelled to throw in their thought that the deficits we are currently running are so large, that the only way out of this situation is to inflate our way out. This is currently the consensus view. While this view may be intuitively obvious to most investors, we believe high rates of inflation are not necessarily a foregone conclusion.

Review of Inflation
The chart below shows the annual rates of inflation as measured by the U.S. CPI Index for Urban Consumers on a non-seasonally adjusted basis since 1926 through 2008.

This information is available from the U.S. Department of Labor and may also be found in the Ibbotson SBBI 2009 Yearbook. The average annual rate of inflation during this time period was 3.0%. During the period from 1926-1933 we experienced deflation. In fact, it took until 1945 for the Consumer Price Index to get back to the level it was at in 1926. During the 1950’s and 1960’s inflation experienced a slow rise. The 1970’s saw inflation rise until it peaked at 13.3% in 1979. This was the year gold reached $850.00 per ounce and silver peaked out at $50.00 an ounce as Bunker Hunt tried to corner the silver market. WIN buttons were passed out which stood for “Whip Inflation Now”. OPEC proclaimed an oil embargo and the price of oil went shockingly high. This was an inflection point for inflation. During the 1980’s inflation steadily declined and this trend continued through the 1990’s until last summer when oil reached $150.00 a barrel. Since then the economy has continued to decline and price increases have been under control. Last year the CPI was only up 0.1% even though gas prices had reached prices of over $4.00 a gallon during the summer. Last summer many investors “knew” inflation had returned and feared interest rates were going higher. So far, during this year the index has increased 1.3% through April. The chart below shows the average annual inflation rate by decade since 1926. By looking at inflation over longer time periods the data is smoothed and we are able to see the long term trends more clearly.

Inflation and Economic Growth
Our research shows a high correlation between economic growth and inflation when the economy grows faster than trend. We used data from the Bureau of Economic Analysis to measure growth of GDP. GDP grew at an average annual nominal rate of 6.68% during the period from 1926-2008. Let’s call this the trend rate of growth for the economy in the U.S. In the chart below we compare the annual rate of growth of nominal GDP minus the trend rate by decade, and compare this growth versus trend to the CPI. The results show a high correlation. During the 1930’s the economy contracted below trend and we had deflation. During the 1940’s, 1970’s, and 1980’s the economy grew above trend and we had high levels of inflation. Economic growth during the the 1950’s and 1960’s was at trend and inflation was low. The last 20 years has shown growth below trend with declining rates of inflation.

Conclusion
Investors would be wise to pay attention to indicators which
are leading indicators of the economy such as the LEI Index or the Chicago Fed National Activity Index. These indicators are currently still showing economic weakness which is way below the trend rate for the economy of 6.68%. Inflationary pressures are not likely to appear until growth in nominal GDP approaches levels in excess of trend.

The Government To The Rescue?

Some large cities and states are seeking help from the federal government. So far, help has not been forthcoming. We expect this to change soon, because budgetary cutbacks by municipalities will put additional pressure on an already weak economy. There is increasing talk of helping municipalities with infra-structure needs such as bridges, roads, and energy.

We believe the best option for the government in assisting municipalities is to create some sort of replacement for the bond insurers. This would help reduce borrowing costs for municipalities, and would ensure that financing would be available to issuers who need to borrow. It would also help to restore confidence in the financial system by eliminating the de-leveraging that has been taking place in most asset classes.

What Did The Government Do Wrong Last Year?

When the government let Lehman go down in mid-September, the strains on our financial system were so great the credit markets ground to a halt. The counter party risk involved with Lehman and other counter-parties were revealed to all, and resulted in widespread fear throughout the system. The government greatly under-estimated the systemic risk they were taking when they let Lehman collapse.

The government also didn’t understand how important the bond insurers were to our funding mechanism for credit. Our system relied on guarantees to create AAA credits in the short term markets. These AAA ratings were the key to cheap funding by all sorts of borrowers. The demand for money market eligible paper was so great, a financially strong issuer could borrow at low rates. This system worked well for years and allowed for various leveraged strategies to exist which lowered borrowing costs for most borrowers. The financial shock to our system from rising default rates of Sub-Prime mortgages, and falling housing prices put immense stress on guarantors who had become over-exposed to this market. As insurers got downgraded, investors began to panic in the short-term markets. First, funding dried up for SIV’s which funded Sub-Prime mortgages. Next, investors sold insured notes by FGIC and XLCA, and bought notes guaranteed by MBIA and AMBAC as it became clear these companies were going to lose their AAA ratings. This steady stream of downgrades of guarantors created an absolute panic in the short term markets as they realized no AAA rating was safe. This resulted in the collapse of the Auction Rate Securities market. As funding costs sky-rocketed in the short-term markets de-leveraging took place in earnest in all fixed income markets. We believe the government’s lack of understanding of the importance of guarantees in the short-term markets led to our funding mechanism breakdown last year. This created a crisis in confidence, de-leveraging, and the decline in asset values.

Inflation Worries

Investors are becoming increasingly concerned about inflation as a result of the massive governmental intervention which is taking place. Their argument is that “the government is running large deficits and the money supply is growing out of control”. They feel sooner or later we will experience inflation, and they are worried about a dramatic fall in the dollar and the possibility of hyper-inflation as a result. We feel inflation fears are currently overblown since the economy is still contracting and is very weak. The chart below shows the Chicago Fed National Activity Index. It is a combination of several leading indicators and shows how we are doing

compared to the long term trend growth rate of the economy which is represented by the line at 0. Inflationary warnings flash when this indicator is at 0.7%, and recession is likely to occur when the index falls below –0.7%. The current reading is about –3.4% which is nowhere near the inflationary warning level of 0.7%.


Most investors have grossly underestimated the deflationary forces at work in the economy due to deleveraging caused by tight money conditions in a highly leveraged economy. The cheap funding through the short-term markets which allowed leveraging to take place has disappeared, because the bond insurers are no longer AAA rated credits. This has reduced the supply of credit dramatically because the “borrow short and lend long” trades no longer work. These trades represented the “Shadow Banking System” which funded leveraged buy-outs, no money down housing loans, and hedge fund activity. The contraction of this form of financing has led to economic weakness, which has caused the velocity of money to fall, which has offset the increase in the money supply. It will most likely take a long period of time for these forces to work themselves out before inflation becomes a problem.

Pushing On A String?

Is The Fed Too Easy Or Too Tight?
There has been much talk recently about the need for the Fed to raise rates to stop rising global inflation. Our work shows that money is still tight, even though the Fed has lowered the Fed Funds rate to 2.00%. The Fed surveys senior bank loan officers about lending practices at banks. This information is gathered through the “Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices”. The Fed conducts this survey quarterly with about 60 large domestic banks, and 24 U.S. branches of foreign banks. The information from this survey is quite interesting in today’s environment. The chart below shows the availability of credit and the cost of credit as shown through the Fed’s survey. As you can see

the credit lending standards have become progressively more restrictive. This is shown by the blue line in the chart. As bank lending standards have grown stricter, the cost of credit has been climbing rapidly (shown by the red line). In fact, the percentage of senior bank lending officers who are raising credit costs to businesses is currently higher than at anytime since the survey began in June 1990. It is interesting that banks have been tightening credit during the same time that the Fed has been trying to ease credit conditions. The chart below shows the cost of borrowing plotted vs the Fed Funds rate during the same period of time (6/1990-6/2008).

The chart shows the expected lags in bank lending costs, but recent developments are an anomaly, since borrowing costs are soaring as the Fed continues to lower short term rates. This implies that the Fed is currently “pushing on a string”. The tool of using rates to control the economy is no longer working as it has in the past. This is an alarming development, because it shows the seriousness of the current credit crisis in the U.S.

The Party’s Over
Over the last few decades the Fed has gained enormous credibility as an institution with the ability to manage our economy out of recessions in a non-inflationary way. The Fed as lender of last resort created the “Greenspan Put”, which meant when things got bad the Fed would be there to make things better. This policy has not, however, been without costs, and has only postponed the inevitable. This led to an incredible leveraging of our financial system, the creation of the shadow banking system, and massive amounts of debt being accumulated by the consumer and guaranteed by our financial institutions. The lax lending standards and cheap credit shown in the first chart during 2005-2007 helped create the debt hangover we are currently suffering. Rising delinquency rates and massive write-down's of loans have created deteriorating balance sheets for our banks and investment banks. They want to forget about the lax credit party that got them where they are today. The Pushing On A String chart shows the party is over. Banks are in no position to party again any time soon. Their hangover is too great. We should expect them to concentrate on re-building balance sheets, by raising capital, deleveraging, and cutting back anyway they can. The thought that money is easy, because the Fed cut short term rates is a misconception. Money is tight and will remain tight until the financial system begins to recover from the excesses of a couple of years ago.