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Earlier this year, Money Morning Contributing Editor Martin Hutchinson advised muni-bond investors to beware the effects of "deadbeat states" – and now the U.S. government is heeding that warning.
The Federal Reserve Bank of Philadelphia this spring cited Martin Hutchinson in a recent regulatory publication, where it warned financial institutions about the looming danger in municipal bond investing.
"Martin Hutchinson, contributing editor to Money Morning, indicates that the problem facing the municipal bond market is the emergence of ‘deadbeat states,' citing the beating that state and local government finances have taken during this economic downturn in particular," wrote Philadelphia Fed Examiner Becky Goodwin in the Supervision, Regulation and Credit Department second-quarter newsletter. "Making matters worse, Hutchinson cites larger debt loads in states, which cannot be covered due to the reduced property tax stream resulting from record housing defaults."
At mid-year 2010, state budget shortfalls totaled $200 billion – the largest gap in recorded history, according to the Center on Budget and Policy Priorities. These shortfalls could trim to $103 billion by fiscal year 2012, but progress is likely to stall since states face fewer options to adequately address their budget issues.
Worse, the U.S. government will likely implement more spending cuts as it battles over the debt ceiling, which means states planning to turn to federal aid when they need extra funding will be turned away.
"States expecting Congress to authorize more assistance are going to be left with a very large hole to fill," said Erskine Bowles, co-chairman of the National Commission on Fiscal Responsibility and Reform.A report by Roubini Global Economics (a research firm founded by economist Nouriel Roubini) in March said there could be as much as $100 billion in muni-bond defaults over the next five years due to state and local government financing issues.
The Roubini report warned it would be "Pollyannaish" to assume low default rates in the muni-bond market would continue.
"Avoiding a crisis will involve real austerity that has only partially been implemented thus far," the report said.
The Roubini report's forecast was conservative compared to earlier predictions by Wall Street analyst Meredith Whitney, who said there could be 50 to 100 sizable defaults totaling hundreds of billions of dollars.
While Whitney came under attack on Wall Street for what some considered an exaggeration of the problem, she said the majority of investors were frighteningly unaware of the severity of deadbeat states.
"The most alarming thing about the state issue is the level of complacency," Whitney told CBS News' "60 Minutes" program in December. "The lack of transparency with the state disclosure is the worst I have ever seen."
With deadbeat states struggling to improve, U.S. banking regulators now are giving more attention to the warning, telling banks – many of which include muni-bonds in their portfolios – to more closely monitor their municipal exposure for heightened credit risk.
"Despite the fact that, historically, municipal bond defaults have remained relatively low, the impact of the economic crisis has many strategists and analysts sounding the alarm," wrote the Philadelphia Fed's Goodwin. "With this alarm ringing, municipal exposure at financial institutions warrants additional scrutiny from both a credit and liquidity risk perspective. Taking additional measures to aggregate and understand these exposures may only be part of the drill at this juncture, but a drill well worth the effort, given the overall economic climate of problem assets on financial institutions' balance sheets."
Examiners for the Office of the Comptroller of the Currency in April asked banks' risk officers to evaluate national banks' exposure to muni-bonds.
"What we're going to ask our examiners to ask our banks…do you know what you're holding? What do you have? How do you break it down?" said Kerri Corn, the OCC director of market risk policy, at an American Banker's Association risk management forum.
Corn said banks' risk evaluation was in the opening stages, but already the lack of financial reporting requirements by many municipalities was a concern.
"I didn't realize until we started looking into it, there are no current financials on so many of these bonds," Corn told The Bond Buyer finance publication. "They're not made available, and they don't have to register with the SEC."
As the problem of deadbeat states persists, more detailed risk assessment for U.S. banks could be implemented.
News and Related Story Links:
- Federal Reserve Bank of Philadelphia:
SRC Insights, Second Quarter
- The Wall Street Journal:
Muni Default Estimate: $100 Billion
- CBS News "60 Minutes" News Magazine:
State Budgets: The Day of Reckoning
- Center on Budget and Policy Priorities:
States Continue to Feel Recession's Impact
- The Bond Buyer:
Municipal Bond Worries Spur OCC Scrutiny of Banks' Exposure