Tuesday, April 2, 2013

From Greece to Stockton, CA: the system fractures

Greece is a sovereign nation; its government is responsible for the totality of its citizens, for all of the services it provides, for maintaining the nation as a nation. And in order to do that, Greece has--like other nations--borrowed money, oftentimes by issuing bonds. Such government bonds carry risk, like all investments, but in first-world nations--particularly those in the EU, the United States, and Canada--the risk has always been considered to be minimal (since they're backed by the full faith and credit of the nation), hence the generally low interest payments on such bonds.

The Greek debt crisis changed all of that, as private bondholders were basically forced to take a loss on their investments. Not simply a loss on any gains, but a loss on actual principal, an unheard of thing for sovereign debt in an EU nation. But the potential outrage over this was easily muted by those who pointed out that the alternative--wherein bondholders did not take a loss, or receive a "haircut"--would be disastrous for the people of Greece, along with the Greek government. Thus the bondholder became the lone villain, despite the rest of the picture:
It's easy to see the bondholders and the EU as villains in all of this. After all, their demands are essentially destroying Greece and will leave it in rubble, with or without the riots. And to be fair, many of the bondholders have made tidy sums loaning money to Greece and many other nations. Eating the losses here won't break them, at all (most of them). Looking at it through the credit card analogy once again, these bondholders kept extending Greece credit, in return for interest payments (maybe a loanshark is a better analogy). But they should have known--and probably did know--that the end-game was bankruptcy/default.

But what of the Greek government's culpability? On what basis did it think it could keep borrowing money? Olive oil futures? It's tourism industry? No, the Greek government was certainly aware that it was living on borrowed time. And that begs the question, where did all of the money go?
This has been viewed--by most--as an extreme and unique situation (like the one in Cyprus), something that did not represent a general change in the way bonds worked, particularly government bonds, with regard to risk. It occurred, after all, in Greece, a small nation that had overspent like mad, created a bloated government bureaucracy, and basically showed no sense of fiscal responsibility whatsoever. The EU's "haircut" on bondholders wasn't supposed to be a new standard.

And yet...

Stockton, California--which declared bankruptcy last year--has just won a ruling in court allowing the city to remain in chapter 9 while it attempts to resolve its financial woes. The city's various creditors--its bondholders--had argued that the city was not following bankruptcy law because it was unwilling to take steps to increase revenues or cuts services, particularly with regard to pensions, thus it should not be allowed to remain under bankruptcy protection.

The court found the opposite to be the case, stating in the ruling that the bondholders' refusal to negotiate with the city--to lower the amount owed--meant there was no good faith on their part:
U.S. Bankruptcy Judge Christopher M. Klein in Sacramento rejected arguments from creditors including Assured Guaranty Corp. and Franklin Resources Inc. (BEN) that the city isn’t eligible for bankruptcy and found that creditors “absented themselves from all further discussions” with the city before it filed.

The city of 296,000, an agricultural center about 80 miles (130 kilometers) east of San Francisco, is among three municipalities that have said they will try to force creditors, including bondholders, to take less than the principal they are owed. The others are San Bernardino, California, and Jefferson County, Alabama.
The city leaders of Stockton may very well feel they have no choice here, that there is simply no way to repay the full principal on the bonds. Be that as it may, this is no small thing if it happens. As the Bloomberg piece notes:
No city or county since at least the 1930s has used the power of a U.S. bankruptcy court to force a reduction in its debt principal.
That fact is exactly why cities and other municipalities have been able to fund pretty much anything under the Sun by issuing bonds: there is a widespread belief that the principal--at the very least--is secure for all kinds of municipal-type bonds.

True enough, not all munis are created equal. The most secure kind are general obligation bonds. Such bonds are very much like sovereign debt; they are guaranteed by the issuer's "full faith and credit." On a municipality's balance sheet, general obligation bonds equal real debt that must be figured against revenues, year in and year out. Because of this, such bonds are often required to be voter-approved.

But in recent decades, municipalities have often opted for other kinds of bonds, correctly assuming that the market would still view them as secure, as safe investments. These are generally termed to be revenue bonds. Their repayment is drawn from revenue streams supposedly created by whatever the borrowed monies are used to finance, from parking garages to sports stadiums, or from special taxes tied to the same. Such bonds do not technically represent debt for the issuer, thus can be issued without voter approval. Some of the most popular kinds involve the issuance of certificates of participation--kind of like stock--wherein the holder is granted a share of the revenue produced by whatever is being funded. The problem is the issuer has full authority to determine when and if payments are made.

These are, by and large, the bonds at issue in Stockton. There are no general obligation bonds, just revenue bonds. Stockton expanded right and left from 2001 to 2007, fueled mostly by the housing bubble (and the City of Stockton thanks you for that idea, Paul Krugman) and the assumption of increased revenues from the same. It built stadiums and docks, bought new buildings, increased the number of public employees, and loaded up on benefits (one had to only work for the city for a single month to receive lifetime health insurance in Stockton).

It did all this by issuing bonds. And true enough, investors were more than happy to help Stockton in this regard, because they all assumed there was just no way a major California city would try to renege on its debt obligations.

And yet that is exactly what Stockton is doing. Once again--as was the case in Greece--it is the bondholders who are being cast as the villains in all of this. They enticed the city into this, according to many experts. They knew the debt was too much, knew the revenue assumptions were unrealistic, but they bought the bonds anyway. So screw 'em, right? The ridiculous pension commitments made by the city? That's a different story. That money must be paid because it affects everyday people.

Such populism plays well--just ask the Democrats and President Obama--but the actual application of it is, in fact, a real fracture in the system. If more municipalities follow Stockton down this road, if Stockton gets away with shirking its financial obligations, municipal bonds in general may cease to be viewed as safe investments. And if this happens, costs will go up across the board for access to new capital throughout the country. It will happen quicker in places like California, of course, but the effects will reverberate throughout the land, no doubt.

And I guess there's an argument to be made in favor of this, in ending the popularity of revenue bonds as a whole. But the consequences in the short term will be extreme, with regard to economic growth and development.

Yet the pundits on the left still insist there's no danger of another Greece here...all is well, remain calm.

Cheers, all.


  1. Blame the creditor for offering money to idiots with no chance of paying it back. When have we heard that before? Oh, yeah, those nasty banks that made all those housing loans to low-income people.

    These are two prime examples of the "blame the victim" game that the left is happy to play, although they're quick to call out others for the same behavior in different circumstances.

  2. Great views. Excellent reading. Thanks for putting this up.