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California: Already Stoking the Next Big Financial Crash?

Walter Russell Mead

T he next f inancial market meltdown may already be brewing: not in the housing market, this time, but in municipal bonds. Greedy bankers, opportunistic politicians and hobbled regulators are putting a time bomb in the muni market that could set of f another devastating crash. Calif ornia is leading the way. It is starting out innocently enough. Looking to expand a number of aging school f acilities but loath to raise the taxes necessary to pay f or it, Calif ornia cities have opted to f und school construction projects with capital appreciation bonds, which allow school districts to borrow money now while putting of f payments f or decades. It sounds like a great deal, but it has one major drawback: T he interest rates involved push the eventual price tag to many times the original amountsometimes as much as ten times more. T he New York Times has the story:

In San Diego, property owners owe $630 million on a $164 million bond. For theFolsom Cordova Unified School District, a $514,000 bond will cost $9.1 million. And in the most expensive case yet, the Poway Unified School District borrowed $105 million to finish modernizing older school buildings, which local property owners will be paying off until four decades from now at an eventual cost of nearly $1 billion. Because payments on the bond do not start for 20 years, current school board members faced little risk of resistance from property owners. [...] In 2009, as the housing market crash drove down tax revenues for schools and state education financing was cut, California lifted its requirement that long-term bonds be paid off at approximately the same rate each year, opening the door for bonds that delay payments for 20 years.

T his is irresponsibility on steroids, but it represents a dream come true f or crony capitalists and Wall Street I-bankers. Fat f ees, enormous interest, and the taxpayers wont even know what hit them when the whopping bills come due. But everyone involved should be put on notice: While not all of these bond issues are equally bad, as a class these bonds are toxic and likely to bring serious pain to everyone connected to them. Some of the deals already done will likely blow up in the f uture; bankruptcy will loom when the pension squeeze and the bond bomb both hit at f ull f orce.

But the worst danger is not f rom the relatively small number of deals already done but in the potential f or this kind of f inance to spread. Like the bad ideas that started of f small but grew until they were big enough to blow up the mortgage market, dangerous practices can become more common and widespread in municipal f inance. More politicians will catch on to the magic of long term bonds that bring benef its now but will savage your town a couple of decades on. Other state legislatures will be pressured to f ollow Calif ornias rash venture into muni madness as investment banks, construction companies and public sector unions lobby non-stop. Politically managed pension f unds will load up on this dangerous paper. Investors hungry f or yield will pile on and tell themselves that the market is saf e. It will all look brilliant until the roof caves in. Investment banks who underwrite these bonds should be very caref ul to police the email traf f ic of the employees who work on them; the risk that every tiny detail and email message relating to them will one day be made public in court and/or legislative hearings is huge. Massive lawsuits are likely and there is serious reputation risk. T he day may well come when well all watch the heads of investment banks squirming in vicious congressional hearings that rip their reputations and the reputations of their banks to shreds when the public wakes up to these Soprano style rip-of f s. Figuratively speaking, some of the people involved in these deals will be hanging f rom street lights when the public f igures out whats been done. Politicians who approve or recommend these bonds should be braced f or a f irestorm of public rage when and as voters realize just how badly theyve been shaf ted. Nobody has an electoral mandate to saddle f uture generations in this way. If any politicians associated with this receive campaign contributions f rom any of the f inancial institutions involved, expect to have every painf ul detail exposed to public scrutiny. (And journalists, have at itthere is gold in these hills: crony capitalists bribe conniving politicians to sign one sided debt indentures that mortgage the f uture of whole communities. T his is the 21st century equivalent of selling Manhattan f or $24 worth of beads and theres a Pulitzer in there somewhere f or somebody who digs up the sordid details behind this mess.) Investors should not under price the risks of these bonds. Because they are so one-sided, because in many communities their impact will be so great, and because both the time and money involved are greater than with many other bonds, the risk on them is much, much higher than on less exotic securities. When these come due, you can expect legislators and quite possibly courts to be so f illed with outrage that the entire political establishment will be looking f or ways to help cities and towns escape the consequences of these f oolish agreements. Do not expect sympathetic treatment in bankruptcy court: Exotic in this case is a synonym f or toxic. Do not believe the snake oil the I-bankers are peddling with these bonds, and realize that attempting to enf orce your rights under them is going to be much, much more dif f icult than the commissionhungry bond salespeople are telling you. T hese bonds are not your ordinary muni, and the risks and liabilities they involve need to be scrutinized very caref ully on a case by case basis. Remember your experience with CDOs during the last meltdowns; I-bankers lie like rats when they are trying to unload securities and you should not trust all the soothing promises they will make. And f inally, voters need to wake up and take some responsibility. T he American muni market is an important and valuable thing; wisely used, it allows cities and towns to spread large capital expenditures over time, and it has been been vital to the development of much of our inf rastructure. But just as liar loans and other abuses in combination with exotic f inancial instruments and razzle-dazzle investment strategies paved the way f or a serious housing and f inancial market meltdown, outrageous instruments like these can damage the entire muni market. Note also that Calif ornia opened the door to these casino style bonds at a time when its credit ratings were f alling and its cities were increasingly cash squeezed. Calif ornia didnt legalize these bonds because it was a strong borrower and because its cities were able to f inance their operations through normal methods. T his was a move of desperation, more like a gambler writing IOUs than like a prudent transaction in the humdrum world of municipal f inance.

T here are two ways these bonds can be paid. In one scenario, inf lation shoots up so f ar and so f ast that by the time the bonds come due, the value of money has f allen so f ar that they can be easily paid. A billion dollar debt isnt a problem if it costs $300 million to buy a pair of shoes. Or more optimistically, economic growth could be so strong and the cities and towns who issued these bonds could have gained so much population that the interest rates can be borne without undue strain. T hat, alas, is unlikely. Af ter all, many of the jurisdictions attracted to this kind of debt have limited credit and resources who dont have better alternatives. T hey also presumably have politicians who are not very good at managing city af f airs. Once upon a time, the mortgage market was a saf e and staid place where widows and orphans could lend to responsible borrowers paying reasonable prices f or sensible housing. But a combination of lax regulation, political opportunism, Wall Street (and Fannie Mae) greed, credulous investors and speculative borrowers turned the mortgage market into a horrible mess that cost this country as much money as a f oreign war. Lets try not to do the same thing with our municipal f inance system, shall we? [Image courtesy of Shutterstock.com.]