August 21, 2012
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Meredith Whitney’s prediction last year of billions of dollars in municipal bond defaults stirred investors’ fears. Earlier this summer, bankruptcies in three California cities reignited them, and last week a Federal Reserve study revealed that muni bonds have defaulted at a higher rate than previously reported.
But no crisis has befallen the municipal bond market, and it is highly unlikely that one ever will. Individual, high-quality muni bonds are still the safest investment, after U.S. Treasury and agency bonds, and they offer the best after-tax returns for individual investors.
We’ll offer some specific guidelines for today’s muni-bond investors, but first let’s consider recent muni defaults, with an emphasis on the California situation, to understand why they happened. We’ll see that, in fact, recent developments should actually safeguard bondholder interests over the long term.
A problem long in the making
When President Franklin Delano Roosevelt was asked in 1937 whether federal employees should be allowed to unionize, he responded that, although he understood that government employees’ desire for adequate wages and working conditions, he could not approve the right of unions to strike, because government requires ”orderliness and continuity of conduct” to be effective. In 1962, however, President Kennedy issued an executive order that granted the right to federal employees to unionize and bargain collectively.
The unionization of municipal workers is jointly governed by state and federal laws. However, unions must win the right to organize in each state. Every state has its own labor laws and labor boards. The state of Wisconsin was an early pioneer in establishing union’s right to organize. Its pro-union workers almost annually threatened garbage strikes at budget time.1 To end the strikes, they granted unions the right of collective bargaining in 1959, the first state to do so.2
But it was not until 1963, after a law was passed setting up union election procedures that Wisconsin’s unions were firmly entrenched. It was not until 1977, after more strikes by police and firefighters, that binding arbitration was established to eliminate them. It was Wisconsin’s historic position in the labor history movement that made their now Governor Scott Walker’s decision to eliminate collective bargaining this year such a challenge to unions everywhere. National union forces tried to recall him. Their failure to do so, and the elimination of the check off that required everyone to have dues deducted from their paycheck, has resulted in a workers dropping their membership in the American Federation of State, County and Municipal Employees union (AFSCME) by half. The American federation of Teachers (AFT) dropped by a third.3
When the U.S. economy was strong and growing, high compensation and benefits for municipal workers was a manageable cost of doing business. Even if wage increases were modest, unions could count on increased pension and healthcare benefits. In the current climate of economic contraction, however, union benefits are often unsustainable. Union practices such as calling in sick and working extra shifts for overtime need to be eliminated. Labor contracts usually govern pensions, but in some states, such as New York, Alaska, Illinois and Michigan, unions successfully forced the passage of constitutional guarantees, making modifications to benefits very difficult.4
State and local municipalities face problems that in large part result from political decisions to allow municipal unions to bargain collectively and strike. Public-service workers earned much less than those in the private sector before unionization. But the right to bargain collectively gave unions de facto monopoly power, which they deployed to great effect. Since municipalities cannot move and face no outside competition, there are few countervailing forces. The only option is for citizens to move away, as they have been doing in Detroit, which has lost more than a quarter of its population in the last decade.5
The wages and benefits of union workers now outstrip those of their private-sector counterparts. Although politicians promised pension and health care benefits, they often chose not to fund them, especially the non-monetary benefits. According to a Pew Center report entitled “The Widening Gap,” in fiscal 2009 states had set aside 78% of the funds needed for pensions, but only 5% of retiree healthcare and other benefits.6
In addition, governments allowed pension plans to operate under the questionable assumption that they would return 8% to 8.5%, or sometimes even more. When market conditions changed, the politicians could no longer deny reality. To put this in perspective, the California Public employees Retirement System (CalPERs), the largest public-pension system in the country, reported a 1% return on investments for the fiscal year7 ending June 2012, while its assumed rate-of-return was 7.5%. In sum, on average other states’ investment returns were only slightly better. The overall rate-of-return for state pensions nationwide for fiscal 2012 year was 1.5%.8 States are reluctant to accept these real rates of return as the norm. Lower assumed rates-of-return, however, increase the funding gap, requiring states to set aside more funds. That deepens the debt they must recognize.
1. Ken Germanson, “Milestones in Wisconsin Labor History,” Wisconsin Labor History Society, August 20, 2012.
2. Bill Frezza. “Governor Walker’s victory Spells Doom for Public Sector Unions,” Forbes, June 5, 2012.
3. Frezza.
4. Jonathan Hemmerdinger. “States’ Laws on Penions and OPEBs Vary, Panelists Point Out,” The Bond Buyer, April 20, 2012.
5. Monica Davey. “The Odd Challenge for Detroit Planners, The New York Times, April 5, 2011.
6. Robert Slavin. “Benefits Still a Major Burden on Municipal Finances,” The Bond Buyer, November 23, 2011.
7. Robert Slavin. “Poor Pension Returns Will Pressure States and Localities,” The Bond Buyer, July 19,2012.
8. Markets - Market News. “U.S. Public Pensions Earn 1.15% for Worst Showing Since 2009,” Bloomberg News, August 6, 2012.
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