I hope someone in the McDonnell administration reads the Wall Street Journal. I’m getting queasier and queasier about the idea of Virginia taking on more debt. I reproduce this blog post from the Boomergeddon blog.
Financial markets have tightened their grip on sovereign debt — especially U.S. municipal debt — in the past two months. The yield on 30-year, AAA-rated general obligation bonds has soared from about 3.75% to 5.0% since late 2010 — the highest interest rates since the darkest days of the Global Financial Crisis.
The squeeze has been caused largely by the anticipated expiration of some $109 billion worth of letters of credit and similar guarantees that municipalities used as short-term financing to get them through the depths of the financial crisis. “Municipalities may be hard-pressed to come up with this money or refinance this debt,” the Wall Street Journal quoted Eric Friedland, a municipal analyst at Fitch Ratings, as saying.
Bond analysts say that the crunch could lead to some municipalities defaulting on their debt, with spillover effects to banks that backed the bonds with letters of credit. “This is one area of risk the market hasn’t focused on,” said Frederick Cannon, a banking analyst at Keefe, Bruyette & Woods.
The Journal highlighted a bond auction that proved disappointing to the New Jersey Economic Development Authority. The government agency fought to refinance a short-term, variable interest loan but had to reduce its planned $1.8 billion offering to $1.1 billion because investors were demanding higher rates. In another sign that investors are shying away from the municipal market, mutual fund giant Vanguard dropped plans to roll out three new municipal bond funds, citing market turmoil.
As investors take a closer look at state/local finances, the more disconcerted they get. I’ve prominently highlighted Meredith Whitney’s analysis in this blog (see “The Next Big Meltdown: Failed States“), in which she predicted a wave of municipal bankruptcies.
Now, it appears, New Jersey’s unfunded pension liabilities are coming under closer scrutiny. Officially, the state’s pension liabilities amount to $54 billion, writes James Freeman in an op-ed into today’s Journal. But the state optimistically assumes an 8.5% return annual return on investment. Independent estimates suggest the shortfall could be as high as $175 billion — and that doesn’t include liabilities for retiree health benefits, which could total another $67 billion. If investors start turning over the rocks of Illinois and California obligations, who knows what kind of bugs will come crawling out? Both states have been relying upon accounting gimmicks for so long, there could be all manner of unpleasant surprises.
If yields on AAA-rated debt have climbed to 5.0%, states with lousy credit ratings will find the cost of capital to be even more expensive. And it’s the states with poor credit ratings that tend to be the most dependent upon the long-term debt to begin with. Fortunately, states are restricted in their ability to fund ongoing operations through debt, so the higher interest rates will not punish state or municipal governments as much as they would hammer federal finances.
But the market is speaking, and investors clearly don’t like what they see. If enough municipal bankruptcies occur, negative sentiment could easily spread to to government obligations of all kind, including federal Treasury securities. Then the state/local problem becomes a federal problem.
With its AAA credit rating, Virginia has less to lose from higher interest rates on munis than other states. But Gov. McDonnell’s plan to borrow another $3 billion for transportation funding would push the state to the outer bounds of prudence. And all for what? We haven’t even seen a list of the transportation projects yet! In all probability, the money would go to projects approved by the Commonwealth Transportation Board, reflecting the priorities of the 2000s decade. But things are very different now, as I’ll explain in a future post about the prospects for continued oil price hikes. We need a new set of priorities. Let’s not invest $3 billion in projects of dubious value.
