It doesn’t take a financial ge nius to see that New York state and city — plus their ap pendages, like the Metropolitan Transportation Authority — are insolvent as far as the eye can see. Yet investors are buying municipal bonds in record amounts, keeping these borrowers’ interest rates low. Everyone seems to be ignoring the all-too-real risk here.
This is eerily similar to the thinking that ruled the mortgage markets, circa 2005:
* Investors and their advisers assume that states and cities will never default, even if paying in full means huge cuts to public services. As Nuveen Asset Management, a big investor, told clients in 2009, “State and local governments have strong incentives to maintain access to the credit markets.” Sure — but housing-bubble investors thought that homeowners would do any thing to avoid losing a home.
* Investors find reassurance in the law. State governments can’t declare bankruptcy: The federal bankruptcy code doesn’t cover them, and they can’t write bankruptcy laws. As for the MTA, Albany explicitly outlaws it from declaring insolvency and promises investors that it will never change the law.
Yet mortgage investors found reassurance in the law, too: Homeowners couldn’t turn to bankruptcy to escape mortgage debt.
* Investors put their confidence in financial engineering that lets governments raise more debt. That is: New York state actually owes only $3.3 billion in bonds backed with its faith and credit, because the state Constitution requires voter approval of such debt. But Albany has racked up $60 billion in other debt, often through complex “trusts” that collect enough tax revenues from the government to pay the annual amount owed several times over.
This engineering lets the state borrow cheaply, because the trusts make the debt seem safe. But the intricate structures’ lack of an official guarantee may come back to burn investors in the same way that mortgage securitization turned out far more problematic than the financial wizards claimed.
* Investors can look to the past. Between 1970 and 2000, no investor took a loss on a state’s or a city’s general-obligation debt, according to a Moody’s study. But history justified confidence in mortgage markets, too: Homeowners wouldn’t default in droves because they hadn’t before.
* Big bond-ratings agencies, which govern investing decisions, see no peril: Moody’s said last month that New York has a “long track record of closing annual budget gaps.” S&P cites the state’s “history of what we consider conservative budgeting . . . and solid debt . . . management policies.” Reports on the city and MTA are similarly complacent.
But the same agencies were just as casual about mortgage-related bonds just four years ago. As the third big rater, Fitch, said in late 2006, while giving a AAA rating to a complex “collateralized debt obligation” backed by mortgage debt, “Previously issued CDO transactions have shown stable performance to date.” Those once-AAA securities are now rated junk: Sometimes, past performance doesn’t predict the future.
Just as they did in the mortgage markets, investors are ignoring the obvious — and they’re partly to blame for New York’s failure to face reality.
Over the last two years, Albany has crossed its fingers in hopes that things would magically improve. Lt. Gov. Dick Ravitch recently even proposed borrowing to pay for operating expenses. Though Mayor Bloomberg would protest otherwise, the city hasn’t cut spending to match long-term reality, either.
As debt grows, the risk mounts that someday it will be politically, economically and financially worthwhile for borrowers to escape it. When that happens, protections for lenders will be meaningless.
It’s easy to imagine some future mayor convincing a bankruptcy judge that it’s only fair for bondholders, along with union members, to take big cuts in a restructuring of all impossible long-term obligations. A governor would have to convince only the Legislature and the public.
Plus, a future official could convince the public that the “trust” structure is a fraud perpetuated by corrupt former officeholders, a deliberate attempt to nullify voters’ right to limit indebtedness — and withhold payments to the trusts and their bondholders.
Today, politicians see the advantages of borrowing more. Ten years from now, it may be more practical to tell the public: We’ve borrowed too much, and we did so because clever Wall Street types convinced our predecessors that it was a good idea.
As for the assumption that financial consideration — that is, the borrowers’ need for future access to bond markets — will always trump such political considerations? Don’t be so sure. A state or city that cut down its obligations by reneging on “exploitative debt” might have an easier time getting financing, since new bond-buyers would know that its finances, at last, were sustainable.
Nor can bondholders rely on Uncle Sam. Yes, the feds bailed out Gotham in the ’70s and the big banks starting in 2008. But maybe not next time.
In recent bailouts where the federal government’s aim has been not to save the financial system from collapse but to force a borrower to restructure its long-term obligations, bondholders have fared poorly. In rescuing Chrysler and General Motors, the White House forced bondholders to take bigger losses than union members did.
Washington can’t guarantee all debt. If it tries, it risks massive inflation — hurting bondholders, anyway.
Bottom line: Both investors and New York governments would be better off with more skepticism about muni bonds. That would provide the financial discipline that the state desperately needs — and prevent both lenders and borrowers from getting swamped by a collapse as bad as the mortgage meltdown.
Nicole Gelinas, a Manhattan In stitute senior fellow, is author of “After the Fall.” From the new City Journal.