Nearly two decades ago, President Bill Clinton had ambitious spending plans for his first term, but the bond market had other ideas. Investors, worried about big deficits, pushed up interest rates on federal debt as compensation for the higher risk that they thought they were taking. As Clinton scaled down his proposals, frustrated advisor James Carville said that in the event of life after death, I would like to come back as the bond market. You can intimidate everybody. How times have changed! Today, investors in bonds—municipal bonds, anyway—dont scare anyone, mostly because they themselves refuse to be scared even by mounting risk.
Consider the markets reaction to the July 24 announcement that Stockton, California, would declare insolvency to restructure its finances, which include more than $700 million in debt. You might think that Stocktons move would worry investors in, say, City of Los Angeles bonds. Both L.A. and Stockton, after all, made impossible pension and health-care promises to their public-sector workers. As Tom Gray has written, Los Angeles administrators said in an April budget document that Stockton, already flirting with bankruptcy, provides a cautionary tale for the City of Los Angeles and other cities struggling to remain solvent. Moreover, two years ago, former Los Angeles mayor Richard Riordan opined that between now and 2014 the city will likely declare bankruptcy. But last week, the 12-year general-obligation bonds that L.A. issued in April yielded 2.4 percent annually on the secondary market—7 percent less than the nearly 2.6 percent that they had yielded at issuance, meaning that investors consider the bonds less risky than they were in April. Clearly, the investors arent panicking.
Why not? For one thing, the investors may figure that cash-strapped cities and towns main quarrel with their creditors concerns not bondholders but public workers and retirees. Stocktons financial details bear that calculation out, showing that the citys chief problem, over the last decade, has been rising benefits for public workers, not rising debt. Its true that the debt that the city owed bondholders more than doubled between 2001 and 2010 (the last year for which audited statements are available)—from $315.4 million to $746.8 million. But thanks to lower interest rates, annual debt-service costs fell as a share of noncapital expenditures, from 12.5 percent in 2001 to 9.9 percent in 2010. Meanwhile, the citys spending on its retirees health care rose from $2.6 million a decade ago to $13.8 million in 2010—a more than fivefold increase, even as the number of retirees only doubled. And Stocktons annual contribution to its employees pension fund averaged a total of $6.6 million between 1999 and 2001—a number that increased more than two and a half times, to an average of $16.7 million between 2008 and 2010.
Its not just numbers that favor bondholders over retirees; its the fact that Stockton never supposed that its muni-bond debt would be costless. Nearly two-thirds of that debt is backed by a specific revenue source, such as the fees that customers pay to park in municipally funded garages. Such revenues dont vanish in a bankruptcy. Retired-worker costs, by contrast, have stunned Stockton. The city made many of its pension promises when the state of California was telling municipalities that they could expect an 8.25 percent annual return on the payments they made into the state pension system, CalPERS, which in turn pays pensioners. (The state has since reduced this estimate to 7.5 percent—still an ambitious goal, given that the average annual return over the past decade is 5.9 percent.) Most cities never thought much about health-care costs. Stocktons $543.7 million unfunded health-care liability and its $135.9 million unfunded pension liability, then, seem to have come out of nowhere.
Bondholders and bond insurers may also figure that even in the event of a bankruptcy, they will be mostly bystanders to the fallout. When a city goes bankrupt, it continues to take in money from taxpayers, and it would make some sense for such a city to use that money to pay bondholders at the expense of workers and retirees. A city that jilts its bondholders may have trouble raising new debt in the future, whereas a city that cuts back on benefits isnt likely to have trouble attracting new employees—at least, not in a tough job market.
Still, its possible that the bondholders are being too sanguine. In the earlier bankruptcy case of Vallejo, California, which began in 2008 and ended last year, the bank that insured the citys bonds did lose money. Vallejo not only reduced the interest rate that it paid on the bonds; it delayed repayment as well.
Could something similar happen elsewhere? Stocktons actions are hardly comforting. In its bankruptcy filing, the city said that it was declaring insolvency because citizens and employees have given enough—meaning that they had suffered enough in cutbacks. The city, it noted, had slashed the police department by 25 percent, the fire department by 30 percent, and civilian employment by nearly half. Individual wages and salaries had fallen between 9 and 23 percent, and workers were paying more for their pensions and health care. Part of the reason that all those cuts werent enough to prevent bankruptcy is that changing future pension benefits makes no impact on past pension promises. California will not allow cities, even bankrupt ones, to renege on previously negotiated pension payments. Inevitably, since cities cant reduce their obligations, theyve got to cut into something else—and they can roll back basic services only so much. Debt payments are an obvious place to cut.
Indeed, Stocktons stated plan is to reduce its debt payments, though a bankruptcy court will have to approve that step. One of the citys big creditors—Assured Guaranty, which insured the debt that Stockton borrowed to make past payments to CalPERS—issued an indignant and unusual public statement last week, complaining that despite the significant benefits provided to [Stockton] and its pension beneficiaries . . . the city now seeks to eliminate all of the citys general fund debt payment relating to the pension bonds; this represents 83 percent of the pension bonds principal. The insurer added that if Stockton is disappointed with CalPERS investment performance, it should be taking that up with CalPERS rather than reneging on the bonds. Too bad Assured didnt realize five years ago, when it mattered, that Stocktons bonds were risky. But bondholders elsewhere are still happy to lend money now and ask questions later, to judge from the low interest rates that they currently require to invest in much of the nations municipal debt.
A logical culprit for the bond markets continued complacency is the Federal Reserve. The Fed, through its purchases of Treasury and mortgage bonds, has pushed down returns on other supposedly safe investments to such an extent that investors have no choice but to look elsewhere, including to municipal bonds. Perhaps, too, the investors are exhibiting a sort of rational fatalism. If Los Angeles or New York were to go bankrupt, wouldnt that mean that everything was bankrupt? And in that case, would it really be better to be invested in, say, a Goldman Sachs or an IBM bond?
A quiet bond market shouldnt lull states, cities, and the feds into thinking that they can all keep muddling through. The lesson for the future is clear: public-employee benefits are unsustainable and are already crowding out public services. Thats what Stockton and other cities are learning now.