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Essays & Articles |
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June 12, 2007 by Gary North, Ph.D.
A major problem for bond holders is the solvency of the issuing institution. Bond-rating services are important for investors, including institutional buyers, especially retirement fund managers. The less likely the ability to repay, the lower the bond rating. The lower the bond rating, the higher the rate of interest the issuing institution must pay. This means that someone who has purchased bonds of an issuing agency whose bond rating falls will suffer a loss of capital. The market value of his bonds falls when the interest rate on newly issued bonds rises. Bonds rise or fall in price inversely to the interest rate. Across the nation, municipal governments are facing downgrading of their bonds. The reason is unexpected health care obligations for retired workers. This problem is growing. There is no way out of it without governments having to revoke promises, either to retired workers or to investors. THE LURE OF TAX EXEMPTION The promise of income tax-free returns has led millions of investors into buying municipal bonds. In states with a state income tax, munis issued by cities within that state are usually exempt from state incomes taxes. This benefit seems great to rich people who have grown tired of paying income taxes all of their adult lives. So, they choose to buy munis instead of higher-interest taxable bonds. They enjoy the pleasure of not having to report this income to the tax authorities. By forfeiting tax revenues from income generated by various local municipal bonds, the Federal and state governments have granted an implicit subsidy to the debt instruments of local governments. This has encouraged local governments to issue more debt than they otherwise would have. They would have had to pay out higher rates of interest than they actually agreed to pay. This higher cost would have made additional debt issues less likely. Investors took the bait of a lower tax burden. The municipalities took the bait of lower interest rates paid by income tax-free debt instruments. The result: lots of debt. The problem with this arrangement is that municipal governments are run by politicians who want to be re-elected. Their time frame is relatively short: the next election. They know that they will not be in office if the obligations to pay off the bonds begin to squeeze the local budget. They stay in office by delivering what appear to be free services to local voters. So, they are tempted to issue debt as a way of buying votes in the next election without personally suffering the political consequences when the future debts come due. This tends to increase the level of municipal debt. A bond is a promise to pay investors. The longer the debt repayment period, the more likely it is that the debt level will increase because of the time perspective of politicians, who issue debt and promote bond issues to the voters. The politicians vote in terms of their personal time perspective -- the next election -- on behalf of an impersonal entity that in theory is immortal: the city government. Just as the hope of income tax-free returns lures investors into buying municipal bonds that pay a lower rate of interest than corporate bonds of equal risk ratings, so is the lure of free health care in old age for municipal workers. They have for decades accepted wages that are lower than those paid to employees in profit-seeking firms because of the seemingly superior health care benefits that municipal governments offer to their workers and retired workers. RISKY ASSUMPTIONS First, bond investors make an assumption: municipal governments will fulfill their obligations because they can tax residents to meet the payment schedule. Because a city government can tax residents, investors assume that residents cannot escape. Second, workers make an assumption: residents will have no choice but honor their obligations to retired workers. Third, residents make an assumption: politicians will not increase the debt obligations of the government to levels unsustainable by future tax revenues. Fourth, politicians make an assumption: tomorrow will not come during their terms in office. Different elected officials will be in office when the bills come due. Fifth, the thought of default is not on the minds of any of the participants. They all assume that the municipality will always be able to meet its contractual obligations. The system of negative sanctions known as bankruptcy is widely assumed by all participants as somehow not applying to municipal governments. There is confidence that governments can somehow escape the laws of economics. Somehow, income will always be there for governments to tap. Somehow, obligations will not exceed revenues. Somehow, the bills will not come due. WARNINGS From time to time, there is a newspaper report, probably run in the section on city or county government, that raises the question of solvency. A local reporter files a story on a report by some committee on the escalating fiscal burden of employee retirement programs, especially the portion associated with health care insurance. The story surveys the fact of rising health care costs and compares this with expected revenues. Residents read these stories, if at all, with no sense of alarm. They figure they can always move away if the local tax burden gets too high. They don't think of what expect this legal tax burden will do to local property values. This unintended consequence is never mentioned in the article. Readers see rising prices on property, and they conclude that there will always be someone ready to buy their homes, no mater what the property tax burden is. In other words, they discount the risks of the future. So do local politicians. So do bond investors. So do employees of the local government. So do retired employees. This is the great threat of debt in our era. People do not believe that governments will default. They assume that political promises to pay will be honored by voters in the future. After all, these promises have been honored so far. CALIFORNIA DREAMING In a June 10, 2007 story run by the Los Angeles Times, a reporter dutifully reported on growing evidence that municipal governments have run up bills to municipal employees on a scale that the public has not imagined. I wish I knew on which page and in which section of the newspaper the print version of this story appeared. The article began with a human interest story. An 83-year-old San Diego woman who suffers from hallucinations if she doesn't receive her medicine. She also suffers from cancer and diabetes. She is now facing hopelessness. She had been a county employee. She has a $1,000 a month pension. She also has medical coverage for whatever Medicare does not cover. The story says she may lose this coverage. "Where has compassion gone?" She asks. It has little to do with compassion. It has do with politics. This woman made the mistake of confusing compassion and politics. So have tens of millions of Americans who are dependent on government payments for work performed or taxes paid decades ago. The issue is contract, not compassion. The courts cannot measure compassion. They can read contracts. If courts allow politicians to break contracts, those who are dependent on former political contracts are at risk. Medicare and Social Security obligations are unfunded. Some estimates are that these two programs are unfunded in the range of $70 trillion. Yet these obligations are not counted as part of the on-budget debt of the United States government. This figure is in the range of $9 trillion. Why the discrepancy? Legally, it exists because the U.S. government says that Medicare and Social Security obligations, unlike public debt in the form of T-bills and T-bonds held by the public and the Federal Reserve System, do not constitute legal obligations of the United States government. Some future Congress may reduce the payments. That is Congress's option. Local governments have obligations to retirees analogous to the obligations of the U.S. government to retirees. The courts are far less willing to enforce these contracts, compared to bonds. The trade unions of course will battle any such unilateral default. But these unions are growing less and less powerful over time. As voters grow tired of the burdens imposed by retired workers, the municipal workers' unions will face a restricted market. Voters are not enamored of trade unions in our day. Well over 85% of all American workers are not represented by trade unions. Most of those who are represented by unions are government employees. Voters who are not union members are not reliable supporters of tax policies whose main beneficiaries are retired city or county workers. The expected obligation of the Los Angeles Unified School District for health care coverage is in the hundreds of millions of dollars, the article reports. "These costs are just crushing," said district general counsel Kevin Reed. Over the next three decades, the state of California is facing annual payouts of a billion dollars a year, and maybe more.
This is not way into the distant future. This is in the next five years. And the flow of red ink is just getting started.
Private companies are now in the process of re-negotiating contracts regarding health costs for retirees. The era of such benefits is coming to an end in the private sector. But it seems to persist in the public sector. It will not persist for long. When taxpayers see their property taxes rise and the value of their homes fall, they will be in no mood to suffer escalating capital losses because of promises made to municipal unions a generation ago.
This is not going to happen. Any retiree who expects it to happen is living in a fantasy world. Voters will not suffer capital losses and ever-rising taxes in order to maintain contractual obligations negotiated in better fiscal days. Compassion is a matter of voluntary considerations and individual circumstances. It has to do with charity. "Where has compassion gone?" It went away a long time ago, when union members decided that contracts negotiated on the threat of organized simultaneous walkouts by workers became a substitute for compassion. When political power was substituted for compassion, compassion moved off the scene. The reporter cites a statement from an employee of an accounting firm that helps municipal governments track their future obligations. "I can't tell you how surprised many of our clients have been," he said. Surprise, surprise! Accounting actually matters. But politicians have paid little attention to accounting. Neither have union leaders, who for years could take credit for negotiating on-paper successes in future health care retirement benefits. Neither have retirees. How large are the benefits? Consider this. The article describes a retired employee of San Diego County who served 30 years. At the time of his retirement, he was earning $80,000 a year. His retirement pension is $70,000 a year, plus the health care benefits. The county's officials are considering a plan to reduce the health care benefits of high-salaried employees. This of course is a means test. It is a clear violation of contract. The municipal union is fighting this decision. But the union is not in a strong bargaining position. The county charter allows the retirement board to cut off retirement benefits to all retirees in one fell swoop. Los Angeles County has no such loophole. State law prohibits this. It is facing costs of $20 billion over the next 30 years. There is some talk that the various governments should put aside present revenues to pay future obligations. This has not been done in the past. Will this work? No.
A political battle looms among retirees, bond investors, and taxpayers. PROPERTY TAXES The housing bubble has obscured the future of housing prices in an era of huge public employee retirement obligations. This much is certain: contracts will be violated. The question is: Which group will be the biggest losers? Retirees, bond investors, or taxpayers? When you consider a place to live out your golden years, one consideration should be local municipal bond obligations. Counties and cities without a long tradition of bond issues are preferable to those that have run up large liabilities. But equally important is the obligation to retired workers. Large cities are generally far more exposed to lawsuits for default and union pressures than small towns are. They have run up larger bills. This is another reason for retirees to get outside of large cities. Don't own a home on the fringes of a tax-hungry city. Nonincorporated areas are being swallowed up by cities, which don't allow county residents to vote on the absorption. County taxpayers are regarded as under-taxed fish to catch. So, it is better to be in a small incorporated city. This keeps urban debt monsters at bay. CONCLUSION Municipal bonds are higher risk investments than most investors believe. I think it is much safer to buy a bond fund filled with bonds denominated in currencies other than dollars. This way, you hedge your risk against a depreciating dollar. You must pay income taxes on the income. Better this than to pay the inflation tax when the dollar is debased by the Federal Reserve System in order to pay off government debts at all levels. Debasing the dollar does not involve breaking any legal contracts. That's why it is so predictable, long term.
Dr. Gary North earned a Ph.D. in history and is one of America's keenest economic analysts and commentators. He supports the Austrian school of economics and is a previous assistant to libertarian congressman Dr. Ron Paul. Visit his website at http://garynorth.com. To subscribe to Gary North's Reality Check go to http://www.dailyreckoning.com/sub/GetReality.cfm If you enjoyed this essay and would like to read more of Gary's writing please visit his website at http://www.garynorth.com or http://www.freebooks.com.
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Resource Center Main Page & Index |
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Investors
like bonds. Bonds are sources of long-term income.
As investors grow older, they invest a greater
percentage of their portfolios in bonds. They are
more concerned about income than they are about
capital appreciation. The louder the clock ticks,
the more important income is, compared to stock
appreciation.
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