A few years ago, it was fashionable to compare California, Illinois, or whatever U.S. state was struggling financially to the troubled island nation of Greece. Now, with Stockton, California the largest U.S. municipality to enter bankruptcy, it may be tempting to make another Mediterranean comparison – this time to the troubled island nation of Cyprus.
In Cyprus as well as Stockton (plus San Bernardino, California and Jefferson County, Alabama), the question is: Who will be left holding the bag? A common theme is “haircuts,” or possible losses for investors (bank depositors in Cyprus; bondholders in California) to spare wider pain to taxpayers, pensioners, public employees, and other local stakeholders.
One problem with haircuts is that they can impair future market access: the government in question may have to pay higher borrowing costs to regain investor confidence. A wider concern is contagion: If investors fear they won’t get their money back, they might demand higher interest rates from the sector as a whole. Moody’s Investors Service publicly worried about such contagion last summer, in a report critical of U.S. municipalities and what the organization viewed as changing norms toward bankruptcy.
But there are a few reasons to be skeptical about the contagion scenario applied to munis. First, although broad (worth about $3.7 trillion in 2012), the municipal bond market is not very deep. On the supply side, a few large issuers like California, New York, and Texas dominate. On the demand side, most investors are households or institutions representing households such as money market mutual funds.
Because of its traditional mom-and-pop structure, muni bonds don’t trade very often and the market is not transparent. When bonds do trade, different buyers may pay different prices for the same issue, and prices can rise faster than they fall (the “rockets and feathers” phenomenon). Economists have rightly criticized these features as inefficient. However, some market participants counter that proposed cures might be worse than the disease.
A silver lining of less-than-perfect information and higher transaction costs in muni markets may be that shocks are transmitted slowly through the system. More educated institutional investors are probably able to sort good apples from bad; other investors simply “buy and hold.” A recent IMF working paper confirms these predictions: after a bad credit event, investors apparently shift their money from places like California and the City of New York to safer issuers. Rather than suffering from Stockton’s misfortune, other states and municipalities will probably benefit, much like U.S. Treasuries after the 2008 financial crisis.
Interestingly, the IMF authors did detect some evidence of contagion, or bad news spreading, but in an unexpected direction from munis to U.S. Treasuries. One explanation is that investors looked at an Illinois or California and worried about prospects for a federal bailout, analogous to Cyprus and the rest of the Eurozone. Still, measured effects were small and took time to surface. The U.S. also has a long history of steadfastly refusing requests for local aid.
In any event, it will take some time to parse through yesterday’s Stockton ruling. Its most significant effects may be felt within California – where many municipalities pay into the state’s CalPERS pension fund. The judge ruled that CalPERS was just another creditor, but we still don’t know who will be left holding the bag.