You’ll begin to hear more and more about this in the mainstream media.  This has the potential to be the next housing crisis and the source of a second dip of a double dip recession.

- Brad

“The downgrade reflects the state’s reduced financial flexibility, illustrated by its reliance on sizable debt issuances during the current biennium to close operating gaps in the context of already high liabilities,” Fitch said.

While Connecticut does have the largest amount of outstanding tax supported debt of any of the 50 states at over $13.7 billion, it also boasts being the wealthiest of the 50 states with a per capita personal income of $54,397 in 2009.  I believe much of Fitch’s concern is due to how the state is using the funds it borrows.  Spending for long term capital improvements that benefit Connecticut citizens is one thing.  At least then you have a hard asset to show for it.  What Connecticut is doing, borrowing to finance a budget deficit, is akin to running up your credit card debt to finance a lavish lifestyle.  Frankly, it is unsustainable.

One has to wonder if this is the first of many such downgrades to come as we witness the consequences internationally (Think PIIGS – Portugal, Ireland, Italy, Greece and Spain) of excessive borrowing to support an unsustainable spending pace.

Well, as reported yesterday by Bloomberg (See Link), the City of Austin is finding out the hard way that the IRS fully intends to exercise its ability to garnish BAB subsidies.  In February, Austin received a letter from the IRS stating that the IRS would be withholding $617,284 from the March 1 payment.  Luckily, Austin was prepared to transfer funds from a reserve account and continue to make the payments to bond holders.  The City continues to negotiate with the IRS over additional payments and may have more withheld from the next payment.

Since their inception, US municipalities have issued over $105 billion of Build America Bonds to the point where they represent the fastest growing segment of the municipal bond market.  The IRS’ willingness to withhold portions of its subsidy is very troubling.  While it appears that Austin and the IRS had been negotiating the withheld amount for some time and knew this was coming, the City of Los Angeles only found out about its reduction in payment when they performed an internal audit.  Fortunately, their’s was a small amount – $28.

As the use of BABs continues to grow, how long is it before the IRS withhold a subsidy from a locality that can’t afford to make up the difference for bond holders?  Or an even scarier thought, how long before the government decides it has the right (and obligation) to withhold BAB subsidies until the locality fully funds it pension plan!?!  Nothing good, for the locality or the bond holder, comes from this…

“The line here between ignorance and dutiful compliance is thin and not meaningful. Though many have alleged that the ratings agencies were on the take outright, it doesn’t really matter if they were or weren’t. Essentially, the ratings agencies were either crooked or they were stupid. Either way, they’re guilty.”

The article raises an interesting question of what role should a Moody’s or S&P rating play in an investors analysis?  Should they still be trusted, or have they lost all investor confidence?  Finally, is there an opportunity for a new player to emerge as a truly unbiased opinion, and what would that new player have to do to earn the respect of the investing community?

I believe there is an opportunity, but the road to respect will be a long one.  Thorough, independent analysis will always be worth much more than a 3rd party report from a vendor whose motivations may be cloudy at best.

To begin with, anything that strains the state or municipal budget will limit their ability to fund new projects.  That’s not good news.  But, there is another tie in here that will severely limit localities access to capital.

As I mentioned a few days ago, Florida suspended its issuance of Build America Bonds (BAB) because of the potential that the IRS would reduce their subsidy amount by any amounts owned from other programs.  The new healthcare reform will significantly increase the costs to the states for Medicaid expenses.  If they are unable to cover the increased costs, the IRS will start taking from their BAB subsidy to get whole.  That puts even more pressure on the states and compounds the issue.  Florida estimates that the new healthcare reform law will add $1.6 billion of Medicaid expenses and force them to hire an additional 1,000 employees.  That’s $1.6 billion that they won’t have available to build schools, maintain roads, or repay bonds.

In a time when the states and municipalities are being hit financially as hard as ever, I struggle to understand the rational behind increasing the burden on them.  Maybe someone can explain it to me…

Florida, however, has some concerns about how that 35% subsidy will be paid and has put its $255 million upcoming issuance on hold.  In a recent call with the Internal Revenue Service, the IRS reiterated that any subsidy due to the locality will be reduced by any amount that the issuer owes the federal government for other programs, including Medicare.  This is not a new provision of the BABs and has been a condition since their inception.  However, many of the localities are just now catching on to the fact that they may not get the full subsidy they have been expecting.

This becomes especially relevant as Congress seeks to pass the Healthcare Reform that could dramatically increase an issuers payments to the federal government for Medicare and similar type programs.  Should an issuer not be able to make its Medicare payments, the IRS will still get “theirs” through the BAB subsidy, leaving the locality in a death spiral of interest obligations.

According to the article, the largest issuer of BABs, California, is aware of the IRS claw-back provision and is continue to utilize BABs as a viable funding source.  It will be very interesting to see how many other states join Florida in taking a wait and see attitude.

While the struggles that state and local governments are facing to balance their budgets is nothing new, we are beginning to see the hardship take a toll on their credit ratings.  Those lower credit ratings will make it much more difficult and costly to issue bonds, exacerbating the problems they are facing.

The Coming Collapse of the Municipal Bond Market (PDF)

It should come as no surprise that analyzing and quantifying “risk” are the name of the game in this economy.  The risk profile for Municipal Bonds is no exception.  Unfortunately, there may be some validity to the concept that Municipal Bonds carry more risk than anyone had anticipated.

In addition, the QSCB’s come with several requirements which may make them costly to implement.  The first requirement, and most punitive, is the requirement to utilize Davis Bacon Wage Labor rates.  Depending on the locality, this requirement alone can increase construction costs significantly.  It is not inconceivable that any interest savings achieved by using the QSCB’s could be eaten away via higher construction costs.  Secondly, there are significant and severe reporting requirements that go along with several of the ARRA created bonds, not just QSCB’s.  We have heard of some municipalities that are having to dedicate a full time staff person to handle the reporting requirements.  In a fiscal environment where every costs is being scrutinized, adding a position may not be palatable.

Much like most things in life, there are always pro’s and con’s associated with any decision.  Municipalities are well advised to lean heavily on their financial advisors as they work through the various funding options for new projects.

“It was just a horrendous result,” said William O’Donnell, head of U.S. Treasury strategy at RBS Securities in Greenwich, Connecticut. – as reported by cnbc.com

It is anticipated that today’s (Thursday) auction of $28 billion of 7-year notes could be met with equally week demand. Overall, the lack of demand and pricing ability for Treasury notes could mean that the cost of borrowing increases significantly for the US. It appears to also be a clear sign from our largest foreign and domestic lenders that we need to throttle back on our levels of debt.