Tax-free municipal bond prices plunged in late February. The market has since stabilized a bit but remains nervous. The positive side of the collapse is that the interest rates investors receive on these bonds have been enticingly high. Municipal bonds (lovingly called “munis”), which finance such things as state and city infrastructural projects, have become “a very good buying opportunity” for investors, exults Philip Fischer, municipal strategist for Wall Street’s Merrill Lynch.
But it is decidedly not a good time for financially decrepit San Diego to sell municipal bonds to finance needed infrastructural projects. The City would have to pay excessively high rates. It would have difficulty getting insurance and possibly couldn’t get it at all. Its books are still a mess, and it continues to make moves that alienate investment professionals, such as scheming to have the auditor appointed by the mayor, when the auditor would be auditing the mayor’s own books.
“I don’t see the mayor or staff being major-league quality when it comes to negotiating ratings with the rating companies, insurance coverage with the insurance companies, and cost [bond yield] with the underwriters,” says Peter Q. Davis, retired San Diego banker. He worries that “any attempt to reenter the market will be painfully more expensive than it needs to be.” San Diego lacks “qualified representatives.”
Mayor Jerry Sanders keeps promising that San Diego’s reentry into the muni bond market is right around the corner. He made such statements in 2006, in 2007, and in his State of the City address on January 10 of this year, points out Steve Francis, his mayoral opponent. But four years after the City’s credit rating was suspended, and a year and a half after Kroll Inc.’s stinging report suggested remedial measures to cleanse the books and the ethical stain, San Diego still can’t sell bonds. On one day, Sanders will talk about the financial progress the City is supposedly making and on the next day reveal a massive four-year deficit. “It’s such garbage, such spin,” says Francis. The bond markets aren’t fooled. City Attorney Mike Aguirre and the mayor argue publicly about what items should be disclosed. Francis agrees with Aguirre: “You should err on the side of overdisclosure,” he says. “This is not a good time to be entering the muni bond market. We haven’t put past audits together,” and the deficits are huge, says Francis.
The market calamity of late February further delays reentry. What happened was largely technical. Hedge funds and other institutions that gamble on exotic combinations of securities got caught in a squeeze and had to unload their bonds. Yields (the interest rates investors receive) soared as bond prices dropped. (Bonds are like two buckets in a well; when prices go up, yields drop, and vice versa.) As Merrill Lynch’s Fischer points out, munis normally yield about 85 percent of what supersafe U.S. Treasury bonds yield. That’s because investors don’t pay state and federal taxes on income received from munis. When the gamblers were forced to sell, munis were suddenly yielding 125 percent of what Treasury bonds were yielding. Market professionals said they had never seen anything like it. People rushed to buy munis. The buying pressure raised prices and lowered yields, calming things, but “the market turmoil may continue,” says Fischer.
Warning: Davis points out that some specialty corners of the market have been evincing illiquidity. “Brokerage firms are calling customers and saying, ‘Your earnings are still good, and your security is good. But you can’t have your money back — just yet.’ Liquidity concerns can scare folks, particularly mom ’n’ pop investors.”
The companies that insure muni bonds are in chaos. Several years ago, they diversified out of muni bond insurance — a very profitable business — and began insuring portfolios of mortgages. Uh-oh. There are stink bombs in those portfolios, as everybody now knows. The muni bond insurers probably don’t have the money to pay. Some moneybags are rushing to prop up the insurers; ultimately the federal government may have to bail them out, although that is only being discussed privately now. One of the troubled insurers, Ambac, backed the ballpark and several other San Diego bonds. If Ambac loses its AAA rating (a real possibility), those San Diego bonds will also lose their AAA ratings.
Could San Diego get insurance? Good question. Could it sell bonds without insurance? Probably. But it would have to pay a stiff price, with a rating that might be down in the slough close to junk bonds. The State of California’s recent $1.75 billion bond offering had no insurance. Across the country, since the beginning of this year, only 39 percent of long-term munis have carried insurance, down from 65 percent during the same period of last year, according to the online news service MarketWatch. Some municipalities now even consider insurance a hindrance in hawking their bonds.
San Diego’s financial and ethical problems are well known. The Securities and Exchange Commission slammed the City for concealing its pension liabilities in bond prospectuses. Two of the councilmembers singled out for complicity in that mendacity are running for city attorney. As that news makes it across the country, San Diego will likely become a national laughingstock again.
On March 3, the council voted 5 to 3 to put a measure on the June ballot that would permit the mayor to appoint the internal auditor in consultation with the audit committee, whose members the mayor would help select. Councilmember Donna Frye, who argued strenuously against the move, says, “If it is perceived by the public and by investors in the market that the mayor has the ability to change or pressure the internal auditor, that has an impact on how believable the audit results will be.” Aguirre also opposed the power grab, saying it was analogous to lawyers appointing their own judges. (Of course, some say that in San Diego, establishment lawyers do name the judges, but that’s another topic.)
The last time the City’s bonds were rated by the agencies, back in 2005, San Diego was barely investment grade, with BBB-plus and BBB-minus ratings. The 2005 certified financial statement, the last one approved, showed that auditors saw material weaknesses in the City’s financial procedures. In the draft of the 2006 audit, still being circulated, the pension fund had a very low 78 percent funded ratio, according to Mark Blake, chief deputy city attorney.