Deutsche Bank unit says muni 'hysteria' over, but budget cuts to pressure local governments

By Paul Deckelman

New York, July 21 - Deutsche Bank has some good news for investors in municipal bonds: the "hysteria" seen in some quarters late last year over the prospect of U.S. states being unable to meet their financial obligations seems to have subsided thanks to tough decisions made by governors and lawmakers at statehouses coast-to-coast.

But there's also some bad news for muni investors: the greater fiscal discipline shown at the state level, and likely in Washington as part of any deficit-cutting deal that congressional negotiators reach, is going to have a trickle-down effect that will put local government entities like cities, counties, towns and school districts dependent on funding from Washington or from Sacramento, Springfield, Albany or other state capitals under intensified pressure.

That was a major takeaway from a mid-week briefing for the financial press from key investment professionals at Deutsche Bank's Americas division Private Wealth Management unit, which manages money for wealthy North American individuals, their families and for select institutions worldwide.

First, the good news

"The hysteria has died down from municipals," declared PWM managing director and head of fixed income trading and research Gary R. Pollack. "Flows have actually turned positive into bond funds. HOORAY."

Pollack said that states facing challenges have balanced their budgets - even two of the most problematic, California and Illinois. He acknowledged that the balanced budget worked out by newly installed governor Jerry Brown and the legislature in California "has very optimistic revenue forecasts, and Illinois still owes many billions of dollars to vendors that they haven't paid for years, but spreads on these bonds in the cash market have narrowed significantly. Spreads on these in the CDS market have narrowed significantly, so the market is telling us that they are not concerned here."

Pollack's colleague, Owen Fitzpatrick, the managing director who heads equities for PWM, concurred. He said, "If you go back six months ago, you had Meredith Whitney out there talking about munis and how states were on hit lists, so to speak, in terms of not being able to pay their debt levels."

Fitzpatrick was referring to the former Oppenheimer & Co. banking analyst's dire warning in a 600-page report last September that the finances of many state governments seemed headed for the same kind of meltdown that rocked the banking industry. Whitney had famously and presciently cautioned in October 2007 that financial sector powerhouse Citigroup Inc. was in for a rocky landing because it was undercapitalized relative to its peers and would be forced to cut its dividend and sell valuable assets. Those things in fact came to pass, along with considerable executive-suite blood-letting and the necessity of a big federal bailout.

In her 2010 screed, "The Tragedy of the Commons," Whitney, by now running her own advisory shop, looked at the economies and financial policies of the 15 biggest states. She found several, including Texas and Virginia, to be in reasonably good shape but predicted possible Citigroup-sized trouble ahead for California, New Jersey, Illinois, Ohio and Michigan, with Georgia, New York, and Florida also having serious problems to face.

"Now it's six months later and no one is really questioning the ability of states to pay just based on the fact that a lot of these things have been resolved," Fitzpatrick said. All of the states at the bottom of Whitney's list, with the exception of Illinois and New Jersey, elected new governors last year, and those new governors, like Brown, New York's Andrew Cuomo, Michigan's Rick Snyder and New Jersey's Chris Christie, who was elected in 2009, moved aggressively to deal with their states' respective financial problems.

Localities under the gun

All well and good. But Pollack cautioned during the briefing that there is a new danger on the horizon for muni investors. "What we are seeing is a 'rotation of risk' away from the states to the local government entities. And this is not surprising because one of the ways states balance their budget is by reducing aid to local governments."

Pollack noted that local entities such as cities, counties, towns and school districts "do not have the same fiscal prowess that states have - that is, they are geographically much smaller, they don't have the ability to levy taxes in an unlimited fashion, they provide very expensive services in terms of police, fire and sanitation and teachers, so they face a much tougher budget to balance than the states have."

While some localities do levy income taxes - New York City, for instance - for most entities below the state level, "their primary revenue source is property taxes, and assessed valuations for a lot of communities are still declining. So if you face a property tax limit and your tax base is declining, what do you do as a local government?"

Besides just the decline in valuations and revenues from property taxes, some government entities face further financing constraints. New York, for example, recently enacted a Cuomo-supported property tax cap that limits to the lesser of 2% or the rate of inflation the amount by which a government entity can raise its annual tax bite, although there are several significant exceptions, notably court judgments, employee pension costs and growth in a town or school district.

Between such conditions hobbling their own ability to raise funds and lowered payments from the respective states, the bottom line, Pollack said, is that "I think you can see much more pressure, both from a ratings point of view and perhaps even worse, at the local levels. As a result, I think that all investors are going to have to do a lot of homework before they buy municipal bonds at the local level."

Fallout from Washington battle

With all eyes on the continuing debt-ceiling donnybrook going on down in D.C., Pollock - in answer to a reporter's question as to the possible effects that budget battle may have on corporate bonds should it result in a loss of Uncle Sam's prized AAA credit rating - opined, "I think there's more risk for a downgrade in the municipal space [than in corporates] because in municipals, you have a lot of bonds tied to the federal government. You've got pre-refunding bonds, which are backed by an escrow account holding U.S. Treasuries. You have various housing bonds, which may have loans insured by HUD or the FHA. You have some hospital bonds with insurance from the FHA and HUD."

He noted that Moody's Investors Service recently put a number of states under review for downgrade because of their ties to the federal government. Among them, he said, were "obviously, Maryland and Virginia because of their [proximity] to the District of Columbia. But when the federal government cuts its budget and they reduce employment, it's going to be across the country. It's not going to be concentrated that much, I think, in Maryland and Virginia, who have very high wealth levels, they have conservative budget practices. So I'm not that concerned about those two states."

The other states under Moody's scrutiny because of their dependence on funding from the feds are South Carolina, New Mexico and Tennessee.

The agency on July 13 also advised that at least 7,000 top-rated municipal credits would have their ratings cut if the federal government loses its AAA status.

Looking beyond that potential calamity to municipal finance, Pollock also noted that any debt deal to come out of Washington - even one that preserves the AAA rating - will be felt "very soon" at the state-capital level.

"While the hysteria over the states has subsided, states still face ongoing budgetary pressures, especially if and when the federal government begins to seriously get its act together to reduce spending, because there will be cutbacks to state governments, which get about 20% to 25% of their revenues, on average, from the federal government," he projected.

The end for tax-free munis?

Among other ideas for closing the perceived revenue gap by raising taxes, one proposal kicking around Washington is the scaling back or even the elimination of tax-free status for most municipals. Pollack suggested that "rather than removing it entirely, what they might do is reduce what you can finance on a tax-exempt basis, just the way the Tax Reform Act of 1986 reduced what [a taxpayer] could finance" by ending the deductibility of the interest on consumer loans such as auto or credit-card debt.

He said that if lawmakers go this route, they might lift the tax-exempt status of housing bonds or industrial development bonds and "just restrict it to your traditional public projects - schools, other types of [public] buildings, highways, where you have a real public benefit, as opposed to some private benefit."

Should such changes come to pass, existing municipals, whatever they were issued to fund, would be grandfathered in and retain their tax-free status, Pollock said. "When the tax code changes - if it does - those bonds would become rarer because they would remain tax exempt."

Even now, not all municipal bonds are tax-free. Pollock outlined that lately, "we've been adding taxable municipal bonds to our portfolios. The taxable muni space is a relatively new space. I don't think it's really fully understood and priced well by the market place, and it's a way to diversify a corporate bond portfolio into an asset class which historically is much safer than the corporate world."

What Deutsche likes

Back among the more traditional kinds of muni bonds, Pollock said that "we still stress high-quality G.O. issuers. I like essential-service revenue bonds - electric utilities, water [revenues], sewer revs."

Another area that Deutsche PWM is bullish on is "higher-education bonds - I'm talking about probably the top 50 to 100 institutions here in the United States, which have a global demand for higher education across the world.

"And to add some value, I do like some health-care entities, the stronger ones - larger, diversified hospital systems, so you get diversification of geographic area, you get the benefits of economies of scale. Again, it's another way to get a little bit of yield in a space where there's not a lot of yield to get."

But he reiterated that "I still need to stress credit quality because the credit cycle in municipals is not on an upswing like it is in corporate America."

Pollock noted this week's heavy calendar of new issuance. In fact, he called this "the heaviest supply week of the year" and said that "it will be a true test to see if the municipal market has truly recovered or not."

Among specific deals now on the radar screen, he said that it would be interesting to watch what happens with the $400 million multi-part offering from Chicago's Metropolitan Water Reclamation District, noting that it's an Illinois-based issuer and "the bulk of it is out on the yield curve, where you don't get a lot of individuals, so we'll see whether you have institutional participation."

"What we are seeing is a 'rotation of risk' away from the states to the local government entities." - Gary R. Pollack, Head, Fixed-Income Trading and Research at Deutsche Bank Private Wealth Management

"No one is really questioning the ability of states to pay just based on the fact that a lot of these things have been resolved." - Owen Fitzpatrick, a Managing Director at DWS Investments, head of the Institutional U.S. Large Cap and Small Cap Equity teams

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