Monday, April 15, 2013

Bond Market(s): End(s) of Western Civilization as we Know It

The following is right, isn't it?  The typical municipal bankruptcy is (and will be) a three-way fight: current employees versus retirees versus bondholders (with taxpayers languishing already beaten in the corner). Sure there is some overlap: you might say  younger/newer employees versus older-plus-pensioners, but it's a fine point.  Anyway you look at it, three into two don't go and something will have to give.

Bondholders clearly know it. The reason you know they know it is that we are beginning to hear those voices telling us how it  can't be that bondholders will ever suffer in a muny bankruptcy; that it will be the end of Western Civilization as we know it!

Right, sure, maybe, whatever.  Sounds a lot like how they tell us that it can't be that bondholders will suffer in a bank failure either; that it would be the end of Western Civilization as we know it!

With banks, the claims strikes me as particularly egregious, recognizing that we start off with insured debtors who have a formal protection against loss--which the banks have more or less paid for--and try to extend the same kind of protection to those who do not have that protection.

What the bondholders do have in each case is not a formal protection; rather they have the assurance that they've got a pretty safe investment--one which, over the long horizon, has done pretty well.  But a bond is still just an IOU, even if tarted up in its Sunday best.  It's a claim; it's on the right hand side of the balance sheet.  It's ahead of equity, but it may or may not get paid in full.

One reason the pious affirmation gets so tiresome is that a moment's reflection give you a little context as to how these bonds came into being.  I.e., somebody had to loan the money and for all practical purposes the landscape presented prime opportunities for guys with suitcase-sized brains (or so they said) whose specialty was  hoovering up  the detritus from the Mayberry mafia.  Was anybody better equipped to appraise risk?  Was there ever anyone less entitled to say "oh, it's munies and they always pay"--?

But one thing I don't know, in either case: how often does it actually work?  We know a lot about failure rates among corporate bonds in the post-Milken generation. We've learned, among other things, that first-tier corporates never were quite as bulletproof as conventionally assumed.  But what, exactly, is the record of munies (or, while I am at it, of bank debt)?  Is there really  substance to the assertion that "they never fail"--?  Or is the landscape actually scattered with more corpses than our memories account for?

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