Wall Street’s Disconnect
There was never a chance the debt ceiling wasn’t going to be raised. Daniel Gross on why Wall Street doesn’t get it.
If there’s one takeaway from the events of the past few weeks, it’s this: Wall Street doesn’t understand government very well.
Time and again, over the last several weeks—and the last several years—we’ve seen investors, analysts, and market pundits hugely underestimate the ability and willingness of American governments, of all stripes, to make interest payments on their bonds. And it’s still happening.
In September, Chris Krueger, an analyst for Guggenheim Partners, said there was a 40 percent chance of a “technical default scenarios” and a 60 percent “probability that the U.S. will not enter into technical default scenarios is based on nothing more than blind faith.” In October, reacting in part to such warnings from analysts, large companies like Fidelity, Citi, and others sold off portions of their short-term bond holdings.
The reality? There was a zero percent likelihood of the debt ceiling not being raised. There was no prospect of those bonds not being paid. As many smart pundits noted, House Speaker John Boehner had to let his wacky caucus posture and pose until the last minute before finally caving and letting Democrats and a handful of Republicans pass the necessary legislation. It was entirely predictable. All the market gyrations, the spikes and plunges in the value of short-term bonds, represented so much wasted effort and time, and money lost. The best way to trade the debt ceiling was, indeed, not to trade it.
Not too long ago, there was widespread fear that the federal government and many states and cities would go bust. During the recession, government revenues fell off a cliff and spending exploded. In 2009, California, the largest state, nearly ran out of money and had to issue IOUs. It was common to hear people, including observers as sophisticated as Alan Greenspan, argue that the U.S. would become the next Greece.
Meredith Whitney, the analyst who made a name for herself calling the financial crisis, put out an alarmist tract on the prospects for municipalities. Speaking on 60 Minutes, Whitney called for “50 to 100 sizable defaults, more,” amounting to the failure of hundreds of billions of dollars of bonds. Whitney, like many on Wall Street, viewed government through the same lens she used to look at companies. And companies that have suffered losses for many years and have terrible balance sheets often find it convenient and necessary to file for bankruptcy. But mayors and governors have a much different set of incentives than CEOs do. And they have many more levers they can pull. They can raise taxes. They can fire large numbers of employees. They can turn shut city parks, close fire stations, and turn street lights off temporarily. They can—and will—stop making pension contributions, or trim benefits. They took drastic action without defaulting. Thanks to a combination of tax increases and steady growth, state revenues have been growing for 12 consecutive quarters.
In effect, the people responsible for managing municipal bonds do what lots of Republicans wanted the federal government to do—prioritize. And it turns out governments can stiff an awful lot of stakeholders before they’ll stiff bondholders. So no states have imposed restructuring actions on bondholders. According to Governing, since 2010 there have been 38 municipal bankruptcy filings, including eight general purpose local government bankruptcy filings, three of which were dismissed. Whitney this fall shut down her advisory firm.
When Detroit defaulted last summer, Timothy Blake, an analyst at Moody’s, said it could be the beginning of a wave. “We have to acknowledge there is a trend,” he said. “If the outcome is that they do reduce some of these liabilities, that could be an incentive for the filing.” But how many municipal defaults have there been since Detroit went belly up? If you guessed one, you’d be too high.
The latest scare situation is Puerto Rico, which has $70 billion in municipal bonds outstanding, a severely underfunded pension plan, and a big budget deficit. Through the summer and early fall, the prices of many Puerto Rican bonds fell as investors fretted about a default. Last week, Puerto Rico had to quell concerns over a bankruptcy.
But a default doesn’t look likely, either. Puerto Rico has increased taxes, reformed its pension, slashed its deficit, and is generally doing a better job getting its revenues in alignment with expenses. Like all other government entities in the U.S., Puerto Rico has many people to shortchange before it will stiff its bondholders.
That is not to say a U.S. government entity can’t default or that it never will. There will certainly be more municipal defaults over the coming years. But the probability of a state or a state-like entity defaulting is exceedingly, exceedingly low. Numerate people should be able to grasp this.