A consulting firm founded by economist Nouriel Roubini said there could be close to $100 billion of municipal-bond defaults over the next five years as state and local government-debt problems damp the U.S. economic recovery.

That figure would by most estimates represent a significant increase over defaults in recent history, but it doesn’t appear to be as dire as a prediction last year by analyst Meredith Whitney.

The report, by David Nowakowski and Prajakta Bhide at Roubini Global Economics and released to clients Monday, says state and local debt problems aren’t “systemic” in nature, nor will they “infect the financial system.” The authors of the report declined to comment.

Most of the defaults will occur among special government projects and revenue-generating entities that aren’t considered viable, it says. “Defaults will continue to be isolated events.”

The Roubini report says that relying on the history of low default rates in the municipal debt market is “Pollyannaish.”

“Avoiding a crisis will involve real austerity that has only partially been implemented thus far,” the report states.

Pollyannaish but not Systemic?

I do think there is a systemic concern in regards to pension funding. State public pension funds are $3 trillion in the hole and that is a systemic concern in and of itself. I do not have an estimate for city and county public pension plans but that could easily be another $3 trillion in underfunding.

Cities and states are without a doubt insolvent as I type. Oakland, Detroit, Miami, San Francisco, Los Angeles, Houston, Cincinnati, Newark, and countless other cities big and small are insolvent.

It is unclear if Roubini Global Economics considers those pension problems as a separate issue. I will see if I can get an answer.

Otherwise, my assessment is similar, at least for now. I do not think we see a massive wave of defaults on bondholders. The biggest defaults will affect pension plans (assuming nothing is done), not bondholders in general. Promises that cannot be met won’t, and public pension plans are near the top of the list.

Nonetheless, the defaults that do occur will rattle the municipal bond market and deservedly so.

Bank Borrow-Short Lend-Long Schemes

I do have another systemic issue in mind. I discussed it in The Next Borrow-Short Lend-Long Guaranteed to Blow Up Bank Lending Scheme; Citigroup, Chase, Bank of America CD Ripoff

The issue is banks have gone straight to direct issuance of loans to municipalities, bypassing the bond market. Banks are lending straight to municipalities at rates as low as 3.85% for 21 years. Those terms are begging for trouble.

Here is my comment from the above link.

Fed or FDIC Should Stop this Fraudulent Scheme Now

The Fed or FDIC should step in right now. There is no way banks can secure cost of funds for 21 years for 3.85%. Moreover, the risk of default is hardly zero, and banks will not be first in line should default happen.

I think borrowing-short and lending-long is fraudulent. How can you lend something for 21 years when you only have the right to use it for 3, 5, or 7?

Please see my discussion for more details.

FDIC Shock Testing

In response to that post, I received an interesting Email from “ABO” a Bank Owner and CEO regarding new FDIC shock testing exams.

ABO writes …

Hello Mish

You nailed it on the CDs. I just got done with an FDIC exam and they requested shock testing 400 basis points up and nothing down. Hard to go below zero.

In terms of 5 to 7 year CDs a 15 year GNMA is probably a better way to go. Don’t buy them at a premium and look at average life of 4 to 5 years. They are zero risk based as well.

Anyway nice job I could not agree with you more.

Last week a Bloomberg columnist asked for details regarding that stress test. Unfortunately, not only are the findings confidential, but so are the questions.

However, I do have a bit more to add from a second email exchange with ABO.

Shock Testing Now Includes Munis for First Time

ABO Writes …

The reports and content are confidential, otherwise I would be happy to help you. They also asked us to audit the Municipal bond portfolio for quality as well. That was also a first.

What I told you is 100% accurate. Previously we used a model of 300 basis points up or down. That was the threshold of the shock test. The change certainly makes sense in that not much chance of rates going down by 300 basis points.

I would like to see the US Treasury shock testing for 400 basis points! By the way we are a very high quality bank with no problems so the request was not about us. We sort of live in the good old days of banking with excess capital and a 50% loan to deposit ratio with no wholesale funding. I am a strong liquidity guy as well.

I asked ABO for a contact at the FDIC so I can raise my concerns directly. I do not have a response on that yet.

Mike “Mish” Shedlock
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