Fiscal Distress Myths and Realities Part III: Government Defaults Have Consequences
Part III of James Spiotto’s Series on Fiscal Distress Myths and Realities: Access and the Cost of Borrowing is a Reflection of the Perceived Risk of the Government Credit
Fiscal Distress Myths and Realities Part I: Default Rate
Fiscal Distress Myths and Realities Part II: Use of Chapter 9
Myth: Historically, There are no Consequences for State and Local Governments Defaulting on their Debt
Reality: Historically, there are Harsh Consequences to Defaults of State and Local Governments Ranging Generally from Higher Interest Rates to Denial of Access to the Public Market for Funding of Needed Infrastructure Improvements and Essential Services
Fiscal distress for government begets higher cost of borrowing and even loss of access to the market:
- The perception of fiscal distress leads to higher interest rates (cost of borrowing) in the global markets.
- On March 2, 2012, Greece had a ten year bond annual yield of 37.1% and in July, 2015, after the third attempted bailout and austerity package being implemented, Greece’s annual yield is still over 10.5% with a 52 week range of 5.5% and 19.5%.
- Since 1826, Greece has defaulted on its sovereign debt since 1826 at least five times prior to its recent financial crisis (1826, 1843, 1860, 1894 and 1932).
- Brazil, a large developing economy which defaulted or restructured its sovereign debt eleven times since 1826, the last time in 1990, had an average ten year bond annual yield between 2006 and 2015 of approximately 12.3% with all time high of 17.91% in October, 2008.
- Puerto Rico, given its recent financial distress experience, had yields on its ten year G.O. bonds exceeding 10% in February, 2014.
- At the same time, other sovereigns experienced unusually low bond annual yields of 2.27% for U.S.A., 1.52% for Canada and 1.03% France.
- A review of the adverse effect of state and local governments trying to balance the budget by defaulting or devaluing the currency has been met with harsh consequences, and the inability to pay due to financial distress, which is understood by the market, raises borrowing costs and could even deny market access.
- The 200-300 basis point spread between strong and weak credits.
- Traditionally the spread in the municipal market between strong credits (top investment grade) and significantly weak credits (lower non-investment grade) was 200-300 basis points.
- Being classified as a weaker credit increases the cost of the borrowing by 25% or more of the face amount of debt and should be avoided if possible.
- To a state or local government, a 200 point per year or 2 percent more interest cost a year on a 20 year bond with a bullet maturity would be 40% more of the principal amount paid as interest over 20 years. Put another way, on a billion dollar debt issue with a twenty year maturity and a bullet payment of principal at maturity, a 2% additional interest cost per annum would be a present value at a 5% discount of about $250 million or 25% of the face amount. That is $250 million not available to state or local government to pay needed infrastructure improvements, public services, worker salaries, retiree benefits or tax relief to its citizens.
Historically the market has demanded increased interest rates for state or local governments that have defaulted assuming access to the market was possible
- From the beginning of state and local government finance default or repudiation have had consequences.
- By 1844, nineteen states and two territories had borrowed money for needed economic growth. The inflationary boom of 1834-39 with the accompanying Panic of 1837 came to an end by 1841, and there was a tightening of credit that put pressure on incomplete construction projects for transportation improvements in the North (Pennsylvania, Maryland, Indiana, Illinois and Michigan) and lack of credit for banks in the South (Arkansas, Louisiana, Mississippi and Florida Territory). All but the Florida Territory and Mississippi resumed payment by 1848. The reason was the cost of default’s denial of access or increase in cost of borrowing. Those that repudiated but resumed payment experienced borrowing yields to complete projects of 32% until they resumed payment and then paid 4% above market to borrow. Mississippi and Florida Territory lacked access to then public market for almost two decades.
- Efforts at balancing the budgets by invalidating debt has been deemed not beneficial.
- Railroad Cases. The Supreme Court ruled in over 300 cases between 1860 and 1896 that efforts by state and local governments to repudiate and invalidate bonds issued to subsidize railroad facilities that did not work out violated the Constitution and thus the rights of secured bond investors. The Supreme Court took a consistent and clear stand upholding the validity of the bonds which had been sold in the public market and represented to be valid and binding. Sometimes the Supreme Court even had to overrule state supreme courts. Gelpcke v. Dubuque, 68 U.S. 175 (1864); Havemeyer v. Iowa County, 70 U.S. 294 (1866).
Needed ability to fund improved infrastructure and essential governmental services may be major motivation for future payments by state and local governments.
- Current Need for Public Market Debt Funding by States and Local Governments:
- Given the aging infrastructure and need for significant reinvestment in state and local government infrastructure and the needed ability to fund essential services at an acceptable level, state and local governments should have little incentive to default and every reason to pay their debt on time. Prompt payment of debt maintains access to the capital market and the historical low financing cost.
- Defaults Make a Significant Difference in the Cost of Future Borrowing:
- Even if defaults cause only a 200 to 300 basis point rise in annual interest expense, that is 60% to 90% more payment of principal over a 30-year period. (Spread between AAA and BBB can vary 100 to 150 basis points. Baird Fixed Income Study, 4/7/14, p. 8.) That additional cost could have been used to reduce taxes, pay for needed infrastructure or services or pay unfunded pension obligations. This appears to be the developing motivation for not defaulting and not filing for Chapter 9.
Look out for more parts of James Spiotto’s Fiscal Distress Myths and Realities coming soon.
James E. Spiotto, Co-Publisher © James E. Spiotto. All rights reserved