Are State Bonds backed by the "Printing Press"?

[Gosso]

I came across this comment from Cullen Roach, over at PragCap (it's an MMRer website):

pat:  Hi Cullen, The USA has a Fiscal Union and a Monetary Union. The EU only has a Monetary Union.  Everyone is talking about how the EU should adopt a Fiscal Union like the USA.  Does it really matter: Some states in the USA are in real bad shape, similar to the countries, (states) in the EU. Think California and others. California has a mandate to balance the budget, but there sure was a lot of talk the Fed would bail out the states in a pinch. That’s what the EU is doing with their members, ( bailing them out)So really what good would a fiscal union do?

CR:  I only see two real solutions in Europe.  You either give each country sovereignty by establishing their old currencies and giving them the chance to rebalance growth through the ability to print money and devalue their new currencies relative to their trade partners.  OR, you create a fiscal union like the USA has.  Personally, I think Europe is likely to become further integrated as time goes on so going backwards towards the old currencies makes very little sense to me.  A fiscal union in Europe would achieve the same things it has achieved in the USA.  The biggest advantage would be stability.  The USA doesn’t suffer state insolvency crises once every few decades because they have the power of the US government backing them. The Federal government is ALWAYS spending money on the states.  On average, about 20% of state budgets are aided by federal spending.  This is a huge persistent “bailout”? if you want to think about it like that, but it avoids constant imbalances and creates stability.  California is never going bankrupt.  The Federal government would never allow it to happen.  Greece doesn’t have this backing.  The USA has lots of weak states or members who don’t pull their weight.  But we don’t kick them out because we’re politically unified.  Europe doesn’t have that unity.  They need to find it.

Source: http://pragcap.com/qa-the-answers-7

Are the States the ultimate Too Big To Fail, and therefore will always receive funding from the Fed Gov when they get in trouble?  

I remember plenty of talk back in 2010 about California and Illinois on the verge of bankruptcy, yet nothing came of it, were they quietly bailed out?

There has been talk of Ontario on the verge of bankruptcy as well, yet their 30 year is at a calm 3.4% (1% greater than Gov of Canada).  If State and Provincial Bonds are backed by a printing press, then is there room for them in the Permanent Portfolio?

[Lone Wolf]

I came across this comment from Cullen Roach, over at PragCap (it's an MMRer website):

California is never going bankrupt.  The Federal government would never allow it to happen.

Are the States the ultimate Too Big To Fail, and therefore will always receive funding from the Fed Gov when they get in trouble?

Wow.  I strongly disagree with the Cullen Roach piece that you quoted.  When you boil it down to its essence, the author is saying that California bonds are every bit as reliable as US Treasury bonds.  This strikes me as absolutely terrible investment advice.  Shockingly bad, really, and especially dangerous for a Permanent Portfolio.

I can easily envision a scenario where California bondholders are asked to take a haircut.  The idea of a holder of a US Treasury default, while theoretically possible, means that we're closing in on a "the end is nigh" scenario.

Treasury securities really are the last stop.  If they are falling over, everything but precious metals are falling over, too.  California defaulting on bonds?  Big news to be sure but would anyone really be that stunned?

Definitely stick with Harry Browne on this one.  California bonds are in no way as good as US Treasury bonds.

[moda0306]

Sometimes Cullen speaks a little too flippantly (in this case it may have been way too much)... I think that might be the case here.

I think he was maybe trying to make the point that 1) the Eurozone has none of the automatic stabilizers as individual states do from a central gov't, and 2) that even if push did come to shove, federal gov't backing of Cali is quite likely.  A self-fulfilling default situation would mimick a TBTF scenario in a state like California, whose GDP is over 13% of the entire country.

I disagree with his certainty almost as much as you do, but he often has to pull back from remarks that take things a bit too far... I hope this is just one of those instances.

[Gosso]

Frig!  And I thought I was going to receive an extra 1% on my long bonds.

[Gumby]

Wow.  I strongly disagree with the Cullen Roach piece that you quoted.  When you boil it down to its essence, the author is saying that California bonds are every bit as reliable as US Treasury bonds.  This strikes me as absolutely terrible investment advice.  Shockingly bad, really, and especially dangerous for a Permanent Portfolio.

Uh, no. Please. He never said that. You've put words in his mouth that he didn't say. He never said state bonds are risk free. He never said that state bonds are guaranteed by the US government. In fact, every word he said is true.

He's just saying that the United States has a fiscal union and Federal support for States. It's 100% true. States get Federal dollars all the time. That's hardly anything new. We all know this. Just because the US has a printing press doesn't mean that State bondholders will get 100¢ to the dollar on their State bond investments. A state could easily default on their bonds and the Federal government would provide emergency funding for basic services, etc.

Cullen is advocating fiscal union for the Eurozone — a United States of Europe of sorts. Many economists support this approach to the currency crisis.

[Lone Wolf]

Uh, no. Please. He never said that. You've put words in his mouth that he didn't say. He never said state bonds are risk free. He never said that state bonds are guaranteed by the US government. In fact, every word he said is true.

Here's what the guy said.

California is never going bankrupt.  The Federal government would never allow it to happen.

The very definition of bankruptcy is that you can no longer pay your creditors.  Roach says that California will never go bankrupt.  Therefore, he is saying that California will never fail to pay its creditors (aka bondholders.)

This is really straightforward.  I am not sure why you're splitting hairs here.

[Ad Orientem]

Here's my take FWIW on state bonds and Munis. In general they suck as an investment asset class for two reasons, and in one situation they look pretty good.  First...

The suck because you are getting a lower interest rate than on most comparably rated bonds. Their tax advantages only work for those in the highest tax brackets. Secondly they are NOT backed by the full faith and credit of the United States. So they don't react the way Treasury obligations do in deflationary situations. They noticeably underperformed LTTs during the crisis of 2008-09. Which makes them unsuitable for an HB PP. That said...

In the right circumstances Munis have uses. First, contrary to popular belief they are not high risk as an asset class unless compared solely with Treasuries. Even during the Great Depression the default rate on municipal bonds was really quite low. Only one state in the entire history of the country has ever gone bankrupt (Arkansas) and there is not even a provision in the bankruptcy code for that anymore. The rule of course (as always) is not to have all your eggs in one basket.

Secondly, IF you were very wealthy and you were prepared to accept the higher volatility for a more growth oriented portfolio than the PP, perhaps a Jack Bogle type (50/50) stock bond split then I could see an argument for Muni bonds. The added risk (very limited) for the tax advantages (possibly considerable if Federal taxes go up and or you live in a high tax state) might make these bonds very attractive.  IF you were inclined to buy Munis you would want to use a super low cost ETF or managed fund that spread the risk around and stay intermediate in your bond duration.

Bottom line... NO, they are not an acceptable component for a PP. But for the very wealthy who have higher risk tolerances I could see a use for them. And to be very frank I cannot see California going broke even if their bonds are not legally backed by the US. California is the world's fifth largest economy. If GM and your big Wall Street banks were too big to fail, I promise you, so is Sacramento. If push came to shove Ben Bernanke would step in and buy their bonds with newly printed (electronically) money. I am not so sure about Rhode Island. But if Cali goes under that would constitute and SHTF scenario in my book. It aint gonna happen.

[Pointedstick]

Uh, no. Please. He never said that. You've put words in his mouth that he didn't say. He never said state bonds are risk free. He never said that state bonds are guaranteed by the US government. In fact, every word he said is true.

Here's what the guy said.

California is never going bankrupt.  The Federal government would never allow it to happen.

The very definition of bankruptcy is that you can no longer pay your creditors.  Roach says that California will never go bankrupt.  Therefore, he is saying that California will never fail to pay its creditors (aka bondholders.)

This is really straightforward.  I am not sure why you're splitting hairs here.

I don't think this is quire fair. First of all, California isn't going bankrupt because federal law doesn't allow it. They may default, but there is no state bankruptcy. Second of all, California is a large, electorally important state, It's also very blue, and the Democrats control the executive branch and half the legislative branch.

Also a federal bailout does not mean than bondholders would be made whole or retain 100% of their assets. The federal government may conditionalize the bailout on California privileging welfare recipients and pensioners (read: reliable democratic voters), etc etc etc.

The implicit backing of a printing-press-endowed sovereign government makes state bonds lower risk certainly than junk bonds, but they're not even in the same league as real treasury bonds.

[Ad Orientem]

Also a federal bailout does not mean than bondholders would be made whole or retain 100% of their assets. The federal government may conditionalize the bailout on California privileging welfare recipients and pensioners (read: reliable democratic voters), etc etc etc.

Aint gonna happen no matter who is running the government. If they even hinted at something like that it would annihilate the municipal bond market in a day.

[Gumby]

This is really straightforward.  I am not sure why you're splitting hairs here.

Not splitting hairs. He never said that state bonds are risk free. Seems pretty clear you're just trying to build up a straw man. And calling him "Roach" isn't exactly helping your argument.

Cullen's own treatise explains in clear terms that States, Eurozone nations and households are currency users, and therefore have solvency restraints.

[Gosso]

This is really straightforward.  I am not sure why you're splitting hairs here.

Not splitting hairs. He never said that state bonds are risk free. Seems pretty clear you're just trying to build up a straw man. And calling him "Roach" isn't exactly helping your argument.

Opps, I called Cullen Roche, "Roach", as well  (a Freudian slip?).  Although, if I knew him personally that would definitely be his nickname. 

Another problem with bailing out a State would be the moral hazard that is created.  At that point no State would strive for a balanced budget.

[Gumby]

Another problem with bailing out a State would be the moral hazard that is created.  At that point no State would strive for a balanced budget.

I think the point is that it's not really an issue, since every State already receives a lot of Federal assistance and almost every state has some form of balanced budget amendment...

http://en.wikipedia.org/wiki/Balanced_b ... .S._states

Most Congressmen spend their entire careers constantly trying to secure pork barrel spending and tax breaks for constituents in their own states. That's how the game works. The Federeal government is basically the sugar daddy for every state in the Nation.

Cullen's basic argument is that States are too big to fail (California is the 8th largest economy in the world). But just because a state or corporation is too big to fail does not make their bonds risk free — particularly since there are different levels of state bonds. State general obligation bonds are generally pretty safe, since they keep the State running. But, state revenue bonds and state private-purpose bonds are lower priorities. I'm sure we can all agree that state revenue bonds and state private-purpose bonds could default even though a state is considered too big to fail. State general obligation bonds are pretty safe, and rarely are at risk of default, but nobody equates them to the risk-free safety of Treasuries.

And, if the Federal government were not contributing so heavily to every state's revenue stream — while also acting as a potential lender of last resort — you can bet state general obligation bonds would be perceived to be far riskier.

[Lone Wolf]

Not splitting hairs. He never said that state bonds are risk free. Seems pretty clear you're just trying to build up a straw man.

*shrug*  "Bankruptcy" means what it means.  If you can't pay your bondholders, you are bankrupt.

I'm not interested in fighting with you over whatever alien definition of "bankruptcy" this person was using.  The important point is made and on this we agree -- California bonds aren't nearly as good as Treasury bonds.

And calling him "Roach" isn't exactly helping your argument.

LOL.  That's just the name that I read in the original post.  I've no idea who "Cullen Roche" is but you must believe that if I wished to make fun of his name that I could be more creative than that. 

[Gumby]

*shrug*  "Bankruptcy" means what it means.  If you can't pay your bondholders, you are bankrupt.

Nope. Not true... States are not legally able to declare bankruptcy. The Federal government forces states to go into receivership — where an appointed judge would force creditors to renegotiate their loans, if necessary. Also, states have sovereign immunity (see the 11th Amendment) so there is no need for bankruptcy protection from creditors.

You can learn more about the process here...

http://www.slate.com/articles/news_and_ ... uptcy.html

And furthermore, States have a sugar daddy — Uncle Sam — that doles out a regular allowance to help the bottom line of every state (on average 20% of state budgets comes from Federal assistance). That's why states don't go bankrupt. The government is constantly helping them out by deficit spending on every state. Eurozone countries don't have that luxury. And therein lies the key point that you tried to build into a straw man. In the end, a state would renegotiate its loans and continue to receive aid from the Federal government. A state would not be allowed to go broke or "bankrupt" and stop functioning.

And yet, nobody — and I mean nobody — is even remotely suggesting that state bonds are as safe as Treasury bonds — since a state is a currency user and not a currency issuer. I mean, this is a very realistic view of the State/Fed relationship, and yet you build it up as it as if it's a major flaw in some kind of logic.