Moody's Negative Outlook on U.S. Local Government Debt

A few days ago, Moody's Investors Service announced that its outlook for the entire U.S. local government tax-backed and related ratings sector is negative. This is newsworthy not only for municipal bond investors but also for anyone following the U.S. recession. It marks the first time that Moody's issued an outlook on this entire sector, although it has issued ratings on the sector since 1914.

Moody's Investors Service is one of the leading issuers of credit ratings. Investors use these ratings to gauge the risks of investing in debt assets. So, one might conclude that the analysts at Moody's are remarkably pessimistic about the impact that recessionary economic conditions will have on the ability of local governments in the U.S. to meet their debt obligations. This means that the risk of defaults on these debts has risen.

However, Moody's hedged its announcement by mentioning that credit pressures will vary significantly across locales due to differences in economic conditions, property assessment methods, and authority to raise revenue. The varying economic conditions can largely be explained by localities' exposure to industries hit particularly hard by the recession. These include real estate development, auto manufacturing, financial services, tourism, gaming, and general manufacturing. Differences in property tax systems will play a major role. Moody's report shows evidence that about 72% of local government tax revenue comes from property taxes. The bursting of the housing market bubble will bring declines in property tax revenue for most local governments because of falling home values.

Several of these governments might have the authority to increase property, sales, or income tax rates to raise revenue. Whether the elected officials running these localities are willing to do this is an open question. Moody's points out that taxpayers are worried about their own financial conditions and are highly resistant to increases in local taxes. Raising taxes in this environment will be unusually difficult for locally elected officials.

Cutting spending during the economic crisis will not be an attractive option either. In part, this is because many of these governments may face service mandates that prevent them from reducing service-related expenditures. An example of a service mandate is that a state government may mandate that local governments provide health services for the poor. Moody's analysts also reported that the demand for improved government services will make it that much more difficult for these governments to sustain healthy finances. Local officials may find that it is more palatable to default on their bonds rather than raise taxes or cut spending.

The credit crunch is also having a direct impact on local government finance. Moody's report states that access to credit will be more expensive for these governments than it had been in recent years. Moody's negative outlook announcement surely caused investors to demand greater yields on the municipal bonds trading in the credit markets. The company also warned that some localities are in such dire straits that they may be completely shut out of the credit markets.

Yet, the situation ought to be tenable for numerous governments. For instance, some well-managed localities increased their reserves during the boom years and were prudent with the funds generated during the real estate bubble. A simple example from portfolio theory can help show why investors may still be willing to buy the bonds of a cross-section of municipalities.

Suppose that a bond investor purchases three one-year bonds with different expected returns and probabilities of default. For simplicity, we'll assume that the investor is risk-neutral and the bonds pay nothing in the event of default. Bond A has a 25% probability of default this year but pays a coupon of 15% if it avoids default. Bond B has a 50% probability of default this year but pays a coupon of 20% if it avoids default. Bond C has a 75% probability of default this year but pays a coupon of 30% if it avoids default. Let's also assume that all the bonds have a face value of $100 each.

What is the investor's expected payoff from investing in this portfolio? It is


(0.75 × $115) + (0.5 × $120) + (0.25 × $130) =

$86.25 + $60 + $32.50 = $178.75


So, on average, an investor would be willing to pay less than 60% of face value on these bonds to make a positive expected return.

This example was purposefully simple, but from it you can see the advantage of diversification and the problem of gauging risk. If the probabilities of default end up being higher than estimated, the investor might lose money but will only lose all his money in the rare case that all bond issuers default. Yet, if the probabilities of default are lower than estimated, the investor might earn a high rate of return.

Discussion Questions

1. How does the bond portfolio example relate to the impact that mortgage-backed securities had on financial institutions? What must have happened to their default rates for them to become known as "toxic assets"?

2. If you had a large sum of money that you had to use for investment purposes, would you put together a portfolio of U.S. local government debt? If yes, why? If not, explain what your preferred investment would be.

3. Besides an economic recovery, what changes, if any, do you think are needed for local governments to avoid defaults in the future? How feasible are your proposed changes?

America's Looming Liquidity Trap

In October 2008, the US unemployment rate hit 6.5%, a 14-and-a-half year high, as announced by the Labor Department. This lofty rate is likely to increase in the coming months in the wake of the ongoing financial crisis and adjustments in the real estate market. It also comes despite two 50 basis point cuts in the target federal funds rate made by the Federal Reserve during that month. These interest rate reductions brought the target fed funds rate down to 1%, a very low target rate by historical standards and close to the nominal rate floor of 0%. The Federal Reserve therefore finds itself in the thorny situation of having only 100 basis points left to work with for possible target rate cuts. (Note that a basis point represents 1/100th of a percentage point, so 1% is 100 basis points.)

The fed funds rate cannot go below 0% because a transaction at a negative nominal rate implies a negative nominal cost of borrowing funds. Furthermore, that implies a positive nominal payoff to the borrower and a positive nominal loss to the lender. Under typical, positive rates of inflation, the real costs and payoffs are amplified. This is shown in the following Fisher equation where i is the nominal interest rate, r is the real interest rate, and is the inflation rate:


This floor for the nominal fed funds rate brings up the very real possibility that the US will soon be mired in a liquidity trap—a situation in which "the monetary authority is unable to stimulate the economy with traditional monetary policy tools." One explanation for this weakness of monetary policy comes from the analysis on the real interest rate given above. In difficult economic times, why would financial institutions take on the risk of lending out money to a borrower who may default on the loan when the real return on even a fully repaid loan is negative!

An excellent source on how our nation might remedy its liquidity trap is given by the 2008 Nobel Laureate in Economic Sciences, Paul Krugman. His 1999 article "Thinking About the Liquidity Trap" offered policy solutions for springing the Japanese economy from the type of liquidity trap that now threatens the United States. Krugman's figure 1 from that paper shows a nice IS-LM example of the ineffectiveness of monetary policy. Wikipedia provides a good introduction to the IS-LM model. Below I present a modified version of Krugman's figure 1, in the context of current US interest rates, to represent traditional monetary expansion with a looming liquidity trap.



An economy may also happen to face declining consumption expenditures, as the US currently does, due to concerns about a rising unemployment rate, which can result in lower exogenous consumption and a falling marginal propensity to consume. In that case, the resulting leftward movements of the IS curve make monetary policy even less effective. Krugman's solution to the scenario is to have the monetary authorities credibly commit to sustained higher future inflation. The expectation that such higher inflation will eat away at the purchasing power of cash holdings should convince consumers to ramp up their spending and move the IS curve rightward.

President-elect Obama and the new Congress will undoubtedly undertake expansionary fiscal policy to attempt to move the IS curve rightward. However, our already massive national debt and the likelihood of waste involved in government spending, support Krugman's solution. Our newly elected officials and the Federal Reserve Board are facing unenviable policy choices.

Discussion Questions

1. Suppose that you were in control of US fiscal and monetary policy. What policies, if any, would you implement to improve US economic conditions?

2. Do you believe that America will soon face a liquidity trap? Why or why not?

3. The International Monetary Fund forecasts that the world's rich economies will collectively experience economic contraction for the first time since World War II. When was the last time America faced a liquidity trap? What circumstances led to that liquidity trap environment?

Subprime Primer

Subprime mortgage lenders make home loans to "subprime" borrowers—people who don't have the income, wealth, or credit history to qualify for the traditional lending terms offered to prime borrowers. The recent housing slump pushed multiple subprime lenders into bankruptcy as a rising number of subprime borrowers failed to make their mortgage payments. As subprime lenders go belly-up and subprime borrowers fall on hard times, lawmakers have been quick to find signs of fraud and abuse, and quicker to propose new regulations for the subprime market. Events in the subprime market offer a glimpse of several issues behind the housing market correction in the United States. A recent New Yorker column by James Surowiecki explains the subprime fiasco.

Surowiecki suggests that focusing solely on "predatory lending" practices does not suffice to explain the trouble in subprime markets. He notes that lawmakers cannot consider instances of lender fraud and abuse without also considering the "overambition and overconfidence of borrowers." For example, borrowers who expected sharp increases in home prices used the easy credit offered by subprime lenders to make speculative purchases—buying a home with the intention of selling quickly and for a substantial profit. Other borrowers were enticed by low introductory interest rates and placed too much confidence in the ability of their future selves to pay the mortgage when the low rates expired and higher, adjustable interest rates kicked in.

University of Chicago economist Austan Goolsbee calls for restraint in the regulatory backlash against subprime lending in his New York Times column. Goolsbee focuses on a research paper by three economists: Kristopher Gerardi and Paul Willen from the Federal Reserve Bank of Boston and Harvey Rosen of Princeton. The paper suggests that innovations in the market for home loans, including subprime lending, offer more upside than down. According to the authors, a government crackdown on subprime lending could reduce homeownership opportunities among young people, minorities, and people without a lot of money for a down payment.

Discussion Questions

1. What's a "liar" loan? How did borrowers use such loans to make speculative gambles in the housing market?

2. What's a 2/28 loan? In what ways do consumers tend to "overvalue present gains at the expense of future costs," as Surowiecki suggests? (Think about decisions on whether to consume today or save for the future, or whether to study for an exam or attend a party.)

3. According to Surowiecki, what percentage of subprime borrowers were living in their homes and making monthly mortgage payments at the time the article was written? What does this suggest about the wisdom of an outright ban on "exotic" subprime lending products like the 2/28's?

4. In what way do subprime loans (such as 2/28's) benefit currently low-income households that expect to earn much higher income in the future? How do subprime rates reflect the fact that the expectation of higher future income is not a guarantee of higher future income?

5. What factors traditionally cause homeowners to foreclose? Do recent numbers suggest that subprime lending is the leading cause of foreclosures in the United States?

6. According to Goolsbee, what is the link between the expansion of subprime lending and the growth of homeownership among African-American and Hispanic households?

7. According to both Goolsbee and Surowiecki, the vast majority of subprime borrowers are making their mortgage payments on time. As higher, adjustable rates kick in on home loans with low introductory rates, how might the rates of delinquency (missed payments) and default (failure to pay the loan entirely) change? Suppose the housing market correction continues and home prices continue to fall. How will this affect the bets of speculative borrowers in the subprime market?

8. How would a continued housing slump affect economy-wide consumption and investment expenditures? (Recall that part of investment is residential investment—purchases of new homes and apartment buildings.)

A Second Nobel for Economics

The Norwegian Nobel Committee awarded the 2006 Nobel Peace Prize to the Grameen Bank, a for-profit business, and its founder, Bangladeshi economist Muhammad Yunus. The Committee's citation lauded Grameen Bank's innovative efforts to reduce poverty through micro-lending schemes that provide some of the world's poorest citizens with access to credit. So, what's microcredit and how do Yunus and Grameen use it to reduce poverty?

Citizens of developed countries like the United States take credit access for granted. With a stable source of income or a bit of collateral, like a house or a car, an American can take out a loan to start a business, remodel the bathroom, or buy an engagement ring.

Access to credit in less developed countries is far scarcer.

Poor peoples' incomes are inherently less stable and often too low to qualify for lending. The ill-defined property rights in many developing nations make it difficult for poor residents to prove that they own the housing or land that they occupy. Lacking income and legitimate titles to what little collateral they actually have, the credit prospects for most of the world's poor seem bleak. As a result, traditional credit schemes ignore low-income entrepreneurs whose business ideas can help their communities escape poverty.

Yunus had the vision to develop a lending model that could reach low-income entrepreneurs in Bangladesh. He realized that collateral requirements provided borrowers with a strong incentive to pay back their loans rather than defaulting and losing their property. To ensure that poor borrowers faced an equally strong incentive to repay their loans, Yunus replaced collateral with the borrowing circle.

The borrowing circle consists of 5 people--the initial borrower, and four friends who agree to help with loan payments if the going gets rough. (The friends may take out loans as well.) Should the borrower default, all four friends lose access to credit until the loan is repaid in full. Replacing collateral with social pressures worked remarkably well, helping people expand or launch small business ventures. Read this New York Times article to find out more about Yunus and the Grameen Bank.

1. Grameen Bank is a for-profit business, but is it profitable? According to the article, what's the U.S. dollar value of Grameen’s loans since 1983?

2. According to the article, how many borrowers has the Bank served? What percentage of Grameen’s loans is paid back? How do Grameen’s payback rates compare to those of traditional banks in Bangladesh?

3. Why might social pressures provide a greater incentive to repay loans than the threat of losing collateral? What's the downside of defaulting in the Grameen scheme versus a traditional, collateral based scheme?

4. How might credit access change the social standing of Bangladeshi women?

5. How does Yunus feel about relying on charity to battle poverty?

Coincidentally, the Aplia Econ Blog recently asked whether microcredit will reduce poverty.

Will Microcredit Reduce Poverty?

Most people in developed countries can easily use their assets to secure credit. With a stable source of income or a bit of collateral, like a house or a car, an American can take out a loan to start a business, remodel the bathroom, or buy an engagement ring.

Access to credit in relatively poor developing countries is far scarcer.

Poor peoples' incomes are inherently less stable and often too low to qualify for lending. The ill-defined property rights in many developing nations make it difficult for poor residents to prove that they own the housing or land that they occupy. Lacking both income and legitimate titles to what little collateral they actually have, the credit prospects for most of the world's poor seem bleak.

Enter microcreditors. As Tyler Cowen describes in his latest Economics Scene column for The New York Times, microcreditors are non-profit, for-profit, or government organizations that lend small sums to people in poor communities. The microloan recipients open businesses, improve their homes, or pay medical bills--using the loans to invest or consume as they see fit. Read Cowen's commentary to find out more about the benefits and controversies surrounding microcredit in India.

1. According to Cowen, microlenders like Spandana offer poor Indians better rates than traditional money lenders. How do the lending practices of microcredit organizations differ from the practices of traditional money lenders? How does Spandana use community pressure to maintain high repayment rates among its loan recipients? What other incentives encourage borrowers to repay the microloans?

2. Why do some state officials in India oppose the practices of microcreditors like Spandana? According to Cowen, what would legal caps on interest rates do to the solvency of microcreditors? How might legal caps on interest rates change the borrowing habits of India's poor?

3. Cowen visited Hyderabad--a metropolis of over 6 million residents. He suggests that microlending works fairly well for poor people in this urban setting. How might the feasibility of microcredit change in a rural setting? Rural residents in developing countries earn income from farming--a relatively risky vocation because of price volatility and unpredictable weather. Would repayment rates among rural residents likely be higher or lower than those among urban residents? How would traveling to rural settings affect the way microcreditors monitor repayment?