Fed Chairman Might be Mulling Municipal Bond Purchases

Published December 12, 2010

Mutual fund data reporting firm Lipper recently noted investors pulled net $3.1 billion from municipal bond funds in one week in November. Also in November, California delayed a $10 billion municipal bond sale, which fueled speculation the Federal Reserve could buy at least some of the bonds. Since the financial crisis in 2008, the Fed has purchased huge amounts of federal government debt, commercial paper, and mortgage-backed securities.

After the California bond postponement, Art Cashin, a New York Stock Exchange floor operations manager at UBS Financial Servcies, sent a note to clients speculating the Federal Reserve would step in to shore up municipal bonds. He cited a 2002 speech by Bernanke to the National Economists Club in which Bernanke hinted at buying all kinds of securities:

“The Fed has the authority to buy foreign government debt, as well as domestic government debt,” said then-Fed Governor Bernanke. “Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects . . . Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.”

‘Rates Are Too Low’
“There is absolutely no need for the federal government to step up and buy or guarantee state municipal bonds,” said Rick Ashburn, chief investment officer at Creekside Partners in Lafayette and La Jolla, California. “The market is there for the bonds. Perhaps at higher interest rates, but rates are near historic lows anyway. While the recent California GO [general obligation] bond sale offered rates about 0.70 percent higher than a month ago, we still did not buy them for our private clients. Rates on this type of generic state debt are still too low to compensate for a 20- to 30-year holding period in the face of pro-inflation Fed policies.”

California called off the bond sale after receiving orders for $6.06 billion of bonds over three days, barely 60 percent of the amount the state had been hoping to sell.

If officials decided to hold off in hopes of higher demand later that would lower interest rates, the strategy won’t work, said Ashburn.

‘Borrowing Strangles Budgets’
“Borrowing money turns up-front cash into annual payments over time. At current interest rates, it’s not interest payments that will further strangle state budgets; it’s the borrowing itself,” he said. “Lower interest rates won’t make a dent in the state’s deficit. They have to get spending under control.”

Curtis C. Greco, founder of the Imperfect Messenger Foundation in Santa Rosa, California, said Federal Reserve purchases of California bonds would “place the financial burden of California” on other states that have been more fiscally responsible.

Greco says most state debt, particularly in California, is driven largely by politics, and the California political environment of the last 35 years has shifted spending toward expanded entitlement and regulatory enforcement programs. This has driven up government costs and reduced private business activity, which hurts tax revenues.

California has a government debt load of $68 billion.

‘Another Noose Around the Neck’
California, like many other states, “must not be given yet another noose around the neck of the taxpayers under the premise of ‘too big to fail,'” Greco said.

He also said it is fiscally irresponsible for states to provide government workers a “defined benefit” pension whose funding rests solely on the shoulders of taxpayers, and cites recent reports that suggest California’s public employee pensions are unfunded by as much as $500 billion, adding that the true number could be closer to $750 billion because of losses in investment portfolios.

“The practice of permitting private institutions — unions — untethered access to government coffers must never be permitted, at any level,” Greco said, and added, “The Fed bailing out the state will not cure its tendency toward all things dysfunctional; it will only delay the ultimate and necessary day of reckoning.”

Phil Britt ([email protected]) writes from South Holland, Illinois.