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Cities and towns need to start planning: The leaking housing bubble has already done a great deal of damage, and is getting worse. What will we do when the worst comes?
Unfortunately, many municipal officials around the country are living in a Charlie Brown dreamland, where no problem is so big that it can't be run away from. They're ignoring what's going on right before their eyes, and acting as if the Hand of God (or, even less likely, the Hand of the Federal Government) were going to reach down and reflate the housing bubble.
On this web site, I frequently post this advice: You can't stop what's coming, but you can prepare for it. Treasure the time you have left, and use it to prepare yourself, your family, your community and your nation.
We've focused a great deal on how to prepare yourself and your family, but how can your community prepare? The purpose of this article is to answer that question, and to encourage cities and towns to start preparing now.
There's certainly a desperate need to prepare. Foreclosures are surging across the country, because so many people are "under water" in their homes.
What this means is that, thanks to falling home prices, homeowners increasingly owe more on their mortgages than their homes are worth. As ARM (adjustable rate mortgage) "teaser" rates reset -- and most resets are due in the next year -- homeowners are faced with double or triple their original monthly mortgage payments.
Even homeowners who theoretically could afford to meet their mortgage payments often see no point to doing so, and simply walk away. According to CNN Money:
Beyond anecdotes, some statistics indicate that hard-pressed owners are deliberately courting foreclosure. An analysis by the consumer credit rating agency Experian last spring found that many borrowers were choosing to pay off credit card and other consumer debt before making mortgage payments. They were electing to put their mortgage at risk rather than their credit cards or auto loans."
And it's going to get worse -- much worse. Municipal officials around the country are sticking their heads in the sands about this, desperately clinging to the belief that housing bubble is going to start inflating again. That's absolutely not going to happen.
In fact, a study by Merrill Lynch says that home prices are going to continue to fall -- by 25% through 2009. Thus, the total value of the nation's housing will fall from $20 trillion to $15 trillion.
This means that the worst is yet to come, according to a study reported in New York Times:
Many owners are only gradually becoming aware that their homes would sell for less than the debt against them — a phenomenon, said Richard T. Curtin, director of the Reuters/University of Michigan Surveys of Consumers, that is "beginning to weigh on people, making them uncertain and nervous about the future." ...
"People can’t believe this is happening to them," said Robert Moulton, president of the Americana Mortgage Group in Manhasset, N.Y. ...
[Bank of America] has warned that tightening credit conditions were leading to "escalating levels of delinquency and default among borrowers" and "an unprecedented number" of homes that would enter foreclosure."
Municipal officials around the country have got to stop living in a fantasyland where they talk about next year's budget as if it were going to stay constant or increase.
The surging foreclosure problem is going to cut deeply into funds available to municipalities:
All of these factors mean that the money available for teachers, schools, police, firefighters and municipal programs must be cut drastically.
I'm constantly reminded these days of a remark by one of my school teachers in the 1950s. Her name was Miss Shepherd, and she had a wooden leg -- I assume she lost her leg in the war, but I don't know. Anyway, one day out of the blue she said, "People think that if you have a job as a schoolteacher, then your job is safe, because they always need schoolteachers. But that isn't what happened in the 1930s. They would put two or three classes together in a single room, and replace three teachers with just one teacher." That's all I remember, except that she was very emotional when she said it -- a combination of anger and sadness.
That's what almost every municipality is going to be looking forward to for the next few years. The earlier that you start preparing, the better off you'll be.
In bubble times, and even in normal times, cities and towns get through rough times by borrowing money. And they get a pretty good deal, because they have to pay very low interest rates.
Muncipalities borrow money by selling tax-free muncipal bonds. Investors who purchase municipal bonds don't have to pay taxes on the earned interest, and this is very appealing to wealthy investors in high tax brackets. Furthermore, municipal bonds are considered extremely safe, because muncipalities can pay them off from real estate taxes if necessary. Because of these two advantages, municipal bonds typically have always been considered very safe, and pay very low yields (interest rates). This was a big advantage to municipalities, who end up borrowing money almost for free.
Unfortunately, most municipalities weren't satisfied with these advantages; they wanted more. And so, just as mortgage loans have been "securitized" into CDOs, municipal bonds have been "securitized."
(For those interested in the math behind the creation of CDOs from mortgage-backed securities, and how they get AAA ratings from "monoline" bond insurers, see "A primer on financial engineering and structured finance.")
Not only that, but additional structured finance techniques were used. They became "auction rate securities" (ARSs) which I described in "Wealthy investors in auction rate securities can't get their money out." The ARS concept is to take advantage of short-term yields, which are usually lower than long-term rates. By running an auction every couple of weeks, the yields are always short-term, even though the underlying bonds are long-term.
That works great as long as the auctions work great. But thanks to the credit crunch that began in August, 2007, investors stopped bidding at these auctions. As a result, municipalities can no longer sell bonds through ARSs.
Financial instruments today are intricately interlocked with one another in ways that no one understands. A short time ago, a ratings agency lowered the debt rating of some of the assets owned by Ambac, the bond insurer. The triggered a lower rating on some state government bonds insured by Ambac, which frightened off investors in these and other muncipal bonds.
And so we have a mess. Investors who own municipal bond based ARSs can't get rid of them, and muncipalities can't sell any more of them.
The result is that municipal bond market today has effectively collapsed.
Some analysts have been ridiculing this situation, pointing out that muncipal bonds have always been extremely safe.
That may have been true in the bubble days, but it's not true any more. Governor Arnold Schwarzenegger declared last month that the entire state of California is in a state of fiscal emergency.
The city of Vallejo, located just outside of San Francisco, will not be able to meet payrolls on March 31, and is close to declaring bankruptcy. Negotiations are continuing, and depend on whether labor unions will agree to forego wage increases. According to Bloomberg,
"What happens in Vallejo is going to be the model for what happens across the state," Stamper said yesterday. "It will have a big impact."
It will undoubtedly also be a model across the country. And so, despite what the analysts and pundits say, municipal bond really aren't particularly safe -- not any more.
The collapse of the municipal bond market is having a domino effect in the world of hedge funds. Many large hedge funds have been investing in municipal bonds, and are getting into trouble, thanks to the same problem with auction-rate securities.
In fact, these hedge funds started to get into trouble in August, when the credit crunch began, according to an article that appeared at the time.
By now, these hedge funds have lost enough money that they've used up all their spare cash. They're now being forced to sell their municipal bonds at fire sale prices, just to get some cash. This fire sale is flooding the market with municipal bonds, pushing their prices down lower and their yields higher. (The lower the price on a bond, the higher its yield (interest rate) is.)
So municipal bonds often can't be sold at all these days or, if they can, it's only at very high yields that would require the municipality to pay exhorbitant interest rates for years.
Perhaps it's natural for city and town officials to play ostrich and pretend that this problem doesn't exist. After all, it's going to have horrible consequences, and nobody wants to think about them until forced to.
Even worse, some town officials may be under water in their homes and may be facing foreclosures themselves. They may be afraid that dealing with the town's problems will lead to their own humiliation. This is no reason why a town should delay planning.
The problem is that this problem will only get worse. A town that starts planning early can at least save money by not making unnecessary expenditures. There's no question that a town whose officials start thinking about this problem early will have more options available than a town that waits until they're forced to act.
Some people may believe that facing this problem will make their town look bad. Actually, I believe that the opposite is true -- a town that starts planning can turn it into a public relations positive, and may thus get some benefit from it.
There are darker reasons why some officials may be unwilling to deal with this problem.
Some municipalities may be in trouble because the town officials invested in CDOs or other structured investments that are now near-worthless, and they're afraid to let this information become public.
Jefferson County, Alabama, is being particularly hard hit. The county commissioners issued $3.2 billion in municipal bonds for the sewer system in the form of ARSs, and now the auctions have failed. The result? The County is now facing hundreds of millions of dollars in additional interest payments.
Even worse, some town officials may have gone even farther.
John Kenneth Galbraith, in his study of the 1929 crash, found that many desperate people resorted to embezzlement to try to save themselves financially. It's possible that some town officials may have embezzled from someone, perhaps even the town, and are afraid the embezzlement might be exposed.
These problems are all going to be exposed anyway. In good times (i.e., bubble times), when everyone is making money, then problems are ignored, and even embezzlement is ignored. When times turn bad, then everyone becomes an auditor, and every account is examined with a fine tooth comb. We're going to see a substantial spike in these kinds of crimes, just as happened in 1930.
These are all good reasons to start planning for this fiscal problem. At the very least, every city and town should "lock down" all its funds right away, to make sure that they remain safe as the situation worsens.
Here's an example: Students from the Flint, Mich., campus of University of Michigan are volunteering to clean up foreclosed properties, performing such chores as cleaning debris, tearing up old carpets, and replacing boarded up windows, so that the house can be made available for another family. Some students were part of a pilot series of classes at the university aimed to get first-time college freshmen more involved with the surrounding community. Others were just volunteers.
Flint is particularly hard-hit, because of the loss of jobs at General Motors, but there's no reason why any town can't proactively set up a program like this, before it becomes absolutely necessary.
Many of these programs could make sense even in "normal" times; but they are essential in these increasingly difficult times.
Here are some examples:
These are just ideas that any city or town might consider.
It's worth pointing out that most of these ideas cost little or no money, but can have ENORMOUS impact in making lives easier for the people of the city or town when the worst comes. It won't be possible to help everyone, but these plans could help a significant number of people who would otherwise have nowhere to turn.
The most difficult problem will be getting people to cooperate in planning, or even to thinking about this situation.
Unfortunately, there's very little sense of community these days, much less so than, say, ten years ago. "Community" is nice, but there's little interest in it these days. Everybody's out for himself, even at the expense of other people. That's why the coming financial crisis.
If people in your community start planning now, before it becomes a full-fledged crisis, then it may be possible to create a cooperative atmosphere that will be to everyone's benefit.
What I've said many times is worth repeating now: Treasure the time that you have left, and use it to prepare yourself, your family, your community and your nation.