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Cracks in municipal debt markets raise questions about future Fed action

Brian Cheung
Reporter

The coronavirus is taking its toll on state and local governments across the country, as funding strains force municipalities into balancing layoffs against providing essential services to Americans that were laid off themselves.

Investors fleeing from the municipal debt market also means municipalities are having difficulty issuing debt to finance themselves. In Jersey City, Mayor Steven Fulop is trying to plug a $70 million hole; $50 million of unanticipated revenue losses and $20 million in higher expenses to continue offering its community services.

“While layoffs are a last resort, the public should be aware that just because we’re government, we’re not immune from what’s happening.” Fulop told Yahoo Finance.

Normally, local and state governments have the option of issuing municipal debt to fund projects or the general account. But investors were hesitant to play in muni debt markets as businesses began closing en masse across the country, raising concerns about financial consequences of collecting taxes on businesses that have closed down.

A man wears a face mask as he leaves the Jersey City State Office Building, after it was closed following the outbreak of coronavirus disease (COVID-19), in Jersey City, New Jersey, U.S. March 19, 2020. REUTERS/Eduardo Munoz

Eroding confidence in the municipal bond market sent yields spiking across the board. 

A one-year Jersey City bond maturing in January 2021 was issued two months ago at a yield of 0.98%, according to data from S&P Capital IQ and Securities Evaluations. On March 18, after New Jersey announced state-wide school closures and ordered businesses to shut down, yields spiked to as high as 4%.

Comparable 1-year U.S. Treasuries were trading at about 0.19% that day. 

“We were trading as if we were going to default and I knew we weren’t, but that’s where the market was,” Fulop said.

The same story is playing out for states and cities across the country. EPFR data cited by Goldman Sachs shows that as of March 27, mutual funds purged $10.7 billion in muni bonds year-to-date. 

The Federal Reserve has stepped in by offering short-term loans to investors looking to temporarily liquidate their muni bond positions, through its Money Market Mutual Fund Liquidity Facility. But with unemployment insurance claims overloading state governments, the Fed is facing calls to act further on muni markets.

Cut, cut, cut

At the state-level, a deeper concern is the massive funding gap that existed before the coronavirus arrived in full form. The U.S. Department of Labor said in February that 22 states and jurisdictions had unemployment insurance solvency levels below recommended standards.

States fund unemployment insurance through taxes paid by employers on wages paid to employees. The DOL broadly measures solvency by comparing the size of the trust fund against the total wages paid under unemployment insurance programs for the year.

The U.S. Department of Labor recommends that states hold their trust fund solvency ratios at around 1. Full methodology behind the DOL's solvency measures are located here. Source: Department of Labor

New York is the second worst state by solvency. Lawmakers are now projecting a total budget shortfall of up to $15 billion as the death count from COVID-19 topped 1,200. Many states will cover fund shortfalls by borrowing from the federal government and issuing muni debt to pay it back.

But with muni markets drying up, states are turning to cutting expenses.

“We’re not in danger of failing to meet our obligations but we’re going to have to cut to the bone and make some very difficult choices about where the state is spending its resources,” New York State Senator Michael Gianaris said.

Other states have already turned to layoffs. In Pennsylvania, for example, about 2,500 part-time and seasonal employees were reportedly cut

All the while, governments are scrambling to support critical resources like unemployment insurance call centers. Despite the record-smashing 3.283 million figure for unemployment claims reported March 26, anecdotes of callers boxed out by stuffed phone lines means that number should have been higher.

In Tennessee, the state had already redirected its workforce development staff into full-time claims processors. Connecticut reportedly did the same.

The federal government’s unemployment insurance program approved last week will offer some relief to those that lost their jobs: an extra $600 each week, for up to four months. 

Action from the Fed

The Fed’s liquidity facility helped bring some calm back to muni markets, but Nomura wrote March 27 that it still expects the institution to directly buy short-dated municipal securities “relatively soon.”

The Fed does not have the authority to buy long-duration muni bonds, but a proposal from New Jersey Senator Bob Menendez would give it the power to buy muni bonds of “any duration.”

The legislation was not taken up in the bill signed by President Donald Trump last week, but the bill does direct the U.S. Treasury to work with the Federal Reserve on some program or facility that “supports lending to states and municipalities.”

In Jersey City, the Fed’s actions brought yields on its January 2021 bonds back down to 1.97%.

Mayor Fulop, who was in touch with Menendez about supporting the muni debt market, says he still sees stresses in the market but has “a little bit more comfort” with Fed actions at this point. He said he expects the Fed to step in further soon.

“The alternative is unsustainable for the country,” Fulop said.

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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