Great Depression lessons for the coronavirus-era municipal market


With some economists forecasting the worst downturn since the Great Depression, municipal bond investors might want to know what happened to state and local debt securities during that event. In short, the Great Depression was a predictably tough time to own municipal bonds, which is one reason the U.S. should try to avoid a repeat.

Research by Dr. George Hempel, more recently replicated by me, indicates that there were around 5000 municipal bond defaults during the Great Depression. These were outright payment failures, and not technical defaults. Many of the defaults were chronicled in the pages of The Bond Buyer — a primary source for my own research. Another great source of default information from the period is old Moody’s Bond Manuals — copies of which are still gathering dust in libraries around the country.

Default rates varied widely across the country. In Florida about 75% of municipal bond issuers defaulted. Other hard-hit states were North Carolina, Louisiana, New Jersey, and Arkansas — the only state to default during the period or at any time during the 20th century. By contrast, I found no evidence of municipal bond defaults in most New England states, which is important because?

Florida did especially poorly because its local governments had taken on enormous volumes of debt to build infrastructure in anticipation of a population influx that failed to materialize. But potential transplants were scared off by the 1926 “Great Miami” hurricane and a fruit fly infestation around the same time; defaults began well before the stock market crash of 1929.

My statistical analysis confirmed the intuition that cities with greater debt burdens and sharper revenue declines were more likely to default than those that borrowed less and maintained more stable revenues. This time around, if the 2020 economic downturn is severe, Florida is at less risk of leading a municipal default wave because its state and local debt load is near national averages.

Comparing Census and BEA data for 2017 — the most recent year available — we see that Florida’s ratio of state and local debt to Gross State Product (GSP) is only slightly above the national average of 10%. States with the highest state and local debt/GSP ratios are Kentucky, Nevada, and Texas. Overall nationally, municipal bond debt as a percentage of national output is far below 1929 levels.

While this might be a source of reassurance for municipal bondholders, two countervailing factors may serve as causes for concern. First, willingness to service municipal bond obligations is much lower than it was during the Depression era. One particularly striking case was that of Yonkers, New York, which stopped paying employees while meeting its bond payments in 1933. That is unimaginable today. It is difficult to imagine a city or state prioritizing paying bondholders ahead of giving its employees their paychecks.

Also, back then, state and local pensions were smaller and less common. Other postemployment benefits, like health care, were virtually non-existent. In recent municipal bankruptcies, pension beneficiaries have obtained better recoveries than some classes of municipal bondholders.

Turning to the issue of revenue declines, one source of revenue volatility is not familiar to modern municipal investors: widespread property tax delinquencies. New York City and Detroit, which both defaulted in 1933, had delinquency rates of 27% and 35% respectively. Chicago had an even higher delinquency rate but was able to avoid default thanks to support from local bankers.

It is hard to imagine such high property tax delinquency rates today because Americans have so much equity in our homes. But an extended economic shutdown and long-term massive unemployment — over 26 million Americans filed for weekly unemployment claims in the last four weeks — could cause severe markdowns in the valuations of many commercial properties. In that case, owners carrying large mortgages might find it rational to walk away from both their mortgage and tax obligations.

More immediate revenues threats today are sharp declines in sales tax, transient occupancy taxes, car rental fees and real estate transfer taxes — sources that played much smaller roles in the Depression era. Local governments in Nevada, for example, may have especially elevated risk given the combination of high debt burdens and the extreme pressure on tourism-related revenues.

State and local government finance has changed a lot since the Great Depression, so a repeat of that era’s default experience is not preordained even if this contraction matches the worst predictions. But, while history doesn’t repeat, it often rhymes, so it is worth studying the lessons of that bygone era.

The two big takeaways for today are that state and local governments should minimize risk by keeping debt accumulation in check, especially by restraining the growth of unfunded pension liabilities. And, as governments focus on public health, they should keep fiscal health in mind as well. Sharp revenue declines will force uncomfortable choices between service beneficiaries, public employees, retirees, and bondholders. Overly broad lockdown policies will make these budgetary choices even more difficult.

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