Thursday, June 10, 2010

Would You Buy This Stock? Then Why Own The Bonds?

Keeping in mind Warren Buffett’s dictum to “buy, for a rational price, a piece of a business that you’re reasonably confident will have materially higher earnings 5, 10, 20 years from now, and never sell,” we hereby examine an incorporated entity which we believe represents a healthy slice of the American landscape.

The enterprise in question has been in existence for more than 200 years, and that alone is remarkable given the horrible mismanagement it has suffered over that time, particularly in the last few decades.

Looking at the income statement, we see that annual revenues approximate $15 million, which is unfortunate because expenses are running $18 million this year and are expected to rise to $20 million next year.

This upside-down “income” statement thus explains the balance sheet, which shows $17 million in general obligation debt.

Worse, the enterprise carries an eye-opening off-balance sheet liability in the form of a defined-benefits pension plan. (Our enterprise unfortunately never switched over to 401-K plans, and so it is stuck with an old-fashioned defined-benefits pension plan and its old-fashioned liabilities.)

The plan is somewhat underfunded. And by “somewhat” we mean “humongously.”

Specifically, the pension liabilities (accruing to a largely unionized workforce) stand at around $35 million.

Assets to support those liabilities, meanwhile, cruise in at a cool $4 million.

So on top of the $17 million in debt outstanding, add a $31 million unfunded pension obligation—and consider that we have no details on the assets themselves or the assumptions used to define the liabilities, so the net obligation could be worse.

All in all, our enterprise generates negative pre-tax income but carries close to $50 million in debt and long-term obligations.

So, to our question, “Would you buy this stock?” the answer, of course, is “No.”You’d pass on the opportunity to buy, and you might even sell it short.

And maybe—after the poor suckers who own the bonds really take the place over, clean house and install good management—you’d revisit the situation.

The “enterprise” in question is not, however, a company in the publicly-traded sense of the term.

It is a city—Central Falls, Rhode Island—whose tale of woe was only partly told in yesterday’s Wall Street Journal, and it is a stark sign of things to come for America’s municipalities.

For while Central Falls appears to have been run into the ground by its own unique blend of corruption and unsupportable promises to unionized employees—according to the Providence Journal, the mayor hired an old pal to board up 200 abandoned buildings at an average cost of $10,000 a piece, while nearby Providence pays $660 a house—it is by no means alone.

Indeed, our backyards teem with thousands of Greeces and Hungarys that, like Central Falls, are in far worse shape than those countries. They are already bankrupt in fact, if not in name.

Yet, oddly, for now, the world—and American fixed income players—seem to focus exclusively on the problems of Greece and Hungary, Spain and, perhaps even the United Kingdom, while using the American Dollar and our own long-term debt obligations as what the press likes to call “safe havens.”

But if you wouldn’t own them as an imagined stock, why would you own their very real bonds?

Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

Photo Courtesy of Providence Journal

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Anonymous said...

I have to admit Jeff, for the first 2/3 of your article I assumed you were talking about the US, not some small town. Scary to think the number of municipalities in the same situation, and then some entire states... where exactly is the revenue supposed to come from to pay US obligations if all of its subsidiaries are dramatically underperforming. ugh.

Anonymous said...

For the first few paragraphs, I thought you were talking of the US Federal government, with the numbers scaled down a few hundred thousand times to not give it away.

frozeninthenorth said...

The problem is so severe, that at the hight of the federal government stimulus late last year, total government contribution to the economy was negative. In other words, despite massive federal expenditure, states, municipalities and cities were cutting expenditure.

My favorite is Nevada; if Nevada fired every single employee on its payroll it would still be in deficit. That's bad!

I understand that 200,000 teachers across America will lose their job at the end of June, because of cut backs. Wait till they cut prison guards, police officer and court services...

Jeff Matthews said...

What all states and municipalities need is a good old-fashioned Chapter 11 restructuring of unfunded liabilities. Our legislators have promised too much to too many.

In Connecticut, for example, if you're a State Representative for 10 years, you get free health coverage for life. For life.

Merely for putting in 10 years' worth of part-time, summers-off, run-the-state-into-the-ground so-called work.

That is what is killing America--funding benefits for unproductive workers.

A restructuring won't happen, of course--because those unproductive workers control the legal system--but it should.


PhillipCharles said...

Chicken Little. The world was not a 'better place' 50 years ago. We are not Greece and Obama is not a Socialist. The entrepreneurial spirit and American drive to work hard is the greatest resource this country has, and in addition to the bounty of natural resources we own, they will continue the fuel the incredible growth the U.S. enjoyed since the middle part of the 19th century. Half of this country thought FDR was a communist and his administrations precipitated the greatest standard of living in the history of the world. This whole doom and gloom story that is being offered up by commercial media is getting old. That being said, I greatly enjoy your posts, Jeff. They continue to be insightful and educational.

wcw said...

Municipalities have the power to tax.

Corporations do not.

I am surprised I have to explain this to you.

FD: long California munis.

Jeff Matthews said...

WCW helpfully explains that municipalities have the power to tax, while corporations do not (try telling that to Microsoft), and recommends buying California munis.

This shocking bit of news causes the mind to reel. Of course! They can tax their way out!

It's not going to help Central Falls, RI. And it didn't help Vallejo, CA. The "power to tax" did not stop that municipality from filing bankruptcy.

Let's hope WCW wasn't long Vallejo paper under that misguided notion that the "power to tax" means municipal debts always get paid...and always will.


PhillipCharles said...

WCW should recommend buying California munis, as does the rest of the market. California has a very strong and robust economy, and debt service is something like 2-3 percent of the state's budget. In addition, munis go bankrupt at a miniscule fraction of one percent. A little due diligence will allow even a Jr.-high investor to avoid a situation like Vallejo.

Jeff, methinks you watch to much Fox Business Channel.

Jeff Matthews said...

PhillipCharles may watch TV for investment advice, we don't.


But What do I Know? said...

Just because they can "tax their way out" doesn't mean they will.

BTW, if it was so easy, why did Obama ask for $50 billion over the weekend so the states and locals wouldn't lay people off?

BobE said...

Looks like someone reads this blog. Or is the timing on this op-ed just purely coincidence?

fd: I don't own or follow munis. Someone else in my firm does that and I didn't ask him what he thinks about California paper. It's not nice to make a man toss his breakfast on a Monday morning.

John said...

The power to tax is limited to the amount of people hanging around to tax. A look at the population of Detroit shows that this is not always an increasing number. Even if municipalities do tax at the revenue maximizing rate it is beginning to appear that unless we enter an unforseen period of growth, many towns are past the point where that revenue will cover their obligations. I think that broadly speaking, investing in municipal bonds is a bet that the federal government will provide funds to bailout states and cities in some form or another. Interestingly then, muni investing also becomes a sort of political futures market as Democrats and Republican will have sharply divided views on who should be the losers in any type of widespread bailout/ restructuring of municipal debt.

James said...

u"nsupportable promises to unionized employees—according to the Providence Journal, the mayor hired an old pal to board up 200 abandoned buildings at an average cost of $10,000 a piece, while nearby Providence pays $660 a house—"

Is the second part supposed to be an example of a promise to unionized employees? I think unionized employees in the US as a whole are around 10% of employees, while being about 30% in the public sector. Not sure why they remain such a popular target.Even without a union, I am pretty sure that much of the public sector costs would still be labor (and you could still blame them).

Jeff Matthews said...

James question the observation that the unsupported promises to unions (in the form of healthcare benefits and pension promises not seen in the private sector) underlie the crisis in public finance.

It is, however, the fact that the teacher's union dominates public spending, and the unfunded benefit promises that go with it.


Anonymous said...

Professor Jeff:

Your post and the various reader responses to it got me thinking about the concept of process – namely, the questions one should ask when investing in an asset like municipal bonds. With apologies to Ron Popeil, the days of “set it and forget it” investments in munis are long gone thanks to: a) the nearly insolvent muni bond insurers like Ambac who bet, and lost, on insuring poorly collateralized mortgage-backed bonds; b) the upside down finances of state and local governments whose expenses loom larger than their shrinking tax revenue base; and c) the credit rating agencies like Moody’s whose opinions cannot be trusted in the wake of poorly timed downgrades on bonds for institutions like Enron, Greece, or even Orange County, California.

Therefore, individual investors need to be more vigilant when investing in muni bonds which some institutional investors perceive as now containing greater risk than either corporate or Treasury bonds. Those risks can, to a degree, be mitigated by asking the right questions about muni bonds such as:

A) What is the bonds’ yield to maturity?
B) What is the taxable equivalent yield of the bond?
C) Is the bond insured, and if so, by whom?
D) Is the bond callable?
E) Is the bond general obligation or is the bond backed by a specific revenue stream like tolls as an example?
F) What would a rise in either interest rates or inflation do to the bond’s price?
G) What events would jeopardize the ability of the issuer to repay either the bond’s principal or the bond’s interest coupon, and does the bond’s price reflect those risks?
H) Do credit default swaps trade on the bond, and if so, what is the basis point spread?

The questions posed above should not be construed as investment advice but as a guide to better understand the risks inherent in a municipal bond. If your broker or your financial advisor cannot answer the questions above when suggesting an investment in a municipal bond, RUN, don’t walk, to the nearest computer, and look the answers up yourself. By thinking for yourself, you cannot possibly do any worse than professional investors looking for the same answers to the questions above.

FD – I have no investment position (long/short) in the bonds of Central Falls, RI.