IF YOU KNEW WHAT I KNOW... Would you buy a municipal bond for the subways in New York City that’s rated AA-, or only A? Would you care what a bond is for as long, as it’s a general obligation backed by the issuer’s full faith, credit, and taxing power? Would you pay 109 for a bond, a premium of $90 for every $1,000 face value, knowing you’re going to get back only $1,000 at the end??Would it be crazy to buy a 30-year bond at age 80? Would you read “these bonds are not a debt of the state” as a fair warning, Buyer Beware??Tax free municipal bonds. Would you buy them at all? STRAIGHT TALK FROM THE MAN WHO PUT MUNIS ON THE MAP FOR THE INDIVIDUAL INVESTOR. Would telling you the whole story about investing in municipal bonds, and making sure you know the risks involved, kill the sale? “I’ll take my chances,” says Jim (Municipal Bonds Are My Babies) Lebenthal. For 45 years, Jim Lebenthal wrote and starred in the Lebenthal family’s municipal bond business commercials - information nuggets that educated the public and turned munis into a household word, wherever his face and voice were seen and heard. Outraged by what Wall Street had done to the financial markets with reckless abandon, and Bernie Madoff with malice aforethought, Jim gives equal time in Lebenthal On Munis…Deciding, "Yes…" or "No!" to the Whys and Why Nots for investing in his "babies." "Balancing the heady appeal of tax exemption with the payment record of municipal bonds in the Depression and the volatility of resale prices during the inflation tortured '70s and '80s, isn’t optional for a broker," says Lebenthal. "Full Disclosure is the law." In Lebenthal on Munis, Jim carries out that law, even if Full Disclosure means turning Jim and his babies, thumbs down. DECIDING, "YES…" OR "NO!"
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About the Author
Jim Lebenthal is chairman emeritus and former president of Lebenthal & Company, a full‑service investment firm in New York City that specializes in municipal bonds. Advest, Inc., purchased Lebenthal & Company in December 2001. Prior to joining his family firm in the late 1960s, Lebenthal held many of the most coveted jobs in the country. He was a filmmaker for Walt Disney—receiving an Academy Award nomination in 1959 for Best Short Feature. He was the Life Magazine Hollywood correspondent, and wrote advertisements for Ogilvy & Mather and Young & Rubicam.
Read an Excerpt
Lebenthal on Munis
Straight Talk About Taxâ?"Free Municipal Bonds For The Troubled Investor Deciding "Yes ..." Or "No!"
By Jim Lebenthal
OPEN ROAD INTEGRATED MEDIACopyright © 2009 Jim Lebenthal
All rights reserved.
"Second in Safety Only to U.S. Treasuries, Son." Verily! Verily!
IN THE YEAR 1963, when sowing oats for me ceased at age thirty-five and seeking happiness and self-fulfillment in municipal bonds began, 75 percent of the new munis coming to market were so-called full faith and credit, unlimited tax general obligation bonds (GOs), considered the blue chips of the bond business.
GO's are backed by all the revenue generating powers of the municipality—the main one being the power of the issuer to peg real-property taxes at whatever rate it takes to pay the interest it owes and principal at maturity. For a GO, payment of debt service isn't an option. It's a must. And bondholders have prior lien on the property tax, meaning bondholders get paid ahead of everyone else. Theoretically they do. Prior lien could turn out to be academic if the money to pay just plain isn't there. Yet just the existence of prior lien in Article VIII, Section 2 of the State of New York Constitution inspired me in 1975 to run a full-page ad in the New York Times that laid it on the line: "As a New York City bondholder, you get yours, before policemen, before firemen, before school teachers, even before the mayor." By the end of the year, New York City declared the moratorium and reneged on $1.6 billion general obligation municipal notes.
How Lebenthal & Company sought to reassure investors about the safety of New York City general obligation bonds in the city's 1975 fiscal crisis. Not so fast, said the SEC.
That ad grabbed more than just the public's eye. It also caught the attention of the SEC. So that when the SEC conducted its investigation into the mass marketing of New York City bonds to the man in the street, it earned me eight anguished hours on the hot seat (with an hour off for lunch) defending the audacity of that ad. "Where'd you get this stuff?" the investigator doing the grilling asked. "Where? Bond lore, sir, learned at the breast."
It was a beautiful day for me when the highest court in the state quashed the moratorium and told the city it had to pay up, adding, "a general obligation is not only an obligation to pay from available revenues, but an obligation to generate the revenues to pay." So yes, when a town is having difficulties balancing the budget, debt service isn't the last thing on the issuer's list of bills to be paid. Prior lien means it's the first. With that off my chest, now let me get practical.
Asbury Park, New Jersey, was flat broke, its taxing power exhausted, and it defaulted in the Depression. In 1942, the Supreme Court of the United States upheld a plan that refunded Asbury Park's defaulted bonds with longer maturities at full face value, but at a lower rate of interest. Justice Felix Frankfurter gave the opinion in Faitoute Iron & Steel Co. v. City of Asbury Park, N.J. "The notion that a city has unlimited taxing power is, of course, an illusion. A city cannot be taken over and operated for the benefit of its creditors." Obviously, all the revenues of a town would not be consumed in debt service, leaving nothing—zero—for the cost of essential services. Kids have to go to school. The garbage has to be hauled. The fire engines have to come. So, police power, public health, and safety, and laws of practicality could work against your immediate interest as a bondholder. But they rarely have.
Yes, as a class, a municipal bond backed by the full faith credit and taxing power of a city or state comes as close to the absolute as you can hope to get on paper. But "safe," "safety," "guaranteed," only address creditworthiness, the assurance of receiving your interest payments right along and getting your principal back at the end, if you stay the course. If you sell before maturity, you can make money or lose money. It all depends whether interest rates are higher or lower than when you bought your bond and on the fortunes of your particular issuer. Fluctuating resale values are simply a fact of life. Bonds go up. Bonds go down. "Market risk" goes with the territory. "Credit risk" is something else. Chancing not getting paid for a yield that is too good to be true is looking for trouble, unless of course, you know what you're doing, you're doing it with play money, and are out to pick up someone else's heartache for pennies on the dollar. Dad, who knew what he was doing, did it with bonds for draining the Florida Everglades in the forties. Those bonds stilled drained more out of him than they ever did the Everglades.
When uncertainty reigns, and the flight to safety is on, Treasuries and munis are ports in the storm. A comforting statistic has worked its way deeper and deeper into municipal bond lore: permanent loss of interest and principal from recorded defaults during the 1929–1937 Depression period totaled $100 million, a mere one-half of 1 percent of the average amount of state and local debt outstanding.
I grew up living with that one-half of 1 percent figure as an article of faith, until the day I discovered the rest of the story in a thin but loaded study of municipal bond defaults in The Postwar Quality of State and Local Debt by George H. Hempel. According to Hempel, 15 percent of the average amount of municipal debt outstanding—$2.85 billion, representing 4,771 state and local units—paid late and were in temporary default at one time or another in the 1929–1937 period. So, where did municipals get that sterling reputation for safety? From their record for eventual repayment. In the 1930s, almost all municipal bonds were GOs, obligated by law to pay. Default isn't allowed. There's also a practical reason why our towns will break their necks to make good, even when the chips are down. To default could permanently damage an issuer's credit. And without credit, the cash-flow problems, the budget problems, and all the other problems that existed before default become worse. Default only postpones the inevitable obligation to pay the full amount due.
Lateness does not forgive indebtedness. But I do want to acknowledge the legal out that could undo your hold on the issuer: Chapter 9 of the Federal Bankruptcy Law, as amended. Under the previous law, holders of 51 percent of an issuer's debt had to consent to any plan that involved taking less than 100 cents on the dollar before a court would even entertain the plan. Consent of the debt holder for the purpose of getting into court is done away with under the amended Chapter 9. Now a municipality can get into court and obtain Chapter 9 relief, if it is insolvent, has permission from the state to file for bankruptcy, has a plan to adjust its debts, and satisfies other conditions among them:
the plan has the consent of the holders of at least a majority of issuer's debt that would be adversely affected,
the bankrupt has negotiated in good faith but failed to reach agreement, or
negotiating with them is totally impractical.
Lateness, by itself, is not bankruptcy. Bankruptcy has to be a formal proceeding in federal court, because the Constitution of the United States forbids the states on their own to pass laws impairing the obligations of contracts. Unless a town throws in the towel and files the petition in federal bankruptcy court that it is unable to meet its obligation, the obligation to pay in full remains in force.
By Hempel's lights, "of the 48 cities with populations over 25,000 that were in default all were reported out of the hole by 1938." Such are the legal and pragmatic obligations to pay that among those forty-eight defaulting cities, five solved their defaults without any change of contract, twenty-eight did not scale down interest or principal in their refunding operations, fifteen scaled interest only, and no city in this group had any reduction of principal.
As an investor considering municipal bonds and knowing the one-half of 1 percent permanent loss but 15 percent late payment record, how would you react to a replay of the Depression scenario? Past performance is no guarantee of future results, but it does tell you what the insurance companies were thinking when they weighed the pros and cons of taking on the risk of guaranteeing the payment of municipal bonds. There may be a model here for informing your own investment decision.
Think about it. Insuring a municipal bond is the same bet on its not defaulting that you make when you buy a bond. It was the minuscule one-half of 1 percent permanent default figure that convinced the insurance companies this business of guaranteeing municipal bonds would be carrying the proverbial coals to Newcastle. For one thing, being late does not accelerate payment of interest and principal before it actually comes due. And by the time the full amount does become due, the Depression showed that the municipality would have the time to get back on its feet and cure the deficiency. Municipalities don't need bond insurance other than for marketing reasons and to lower borrowing costs by coming to market "triple-A, insured." What a peach of a business! It was when the municipal bond insurance companies took to wrapping with their guarantee and good name pools of subprime mortgages, packaged into Collateralized Debt Obligations (CDOs), that already were inexplicably deemed triple-A by the rating agencies, that the insurers then became casualties of the subprime mortgage disaster.
In 2005, the heyday of municipal bond insurance, 57 percent of the $408 billion new bonds that came to market were insured and rated triple-A by Fitch, Moody's, and Standard & Poor's. Forty-one percent of the 57 percent were guaranteed as to payment by the original big four insurers—AMBAC, FGIC, FSA, and MBIA. Since being stripped of their triple-A ratings, bonds insured by AMBAC, FGIC, and MBIA currently trade in the open market based on the rating of the underlying bonds, as if they had no insurance at all. Just when local economies are being strained by hard times, the value of municipal bond insurance is unquantifiable—and won't be known until an insured bond defaults and the guarantee is put to the test. Who wants to be stuck with an insured bond until that happens and find out the hard way what the insurance is worth? Stay tuned for an answer from FGIC-insured Jefferson County, Alabama—county seat, Birmingham.
Jefferson County debt is already past due on $3.2 billion sewer bonds that would be in default but for the forbearance of creditors who have agreed to stand still insofar as pressing their claim. Jefferson County is on the brink of filing for bankruptcy. What a feat it would be for all the municipal bond insurance companies if FGIC, once AAA, then CCC, and now unrated, had to make good on its guarantee—and actually could! Or, if an industry-wide consortium of municipal bond insurers stepped up to the plate and reinsured the troubled bonds. That kind if joint effort might save the day for the municipal bond insurance industry, while preventing the largest default in municipal bond history.
In the entire decade of the 1990s, according to Standard & Poor's, less than 1 percent of the average municipal bonds of all types outstanding were late paying. A surprisingly large number of $827 million out of $9.83 billion defaults were general obligation bonds, owing to one single issuer: bankrupt Orange County and its default on $800 million school GOs. After a year, when Orange County got back on track and repaid the $800 million, total GO defaults dropped down to $27 million, in the scheme of things almost zero. The record of payment in full and on time, notwithstanding, until confidence in municipal bond insurance is restored, it's back to analyzing municipal bonds on their own ability to pay and getting the answers to the questions you almost forgot to ask when most of the bonds that came to market were triple-A insured. You now have to analyze an underlying bond with insurance on the borrower's own ability to pay, its insurance be hanged.
Oh the things investors would ask before municipal bond insurance and so many AAAs suspended critical judgment.
So far, the power behind the GO to tax and the power behind the revenue bond to charge for a necessity of life have kept the flag off the ground. But, suffice to say, bad times don't just float up there in the clouds. It rains on the same place where the sun shines and where the revenues have to come from in all seasons—the cities and towns where the people, their homes, jobs, factories, and farms are. Advice to the trusting as well as the suspicious and questioning: go into municipals with your Hempels and your eyes open.CHAPTER 2
Income, and No Tax: How Long Can a Good Thing Last?
SINCE 1913, EVERY federal income tax law has exempted municipal bond income from federal income tax, although with increasing restrictions and limitations. When a state, U.S. territory, or local government needs money to build, say, a new sewage disposal facility, it borrows it in the tax-free municipal bond market—from firms like mine. We, in turn, lay off the loan, $25,000 here, $100,000 there, to investors like you. Two beneficiaries and one interested onlooker are involved.
Beneficiary One: The issuer who is able to borrow at below market rates because of the demand for any income that is tax free.
Beneficiary Two: You, the lender, who take a lower rate of return, hoping to gain more in taxes saved than in interest forgone.
The Interested Onlooker is the IRS, watching and almost tasting the mouth-watering aroma of $72.9 billion (in the year 2006 alone) in untaxable municipal bond interest waft under its nose like a pie cooling on a windowsill.
At first, immunity from taxation was accepted constitutional doctrine. The states couldn't destroy the instruments of the federal government for carrying on its lawful affairs. And the Feds couldn't tax the bonds of the states and their political subdivisions. But then in South Carolina v. Baker, 1988, the Supreme Court struck down a century of established case law with these words to the wise: "States must find their protection from Congressional regulation through the national political process," and not look to the Constitution. Oh, munis are still tax free—but only by the grace of Congress and only as long as 535 senators and representatives are convinced that states and communities should be allowed to borrow at low tax-free interest rates for genuinely needed public works. On the other hand, the case for tax exemption weakens when the spread between tax-free and taxable interest rates narrows to the vanishing point. The tax collector starts licking his lips when the issuer saves too little and the buyer of its bonds pockets too much. Would Congress ever tax municipal bonds? Would they? Could they? They can. And they do with:
estate taxes on the lower of market value at time of death or six months later
capital gains or ordinary income taxes on market appreciation
the Social Security tax on municipal bond interest
the alternative minimum tax on so-called private activity bonds
the outright ban of tax-exempt bonds for ballparks, health spas, funding state and municipal pensions, and anything else deemed blatantly nongovernmental
All that, plus rulings allowing the IRS to declare the interest of any municipal bond taxable that has not been issued in compliance with tax law.
One other question periodically pops up. What if the Congress overhauls the income tax system with a flat tax, consumption tax, or value added tax? What if the new system involves taxing all savings income alike, including municipal bonds, or leveling the playing field and extending tax exemption to all savings income alike? Without making too much of the risk of either happening, I do acknowledge the sensitivity of market values to anything that smacks of encroaching on the last bastion of tax exemption around. Having brought it up, I don't see a change in the preferential tax treatment of outstanding municipal bonds in the cards. But the discussion is heat from the kitchen investors have learned to live with. So consider the suitability of tax free municipal bonds for you in your tax bracket under the laws that exist now. Introducing the Taxable Equivalent Yield Table, the municipal bond industry's Rosetta Stone for turning tax exempt income into money that talks.
Excerpted from Lebenthal on Munis by Jim Lebenthal. Copyright © 2009 Jim Lebenthal. Excerpted by permission of OPEN ROAD INTEGRATED MEDIA.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Table of Contents
ContentsPreface. Because Disclosure Isn't an Option. It's the Law.,
1. "Second in Safety Only to U.S. Treasuries, Son." Verily! Verily!,
2. Income, and No Tax: How Long Can a Good Thing Last?,
3. In Pursuit of a Knowable, Quotable Fixed Rate of Return:. Yield to Maturity,
4. Never All Short, Never All Long, Never All Wrong,
5. Degrees of Sincerity in the Commitment to Pay,
6. How Much Is That in Dollars?,
7. When the Flag Touches the Ground,
8. Matching One You with a Million and a Half Possibilities,
9. The MuniProfiler A Model of Lebenthal in a Bottle,
10. Triple-A Insured 1971–2008,
11. Auction Rate Securities: the Risk that Wouldn't Go Away,
12. "By Their Deeds You Shall Know Them.",
13. Who Reads the Prospectus, Anyway? (Hey, It's Only Your Money!),
14. How to Slow Down a Fast-Talking Bond Salesman,
15. To the New Kid in Sales (and Talking to Investors Over the New Kid's Shoulder),
16. Munis Doing Just Swimmingly in Waste-Water Treatment Plant Cleaning Up Our Rivers and Streams,
Epilogue. Build America Bonds Go To War,
The Entertaining and Highly Informative Lebenthal Glossary,