MIKE TOWNSEND: Congress made its first attempt at a return to normalcy last week, with the Senate reconvening for a regular week of sessions for the first time since March 26. And the result was … really weird.
Seven senators never came back to Washington at all, refusing to risk their health for what several termed non-critical votes on low-priority business. Many senators stayed hidden in their offices or even their local apartments, videoconferencing into committee meetings and appearing in person only for the four votes that were scattered over the course of the week. Some showed up in masks when they were on the Senate floor, and others did not. Social distancing made for awkward meetings in cavernous hearing rooms. And most staffers continued to work from home.
In spite of all the precautions, by the end of the first week, Senator Lamar Alexander, a Republican from Tennessee and the chairman of the Senate Health, Labor, Education, and Pensions Committee, was announcing that he would self-quarantine for 14 days in his home in Tennessee after one of his staffers tested positive for the coronavirus. It was a sobering reality check that underscored just how complicated the decisions facing policymakers in the nation’s capital are and will continue to be.
Welcome to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend, and on this show, our goal is to help investors sift through the avalanche of news and information to better understand how this unprecedented crisis is affecting the markets.
Coming up in just a few minutes, we’ll explore the “state of the states,” with a closer look at the impact the pandemic is having on state budgets and the implications for municipal bond investors.
But first, let’s take a look at the other stories making news right now.
On Capitol Hill, all eyes are on House Democrats as they put the finishing touches on their proposal for the next round of coronavirus aid legislation.
To date, Congress has passed four other aid bills, but this time feels different. Those bills were the products of bipartisan negotiations and all achieved near unanimous support. Not so with this round.
Democrats in the House are making no pretense about bipartisanship: They are going this one alone. House Speaker Nancy Pelosi acknowledged late last week that the bill is likely to pass the Democrat-controlled House without much, or possibly any, Republican support. “We have to start somewhere,” Pelosi said. But she added that eventually, “we will need a presidential signature, so at some point, we’ll have to get an agreement.”
Instead, Pelosi has been focused over the last couple of weeks on getting buy-in from members of her own party. Many Democrats had grown frustrated that the previous rescue bills were negotiated by a tiny group of leaders from the two parties, without the usual committee process or any input from rank-and-file members, who were then expected to support the result without question. So Pelosi directed House committee chairs to collect ideas for this round of emergency spending and submit those ideas to party leaders. Not surprisingly, the result was a lengthy wish list that represented the priorities of more than 200 Democratic House members—running to more than 1,800 pages, and the price tag is at least $3 trillion.
So what made it into the House proposal? The centerpiece is $875 billion for state and local governments. The proposal also replenishes programs from the CARES Act, including more funding for hospitals, more funding for small-business loans, and additional unemployment benefits, as well as another round of payments to individuals.
New ideas include money to stabilize the Postal Service, hazard pay for front-line workers like doctors and nurses, and assistance with rent and mortgage payments for those who are struggling to keep up.
With Democrats holding a 233-196 advantage in the chamber, they should be able to pass the bill easily—and a vote is expected on May 15. But that’s when the real work will begin, as Senate Republicans have shown little enthusiasm for moving quickly on any bill. And when they do, it’s likely to be with hugely different priorities, including liability protection for businesses and possibly even a tax cut.
So don’t expect a quick resolution. In fact, it’s looking increasingly likely that the next round of emergency spending won’t happen until the early part of June.
Elsewhere, there is intrigue rising around the Paycheck Protection Program, the emergency small-business loan program that was passed by Congress as part of the CARES Act in late March.
The program blew through its original allocation of $379 billion in just 13 days in early April. It then received an additional $320 billion in funding in the so-called “interim” bill that passed in late April. But the second round has seen a dramatic drop-off in lending.
In the first week of the re-started program, about $175 billion was loaned to more than 2.2 million businesses. But last week, the second week of the program, just $13 billion was accessed by fewer than 400,000 businesses.
One spin on these numbers is a positive one. After the program was criticized for making loans to businesses that met no one’s definition of “small” in the first round, the second round has emphasized small lenders making loans to the smallest businesses, as well as businesses in underserved areas. That has resulted in the average loan size, which was $206,000 in the first round, dropping to $73,000 in this round—a clear signal that smaller businesses are getting more of the help they need.
But there are also concerns that the numbers are masking more worrisome trends: that businesses are being scared off from requesting loans by complicated rules, a glitchy system, and the risk of public relations blowback. And most worrisome of all, some think that the program has seen a big drop-off because many business owners have already given up and shuttered their businesses for good.
Treasury Secretary Steven Mnuchin said earlier this week that he was open to relaxing some of the rules in place for the program, in hopes that it might make it easier for small businesses to get the help they need.
On my Deeper Dive this week, I’m pleased to welcome Cooper Howard, director of fixed income at the Schwab Center for Financial Research. Cooper’s going to help us better understand how the pandemic is affecting state budgets—and what that means for municipal bond investors.
Cooper, thanks so much for joining me.
COOPER HOWARD: Thanks for having me Mike, It’s great to be here.
MIKE: Cooper, let’s begin with something that got everyone’s attention last month. Senate Majority Leader Mitch McConnell suggested that states should declare bankruptcy rather than wait for more federal aid. Can a state even do that?
COOPER: The simple answer, Mike, is no. And the reason is that there is no provision in the bankruptcy code that allows for a state to file for bankruptcy protection. And in fact, Congress would have to pass a new law allowing a state to do that. And given the current makeup in Congress, we think that that’s extremely unlikely. Even if you fast-forward to November and assume that the makeup in Congress changes, we think that it’s still a highly unlikely scenario that would play out. And the reason being that it would likely be challenged in court as being unconstitutional under the Contracts Clause.
And it’s probably an issue that would make its way all the way up to the U.S. Supreme Court. And the reason being is that there’s a Supreme Court case dating back to 1977, where the Court found that “a state cannot refuse to meet its legitimate financial obligations simply because it would prefer to spend the money on something else.”
So if it made it up to the Supreme Court, they’d actually have to reverse course and rule differently than they previously did. So the bottom line that I would say on this, Mike, is that the phrase “state bankruptcy”—it’s akin to the boogeyman. It’s something that is very scary to talk about, but the reality is that it just doesn’t exist.
MIKE: Well, Cooper, one of the reasons that Sen. McConnell brought this up was because allowing states the ability to file for bankruptcy could be a means of addressing their pension expenses. So under the imaginary scenario where states could file for bankruptcy, what are your thoughts on how that would play out?
COOPER: Well, we’d have to look at city bankruptcies as a guide here, because, like you said, it’s an imaginary scenario to allow a state to file for bankruptcy. And in city bankruptcies, it hasn’t been an effective way of reducing a pension expense. And in fact, recent city bankruptcies have actually favored pensioners over bondholders. Meaning that when all of the dust was settled, pensioners actually received more money in terms of a percent of what they were owed, versus bondholders.
An example would be Stockton, California’s bankruptcy from 2012. And in that case, a judge allowed retirees to recover all of their future pensions, including the unfunded liability, while lowering recovery rates for bondholders.
So from a bondholder’s perspective, it’s actually more important to look at, what is the cost of the pension? In other words, a municipality that provides a pension, they have to use a portion of their revenues to help fund that plan. And these revenues have to compete with other priorities like debt service.
And the good news is that pension contributions, they’re generally a low amount of revenues.
So they average about 4-5 cents per dollar of own-source revenues. Own-source revenues would be something like tax revenues, things of that nature, that the state actually produces. Obviously, there’s a little bit of variability in this—it can range from the low single digits all the way up to about 27 cents on the dollar, and that’s for the state of Illinois.
MIKE: Well, it sounds like there are a lot of hurdles, both politically and legally, to get over for a state to file for bankruptcy. But what about a situation where a state doesn’t have the money to pay their bonds and then just decides to default on them. Is this something that’s possible, and what would happen if they did?
COOPER: That reminds me of an old quote: “The only sure things in life are death and taxes.” So is this something that’s possible? Sure, it’s possible. Is it likely? No, it’s highly unlikely.
And it’s very rare, in fact, for a city or a local government to default on their debt service. And it’s even more rare for a state to default on their debt service. And the last state to actually default on their debt was Arkansas, in 1933, during the Great Depression.
But that’s backwards looking. We think going forward there’s going to be a very low likelihood of a state defaulting. And that’s both for legal and practical reasons.
First, on the legal side, many states have provisions that make debt service a very high priority in their state constitution.
For example, the Illinois constitution requires that the state pre-fund the next 12 months’ worth of debt service. So when they prepare a budget, they have to take the next 12 months’ worth of debt service and separate those funds from general funds for operations. So they can’t be mingled together with other things.
In California, debt service is actually the second-highest priority of payments, only after payments to public and higher education. So this is an issue that really varies by state, but in general, it’s a very high priority for states to pay their debt.
And the final reason why I don’t think it’s very likely that a state would default on their debt service is that it would probably cause them more pain in the long run than it would provide gain in the short term.
And the reason there is that the ability to issue bonds is actually a cost-effective way for a state to borrow money and to help fund operations. So if a state were to default on their debt, Mike, it could scare away future investors or cause the state to have to pay a higher rate than it would have had they not defaulted, and this could increase expenses going forward for that state.
MIKE: Well, that’s a great explanation of the differences between bankruptcy and default. Let’s turn our eyes to the current situation. What is the “state of the states” right now? We know that state revenues have taken a huge hit as a result of this crisis. But are there states that are really in trouble?
COOPER: Pretty much all across the board revenues are supposed to decline for a lot of the states. The states that’ll probably see an outsized effect are the tourism-dependent states, such as Hawaii for example. Another area is energy-producing states, and those would be like Alaska, Louisiana, North Dakota, and Wyoming, and the reason that they’ll probably feel a revenue hit is due to the decline in oil prices.
But the good news is that these states generally know that they have volatile revenue streams, so they’ve built up large rainy day funds and other reserves to help mitigate that impact.
A notable example is actually Texas, though, Mike. Even though Texas has a very big energy production, in terms of how much revenue they rely on from energy production, it’s not that much. It’s because they have a pretty diverse revenue stream from other areas.
And I’ve recently published an article on this on Schwab.com—and it goes into a little more detail.
But there are 19 states that have enough funds in their rainy day fund and general fund to absorb the estimated decline in revenues.
And the ability to generally absorb this economic decline is one of the reasons why we like higher-rated municipal bonds in this environment, Mike.
MIKE: Well, Cooper, the CARES Act pushed back the federal tax filing deadline to July 15. And almost every state has followed the IRS and pushed back their state tax filing deadline as well. That’s obviously great news for taxpayers, but it’s bad news for states, because they are not seeing the tax revenue they expected in April. So how has that impacted state budgets?
COOPER: You’re right that it’s been bad news for states because it has created a bit of a temporary gap in their budgets. And just to illustrate, the state of Illinois is actually reporting that they’re receiving a billion dollars less in revenue than they have in the same time last year.
So the Fed actually stepped in to provide a little bit of support here for the municipal bond market, and they created the Municipal Liquidity Facility. And what that is, is that the Fed is buying short-term obligations from states, large cities, and counties. Now these are short-term obligations—they’re no more that 36-months in maturity. And states in normal times issue these types of bonds if they expect a revenue source to be coming in.
So now, even though they expect to receive those taxes, even though they’re delayed, if they need to, they can issue these types of bonds and rely on the Fed to step in and provide a little bit of support.
The bottom line on something like this is it’s essentially a bridge loan, and I would also say that the Fed is trying to be the lender of last resort here. So they hope that the markets will actually do the job for them, but if they don’t, then the Fed is able to step in and provide a little bit of support.
MIKE: Well, Cooper, debate over the next coronavirus aid bill has begun in Congress, and I think it’s clear that there will be some aid for state and local governments coming—the question is really how much. House Democrats just unveiled a bill that designates about $875 billion for state and local governments. Many Republicans have acknowledged that some aid will be needed to states, but they’re talking about a smaller number. Regardless of where the number ends up, what will states do with this money once they get it? Do they just plug it in to fill holes in their budget?
COOPER: I think if states had their way, then yes, they would just use this money to fill holes in their budgets. But I expect that there are going to be strings attached to this aid. Just to illustrate how big the holes in their budget are, California actually projects a budget deficit of about $54 billion through fiscal year 2021.
It’s important to note that the aid provided in the CARES Act—and just as a reminder, that was $1.2 billion per state, plus more depending on your population—that actually had strings attached to what it could be used for. So it couldn’t be used to fill these revenue gaps; it had to be used toward paying for expenses related to fighting this coronavirus crisis.
The other thing that I would say is that McConnell and other Republicans have said they don’t want it to be used to help pay for the unfunded pension liabilities. So I expect that there are going to be some sort of strings attached with this aid—what they will be, that’s going to depend on the final bill, and that will really dictate how states use this.
MIKE: Outside of waiting for federal aid, what other options are available to states to fix their budgets?
COOPER: So states have a lot of different levers that they can pull in this regard.
And in fact, 49 out of 50 states, they have to operate under a balanced budget requirement. What that means is that they have to make sure that revenues match expenses. So given that we are likely to see a decline in revenues, they’re going to have to reduce expenses. One way that they can do that is reduce employment.
And the reason being is that 20% of a state’s budget goes towards employment. And states and local governments are already taking steps to reduce employment. April’s job report actually showed the biggest year-over-year decline in state and local employment since 1955.
So I think that this is going to lead to a lot of difficult political choices of what jobs to cut or what services to cut, and it’s going to vary from state to state. A positive, though, is that a state has to provide services to individuals, so there are going to be services that they’re still going to provide.
The other option and the other lever that a state has is to increase revenues. One way of doing that is to increase taxes. I think that that’s going to be politically difficult, especially in this environment that we are in right now. They could also tap non-recurring revenue sources. That would be something like tapping into their rainy day fund.
So the bottom line on this, Mike, is that none of these levers that states can pull are politically attractive, but I think that there are levers that they can pull.
MIKE: Well I agree with you there, Cooper. I think it really underscores what a difficult situation some states are in when you’re talking about cutting jobs in this environment that we are in right now. Well, you’ve given us a lot of great information. But I want to turn this back to the individual investor. What has been the impact on municipal bonds of all of this?
COOPER: There’s been a lot of volatility in the muni market, but we don’t think that’s a reason to shy away from municipal bonds. One of the reason that we think municipal bonds are attractive right now are the yields that they’re paying. And in fact, highly rate munis pay about one and a half to three times more than a Treasury of similar maturity. And that’s even before accounting for the tax benefits that munis offer.
Because municipal bond interest is generally exempt from federal income taxes. We’re also seeing a distinction among different sectors in the municipal market. For example, returns for riskier sectors in the muni market have suffered—so like high-yield for example. And another sector that’s suffered is hospitals, and that might seem counterintuitive given the increased utilizations that hospitals are seeing right now. But part of the reason is because elective surgeries are very profitable for hospitals, and they have been cancelled.
You’re also seeing expenses increase, and that’s related to supply chain issues—raising costs there. We’ve heard a number of different examples about the costs of ventilators and personal protective equipment increasing.
Finally, we’re seeing increased notices of revenue declines or draws on rainy funds and the like. The thing I’d say there, though, Mike, is that issuers across the board are feeling the financial strain, but we don’t think that you should throw the baby out with the bath water. There are highly rated municipal bonds that can be attractive in this environment.
MIKE: Well then let’s wrap up with the question that’s on every investor’s mind these days: What should I, as an investor, do?
COOPER: The bottom line is we like municipal bonds. We’d suggest focusing on higher-rated issuers. In general they have the financial flexibilities to be able to manage through some of these revenue declines that are expected. We’d also suggest looking for issuers that are less dependent on economic activity. For example, local general obligation bonds. Those are usually backed by property taxes, and that’s a lagging revenue source.
And then finally, you don’t have to do this on your own. So the municipal bond market can seem complex, Mike. But there are a number of different resources available at Schwab to help wade through it.
MIKE: Well those are great suggestions, Cooper. And I think we all think that municipal bonds should continue to play an important role in a well-diversified portfolio. Thanks so much for being with me today, Cooper.
COOPER: Thanks for having me, Mike. I’ve enjoyed it.
On my Election 2020 update, some interesting news out of California this week. Governor Gavin Newsom signed an executive order that directs counties to mail a ballot to every voter in the state for this November’s election. Some polling places will remain open for in-person voting, but the details of how many and where they will be located are still to be worked out. But California is the first state to commit to mailing every single registered voter a ballot this fall.
In doing so, California gets out ahead of what could be a growing trend nationally—the acknowledgement that it is looking increasingly unlikely that it will be safe to vote in person by November. But it adds more fuel to an already raging debate between the two parties, one that could even lead to court challenges.
The disastrous Wisconsin primary last month has accelerated the push for alternatives to in-person voting. Wisconsin tried a hybrid model—mailing absentee ballots to all voters while also keeping polls open on Primary Day. But neither approach really worked. Tens of thousands of mail ballots never reached voters, and there was confusion about the rules for mailing them back. But those trying to vote in person were stymied by long lines, many of which resulted from a lack of poll workers. In Milwaukee, only five of the usual 180 polling places were even open. Compounding the disaster, as many as 52 people are now thought to have contracted the coronavirus as a result of voting in person on April 7.
At the moment, just five states—Colorado, Hawaii, Oregon, Utah, and Washington—have statewide voting by mail. Twenty-nine other states have “no excuse” absentee balloting, which means you can request an absentee ballot without a reason. But in most states, voters are required to proactively request a ballot, which typically has to be mailed well before Election Day in order to be counted.
While everyone agrees that voting needs to be safe, Democrats are pushing to include in the next coronavirus aid bill billions in funding to help transition from in-person voting to voting by mail. Republicans, led by President Trump, have been hostile to voting by mail.
And it has led to uncertainty for campaigns, from presumptive Democratic presidential nominee Joe Biden down to candidates for local offices. How much time will they need to spend explaining to voters how to vote, in addition to explaining their positions on the issues? What is the timing for when voters will begin casting ballots, since some states open absentee balloting as much as 45 days before Election Day, and what impact will these challenges have on voter turnout?
I’ve said before on this podcast that I think the impact of voting in this year’s critical election is one result of the pandemic that is just beginning to get the attention it deserves. I’ll continue to follow this in the weeks and months ahead.
Finally, it’s time for the Why It Matters segment, where I look at a story you may have missed and tell you why I think it is important.
Last week, the SEC voted unanimously on a first step of what is likely to be a major overhaul of the market data system. Now market data is the lifeblood of the markets—it’s literally the information that scrolls across the bottom of the screen on your favorite financial network. It’s the bids and asks, the prices, buys, sells, spreads—all the information you need when making an investment.
For years—more than two decades, really—Schwab has been arguing that the market data system, which is controlled entirely by the exchanges, is unfair to individual investors. We’ve argued that institutional investors get better quality information at better speeds than ordinary investors.
The SEC seems to be agreeing that this is something that needs to be looked at. Last week’s vote was on a rule that will require the exchanges to open up seats on the committees that oversee the dissemination of market data to a wider group of participants, and that should mean that institutions catering to individual investors will get a seat—and a voice—at the table.
So why does it matter? It’s a first step towards what is looking like an SEC-led overhaul of the entire market data system. There’s a second SEC proposal, which is likely to be voted on later this year, that would direct the exchanges to consolidate various market data feeds into one feed for all investors.
It’s kind of a boring topic, it will take a long time to resolve, and it could be subject to court challenges. But individual investors should keep an eye on this story, because the end result could be a leveling of the playing field between ordinary investors and institutional investors, giving everybody access to the same high-quality market information at the same time. And that would be a big win for investors.
That’s all for this episode of WashingtonWise Investor. We’re going back to our every-other-week schedule for now, so the next episode will be out on May 28. But we’re not wedded to that schedule—we will have extra episodes whenever developments in Washington warrant them.
Please take a moment to subscribe so you don’t miss an episode. And if you like what you’ve heard, please leave us a rating or a review on Apple Podcasts or your favorite listening app—those ratings and reviews really do matter.
For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I’m Mike Townsend, and this has been WashingtonWise Investor. Wherever you are, stay safe, stay healthy, and, most importantly, stay home. And keep investing wisely.