Despite fiscal woes, muni bonds' appeal stays strong

The good news in the sell-off that has clipped California tax-free municipal bond prices over the last six weeks is that the market now should be harder to shock.

So for muni investors, the report Wednesday that Sacramento already may be facing a $21-billion budget gap over the current and next fiscal years was more a firecracker than a bomb.

After rallying sharply in August and September, the California muni market has given back some of those gains since early October. Amid a flood of new bond sales by the state investors have demanded higher yields, which in turn has pushed prices of existing bonds down.

California is back in the market this week with a $1.34-billion revenue bond offering from the Public Works Board to finance infrastructure projects. Yields on those bonds will be set today.

All in all, though, the damage to the market from the supply glut has been relatively modest, at least for muni mutual fund investors who have the benefit of wide diversification. Case in point: The per-share net asset value of the Franklin California Tax-Free Income fund, which holds $14.2 billion of state and local debt, was $6.90 on Wednesday, a drop of 4% from the 52-week high of $7.19 on Oct. 5.

That’s unfortunate for anyone who bought near the high, but year-to-date the fund’s total return (share price gain plus interest earned) still is a hefty 15.6%. And that’s even better than it looks, given that the interest earned is exempt from state and federal income tax.

The muni market nationwide has been suffering a bout of indigestion since September, driving yields higher. But nationally and in California the market has been stabilizing over the last week or so.

Despite the dire fiscal outlooks for many state and local governments, there are three main reasons to believe that the muni market is unlikely to fall off a cliff from here and wipe out all of its recovery from the worst of the credit crunch:

--- Big investors just don’t buy the idea that actual defaults by muni issuers in 2010 will match the doomsday predictions that are out there.

"There is going to be a lot of ‘headline’ risk in the market over the next 12 to 18 months," said Chris Sperry, co-manager of the Franklin California fund. But local governments of any size know, he said, that the decision to default would make it impossible to get the basic credit they need to function. The market clearly believes that the vast majority of politicians will get out the cleaver and hack expenses further, not bond payments.

--- Muni yields still are historically high versus yields on taxable bonds. A 10-year California state general obligation bond now yields about 4.55% tax-free, compared with 3.36% for a 10-year U.S. Treasury note that is federally taxable. Muni bond yields normally are below Treasury yields.

"In order for muni yields to get a whole lot [higher] you’re going to have to see the Treasury market sell off," said John Carbone, manager of the Vanguard California Long-Term Tax-Exempt bond fund. That could happen, of course, but it probably would require the backdrop of a robust economic recovery or an inflation surge -- neither of which seems likely in the near term.

--- Many muni investors figure that tax rates at the federal, state and local levels can only go up as governments struggle to close deficits. That would boost munis’ appeal for yield-hungry investors. "Munis are going to become more attractive from a pure income standpoint," Sperry said.

Yes, he’s talking his book. But raise your hand if you think taxes are more likely to go down than up.

-- Tom Petruno

Millions may have to repay part of Obama tax credit [Updated]

For more than 15.4 million people, the Making Work Pay tax credit enacted as part of the $787-billion economic stimulus package could turn out to be a Making You Pay Back tax credit.

That's the finding of a government watchdog report out today about the credit, which provides as much as $400 for individuals and as much as $800 for joint filers. It is the signature tax cut that President Obama promised in his campaign and was delivered with much fanfare in February.

The problem: In order to maximize the credit's stimulative effect on the economy, withholding changes for taxpayers kicked in within days of Obama signing the legislation and taxpayers started seeing the changes in their paychecks in April. In essence, the credit was "advanced to taxpayers through their wages by a decrease in federal income tax withholding" for the 2009 and 2010 tax years, according to the report by the Treasury Department's Inspector General for Tax Administration.

If too much of the credit was advanced, a person would end up having to pay the extra money back. After analyzing 2007 tax return data, the Inspector General found that more than 15.4 million people could fall into that category this year. Among the reasons for having to pay back some of the credit are having more than one job or receiving pension or Social Security payments while still working.

The Internal Revenue Service said the report overstated the problem. The agency noted that about three out of four taxpayers receive refunds on their tax returns each year, averaging about $2,700 each. For most households, the withholding problem associated with the tax credit "means a reduced refund and not an out-of-pocket tax liability," the IRS said in a letter to the Inspector General.

[Updated at 1:42 p.m.: IRS spokesman Eric Smith said this afternoon that the agency would waive any underpayment penalty related to the tax credit. The agency is working on a waiver process for the approximately 65,000 people it said would face a penalty.]

[Updated at 9:15 a.m.: The Treasury Department put out its own statement on the issue. "Making Work Pay was designed to deliver much-needed boosts to the paychecks of 95% of all working Americans. Since enactment, more than 110 million families have benefited from as much as $60 in additional take home pay each month to put toward their family budgets -- serving as a steady boost to spending and consumption. The IRS has worked quickly and effectively to ensure that taxpayers received the benefit of this credit as soon as possible -- starting just days after the Recovery Act became law -- and will continue to do so going forward."

-- Jim Puzzanghera

Photo: Gary Friedman / Los Angeles Times

Study: Nine states risking California-style 'fiscal peril'

If misery loves company, the Pew Center on the States public policy think-tank has some comforting words for Californians: Though our fiscal problems "are in a league of their own . . . some of the same factors driving California toward the brink of insolvency also are hurting an array of other states."

Do you feel better already?

A new study from the non-partisan Pew -- "Beyond California: States in Fiscal Peril" -- looks at nine states that the organization asserts aren’t far behind the Golden State in suffering havoc from the Great Recession. The nine, alphabetically: Arizona, Florida, Illinois, Michigan, Nevada, New Jersey, Oregon, Rhode Island and Wisconsin.

The Pew scored all 50 states based on six factors that "contributed substantially to California’s ongoing fiscal woes": high foreclosure rates; increasing joblessness; loss of state revenues; the relative size of budget gaps; legal obstacles to balanced budgets (specifically, a supermajority requirement for some or all tax increases or budget bills); and poor money-management practices.

California, of course, scored worst of all, but it was closely followed by Arizona, Rhode Island and Michigan, in that order.

Considering that Arizona and Nevada, in particular, might be expected to benefit as business refuges from California’s nightmare, here’s what the Pew study has to say about those two states:

--- Arizona: "As the economic news grew bleaker and state revenues sank during the past two years, Arizona’s lawmakers relied on one-time fixes to balance its budget instead of making long-term changes. In part, they were hamstrung by voter-imposed spending constraints, a tax structure highly reliant on a growing economy and a series of tax cuts, made in the 1990s, that has limited revenue. At this writing, policy makers still had not decided how to bridge a $1 billion gap in the current fiscal year’s budget."

--- Nevada: "Nevada’s unique gaming-based economy is in jeopardy, as its state budget relies on gambling and sales taxes to provide 60% of its revenues. Year-over-year revenue has fallen for two consecutive years, a record. But changes to the tax system are difficult to make because, unlike most states, Nevada has written some of its tax laws into the state constitution. So increasing the sales tax or adding an income tax, for example, would be nearly impossible because it requires voters to amend the constitution."

And what did Wisconsin, California’s dairy rival, do wrong to get on the Troubled-10 list?

"The recession has hit Wisconsin harder than most state governments, especially when it comes to lost tax revenues and the size of the hole in its budget," the Pew study says. "Wisconsin’s history of budget shortfalls and pattern of borrowing frequently to cover operating expenses, among other measures, made it poorly positioned to weather the most recent severe economic downturn."

At the opposite end of the spectrum, Wyoming scored best in the Pew study, followed by Iowa and Nebraska (tied for second place) and Montana, North Dakota and Texas (tied for third).

Are the Great Plains states the economic future of America?

-- Tom Petruno

The last analyst says goodbye to FirstFed

Paul Miller, the last analyst covering FirstFed Financial Corp., gave up today, saying in a note that “it is unlikely that any value remains for shareholders” of the Los Angeles savings and loan company.

The FBR Research analyst had last published comments on the parent of First Federal Bank of California in February, when he advised investors to sell the stock. Back then, Miller valued FirstFed shares at 60 cents; the stock was unchanged at 32 cents today in the over-the-counter market.

For FirstFed, which stumbled with its pay-option adjustable mortgages, the issue is no longer existing investors as much as whether new shareholders can be found. As Miller pointed out, regulators have ordered the company to liquidate itself, merge with another financial institution or find new investors to provide a shot of fresh capital.

FirstFed is hoping to sell new shares to private investors in a deal that would all but wipe out existing shareholders.

Part of the money raised would pay off holders of $150 million in FirstFed bonds at 20 cents on the dollar, and part would be used to bolster the thrift’s capital cushion against losses.

The thrift got some good news today as President Obama was expected to sign legislation allowing companies to use losses from 2008 and 2009 to offset taxable profits going back five years, rather than just two years. FirstFed has reported $547 million in losses since the beginning of 2008 -- losses that could be used to apply for greater tax refunds.

FirstFed’s executives weren’t talking today, saying they were in a “quiet period” because of the coming attempt to sell new shares. The Securities and Exchange Commission has yet to clear the offering so FirstFed can issue a prospectus describing the proposed stock sale.

In an SEC filing this week, FirstFed provided fresh evidence of how its operating focus is shifting from modifying loans for troubled borrowers to dealing with foreclosures for those who can’t be helped.

Single-family home loans that were 60 to 89 days delinquent -- the most serious threats to go into default -- totaled $7.5 million, down from $12.6 million a month earlier and $97 million on Sept. 30, 2008.

So the pipeline of sludge is drying up at the entry point. But there was still plenty to deal with at the other end.

Even after selling 356 foreclosed properties in the third quarter, the bank owned 665 foreclosures valued at $176 million at the end of September, up from 413 worth an estimated $98 million at the end of June.

-- E. Scott Reckard

Michael Hiltzik: The absurd ban on Internet gambling

One way to gauge the sincerity of lawmakers is by their willingness to let their bills be debated out in the open. The federal ban on Internet gambling flunks that test.

It was enacted in 2006 when Sen. Bill Frist, R-Tenn., who thought he'd be running for President, made common cause with a gang of Congressional blue noses and added it to a bill on port security. The gambling measure wasn't afforded a minute's debate in the Senate, but no one could vote against the ban without voting to open our ports to terrorists, so there you have it--a measure that fails to achieve its purposes politically, fiscally, or moralistically.

Among its flaws, as my Monday column observes, is the lack of any definition of "gambling," which you would expect to be Job One. It exempts betting on horses, for instance, but includes poker. This drives poker players nuts, because they think of their pastime as an expression of psychological warfare and high-level game theory. There's much to be said for their position, but one doesn't have to share it to decry the ban. The column starts below. 

No issue brings out America’s talent for self-deception like gambling.

To persuade ourselves that we can keep this particular sin under control, we sequestered casinos in isolated places like Las Vegas and Atlantic City reachable only by superhighways, and isolated them on riverboats where not a single card could be dealt or slot lever pulled until the vessel left the dock.
 
In Mississippi, the law used to say you couldn’t have a casino unless it floated on water. After Hurricane Katrina forcibly relocated a few of these sin barges onto land the legislature, reading the disaster as a sign from God, revised the law to let them stay put. (The riverboat states, similarly, eventually allowed their floating casinos to remain tied up dockside.)

Which brings us to Internet gambling.

Read the whole column

--Michael Hiltzik

House Democrats to push for tax hike on private-equity chiefs

As the fortunes of private-equity firms improve with rebounding financial markets, House Democrats are renewing a push for a long-sought tax increase on the industry.

From Bloomberg News:

Matthew Beck, a spokesman for the House Ways and Means Committee, said the panel will revive an effort to raise the 15% tax rate on “carried interest,” a term for the share of [an investment] fund’s profit that is paid as compensation to its executives.

That portion of an executive’s pay, now taxed at lower capital gains rates, would be subject to income tax rates of as much as 35%.

“There is strong support for taxing carried interest as ordinary income and I expect this issue to move forward in the coming months,” Beck said.

Managers of private-equity firms, hedge funds, venture capital firms and other investment partnerships typically use the "2-and-20" compensation structure: They earn an annual fee of 2% of assets under management and then take 20% of any profit above preset levels. The rest goes to the investor-clients who put up the capital the managers invest.

The 20% profit is known as carried interest, and is treated as a capital gain for tax purposes if the underlying return was generated on investments held more than a year.

Many Democrats say that such compensation should be classified as regular income and taxed accordingly. The House in June 2008 passed a bill mandating that change but Republican opposition scuttled it in the Senate.

Now, with Democrats in control of the House, Senate and the White House, carried interest is a ripe target as Washington looks for ways to boost revenue.

From Bloomberg:

Ways and Means Committee Chairman Charles Rangel, a New York Democrat, and other Democrats including Michigan Representative Sander Levin say [carried-interest] fees are more like wages than capital gains because executives usually haven’t risked their own capital.

Revenue from the tax proposal may be earmarked by House Democrats to help pay for renewal of tax subsidies designed to help economic recovery. For example, Rangel said lawmakers should extend an $8,000 tax credit for first-time homebuyers, and the White House is pushing renewal of an incentive that lets companies use current losses to get refunds for past taxes.

Arguing against the tax change, the private-equity industry in the past has countered that fund managers should qualify for the lower capital gains tax rate on carried interest because they "act as owners, not employees" and "bear significant economic risks."

This time around the industry also will try to play the economy card, asserting that after private-equity firms buy companies they make them better (a debatable point, to say the least).

Douglas Lowenstein, president of the Private Equity Council, told Bloomberg that as the economy begins to recover a “tax increase on growth investors with a demonstrated record of building stronger companies and creating new jobs would be exactly the wrong policy at the wrong time.”

-- Tom Petruno

Are you willing to pay higher taxes to be 'fiscally responsible'?

Bruce Bartlett, once a Republican champion of supply-side economics and more recently best-known for his scathing attacks on President George W. Bush's economic policies, argues in Forbes magazine that the U.S. now has no alternative but to raise income tax rates.

From "Fiscal Responsibility Requires Higher Taxes":

Everyone knows that fiscal discipline must be restored eventually, or we will face truly horrifying consequences -- defaulting on the debt, nonpayment of Social Security benefits, a collapsing dollar, and double-digit inflation and interest rates. Everyone also knows that this will involve a combination of higher revenues and lower spending. The idea that we can restore fiscal health only with spending cuts is childish . . .

What we face is a game of chicken. Republicans think if they wait until the last possible second to support the smallest possible tax increase necessary to make a budget deal work, they can get the largest possible spending cuts. The problem is that there is not one iota of historical evidence that this strategy will work. The budget deals of the 1980s and 1990s were all roughly 50-50: half tax increases, half spending cuts.

At some point, taxes have to be back on the table as the price that must be paid for profligate spending. Only then will the American people realize that they can't have their cake and eat it too, as Republicans have preached for the last decade. Only when the American people go back to believing that spending must be paid for will they stop demanding something for nothing and put the country back on the path to fiscal sanity.

Many of the comments that Bartlett provoked expressed outrage at the idea of the federal government taking even one more dime from taxpayers. Instead, the no-higher-taxes camp asserts simply that federal spending should be slashed to balance the budget -- even if that means gutting Social Security and Medicare. As if that would have no consequences for the nation's social fabric or the economy.

What Bartlett doesn't address is the complicity of our foreign creditors. As long as the U.S. can borrow with abandon from foreigners, the pressure to face up to fiscal responsibility just isn't there. But this is, of course, a case of pay now or pay later.

As one commenter put it:

The real choice is between increasing taxes or borrowing [from] the Chinese and having our children pay them back. Because the ability to borrow is predicated on the ability to tax incomes, it is not all of our children that will pay this back, only the children who will be among the top income earners -- who usually have high income parents (the very people whose taxes were cut by George W. Bush).

-- Tom Petruno

Photo: Bruce Bartlett

California holds at No. 48 in annual ranking of state business tax climates

California maintains its position as the state with the third-worst overall business tax climate, according to the annual study by the Tax Foundation think tank in Washington.

California ranks 48th among the states based on the foundation’s assessment of what businesses would consider a friendly tax climate, the tax watchdog said today. At the bottom of the listing is New Jersey, preceded by New York at No. 49.

The state with the best overall business tax climate is South Dakota, which moved up from the No. 2 position last year, the foundation said. Wyoming, No. 1 last year, slipped to No. 2.

The foundation ranks the states based on five taxes: corporate income, individual income, sales, unemployment insurance and property. Scores are based on the level of tax rates and how fairly the taxes are applied.

The foundation’s judgment: "Good state tax systems levy low, flat rates on the broadest bases possible, and they treat all taxpayers the same.

"Variation in the tax treatment of different industries favors one economic activity or decision over another. The more riddled a tax system is with these politically motivated preferences the less likely it is that business decisions will be made in response to market forces."

To that point, my colleagues P.J. Huffstutter and Richard Verrier have a good story today on how some states are reconsidering the tax breaks they’ve offered Hollywood studios to lure film and TV production.

Back to the Tax Foundation study: Not surprisingly thanks to Proposition 13, California scores high on property taxes, ranking 13th best among the states. It also ranks favorably, at No. 14, on unemployment insurance taxes.

But the state ranks 48th on individual income taxes, 48th on sales taxes and 34th on corporate income taxes.

In the overall rankings, South Dakota and Wyoming were followed in the top 10 by Alaska, Nevada, Florida, Montana, New Hampshire, Delaware, Washington and Utah.

From the bottom up, New York, New Jersey and California were followed by Ohio, Iowa, Maryland, Rhode Island, Minnesota, Wisconsin and Vermont.

-- Tom Petruno

Photo: The Capitol in Sacramento. Credit: Ricardo DeAratanha / Los Angeles Times 

Geithner mulls whether to push extension of first-time home buyer credit

Treasury Secretary Timothy Geithner said today he hasn’t "made a judgment yet" on whether to recommend extending the tax credit for first-time home buyers.

"Obviously that's something that I'm going to take a careful look at," he told reporters in Washington.

The heat is on to keep the credit (worth up to $8,000) alive, as the Associated Press reports:

There have been more than a dozen bills introduced in Congress to prolong the life of the tax credit past the Nov. 30 deadline.

The credit is helping stabilize the housing market, but there are conflicting views about the practicality and cost of an extension. The National Assn. of Realtors and the National Assn. of Home Builders have launched marketing campaigns touting the credit and have pushed Congress to keep it going.

But some lawmakers are balking at the cost, which may hit an estimated $15 billion -- more than double the amount projected in February's economic stimulus bill.

As long as the Treasury is having no trouble selling debt (and it isn’t having any trouble at all), Congress and the administration may figure the incremental cost of the tax credit is no big deal. When you’re already running an annual deficit of $1.6 trillion, what’s another $15 billion?

But gems like this from the AP story may give some in Congress pause:

Critics . . . see the credit as a subsidy for people who don't need one.

Charles Curtis and his wife weren't even aware of the tax credit until they put a $895,000 all-cash offer in July on a two-bedroom apartment in New York City. "It was a wow moment," said Curtis, 27, a freelance writer and researcher.

Not surprisingly, builders see extension of the credit as critical. The National Assn. of Home Builders, lamenting the 3% drop reported today in single-family housing starts in August, put out a release pleading for action on the credit.

"With the $8,000 first-time home buyer tax credit set to expire at the end of November, the window is now basically closed for being able to start a new home that can be completed in time for purchasers to take advantage of that," said Joe Robson, the group’s chairman. "Builders are therefore pulling back on new construction at this time. Clearly Congress must act now to extend the tax credit if we are to keep the market moving toward a recovery."

-- Tom Petruno

Small investors forced to fight for leftovers in the muni bond market

Yield-hungry individual investors put in orders to buy $198 million of tax-free revenue bonds offered by the University of California system this week.

But most of them came up empty-handed. State Treasurer Bill Lockyer, who sold the securities for UC, had just $65.5 million of the bonds to fill individuals’ orders. The rest of the $300-million deal went to institutional investors.

The UC debt offering points up the dearth of supply of the kind of municipal bonds that individual investors traditionally have preferred: mainly shorter-term securities, maturing within 10 years.

The relative shortage of shorter-term muni debt nationwide has turned new offerings into food fights as investors try to pile in.

"Retail investors fighting for scraps," the Bond Buyer newspaper headlined a recent story on small investors’ plight in the muni market.

The situation is a boon for muni issuers such as UC (and for taxpayers) because it has pushed down the interest rates they need to offer to sell bonds -- in UC's case, to finance projects such as dorms and research facilities.

The flip side, of course, is that individual investors aren’t getting nearly as a good a yield as they would have even a few months ago.

When the California State University system sold revenue bonds in March, it paid a tax-free yield of 3.19% on the five-year debt in the offering. By contrast, the five-year securities in the UC sale this week will pay just 2.06%.

Many muni issuers, including UC, prefer to sell bonds maturing in 10 years or longer. Those also are the maturities favored by many institutional investors. So even though Lockyer routinely offers individuals the ability to place orders for muni bonds ahead of big investors such as mutual funds, the issues made available to individuals in the shorter terms they want often are limited in supply.

The shortage of tax-free bonds is worse this year because many issuers, including UC, are opting to sell long-term taxable bonds instead via the Obama administration’s Build America Bonds plan.

Under the program, states and other municipal issuers can choose to sell taxable bonds for public-works projects and have the federal government pick up 35% of the annual interest expense on the securities.

Selling taxable bonds means issuers can attract hefty demand from pension funds, foreigners and other investors that normally don’t buy tax-free bonds.

UC used Build America Bonds for the vast bulk of its financing this week: It sold $1.02 billion of 22-year and 34-year taxable BABs. The 34-year bonds will pay an interest rate of 5.77%. But with the 35% federal subsidy, the net interest rate to UC is just 3.75% -- far less than the system would pay on a tax-free bond of that maturity.

That's good for UC and for the BAB buyers. But as the Bond Buyer headline put it, individual investors are left fighting for the muni market's scraps.

-- Tom Petruno