They Should Have Learned

educateI believe that education helps people take control of their financial lives. However, I have learned through the years that you can’t force an education on anyone. A person must want to learn.
I don’t understand those folks who come to see me, and for whatever reason, do not want to learn anything about their financial situation. But my mother always told me that you can only help those who want to be helped.
Early last year a couple, let’s call them Dwayne and Diane, came to see me. They were very nice, about 68 and 64 respectively and retired to Cape Cod about 4 years prior. As I recall, they had about $750K in their portfolio.
Dwayne and Diane had a classic brokerage portfolio, with a combination of mutual funds, stocks, and fixed instruments (e.g. bonds). I specifically remember they had a lot of municipal bonds. Dwayne told me that his broker said they were generating around 7% in interest income, and that the income is guaranteed.
I asked Dwayne to help me understand why he and his broker decided to purchase municipal bonds (munis). Dwayne explained to me that he told their broker that they wanted bonds that will pay higher interest rates than other bonds and they wanted predictable and sustainable income. Sound familiar?
Munis are often billed by brokers and financial brokerage firms as extremely low risk, safe and secure investments that generate federal (and sometimes state) tax-free interest income. But this is not always an accurate description of munis. Quite often, brokers never explain default risk. Folks are sold on the fact that these bonds are backed by the “full faith and credit” of the municipality that issues the bonds. And although the percentage of interest is higher if the municipality is considered risky – what happens if the city, town or state that issues a bond goes bankrupt?
Hmmmm . . . Let’s talk about Detriot.
Detroit is in serious trouble. The city is bankrupt. It can’t pay its bills, and the city’s pensions are unfunded by more than $3 billion (1). Every creditor of Detroit is ticked off and is looking for its cut of whatever assets are available to settle claims.
Generally, bankruptcy ranks creditors by the quality of their claim. The strongest claims are secured by identified assets. The weakest claims are unsecured debt. Every creditor in the same classification is typically treated equally. A city’s creditors include its bond holders. Generally, there are two major types of municipal bonds, general obligation bonds and revenue bonds. General obligation bonds represent a promise by the issuer to levy enough taxes as necessary to make full and timely payments to investors. Revenue bonds are issued for specified projects and are secured by revenues generated by the particular project being financed. Bondholders who own either general obligation bonds or revenue bonds own unsecured debt.
Similarly, the folks who are entitled to either current or future pension payments from the city of Detroit are no more than unsecured creditors who rely on the “full faith and credit” of the city to make good on its promises. Those people unfortunately do not have a “strong” claim. As explained above, neither do many bondholders, but the pension fund trustees are arguing that they deserve more than the bondholders, because . . . well, just because. It’s true that the pension funds represent individuals; I get that. But at the end of the day, bondholders are people too, right?
It is important to understand that many of Detroit’s bondholders are also reliant on the city’s “full faith and credit” to fund their retirement plans. Nevertheless, Kevin Orr, the Emergency Manager of Detroit, argues that the pensioners are more important than the bondholders. Orr wants to pay the pensioners 40 to 50 cents on the dollar, while paying bondholders, only 20 cents on the dollar . . . even though their claims are backed by the exact same thing — the full faith and credit of the city.
Many years ago, Warren Buffett saw this coming. In the past, he provided insurance for municipal bonds, called BH (Berkshire Hathaway) Insurance, but he stopped doing so in the mid-2000s. Buffet believed that when municipal authorities fail to manage their finances well, and need to make a choice, they will always choose their constituents over bondholders, no matter what the law says. It looks like he nailed that one.
Avoiding landmines, like Detroit, takes a lot of research, due diligence and number crunching. And still, you’re exposed to the risk that rules will be bent (or completely made up on the fly) when things go wrong.
My suggestion to you, Cutter Family Finance readers is this . . . with a Puerto Rican $70 billion default in Puerto Rico looming (2), and other unknown landmines sprinkled throughout the U.S., now is a good time to scan through your portfolio and make sure you know what you own. It is entirely possible that one day you will get a letter pointing out how you have been deemed “less equal” than someone else who is also scrambling for the few remaining assets of a municipality in bankruptcy…
Be vigilant and stay alert, because you deserve more!
1. http://tinyurl.com/kowh4tm 2 http://tinyurl.com/kv34yhw
Photo courtesy of Microsoft Office