[COPY] Municipal finance: Living in a bubble

Hurricanes Helene and Milton won't shake muni bond markets, but will lead to crushing increases in insurance costs. That's a problem for the entire system.

As Hurricane Milton bears down on the west coast of Florida today, commentators are running out of descriptors. It's a cataclysmic, terrifying storm. We know that the 80º F waters of the Gulf of Mexico accelerated the storm's extraordinary single-day intensification into a Category 5 hurricane, and we hope that the people living in Tampa and along the 700 miles of coastline nearby have found shelter.

All the attention being focused on this hellacious storm makes today the perfect time to take a look at municipal bonds—the instrument used to support three-quarters of public building by local governments. 

It should be troubling that the muni market in risky places will not be shaken by these monster storms, given the grave physical risks that are ahead. At the same time, it's worth noticing that insurance/reinsurance in Florida will get much more expensive at the beginning of next year, and that property markets in risky locations are already repricing and softening in response to increasing costs.

These realities, taken together, spell out why we have so much trouble thinking ahead about climate adaptation: It is usually in no one's interest to say that particular places face physical climate risk. We have to look for clues in the form of insurance rate hikes and exits and the departure of institutional property investors. But individual Americans are on their own in shouldering these accelerating risks, at a time when we should be investing enormous sums in planning and building for our climate reality. 

Let's start with the muni bond story. These bonds depend on state and local governments being in good financial shape to pay their debts. Local governments depend on property taxes for a third of their revenue, in general, and places that see market values of properties go down will take a substantial revenue hit.

As I wrote recently, credit ratings agencies look mostly at issuers' ability to pay—their risk of default—and don't differentiate between long-term and short-term bonds in providing ratings. Defaults are very rare for muni bonds (although both Paradise CA and Clyde TX recently had climate-related defaults), and so the ratings look high given physical climate risk. 

Ratings agencies might have good reasons not to look too hard at softening property markets. When the agencies tried to incorporate emissions-related rankings in their ratings calculations, they ran into political buzzsaws in states like Florida, Texas, and Utah. They may be leery of doing the same thing on the adaptation side. And local governments want their ratings to stay high so that their borrowing costs stay low. 

So—no one has an interest in telling the truth: local governments don't want to talk about physical risks because that might undermine their property markets and property tax receipts, don't want to borrow the amount of money they might really need to protect their citizens, because that would lower their credit ratings; and don't want the ratings agencies to yammer on about risk, because that would make financing projects they're willing to talk about too expensive.

There might be investors out there who would be interested in funding adaptation projects, but these structures would have to shift first—and that would likely take federal leadership and regional planning efforts. 

Meanwhile, the entire muni bond structure is backed up by property values. And these are threatened in risky areas, even though the standard long-term credit ratings don't reflect this.

Large investment advisors have their own internal metrics and data that they use to decide which bonds they will buy and sell for their clients, so they are largely indifferent to these standard credit ratings. But the retail, individual investor probably does rely on credit ratings to some extent, and may be underestimating the riskiness of their bond holdings. These people make up about 40 percent of bondholders in the $4 trillion muni bond sector. 

Now, let’s take a look at the markets that are visibly repricing. The people writing about reinsurance and catastrophe bonds are looking ahead:  Hurricane Milton may "help instill more discipline into the primary market where property rate increases are moderating," say analysts working within investment banking firm Evercore's research arm.

That means they think insurance premiums paid by homeowners in Florida should go up more in light of the accelerating risks posed by climate change. Higher primary premiums will lessen the risk of loss shifted onto reinsurers and investors in catastrophe bonds. And, they say, reinsurers and cat bond issuers should be able to charge more at the beginning of January 2025 because of the storm. (It is a rough time for reinsurers right now, whose stocks are swooning a bit.)

This is all rational behavior. Of course insurance will be more expensive following what is likely to be a major insurance loss event. Of course reinsurance costs will continue to climb, and those costs will be passed through to policyholders. 

But we are also learning that these greatly increased insurance costs are becoming too much for some homeowners in Florida and other risky places. Home sellers in California are allowing buyers to back out of deals if they can't find appropriately-priced insurance. The front page of today's WSJ featured Deborah Acosta's reporting about a surplus of housing inventory and stagnant demand in Florida, where insurance premiums have climbed as much as 400 percent in some areas. The tipping point has arrived for some of these places. 

These lower property values will eventually affect the perceived credit strength of local governments. But it's all backward: we should be spending more money now on sensible, prioritized planning and building in advance of the climate depredations ahead. We'll save money that way. 

Good luck to all.