What the 2008 financial crisis tells us about the looming threat to the municipal bond market

Unpriced physical climate risks pose a direct challenge to the stability of the municipal bond market, echoing the financial crisis of 2008—but with potentially permanent consequences

Unpriced risk undermined the global economy during the Great Financial Crisis of 2008. Today, researchers say unpriced physical climate risk will lead to rapid declines in property values—and point out that this is already happening in some Florida markets. They often compare what’s happening now to the run-up to 2008. If the analogy holds, we will likely see disruption in other related financial structures. In particular, as the physical reality of climate change begins to have an effect on the attractiveness of bonds in risky areas, the ability of local governments to raise money to adapt to rapidly changing climate conditions may be undercut.

But comparing the effect of the '08 unpriced risk on the municipal bond market with the potential effects of physical climate risk shows the suffering will likely be much greater this time. Today, there's a direct rather than indirect connection between risk and public finance markets.

The solution? Last week, Tom Doe, CEO and founder of Municipal Market Analytics, said cities should act now to raise as much money as possible for adaptation before the municipal bond market starts pricing in physical climate risk. It's only going to get more expensive later, in his view.

During the 2008 collapse, issuers of municipal bonds suffered. According to the final report on the crisis, New York State was stuck making suddenly skyrocketing interest payments to investors—the rate went from about 3.5% to more than 14%—on $4 billion of its debt. The Port Authority of New York and New Jersey's interest rate went from 4.3% to 20% in a single week. Investors who had bought municipal bonds in auctions suffered too, because the pool of new buyers dried up very quickly in early 2008.

Since then, the muni market has bounced back in a big way, with professional investment managers urging tax-avoidant retail investors to buy individual bonds through separately managed accounts (rather than through a mutual bond fund or an exchange-traded fund). Most people think $500 billion in bond issues is likely in 2025, and the group of buyers has a seemingly unending appetite for what they perceive to be safe and highly-liquid investments—essentially the equivalent of money market accounts that promise federal-tax-free interest payments.

But the risks now posed by physical climate change to municipal bond issuers and investors are different and likely greater than they were in 2008. The last time around, the municipal bond market suffered because of a domino effect: the insurance companies the issuers were using were exposed to mortgage risk.

According to the Financial Crisis Inquiry Report, so-called "monoline" insurers (writing policies for single financial structures rather than a broad array of products) had gotten into the mortgage-backed securities business, issuing a boatload of guarantees covering more than $250 billion of these structured products. The CEO of one of these monoline businesses, Alan Roseman of ACA, said, "We never expected losses. . . . We were providing hedges on market volatility to institutional counterparties." In other words, ACA believed its risk was limited because it wasn't directly investing in the underlying assets. Their risk was limited to ups and downs in the market value of the mortgage-backed securities. But when the value of huge numbers of MBSs plunged as the credit-rating agencies woke up and repriced the risk of the subprime mortgages buried within them, ACA and other insurers were faced with stunning losses.

Those same insurers (MBIA, ACA, Ambac) were then substantially downgraded. And they hadn't been insuring only mortgage-backed securities. They were also insuring municipal bonds and "auction rate securities" based on those bonds (structures that allowed local governments to borrow money at variable interest rates). When the insurance companies froze up because of the sudden repricing of mortgage-backed securities, and their guarantees became worthless, the auction markets froze as well. As a result, issuers of muni bonds (and investors in them) suffered. In other words, in 2008 it was risk in a different financial arena—mortgage-backed securities guaranteed by insurance companies—that slopped over and caused problems for municipal bonds.

By contrast, when it comes to physical climate change today the municipal bond market is directly exposed to the central risk: Will the communities that effectively guarantee these bonds continue to be viable? Will these communities be insurable? Will community property values and thus property taxes suddenly decline?

Not only that, the 2008 risk was different because it could be eventually unwound. Property markets could get going again—as they have in spades. This time, deterioration of the underlying asset—the communities themselves—will likely be irreversible. Chronic flooding will not cease on any human-relevant time scale.

Issuers are not being penalized—yet—for the physical climate risk facing their communities, according to Tom Doe’s conversation with Will Compernolle of FHN Financial last week. "This risk is not being priced in," Doe says. "There's no evidence of that right now. And in addition, the rating agencies have not reflected [physical risk] in their letter scoring of credit risk...so there is not a ratings penalty right now. There's not a pricing penalty."

Doe’s suggestion is that local governments may want to get out there and raise as much money as they can right now for adaptation. "State and local governments who are in harm's way that need to do this [adapt] can go to the market right now, and investors are not penalizing them. The market is not. So this is essentially cheap money if they issue for these projects today," Doe says.

That’s one way of looking at the situation. Public money for adaptation is cheap, there's a lot of it potentially available, and it is much less expensive to raise that money now than it will be once the credit rating agencies and the investors start pricing in physical risk and demanding higher interest payments in exchange for the use of their cash.

It's a race against time: Eventually, as in 2008, the mispriced risk will be correctly assessed. This time, unlike the last crisis, the harm to the underlying assets will be permanent.

Map of New Orleans by Jacques Nicolas Bellin, published in Paris in 1764