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Q

Do you have any information or research available on how muni bonds performed during the Great Depression? It would be instructive to understand default rates and similar information, to better assess today’s market and risks.

A

James A. Klotz responds:

The classic study of municipal defaults in the Great Depression was written as a doctoral dissertation by George Hempel in 1964 entitled, “The Postwar Quality of Municipal Bonds.” Hempel found that 3,252 existing issues were in default as of 1935, the height of the Depression. Our modern rating systems by S&P and Moody’s emerged as a result of this study. Prior to the Depression, great numbers of issuers were rated in the top categories, “Aaa”/“AAA” which obviously did not reflect the true risk. The tougher standards implemented by the rating agencies since that time have helped to enforce better financial practices and have provided more meaningful guideposts than were available in the 1930s.

For example, audited financial statements were not readily available until even the 1980s. Today, thanks to pressure from the rating agencies, it is rare to find a unit of local or state government that does not provide annual financial statements that are not in conformity with rules delineated by the Government Accounting Standards Board (GASB), the Government Finance Officers Association (GFOA), and the rating agencies. The transparency brought about by modified accrual accounting, as reflected in local government Comprehensive Annual Financial Reports (CAFRs), now acts as a method of discipline to insure that both professionals and the public can better hold government to account for its financial practices and results so that a repeat of the default incidence in the Great Depression never happens again.

It is encouraging to note that Hempel estimates the total loss of principal and interest resulting from defaults during the Depression years to be approximately $100 million, or about .5% (less than1%) of the average amount of state and local debt outstanding in this period.

Hempel’s study has also been used by the municipal bond insurance industry to develop their assumptions regarding the likelihood of municipal default. While the insurers have suffered from risks undertaken in the structured finance sector, their scorecards in municipal finance have been strong.