Money Morning Mailbag: There's No Way Around the Dangers of Municipal Bonds

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Money Morning Contributing Editor Martin Hutchinson last month introduced readers to the dangers of municipal bonds. While many investors assumed munis offered a safe haven in turbulent times, the battered condition of state and local finances has left many munis running the risk of default.

"Brokers will tell you that particular state and municipal bond issues are 'safe,' meaning that they are rated highly by the rating agencies," said Hutchinson. "However, the rating agencies got it wrong on subprime mortgage instruments, and it seems pretty clear that they are getting it wrong on states and municipalities."

On the municipal level, local property taxes are the primary revenue source. Declining home prices and increased mortgage delinquencies are creating a housing market that offers little local revenue. Municipalities are then left struggling to make ends meet.

Hutchinson said the vicious cycle could send municipal-bond defaults soaring past 2009's $6.4 billion.

Readers wrote into the Money Morning Mailbag for more clarification on why munis might not be the safest place for investors' money. Hutchinson answers some of their questions below.

You forgot to mention the insured munis. Insured munis will not lose any money, because, they are in fact insured against loss - why did you not mention them?

- Larry L.

M.H.: You're assuming the insurance is any good. Since muni insurers were mostly also insurers of subprime housing bonds, most of them are in sorry shape. There may be the occasional solid deal, just as there are municipalities that won't go bust, but it's not an asset class I'd invest in right now.

Is there a source for determining which states are vulnerable to muni default? There are rating agencies for just about everything, so I assume one exists for the creditworthiness of munis by state.

- Gary T.

M.H.:  I know of no resource available to the public that estimates state probabilities of default. A big muni brokerage would probably have research on the subject.

We'll certainly see more local defaults going forward and may even see the first state default since 1933 -- so given the interest rate risk as well, the overall risk of munis currently is huge.

MM: There is a quick reference to compare states' unemployment rates and foreclosures, as a starting point for researching states' financial condition: Where Does Your State Rank?

Isn't it true that, pursuant to the passage of the Buck Act (1940) and the fact that all states receive annual federal funding, the federal government is ultimately liable to secure states debt in case of an unlikely default?

Also, given that all states enjoy the luxury of owning and operating their own Comprehensive Annual Financial Reports accounts via which they use hundreds of billions and even trillions of dollars in equity market, money market, real estate market, exchange-traded funds and currency exchange market, commodity market, etc., how can the state manage their wealth (CAFR accounts) so poorly to run the risk of a default?

- Ben Z.

M.H.:  The Federal government isn't responsible for states' debts, any more than the European Union is responsible for Greece's debt. When Pennsylvania defaulted in 1841, the Federal government was so small it probably couldn't have bailed it out anyway. In practice, if California or Illinois got close to default, there would be big pressure on Congress to bail them out - and even bigger pressure not to. From a devolved powers/Tenth Amendment point of view you don't want the Feds bailing out states, otherwise states would become completely irresponsible.

I don't think the Comprehensive Annual Financial Report system is anything powerful enough to control state and local and government finances. In theory, states can't run a budget deficit. In practice, they do, but the controls at least hold them back a little.

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