Will Fiscal Cliff Trigger Muni Bond Defaults?

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Turns out our nation's counties and cities are in much worse financial shape than previously believed – and the impact of the fiscal cliff could drag these municipalities down even lower.

A recent report by the New York Federal Reserve determined that while Moody's Investment Service reported only 71 defaults from 1970 to 2011, there were actually 2,521.

That's because Moody's only reports on the defaults of rated bonds, which are safer for investors. Taking all U.S. muni bond defaults into account, the default rate is actually 4%, not 1%, according to The New York Times.

It's not just Moody's that missed on municipal bond default statistics. The Fed's combined database indicated 2,366 defaults from 1986 to 2011, compared with Standard & Poor's 47 defaults during this same period.

And now the looming fiscal cliff, scheduled to be reached on Jan. 2, 2013, could drive up many more city debt levels to dangerous highs.

If Congress doesn't agree on a solution, $530 billion in tax increases and reductions in federal spending will take place at the start of next year. According to a recent study by the Congressional Budget Office (CBO), going over the fiscal cliff could take the United States -and its cities and counties – back down into the valley of another recession.

That's when muni bond defaults could tick up.

The U.S. Muni Bond Market

The municipal bond market in the United States totals $3.7 trillion.

These securities are very attractive for retirement plans and other types of conservative investing due to the historic security of the offerings and their triple-free tax status. The bonds' interest income is free from local, state and federal taxes. As a result, municipal bond yields are lower than those of other securities.

Also affecting the return on muni bonds is the implied security in the issuing body.

Municipalities, such as a county or city, are historically considered to be more stable than corporate bonds. With the local tax base for general obligation bonds or a dedicated income stream such as tolls from a bridge (known as revenue bonds), these securities have always been considered to be virtually immune from default, and priced accordingly.

But irresponsible fiscal management coupled with the impact of The Great Recession has resulted in far more municipal defaults than expected.

In the boom years before The Great Recession, state and local elected officials made generous financial promises that later became difficult or impossible to keep. Pay packages and pension benefits for municipal employees are now bankrupting cities across the United States.

This just happened in San Bernardino, CA, as well as others.

On the revenue side, much of the income for cities and counties is derived from property taxes and related transactions. Falling property values has resulted in lower taxes. With fewer homes being bought and sold, municipalities are deriving much less revenue from transfer fees. Every time a house goes into foreclosure, the municipality loses a revenue stream.

Plain and simple abysmal financial stewardship led to the bankruptcy of Jefferson County, the biggest in the state of Alabama.

This bankruptcy filing of $4.1 billion in November 2011 resulted from the costs of building a new sewer system, combined with losses in interest rate swaps created to help finance the infrastructure project. While the interest rate swaps were designed to lower the interest rate payments for Jefferson County, it had the opposite effect.

A bankruptcy doesn't necessarily mean a city will default on its debt, but if the fiscal cliff slams municipalities' finances as hard as expected, it could make it impossible for them to avoid bankruptcy and defaults.

Investors Beware the Fiscal Cliff

The news that the bond default rate is higher is disturbing as individual investors have purchased about three-quarters of the municipal bonds issued by such entities in the United States.

About half of these securities, $1.87 trillion, are in bonds held directly by households.

Investors keep flocking to muni bonds. About $964 million flowed into the investments the week of Aug. 13.

"There is a need for concern," Bill Brandt, chairman of the Illinois Finance Authority and chief executive of Development Specialists Inc., which advises troubled cities and companies, told The Wall Street Journal. "Many of these municipal leaders appear ready to sacrifice bondholders on the altar of the taxpayers rather than the other way around, which has historically been the case."

With economic growth decreasing and unemployment increasing, it is debatable how much the United States has actually recovered from The Great Recession. The municipal bond defaults certainly define that issue with a negative bias.

Buttressing this view is the recent action by Warren Buffett to terminate credit default swaps that were insuring $8.25 billion in municipal bond debt. Buffett's Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) canceled the contracts – which would require BRK to pay if the bonds defaulted – five years before their expiration.

Maybe Buffett sensed the fiscal cliff danger isn't worth a gamble on muni bonds.

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