Munis About to Blow Up

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Munis About to Blow Up

By: John Rubino | Mon, May 24, 2010


So I'm sitting here trying to turn a pile of (mostly terrifying) data on muni bonds into a post that explains why this is the next domino to fall, and here comes Time Magazine with a feature on that subject:

    Municipal Bonds: The Next Financial Land Mine?

    As Wall Street nervously watches the sovereign debt crisis unfold in Greece, another potential landmine is looming closer to home, one that could bring U.S. cities and towns to their knees, force the federal government to cough up another bailout package, and potentially send the unemployment rate much higher. The danger this time? Municipal debt.

    State and local governments are frantically scrambling to meet budget shortfalls as high unemployment and shaky consumer confidence mean less income tax and smaller sales tax revenue for government coffers. At the same time, falling home prices and rising foreclosures will start to hit municipalities hard this year as all those property reassessments done over the past 18 months kick in.

    A couple of municipalities, such as Los Angeles and Detroit, have even whispered the "B" word. Former Los Angeles Mayor Richard Riordan argued in an editorial in the Wall Street Journal earlier this month that the city will likely have little choice but to declare bankruptcy between now and 2014. Also, several smaller markets, such as Harrisburg, Pa., and Jefferson County, Ala., have openly talked about filing for Chapter 9 bankruptcy -- a reorganization available only to municipalities.

    In general, municipalities try to avoid Chapter 9 filings. Although such filings make it easier for a city to break onerous labor contracts or make other politically tough cost cuts, they can have hidden costs, such as distracting politicians, alienating business and making it more difficult for a city to raise cash in the capital markets going forward. The city of Vallejo, Calif., for example, has been in Chapter 9 since spring 2008, and observers say the process has been costly and hurt the city's ability to attract new business. "It's been two years and the case is still going on and there's still significant disputes with the unions," says Eric Schaffer, a partner at Reed Smith LLP. "Ultimately you hope to bring everybody to the table and share the pain, but that can be a messy process."

    Bankruptcy is a particularly unnerving prospect for bondholders. Municipal securities are a $2.8 trillion market, according to Municipal Market Advisors. An avalanche of investors sought refuge in the sector in recent years, lured by the stable, tax-free nature of muni bonds. More than $69 billion flowed into long-term municipal bond mutual funds in 2009, up from only $7.8 billion in 2008 and $10.9 billion in 2007, according to the Investment Company Institute. Another $15.2 billion has been added so far in 2010.

    But increasingly munis are seen as vulnerable to the same forces that have put companies and some sovereign governments in crisis. "The whole system is pretty fragile," says Brian Fraser, a partner at the law firm Richards Kibbe & Orbe LLP. "The assumption has always been that municipalities aren't going away and that they can always raise taxes to pay debt," but that's no longer the case, he says. He noted how Jefferson County, which is teetering on bankruptcy, was unable to raise sewer rates to meet its sewer bond obligation. Adds Richard Raphael, executive managing director at Fitch Ratings: "This is the worst downturn ... and most pressured environment for municipals in decades." Read the rest of the article here

Some thoughts:

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      Note the process at work: The housing bust caused home prices to fall, which over time causes assessments to decline, which results in lower property taxes. This is just now playing out, lowering tax revenues for cities that are already unable to pay their bills.
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      Along with U.S. Treasuries, munis are where capital hides during uncertain times. This isn't speculative money; it's "cash" that risk-averse investors assume will hold its value and be readily accessible. So most muni owners aren't paying attention and will be doubly shocked when they not only lose money but can't get at it because of default or bankruptcy.
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      This is America's Greek crisis. A major city or state will default on its debts, threatening a cascade failure of the many others in similar straits. The federal government, like the EU, will stare into the abyss and will blink, agreeing to take muni debt onto the federal balance sheet.
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      At some point the global markets will notice that the U.S. is just California writ large and will treat the dollar accordingly. Maybe munis are the wake-up call.

Author: John Rubino

John Rubino
DollarCollapse.com

http://www.safehaven.com/article/16909/ ... to-blow-up