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Here it comes ...

SACRAMENTO, Calif. (NYSE:AP) — The people of Stockton will feel financial fallout for years after a federal judge ruled Monday to let the city become the most populous in the nation to enter bankruptcy.

But the case is also being watched closely because it could answer the significant question of who gets paid first by financially strapped cities — retirement funds or creditors.

What Stockton did is what was done here in Destin (and which is now the subject of a millage-rate hike fight) and what was done across the nation -- promising that which anyone with half a brain knew was bogus and could never be paid to retirees, coupled with ridiculously-generous work rules such as "20 and out" for firefighters and cops.

This bit Stockton hard and now its bankruptcy petition has been granted, which leads to an interesting setup between the 10th Amendment and Federal Bankruptcy law, the latter of which is an explicitly delegated power in the Constitution.

Unlike most such issues this one doesn't require stretching Constitutional boundaries -- the clear principle is that the Federal Government has the power to establish and regulate uniform bankruptcy laws across the nation. This is a good, by the way, not a bad, as it prohibits venue-shopping and other sorts of hinky games that could otherwise be exploited (and would be by particularly powerful plaintiffs) to screw the common investor.

But in this case it's going to bite hard, because now we have bond insurers who wrote credit insurance on California municipal bonds and leads to the open question: Can they pay?

It also leads to one of my more-serious concerns in today's world -- unlike in 2000 when I hid in munis, today that's dangerous as hell, especially if you try to do it with mutual funds such as the closed-end favorite of mine, [IQI].

IQI is down from a high of $15.07 last summer (and was pretty stable through into December) to a latest quote of $13.30. That's a roughly 12% decline.

To put this in perspective, the company has been paying a 6.875 cent/share dividend of late, or about 82.5 cents/share/year. At $15/share that's a ~5.5% yield, so the recent decline in price has wiped out about two years of earnings, assuming you sell.

The attraction of these funds is obvious on its face; 5.5% tax-free (federally anyway) is damned attractive in a world of ZIRP.

It remains attractive right up until 2+ years of those dividends disappear in capital loss at which point the clue-by-four hits you upside the head.

Remember, Stockton is one little town and by itself probably isn't even represented in IQI's portfolio -- and if it is, it's almost-certainly a small piece of it.

That's not the problem -- the problem is that this is likely to spread dramatically over the next five to ten years and as it does it will hammer the ever-loving hell out of these closed-end funds and their total return.

This is a point I've made repeatedly -- that formerly "safe" asset classes in which to hide are being narrowed dramatically, especially for people who don't have several million to spread around on their own. If you're in the "many million" camp you can buy individual bonds (which are typically sold in units of $10k each) and with some care in selection you can (mostly) evade these risks. But the smaller investor really doesn't have that choice because they are unable to get enough diversification in a bond ladder to both deal with duration and specific-issuer risk in a rational fashion, and thus they're pretty-much forced to turn to mutual funds in some form or fashion.

Municipal finance, in general, is a damned mess, even in places where you think it might not be. Virtually all of that is due to outrageously irresponsible "negotiations" that took place years ago where municipal and state employees were made ridiculously-rosy promises -- negotiations that anyone with half a brain had to know were going to eventually lead to massive budget blowups.

The responsible parties in municipal and state governments did not care about the fact that any sort of dispassionate mathematical analysis had to inescapably lead to the conclusion that they would go bankrupt. They did it anyway, and yet there has not been one prosecution or even serious investigation into the conduct of these people, all of whom have a fiduciary responsibility to the residents of their city, town or state.

All of these people -- every last one of them -- should be in prison, but just like all the other looting that has gone on in the economy over the last three decades none of them are.

Enjoy the ride folks -- it's going to get rough.

Source: Nowhere To Hide: Munis