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David Goldman has reacted with a curious mixture of alarm and reassurance to Dakin Campbell’s story about U.S. bank holdings of municipal debt:

If municipal debt actually defaulted, the capital position of the banking system would be impacted, bank preferred debt might stop paying, and the holders of bank preferred debt–starting with the insurers–would be in serious trouble…

Why buy munis? For all of Warren Buffett’s dire warnings about municipal finances, the fact is that the federal government can’t let major municipal debtors (at the level of states, for example) go under without also bringing down the banking system and everything else.

If it goes, it all will go together. That’s why munis ultimately will be bailed out.

This is altogether far too sanguine. And if you look past the alarmist headline that Bloomberg has put on Campbell’s story, and the out-of-context numbers in his first few paragraphs, he eventually reveals just how much of a non-issue muni debt really is to the banks:

Lenders hold just 8 percent of the $2.8 trillion state and local government debt market, and municipal bonds are only about 2 percent of total bank assets, according to the Fed.

Muni bonds are relatively safe for two reasons. Firstly, they very rarely default; and secondly, when they do default, they generally have very high recovery values.

But let’s get ultra-pessimistic here, and say that 25% of municipal bond issuers will end up defaulting, and that recovery on those bonds will be just 50%. Then banks would have to take a hit of 12.5% on their muni bond holdings, which would correspond to a hit of about 0.25% of their total balance sheets. Needless to say, that’s not the kind of event which would precipitate a default on their preferred debt.

A widespread municipal default would be harmful to the economy more generally. With $2.8 trillion of munis outstanding, a hit of 12.5% would mean $350 billion of losses, spread across individual investors who were looking for safe, tax-free investments, and a lot of monoline insurers. That kind of thing can hurt. But investments in municipal bonds tend not to be leveraged, and for long-only investors, a drop of $350 billion is equivalent to roughly a 2.5% wiggle in the level of the U.S. stock market.

So I don’t think that munis pose a major systemic risk in and of themselves, although a handful of them — California first and foremost — are probably too big and politically important to be allowed to fail. There will certainly be a lot of wailing and gnashing of teeth if munis do start defaulting, since they’ve long been sold as extremely safe investments, and because they’re largely held by individuals rather than institutional investors. But no one’s going to bail them out because they’re worried about the banks.

Source: Why Munis Don't Pose a Systemic Risk