Beware Municipal Bonds

by: Felix Salmon

Meredith Whitney has a 600-page report warning of municipal bond defaults. I think she’s right — and I also think she makes a very smart distinction between municipal debt, as in the debt of towns and cities, and state-level debt.

The states are spending 27% more than they’re raising in taxes — but states can and will get bailed out by the federal government, in extremis. Cities, by contrast, are on their own:

Municipalities receive one-third of their revenue from the states. If the states hold back that money for their own stricken budgets, towns and cities won’t have the funds to make their interest payments. “It has to happen,” says Whitney. “The states will secure their own shortfalls, and leave the cities to fend for themselves.” It’s all about inter-dependency, she says, with the federal government aiding the states, and the states funding the last and most vulnerable link, the municipalities.

I’m not sure that interdependency is really the mot juste here: what we’re seeing is good old-fashioned dependency, with cities reliant on states and states reliant on the federal government.

And then, of course, there’s the monolines. Very few cities issue unwrapped bonds, and as a result it’s not the bondholders who are going to be hurt the most here. Instead, it’s the bond insurers. Insurance in general, and bond insurance in particular, is one of those businesses where you can make steady profits year after year until you lose a fortune. So while a lot of people reading Whitney’s report will be looking for clever positions they can put on in the market for municipal credit default swaps, I’d be careful there: the recovery value on defaulted bonds, at least in the first instance, is likely to be 100%, thanks to those bond insurers.

The more lasting effect of widespread defaults will be in the real economy, where public employees and public services will start feeling the pinch of forced austerity. Once you approach default, no one will roll over your debt any more and no one will insure your bonds. So you have to slash your budget: you have no choice. That process has barely begun, in the U.S., and depending on the timing, it could contribute markedly to a bout of deflation or even a double-dip recession. If the first recession had its causes in the nexus of finance and real estate, its follow-up could well be based in local government.