The New Danger in the Municipal Bond Market: State Bankruptcies

| About: BlackRock Municipal (BBK)

The headlines are nothing new: States are facing massive and unprecedented deficits. There is a crisis ahead in the municipal bond market. Defaults could amount to “hundreds of billions." And on top of everything, this September, states will have to begin making interest payments (to the tune of $1.3 billion) on funds borrowed from the federal government ($41 billion was borrowed to cover jobless benefits). Add to that the fact that state revenues are still 12% below pre-recession levels.

And now there is another problem facing the municipal debt market: Congress. Word is circulating that a bill to allow states a bankruptcy option (currently, local governments can declare bankruptcy – states cannot) could be in the works. To date, there is no draft of such a bill, and no member of Congress has offered to act as a sponsor. But the seed has been planted ... and the consequences could sprout.

Giving states a bankruptcy option would mean allowing them to modify pension obligations (pensions are underfunded by as much as $3 trillion, though other estimates suggest a lesser gap). That means that retirees, as well as investors, stand to lose.

Source: Center on Budget and Policy Priorities

The reality: The really severe underfunding issues are confined to a handful of states (Illinois, New Jersey, California). And according to a report released last week by the Center on Budget and Policy Priorities (CBPP), states likely have the means to meet pension obligations over time (by increasing contributions beyond the 3.8% average of operating budgets, modifying eligibility and benefits).

The problem: The introduction of such a bill, even enough media chatter about it, will lead to higher borrowing costs which many states can ill afford. But more than that - the question: Do states really need a bankruptcy option?

Quite possibly ... no.

The CBPP makes an important point: we need to keep a clear distinction between states immediate fiscal problems and long-term structural deficit issues.

The current operating deficit that many states face today is an immediate problem that needs a near-term solution, no question. But the pension obligation mess is a long-term issue, one that will linger for decades. A statute allowing states to modify these obligations is an immediate solution to a long-term problem ... and a solution that will only lead to further problems. According to the report: “Such a provision could do considerable damage, and the necessity for it has not been proven."

The municipal market is already being crushed: Muni bond mutual funds have seen outflows in the neighborhood of $25 billion over the last couple of months (according to the Investment Company Institute). But interestingly, debt levels are still within historic parameters, according to the CBPP, leading to calls that the risk of defaults is “exaggerated” (CBPP) and munis are being “over punished” (Barron’s).

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Source: Center on Budget and Policy Priorities

When the cure is worse than the illness ... don’t take the medicine. The muni market has enough problems, and state bankruptcy legislation will only lead to more panic selling. Let’s hope Congress recognizes that bankruptcy is not the prescription that states need.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.