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The Municipal Credit market year-to-date is up an unprecedented 76.3% to $112.2 billion, compared to last year's 2,680 municipal issues for the first four months of 2011 reining in about $63.65 billion dollars for states here in the U.S. The recent growth associated with the municipal credit markets can be directly attributed to advanced refunding bonds issued in 2012, which account for a substantial portion of municipal bond issuances in the first quarter of 2012. Forty-seven percent of all municipal bond issuances derived from refunding bonds in 2012. Now that the existing trend in the municipal credit market is becoming overwhelmingly flooded with new refunding bonds set to pay outstanding debt obligations on the part of indebted counties across the United States, the U.S. Federal Reserve Bank should consider widening its "Operation Twist" or administer QE3 to include distressed municipal debt that could ultimately yield tremendous gain for investors and government entities which are a part of defaulting notes trading at a premium to Treasury debt.

At the moment, there are 29 U.S. states and the District of Columbia projected to exceed fiscal 2012 obligations by $9.1 billion dollars. Thirty-one states are now projecting total budget gaps of $55 billion dollars for fiscal 2013, as these shortfalls are more daunting for states to address because options for addressing them are fewer and more difficult than in recent years. A study out of the Center on Budget and Policy Priorities, highlights temporary aid to states enacted in early 2009 as part of the Federal Recovery Act was enormously helpful in allowing states to avert some of the most harmful budget cuts in fiscal 2009, 2010, and fiscal 2011. As the federal government allowed that temporary aid to largely expire at the end of fiscal 2011, some of the countries deepest cuts to state services since the "great recession" are now coming to light.

Tax revenue has become the consistent catalyst in 2012 for state and local governments to meet their fiscal targets for the year. Fiscal year 2012, marks the second consecutive year state officials are forecasting state tax growth compared with the previous fiscal year. Although most states are projecting tax collections to rise in FY 2012, two-thirds anticipate tax growth of less than 5 percent. Tax collection targets not in-line with state budgetary forecasts for the fiscal year reduce the likelihood of a FY 2012 catalyst extending into FY 2013.

The country is left no other alternative, but to access the debt markets to raise sufficient capital from municipal debt issuances to run state and local affairs across the U.S.. John Hallacy, head of municipal research at Bank of America Merrill Lynch, said back in June of 2012 that he expected new bond sales to pick up and rise to $330 billion this year. While borrowing costs for many municipalities are at their lowest in a generation, a majority of these new bond issues are raising money to refinance higher-interest debt. This brings up the age-old question on whether the U.S. Federal Reserve Bank is ready to buy municipal debt as part of its stimulus policy, to include QE3 and "Operation Twist" this time around.

Back in 2010, there were numerous proponents for the same idea to bail out municipal credit markets as part of a brilliant QE2 measure. David Blanchflower, who was an MPC member at the Bank of England at the time, shared his view to Bloomberg about what the U.S. Federal Reserve Bank was able to purchase under its QE2 stimulus policy and what the Fed was not allowed to purchase under these conditions. Blanchflower writes:

"What will they buy? They are limited to only federally insured paper, which includes Treasuries and mortgage-backed securities insured by Fannie Mae and Freddie Mac. But they are also allowed to buy short-term municipal bonds, and given the difficulties faced by state and local governments, this may well be the route they choose, at least for some of the quantitative easing. Even if the Fed wanted to, it couldn't buy other securities, such as corporate bonds, as it would require Congress's approval, which won't happen anytime soon."

As Federal Reserve Chairman Ben Bernanke was laying out his $100 billion a month plan in 2010 to buy Treasury securities to stimulate the lending environment, there is a tiny $55 billion shortfall today for FY 2013 here in the U.S. as far as state and local governments are concerned. Extending "Operation Twist" to include refunding/defaulting municipal debts or simply buying faulty municipal debts as part of extending more QE3 measures, will not cause any major disruptions to the value of U.S. sovereignty on any level. $55 billion dollars, over 12 months, is considered a drop in the bucket when compared to $100 billion dollars in asset purchases over six-months to include defaulting mortgage-backed securities by Fannie Mae and Freddie Mac.

Investors are fairly optimistic today that the state of the municipal debt market is beginning to recover from 2010. Municipal bonds issued by hospitals have drastically outperformed the debt markets, returning 6 percent in 2012 and 15 percent over the past year. Municipal bond investors on July 11th, also shrugged off the move by San Bernardino, California to file for bankruptcy as the broader markets continue to perform relatively well. "There's still strong demand because there are more compelling reasons to jump into municipal bonds," said James Barnes, senior fixed-income manager at National Penn Investors Trust Co. "We're going to have bankruptcies here and there," Barnes said. Unless it turns into a streak of smaller bankruptcies or a big one that comes out of the blue, "the market is absorbing the news pretty well."

Muni pundits continue to point out that municipal credit has been amongst one of the safest and highest performing investments over the past two years, with defaults still down from last year and state budgets coming in on time. I am sure that a $55 billion dollar shortfall would seem very insignificant in the eyes of policymakers, who are making even bigger bets on risk-return buying relevant government instruments. Investor confidence in the municipal bond market is at a high point, as this creates further incentive to protect all gains accumulated within the municipal credit market. Proposing a mild extension to government incentives just in case FY 2013 comes in worse than expected for U.S. municipalities, should not send Wall Street running for the hills as of yet.

Source: QE3 And The U.S. Federal Reserve: Revenues For The Municipal Credit Markets