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The Problem With Muni Bonds

The situation in the municipal bond market turned seriously ugly. Muni bond ETFs and muni bond funds have taken a beating. And, if Meredith Whitney is to be believed, it's going to get far worse as cash-strapped cities and towns start defaulting on their debt.

Matthias Tunger | Digital Vision | Getty Images

It may be hard to believe, but not that long ago some of the smartest market watchers were actually claiming that muni bonds were relatively risk free—because the bonds have a long history of low default rates.

Felix Salmon, the Reuters blogger who once won an award from the American Statistical Society for "Excellence in Statistical Reporting," joined with investigative reporter Jesse Eisinger in early 2008 to complain that muni bonds were being rated too low by credit ratings agencies. Their idea was that ratings agencies were purposefully over-stating the risk of muni bonds in collusion with monoline bond insurers in order to force cities and towns to pay for bond insurance to get better ratings.

"The reason the business can be so rewarding is that government bonds are intrinsically safe: Municipalities almost never default," Eisinger wrote in the March 2008 issue of Portfolio.

Eisinger's thesis was relatively simple: municipalities are intrinsically safer than corporations because they have the power to tax. What Eisinger, and many bond investors, didn't appreciate is that the power to raise revenue through taxation can be limited by economic reality. In a downturn, revenues plummet. Higher taxes become impossible because raising rates will only choke off the economy even more, making the rate hikes self-defeating.

Muni bonds have always had a hidden danger: Cities and towns have far less—and less consistent —financial transparency than corporations, especially public corporations. Without an exchange traded equity market, and free from many financial disclosure rules governing public companies, muni investors are dependent on analysts and ratings agencies to discover information about the financial health of issuers.

How bad can things get for munis? Very, very bad. During the 1873 Depression more than 24 percent of the outstanding municipal debt defaulted.

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