How Muni Bond 'Molotov Cocktail' Could Do Big Damage

It's the other U.S. debt problem.

States are scrambling to close $114 billion in budget shortfalls over the next year and a half. For now, they can borrow at curiously low rates in the bond market — but they better hurry.

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Lenders are still throwing money at the federal government, despite its trillions of dollars of debt. But when it comes to states, cities and local governments deep in the red, their generosity appears to be running out.

Prices of municipal bonds, which are issued to build schools, lay water pipes and pave roads, dropped last month at one of the fastest clips since the credit crisis two years ago. Shares of mutual funds that hold the bonds have fallen hard, too.

Some experts worry that problems in the municipal bond market could spread to other markets. Their worst case: A plunge in muni prices triggers panic among investors and widespread selling of other financial assets. That happened during the 2008 credit crisis, when the market for mortgage-backed bonds collapsed. Credit markets froze and stock prices plunged worldwide.

A recession that had begun nearly a year earlier became the worst downturn since the Depression.

"It's a Molotov cocktail," Envision Capital founder Marilyn Cohen says of the muni market. "It could explode."

The causes of turmoil in the $2.8 trillion muni market are myriad, but critics say one was misplaced investor enthusiasm.

State and local governments have rarely been in worse shape, but the average investor was convinced they would always pay back what they owed anyway. So bonds were scooped up, prices rose and yields, or the interest paid each quarter as a percentage of those prices, fell to the lowest in decades. New buyers of muni bonds earned less in interest, even as the risk grew that a state or city or town couldn't pay it.

At this point after a recession, the economy typically would be growing strongly, raising the tax revenue needed to close budget gaps. And if the economy snaps back, city and state tax revenues will grow quickly, making the crisis a memory.