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Tax Supported Munis May Be Riskier Than You Think

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Many municipal bond investors who are shunning bearish forecasts of widespread defaults are relying on the fact that such a huge portion of the bonds issued are “general obligations” of the states and cities issuing debts. Historically, the default rate on general obligation bonds has been vanishingly small. Only 3 defaults have occurred since 1970.

That may change.

Here’s how the bulls say the muni market breaks down. About $1.2 trillion is held by the states. About $460 billion of that is what my CNBC colleague Steve Liesman describes as “tax supported,” which means that the bonds have rights to a state’s general tax revenues. About $1.6 trillion is local debt, with $1.2 trillion of that counted as “tax supported.” All in all, about $1.8 trillion of muni debt is “tax supported.” The bulls consider this tax supported debt virtually risk free.

That might not be such a sound conclusion. States and local governments facing a financing crunch may have to choose between a number of options: raising taxes, defaulting on pension obligations, or defaulting on bonds. Traditionally, muni debtors have chosen the first two paths, raising taxes or slashing pension benefits while leaving bond holders whole. But politics and economics may have shifted in a way to make it less likely that bond holders will be made whole.

How have the politics shifted? In the first place, the identity of municipal bond holders has changed. Once, muni bonds tended to be owned by local, wealthy individuals and local financial institutions. They are increasingly owned by large financial institutions. Politicians may be less hesitant to push losses onto these institutions than they were their local constituents. What’s more, the institutional investors may be less willing to cut deals with local politicians than people who actually had a stake in local prosperity once were. What was once a comity of interests could well become a clash.

Cuts to local spending and public pension funds may not be as easy as they once were. When cities tried to cope with debt problems in the 1970s by undertaking similar measures, they saw an explosion of crime and a deterioration of the quality of life for their residents. It’s easy to see how politicians and voters would be loathe to repeat this experience.

Politically, tax hikes have never been popular. In the aftermath of voter outrage at the bank bailouts, tax hikes to keep large, national banks and financial institutions from seeing losses will be politically unpopular, if not impossible.

The economics has shifted as well. Debt burdened states and localities may find it hard to raise taxes to fund their debts. Their tax bases have been devastated. For many states that have seen their core economic sectors hollowed out, there's little recovery in sight. They are now in a zero sum game, competing with each other for businesses and jobs. This makes hiking taxes even more difficult. We’ve already seen the neighbors of Illinois react to tax increases their by attempting to poach local businesses.

The muni bulls have history on their side. But the current situation may be unlike anything we’ve seen in recent history—anything, that is, we’ve seen since the Great Depression.

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