The looming federal government shutdown should worry muni investors.
Many investors in municipal bonds take comfort in the fact that it simply doesn't make sense for many bond issuers to default. It is far wiser, in most cases, for a city or a state to continue making timely payment on debt—even if it means cutting services or raising taxes—than to default.
But this flirtation with a government shutdown shows that governments don't always act prudently or wisely. Partisan disputes, political ambition, and conflicting policy goals can result in public policies that would otherwise appear to be highly irrational.
Think of a government default along the lines of a homeowner who can afford to pay his mortgage but decides not to. These so-called "strategic default" are sometimes rational responses by homeowners who are "underwater" on their mortgages. But, as University of Arizona law professor Brent White showed in a study last year, often the decision is driven primarily by emotion.
What's more, borrowers can be encouraged to default by the knowledge that others are defaulting, White found. This creates a contagion effect for strategic defaults.
Could the same thing happen in muniland? Undoubtedly.
There's no rule that governments must act rationally. Even if defaulting on their bonds is a bad idea from the perspective of the broad public, it may be a rational path for individual politicians or parties to purse. Or it might come about as the accidental byproduct of other political activities.
And once a few cities default, the temptation for other issuers to stop paying their debts could grow.
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