Muni Bondage: States in Pain

When I asked him recently about the possibility of state failure, legendary investor Jim Rogers said, “This is old news. I and others have been explaining about the perilous state of the US states for a few months.”

Uncle Sam taking money out of your wallet
Uncle Sam taking money out of your wallet

It may be old news to Jimmy, but state failure is an issue that could be new news once we get through the midterm elections, especially come January 1st when states can no longer stuff their budgets with federal cash.

Couple that with a looming municipal bond failure that Meredith Whitney believes is the real threat to the US States and you've got some states in pain.

Whitney says that municipal debt has doubled since 2000 and spending has long outgrown revenues. Remember that municipal bonds are guaranteed by the cities and towns themselves, who in turn receive about a third of their revenue from their state governments. If the states get into hot water with their own fiscal houses — as is already the case for many — they may withhold their revenue from the cities and towns, causing those municipalities to default on their loans.

Tony Crescenzi, VP of bond firm PIMCO, told me that the pressure on the municipalities is heightened by local unemployment data, especially in the education sector. He said that the large number of layoffs in local government leads to weakened tax receipts, making the ability to pay back loans even more difficult.

“States are pushing down their burdens onto local municipalities,” said Crescenzi, “So it is important for now to focus in particular on local governments.” He said "now"- did you hear that Mr. Rogers?

Technically, states can’t file for bankruptcy protection under Chapter 9, although local municipalities can. But Crescenzi said that should the states truly be in danger of folding, it is assumed that the federal government will step in to help.

However, he said, “Investors should not depend on this and should not expect states to be able to close their budget gaps through taxation alone.”

Crescenzi recommended that investors take a harder look at revenue bonds because they are backed by the municipalities’ essential services, like water and sewer. It’s assumed that these services aren’t going to be shut off any time soon, giving investors more confidence that the municipalities will be able to back them up.

Between Whitney and Crescenzi, it sounds like the states are in deep you-know-what. But Peter Delahunt, of Raymond James financial services company, offered this timid bright spot: according to recent Moody’s & Fitch ratings, the incidence of municipal defaults and bankruptcy filings has actually been quite modest when compared with other markets.

“For the first three quarters of this year, municipal defaults are under $3 billion or less than 1% of issuance,” he said, “And this after two of the most stressed years economically since WWII.”

Delahunt said that default risk might grow marginally, yet downgrade risk is a valid concern which could have an impact on liquidity. “This doesn’t necessarily assure comfort for the future,” he added.

So I went back to Rogers and asked him: “When will this all come to head? Q1? What will happen?”

He responded as only Jim Rogers could: “I do not know. You should watch CNBC. They have people on every day who know everything and can answer all questions down to the hour and the day.”


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