Muni Market Mayhem?

If chaos in the municipal bond markets is the big financial story of 2011 heaven help us all.

Meredith Whitney
Meredith Whitney

The story of weakness in the muni market is threatening to cross over into the mainstream media — just as the U.S. housing market story crossed when that bubble spectacularly imploded — like an economic supernova metamorphosed into a financial black hole.

60 Minutes did a layman's introduction last night to the budget woes faced by the states. (Meredith Whitney spoke on camera: She called the state debt issue "certainly the largest threat to the U.S. economy". ) The Wall Street Journal ran a piece this morning on the ongoing woes in muni-land. And The Financial Times Alphaville did a wrap-up today, linking to other troubling stories they'd done in the past.

So what is going on here?

If you're new to the topic, here's a summary necessarily stripped of nuance in the interest of concision.

Like seemingly everyone else in this economy, some of our individual states are in serious financial trouble.

The recession has caused a drop in tax receipts that the states have taken in: And — like the structural weakness of a pier exposed at low tide — the chronic overspending of certain states has come to light.

The threat is this: The bond market will begin to take a dimmer view

of debt issued by those states — and their muni bond prices will drop.

(As I observed in an early piece: "One day, reality sets in. The most powerful force in the universe isn't love: It's the bond markets.")

When bond prices take a nose dive, yields spike.

And when yields spike borrowing costs for issuers are driven up.

And then interest costs become an even larger burden on the states — relative to overall spending and in absolute dollars.

And that has the potential to further financially weaken the states. Which is likely to cause more deterioration in the states creditworthiness. Which, in turn, causes higher borrowing costs.

If you think that this scenario sounds a lot like what is informally called a vicious circle, you'd be correct.

And If you think this all sounds familiar — like precisely the scenario unfolding in the eurozone — you would be correct again.

There are, of course, differences between the states muni debt and the situation in Europe. (And some of the differences favor the states in the comparison.)

But perhaps the biggest difference of all is this: The ECB has been buying up weak debt to help support the market — while the Federal Reserve is statutorily limited in the exposure it can take on vis-vis municipal debt.

A major deterioration in the municipal bond market would affect the states at nearly every level including their ability to provide basic services to their residents.

And perhaps to the glee the Austrians among US States do not have the option of debt monetization.

Where that leaves them — in the event of a major Black Swan type financial crisis — is really anyone's guess.

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