Why Muni Bond Crisis May Be Exaggerated

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Even in a world where we’ve become numb to ever-larger numbers, the $2.9 trillion of outstanding muni debt sounds big.

It’s a quarter of the nation’s GDP. It’s nearly double the federal government’s deficit projected for 2011.

The size of the outstanding debt—up $85 billion in a year, and nearly $1 trillion in the past five —has become Exhibit A among those who worry the nation could soon see a wave of local and state government defaults.

Savvy investors are looking at the market a little differently. They acknowledge there are serious problems, and the situation could worsen in coming years as debt comes due and local government are forced to pay for the surging medical costs of their retirees. They even believe there could be substantial defaults.

Municipal Bond Maze - See Complete Coverage
Municipal Bond Maze - See Complete Coverage

But instead of looking at the number as a whole, they break it down into its pieces and see both a far more manageable problem than is seen by those who gross up the problem and opportunities. Fundamentally, those looking at the problem analytically understand that the ability of Indiana to repay its debt is not arbitraged by Illinois.

For example, the total debt may well be $2.9 trillion, but only about $1.2 trillion is owed by the states, of which roughly $460 billion is tax supported, that is, the obligations have a call on the state’s general tax revenue, according to Michael Schroeder, a principal at Wasmer, Schroeder & Co.

About $1.6 trillion is local debt, and about $1.2 trillion of this is tax-supported. The remainder is the debt of non-profits, such as hospitals and universities, or industrial revenue bonds. So, all in, about $1.8 trillion of the state and local debt is tax supported. Of this, about $200 billion is pre-funded with treasuries.

How big is this problem? On one level, it’s a mess because the local obligations fail to take account of unfunded pension and benefit liabilities so it could grow. On another level, not so bad, because it is exactly equal to state and local annual GDP.

It’s the equivalent of earning $50,000 in a year and having a $50,000 mortgage. That is, relative to the total size of the state and local economies—in aggregate—the debt levels are manageable.

And the most important point may be that there is no aggregate problem at all. That is, the $23 billion of state debt for Illinois is a separate problem from the $107 billion of California debt.

There are some 90,000 different government entities in the U.S. To be sure, their economic prospects rise and fall together at least somewhat, but their debts levels and abilities to repay are vastly different.

For example, the map of the most indebted states is one clue to looking for problem areas. California, New Jersey, New York and Texas stick out.

Then again, maybe it’s not a good way to look at it. Note that the biggest, most populous states are always the most indebted. It’s exactly what you’d expect and, in fact, not a sign of trouble at all.

CNBC asked the research company Lumesis to identify problem states through just one potential metric: state debt relative to personal income by state. This is a way of showing debt relative to one measure of an ability of the state to repay.

The result is that some states that looked worrisome in the first map, like Texas and Florida, become less worrisome when you look at the income of the state’s population to repay.

So Texas and Florida look troubling when considering their aggregate debt, but less so when looking at their debt as a percent of personal income. New York ends up looking a little better this way as does Michigan but California and New Jersey remain the problem that markets perceive them to be.

Of course, sometimes the problem isn’t on the state level, but rather local where a given water authority or municipality has far overstretched its means.

The bottom line is that a panic has come over the muni market with widespread fears of default at all levels. Some investors have stepped in, believing that the problem itself is overstated and finding arbitrage opportunities where credit spreads have widened with the broader concern about munis to point that is out of line with the underlying credit risk.