The Problem with Muni Bonds

The $3 trillion muni bond market.. where state, city and county governments borrow money.. looks to be in some trouble, though probably not too serious yet. Here's a summary of the problem:

http://www.ritholtz.com/blog/2009/11/state-local-taxes-plummet/

* Many states and cities have had their tax base crushed in the last year; New York and California saw revenues drop 20-25%, with lesser drops nearly everywhere in between. Some cities got it even worse.. imagine being the financial chief for the city of Detroit these days. On the county level (in most cases) a significant part of the tax revenue comes from property taxes.. and in most cases, this is falling as property value plummets and foreclosures bring fewer and fewer property tax payers. Whoops.

* As part of the economic stimulus of 2009, local governments got about $50 billion in aid from Uncle Sam. This won't happen again next year.

* As the economy got worse, the demand for social services (food stamps, medical assistance, welfare etc) grew expotentially.

* Many of these governments had invested in the stock market as a way to earn money and pay bills and/or retirees (CalPers). This year isn't too bad with the stock market rally; last year was brutal.

* Many of these governments were running deficits during the good years of the 1990s and 2000s, thinking that the good times would never really end and/or that if debt became a problem, it was a problem for the dude elected after I left.

Under these circumstances, the fear that a city or county will simply say "sorry dude.. not this year" and default is higher than ever.. and muni bond markets are pricing this risk accordingly, cruelly making the problem even worse as they charge higher rates. So far not too much higher, but the rates are creeping up, especially for those municipalities who are deeply in debt or who have been hit hardest by the downturn.

Recently the city of Vallejo, CA filed bankruptcy.. this will be a test case. During the Depression, municipalities initially were not allowed to file banko.. with the results being property tax hikes to unimaginable levels.. West Palm Beach had property taxes at 42.5% of assessed value. It was insanity, and eventually they were allowed to file bankruptcy, allowing a mad rush to the bankruptcy courthouses.

Today its a little more complex.. for example, who has the highest claim to what is left of Vallejo CA.. retirees or bondholders ?? Remember that when GM and Chrysler went under, the Obama Administration rose up for their union buddies and gave the bondholders (who had legal claim to first rights on whats left of the company) the shaft. Should this be how it shakes down in Vallejo, look for muni bond rates, especially for those deemed in trouble, to spike up nicely; some cities might not even be able to get anyone to buy them.

Remember that it's a $3 trillion dollar market.. the Vallejo case is important for those reasons. If Vallejo goes under without any real consequences, what would prevent a hundred other cities from doing the same ??

Here's a good article on this mess:

http://blogs.law.harvard.edu/philg/2009/11/03/the-coming-collapse-of-the-municipal-bond-market/

Here's the latest from Vallejo:

http://www.vallejobankruptcyupdate.com/

My impression overall here is that this mess is completely unnoticed.. everyone is concerned with the stock market, unemployment, housing, the USD, gold.. and if my hunch of deflation is correct, municipalities will have a very hard time finding buyers for their bonds at decent rates. The Vallejo case is important to watch. This is a HUGE market folks..