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June 23, 2010

The Municipal Debt Problem

 The municipal debt market is $2.8 trillion worth of risky debt.  However, according to a recent Wall Street Journal article, the debt isn’t priced as risky. Why?
The June 14th edition of the Wall Street Journal gave a good report at the health of the municipal debt market.  What I found interesting was that municipal debt was trading at 3.15% interest for the week ending June 11th and was down from 3.3% in April.  Lower interest rates suggest that the debt is becoming safer, yet is this really the case?
According to the WSJ, only .002% of municipal debt defaulted in 2009, signifying that the municipal market appears to be stable.  Despite this, investors, including Warren Buffet are steering away from municipal debt in the latter half of 2010.  Why? 
Municipal governments have yet to stand on their own two feet after being propped up from the federal stimulus over the past 18 months.  As state and local governments begin to lose federal funding, they will need to rely more on property taxes and sales tax revenues in order to continue paying their interest payments.
Despite some optimism, we have to keep in mind that asset prices are still low (therefore less property tax income), foreclosures are still high, and there is still a massive amount of pension costs coming down the pike.  So, why are municipal bond rates trading so low?  I believe part of this is because bond demand is still high in a shaky stock market.
We have to keep in mind, however, that municipal debt is a problem we’ve kicked down the road and as the stimulus ends, defaults will begin to rise and spread.  Investors know this, yet they continue to buy municipal bonds at low interest rates (which means they are paying a high price for the debt).  It appears for the time being, that investors are expecting some type of future “bailout” from the federal government if local governments begin to have a “Greece-like” mentality.
So, why am I sounding the alarm on municipal debt?
Keep in mind that as debt rates go up, municipal governments have to pay more to service their current debt.  Therefore, if municipal governments begin having problems paying off their debt, interest rates will rise and make the problem even worse.  The essential “snowball effect” could have devastating effects on our recovery.
Government layoffs will likely rise (making the employment issue worse) and local governments will once again need to turn to the federal government for help.
Do you think an austerity plan to cut these municipal costs in 2009 would have helped more as opposed to “kicking the can” down the road through the federal stimulus programs?

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