Municipal Bonds: The Next Financial Land Mine?

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Raimund Koch / Corbis

As Wall Street nervously watches the sovereign debt crisis unfold in Greece, another potential landmine is looming closer to home, one that could bring U.S. cities and towns to their knees, force the federal government to cough up another bailout package, and potentially send the unemployment rate much higher. The danger this time? Municipal debt.

State and local government are frantically scrambling to meet budget shortfalls as high unemployment and shaky consumer confidence mean less income tax and smaller sales tax revenue for government coffers. At the same time, falling home prices and rising foreclosures will start to hit municipalities hard this year as all those property reassessments done over the past 18 months kick in.

A couple of municipalities, such as Los Angeles and Detroit, have even whispered the "B" word. Former Los Angeles Mayor Richard Riordan argued in an editorial in the Wall Street Journal earlier this month that the city will likely have little choice but to declare bankruptcy between now and 2014. Also, several smaller markets, such as Harrisburg, Pa., and Jefferson County, Ala., have openly talked about filing for Chapter 9 bankruptcy — a reorganization available only to municipalities.

In general, municipalities try to avoid Chapter 9 filings. Although such filings make it easier for a city to break onerous labor contracts or make other politically tough cost cuts, they can have hidden costs, such as distracting politicians, alienating business and making it more difficult for a city to raise cash in the capital markets going forward. The city of Vallejo, Calif., for example, has been in Chapter 9 since spring 2008, and observers say the process has been costly and hurt the city's ability to attract new business. "It's been two years and the case is still going on and there's still significant disputes with the unions," says Eric Schaffer, a partner at Reed Smith LLP. "Ultimately you hope to bring everybody to the table and share the pain, but that can be a messy process."

Bankruptcy is a particularly unnerving prospect for bondholders. Municipal securities are a $2.8 trillion market, according to Municipal Market Advisors. An avalanche of investors sought refuge in the sector in recent years, lured by the stable, tax-free nature of muni bonds. More than $69 billion flowed into long-term municipal bond mutual funds in 2009, up from only $7.8 billion in 2008 and $10.9 billion in 2007, according to the Investment Company Institute. Another $15.2 billion has been added so far in 2010.

But increasingly munis are seen as vulnerable to the same forces that have put companies and some sovereign governments in crisis. "The whole system is pretty fragile," says Brian Fraser, a partner at the law firm Richards Kibbe & Orbe LLP. "The assumption has always been that municipalities aren't going away and that they can always raise taxes to pay debt," but that's no longer the case, he says. He noted how Jefferson County, which is teetering on bankruptcy, was unable to raise sewer rates to meet its sewer bond obligation. Adds Richard Raphael, executive managing director at Fitch Ratings: "This is the worst downturn ... and most pressured environment for municipals in decades."

Since last July, 207 municipal issuers defaulted on bonds valued at $6 billion, and that number is expected to escalate, says Matt Fabian, managing director at Municipal Market Advisors. Of the 207 defaults, the large majority involved riskier bonds that were backed by land, casinos, residential developments, hotels, or specialty projects, such as Las Vegas' Monorail project, he says.

Economic recovery may be showing up in corporate earnings, but it hasn't lifted the dark cloud over big-city muncipal budgets. A survey, released this week by financial advisory firm AlixPartners LLP, found that 90% of restructuring experts polled believe a major U.S. municipality will default on its debt in 2010, which is even bigger than the 63% who said a sovereign debt default would happen.

Adding to the muni-bond sector woes — the credit crisis caused many bond insurers to close shop, increasing the risk to muni bond investors. Currrently, less than 10% of new municipal bond issues are insured, which is down from about 50% in 2008, according to the Municipal Securities Rulemaking Board.

All of this has prompted ratings agencies to downgrade muni bonds. "There are definitely a lot of municipalities out there that are in trouble, and it's important to do research on the actual bond rather than just rely on Ratings," says Greg Gurevich, a municipal bond trader at Legend Securities.

Some investors, smelling blood, are jumping into the credit default swap market to bet against cities, towns and states. CDS instruments, which are basically insurance contracts that protect a bond holder against default, can be bought or sold, depending on the investor's bet. "The spreads on CDS's have been growing and the dollar amount of CDS's on municipals has grown in the last year," says Fraser. "That's a clear warning sign that people are effectively starting to short the muni market."

Marilyn Cohen, president of Envision Capital Management, a Los Angeles bond investment firm, believes that if a major market, such as Detroit or L.A., filed for bankruptcy or had a major default, it could trigger panic through the entire muni market. "A major default by a major city would really set the muni market on its head because people would be frightened," she says.

But some experts believe the risk of a nationwide muni bond crisis remains low.

"Just because something happens in the state of Washington or Michigan, that doesn't necessarily mean that the credit in Pennsylvania or New York is bad," says Tom Kozlik, an analyst at Janney Montgomery Scott. "I don't think it's going to be an all-out scare that leads to a municipal meltdown where people want to sell their securities like dominoes." Still, he says a default by a city such as L.A. or New York could have wide repercussions.

Market experts say they're keeping a particularly sharp eye on Detroit and Los Angeles, as well as markets that were hit hard by the boom-and-bust housing meltdown, such as Las Vegas, Phoenix, Miami, Jacksonville, Orlando and Orange County.

Cohen says many investors believe that if such a doom-and-gloom scenario becomes reality, the federal government will step in.

"I think there is a complacency mentality that if something big happens, well, the government will bail us out," says Cohen.

Indeed, even billionaire investor Warren Buffett expressed a similar sentiment during Berkshire Hathaway's annual meeting earlier this month. "It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they've gone to General Motors and other entities and saved them," said Buffett, while addressing shareholders. "I don't know how you would tell a state you're going to stiff-arm them with all the bailouts of corporations."