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Huge Flaw in Municipal Bond Assumptions

By Mike Shedlock on 09/30/2010 – 8:54 am PDTLeave a Comment

Everyone plowing into municipal bonds on the assumption the federal government will bail out the states may have another thing coming says Herbert Gold at Institutional Risk Analyst.

Please consider The Great Contraction Coming in State Finances

Back in August, the U.S. House of Representatives took a break from its recess to pass legislation giving $26 billion to the States for education and healthcare. This $26 billion is a stealth bailout for States on the verge of default. As such it is a band-aid that prolongs the crisis while sending a false signal to the markets. In the event of a State default Washington will not rescue the States.

The municipal debt crisis is well known. California by some measures has the world’s 8th largest economy, yet it faces the prospect of once again issuing IOUs to its creditors as its government continues to struggle to pay its bills. Illinois, America’s fifth most populous state, is running nearly half a year behind on meeting many of its obligations. New York and New Jersey, the latter despite some bold political moves by Governor Chris Christie, are similarly situated. Indeed, according to the Center on Budget and Policy Priorities only four states have avoided budget shortfalls this year.

Despite these conditions the market for State debt remains placid. Municipal securities continue to trade at favorable rates even though the larger economy has shown no solid signs of meaningful growth. The reason for this lies both in the fact that States historically don’t default, and the belief that Washington will provide funding in the event of a true crisis.

The market continues to assume the federal government would not let a big issuer like California default. But this theory has a huge flaw: absent a vote from Congress there is no easy mechanism for the federal government to rescue the States. And after the political backlash from the TARP vote it is safe to say Congress will be loathe to issue any more blank checks to bail out the states.

It’s unlikely the Fed would be inclined to bailout a State in distress given the political backlash the institution would face after another open-ended program that told the world (yet again) the US was ready to simply print its way out of its problems.

The market remains convinced that, in the worst-case scenario, Congress would not risk the disruption that would follow a State default. But countering this idea is the role federalism plays in our political system as well as an appreciation of the damage done to politicians who supported TARP.

Senator Bob Bennett (R-UT), a highly respected member of the Senate, was unceremoniously dropped from the ballot in the Republican primary in Utah in large part because of his vote on TARP. At least five other sitting officeholders have lost in their own party primary this year for the same reason, to say nothing of the large- scale losses likely to occur this November. Any politician interested in keeping his or her job would be very wary of voting for a State bailout. And this does not account for the role the States play in America’s governing system

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Tags: center on budget and policy priorities, , herbert gold, , political backlash,

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