The Corner

The Next Crisis Will Come from the States

As we watch the debt crisis unfold at the federal level, another disaster is looming closer to most of our homes (literally). It could bring many of our cities down. What’s more, the scale of the damage could be so large that the federal government wouldn’t be able to provide a bailout big enough to help (though I would be against a bailout anyway). The looming crisis: municipal debt.

To anyone who claims that the reason state and local governments have trouble meeting their budgets is lack of revenue rather than overspending, I would suggest a look at the growth in municipal debt since 2000. According to a new report by the Meredith Whitney Advisory Group, it has doubled since then. Spending has grown much faster than revenues. And those were the good years, the years when states’ coffers were filling up quickly. Just not as fast as needed to satisfy state and local governments’ endless appetite for spending.

According to Time Magazine, some cities are even looking at bankruptcy:

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.

The mystery, you may ask, is why anyone would be willing to lend money to L.A. or Detroit. They are, after all, not known for their fiscal responsibility. The answer is that a series of artificial legal, tax, and regulatory incentives lured investors into thinking that lending to bankrupted cities would be profitable (in pretty much the same way that government incentives led banks to lend money to people who should never have been able to borrow that much to buy a house).

In this case, it is the stable and tax-free nature of muni bonds that explains why we have seen investors pouring their money into municipal debt in recent years. We are talking billions of dollars here: According to the Investment Company Institute, $84 billion went into long-term municipal bond mutual funds in 2010, and about $69 billion in 2009. The 2009 level represents a 785 percent increase from the 2008 level of $7.8 billion.

Why should you care? Meredith Whitney explains:

You have to look at the states and the risk that the states pose, because the crisis with the states will result in an attempt at least for the third near-trillion-dollar bailout,” Whitney said. “That has consequences on the dollar, that has consequences on just about everything. It certainly has consequences on the US recovery.”

And if you need evidence that the muni-bond market could be next, here is a frightening paragraph:

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.”

I like how the market works.

Thanks to Eileen Norcross for the pointer.

Veronique de Rugy — Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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