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Saturday, March 01, 2008

The Snowballing Crisis of Debt

I don't worry (too much) about the subprime credit crisis at Merrill Lynch, Goldman Sachs and others. Sure, it could total $600 billion, but these are smart people who will figure a way out of the the problem they created. If they don't, these companies will go bankrupt. Life will go on.

But the crisis in the municipal bond market is scaring the bejeezus out of me. Let's look at this mess.

As Forbes explains ...

Municipal bond insurance got its start as a way to protect investors if their bond issuer defaulted. After starting in 1971 ... The invention of municipal bond insurance revolutionized the public debt markets over the next 36 years.

The U.S. municipal bond market grew steadily over several decades to about $2.6 trillion in value as of year-end 2007, according to the Securities Industry and Financial Markets Association (SIFMA).

$2.6 trillion is about as much as the US will spend on the Iraq War. It's a heck of a lot of money. But this is basically how states and cities function now. They issue debt for projects at very low interest rates because the bonds are insured. But that insurance may turn out to be a mirage, or at least, it may no longer be available.

Bloomberg explains ...

Yields on top-rated 30-year bonds rose to 4.99 percent today, the highest in almost four years, as U.S. state and local governments plan to sell $20 billion of new bonds in the next 30 days, the most since December.

The biggest buyers of variable-rate notes, tax-exempt money-market mutual funds, are avoiding issues backed by insurers and local governments whose own rating is less than AA, said Joe Lynagh, who manages about $2 billion of tax-exempt money funds.

New York state paid rates ranging from 2.80 percent to 10.94 percent on seven-day variable-rate demand notes sold Feb. 27, the most recent data available. Bankers set interest rates of 5 percent or higher on six of the 18 issues sold that day.

Now, the market is actually seizing up.

Reuters explains ...

Two of these markets, auction rate and variable demand note obligations, have frozen because investors fear some bond insurers that backed this debt are no longer credit-worthy as a result of their bad bets on subprime mortgage investments.

This couldn't come at a worse time for municipalities. Their tax revenues are drying up due to the implosion of the housing market. Suddenly, it turns out that many municipalities may not be able to make good on their debt payments.

And that brings us to the next logical step -- municipal bankruptcy.

As the LA Times blog explains ...

The city council of Vallejo, Calif., had planned to vote late Thursday on whether to file for bankruptcy protection because its employee-benefit costs are soaring even as tax revenue declines. The vote was put off after officials said they had reached a tentative deal with their major unions.

Is the problem snowballing? In a word, "yes."

Even high-quality muni issuers that have no credit problems may pay more if they borrow soon, simply because of the heavy supply of bonds expected to hit the market.

This is absolutely the worst time to bring debt to market. Naturally, states and cities aren't changing their plans at all ...

In Sacramento, state Treasurer Bill Lockyer intends to proceed with next week's planned sale of general obligation debt, said Paul Rosenstiel, head of public finance.

Although the state may have to pay higher yields on the bonds than it would like, "we have a need to get into the market because we have a lot of projects to build," Rosenstiel said, noting the numerous infrastructure programs approved by voters in recent years.

"We have a schedule, and we're probably going to stick with it," he said.

And now Bloomberg explores the crisis of cities forced into loans with "predatory yields" ...

U.S. municipal borrowers from Camden, New Jersey, to Sacramento, California, might face a third week of higher interest costs as failures in the auction- rate bond market persist.

How bad will the crisis get? On Minyanville, Professor Bennet Sedacca takes a guess ...

Net asset values of all sorts of municipal mutual funds, both closed end and open end will likely get smashed. How badly? It depends on the quality but I am guessing anywhere from 5-20%.

Forbes says the municipal bond market is worth$2.6 trillion, but Sedacca's estimate is closer to $3.5 trillion. 20% of $3.5 trillion would be $700 billion. And as with all of these credit crisis estimates, they usually go much higher.
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