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The Looming Threat of Municipal Bond Defaults

Can insurers take another hit?

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The arsenal of stimulus programs seemingly has stemmed the tide of capital market disasters and some think "green shoots" are taking root. But a new problem, perhaps even more daunting, is popping up: Municipalities across the U.S. have deep budgetary problems and the chance of default on their bonds grows every day. Recent estimates put the State of California budget deficit in excess of $24 billion, about a quarter of the size of the total budget, a shortfall that must be addressed in the next 30 days. What's more, while California has become the poster child for the problem, many other state and local governments are in the same fix. Some estimates put the total shortfall for all state budgets at almost $170 billion.

To be fair, some municipal bond holders are somewhat better protected than others. As pointed out in an article by Charles Schwab & Company, state general obligation bondholders in California are second in line for payment after mandatory education benefits are paid. Furthermore, because the bonds are backed by the full faith and credit of the state, alternatives such as raising state taxes to pay bond creditors is still possible and allowable under the California state constitution. However, payments from the state to local municipalities could be cut, endangering the ability of those bond issuers to meet their payments. Not all municipal bonds are state-backed general obligation bonds, and the spill-over effects from defaults at the state level to local government, especially those backed by only specific revenue districts, can be equally dramatic. Even if default never occurs, the credit rating of the bond could be cut, reducing the value of the bond in the near term.

Jim Ryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.