Friday, December 26, 2008

The coming calamity: Cities defaulting on bonds

If you believe the mess on Wall Street was bad, then you'll be down right terrified if predictions come true that many U.S. municipalities will be defaulting on their bonds sold to investors -- mostly the elderly and affluent.

Municipal bonds, or MUNIs, are bond sold by cities to finance infrastructure projects – such as the construction of schools, other public buildings, sewers, etc. The bonds usually are 30-year notes, paying tax free interest. The city backs the MUNIs with its ability to tax its citizenry. Most bonds with a high rating AAA or AA pay from 4 to 5 percent in interest on a monthly basis.

So what's the problem?

Cities and states are sinking under growing budget deficits as people no longer buy as much and thus pay less in sales taxes for government operations. Homes are being foreclosed upon, meaning no one is paying property taxes. Next year, one in 10 Americans will be behind in their mortgage payments. That will be a record high.

The state of California will be out of money by February. Tennessee must cut $1 billion from its current budget. That will mean the local share of tax revenues that states deliver to counties will be severely cut. Local governments will be forced to raise taxes or cut services or both. And people being laid off and losing their homes are not going to be able to pay those higher taxes.

So the result is that bonds backed by the power of municipalities to tax their citizenry are not going to be safe places to have one's money invested. Some cities will not be able to make the interest payments on the bonds to investors. And the ripple effect will be Tsunami-like.

The U.S. government will not have the means to bail out these municipalities since it will be delivering economic stimulus checks to the American people. Perhaps the only hope will be the Chinese, who already own more than $1 trillion in our nation's debt. They might want to buy your city. And you might want to sell it to them.

Conversely for investors, MUNIs have been one of the safest and most rewarding places to put money. They have ensured that the wealthy stay wealthy. And they've attracted a diverse group of the monied from Suze Orman to Teresa Heinz Kerry. The loss of wealth in this nation from MUNI defaults will be staggering.

The fall of some MUNIs will send shockwaves throughout the economy and make this depression one to rival the great one of the 1930s.

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