Municipal bonds rates are floating higher than treasuries, which is significant, because muni-bond interest enjoys tax exemption, whereas treasuries do not.  This doesn’t happen often, for obvious reasons.  Both muni’s and treasuries are considered to be very low risk, so if one carries no taxes, as muni’s do, all other things equal, it should carry a higher price (i.e., lower interest rate). 

It’s too early to tell why exactly muni’s are suffering, but it might be the dismal state of the issuing entities.  According to Bloomberg, state and local governments face an $18.5 billion funding shortfall this fiscal year.

But what happens if a state or local government defaults on a bond?  If the experiences of Jefferson County, Alabama are any indication, not a lot.  Jefferson County defaulted on $3.2 billion in sewer bonds in 2008.  Nothing happened.  There was talk of possible bankruptcy, but it really never got past the initial-discussion stage.  It wasn’t until this year, over two years after the initial default, that a US District Court appointed a receiver to manage the sewer system for its many constituents (sewer system clients, bondholders, et al). 

So far as the bondholders are concerned, the receiver has very little ability to improve their recovery prospects.   He can’t raise rates too much–Jefferson County’s residents already pay some of the highest rates in the country.  He could, but said he won’t, impose non-user fees on the poor saps in the county that are not connected to the sewer, but still will undoubtedly be forced in some way to pay for its mismanagement. 

So, what to do?  Effectively nothing.  Just wallow along in the muck (pun sort of intended) until the bondholders get paid what can be paid.   Some efficiencies in operation ought be available, considering the sewer system is no longer used to fund the lavish lifestyles of the County Commission and its multitude of indicted and convicted Commissioners and contractors.  But other than that, it’s a haircut.

This reality will play out again and again across the nation as state and local governments are faced with budget shortfalls that prevent servicing their debts. 

State and local debt will likely be the catalyst for a return to the nascent financial crisis, still in its early stages (which probably means the federal government would step in, outside of their Build America Bond program already in place, to rescue the bondholders).  Muni’s were once thought to be safer than residential mortgages, though their only security interest is in the tax revenue (or user fees) of the issuing locality.  Bondholders will soon find out, like mortgage-backed security holders already have regarding housing prices, that revenues do not grow to the sky; that an impaired security interest can’t always be resolved with ever-higher prices or revenues.  

But a bondholder can’t foreclose on a town.  Or even a town’s sewer system.   Bankruptcy is of little benefit, to either the bondholders or the local entity, particularly in the case of a municipal-owned utility, like a sewer system.  Bankruptcy can’t change the crux of the obligation that is forcing the entity into bankruptcy.  It can only discharge or adjust a few of the obligations around the margins (e.g., employee pensions) that are eating up some of its free cash flow.

Jefferson County effectively accomplished all that a bankruptcy could with a judicially-appointed receiver for its sewer system, but with something less of the stigma.   Had it gone bankrupt, it would have been the biggest since Orange County, California’s bankruptcy in the early 90’s. 

But the bottom line is what everyone likes to pretend isn’t:  When muni’s go kaput, there’s really nothing for a bondholder to do except take a haircut,  and/or  hope and pray it’s bad enough everywhere until Uncle Sam prints some money to make everyone, at least nominally, whole.

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