It is certain that someone will left “holding the bag” on municipal bonds that likely will default in the next few years, but there is no program set up to handle this risk, that is “strong” enough to actually shoulder the risk.
An unusual number of letters of credit are rolling over now, because many municipalities were forced to arrange new financing in 2008, and the letters of credit written then were written to last for only two or three years. Without the letters of credit, they are in danger of losing their financing. We don’t know that this is a direct result of the MBIA ruling, but it no doubt didn’t help. The WSJ indicates that there are many municipalities in need of new letters of credit, but are having difficulty getting them. In an article this morning, the Wall Street Journal tells us that bank letters of credit, which would also insure against the risk of default, is becoming less available and more expensive. Now, this week, a New York appeals court overturned the lower court’s ruling, leaving the banks with less protection. Banks sued to challenge MBIA’s restructuring plan, and initially a lower court ruled in favor of the banks. It restructured in such a way as to provide less protection in the case of default, because of its financial difficulties. If insurance companies cannot provide coverage in the case of a municipal bond default, banks who have issued letters of credit guaranteeing these loans are next in line to pay.
One of the big ones, MBIA, is in the news again now. Several municipal bond insurers did run into difficulty. I wrote back in early 2008 that “monoline” bond insurers–the ones insuring municipal bonds were likely to encounter financial difficulties. Higher interest rates are themselves a problem, because if makes it more difficult to afford the current level of debt.Īn even bigger part of the problem has to do with defaults. Interest rates seem to be rising, especially on longer-term debt. We read yesterday that New Jersey scaled back its offering by 47% yesterday, when it found required interest rates were higher than expected. Now municipal bonds seem to be having some of the problems that have been expected. States find themselves in poorer financial condition, in part because they have to pay more benefits to the unemployed (without an increase in tax revenue), and in part because road repairs cost more. Some of these debt default problems fall through to cities that try to collect taxes on the value of homes. Higher oil prices -> business layoffs -> unemployed unable to make debt payments->defaults on loans. Higher oil prices -> less money to spend on discretionary items -> less demand for new homes -> lower home prices -> more debt defaults There are many ways debt default problems arise from higher oil prices. But if one looks at the long term oil situation, and the problems states and cities are having already, it is pretty clear that the debt default problem is likely to get worse over time, and there is really no one set up to handle the default risk. To date, everyone has assumed that there is not much risk of default, and even if there is, someone else will handle it. “Municipal” bonds include bonds issued by states, as well as bonds issued by cities and by many types of smaller entities, such as hospitals and toll roads. The question is, “Who ends up holding the bag, if major municipal bond defaults take place?” For a while, some of this was hidden through lower oil prices and stimulus programs, but we are now beginning to see problems arise again, this time in the area of municipal bonds. I have written quite often saying that rising oil prices can be expect to lead to debt defaults.
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