Warning: Muni Bond Chaos Imminent

Whenever folks from Washington or Wall Street try to persuade you that the Great Debt Crisis is now “over,” I suggest you shake their hands politely, usher them to the door, and tell them to never come back.

They didn’t see the crisis coming. And they have no idea when or how it might end.

The reality: We now have not one — but FOUR — sweeping debt crises striking at the same time …

1. The mortgage debt crisis, said to be “mostly behind us,” has continued to deepen, fester, and spread — a shocking 13.78 percent of U.S. mortgage loans now delinquent or in foreclosure, despite trillions spent or lent by Washington on housing market bailouts. (For our early warnings, see Housing Bust Spreading published here in 2005 and for our latest commentary, see Mortgage Mayhem Spreading.)

2. The sovereign debt crisis, thought to be “history” after Europe bailed out Greece earlier this year, is now back with a vengeance, smashing the economies of Greece and Ireland … hammering the euro … spreading to Portugal and Spain … engulfing Belgium … and even threatening to bust apart the entire European Union, the world’s LARGEST economy. (See our most recent update in New Phase of Debt Crisis! Striking NOW.)

3. The bank failure crisis, assumed to be “under control,” has actually been worsening all along: The number of bank failures is the highest since the 1980s … while the FDIC has a record number of banks on its “problem list.” But the FDIC’s list is just the tip of the iceberg, since it fails to include some of the country’s largest weak banks.

4. The city and state debt crisis, which we warned about in “The Case Against Tax Exempts” chapter of The Ultimate Safe Money Guide … in “California Collapsing” … and many times since.

Now, after ignoring it for many moons, Wall Street and the financial media are finally waking up to the dangers.

Consider, for example, these excerpts from yesterday’s damning lead article in the New York Times …

“Some of the same people who warned of the looming subprime crisis two years ago are ringing alarm bells again. Their message: Not just small towns or dying Rust Belt cities, but also large states like Illinois and California are increasingly at risk. …

“The finances of some state and local governments are so distressed that some analysts say they are reminded of the run-up to the subprime mortgage meltdown or of the debt crisis hitting nations in Europe.

“Analysts fear that at some point — no one knows when — investors could balk at lending to the weakest states, setting off a crisis that could spread to the stronger ones, much as the turmoil in Europe has spread from country to country. …

“As the downturn has ground on, some of the worst-hit cities and states have resorted to fiscal sleight of hand to stay afloat, helping them close yawning budget gaps each year, but often at great future cost.

“Few workers with neglected 401(k) retirement accounts would risk taking out second mortgages to invest in stocks, gambling that the investment gains would be enough to build bigger nest eggs and repay the loans.

“But that is just what Illinois, which has been failing to make the required annual payments to its pension funds for years, is doing. It borrowed $10 billion in 2003 and used the money to invest in its pension funds. The recession sent their investment returns below their target, but the state must repay the bonds, with interest. The solution? Illinois sold an additional $3.5 billion worth of pension bonds this year and is planning to borrow $3.7 billion more for its pension funds.

“It is the long-term problems of a handful of states, including California, Illinois, New Jersey and New York, that financial analysts worry about most, fearing that their problems might precipitate a crisis that could hurt other states by driving up their borrowing costs.

“But it is the short-term budget woes that nearly all states are facing that are preoccupying elected officials.

“Illinois is not the only state behind on its bills. Many states, including New York, have delayed payments to vendors and local governments because they had too little cash on hand to make them. California paid vendors with I.O.U.s last year. A handful of other states, worried about their cash flow, delayed paying tax refunds last spring. …

“So some states are essentially borrowing to pay their operating costs, adding new debts that are not always clearly disclosed.

“Arizona, hobbled by the bursting housing bubble, turned to a real estate deal for relief, essentially selling off several state buildings — including the tower where the governor has her office — for a $735 million upfront payment. But leasing back the buildings over the next 20 years will ultimately cost taxpayers an extra $400 million in interest.

“Many governments are delaying payments to their pension funds, which will eventually need to be made, along with the high interest — usually around 8 percent — that the funds are expected to earn each year.

“New York balanced its budget this year by shortchanging its pension fund. And in New Jersey, Gov. Chris Christie deferred paying the $3.1 billion that was due to the pension funds this year.

“It is these growing hidden debts that make many analysts nervous. States and municipalities currently have around $2.8 trillion worth of outstanding bonds, but that number is dwarfed by the debts that many are carrying off their books.

“State and local pensions — another form of promised debt, guaranteed in some states by their constitutions — face hidden shortfalls of as much as $3.5 trillion by some calculations. And the health benefits that state and large local governments have promised their retirees going forward could cost more than $530 billion, according to the Government Accountability Office. …

“So far, investors have bought states’ bonds eagerly, on the widespread understanding that states and cities almost never default. But in recent weeks, the demand has diminished sharply. Last month, mutual funds that invest in municipal bonds reported a big sell-off — a bigger one-week sell-off, in fact, than they had when the financial markets melted down in 2008.”

The crux of the problem for investors …

Safety Nets Are Crumbling

In years past, municipal bonds investors relied on a series of protections that insulated them from a wholesale default scenario. Specifically …

■ They leaned on municipal bond insurance provided by giants in the industry, such as Ambac and MBIA.

But today, Ambac is in bankruptcy and MBIA is so strangled by litigation that it has stopped writing new policies. The ONLY significant player still in the business is the smaller Assured Guaranty Ltd. But even this insurer has lost its own top ratings, which effectively renders it useless as a muni bond insurer.

■ They relied on federal aid to states … and state aid to cities.

But today, the Republicans who will control federal aid going forward have vowed to block any further handouts to state and local governments. If anything, expect major cuts.

■ And to this day, despite all the evidence revealing serious biases and conflicts, many investors still seem to trust the bond ratings issued by Moody’s, S&P, and Fitch — along with their constant drone of reassurances that “muni defaults are highly unlikely.”

But these are the same rating agencies that deceived the public about looming banking failures in the 1980s, deceived the public again about major insurance company failures in the 1990s, and did it again in the 2000s with virtually every major failure of the debt crisis.

Here’s What to Expect Next …

First, municipal bond prices, which are already sinking rapidly, will suffer one of the greatest collapses of all time.

Second, the muni bond collapse will spread to other bond markets, which are already vulnerable for their own reasons — especially mortgage-backed bonds and long-term Treasury bonds.

Third, with sinking bond prices, interest rates will automatically rise — driving up the borrowing costs not only for cash-strapped local governments, but also for home buyers, corporations, and sovereign governments.

Fourth, with all other escape routes blocked, thousands of city and states governments will have no choice but to gut their budgets, declare bankruptcy, and in many cases, even shut down entirely.

My recommendation: Don’t wait for this crisis to escalate. Move swiftly now to greatly reduce your exposure to municipal bonds — especially long-term issues. Then, follow the alternative strategies that we recommend in Money and Markets.

Two caveats: If you work with a money manager, be sure to discuss possible exceptional situations. And if your municipal bonds are thinly traded, give your broker a few days to work the market and seek a fair price. If you tell him to sell immediately at any price, you could be disappointed with the results.

Good luck and God bless!

Martin