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SKARBECK: Municipal bond defaults might be next crisis

June 12, 2010

Ken Skarbeck InvestingIs the United States on the verge of a wave of municipal bond defaults? Some experts are warning that, over the coming years, public officials may opt to default on municipal bonds and seek bankruptcy rather than push through the tax increases needed to cover their debts.

The credit crisis and prolonged high unemployment have led to falling tax revenues that, along with underfunded pension fund liabilities, have placed severe stress on state and municipal budgets.

In 2008, Vallejo, Calif., a Bay Area community of 121,000, unable to pay its bills and faced with declining revenue and escalating pension costs, filed for bankruptcy. To address its budget woes, it was clear the city needed to attack its pension costs. The bankruptcy judge overseeing the case even ruled the city had the authority to void existing union contracts. Nevertheless, the city has balked at reworking public employee pensions.

Observers believe Vallejo’s pension gaffe sets a bad precedent for other cities struggling under crushing pension obligations. If a municipality cannot, or is unwilling to, address a root cause of its financial woes in bankruptcy, its ability to emerge fiscally healthy is compromised. It also points to the lack of political will around the country to negotiate with the unions in an effort to address pensions—a major financial burden in many cities across the country.

Of course, for decades, politicians have regularly boosted public pension benefits to score election gains, while neglecting the long-term costs to municipal budgets. However, now the bills are coming due.

Elsewhere, officials in Harrisburg, Pa., the state’s capital city, are considering bankruptcy protection to restructure $68 million in payments due on an incinerator project. The city’s debt payments this year add up to four times the amount collected in property taxes each year. Harrisburg’s general-obligation municipal bonds now trade at five levels below an investment grade rating.

Central Falls, R.I., a small city of 19,000, is wrestling to pay interest on $17 million of general-obligation debt. The city’s budget of $18 million is saddled with a $3 million deficit this year, and its pension fund has $4 million in assets supporting $35 million in liabilities. Since Rhode Island, along with 22 other states, does not have laws that permit municipalities to reorganize their finances under Chapter 9 of the federal bankruptcy code, the city has chosen receivership.

Then there is Jefferson County in Alabama, which defaulted on $3 billion of bonds backed by sewer fees after a failed derivative strategy exposed corruption between municipal officials and their investment banks. In fact, the Justice Department is in the midst of a massive investigation of a nationwide conspiracy of municipal-bid rigging. Numerous indictments are expected of bankers charged with paying kickbacks and skimming fees to win municipal business, while cheating taxpayers in cities and towns across the country.

Recently, Warren Buffett warned the municipal bond market is a “terrible problem” and wondered if the federal government would feel compelled to rescue states facing a default, particularly since it bailed out corporations.

Considering that municipal budgets will continue to be under stress for some time, municipal bond investors need to be more vigilant than ever in assessing the quality of the revenue streams and the finances of the taxing authorities that back their bond holdings.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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