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Are Municipal Bonds the Next Big Unknown Unknown?

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In the financial crisis of today, to use a popular maxim of Donald Rumsfeld’s invention, “there are known unknowns and unknown unknowns.” Some major unknowns have surfaced to become economic hurricanes reeking havoc on financial markets worldwide, such as the failure of Freddie Mac and Fannie Mae. But what unknown unknowns are still lurking under the surface, waiting to be discovered, buried in the media headlines, that could have an equally devastating effect on the economy and real estate markets across the country? One such potential dangerous unknown unknown that hasn’t received very much press attention recently is the current lack of financial stability in the municipal bond market.

Municipal bonds are sold by cities and municipalities across the nation to fund large real estate and infrastructure construction projects. They offer investors a tax free stream of income and offered by brokers around the nation as a low risk way to receive income without increasing the investor’s tax burden. Well, it turns out that the municipal bond markets now are starting to sound like a familiar story. Municipalities across the nation have taken advantage of low interest rates over the past two years to fund construction projects. However, about a one third of these funds were borrowed using a variable rate of interest. Now the municipalities are having trouble paying back their investors. Does that sound familiar? In fact, according to Joe Mysak of Bloomberg.com, “for all of 2007, something like $300 million in municipal bonds defaulted, according to the Distressed Debt Securities newsletter of Miami Lakes, Florida. So far this year, the figure is more than five times that, and climbing.”

To cite one specific example of how municipalities spend their borrowed money, Mr. Mysak describes how many cities over the past few years have borrowed billions of dollars to build and develop downtown convention centers. The hope was that the influx of the visitor’s spending money would fill city’s coffers with enough tax revenue to repay the loans. “How likely is that? Do you think American businesses are going to send their employees on a binge of convention-going in the next year or two? What happens to all this space and the billions of dollars in bonds that were used to build it?” Mysak sadly quips.

One great known in all of the financial problems that have beset the US economy is the fact that there are many more unknown unknowns that will simply become unknowns as the weeks and months grind on.

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2 Comments

  1. George Kennan on

    Next to US government Treasury bills, municipal bonds are just about the safest investment around. What your article fails to note is that states have a power that no corporation or private entity can possibly have — — the tax power. In other words, if a state has any prospect of default, it can raise taxes to pay off its bonds. In fact, in major states like California, the state constitution absolutely requires this. In a sense, municipal bonds are safer than Treasury bonds, because of a power the state lacks — — the power to print money. If the U.S. Treasury comes anywhere near the need to default on its debt, it has a choice of either raising taxes or printing money. Which do you think it will do in times like? We do need to make one important distinction, however. I am referring to what are called “general obligation” bonds. You would want to stick to these only, as opposed to municipal bonds backed by revenues, e.g., a hospital or sewer system. Any competent municipal bond broker can steer you to these. If you keep this in mind, you can have a long-term investment that is paying 5 1/2 percent tax-free right now, which is approaching the long-term expected returns from the stock market even in good times — — with the added plus of allowing you to sleep at night.

  2. California is asking for a $7 Billion federal bailout now – instead of solving their problems thru taxation.

    Nuveen bond funds – one of my favorite investments (past investment, thankfully) is headed for the basement as I write this note. It’s sure making the yields look terrific though.

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