2011 Outlook: Municipal Bonds

Similar to the European Union the United States is made up of many local state and governments which currently find themselves insolvent.

State and local governments receive a majority of their revenue from taxes on residential real estate. During the boom years of the real estate market (2000-2007) their revenues surged as rising property values created a rising tax basis.

Budget committees then used this trending growth as a guide for future spending. They provided huge pay boosts to current government workers and went on both a hiring and spending spree.

Then in December 2007 our country entered a depression, which it still finds itself in today 3 years later. Real estate prices have collapsed, unemployment has skyrocketed, and consumer spending and business activity have crumbled. All these factors have decimated the balance sheets of these local governments who continued to spend based on fantasy projections, but no longer have the income to pay for it.

This disaster would have surfaced far sooner, but Congress approved the $800 billion stimulus plan during the 1st quarter of 2009, and within that plan was $150 billion to boost the economy through state and local governments.

This money was not used to boost growth, but instead used to keep the states on life support as they began to hemorrhage money across the board.

In 2010, the Build America Bond program was introduced that backed a large portion of municipal (state and local government) debt payments by the federal government. This guarantee allowed the local governments to raise a tremendous amount of new debt in the market and bought them some more time.

As we enter 2011 the Build America Bond program is coming to an end, and the $150 billion in stimulus has been spent. We have reached the point of crisis.

The crisis comes in two forms. The first is payments to current government workers and current spending needs such as city construction projects.

The second is payments to retired government workers that collect pensions. This is known as “unfunded” pension liabilities.

It is estimated that there is close to $1 trillion in current budget deficits, and close to $3 trillion in unfunded pension liabilities.

Without some sort of new bail out, cities and towns will begin to declare bankruptcy in 2011. The process will start slow, and then begin to move rapidly as investors run from the municipal debt markets making it more difficult and more expensive for remaining governments to borrow money to stay alive. The process will be another form of contagion, as seen in the subprime crisis when investors shunned all forms of mortgage backed securities.

The outcome of the disaster, just as with the European debt crisis, will be based on the response by both our government and the Federal Reserve.

My personal view is that the Federal Reserve will step in and begin to purchase municipal debt through QE3, at some point during this year. Or Congress can push through another state “stimulus” package to try and put a backstop in the market.

The federal government will just add this cost to the federal deficit, and the Federal Reserve will purchase more federal debt through QE3. The end result will be the same.

In either case (Fed purchases or bankruptcies) you will see a massive reduction in government spending and government employment which will add to the current unemployment problems in the United States.

Continued unemployment will have an effect on US economic growth as well as the stock market in 2011.