Vellejo, California: Ground Zero

Vellejo, California made major news this week when they announced their plan to exit bankruptcy through reorganization of the debt owed to its largest creditors:

They will be paying unsecured bond holders 5 to 20 cents on the dollar.

To understand what this means, let's say that Vellejo, California needed to raise money to pay for their city expenses because their income did not cover their expenses in 2010.  They pick up the phone and call your home and tell you they would like to sell you $100,000 in bonds.

They agree to pay you 6.5% interest on your bonds every year for the next 10 years, and at the end of 10 years you will receive your $100,000 principle back in full.

This sounds great to you since the bank is paying you less than 1% to hold your money in savings.

You write the check, put it in the mail box, and your interest payments begin to come in. 

Life is good.

Until you pick up the newspaper and find out Vellejo is declaring bankruptcy.  You read they will be paying out 5 to 20 cents on the dollar for the debt they currently owe.

This means they will be sending you a check in the mail for between $5,000 - $20,000 on your $100,000 investment, and hopefully some sort of apology letter.

Municipal bonds are owned by banks, government and private pension funds, foreign governments, and they are laced across 401ks all over America.

Vellejo is the first taste of what is to come, similar to the New Century subprime mortgage office that closed back in 2006.  The mortgage market was $14 trillion in size, while the municipal bond market is less than $3 trillion.  Just like the mortgage market there is "prime" debt, and there is "subprime" debt, so the entire $3 trillion is not going to be wiped away.

However, this will be the main story in America during 2011 (unless the stock market collapse back down to fair value) and investors should be very cautious what loans they currently hold in the bond funds in their 401k's and IRA's.