11.09.2011 0

The Municipal Bond Market Ponzi Bubble Inflates

By Robert Romano — Moody’s recently announced that the quality of credit in the state and local municipal bond markets is deteriorating, which credit downgrades outpacing upgrades by 5.3 to 1.  This led BigGovernment.com writer Chriss W. Street to proclaim that “The Municipal Bond Market is Imploding”.

A more accurate headline might have been that “Muni Bonds May Face Implosion,” because the selloff has not commenced.  Not yet.

As reported by the Wall Street Journal, municipal bond yields have recently been plummeting and governments are taking advantage of the low interest rates.  Sinking interest rates mean that auctions are doing just fine — the bond issues are selling.  $34.9 billion were sold in October alone, the highest all year.

But, if the credit quality of $2.8 trillion of outstanding municipal bonds is plummeting, why is demand for them rising? Easy, we’re in a bubble.  Although, there is a bit more to it than that.

Americans for Limited Government President Bill Wilson believes that the weak economy may be a part of the answer.  He said, “Stocks and all other vehicles are so volatile and risky that investors and pension funds are still flocking to perceived safety, preferably with a yield.  So far, that has been commodities like gold and particularly, government debt.”

But isn’t the weak economy what is making government bonds more risky?

“This underscores the insanity of government debt,” Wilson said.

“State and local governments, four years into the housing downturn, have failed to get their fiscal houses in order.  Property values are still depressed, and so too therefore are property tax revenues.  Meanwhile, spending is still too high and now federal stimulus monies are dried up.  Therefore, borrowing is the means to make up the difference,” he explained. States face consolidated deficits of about $103 billion, according to the Center on Budget and Policy Priorities.

So, the downed economy has increased governmental demand for financing, and financial institutions are meeting that demand in search for a safe investment during the recession.  Wilson called the relationship between the two “incestuous.”

“At the end of the day, investors are betting that government at the federal and state levels as well as the nation’s central bank will guarantee all government debts.  That, no matter how irresponsible these governments are with fiscal matters, that lending to them is essentially a risk-free enterprise,” Wilson said, noting that under the ongoing Basel capital accords, sovereign debt is classified as risk-free.

“This is why they call it easy money,” he added.

So far, the European experience has shown the lengths that governments will go through to prevent themselves from defaulting on debts they never have any intention of actually repaying.  Every year, the size of the consolidated governmental debts always rises, and merely refinancing requires an ever-expanding capacity of the financial system to extend credit.

Which is why it’s a Ponzi scheme.  By definition, later investors are required to pay off the interest owed to earlier investors.  In this case, the ones who wind up holding the municipal bonds are primarily pensioners.

Chriss Street warns, “many individuals have their entire life savings in municipal bonds.  When defaults become a reality, the press will run endless stories of tearful traumatized seniors and cringing corrupt politicians.  Then there will be panic!”

Which is the danger. While it is impossible to say when the bubble will pop — it comes at the point when the government’s demands for financing cannot be met by financial institutions, which is difficult to quantify — historically, whether on tulips or housing, they always do pop.

Pensioners and investors will likely not pay one cent for their losses — even though lending to profligate credit junkie governments that refuse to clean up their fiscal crack houses was a bad investment.  Once again, taxpayers will be the ones to pay — who while blameless will most certainly not be held harmless.

Robert Romano is the Senior Editor of Americans for Limited Government.

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