Muni Bond Market May Be Next Phase of Financial Crisis

The municipal bond market faces a "terrible problem," Warren Buffett told a Congressional committee and the public in his June 2, 2010, testimony.

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The public debt crisis that first appeared in Greece may blow through Portugal, Spain, Ireland and France—and right into Illinois, California, New York and Pennsylvania.

There's growing anxiety about the health of the $2.8 trillion municipal bond market, because issuers are facing a drop off in tax revenue, rising social services spending, and the prospect of higher interest rates at some point in future. Warren Buffett warned Congress and the public on June 2 that the municipal bond market faced a "terrible problem," although it might not manifest itself for as long as five to 10 years. Buffett has reduced his muni bond exposure from $4.7 billion to less than $4 billion. (A video of Buffett's testimony can be seen here. He addresses the muni bond market toward the end of the video, which is more than two hours long.)

The city of Harrisburg, Pennsylvania is considering a bankruptcy filing and Central Falls, Rhode Island has turned its finances over to a receiver. But the pressure is mounting even on solvent borrowers, who are paying higher muni bond rates.

The latest evidence of trouble in the municipal bond market emerged on Friday, as Illinois issued debt under the federally supported Build America Bond program, which includes a 35 percent interest rate subsidy. A Bloomberg analysis showed that the cost of the bonds—measured as the premium it paid relative to the Treasury bond market—was 40 percent higher than it was just two months ago, reflecting a $13 billion shortfall in its budget for the fiscal year that begins on July 1.

Moody's and Fitch downgraded the state earlier in June. The state plans to issue even more debt under the program, which is part of President Barack Obama's economic stimulus.

If state and local governments face default on a mass scale, the federal government will be under pressure to bail them out. Given the scope of federal spending and the size of the federal deficit, it may not be able to backstop municipal borrowers. "Perceptions of a large U.S. borrowing capacity are misleading," former Federal Reserve Chairman Alan Greenspan warned today in the Wall Street Journal. If the federal government ends up paying higher rates to borrow less money, it won't be able to offer much helped to strapped municipalities, short of a big tax increase.

The impact of defaults on muni bond investors, which often include retirees, would be huge. Local busineses could face higher interest rates to cover budget shortfalls and the overall business environment would suffer, creating a drag on economic growth.