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Municipal Finance: Will Uncle Sam Post Bail?

Posted by Larry Doyle on May 26, 2009 3:09 PM |

Is every village, town, city, and state in our country poised to receive a “get out of jail” free card from Uncle Sam? I linked to The New York Times article, Localities Want U.S. to Support Muni Bonds, in the Newsworthy section of Sense on Cents. Upon further review, it deserves comment.

In my opinion, this support of the municipal market may very well represent the greatest violation of a moral hazard to date. Why? Municipalities are by edict required to balance their budgets. A municipal budget which is able to obviate the tough decisions and choices in the budgetary process will lose that rigor.

Politicians of all stripes will make the case that the municipal default rate is extremely low and, as such, a federal backstop in the form of bond insurance is truly a very low risk proposition. Please allow me to opine that the same argument was made in the quasi-guarantee provided to Freddie Mac and Fannie Mae. Those two giants are now wards of the state having been utilized by politicians from both sides of the aisle as campaign “piggy banks” for the better part of twenty years.

The New York Times highlights that the federal guarantee of municipal debt is not all that Uncle Sam may be asked to bail:

“All kinds of municipal borrowers are facing revenue shortfalls,” said Mr. Decker. “California is the largest example. Some states are better off than others. But all outstanding debt is backed by tax revenues. And municipalities are facing a greater or lesser level of distress.”

Also clamoring for help is a group of municipalities that purchased Lehman debt, which is now nearly worthless. Legislation authorizing the use of relief money to make these purchases was introduced by two California Democratic representatives, Jackie Speier and Anna Eshoo. If approved, this would be more like a bailout than a guarantee, because the federal government would be paying face value for debt that otherwise has little value.

The price tag on that proposal is around $1.6 billion. The argument promoted by the two congresswomen is that the Treasury and Fed allowed Lehman to fail, causing governmental bodies to lose money.

Whether a price tag is $1.6 billion, $1.6 million or $1.6 trillion a potential federal bailout of a poor investment decision is the antithesis of free market capitalism. Where does it end?

Over and above the potential federal bailout of municipalities via bond guarantees (insurance), in speaking with friends at SecondMarket, I learn that this legislation may also include funds to bailout the Auction Rate Securities market. I have written extensively about the ARS market. The ARS market was a $330 billion market that imploded in 2007 and totally froze in early 2008. It is speculated that approximately 50% of the ARS holdings are currently on bank balance sheets, while the other 50% are still in investors’ hands.

The investors, especially individuals, were defrauded in the process of purchasing ARS. That said, are taxpayers about to bailout not only the investors but also the banks that fraudulently marketed and distributed ARS? Who is monitoring this legislation? What politicians will stand on principle and not allow taxpayers to be party to this fraud?

Sense on Cents will be monitoring this very closely!!


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