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Just How Strong Are Muni Bonds?

Vallejo, California's bankruptcy last year represented the largest municipal default in 14 years. For 16 months, Jefferson County, Alabama has been unable to pay debts on billions...

Vallejo, California's bankruptcy last year represented the largest municipal default in 14 years. For 16 months, Jefferson County, Alabama has been unable to pay debts on billions of dollars in sewer bonds. Almost everywhere, tax revenues have plummeted, throwing the finances of local governments into disarray. So, are municipal defaults becoming more common?

As it turns out, that question is part of the backdrop to a dispute between the Securities and Exchange Commission and local governments over regulation of the municipal bond market. And the answer all depends on your definition of "municipal."

Defaults on municipal debt increased dramatically from $329 million in 2007 to nearly $7.8 billion in 2008, according to Richard Lehmann, publisher of a newsletter that tracks defaults. Municipal defaults are once again in the billions of dollars this year. However, if you haven't heard about the wave of cities and counties that are defaulting on their financial obligations, there's a good reason why: The wave doesn't exist, at least not yet.

In the bond market, "municipal" doesn't mean the same thing it does everywhere else. All manner of tax-exempt bonds are counted as municipal, whether they're issued by local governments or colleges or hospitals or nursing homes. Sometimes, local governments will even help private companies issue what are known as "conduit bonds" -- tax-exempt municipal bonds, but ones without any obligation for the government to guarantee the debt. For example, when General Motors went bankrupt, Lehmann says, a few municipal bonds went into default.

While more bonds in the municipal market have gone into default lately, most of the defaults haven't been on bonds issued by the cities and counties that most people think of as municipalities. Instead, non-profits and private companies -- which typically lack the financial reserves or revenue-raising power of local governments -- have been hardest hit.

Some special-purpose government entities are suffering too. In Florida, dozens of community development districts have entered defaults that total billions of dollars. These districts have some taxing authority, but they're very different from what most people think of as governments. They're essentially developer-created vehicles for paying off the costs of roads and utilities. As home sales have decreased and home prices have dropped, many of Florida's community development districts have been unable to pay their debts.

All of that might seem to suggest that the rise in municipal defaults isn't really the concern of large general-purpose governments, except the unfortunate few such as Vallejo and Jefferson County. But local governments can't ignore this development for at least one big reason: Federal regulators won't let them.

In June, Mary Schapiro, who chairs the Securities and Exchange Commission, mentioned statistics similar to Richard Lehmann's. Schapiro's point was that, despite their reputation for safety, municipal bond defaults do take place. Her bigger point was that, because of that risk, municipal bond issuers should face tougher financial disclosure standards, similar to the ones that corporate issuers face. Last month, the SEC preliminarily voted for tougher disclosure rules, over the strenuous objections of some government officials.

Frank Hoadley, chair of the Government Finance Officers Association's debt committee and a Wisconsin state government official, bristles at the notion that the bonds of state and local governments are at a substantial risk of default. He thinks that Schapiro and others have misused statistics in their push for new disclosure requirements -- requirements that he says would impose major burdens on governments. "Next to United States Treasury bonds," Hoadley says, "governmental municipal bonds have to be considered the safest in the world."

Few would question whether bonds issued by cities and counties have been reliable investments for years. The question now, however, is to what extent these governments are immune to the same troubles that have forced major corporations, non-profits and special-purpose governments into bankruptcy. Many experts on the municipal bond market are deeply concerned that more Vallejos are on the way. "We haven't seen a real increase in general government defaults," notes Matt Fabian, managing director of Municipal Market Advisors. He adds: "You have to assume that some of that is coming."

Josh Goodman is a former staff writer for GOVERNING..
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