Just for fun, our friends at Municipal Market Advisors have looked at how municipal bonds fared during the Great Depression. Citing Prof. George Hempel, premier municipal analyst in the postwar period, MMA notes that

between 1929 and 1937, 4,800 municipal bond issuers defaulted, representing 2.7% of all issuers and] $2.8 [billion] in debt …. Still, Prof. Hempel notes: “the total loss of principal and interest … is estimated at $100 [million], or about 0.5 percent of the average amount of state and local debt outstanding during this period.

Hempel’s research also tells us that back then, muni bond failures lagged economic failures, with issuer problems becoming “a serious economic problem only in the later states of the depression.” (In a very rough analogy, indicating far lower levels of stress, one remembers that ratings agencies didn’t downgrade credits like New York State after the tech bubble burst in 2000 until months after serious problems had become obvious to almost everyone else.)

It would be nice to think that municipal bond investors will suffer low losses this time around, too. But, as MMA says, since 1970, “historical default rates” for muni bonds “have been exceptionally low” — not necessarily a good thing, because just like with mortgages, near-nonexistent default rates likely caused investors and independent surveyers to become complacent.

Plus, “issuers, their advisors, and state regulators are now substantially more sophisticated and connected with the greater financial markets than in any past financial cycle” — again, not necessarily a good thing, as we’ve seen already, with some states and public authorities facing additional cash pressures at exactly the wrong time due to bad hedges related to the variable-rate debt they borrowed.

Indeed, MMA says that it expects Chapter 9 bankruptcies — that is, municipal filings — to rise, along with defaults on particularly risky projects like land-secured and nursing-home deals.

This analysis makes one wonder if it was a good idea for cities like New York to aggressively push for tax-exempt classification for risky “private-activity bonds” like the ones for the new Yankee Stadium. By definition, such bonds are riskier than bonds backed by a municipality’s full faith and credit or by a steady stream of revenue like, say, for sewer bonds. But if such private-activity bonds default in the coming years, the failures could taint the entire municipal asset class for worried, risk-averse investors, at least for a short while.

Finally, a general warning from MMA: “safe-sector credits are most prone to default when political will to pay fails.” As walking away from debt on everything from credit cards to corporate buyouts increases, such defaults could seem, even for municipal issuers, if not quite normal, not quite as shocking as they once would have.

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