Minyanville professor Kevin Depew made some important observations in a Buzz late in the day yesterday that I think are worth sharing with everyone.

Summer of Municipal Discontent

With fiscal years for states beginning on July 1, this summer could very well bring a host of unwelcome headlines for financial markets. Miraculously, Illinois has managed to surpass California in terms of fiscal distress.

Fine, we all know that fiscal woes are coming. But here’s the nut of the thing: Who owns this muni debt?

Well, consider this round two for American households.

According to page 91 of the Federal Reserve Flow of Funds report, there is $2.8 trillion in muni debt outstanding. Here’s the order of ownership:

  • Households ­ $1 trillion
  • Banks ­ $220 billion
  • Insurance companies ­ $350 billion
  • Mutual funds ­ $500 billion
  • Money markets ­ $370 billion
  • Broker/dealers own just $40 billion.

My friend Conor observes that, “for the cynical folks who think bailouts only happen if Goldman Sachs (GS) stands to benefit…” Well, that belief will likely be put ot the test.

Even worse, consider the fact that households make up a significant portion of holders of muni debt indirectly though the banks, insurance companies, mutual funds and money markets above. The $1 trillion ownership figure is actually much higher.

And still worse than that, over the last three quarters the household sector has bought 80% of all flows into munis.

Federal Reserve Flow of Funds

Here is the pertinent snip from the Federal Reserve Flow of Funds Report.

My friend “HB” comments …

Warren Buffett recently declared he was nervous about insuring any muni debt, a business he eagerly took on in 2008.

I would further note, given the reality of unfunded liabilities, mostly pensions, and the state of financial markets and continued declines in tax revenues – specifically in terms of property taxes – there is every opportunity for municipalities to default in great numbers.

Moths to a Flame

Investors badly burnt in the stock market crash have been attracted to municipal and junk bonds like moths to a flame. It remains to be seen if states will default, but to escape untenable pension obligations I believe they should.

Sovereign Default Risks

CMA data shows Illinois and California are in the top ten list of sovereign default risks, with Illinois leapfrogging California in terms of increasing risk.

Please consider CMA Market Data as of Wednesday, 23 June 2010.

Illinois is ranked as a better risk than Iraq, but riskier than Portugal and California. Is that supposed to be comforting?

The countries (or states) are ranked by their cumulative probability of default (CPD), which gives the market’s assessment of an issuer’s likelihood of default over the life of a CDS contract.

Regardless of whether or not states and municipalities default on municipal bonds, I am quite sure of two things:

1. The risk of default is well above zero
2. Municipal bondholders are not being compensated for the risks they are taking.

Mike “Mish” Shedlock
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