Municipal Bond Woes

With the recent exception of the Dubai World financial crisis, fall 2009 has been relatively kind to the stock market, which is comprised of the financial investments that generally get the most widespread media attention. The same is not true for the municipal bond market, however, whose index has fallen 5% since its September peak.

At present, Detroit looks to be the city with the most significant debt problem. Business Week reports:

A few years ago, Detroit struck a derivatives deal with UBS and other banks that allowed it to save more than $2 million a year in interest on $800 million worth of bonds. But the fine print carried a potentially devastating condition. If the city’s credit rating dropped, the banks could opt out of the deal and demand a sizable breakup fee.

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The seeds of this looming disaster were sown during the credit boom, when Wall Street targeted cities big and small with risky financial products that promised to save them money or boost returns. Investment bankers sold exotic derivatives designed to help municipalities cut borrowing costs.

Last year, Jefferson County, Alabama made headlines for coming close to defaulting on its bonds but has managed to continue making payments. Now, the county has filed suit against JPMorgan for underwriting this debt, asserting that the investment bank sold the county financial instruments of little value.

The common angle in this all too common story is to come down harshly against Wall Street, which is taking heat for issuing debt with fine print attached that gives banks the right to vary their offerings depending on municipalities’ bond ratings.

Another, lesser examined take is that city, county, and state officials are taking ever-increasing risks with taxpayer money, which could either benefit or harm the people whose money they are spending. For an individual this would be an expression of a higher risk tolerance, but it is unclear whether or not the same option should be open to those in charge of the public coffers.

In the subprime mortgage crisis, banks took flack for loaning money to consumers who did not understand the fine print in the contracts that they signed. Even if we can excuse this ignorance in consumers, can we really do the same for public officials?

Rather than being angry at Wall Street for underwriting municipal debt, taxpayers should hold their politicians accountable for lacking the diligence or competency to understand the debt that they issue.