Another Way to Profit from the Coming Plague of Busted Banks“To disrupt our services because we can’t make a bond payment would just be unconscionable. And as a leader I couldn’t do it.” So explained Linda Thompson, the mayor of Harrisburg, Pennsylvania. She was explaining the city’s refusal to repay part ($3.29 million) of the $288 million it owes for an incinerator it bought. The total obligation for the incinerator comes to roughly $6,000 per citizen of the city. It is a debt that can’t be repaid and should have never been lent.

Unless you happen to live in Harrisburg, you probably didn’t see this item in your local paper. And you probably wonder why we’d lead with it in the Digest. After all, why should the impending bankruptcy of a small Pennsylvania city matter to you?

We led with it today because it represents the next leg of the debt crisis – the failure of municipal finance. We were also struck by the logic of the mayor… who clearly views paying the city’s debts as optional. She knows the state of Pennsylvania will be forced to bail out her city. (If the state doesn’t intervene, it will be impossible for any other city in Pennsylvania to issue bonds.) And even if the state refuses, the bonds are insured by Ambac, which means, in the eyes of the mayor, it’s likely that no one will get hurt by her decision. That’s how a $288 million loss can become irrelevant to an elected local official. Like a subprime borrower living in a house without paying his mortgage, the mayor of Harrisburg thinks paying for its debts is someone else’s problem. She’s bringing Obamanomics to city finance.

[ad#Google Adsense]We have this warning to offer: When our elected officials no longer care about repaying hundreds of millions of dollars, the entire system of municipal finance is going to collapse. And the damage that’s going to occur will be material to our entire country. The system that exists today was created in the 1970s. The entire system is predicated on the lie that states won’t allow losses to muni-bond holders. That’s the only reason muni-bonds are insurable: The insurance companies know there will never be a claim. They have no reserves to cover the risk of municipal losses because there have almost never been any. Over the last 40 years, the default rate on investment-grade municipal debt was 0.03%, according to the credit-ratings service Moody’s.

You can think of this system as similar to the subprime-credit bubble. No banker in his right mind would loan money to a person with no credit and no job who was buying a house in a slum. But once you took the credit risk away from that banker, he was happy to lend billions on deals like that because the risk became someone else’s problem. Billions in bad debts piled up. Suddenly, it was the banker’s problem again because he’d destroyed the entire system.

The same thing is about to happen in the muni-bond market: Nobody has paid any attention to credit quality because everyone believed the states won’t allow cities to go bust. As a result, a truly stupendous amount of money has been lent to cities – cities that have no hope of ever repaying the debts. Specifically, municipal debt now totals $2.8 trillion – roughly 22% of our country’s GDP. That’s an all-time high. The amount of debt owed by cities has doubled since 2000. And the debts are now too big for individual states to guarantee.

Harrisburg is small potatoes. Mass transit systems are a much, much bigger problem. Almost every local politician in America has promised a subway, a train, or a bus to take his constituents to work for next to nothing – but running these systems is incredibly expensive. In Boston, the mass transit authority is now $8.5 billion in debt and has been paying $500 million per year in interest. Does that sound sustainable?

What about all of the stadiums and arenas built over the last 20 years? Politicians love to build these things as part of citywide “revitalization” efforts. But paying for them? That’s somebody else’s problem. Take the Meadowlands – the football stadium built nearly 40 years ago. It was torn down last year, but it has never been paid for. The New Jersey Sports and Exposition Authority (aka the State of New Jersey) borrowed $302 million to build it and never repaid the debt. Today, it owes more than $800 million and spends $100 million per year on interest for a stadium that no longer exists. California has 380 different local redevelopment agencies, which collectively owe $29 billion. This money will never be repaid.

When I warn people about muni-bonds I always get the same reply: “Governments don’t go broke.” Oh yes, they do. States face a cumulative budget gap of $140 billion in the next year – they don’t have the money to guarantee these debts. Meanwhile last year, more than 187 tax-exempt issuers defaulted on $6.4 billion of securities – the most since 1992. These numbers are going to get bigger – a lot bigger.

You see, all of this credit was only made available because lenders believed (foolishly) that there was no risk in lending to cities and states… just like they handed out all those subprime loans, believing they would never default because “home prices never decline.” But after a few city bankruptcies (like Harrisburg), that thinking is going to change – forever.

With less (or no) additional credit available, how will cities and states be able to refinance at a reasonable price? Just like when the subprime credit markets shut down, the whole system collapsed because no one could refinance. The same thing is going to happen with the cities and the states. There’s a very good chance that once the dominoes start falling, there won’t be any way to stop them without a massive federal bailout.

Oh… one more thing… guess which bank has the most exposure to the muni bond market? Again, just like with subprime, it’s Citigroup. It holds $13.4 billion, roughly twice as much as the other major banks.

— Porter Stansberry

* Source:  The Daily Crux