Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.

TO BE NOTED: From Accrued Interest:

"Municipals and Chrysler: What happens to one will affect the other

I've been notably absent in expressing my outrage over how the Obama Administration treated Chrysler's secured debt holders. Let it be known I'm sufficiently outraged on the inside, but resigned on the outside. We should all take it as a lesson: you simply never know what the government might do. The more they tighten their grip, the less I want to invest in any company which has taken government money. Especially in the investment-grade bond market, where, generally speaking, the potential for appreciation is limited.

This brings us to the municipal bond market. In Berkshire Hathaway's 2008 letter to shareholders, Warren Buffett had this to say about the municipal insurance business (the section starts on page 13 if you want the total context). Hat tip to downwithcapitalism who, despite his evil galatic moniker inspired this post.

"A universe of tax-exempts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different.

To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city’s bonds had instead been insured by Berkshire. Would similar belttightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to “share” in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial."

At the time the letter was made public, back in February, I thought it was mostly just Buffett's way of 1) Making sure he could keep charging exorbitant sums for muni reinsurance, and 2) Temporing shareholder's expectations for the muni insurance sector. After all, there is no record of insured bonds defaulting at a higher rate than uninsured bonds, controlling for all other factors. And the type of behavior Buffett warned of hasn't been evident with Jefferson County, where the overwhelming majority of outstanding bonds are insured. In fact, I'd bet that the insurers have better lawyers and other workout specialists at their disposal compared to what any ad-hoc group of bond holders could put together.

In addition, notice Buffett says "imagine all the city's bonds had been insured... by Berkshire." This isn't the case in reality. Any large issuer is going to have a mixture of insured bonds with various monolines. Given the state of XLCA, CIFG, FGIC, and Ambac, I'd say that de facto, most issuers have a fair number of bonds that are now uninsured. Certainly its fair to say that the local investors, who Buffett argues prevented politicians from ravaging bondholder rights, would suffer a large market value decline if any issuer fell into default, even if the bonds were insured, since all insurers are seen as weak.

Still, we've seen the precedent set by Chrysler. I've argued many times before that state and local governments can't choose to pay teachers and not bond holders. But can we universally assume this will remain the case? As readers undoubtedly have read numerous times, Chrysler's "secured" bondholders suddenly found themselves unsecured by Fiat (pun intended). Why? Because it was politically expedient.

Couldn't the same thing happen in a municipal bankruptcy? Especially if the Federal government gets involved? Absolutely it could.

I don't see this happening with some local school district someplace. Take Vallejo or Jefferson County, both of which are going on right now. So far it looks like the courts are playing a lesser role in both cases, with politicians and debt/swap holders negotiating directly. These are the kinds of bankruptcies I expect out of munis in the next few years.

But what if a really large issuer, like the city of Detroit, were to enter Chapter 9. Then what if the Federal government stepped in to provide some sort of bridge financing. Then suddenly the Treasury gets to dictate terms, and Obama has shown he's not going to make the unions bear the same burden as bond holders. I'd argue that the public employees unions are more powerful than the UAW!

If that happened, then immediately local governments would see bankruptcy as an expedient solution, solving structural deficits by punishing bondholders.

Ultimately, this would be an incredibly foolish course of action. Consider the consequences: the municipal bond market would shut down, with only the strongest issuers able to come to market, and maybe not even those issuers. Suddenly the Federal government would become the only source of municipal funding. The U.S. would turn into a true Federal state.

So I sure hope this isn't the direction we head. The long-term consequences would be devastating. You'd like to think the Administration has the sense to consider the long-term impact of their decisions, and wouldn't kill municipal bond holders. But then that's what I said about letting Lehman go bankrupt..."