Rep. Patrick McHenry warns that government bailouts are over, leaving states in a bind.(Getty Images)
Rep. Patrick McHenry warns that government bailouts are over, leaving states in a bind.
(Getty Images)

Is the State Bond Market the Next Bubble to Pop?

February 17, 2011  •  From
The immutable law of the bond market is about to be broken.

The perfect storm is brewing, says Republican Congressman Patrick McHenry. States are lining up cap in hand before President Barack Obama, expecting a bailout just like everyone else. But “the era of the bailout is over,” he says.

What this means is that for the first time in decades, states face a Hobson’s choice to balance their budgets. No matter how they do it, it will be extremely painful.

Hurricane-force winds are tearing at state economies. Government revenues are falling. Tax increases are hugely unpopular. Unemployment is high and unemployment insurance payments are draining coffers. House prices continue to fall. Economic growth is near stall speed.

And most dangerous of all, pensions are underfunded by an estimated $3 trillion.

Taken together, it is a storm that threatens one of the very foundations of American finance: the state bond market.

To solve past-year financial woes, many states turned to the bond market to borrow money. But as economic conditions have worsened and states like California, Illinois, New York and New Jersey are becoming more dependent on the goodwill of lenders, the whole bond market is getting jittery. And for good reason.

States are not allowed to go bankrupt. This is the ironclad law of the state bond market. It underpins the ability of states to borrow money at low interest rates. Investors are sure they will get their money back, so they do not demand high interest rates to compensate them for risk.

This may be a miscalculation on the scale of America’s housing bubble—with implications just as enormous.

Republican leaders are pushing separate pieces of legislation which taken together have the potential to ignite a bond market crisis.

The first is legislation that would require state pension plans to report their assets and liabilities using a uniform standard, as is required for private companies. This change would help prevent governments from hiding the true extent of their obligations. The legislation would also prohibit the federal government from using taxpayer dollars to bail out underfunded state pension plans.

The second is a plan by former House Speaker Newt Gingrich and former Florida Gov. Jeb Bush that would enable troubled states to go into bankruptcy to deal with their debts. Under this scenario, instead of states being forced to slash employment and raise income and property taxes 50, 100 or 200 percent, they would instead be able to declare bankruptcy and only pay lenders and state pension plans a fraction of what is owed. According to the Washington Times, the House Judiciary Committee will hold a hearing this month on allowing states to declare bankruptcy.

If these two pieces of legislation gain support, many states, including some of the biggest, may be headed for a crash.

States will face a dramatic choice: Cut services and programs to the bone and issue massive state layoffs; renege on pension promises and slash payouts; or default on debt to bondholders.

Even the suggestion that states may default on their debt has the potential to collapse the bond market. For the past 13 consecutive weeks, investors have pulled money from the state bond market. If this continues, the cost to borrow money could skyrocket—creating a self-fulfilling cycle which causes more states to go bankrupt and interest rates to rise further.

“Muni bondholders, worried about states’ finances, might be panicked by fears that lawmakers will change the rules mid-game,” and the resulting market turmoil could drive some hard-pressed governments to the brink of bankruptcy, said Nicole Gelinas of the Manhattan Institute. “While Congress may intend the bankruptcy idea to avoid a bailout of struggling states, all the talk might bring us closer to just that.”

Tensions on Capitol Hill are heating up. Democratic-voting states are currently struggling with the worst budget problems. Democrats and left-leaning groups charge that Republican legislation is a nefarious plan to force blue states into bankruptcy. Republicans say bankruptcy is an important tool to let states deal with debt problems without putting all the burden on taxpayers and letting bondholders and posh union pensioners off the hook.

Regardless of political persuasion, the long and the short of it is that America’s addiction to debt may be about to push the country into an economic storm of historic proportions. As Greece and Ireland found out, rising interest rates spell doom for debtors. And here is the really scary part. If the state debt bubble pops, the federal debt market might become infected too. The federal government might be able to bail out a few states, but there is no one big enough to bail out the feds.

For more information on the soon-to-pop debt bubble, read “Pensions Versus Bondholders: Who Will Win?