Zywicki in Forbes: Municipal Bond Investors Face Unclear Legal Rights

Municipal bonds, normally considered a safe investment, could present their holders with some unanticipated problems in a tumultuous market, says Professor Todd Zywicki, because investors' legal rights are unclear under current law.

Zywicki's comments appear as part of a Forbes article on defaults in municipal bonds. With many municipalities currently facing increased pension and unemployment claims, drops in tax revenues, and a host of other problems, the danger of default becomes very real, and the mechanisms in place to protect bond holders vary greatly.

While defaults in municipal bonds have been rare, 16% of municipal bonds defaulted during the Great Depression, with a 23% default rate during the downturn of 1873.

Beware Defaulting Munis, Forbes, March 16, 2009. By Scott Woolley.

"Does the 'full faith and credit' of a government mean the government can be compelled by a court to raise taxes in order to pay off a bond? Don't count on it.

"Here are some ways to minimize your default risk.

"Prefer states. History suggests it's safer to own bonds issued by a state than by an obscure town or sewer authority. At the peak of the Great Depression, 851 cities and towns were in default, but Arkansas was the only state. (Its bonds fell to 10 cents on the dollar, but creditors who hung on were eventually repaid in full.)

"There's some logic to the notion that states are just too big to fail. If the federal government couldn't resist pressure to throw lifelines to Merrill Lynch and aig, it's hard to imagine it would let California or New Jersey go bust. In fact the Obama Administration and members of Congress have already said they will guarantee at least some munis against default.

"Prefer better states. When Alexander Chisholm sued Georgia to make good on Revolutionary War debts, the U.S. Supreme Court ordered the state to pay up. That 1793 ruling led to passage of the Eleventh Amendment barring future federal interference in similar cases. The practical result is that states have been free ever since to set their own rules for how to deal with creditors.

"'It's functionally similar to what would happen if Venezuela repudiated its debts,' says George Mason's Zywicki. (Insolvent municipalities, by contrast, are likely to file for Chapter 9 reorganizations and end up before bankruptcy judges.)

"While the U.S. Constitution grants states leeway to stiff bondholders, state constitutions often constrain them. Muni bondholders spooked by California's $40 billion budget deficit can take solace in the fact that its constitution declares it will honor general obligation bonds before all other obligations, except funding mandates for public education.

"In New Hampshire, by contrast, the constitution says nothing about bondholders' standing relative to other creditors'. (The online version of this story describes the constitutional protections afforded bondholders in a variety of states.) One way to add a measure of safety is to own only muni bonds backstopped by private default insurance. But remember: In a severe financial meltdown the insurer's claims-paying ability is likely to be stretched, too.

"Avoid most revenue bonds. Revenue bonds, which are backed by income from parking garages, sewers and other projects, are a relatively risky class of munis. Their cousins, general obligation bonds, are backed by the full taxing authority of a municipality and thus safer.

"Usually, anyway. Owners of Vallejo's revenue bonds, backed by revenues from the water district and motor vehicle license fees, have continued receiving payments without a hiccup. The city's general obligation bond creditors have no right to the revenue bonds' cash streams.

"Find pre-refunded bonds. In some cases tumult spells opportunity. That seems to be the case with pre-refunded muni bonds. These are bonds that issuers plan to call and have fully collateralized with Treasury notes."

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