So where are all the muni bond defaults?

Illinois let $5 billion of bills go unpaid. Washington closed state offices. California may cut 200,000 workers' pay to the minimum wage. Minnesota is delaying tax refunds for a second year. As fiscal 2011 budgets took effect July 1, state and local governments coping with revenue declines from an economic slowdown are fulfilling legal obligations to balance their books by shaving costs and raising taxes to protect a key constituency: owners of $2.8 trillion of municipal bonds. “States have taken all measures so far to make sure they keep capital markets open by honoring their debt payments,” said Richard Ciccarone, a managing director for McDonnell Investment Management LLC in Oak Brook, Illinois, which owns $7 billion of municipal bonds. “They are doing everything they can.” States cut spending by $74 billion since 2008 and more than half raised taxes and fees in 2009, the National Association of State Budget Officers said. That's as the worst economy since the 1930s sent May unemployment as high as 14 percent in Nevada, topping the 9.5 percent U.S. rate, and deflated real estate values. As a result, state revenue fell $95 billion, or 12 percent, from September 2008 to the end of 2009, according to the U.S. Census Bureau, pushing tax collections to 2006 levels. “It's a tremendous amount of pain,” said Illinois Comptroller Daniel Hynes. Schools, foster homes, hospitals and other agencies as well as outside vendors will have to wait for their money until the state raises cash to pay bills, he said. Investors Protected Illinois, which is selling $900 million of bonds for capital projects this week, won't let investors down, said Governor Pat Quinn. Moody's Investors Service lowered the state's credit grade last month by one level to A1, matching California as its lowest-rated state. “Our bonds have always been repaid,” Quinn said in an interview at the National Governors Association meeting in Boston July 10. “We have provisions in our constitution that are very protective.” To make ends meet, half the states, including Indiana, Massachusetts and Nevada, have fired workers in the past budget year and 22 put staff on temporary leave, the governors group and budget officers association said. Minnesota is delaying corporate and sales-tax refunds, postponing school and medical aid and setting up a $600 million bank line of credit. New Jersey is planning to refinance about $250 million of general-obligation bonds to push $202.5 million of debt-service costs into future fiscal years. Selling Assets To raise money, Arizona sold its House of Representatives and Senate buildings and California solicited bids for 11 of its office complexes. No sacrifice is too small: Delaware saved $29,000 by eliminating flowers at the state psychiatric hospital and health department. Local governments are responding, too. Unpaid days off in Los Angeles helped the second-largest U.S. city close a budget gap and Detroit shut schools. Seventy percent of cities are cutting payrolls, said a survey by the National League of Cities released in May, with some 68 percent reducing capital projects. “The cuts are much more meaningful and more pronounced than anything we have seen,” said Peter Hayes, who oversees $106 billion of municipal bonds for New York-based BlackRock Inc., the world's largest money manager. Such actions may be helping investors regain confidence in the tax-exempt debt market based on prices for credit default swaps, derivatives used to insure against bond failures or speculate on creditworthiness. When the fiscal year began for most states on July 1, it cost $260,155 to insure $10 million of municipal debt for five years, according to an index of swaps on 50 state and municipal general-obligation and revenue bonds maintained by Markit CDX. Company Debt That was $137,355 more than to insure the same amount of debt of companies, including General Electric Co. and Cisco Systems Inc., in the Markit North American Investment-Grade Index of default swaps. By yesterday, the difference had fallen to $112,002 as 10-year borrowing costs for top-rated municipal borrowers slid to 2.93 percent, the lowest since at least 2001, a Municipal Market Advisors index shows. “Municipal credit concerns have diminished,” Janney Montgomery Scott LLC, a Philadelphia-based adviser, said in a note to bond clients on July 12. “Investors continue to seek tax-free income and the strong credit track-record of general- obligation and essential-purpose municipal bonds.” Lawmakers are willing to anger voters with reduced services and higher taxes to retain the favor of investors, who buy more than $400 billion of state and local debt each year to finance roads and bridges, pay for new schools and maintain parks and libraries. “They don't want to lose that access,” Hayes said. Fewer Failures Municipal bonds default less than company debt, Moody's said in a February report. The average failure rate for investment-grade municipal debt from 1970 through 2009 was 0.03 percent, compared with 0.97 percent for similar corporate bonds, the analysis said. Of 54 municipal defaults in the period, only three were general-obligation bonds backed by the full faith and credit of the issuers, Moody's said. Defaults occur when a borrower misses interest payments or fails to maintain adequate reserves for future interest. Since the Great Depression of the 1930s, only one state -- Arkansas -- has defaulted. That was after it assumed debts of its municipalities to keep them from financial failure. Most of the $15.5 billion of such events in the municipal market since 2008 involved debt backed by specific revenue streams, like levies on new Florida housing developments, rather than by a government's obligation to repay investors from taxes. Fee-Backed Bonds Jefferson County, Alabama, defaulted on more than $3 billion of sewer-system bonds backed by water bills when officials balked at raising residents' costs to meet soaring interest expense. Harrisburg, Pennsylvania, has been pushed close to bankruptcy because the city guaranteed bonds funded by fees from an incinerator that weren't enough to cover debts. “There may be an increase from what we have seen historically, but we think they will be isolated to smaller, weaker issuers and ultimately will not cause any market disruption,” said Hayes. Two states remain at impasses over bringing expenses into line with incomes. California is without a budget and New York legislators passed spending bills while putting off action on revenue measures. New York, the third-biggest state by population, has delayed payments to schools to preserve cash while legislators wrangle with Governor David Paterson over how to close a $9.2 billion deficit for the year that began April 1. Acceptable Answer “Withholding the payments has been an answer and it's been one that's been acceptable to the markets,” Paterson said in an interview at the Boston governors' meeting. “The only other way would be to make the payments and run out of money, and I don't think the bondholders would like that.” California Governor Arnold Schwarzenegger, facing a $19 billion budget deficit for the year that began this month, is trying to force 200,000 state workers onto minimum wages temporarily. State officials are standing by with authority to cut off payments to schools to conserve cash until a budget is passed. Public officials should take more such steps to cut expenses and stem borrowing or risk falling prices in the municipal bond market, said Thomas Wilson, chief executive officer of Allstate Corp., the largest publicly traded U.S. home and car insurer. Out of Control “Government borrowing is way out of control,” Wilson, 52, said in a Bloomberg Television interview July 6. “We need to get our house in order.” Allstate cut its municipal-bond portfolio in three straight quarters, reducing its holdings to $20.1 billion through the end of March from $23.1 billion on June 30, 2009. With the Federal Reserve keeping interest rates near zero, the cost of servicing debt hasn't grown more burdensome for governments. In the first quarter, state and local borrowers spent an annualized $109 billion, or 5 percent of their revenue, on interest payments, U.S. Commerce Department data show. That's little changed from before the beginning of the recession and down from as much as 8 percent in 1987. “The problem of states is a problem of deficits, not debt,” Alan Krueger, assistant U.S. Treasury Secretary for economic policy, said in an interview. “They have the ability to carry their debt.”