This kind of corruption is what I attempted to explain to City Hall reporters when I was working in my city's mayoral primary, but they weren't all that interested in it. Too much like math, and besides, it challenged their version of how the world works. They don't seem to have much of a feel for systemic, inherent corruption - they prefer to see it as an occasional crime of greedy individuals.
Municipal bonds are where all the serious money is hidden - where politicians get kickbacks, where political deals are made, and even where the big bribes are. (Local reporters said it was of no interest to them that the mayoral candidate they'd endorsed had been a municipal bond salesman working for a company that received a record SEC fine for bribing officials in another city. They told me - and I'm not making this up - that his background in finance meant he was well qualified to handle the city's finances.) Now, add another dozen layers of deceptive and even fraudulent practices on the part of the banks to the whole mess, and you have a very toxic cesspool.
After one of the big bond scandals, they (the SEC) finally set up a system where firms that weren't in on a specific deal were required to analyze and approve a deal before it could go through, but of course bond companies simply trade off with each other. So munis aren't much different than the various mortgage instruments that led to the first wave of the housing crash - they're layered with many, many strains of opaque system-gaming. God only knows what they're really worth.
In other words, they're at high risk for a massive crash. Wheee! Isn't deregulation and lack of effective oversight fun?
Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.
Size and potential systemic effects. That this is a big market in the credit space goes without saying.
Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?
Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky -- the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.
Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the under funded portion of the portfolio.
Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.
Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.
Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt – democracy at work.
If I had anything to spare, I wouldn't "invest" in anything I couldn't hold in my hand - you know, like groceries.