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Municipal Bonds Providing No Safe Haven From Stock Market Storm

By , Money Morning •

By Martin Hutchinson
Contributing Editor

Whenever the stock market is down, and seems destined to drop further, wise investors naturally look for a safe haven.

Municipal bonds are typically one such appealing haven, since they provide tax-free returns to individual investors in return for apparent safety of principal. Investors are soothed by the knowledge that no state has defaulted since 1841, and that smaller defaults - like that of Orange County in 1994 - are often fully repaid in the end.

Investors beware: This time around, municipal bonds may be altogether too close to the firing line for investors who are looking for a safe haven well to the rear of the action.

Bill Defeat a Sign of Trouble Ahead

The surprising defeat of California Gov. Arnold Schwarzenegger's healthcare bill by the California state senate health committee shows that state lawmakers are becoming aware of the problem.

The bill had long been viewed as invulnerable, although there was some grumbling at its "individual mandate" feature, whereby middle-income taxpayers would be forced to buy expensive insurance.

But even with this bit of grousing, the bill was at the very top of the wish-list for California's powerful liberal legislature, and was backed by Schwarzenegger, who retains considerable Republican support in spite of the fact that he nowadays governs primarily like a Democrat.

So what was the bill's stumbling point? Apparently, the healthcare bill's estimated $14.5 billion cost was deemed too great a burden for the suddenly rocky finances of California State. Since there is no sign, yet, of similar worries in Washington - it's just the opposite, in fact - it's worth looking very closely at just why California has suddenly become cautious.

How Taxing are These Taxes?

Property taxes are a major revenue source for both state and local governments. Thus, a serious real estate decline has a major effect on both, whereas at the national level it may have little revenue effect unless it is accompanied by a general recession.

In California, property taxes generally accrue at the local - and not the state - level, making it theoretically possible for only selected localities to default in a downturn. But in practice, the great majority of the state budget is used to prop up local tax bases, and resources are thus equalized across the state. After all, the principal use of property taxes is to fund local school systems, which most voters would put at the top of their priority list to be preserved in a downturn.

In California, property taxes fund about 22% of state revenue, including both state and local government. In addition, the state is protected to some extent in a downturn by "Proposition 13" of 1978, which capped the annual increase in the taxable value of a house while the resident remains in it. Thus, a house bought in 1980 may have half the tax valuation of an identical house next door, if that neighboring dwelling changed hands in 2006.

This has the effect of protecting the tax base from immediate downturn: Even if prices decline, some old houses will always be sold, unlocking their elevated valuations for taxation purposes.

Nevertheless, California local governments got used to their property tax base increasing by more than 10% each year from 2000 - including a 12.3% boost in 2006 - so the housing downturn will quickly affect the provision of local services, which inevitably have become bloated during the boom.

Add to that the effect of downturns in both corporate income taxes [because corporate incomes do actually decline in a downturn] and state income taxes [as residents, particularly in mortgage-banking and other real-estate-related industries, lose their jobs and no longer receive outsized bonuses], and you can see why the California legislature is worried that hard times may be ahead.

The State of These States

 There hasn't been a state bankruptcy since 1841 [a year in which no fewer than eight states defaulted, including the supposedly prime quality "Keystone State" of Pennsylvania], but we haven't had this significant a real-estate downturn since World War II.

The odds are that the places most affected will be the areas that had the largest price run-ups and that, conversely, can expect the greatest declines in the future. In addition, states that spend more lavishly than average, or that depend heavily on the troubled financial services industry, may be in particular trouble.

 In a November special issue, Fortune magazine calculated the amount that housing prices would have to decline in 54 major U.S. metropolitan areas to bring them back to an approximate equivalency with local rental levels. The article demonstrates that, in a number of metropolitan areas, prices are likely to decline by 30% or more in the next few years, whereas in others, the decline may be limited, or prices may even advance by a modest amount.

 The bottom line from Fortune's analysis is that California [rated A+ by Standard & Poor's and A1 by Moody's Investors Service (MCO)], Florida (AAA/AA1) and Nevada (AA+/AA2) may be especially exposed to real-estate-price declines and consequent property-tax-revenue shortfalls.

 In addition, Maryland (AAA/Aaa), the District of Columbia (A+/A1), and to a lesser extent, Virginia (AAA/Aaa), are all vulnerable. On the other hand, Connecticut (AA/Aa3), Massachusetts (AA/Aa2), and Texas (AA+/Aa1), which suffered badly from the real estate downturn of the late 1980s, are much less vulnerable, and may even see modest price rises.

 New York (AA/Aa3) is only moderately vulnerable, but New York City (AA/A1) is especially in danger because of its very high exposure to the beleaguered financial services industry and its tradition of government waste.

 Of course, it's likely that few - if any - of these municipal bond issuers will default. But if their ratings are substantially downgraded, municipal bond yields will increase and the bond prices will correspondingly decline. The issuers most vulnerable to housing woes should thus be avoided.

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