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State & Local Finance

Fed Banks: Defaults Unlikely

WASHINGTON — Two Federal Reserve economists are refuting claims by some analysts that the muni market is headed for several billion dollars in defaults, calling the projections overblown and out of sync with past recessions.

The two separate reports, released by economists at the Federal Reserve Banks of Chicago and Atlanta, contend that the fiscal challenges faced by state and local governments are more likely to result in cost-cutting agony for their elected leaders and messy court battles between them and their employees over pension benefits.

Even local governments, which are more stressed than states, will dodge the default wrecking ball, the economists argue. Local government defaults are historically low, and a potential default would so severely impair a local government's access to credit that it would likely weigh all other options first — including a receivership by a state, the economists said.

"Clearly, conditions for the local sector are challenging at this point," said Richard Mattoon, a senior economist at the Chicago Fed and author of the report, "Local Governments on the Brink," which was released Monday.

"Not only are localities going to have their own source revenues under pressure, they are also going to see that the normal aid they would be getting from state governments potentially is in jeopardy," he said.

States are increasingly looking at workout mechanisms to save local governments from default, Mattoon said. This increases the "potential spillover" effect for states if they need to shoulder local government bailout burdens.

States will be further pressured by the loss of federal stimulus aid in fiscal 2012, the report said. Meanwhile, state pension funds remain a credit risk. Illinois, Mattoon noted, has issued bonds during the past for three years to fund its pension obligations.

States are increasingly looking to rein in pension benefits, either through the legislative process, like Wisconsin, or in court, according to Mattoon.

"It's very likely" that states "will challenge in court" the pension obligations to workers, he said.

Mattoon's work was preceded by a March report, "Municipal Bond Woes," authored by Atlanta Fed economist Gerald Dwyer, that said the data on state and local governments "do not support a forecast of widespread defaults and losses on municipal bonds."

Both reports were released after Meredith Whitney and Nouriel Roubini each separately forecast several billion dollars of muni bonds would default. The forecasts roiled the municipal market earlier this year and stirred up calls by some Republican lawmakers in Washington for legislation permitting states to file for bankruptcy protection to avoid federal bailouts.

Dwyer, elaborating on his report in an interview Friday, said the Whitney and Roubini default projections "are really outsized."

"I'm not sure about the dollar magnitude" of defaults they are predicting, he said. "That I am extremely dubious about."

Their estimates "are surprisingly large relative to anything we've seen before," he said.

Dwyer analyzed Whitney's claim on "60 Minutes" that $100 billion of local government debt could default.

There was $1.539 trillion of local government debt outstanding in 2008, the most recent data available from the Census Bureau. Dwyer's report said that $100 billion of local defaults would equal 6.5% of the 2008 total outstanding local government debt.

The default estimate figures are not impossible to reach, but looking at past recessions, the scale of defaults were not comparable to the figures Whitney and Roubini predicted for the near future, Dwyer said.

Still, both economists acknowledged that a backward-looking argument does not close the case against the Whitney and Roubini predictions. Conditions for issuers, especially local governments, are different this time around.

"House prices have fallen and so property tax revenue has fallen, and that affects local governments in a way that a decline in sales taxes does not," Dwyer said.

The revenue picture at the local level is "the real tension at this point" for gauging the default scenario, Mattoon said.

Dwyer said he became interested in the municipal market following the collapse of many monoline bond insurers. Before the financial crisis, issuers would often buy insurance for a triple-A rating so that the probability a municipal bond would lose value on weakening credit or the probability of outright default "really [was] not very high for municipal debts compared to comparably rated corporate debts," he said.

Now, investing in the municipal market "is like putting a deposit in a bank without FDIC insurance," Dwyer said, referring to the Federal Deposit Insurance Corp. guarantee for deposits of up to $250,000 per insured bank.

The post-insurance environment may force governments to improve their disclosure of financial information, both economists said.

Without insurance, "I would guess it might change the incentive that the governments have for providing information, to make it more readily available than they did before," Dwyer said.

Mattoon agreed, saying: "Anything that would increase the transparency of the accounts and also normalizing the accounting across governments would help."

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