WASHINGTON - Lawmakers Friday disagreed over the level of default risk in the municipal sector, at a time when recent bankruptcy filings in California raise the question of the eroding stigma associated with taking that step.

Rep. Barney Frank, the Ranking member on the House Financial Services Committee, brought up the issue in the context of what he deems the unfair treatment of municipal issuers by rating agencies.

Municipalities "almost never default," said Frank, whose personal investment portfolio is nearly entirely in Massachusetts municipal bonds, "because they are double tax exempt and because the rating agencies inaccurately tell people that there is a risk of default, which is not existing."

He noted that in the recent bankruptcies, "the bondholders are getting paid," adding in Rhode Island, pensioners were "put behind" bondholders.

Barney indicated municipalities do fear the contagion risk associated with a bankruptcy and "communities can't afford that contagion that would be there."

However, Rep. John Campbell strongly disagreed and even warned of more to come.

"I could not disagree more, coming from California where we've had three municipal bankruptcies -- we probably will have nine more very soon," said Campbell.

Once municipalities and a lot of districts properly account for their healthcare and pension obligations under the "new -- and I believe correct -- government accounting standards" he continued, "many of them will be on paper insolvent."

In fact, he said, "most of them" in California that he knows of will be likely be insolvent on paper.

Campbell referred to the new Pension Accounting and Financial Reporting standards adopted in June by the Governmental Accounting Standards Board, that are expected to make state and local governments' balance sheet look weaker than they are today.

So "I think we have great concern about municipal bonds," said Campbell, who unlike Frank does not own any municipal bonds in his personal investment portfolio.

"You can't assume they are not going to be at fault, and when there is as much trouble as there is out there and as many insolvent cities and special districts this is a concern," he said.

"There is a lot of risk out there," he concluded.

Campbell represents California's 48th Congressional District which encompasses Newport Beach, Irvine, Tustin, Lake Forest, Laguna Beach, Laguna Hills, Laguna Woods, Laguna Niguel, Aliso Viejo, Dana Point, and portions of San Juan Capistrano, and Santa Ana.

However, Frank argued that when looking at the likelihood of default, "municipalities pay an unjustified risk premium."

He added that when the rating agencies rate municipalities, they look at what seems to be sometimes "how well dressed the members of the city council are, which is often not so good."

Robert Doty, president of consulting firm AGFS and a California-based municipal advisor, said "there really are very few defaults overall," with some sectors more vulnerable than others.

"Traditional governmental securities virtually never default," he said, adding that a key factor in defaults is the "feasibility" of the project.

The recent bankruptcy filings in California prompted rating agencies to comment.

"The looming defaults by Stockton and San Bernardino raise the possibility that distressed municipalities -- in California and, perhaps, elsewhere --  will begin to view debt service as a discretionary budget item, and that defaults will increase," said Van Praagh, author of the report titled "Recent Local Government Defaults and Bankruptcies May Indicate A Shift in Willingness to Pay."

However "Our expectation is that unwillingness-driven defaults will rise but remain rare, particularly among Moody's-rated issuers."

"Recent bankruptcies and defaults of distressed municipalities have added to the headlines and default totals for 2012 but the amount of new defaults is nowhere near the pace predicted by some analysts late in 2010," said S&P Dow Jones Indices' Vice President of Fixed Income Indices, JR Rieger.

"As of the end of June 2012, outstanding monetary defaults based on par value as tracked by the S&P Municipal Bond Index have risen to 0.62% (over $8.4billion) of the index which tracks over $1.35trillion in municipal bonds," the note continued.

In the case of California, he said that despite the recent developments, "munis issued within the State continue to outperform the overall municipal bond market" on a year-over-year basis. That is not the case on a monthly comparison, however.

Year-to-date, underperforming states have been Connecticut, Georgia, New Mexico and Utah.

Friday's hearing about "The Impact of the Dodd-Frank Act on Municipal Finance" otherwise focused on the definition of Municipal Advisors, with witnesses opposing the Securities and Exchange Commission's interpretation of the law, arguing the agency went beyond Dodd-Frank's intent.

In fact, Rep. Frank sided with them.

In particular, normal activities of a bank that work with municipalities "should not trigger a registration requirement," he said, which is different from offering active investment advice or advising another structure.

"The language of the law does not support a more intrusive effort to put regular banking activities under this provision and I hope the SEC will listen to this," Frank added.

"The SEC should be listening to us and following the intent," he concluded.

American Bankers Association Chairman Albert Kelly said earlier during his testimony that "the SEC has proposed rules that interpret the scope of the 'municipal financial products' in Section 975 far beyond the securities activities of state and local governments to reach all 'funds held by or on behalf of a municipal entity.'"

He added, "This would mean that giving advice about traditional bank products such as deposits and loans could trigger registration as municipal advisors by most banks and each of their employees who may give 'advice' to local governmental bodies such as schools, libraries, hospitals, etc."

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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