What Happens to California State Bonds if the State Goes Bankrupt?

BY busadmin  June 11, 2009 at 11:13 AM EDT

california flag; scazon via Flickr

Question: I live in California and own California State Bonds. What happens to state bonds if the state goes bankrupt?

Paul Solman: They stop paying, both interest and principal. That’s what a default IS.

Last September 15, Lehman Brothers went bankrupt and thereby defaulted on massive amounts of corporate bonds. Three days later, an article entitled ‘The Coming Bond Default Wave’ was featured in Forbes by Richard Lehmann (no relation, presumably), whose “business has maintained a database of all corporate and municipal bond defaults since 1982.”

“You might presume that municipal bonds aren’t vulnerable to default,” wrote Lehmann, “but they, too, fail in significant numbers. In fact, of the 4,400 defaults in our database [since 1982, that is], 2,900 are of municipal bonds. Their total principal amount of $44.5 billion is low compared with that of corporate defaulters, because the typical municipal issue (especially revenue bonds, which are most prone to default) is much smaller than a corporate one. Insurers, including the federal government, made good on the loss of 30% of that default volume. In those cases, muni insurance was really worth something.

The causes of municipal bond defaults are many: nursing homes that don’t fill up, housing developments that were started too late, commercial projects with thin revenue streams and so-called “economic development” tax exemptions. This year we’ve seen an unsurprising surge in defaults connected with housing developments in Florida, California and Nevada. Jefferson County, Ala. issued $3.2 billion of water bond issues that were structured unwisely, relying on sewage-service revenues to fund them as they rolled over every month and a half. Those bonds have collapsed as interest rates soared, and they’re being kept alive only by the fact that the investment bankers and underwriters who have been left holding many of them face conflict of interest charges if they try to recover all they think they’re owed.

The good news about bond defaults, such as it is, is that when they do happen, all is usually not lost. Bondholders have a claim on a company’s assets before stockholders, although not before banks. On average, holders of defaulting corporate bonds recover about 72 cents on the dollar. Future defaults will do worse, though, because recent changes to bankruptcy law have added to banks’ advantage. Municipal bond defaults repay an average of 85 cents on the dollar for those with some sort of insurance and 70 cents for those without (the range of repayment goes all they way from zero to full face value).”

That’s what Lehmann had to say. I should quickly add, however, that your very own Orange County, Robert (or do you now simply call It “the OC”?) was not only the largest municipal bond default of recent vintage (1994), but that investors got paid back in full? AFTER a long legal battle.

The risk of default is WHY municipal bonds have been paying such a premium over Treasuries. At a panel of Nobel laureate economists in October, one of the Nobels, I believe it was the legendary Paul Samuelson, said:

“Why wouldn’t one be interested in a Harvard University 28-Year Bond at par that pays 5 percent? What credit risk do you think?”

Note that he did not say there was ZERO credit risk, even though we’re talking about Harvard University and its endowment of, what, $25 billion?

One of the bedrock verities of finance: For every extra increment of reward, you take an extra increment of risk. Municipal bonds are a special case, because of their tax-exempt status. But the risk of default is always present.