Will the Debt Ceiling Standoff lead to a Muni Bond Crash?

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A girl protests about her mother being laid off during a rally against education budget cuts in Los Angeles. The debt ceiling standoff could lead to more local government layoffs. (Lucy Nicholson / Reuters)

Meredith Whitney may end up being right about about the municipal bond market.

Late last year, the Wall Street analyst famous for predicting the financial crisis began warning that the municipal bond market may be headed for a crash. Whitney predicted that there could be as many as 100 municipalities that end up being unable to pay back their debt, causing hundreds of billions of dollars of losses for investors. So far that prediction hasn’t really played out. But the debt ceiling standoff is causing new fears for problems in the municipal bond market. Here’s why:To be sure, as my colleagues over at Moneyland have pointed out, if the debt ceiling is not raised and the U.S. ends up getting a debt downgrade or defaulting on its bonds, markets in general are likely to go down. But some are worried that U.S. muni bonds could be hurt more than say corporate bonds or stocks.

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First of all, more than corporate bonds, the rates that municipalities get on their debt is influenced by the overall high rating of the U.S. debt in general. On Wednesday, bond rating firm Moody’s put U.S. Treasury bonds on review for a downgrade due to the stalled debt ceiling negotiations. Along with that announcement, Moody said a U.S. federal debt downgrade would trigger an automatic downgrade of 7,000 highly rated municipal bonds that are directly tied to the U.S.’s credit rating. Second, municipal bonds are typically thought of as one of the safest investments around. And so any threat of problems in general hits the muni bond market more than say corporate bonds, which are already viewed as somewhat risky. Third, a number of states do get a significant portion of their revenue from Medicare, Medicaid and other federally funded programs. If the federal government were unable to pay it bills, that money could stop flowing to the states. Lastly, the stimulus bill created a new class of muni bonds called Build America Bonds. As part of the program, the federal government picks up about a third of the interest that states and other local governments that issued the bonds have to pay out. If the government defaulted, the muni issuers would now be on the hook for the entire interest payments due on those bonds.

Of course, not all of those things could turn out to be as bad as they sound. The muni bonds that Moody’s would automatically downgrade, despite the large number, represent just 5% of the local government debt market in general – a type of muni bond in the industry called slugs that are backed directly by U.S. Treasury bonds. State and other large issuers wouldn’t be automatically downgraded. Nonetheless Moody’s says in the next few weeks it plans to reassess ratings of all muni bonds in light of the U.S.’s debt problems. So there could be more downgrades. Peter Hayes, who heads up the muni bond business at investment firm Blackrock, says his firm is being slightly more cautious in the muni bond market than usual, but is not overly concerned. He thinks the chances of a U.S. debt default are small. He says a downgrade is higher, but still not likely. Even without the funds they get from the U.S. government, state and local governments will be able to meet their obligations.

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Nonetheless, at a time when state and cities are already letting workers go, higher borrowing rates will only make it more necessary for local governments to cut their staffs. So a debt default is likely to make what has become one of the job market’s biggest headwinds that much worse. As Megan McArdle correctly points out, it’s just another thing to think about as politicians play chicken with the debt ceiling, and shutter.

Stephen Gandel is a senior writer at TIME. Find him on Twitter at @stephengandel. You can also continue the discussion on TIME‘s Facebook page and on Twitter at @TIME.