Dr. Doom Adds $100 billion to Muni Scare

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NYU’s Roubini is worried about muni bonds (Mike Segar/REUTERS)

They don’t call him Dr. Doom for nothing. A new report from the research firm headed by New York University Professor Nouriel Roubini, who is credited for predicting the housing bust and subsequent financial crisis, is saying debt defaults of local and state government could rise 650% in 2011. In all, Roubini is predicting that $100 billion in municipal bonds could go bad during the next five years. Last year, defaults in local and state debt totaled just $2.65 billion. And that apparently was the good news.

The issue is that Dr. Doom’s prediction on muni bonds, while bad, is not the gloomiest out there. Noted bank analyst Meredith Whitney warned of hundreds of billions in defaults in municipal debt. And intimated that it was possible that even a state could default. Investors have already pulled $23 billion out of the muni bond market, which is normally considered a safe haven, since November.  And then there is Governor Scott Walker in Wisconsin and Chris Christie in New Jersey, among others, warning about a budget crisis in their states if billions are not cut. Compared to those predictions, Roubini’s outlook is kind of sunny.

Most of the municipal bond funds that individual investors put their money in invest in highly rated debt. Since bonds of state and local governments rarely default, some are worried that a rash of defaults in what has been considered a rock-solid market, could cause investors to rush out of the muni bond market. So even if the municipal bond you own or is owned by the fund you have money in doesn’t default, the price could fall as investors rush out of muni bonds in general, much in the same way they did after the financial crisis, or the stock market after the tech bust.

But Roubini isn’t really predicting that scenario. And he says that he doesn’t think defaults in the muni market will lead to any of systemic problems for the economy that happened when the sub-prime mortgage market had its meltdown. What’s more, Roubini thinks many of the bonds that go bad won’t be worthless, and local governments will make good on around 65% of their bad debts. The bonds he thinks could default are generally smaller issue bonds that back specific projects, like roads or water treatment centers. Many will be unrated and not the type individual investors and other safe-haven seekers buy. While defaults on these bonds are still far from common, they have happened in the past.

So what should an individual investor do? The average 10-year municipal bond is 3.22%. If you are in a municipal bond fund and see that it is yielding significantly more than that, it’s time to switch funds. They way the manager is getting that higher yield is by being in riskier munis, and that puts the fund in the most danger of being hit by defaults. Other than that, now might be a good time to stick with the muni bond market, or even buy in. Yields have risen in the past six months. Much of the bad news may already be priced in.

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Muni Bond Default Estimate: $100 billion (WSJ)