Payback Time - Budget in the Red, Illinois Has Stopped Paying Bills - NYTimes.com

It's no secret to anyone who reads a paper or listens to the news that municipalities throughout the United States are in deep financial crisis.

This article in last Saturday's New York Times had a long piece about the problems confronting the state of Illinois. Here's an excerpt:

For the last few years, California stood more or less unchallenged as a symbol of the fiscal collapse of states during the recession. Now Illinois has shouldered to the fore, as its dysfunctional political class refuses to pay the state’s bills and refuses to take the painful steps — cuts and tax increases — to close a deficit of at least $12 billion, equal to nearly half the state’s budget.

Then there is the spectacularly mismanaged pension system, which is at least 50 percent underfunded and, analysts warn, could push Illinois into insolvency if the economy fails to pick up.

States cannot go bankrupt, technically, but signs of fiscal crackup are easy to see. Legislators left the capital this month without deciding how to pay 26 percent of the state budget. The governor proposes to borrow $3.5 billion to cover a year’s worth of pension payments, a step that would cost about $1 billion in interest. And every major rating agency has downgraded the state; Illinois now pays millions of dollars more to insure its debt than any other state in the nation.

Payback Time - Budget in the Red, Illinois Has Stopped Paying Bills - NYTimes.com

After reading stories like this, one cannot help but wonder whether we should be considering avoiding investing in municipal bonds.

I wouldn't, judging from past history.

As the Times article notes, states cannot technically go bankrupt. Cities and towns can, but have done so only on very rare occasions.

Municipal bonds almost always pay creditors on time for the very simple reason that they cannot afford not to. In the 1970's, for example, New York City decided to forgo paying interest on its bonds - and then was shut out of the credit markets for the next 7 years. It could only return to the bond market after it paid all of the interest due in arrears. Orange County in California tried to declare bankruptcy in the mid-1990's after massive losses on its investment portfolio, but then realized that it needed to issue more bonds, and so all creditors were eventually repaid.

Even during the Great Depression of the 1930's very few municipal bonds defaulted.

This is not to say that the poor financial health of our cities and towns should be dismissed. Much like the problems at the federal level, the only way out of most of the problems is to cutback services (which will hurt the poor and the needy) and raise taxes (slowing economic growth). Unfortunately, as the Times series is titled, it's Payback Time in America, and it's going to be painful.