Wall Street’s Tricky Game With States' Debt

We've talked a lot on this show about the debt strangling so many states and cities across the country.

According to the Wall Street Journal, 15 states are facing budget gaps nearing $27 billion and Illinois, no surprise, is in the worst shape with a $13 billion deficit. Now, news that Wall Street has found a way to essentially short some of this debt; traders will be able to bet against the very cities and towns and counties and states that they live in.

Here's how it works: these investments - called credit default swaps - would require sellers to compensate buyers if a city or state misses a payment on debt - or other words, if they default.

Now, this isn't as rare as you might think.

In fact, in a recent interview, Meredith Whitney, a well-known analyst, said 50 to 100 municipalities could default on debt in the next year alone, totaling nearly $2 trillion, if that were to happen it would mark a huge change.

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Between 1970 and 2007, there were just 54 defaults, according to Lebenthal and Company. To be sure, the market for these souped up derivative  investments--some $50 billion--right now is tiny compared to the size of the municipal market, which is $2.8 trillion.

But these investments could create huge headaches for small investors, and the very governments whose debt is at issue.

Here's why:

Individual investors-- usually retirees-- are the biggest holders of municipal bonds; some two-thirds of these investments are in the hands of mutual fund owners, many of whom are relying on returns for retirement.  They are the ones at risk.

Second, many market participants are worried about whether trading in derivatives connected to muni bonds could make a bond route worse than it otherwise would be.

For example, what if a fair-sized city were to default? Investors might leave the market like they leave the stock market from time to time. Borrowing costs would skyrocket.

Muni swaps would be in the money, but local governments might find it impossible to raise money.

John longo, an investment strategist at MDE Group,  who watches the market, puts it this way: "Sometimes the tail can wag the dog... shorting can put stress on municipalities."

Proponents of these swaps say they will make the market more transparent.  Maybe so, but my advice is this:  stick with muni bonds mutual funds from companies you know.

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