"Blue State Armageddon On The Way"

How the "meltdown" goes nuclear.

If things go wrong in the markets for blue state debt, watch out. If big blue states like New York, California and Illinois hit a point of market failure when private investors will no longer buy their bonds, Washington will have to decide what to do. Fast.

It will be ugly, and it will hurt.

Will GOP legislators bail out the public sector unions and shovel cash into the maw of improvident and badly managed blue states like so many steaming German taxpayers bailing out the lazy Greeks? Or will Congress sit on its hands while vital state services close down, unemployment spikes, and the financial markets panic? Will all parties turn to the Fed to buy up state bonds? If so, on what conditions and terms?

While an unprepared, polarized Washington argues, markets will be melting down. Risk unnerves bondholders; the sight of clueless debates among angry politicians makes markets unhappy in good times. In times of crisis this is a scenario for total panic.

It’s hard to overstate the havoc that a meltdown in the state and municipal bond market would cause. Many private investors and retirees are heavily invested in securities long thought safe. Worse, many pension funds, including state pension funds, have large positions in the muni market. The meltdown could feed on itself as falling bond prices would undermine state pension fund reserves and raise the interest rate on new debt issues. The panic will intensify and spread, sucking new states into the maelstrom — as more and more European countries have been affected by a crisis once limited to Greece.

Bond investors are much more skittish than stock buyers. Any risk of default sends them running for the exits. Without swift federal action, a crisis in the market for some cities and states would inevitably lead to sharp spikes in interest rates for other state and city governments whose positions suddenly looked risky. Massive layoffs of government employees would be inevitable in a widening range of affected states, throwing the weak recovery off course and quite possibly bringing on the much-feared second dip of the recession. Many banks and other financial institutions like insurance companies hold significant portfolios of state debt; if those bonds tank in value, we could go back to the darkest days of the financial crisis of 2008 as big banks and insurance companies come running to Uncle Sam for more bailouts.