Nicole Gelinas wrote an excellent article in City Journal about the possibility of a coming bubble-burst in the muni-bond market.

The financial crisis has exploded plenty of long-held beliefs, including the idea that mortgage debt is a risk-free investment. But nothing has shaken the articles of faith that underpin another massive debt market: municipal bonds. Investors in municipal bonds don’t have to worry about a thing, the thinking goes, because the states and cities that issue them will do anything to avoid reneging on their obligations—and even if they fail, surely Washington will step in and save investors from big losses.

These are dangerous assumptions. Just as with mortgages, the very fact that investors place unlimited faith in a market could eventually destroy that market. If investors believe that they take no risk, they will lend states and cities far too much—so much that these borrowers won’t be able to repay their obligations while maintaining a reasonable level of public services. The investors, then, could help bankrupt state and local governments—and take massive losses in the process. To avoid that scenario, investors must take a long, hard look at what they’re doing. Where state and local finances are untenable, they should stop throwing good money after bad.

He explains that there is good reason to be concerned about the muni-bond market. Plummeting tax revenues, and lack of will to cut expenditures on the part of local governments can mean a looming insolvency. Yet the rating agencies still consider muni-bonds low risk. “We do not expect that states will default on general-obligation debt, even under the most stressed economic conditions,” analysts at Moody’s, one of the three major credit ratings agencies, wrote in a February 2010 report. As for cities and towns, “we expect very few defaults in this sector given the tools that local governments have at their disposal.” The firm’s chief competitor, Standard and Poor’s, agrees.

They consider the bonds low risk because they feel the municipalities will do whatever they have to in order to avoid default. They also feel that municipalities have an endless source of funds to repay debt. They can always increase taxes to pay bond debt service.

But, can they?

The author goes on to explain the reasons why analysts feel that muni-bonds are a safe bet, and then says:

Municipal bond buyers are partly to blame for state and local governments’ failure to face reality. True, there are other culprits, such as President Obama’s 2009 stimulus package, which poured more than $200 billion of reality-distorting funds into municipalities’ coffers so that they could keep hiking their spending. By 2011, stimulus money will have filled about 6 percent of states’ revenue shortfalls, obscuring the need for fiscal reform. But now that stimulus cash is running out, states are falling even more passionately into the arms of all-too-willing debt markets. In New York, for instance, Lieutenant Governor Richard Ravitch has proposed an intricately detailed $6 billion borrowing plan to help close $60 billion in operating deficits over five years but hasn’t said a word about how exactly to cut spending. The ratings analysts remain calm, with Moody’s observing in early March that New York has a “long track record of closing annual budget gaps” and Standard and Poor’s reminding investors of the state’s rosy “history of what we consider conservative budgeting.”

Washington has made things even worse with “Build America Bonds,” part of the stimulus package. Usually, municipal bonds offer comparatively low interest rates because lenders don’t have to pay taxes on their interest income. But investor demand is limited to people who need this benefit. Build America Bonds, by contrast, are taxable, so they offer higher interest rates; state and city governments issue them to a bigger market, but the feds cover the higher interest costs. Big borrowers have ably exploited this invitation to borrow still more. California, New York, and Illinois have already issued $31 billion in such bonds, or 40 percent of the year-old program.

Thanks to Build America—and also to the Federal Reserve’s 0 percent interest-rate policy, which lets borrowers access cash cheaply—2010 may be a record year for municipal-debt issuance and a lost year for fixing state and local budgets. The average state owes 2.1 percent of its citizens’ annual personal income. California owes 4.4 percent, New York 5.4 percent, and New Jersey 6.7 percent. New York’s Citizens Budget Commission recently added future retiree obligations to that statistic and found that six American states—New York and New Jersey among them—are on the verge of a “danger zone.”

What will they do if they enter that danger zone in the coming years? Perhaps what overindebted homeowners did in tearing up the conventional wisdom about their ability and willingness to repay their mortgages. Once state and local governments have borrowed too much, they may well find a way not to pay their lenders back.

The author then illustrates what happened in Vallejo, California when it filed bankruptcy.

There are risks to municipal bonds and the rating agencies may be relying imprudently on the fact that municipalities have rarely defaulted.

The uncomfortable truth is that as municipal debt grows, the risk mounts that someday it will be politically, economically, and financially worthwhile for borrowers to escape it. When that happens, the protections that lenders supposedly enjoy will be meaningless. Lenders shouldn’t take solace in states’ inability to access federal bankruptcy codes: a state could certainly stop making payments on its debt without formally going into bankruptcy. As for complex financial engineering, a future elected official could convince the public that the “trust” structure that New York uses to issue bonds is a fraud perpetuated by corrupt former officeholders—a deliberate attempt to nullify voters’ right to limit indebtedness—and withhold payments to the trusts and hence to their bondholders. This would mean years in court, and, in the meantime, the bondholders would go unpaid.

But there’s always Uncle Sam, right?  Maybe not.

In relying on future bailouts, investors are taking a gamble. Consider how thoroughly the public remains fed up with the bailouts of AIG’s creditors, who should have known better than to lend so imprudently. Furthermore, in bailouts where the federal government’s aim has been not to save the financial system but to force a borrower to restructure its obligations, bondholders have fared poorly. When the White House rescued Chrysler and General Motors, it forced bondholders to take bigger losses than union members did, despite bondholders’ higher claim.

A practical limitation on federal bailouts exists, too, and investors would do better not to reach it. Washington cannot guarantee all debt. In March, Moody’s questioned the resilience of America’s AAA credit rating, noting that “preserving debt affordability” at the federal level “will invariably require fiscal adjustments of a magnitude that . . . will test social cohesion.” To get its finances in line, in other words, the United States must already slash spending to such an extent that it will risk the wrath of the targets, likely including public-employee unions and Medicaid recipients. Shouldering the debt burdens of bankrupt states and cities would make the situation even graver. Faced with a choice between preserving “social cohesion” and saving municipal or corporate bondholders, the feds would be likely to pick social cohesion, throwing some creditors out of the bailout boat.

That’s the better scenario, in fact. The worse one is massive inflation, effectively a wholesale repudiation of all government debt.

This is not a signal to panic. Just a suggestion to review carefully the financial condition of the municipality, to not rely heavily on rating agency analysis, and to proceed cautiously and prudently.