Buying Into The Hype

California's selling some $14 billion in bonds starting today.  The question is simple:  with the state facing tens of billions in shortfalls next year, who's going to take that bet that California's going to be able to pay them back in May?

The Golden State is the starkest example of the financial difficulty facing US local governments. Worries are mounting of a possible rise in defaults or a reassessment of risk in the $2,800 billion municipal bond market, hitherto perceived as a safe place to invest.

California’s plans to sell its debt come just days after Arnold Schwarzenegger, the state governor whose term ends in January, called a special session of the legislature to address a state deficit projected to be more than $25 billion over the next 18 months. 

Orders begin on Monday for a $10 billion, two-part sale of so-called revenue anticipation notes (Rans), an annual event that allows California to bridge the gap to its tax season in the spring. The notes, due in May and June, are targeted mostly at individual investors who benefit from tax breaks on so-called “munis.”

Muni bonds generally last week sold off on concerns about shaky finances and the looming end of federal subsidies for the Build America bonds (Babs) program, which has boosted the market since the credit crunch. 

The yield on 30-year triple A munis rose 15 bps last week, the largest such rise in about 18 months, according to an index compiled by Municipal Market Advisors.

Republican gains in midterm elections called into doubt an extension of these subsidies, prompting a rush to sell bonds before their expiry at the end of the year. Long-term muni bond yields were also rose in line with US Treasuries. 

With the GOP in change of the House purse strings, odds are very good that the buyer of last resort, the Treasury, isn't going to be allowed to continue its bond-buying program.  That leads me to believe that the Fed will be allowed to step in instead.

That means the most likely scenario is indeed a Helicopter Ben Fed bailout of the Golden State through purchase of bond debt.  And you can bet your bottom dollar (hey, in a real sense you have already!) that other states will follow through.  Somebody's going to have to buy the next batch of bonds when California doesn't have the money to pay back this set of bonds in order to raise the money to start making payments.

At some point in 2011, the Fed's going to do this.  And California's just the beginning.