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Rising Oil Prices and Municipal Bond Defaults

I have written quite often saying that rising oil prices can be expected to lead to debt defaults. For a while, some of this was hidden through lower oil prices and stimulus programs, but we are now beginning to see problems arise again, this time in the area of municipal bonds. The question is, “Who ends up holding the bag, if major municipal bond defaults take place?”

“Municipal” bonds include bonds issued by states, as well as bonds issued by cities and by many types of smaller entities, such as hospitals and toll roads. To date, everyone has assumed that there is not much risk of default, and even if there is, someone else will handle it. But if one looks at the long term oil situation, and the problems states and cities are having already, it is pretty clear that the debt default problem is likely to get worse over time, and there is really no one set up to handle the default risk.

There are many ways debt default problems arise from higher oil prices. One path is

Higher oil prices -> less money to spend on discretionary items -> less demand for new homes -> lower home prices -> more debt defaults

Another is

Higher oil prices -> business layoffs -> unemployed unable to make debt payments->defaults on loans.

Some of these debt default problems fall through to cities that try to collect taxes on the value of homes. States find themselves in poorer financial condition, in part because they have to pay more benefits to the unemployed (without an increase in tax revenue), and in part because road repairs cost more.

Now municipal bonds seem to be having some of the problems that have been expected.

Municipal Bond yields
Wall Street Journal illustration

We read the other day that New Jersey scaled back its offering by 47% yesterday, when it found required interest rates were higher than expected. Interest rates seem to be rising, especially on longer-term debt. Higher interest rates are themselves a problem, because if makes it more difficult to afford the current level of debt.

An even bigger part of the problem has to do with defaults. I wrote back in early 2008 that “monoline” bond insurers–the ones insuring municipal bonds were likely to encounter financial difficulties.  And I was right. Several municipal bond insurers did run into difficulty.

One of the big ones, MBIA, is in the news again now. It restructured in such a way as to provide less protection in the case of default, because of its financial difficulties. If insurance companies cannot provide coverage in the case of a municipal bond default, banks who have issued letters of credit guaranteeing these loans are next in line to pay. Banks sued to challenge MBIA’s restructuring plan, and initially a lower court ruled in favor of the banks.  Now, last week, a New York appeals court overturned the lower court’s ruling, leaving the banks with less protection.

In an article last week, the Wall Street Journal tells us that bank letters of credit, which would also insure against the risk of default, is becoming less available and more expensive. We don’t know that this is a direct result of the MBIA ruling, but it no doubt didn’t help. The WSJ indicates that there are many municipalities in need of new letters of credit, but are having difficulty getting them. Without the letters of credit, they are in danger of losing their financing. An unusual number of letters of credit are rolling over now, because many municipalities were forced to arrange new financing in 2008, and the letters of credit written then were written to last for only two or three years.

It is certain that someone will left “holding the bag” on municipal bonds that likely will default in the next few years, but there is no program set up to handle this risk, that is “strong” enough to actually shoulder the risk.

Insurance companies do not charge much for insurance coverage for this risk, so they do not have much in the way of funds backing the coverage. If the insurers fail, there is no federal program guaranteeing the programs if they go under.

Banks offer backup default coverage (or full coverage, if there is no insurance available) through their letters of credit. But until recently, they seem to have paid little attention to this risk. They are not required to report this risk in their financial statements, so no one knows how much coverage is offered by banks.

Ultimately, if there is no coverage from banks or insurance companies, the risk of default goes to those holding the municipal bonds. There are obviously many different types of bond holders, but insurance companies tend to be big buyers of municipal bonds. Because of this, I would expect that insurance companies would be affected more than most businesses. Defaults would  first act to reduce the “equity” cushion of insurance companies, but eventually would reduce the funds they have available to pay claims to policyholders.

If the funds insurers have available to pay claim are reduced, the effect of municipal bond defaults may come back to those with insurance policies. While there are programs set up to handle many types of insurance company failures, they generally assume that solvent insurers will be assessed to pay the costs of insolvent companies. Such a scheme works for a while, but not if there are huge numbers of claims.

Ultimately, I am afraid we all may pay for municipal bond defaults. The federal government will try to bail out municipalities, banks, and insurers, but it won’t really be able to. Interest rates will rise. The result will be increased financial difficulties all around.

By. Gail Tverberg

Gail Tverberg is a writer and speaker about energy issues. She is especially known for her work with financial issues associated with peak oil. Prior to getting involved with energy issues, Ms. Tverberg worked as an actuarial consultant. This work involved performing insurance-related analyses and forecasts. Her personal blog is ourfiniteworld.com. She is also an editor of The Oil Drum.

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  • Anonymous on January 18 2011 said:
    Of course the rising oil price COULD lead to bond defaults, because the oil price is moving into a region where it could weaken the macroeconomy, which in turn COULD lead to bond defaults. Whether it WILL or not depends on a few things. I just wish that I remembered enough to tell everybody exactly what.

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