Here's The Real Reason Cities And States Would Never Be Allowed To Default

Arnold Schwarzenegger

David Goldman at Asia Times nails it: It’s not about the impact on the real economy (the attendant cut in public services and public employment), it’s about the effect that such defaults would have on the banks.

In fact, that’s a good rule of thumb. If it’s going to hurt the banks, it’s probably not going to be allowed to happen.

If municipal debt actually defaulted, the capital position of the banking system would be impacted, bank preferred debt might stop paying, and the holders of bank preferred debt–starting with the insurers–would be in serious trouble. The $800 billion bailout package for Europe’s PIIGS (Portugal, Ireland, Italy, Greece, Spain) in May was in fact a bailout for the banking system, which holds hundreds of billions of dollars worth of such debt. We don’t know quite how much, because European banks don’t have the same reporting requirements as American banks (and American banks’ overseas branches don’t have the same reporting requirements as their domestic branches).

As such, maybe it’s time to — as PIMCO put it — shake hands with Uncle Sam:

Why buy munis? For all of Warren Buffett’s dire warnings about municipal finances, the fact is that the federal government can’t let major municipal debtors (at the level of states, for example) go under without also bringing down the banking system and everything else.

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