The municipal debt bubble: as cities and states boost their debts by 800 percent, a housing-like crisis looms.

• Author: de Rugy, Veronique
• Position: Columns

WHEN STATE AND LOCAL governments want to spend more than they collect in revenues, they issue bonds. Such bonds are a longstanding feature of the American landscape, going back at least as far as 1812, but during the last decade they have spun out of control, as states and cities have increased their borrowing to indulge in more and more spending on new stadiums, schools, bridges, and museums. They have even started borrowing to cover their basic operational expenses.

Since 2000 the total outstanding state and municipal bond debt, adjusted for inflation, has soared from $1.5 trillion to $2.8 trillion (see chart). The recession didn't slow the spending.

One reason for the increase in demand for these bonds is that in times of crisis, investors tend to abandon high-risk, high-return assets for safer investments. The presumed reliability of municipal bonds--only U.S. Treasury bonds are considered safer--have made them very attractive. From 1970 to 2006, the default rate for municipal bonds has averaged 0.01 percent annually. And the average recovery rate for those few municipal bonds that have defaulted is also notably high, about 60 percent. In comparison, corporate bonds' recovery rate is about 40 percent.

Municipal bonds are perceived as safe investments because, like U.S. Treasury bonds, they are backed by the full faith, credit, and taxing powers of the issuing governments. Investors know that states and localities can always raid taxpayer wallets to pay off their debts.

But in the last two years tax and fee hikes have faced greater public opposition. Last year, for example, Jefferson County, Alabama, was unable to raise sewer fees to meet its sewer bond obligation. Since governments are generally unwilling to cut spending either, the result of resistance to new revenue raising has been substantial increases in states' and cities' debt levels. Detroit and Los Angeles have announced that they may have to declare bankruptcy, as have a number of smaller cities.

Usually, as a borrower becomes a riskier prospect, lenders start pulling away. At the very least, worried about the prospect of losing their investment to default, they don't increase the amount they lend.

But municipal bonds have not yet lost their low-risk reputation. According to the Investment Company Institute, $84 billion went into long-term municipal bond mutual funds in 2010, up from $69 billion in 2009. And the 2009 level represents a 785 percent increase from the 2008 level...