Investors deserve to get burned if they bought “non-debt debt” from cities.

urban decay cc

Basically what we are talking about are municipal bonds of another kind and of lower typical quality than most investment grade munis. (Though investors have not demanded that much more in yield historically.) Such bonds are often issued by government agencies in a way that helps municipalities get around restrictions on floating bonds. Kind of junk muni bonds, without the nice payout. Many think this “non-debt debt” is as legit as municipal bonds, but according to the attached article this is far from the case.

The author says that if one holds this kind of debt in one’s portfolio, especially in the wake of the Detroit default, one deserves to get burned. He’s right. Don’t come crying for a bailout in 5 years.

(From Real Clear Markets)

Here’s what I mean. The vast majority of state constitutions include limitations on how much a government can borrow, and restrictions on when it can borrow. Just as predictably, politicians in many states and cities have spent decades evading these restrictions and piling up borrowing that falls outside constitutional restrictions.

In a 2003 scholarly article, Columbia Law School Professor Richard Briffault estimated that nearly three-quarters of state debt and two-thirds of local borrowing has taken place outside the legislative limitations on debt that taxpayers think offer them protection from borrowing-happy politicians. States and cities have accumulated this borrowing, Briffault argues, by calling it something other than debt, what he terms ‘non-debt debt.’ To evade constitutional limits, local governments often float this debt by claiming it’s not actually the responsibility of taxpayers to pay back.

Click here for the article.