<b>INsider:</b> ‘Death spiral’ awaits if muni tax break erased

Never underestimate the ability of Washington lawmakers to think in the shortest possible terms.
The latest example comes from the congressional supercommittee, which is said to be considering dumping the tax exemption for municipal bonds, a $2.9 trillion market
From Washington’s perspective, this certainly must look like low-hanging fruit in the overall deficit reduction effort. But by looking just beyond the immediate impact of taxing the interest on bonds issued by tens of thousands of states and municipalities, you can see big problems ahead.
“Something like that could end up costing taxpayers hugely, because it would raise the cost of borrowing just when municipalities need that cost to stay low,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate accounts.
Under the current tax-exemption rules, municipalities are able to borrow money by offering yields below Treasury rates — as long as the after-tax return is competitive with government paper. But eliminating that exemption, especially at a time when austerity efforts have become the top priority of most local governments, changes the game and possibly eliminates a major segment of the investor market.
While it’s way too early to speculate on the specific effect of doing away with the tax exemption, it certainly would increase the odds of default and, ultimately, the odds of the federal government’s having to bail out some municipalities.
Although the muni market was able to survive the apocalyptic forecast of sweeping defaults less than a year ago by banking analyst Meredith Whitney, the fallout could be more significant this time if the most appealing aspect of a muni bond is stripped away.
“Right now, municipalities will do whatever it takes to avoid default, because they don’t want to get locked out of the credit markets,” Mr. Burns said. “But if there was a couple of big defaults, that could lead to contagion, and maybe that starts leading us down the path that Meredith Whitney was warning about.”

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Similar to the impact of Ms. Whitney’s celebrated forecast, the first and biggest concern might be the threat of a major change to the tax rules involving muni bonds.
While most individual investors are probably not yet paying close attention to this particular issue, the elimination of the tax exemption could result in rapid price adjustments on some bonds. This could present a major challenge for muni bond fund managers, who overseeing more than $480 billion in nearly 600 distinct funds.
“If investors start to bail out of muni funds in search of greener pastures, that puts more pressure on fund managers to sell to meet redemptions,” Mr. Burns said. “They end up selling their best stuff first, and that creates a death spiral.”
And let’s not forget the impact of investors’ writing off muni bond losses in their taxable accounts, which could put a superdamper on whatever superrevenues the supercommittee was expecting to generate.