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Investing through the rearview mirror, with excessive dependence on historic default rates, has been discredited by the financial crisis. But government officials still do it when it suits their purposes. Last week’s stress tests of bank balance sheets, for example, assigned the same risk-free rating to top-tier municipal debt that US Treasuries enjoy. Admittedly, muni default rates in recent decades have been minuscule – lower even than on corporate debt of the same rating. This was the argument Bill Lockyer, California’s treasurer, made last year in saying that rating agency methodologies needlessly saddled state governments with added debt servicing costs.

But it is Mr Lockyer’s state that is most likely to upset this tax-exempt $2,700bn market much favoured by individual savers. Downgraded to the lowest rating of any state this year, California could face a $23bn cash shortfall by July. Polls indicate a May 19 vote on propositions to reduce the gap will fail. It is not only voters who may leave California’s hands tied – the Obama administration intervened on behalf of an influential union facing pay cuts, threatening to revoke $6.8bn in stimulus if they are not reversed.

California is not alone, as several states face gaps next fiscal year exceeding 15 per cent of their budgets. The National Conference of State Legislatures projects shortfalls of $62bn this year, mushrooming to $121bn in 2010 – 10 times 2008’s gap.

Even if states navigate the crisis, the finances of about 52,000 local governments look shaky. Some may follow Vallejo, California, into bankruptcy. These woes prompted a negative outlook by Moody’s last month for the entire market.

More than 70 per cent of municipal revenue comes from property taxes that are typically a percentage of assessed value. The remainder comes from sales and income tax and fees from activities such as tourism.

Past performance will be no saving grace if pressures on these revenue sources persist. Bond insurers protected savers in Vallejo’s case but multiply that by several thousand and there could be a problem.

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