Guaranteeing US states’ debt

If anyone should have learned the hard way the economic truism that there is no such thing as a free lunch it is congressman Barney Frank. But the lawmaker who once claimed there was “no federal liability there whatsoever” for Fannie Mae and Freddie Mac is now seeking to backstop parts of the $2,600bn municipal bond market, which he claims “would cost the government zero”. If only.

Private insurance from firms such as MBIA and Ambac and bank backstops has long been available for public borrowers, but the costs are becoming prohibitive for some – like California, the lowest-rated state, which faces a $23bn cash shortfall this year. Undercutting this private insurance market not only carries actuarial risk but might make defaults more likely. Warren Buffett’s Berkshire Hathaway recently entered the municipal debt insurance business and he cited the example of New York City’s financial crisis in 1975. As default loomed on uninsured bonds held mainly by city residents, a painful round of belt-tightening ensued that might not have transpired with an insurer to share the burden. Given its recent threat to withhold stimulus aid from California if it were to cut salaries for unionised employees, the federal government would be a softer touch than a private insurer responsible to shareholders.

Mr Frank has also assailed credit rating firms’ stringent criteria for municipal borrowers, forcing them to buy insurance. It seems unlikely that the same investors who were overly sanguine about mortgages were overcautious about public entities. If this insurance is pricier as states face a 10-fold increase in budget deficits and horrific pension shortfalls, then the market is working, not dysfunctional. State politicians who find themselves faced with painful budget choices will be tempted to stick residents of all 50 states with the bill if given the opportunity. Rather than “zero”, the bill for taxpayers may well be a number followed by plenty of zeroes.

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