Over the July 4th weekend, the state government of New Jersey shut down, as its governor and legislators were at a budget impasse. Lost in this political food fight was the fact that state and local governments have been piling on debt.

In the 1990's, state and local debt levels were stable, but since then have increased 55% from $1.19 trillion to $1.85 trillion. The mix is approximately 39% state debt and 61% local debt. Adding to this burden are skyrocketing pension and health care benefits.

Funded ratios have fallen from 100% to around 83.5%. The eye-opening detail is this debt explosion has occurred during one of the strongest economic growth expansions in memory.

The five worst-funded state pension plans are:

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This leads to the question as to how this will affect equity investors.

Well, leaving aside the negative sentiment on the equity markets and the consumer, if state and local governments begin to default on payments, there are listed stocks whose business it is to insure the principal of these municipal bonds.

Just like life insurance, or private mortgage insurance on your home, the issuing entity purchases insurance by paying a premium to one of these companies. The most prominent bond insurers are Ambac Financial (ABK), MBIA (MBI), Assured Guaranty (AGO) and RAM Holdings (RAMR).

With the exception of RAM Holdings, they are all essentially large cap stocks. Based on current Street estimates, this group is selling at 10.9 times 2006 earnings and 9.7 times 2007 earnings. While this seems to be cheap, in reality they are only selling at a slight discount to the long-term average (1991-2006) of 11.9 times.

Now consider the risk that faces these companies. As state and local governments come under pressure, the probability of a default increases significantly. This is not without precedent: anyone remember Orange County?

In addition to coming under increased regulatory scrutiny, these companies may face a need to dramatically increase loss reserves. One or more of these companies may have an incidence of financial crisis and a major loss from a default.

This would lead to a downturn in new business production that in turn will increase earnings volatility. Not only will the holders of municipal bonds be in for a surprise, so may the holders of these equity securities.

Debt, pension and health care problems are not limited to the federal government systems.

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