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:


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.

Related Articles
  1. Stock Analysis

    Allstate: How Being Boring Earns it Billions (ALL)

    A summary of what Allstate Insurance sells and whom it sells it to including recent mergers and acquisitions that have helped boost its bottom line.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Investing Basics

    How to Deduct Your Stock Losses

    Held onto a stock for too long? Selling at a loss is never ideal, but it is possible to minimize the damage. Here's how.
  4. Economics

    Is Wall Street Living in Denial?

    Will remaining calm and staying long present significant risks to your investment health?
  5. Stock Analysis

    When Will Dick's Sporting Goods Bounce Back? (DKS)

    Is DKS a bargain here?
  6. Investing News

    How AT&T Evolved into a Mobile Phone Giant

    A third of Americans use an AT&T mobile phone. How did it evolve from a state-sponsored monopoly, though antitrust and a technological revolution?
  7. Stock Analysis

    Home Depot: Can its Shares Continue Climbing?

    Home Depot has outperformed the market by a wide margin in the last 12 months. Is this sustainable?
  8. Stock Analysis

    Yelp: Can it Regain its Losses in 2016? (YELP)

    Yelp investors have had reason to be happy recently. Will the good spirits last?
  9. Stock Analysis

    Is Walmart's Rally Sustainable? (WMT)

    Walmart is enjoying a short-term rally. Is it sustainable? Is Amazon still a better bet?
  10. Stock Analysis

    GoPro's Stock: Can it Fall Much Further? (GPRO)

    As a company that primarily sells discretionary products, GoPro and its potential falls right in line with consumer trends. Is that good or bad?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center