The municipal meltdown in double-dip Europe is a clear warning sign

I think it goes without saying that the problems for Spanish and Italian regional governments are due to the austerity-induced double dip recession those economies are suffering. The real insight here is that this municipal – double dip nexus is transferable beyond Spain and Italy because key municipal and state revenue sources fall dramatically in these cases.

For example, many Spanish regional governments have really gone to town on budget-cutting already. But revenue is in freefall as regional noninterest income and property taxes have fallen even further. The regions have, therefore, lost access to debt markets and bank lending and have turned to the central government for aid. In Italy, Sicily, one of Italy’s poorest (and most corrupt) regions is on the verge of bankruptcy. The unemployment rate is 19.5%, double the Italian average and regional debt is 21 billion euros. Yet, cost cutting measures have not begun. And so the region’s deficit has skyrocketed. Moody’s still has Sicily at a rating of BBB+ despite the obvious potential of default.

The implications for the US are clear. If the US enters recession and falls off the fiscal cliff, state and municipal revenue streams will be severely impacted and expenses on transfer payments will increase. The first big missing piece is property tax revenue. If house prices continue to fall, this will be a deadly blow to many a county or municipality. The second missing piece is pensions. The underfunding at municipalities will be a big problem if asset markets fall in the recession.

As I said when Meredith Whitney first made her muni debt pronouncement:

My takeaway from the state and local government financial situation is that there will be defaults. The question is when and in what measure. If we see recovery through to the end 2011 and beyond, there isn’t likely to be a crisis in municipal bonds.

But this is only crisis delayed. Nouriel Roubini has said that we could see “close to $100 billion of defaults over five years.” I think he’s right. State and municipal governments have operating and pension costs that cannot be sustained through downturns and a secular bear market. What is happening in Spain and Italy’s double dip is a harbinger of problems to come in the US when the US falls into recession.

But don’t expect the ratings agencies to warn you. Expect a seizing up of markets to occur first.

Note: I am on holiday through mid-August and so I may not be able to post as much as I would like.

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