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Stockton to enter bankruptcy. What happens next?

Stockton, Calif., will be the largest US municipality to enter bankruptcy. The question, Gordon writes, is: Who will be left holding the bag?

A few years ago, it was fashionable to compare California, Illinois, or whatever U.S. state was struggling financially to the troubled island nation of Greece.聽 Now, with聽聽the largest U.S. municipality to enter bankruptcy, it may be tempting to make another Mediterranean comparison 鈥� this time to the troubled island nation of Cyprus.

In Cyprus as well as Stockton (plus聽), the question is:聽 Who will be left holding the bag?聽 A common theme is 鈥渉aircuts,鈥� or possible losses for investors (bank depositors in Cyprus; bondholders in California) to spare wider pain to taxpayers, pensioners, public employees, and other local stakeholders.

One problem with haircuts is that they can impair future market access:聽 the government in question may have to pay higher borrowing costs to regain investor confidence.聽 A wider concern is contagion:聽 If investors fear they won鈥檛 get their money back, they might demand higher interest rates from the sector as a whole.聽 Moody鈥檚 Investors Service publicly worried about such contagion last summer, in a聽聽critical of U.S. municipalities and what the organization viewed as changing norms toward bankruptcy.

But there are a few reasons to be skeptical about the contagion scenario applied to munis.聽 First, although broad (worth about聽聽in 2012), the municipal bond market is not very deep.聽 On the supply side, a few large issuers like California, New York, and Texas dominate.聽 On the demand side, most investors are households or institutions representing households such as money market mutual funds. 聽

Because of its traditional mom-and-pop structure, muni bonds don鈥檛 trade very often and the market is not transparent.聽 When bonds do trade, different buyers may pay different prices for the same issue, and prices can rise faster than they fall (the 鈥渞ockets and feathers鈥� phenomenon). Economists have rightly criticized these features as聽.聽 However, some market participants counter that proposed cures might be worse than the disease.

A silver lining of less-than-perfect information and higher transaction costs in muni markets may be that shocks are transmitted slowly through the system.聽 More educated institutional investors are probably able to sort good apples from bad; other investors simply 鈥渂uy and hold.鈥澛� A recent聽聽confirms these predictions:聽 after a bad credit event, investors apparently shift their money from places like California and the City of New York to safer issuers.聽 Rather than suffering from Stockton鈥檚 misfortune, other states and municipalities will probably benefit, much like U.S. Treasuries after the 2008 financial crisis.

Interestingly, the IMF authors did detect some evidence of contagion, or bad news spreading, but in an unexpected direction from munis to U.S. Treasuries. 聽One explanation is that investors looked at an Illinois or California and worried about prospects for a federal bailout, analogous to Cyprus and the rest of the Eurozone.聽 Still, measured effects were small and took time to surface.聽 The U.S. also has a long history of steadfastly refusing requests for local aid.

In any event, it will take some time to parse through yesterday鈥檚 Stockton ruling.聽 Its most significant effects may be felt within California 鈥� where many municipalities pay into the state鈥檚 CalPERS pension fund.聽 The judge ruled that CalPERS was just another creditor, but we still don鈥檛 know who will be left holding the bag.