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Municipal Bond Meltdown Solution is Simple

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Hard to imagine but true: the once-mundane muni market has become a red-hot topic of conversation.

We knew the national debate about the $2.9 trillion municipal bond market had reached fever pitch when our younger cousin - a PhD candidate in History who, if reports prove accurate, will soon have way too much time on his hands - even emailed us for our .02.

The back-and-forth between headline-making strategists and analysts certainly ratcheted up this week: On CNBC, Meredith Whitney, who is predicting 50 to 100 “significant” municipal-bond defaults, said she expected accelerated “outflows” from the municipal-bond market as state finances deteriorate in the next six months.

Bill “Bond King” Gross begs to differ. On Bloomberg Television, the mustached fixed-income aficionado had this to say: “Ultimately, municipal bankruptcies will be at a lower level. I don’t subscribe to the theory that there will be lots of them.”

This morning, the Wall Street Journal - front-page, top-of-the-fold – weighed in on the discussion, reporting that cities, hospitals, schools and other public borrowers are scrambling to refinance tens of billions of dollars of debt this year, another sign that the once-safe market is under duress.

The market fell every day this week, and investors have been net sellers of their holdings in municipal-bond mutual funds for nine straight weeks, according to Lipper FMI. And check out the MUB - the national muni bond ETF – which is now at the lowest level since December 2008.

There is certainly a crisis, economists emphasize, and it will become much more severe in the coming fiscal year for many debt-choked state and local governments as federal stimulus funds are expected to drop from $158 billion - covering 27% of state shortfalls from FY2009-2011 – to $6 billion, or 4% of total projected FY2012 state budget gaps.

The solution to the problem, says Dr. Ed Yardeni of Yardeni Research, is likely to be severe layoffs and budgetary cuts, including significant changes in pension benefit programs. Although he doubts the range of defaults that Whitney forecasts, the economist and strategist does think the cost-cutting measures among the states and cities could prove a significant drag on the economy in the back half of the year.

Stay tuned.
POSITION:  No positions in stocks mentioned.