The municipal bond market players are a paranoid and merciless bunch. In 1975, New York City skated on the edge of bankruptcy, but never defaulted. Today the city still trades cheap to other large cities with similar bond ratings, despite the fact that S&P just upgraded it to AA-. The Washington Public Power Supply System defaulted on certain power plant projects in 1983, basically because there was inadequate demand for their last 2 plants to be viable. Today, the system is so strong that their bonds are rated AAA by S&P, and yet those bonds still trade cheap. In fact, many of their deals carry bond insurance on top of being naturally rated AAA!!
Moving on to the current situation in New Jersey, its entirely political. Unless you own some sort of casino-backed bond, the odds are extremely low that the current impasse will have any effect on the ultimate credit worthiness of any New Jersey municipal. And yet, it will only be a matter of time before media pundits and politicians start claiming New Jersey is on the brink of bankruptcy. Then retail owners of New Jersey municipals start calling up their brokers insisting that they need to sell their bonds (and probably pay 2-points in bid/ask on 15 bonds). Before selling your bonds, think it through. Right now, Jon Corzine wants to exercise his political muscle to get the budget he wants. Meanwhile, the legislature wants the budget they want. They will fight this out just until it actually becomes politically painful, and whoever is in the most pain at that moment will cave in to the other.
By the time this situation stretched out to a municipal issuer defaulting, it would have gone way past just painful to the politicians involved. Does Corzine want to find out what the political backlash would be if a school district went bankrupt because state matching funds were withheld?
The California near-bankruptcy didn't cause any actual defaults. Katrina didn't cause any actual defaults (among issuers with taxing power anyway). This situation won't cause any defaults either, no matter how long it drags out.
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