Barney Frank, chairman of the House Financial Services Committee is apparently putting together a bill to guarantee municipal bonds. In particular, variable rate demand obligations (VRDOs), which make up a little under one-seventh of the muni-bond market, have been imploding, with their interest rates jumping to higher rates, costing municipalities a great deal of money when they can least afford it.

Debt guarantees are one of the main ways the Feds have dealt with the crisis.  The Feds have promised that if a raft of banks default on their loans, the Feds will make it up.  With such promises, the banks (among others) have been able to borrow money at lower rates than they otherwise could have, and in some cases borrow money when they normally couldn’t have at all.

The problem with debt guarantees is that the Fed is on the hook.  That is to say, you, the taxpayer, is on the hook for what are essentially no different than credit default swaps (CDS), in which a private entity promises to pay up if a loan or bond defaults.  CDSs are the business which destroyed AIG.

Moreover, as with CDSs, rather than decreasing risk, debt guarantees increase them.  If you know that you’re going to get paid whether the borrower defaults or not, you’ll be willing to lend money even to folks who probably will default.  Heads you get the money, tails the taxpayer will give you the money.  This sort of systemic risk transfer is one of the major causes of the current financial crisis.

So if the government goes ahead and guarantees muni-bonds, expect defaults to increase, not decrease, as municipalities borrow even more money they can’t afford to pay back and investors lend it to them knowing they’re covered no matter what.  Then you, personally, as a taxpayer, will eventually pay for it.

Now that’s not to say that guarantees are necessarily always a bad idea.  The advantages of not having municipalities go bankrupt right now may outweigh the disadvantages.  But at the least some protections need to be added in.

First: New issues of VRDOs need to not be guaranteed.  Perhaps guarantee the old ones, on the condition that once guaranteed interest rates drop, since default chances have dropped, but not new ones.  Such bonds are inherently risky, and municipalities shouldn’t be playing in that market.

Second: new bonds guaranteed must be vanilla bonds.  Fixed rate, fixed curation, no fancy features.

Third: the municipality must have a reasonable shot at repaying its debt load.  The worst of the housing crash is not over, there is a wave of defaults yet to move through the system.  Housing prices, and thus housing taxes, will not recover to pre-crash levels for many years, probably not for over a decade, at best.  Municipal revenue projections and budgets which assume otherwise are unrealistic, and guarantees made to such municipalities will default.  That’s not insurance, that’s giving municipalities money.  So just give them the money if you want to, instead of making guarantees you know will fail.

In general, just giving municipalities the money they need is the smarter way to go.  There is going to have to be a new round of stimulus, since the last one wasn’t large enough.  One of the focuses will have to be local government.  Debt guarantees are much more problematic, due to the way they actually increase systematic risk, because of how they encourage municipalites to borrow money they may not have the capacity to pay back, and because they increase rather than decrease certainty about the final cost of the intervention.