Another weapon in the debt arsenal is the so-called pension-obligation bond. For two decades, governments have played a risky arbitrage game in which they issue bonds and then deposit the money in their pension funds to be invested in the stock market with the hope that the money will outperform the interest rate on the bonds. In a stock market that's been stagnant for years, pension bonds have become fiscally toxic. As the Center for State and Local Government Excellence noted in a report earlier this year, most pension bonds issued since 1992 have been money losers for states and cities, exacerbating severe underfunding of pension systems in places like New Jersey.
These abuses came to a head in the second half of 2008, when spooked investors were unwilling to bet on more municipal debt after several insurers who typically back these bonds exited the market. Then Washington stepped in with a new Build America Bond (BAB), allowing states and municipalities to issue them. Thanks to a federal subsidy, they carry attractive interest rates. Last year municipalities used BABs to rack up another $58 billion in debt.
Taxpayers are only slowly realizing that their states and municipalities face long-term obligations that will be increasingly hard to meet. Rick Bookstaber, a senior policy adviser to the Securities and Exchange Commission, recently warned that the muni market has all the characteristics of a crisis that might unfold with "a widespread cascade in defaults." If that painful scenario materializes, it will be because we have too long ignored how some politicians have become addicted to debt.