If you live in the United States, there is a good chance the crisis in California is going to affect you. And if you own municipal bonds — either directly or indirectly through other investments — what’s happening in California could have a major impact on your finances.For years, state government budgets have been expanding as the economy grew and the rising housing market swelled property tax coffers. But the severe recession that has brought rising unemployment and a collapse in property values has drastically cut revenues from income, property, sales and corporate taxes.

And state governments are feeling the pinch. According to the National Conference of State Legislators, there are only three states (Arkansas, Wyoming, and North Dakota) that do not face budget shortfalls for fiscal years 2009 or 2010. In other words, 47 states are currently projected to run short on cash in the near future.

And California – the world’s eighth largest economy – is in the worst shape of all. Currently, the state has committed to spend $26.3 billion beyond what it takes in. Controller John Chiang estimates that the state has enough cash to last through July. To avoid defaulting on debt payments, California will issue more than $3 billion of IOUs this month.

But while the plan may buy some time, it will only make the situation worse. The big banks (Bank of America -NYSE:BAC-, Citi -NYSE:C-, Wells Fargo -NYSE:WFC-, JP MorganChase -NYSE:JPM- and others) have stated that they will not cash the IOUs after July 10th. On a side note, this likely means that the banks are either so short on liquidity that they can’t afford to do so, or they are not confident that the state will honor its commitments when the IOUs mature in October.

That means that the state’s contractors and vendors must either hold these IOUs until they mature, sell them at a discount in the secondary market (listings are already popping up on Ebay and Craigslist) or, for smaller denominations, take the hit at a check cashing store.

Many of these contractors are already strapped for funds to pay their employees and subcontractors and can ill afford the disruption in cash flow. Undoubtedly, this will cause a cascading domino effect of layoffs, defaults and business closures. This will depress tax revenues even more, while increasing the demands for government services.

And it is not just contractors and vendors taking a hit. Local governments are also receiving IOUs for the state’s financial obligations. That could force some local governments to default on their municipal bond payments.

But this is not what constitutes the greatest threat to municipal bondholders nationwide. That threat comes from the federal government.

You see, state governments are not permitted to run budget deficits. Unlike the federal government, state governments are required by law to balance their budgets each year. And they can’t just print money like the federal government does (California’s quasi-legal IOUs notwithstanding).

That means the states must either cut services, raise taxes, or both. Neither alternative is easy to get through the legislature. In the case of California, Schwarzenegger recently declared that tax increases are “politically impossible.” And yet the alternatives include slashing spending on health care and education and releasing inmates from prison.

Political difficulties aside, California and just about every other state will be cutting services. And you can guarantee that just about every tax you pay will be going up in the future. But the states will also be putting increasing pressure on Washington for handouts. If there was money for the banks and the car companies, certainly there must be something for the states, right?

So far, Washington has rebuffed California’s calls for bailout money. The aid they have issued has come in the form of stimulus, such as increases in Medicaid and education funding. But the stimulus is obviously not working, and it’s not just California that is in trouble.

Corina Eckl, Director of National Conference of State Legislators, recently wrote, “The state fiscal situation is rapidly deteriorating and the figures for fiscal year 2009 and fiscal year 2010 have moved from sobering to distressing”. She compares the situation to a bad horror movie, where the “details get more gruesome, and the story never seems to end.”

As the cries for help become more urgent, the possibility grows that Washington will come to the aid of California and other states facing serious shortfalls. But don’t think for a moment that this assistance will come without strings. And one of these “strings” could well be the elimination of the tax exemption on interest payments from municipal bonds. In fact, the Obama administration has already pushed us over that slippery slope.

The interest payments on state and local bonds for public projects have always been exempt from federal taxes. But since the FDR administration, various presidents and legislators have tried to remove this exemption.

Given the “tax the rich” mentality in government, and the fact that nearly 50% of tax-exempt bond income is claimed by households earning over $500,000, it’s no wonder that efforts to roll back the exemption have grown stronger. And the “extenuating circumstances” of the current financial crisis have provided just the cover that was needed.

As part of the “American Recovery and Reinvestment Act of 2009” state and local governments are now authorized to issue taxable “Build America Bonds” to finance projects for which they could otherwise issue tax-exempt government bonds.

State and local governments that issue these bonds would “receive a federal subsidy payment for a portion of their borrowing costs on Build America Bonds equal to 35% of the total coupon interest paid to investors.”

And because there was no hearing on these bonds, there was no opposition. Investment manager, Richard Shaw of QMV Group, calls this the proverbial “camel’s nose under the tent.” Before long, the entire beast is sleeping right beside you. It was enough for Bloomberg to state that, “Barack Obama may be the worst thing that ever happened to tax-exempt bonds…”

Now, you might be saying that issuing new taxable municipal bonds is a far cry from re-writing the rules on existing bonds. And I would say the same thing, if it were not for what happened recently to bondholders of Chrysler and General Motors.

In both cases, once the government got involved the contractual rights of capital were superseded by the “greater good of society” – a blatant violation of contractual law and more than a thousand years of common law. Chrysler bondholders were denied first priority in liquidation. And GM bondholders were shafted in favor of the union.

I am not saying the rules will be re-written for municipals. But I wouldn’t rule it out either. If the federal government intervenes in state finances, you can be sure there will be strings attached. And one of them could involve an assault on tax-exempt income.

Quoting Richard Shaw again: “If the federal government steps in to provide ‘exceptional assistance’ to California or any other state, it would be imprudent to deny the possibility of the rights of bondholders being subordinated to the ‘greater good.’”

Considering the tenuous state of state and local finances, the risk of default on municipal bonds is almost certain to increase. Add to that the outside potential for a change in tax status and caution is advised. If you own municipal bonds, diversification is paramount. And stick to general obligation bonds, which are backed by the full taxing power of the issuing jurisdiction.

And don’t forget, banks and Property & Casualty insurance companies own about 25% of all municipal bonds. So, if the municipal bond market takes a hit, these sectors will suffer the consequences. Invest accordingly.

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Since September, 59 out of 62 of Steve’s recommendations have increased in value… two are breakeven and only one is down. Compare that to the stock market and you might wonder why you’re taking such a big risk in stocks. Learn more about The Bond Trader here.

Source: Will the Feds Use the California Crisis to Change the Rules on Munis?