Domino Scenario: Dynamic Analysis of US State Debt Default Risk

Executive Summary: "non-defaultable" state vulnerability

This report examines the hypothesis that a systemic crisis in the US state bond market, namely a scenario that leads to a de facto default (suspension of payments), exists as a plausible tail risk, and concludes this as reasonable. The central point is that dynamic market movements dominate over static legal and financial frameworks.

The mechanism of the crisis is that large-scale bond sales in states with financially vulnerable and market-high profile (e.g., Illinois, California) create self-proliferating liquidity crises. The crisis will spread through interrelated channels such as forced selling from mutual funds and ETFs, propagating credit insecurity through monoline insurers, dysfunction in the short-term financial markets such as floating-rate debt (VRDOs), and a general spike in benchmark yields (such as M/T ratios).

The critical vulnerability in this scenario is that state bonds do not have a permanent, congressionally empowered "last lender" for U.S. Treasury bonds. The Municipal Liquidity Facility (MLF), established in 2020, is merely a temporary and ad hoc intervention, not a structural safety net.

In conclusion, it is extremely important to distinguish between insolvency on the "books" and suspension of payments "market-forced"; The state does not legally collapse, but by cutting off access to capital markets, the market can put the state insolvent in operational terms. Therefore, in risk management, it is essential to monitor dynamic market signals as well as static financial reports.

I. Coatthesis: When market dynamism surpasses legal structures

Validation of user presentation assumptions

The critical differences between static analysis ("book talk") and dynamic market behavior ("running talk") are the correct perspective in assessing state bond risk in modern financial markets.

Quiet explanation: The state is fundamentally different from the corporate issuer. The state has the sovereignty of taxation rights, which is the ultimate source of its ability to repay debt. Furthermore, bankruptcy proceedings under Chapter 9 of the U.S. Bankruptcy Code apply to local governments, but states themselves are explicitly excluded from the scope of this. This legal framework states are "non-defaultable."

fantasy is producing. Considering only static accounting standards and legal systems, it appears that principal and interest payments on state bonds are guaranteed.

Dynamic reality: However, the $4.2 trillion municipal bond market is not a closed system exclusively for investors, with long-term holdings. Market price formation is led by institutional investors such as mutual funds, exchange-traded funds (ETFs), and insurance companies. The actions of these investors are defined by capital flows, risk management regulations, and market value accounting pressures. When these institutional investors all create a "flight to quality" at once during a crisis, a liquidity vacuum will be created in the market, making it impossible to refinance debts that will reach maturity. This could force physical suspensions to be made independent of the state's fundamental taxable capacity. This is the essence of the phenomenon of "price overriding the system."

The fact that states cannot legally file for bankruptcy is actually a double-edged sword. On the one hand, this shields prevent creditors from unilateral asset seized, but on the other hand, it also takes away important tools for orderly restructuring of debt. Local governments such as Detroit were able to negotiate with creditors and restructure their obligations under the framework of Chapter 9 under court oversight. This process is painful, but there is a predictable and structured endpoint.

In contrast, the state does not have this legal framework, so there is no legal mechanism to force creditors to be placed at the negotiation table and to cut hair (debt exemption) in the event of a serious financial crisis. As a result, the only possible outcome is a one-sided suspension of payments, or "effective default." The absence of such a predictable solution increases investor uncertainty and incentives to escape the market at the early stages when signs of a problem appear. Ironically, the structure that avoids the orderly state that the legal system assumes is increasing the chances of a disorderly, market-driven outcome.

II. Anatomy of Crisis: Decomposition of DominoMechanisms

This section provides a detailed analysis of the six-stage propagation process. To verify its validity, the 2008 Global Financial Crisis (GFC) and the March 2020 Coronavirus shock are used as historic case studies.

A. Early Shocks: Shooting in Vulnerable States ("First Domino")

Analysis confirmed that Illinois and California are the most likely triggers of the crisis.

• Illinois: Although the rating has recovered to the "A" category (A-/A3), its rating history has been downgraded to the level of ineligible investment, with the fact that it has been relegated to the point of being ineligible for investment. The state's biggest vulnerability is about

  $144 billion It is a huge pension liability, and its reserve ratio is small. 約46% It's just. The budget for 2025 has superficially shown a small surplus, but independent forecasts point to a regression to a structural deficit-like structure, which is well known to market participants.

• California: Although it maintains a higher rating than Illinois (AA-/Aa2), its finances are highly dependent on capital gains taxes from high-income groups and are extremely volatile. The state is currently

  $45 billion to $68 billion It is facing a massive fiscal deficit estimated. The state's pension plan (CalPERS) is the largest in the nation, and although it is healthier than Illinois, it still has a large amount of unsubsidized debt.

The trigger for a sale doesn't necessarily have to be a formal default declaration. It would be sufficient to have a rating downgrade, revenue reporting that is significantly below expectations, or major institutional investors, such as major fund managers and insurance companies, publicly liquidate positions in Illinois and California, citing changes in risk assessments.

B. Feedback Loop: Death Spiral of Price and Panic

Historically, it is correct to point out that a "business riot" occurs on the fund. In March 2020, Mutual Bond mutual funds will be in just a few weeks. $45 billion It was hit by a record-breaking weekly capital outflow. This is not a discretionary selling, but a forced liquidation to meet an investor's cancellation request.

Modern market structures include large, highly liquid ETFs like MUB, which amplifies the crisis. During the panic in March 2020, these ETFs traded at a significant discount on their net asset value (NAV). This led to an arbitrage where the designated participants (AP) purchased discounted ETF shares, exchanged them for a physical, less liquid bond, and then sold the bond on the market. This mechanism has put a lot of mechanical selling pressure on the market, accelerating price declines.

As secondary market prices plummet and yields skyrocket, bond issuance markets freeze. Issuers will be forced to postpone or suspend new bond issuances due to exorbitant borrowing costs. This phenomenon was seen in both 2008 and 2020. This directly undermines the state's ability to refinance maturity obligations and raise operating funds.

C. Propagation pathway: from local shock to systemic freeze

1. Monoline insurance chain

• Precedent for 2008: The GFC perfectly demonstrated this propagation route. Monoline insurers, such as Ambac and MBIA, which previously guaranteed municipal bonds, suffered catastrophic losses from structured finance products they had secured (especially mortgage-backed securities). As a result, the credit ratings of these insurers were significantly reduced, which also automatically reduced the ratings of the thousands of "guaranteed" municipal bonds they had guaranteed.

• Reversal phenomenon: This has created a perverted situation in which guaranteed bonds, once considered safe, are traded at a higher yield (lower prices) than unguaranteed bonds. This is because the creditworthiness of the insurance company has deteriorated more than the creditworthiness of the local governments covered by the warranty.

• Future scenarios: If GO bonds in major states fall into crisis, surviving monoline insurers (e.g. Assured Guaranty, Build America Mutual) could result in huge valuation losses, leading to downgrades. These insurers' CDS spreads will expand rapidly, as seen in Ambac and MBIA between 2007 and 2008, and will be a signal to propagate across the guaranteed bond market.

2. Short-term financial market dysfunction (VRDO)

• Precedent for 2008: The floating-rate bond (VRDO) and auction rate securities (ARS) market collapsed in 2008. VRDOs are long-term debts with short-term interest rates and rely on remarketing agents to find buyers and liquidity providers (banks) that can backstop in case of poor remarketing. During the GFC, remarketing failed on a massive scale as investors fled the market and banks' balance sheets were squeezed.

• Surge in SIFMA indexes: The SIFMA Municipal Swap Index, a benchmark for VRDO interest rates, rose from under 2% to nearly 8% in September 2008, and showed a similar, but shorter-term rise in March 2020. This sudden rise in the index is a direct indicator of serious fluidity stress.

• Future scenarios: The state's default crisis will cause widespread VRDO remarketing failures. Banks either hesitate or become unable to act as liquidity suppliers due to pressure on their balance sheets, and the issuer is either forced to pay punitive interest rates or, in the worst case, to pay early repayment of their obligations, falling into cash crunch. The sudden and sustained rise in the SIFMA index gives this distinct "sound" of dysfunction.

3. Benchmark effect (M/T ratio)

• 指標： The M/T ratio (muni/treasury ratio) compares the yields of AAA-rated municipal bonds of a given maturity with US bond yields of the same maturity, and is an important indicator that measures the relative value of municipal bonds. Because interest income on municipal bonds is not federal tax-exempt, this ratio is usually less than 100%.

• Surge in times of crisis: During the GFC, the 10-year M/T ratio peaked at about 150%. During the panic in March 2020, there is no precedent

  400% super It rose explosively to the This indicates a complete dysfunction in the market, meaning investors have demanded a huge premium for risk-free US Treasury, even to hold the highest rated municipal bonds.

• Future scenarios: If Illinois and California bonds are sold out, there will be a flight to quality across the market, and investors will sell all municipal bonds and transfer funds to US bonds. This causes the M/T ratio to rise rapidly above 120%. Such a move would exorbitantly increase new bond issuances, even in states with AAA ratings, and effectively block market access for all states. In this way, the problem becomes systemic.

The modern market structure, particularly the rise of ETFs and algorithmic trading, has led to the spread of crisis. speed increased the number. The crisis that unfolded over several months in 2008 could now reach its final stage in days or weeks. This means that policy makers leave little time to respond. The 2008 crisis spread relatively slowly through downgrading bank balance sheets and insurance companies. In contrast, the 2020 crisis was caused by large and rapid capital outflows from highly liquid investment vehicles (mutual funds and ETFs). In particular, ETFs communicate stress almost instantly through price and NAV arbitrage mechanisms. This means that shocks that occur in a corner of the market (e.g., the sale of Illinois GO bonds) are no longer buffered by dealer inventory that has been reduced since GFC, and are immediately propagated and amplified through forced and non-discretionary selling by index-linked vehicles. Therefore, the presented "domino" effect is more likely than simply possible, but is likely to be faster and more intense than previous cases suggest.

This table quantitatively illustrates the market disruption during the last two systemic crises. This directly validates the validity of focusing on a particular indicator, and establishes a quantitative benchmark of what future crises will look like. It has been shown that liquidity panic in 2020 was more severe on some indicators (M/T ratio) than the 2008 credit crisis.

III. The Messiah of Absence: Limited Federal Reserve Authority

2020 Municipal Liquidity Facility (MLF): Case Study of Accidental Interventions

• Establishment and purpose: The MLF was established in April 2020 with emergency powers under Section 13, Paragraph 3 of the Federal Reserve Act and was supported by the Ministry of Finance's capital injection under the CARES Act. The aim was not to resolve underlying financial issues, but to act as the final buyer of short-term bonds from eligible large issuers and restore market function.

• Announcement Effect: The main effect of MLF was psychological. The announcement that a backstop exists was enough to calm the market and reverse the sudden rise in yields, long before the facility was fully operational. Actual use was extremely low, only used by the Illinois and the New York State Urban Transportation Agency (MTA).

• Strict constraints: MLF was a temporary measure and its operations were suspended on December 31, 2020. Eligibility was limited to large states, cities and counties, and there was a cap on loan amounts. This was not a comprehensive guarantee for all municipal bonds.

Why can't you expect a permanent backstop?

• Legal and political barriers: The Federal Reserve Act places great constraints on the Fed's ability to purchase municipal bonds during normal times. It is likely that legislation will need to be amended by parliament to establish a permanent facility.

• Moral Hazard: A permanent backstop creates a huge moral hazard that encourages states to take financially irresponsible actions in the hopes of federal relief. This effectively federalizes state-level financial decisions, creating a major political obstacle.

The market correctly recognizes that there is no unconditional and permanent "Fed put" against state bonds. In future crises, the creation of new facilities will depend on the whims and timelines of Congress that could potentially stalemate politically. This can lead to fatal uncertainty and delays at worst.

IV. Scenario Analysis: Chain of "The Night of Walpurgis"

This section integrates previous analyses and explains the time-series development of domino scenarios in a narrative format. In this case, the market signal ("sound") that has been pointed out is clearly referred to.

Phase 1: Sparks (Week 1)

• event: A major credit rating agency will downgrade Illinois' GO bonds two notches, citing worsening pension funding and downward revisions to revenue outlook. It is reported that a prominent global macro hedge fund is currently under liquidation of all Illinois positions.

• Market Signals:

  • Illinois 10-Year GO Debt Spread (AAA): The program suddenly expands from +150bp to +220bp in two days.

  • News Flow: Financial news media reports on top news about downgrades and fund withdrawal.

Phase 2: Fire (weeks 1-2)

• event: Individual and institutional investors will begin termination of municipal bond mutual funds and ETFs, particularly those with high exposure to Illinois and other low-rated states.

• Market Signals:

  • Weekly Fund Flow (Lipper/ICI): Reports have turned from a mild inflow to a net outflow of $5-10 billion, the largest in the past year.

  • Bond issuance market: The planned issuance of California GO bonds will be postponed due to "market volatility." The recently issued bid ratio (BTC ratio) for Texas GO bonds is an unusually low.

Phase 3: Great fire (weeks 3-4)

• event: Forced selling from the fund will dramatically accelerate. The market is becoming one-sided, with no dealers offering liquidity or absorbing inventory. Panic generalizes from Illinois-specific credit risk to market-wide liquidity risk.

• Market Signals:

  • Illinois/California 10-Year GO Debt Spread: For AAA +350bp It exploded to the public, and was daily +20～30bp continues to expand.

  • M/T ratio (10 years): From 90% 125% And more 150% It suddenly rose to. Local bonds are "cheap" on paper, but in reality they are not tradeable.

  • Weekly Fund Flow: The capital outflow reaches a record $20 billion.

  • VRDO / SIFMA: Remarketing failures have skyrocketed. A penalty interest rate will be applied, and the SIFMA index will jump to 4.0%.

  • Monoline CDS: Assured Guaranty's CDS spread has expanded by 300bp, causing the company's stock price to plummet.

Phase 4: Systemic collapse (2nd month)

• event: The entire local bond market will freeze. No state has access to the debt issuance market to refinance maturity obligations. Illinois announced that it is lacking in cash needed to pay principal and interest on large-scale GO bonds scheduled for June 1, as it is impossible to refinance short-term bonds that will reach maturity. This is effectively the default.

• Market Signals:

  • M/T ratio: It reaches over 250%.

  • propagation: As market liquidity has completely evaporated, even spreads in AAA states like Virginia and Texas will expand by 100bp.

  • Federal government response: The president and the Treasury Secretary hold an emergency press conference. The Federal Reserve announces that it is "keeping the situation close," but political conflict over "salvation" emerges in Congress, and the establishment of a concrete facility will not be announced anytime soon.

V. Conclusion: Validity assessment and strategic implications

The validity of the hypothesis

This report concludes that the presented "domino default" scenarios are not merely possible, but are also a logical extension of the market dynamics observed during the 2008 and 2020 crises. The mechanism is sound and the main vulnerability, namely the absence of the last lender, has been correctly identified.

Static and dynamic risks

The core lesson is the inadequacy of relying solely on static financial analysis and legal frameworks. States like Illinois may not be "insolvent" in an accounting sense, but are extremely vulnerable to liquidity-driven, market-forced payment suspensions. Market perceptions of risk and the market's ability to escape from it are the ultimate arbitrary of its ability to pay in a crisis.

Strategic Implications for Investors

• Active monitoring: Investors must actively monitor the dynamic "sounds" that have been pointed out, such as GO debt spreads, M/T ratios, weekly fund flows, SIFMA indexes and monoline CDS. These are coal mine canaries.

• Liquidity assessment: When building a portfolio, the liquidity characteristics of the assets held must be considered as the number one priority. In a crisis, credit ratings are secondary to their ability to sell assets at any reasonable price.

• Understanding systemic linkages: It is necessary to recognize that propagation is thematic, not geographical. The crisis caused by the Illinois pension problem will also affect Florida utility bonds through common fund holdings and benchmark repricing. Diversification must take these hidden correlations into account.

最終見解

The claim that "prices override the system" is the most important insight in sailing modern municipal bond markets. While states may not legally go bankrupt, the markets can make states bankrupt for any practical purpose.