The Smart New Solution to States' Financial Woes

After the financial crisis of 2008 and early 2009, many pointed to the municipal bond market as the next potential source of economic catastrophe. Yet as state and local governments take extraordinary measures to try to survive in the face of falling tax revenue and soaring costs, one state has made a proposal that harkens back to World War II money-raising measures.

Earlier this week, California Gov. Jerry Brown signed a bill that authorizes the state's treasurer to sell municipal bonds in amounts as low as $25. In a state with more than $27 billion in bond sales during 2010, $25 may not seem like a big deal. But the move toward "minibonds" could actually start a very healthy trend to encourage savers to get back into a more active role in financing their own government.

Buy bonds for the war on deficits
In 1940, the U.S. government was already preparing for the financial impact of getting involved in World War II. Although the government proposed tax increases, the Treasury secretary also advocated a voluntary loan program whereby ordinary citizens would contribute to the effort by buying bonds. A huge advertising campaign followed to support the three series of bonds, one of which lived on for decades as Series E savings bonds.

War bonds were available for as little as $18.75. But back then, that was a lot of money, so the government also offered savings stamps for $0.10 that buyers could accumulate in stamp albums until they had enough to trade in for a full bond.

More recently, though, savings bonds have largely lost their luster. Although the federal government has tried to make it easier to buy savings bonds, the rates they offer reflect the low-income environment that has plagued savers for years now.

Time for munis?
In contrast, municipal bonds offer quite competitive rates right now. Despite the fact that they are free of federal tax, the average yield on munis is actually higher than that for Treasuries for most maturities.

Admittedly, there's a good reason for that extra yield. State and local governments are in terrible financial shape. Warren Buffett and Wall Street analyst Meredith Whitney have both warned about the potential for municipal bonds to cause the next financial crisis. Yet at least for now, the wave of defaults that Whitney expected hasn't happened. Moreover, although bond insurers Assured Guaranty (NYSE: AGO  ) , MBIA (NYSE: MBI  ) , and Radian Group (NYSE: RDN  ) could easily get swamped by a massive default, many muni-bond buyers still benefit at least partially from their coverage.

Skeptics will argue that the move is simply an attempt by underwriting banks to reap more fees from an increased number of bond transactions. Institutions benefiting from wider bond use would potentially include U.S. banks Morgan Stanley, Citigroup (NYSE: C  ) , and Wells Fargo (NYSE: WFC  ) as well as Canadian RBC Capital Markets, a division of Royal Bank of Canada (NYSE: RY  ) . All of these institutions solicited the California treasury on ways to offer lower-denomination muni bonds.

But states are smart to try to tap into ordinary savers, who have largely been abandoned by more traditional savings vehicles. Especially with the lure of double-tax-free treatment of interest for California taxpayers who buy the bonds, the state government has something that most other ways to save lack -- and that tax-free status could become even more valuable if taxes rise at the federal and state level in the years to come.

Why buy an ETF?
Of course, investors already have ways to buy muni bonds on the cheap. With ETFs like iShares S&P National AMT-Free Muni Bond (NYSE: MUB  ) , you can get exposure to many different bonds for around $100 per share. But for the millions of savers who don't have brokerage accounts, minibonds might well take off. All issuers need is to create the zeal that made war bonds so successful in their time.

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Fool contributor Dan Caplinger would love to see a war on deficits. You can follow him on Twitter here. He doesn't own shares of the stocks mentioned in this article. The Motley Fool owns shares of Citigroup and owns shares of and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy saves you money.

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