Is the municipal bond market in the same state of denial as the equity and mortgage-backed securities markets were in late 2007? Jeffrey Gundlach, the founder of Doubleline who put together a track record at Trust Company Of The West rivaling the likes of Bill Gross and Dan Fuss, thinks it is.

"Even if [muni bond] default rates don't reach Meredith Whitney levels, just talk of widespread defaults will create" a cycle of fear that will impact muni prices negatively, Gundlach says.

Of particular alarm is the possibility that Congress might amend Chapter 9 of the federal bankruptcy code to allow states and other municipalities to give haircuts to bondholders and retired employees' pensions. Described in the January 21 New York Times, the so-called Chapter 9 amendment is the brainchild of University of Pennsylvania corporate law professor David Skeel.

The NYT article mentioned that his Chapter 9 amendment has captured the attention of House Republicans, senators from both parties and former House Speaker Newt Gingrich. "If all you have to do is sign a piece of paper" to escape or reduce debt and pension obligations, states will start considering it "as a financial planning tool," Gundlach says.

He expressed amazement that the day the article appeared, the muni market rallied. "Most muni investors are choosing to hold their hands over their eyes and ears," Gundlach remarks. "That's what happened [early on] in the subprime crisis."

At some point this year, states like Illinois and California are likely to go to Washington and ask for a bailout. They won't get one. But a Chapter 9 amendment might look like an attractive alternative to closing 45% of an entity's schools or laying off 30% of their firemen. Even if a bill never becomes law, just the introduction of it could have dramatic ramifications for muni prices.

Right now, states cannot legally go bankrupt--California would have to empty its jails before it could stop paying its teachers. But states can run out of money and many have.

A change in federal bankruptcy laws permitting states to slash debt and pension costs with the flick of a pen could spark a crisis. "If a few states start defaulting, all states will start to ask why shouldn't they?" Gundlach says. That's what happened in Florida and Las Vegas when people who could easily afford their mortgages started asking themselves, "Why am I the only sucker still paying my mortgage?"

Would actual or strong fears of defaults render it impossible for states to raise money in the future? Maybe not. Just look at the stampede of investors to get into the General Motors IPO last fall.

An actual raft of muni defaults would shock the entire financial system, Gundlach says. Remember when Ben Bernanke and Ben Stein and many others told us that the subprime crisis would be confined to the housing market. That was a great call.

"If the muni market blows up, it would affect everything," "Defaults would clearly be a negative for consumers."

Right now, the complacency of investors spooks Gundlach. The slow reaction means that the longer it simmers, the harder "the lid will blow off the pressure cooker," he explains.

How powerful are the muni investor and public employee political constituencies that could short-circuit any attempt to amend Chapter 9? Not as powerful as one might think. Stuck with piddling 401(k)s, most Americans are growing increasingly resentful of public employees' generous pensions. As Gundlach notes, these same Americans may also view municipal bond investors as old, rich folks already receiving hefty Social Security checks that average Joes are paying for.

Nor is the reaction of states very encouraging. CALPERS is about $200 billion in the hole. "To fill that hole they are going to have their internal staff start trading derivatives," Gundlach says. "A lot of very smart hedge funds go bankrupt trading derivatives. These [CALPERS] are guys who work four days a week and take four-hour lunches."