Have you been following the story of the rich public officials of dirt poor Bell, California?

If so, you know that the small town, one of the poorest in Los Angeles County, was paying its city manager a $787,637 salary. The chief of police was pulling down $457,000, or 50 % more than the sheriff of the county. Alas, the assistant city manager had to get by on a scant $376,288 annually.

For me, Bell was the story of how public officials are all too often paid way above their market value writ large (very large). Nicole Gelinas, the fine financial writer at the Manhattan Institute, sees another angle to the story. “How many Bells are out there, posing a silent risk to the financial system and to economic recovery?” Gelinas asks in an article in the City Journal.

The overpaid city employees were just the tip of the iceberg. Bell is drowning in debt, and homeowners in this poor community pay the second-highest property taxes in the county. Tax rates have skyrocketed in the last decade. How did Bell get in so much trouble? Gelinas has a chronicle of how this happened. Here are a few choice highlights:

In late 2005, Bell had a problem. It owed money to CalPERS, California’s state-pension system, for retirement benefits that the city’s public-safety workers had already earned. Bell didn’t have the cash on hand-so it borrowed more than $9.2 million through a bond offering. The deal should have raised questions among the underwriters at Wedbush Morgan, the Los Angeles firm that bought the bonds from Bell and resold them. They should have wondered why, if Bell was already struggling to pay for past benefits, the city had agreed to expand pensions for non-union workers in 2003-including an extra 1 percent cost-of-living allowance for city council retirees only, 50 percent higher than other workers got….

Underwriters and investors had another reason to be complacent: the bonds they sold had triple-A ratings, the safest in the world. Though the ratings agencies, Standard & Poor’s and Fitch, had been rightly skeptical and given the bonds much lower ratings, Bell and its advisors circumvented this limit by taking out bond “insurance.” For a fee, insurer Ambac used its own triple-A rating to guarantee Bell’s $9.2 million pension debt; a competitor, CIFG, similarly guaranteed the $35 million public-improvement debt. That is, the insurers agreed that they would reimburse investors for any default losses. From the investors’ perspective, then, this business was risk-free. For their part, the insurers provided these guarantees because, they figured, municipalities almost never renege on their debt. In the years since, the bond insurers, having applied the same theory to the mortgage markets, lost their triple-A ratings.

We now know that many municipalities and several state governments could renege on their financial obligations. As a free market person, I say let it happen. There must be consequences for bad economic behavior. Don’t make us bail them out. But it will be painful.

So painful that we’ll no doubt stall with bailouts until we’re all in the hole.