More Facts about Muniland
February 3, 2011
“We don’t at this point see anything of that magnitude happening. State and local governments have the tools to deal with their fiscal problems and debt, and the municipal bond market currently seems to be functioning reasonably well.” Ben Bernanke, Senate Banking Committee, when asked by Sen. John Cornyn about “hundreds of billions of defaulting municipal bonds.”
“Hundreds of billions. That, in the context of the relatively small $2.8 trillion municipal bond market, is a huge number; I think we’d all agree. Even a former bank equity analyst would agree – or at least I hope so, since it was a former bank equity analyst in a recent TV interview with CNBC’s Maria Bartiromo who said it. Meredith Whitney claimed this was the dollar amount of municipal debt that would default in the next 12 months.” Mike Schroeder, principal of Wasmer, Schroeder & Co., January 4, 2011. For Mike’s full essay see: http://www.cumber.com/content/special/Michael%20J%20Schroeder.pdf .
At Cumberland, we continue to watch the two sides of the debate develop. We are declared on the anti-Whitney side, as readers know. We do not expect 50 to 100 large Muniland defaults amounting to 100s of billions. She does. Furthermore, we believe a well-selected and -researched Muni portfolio can be assembled right now at one of the cheapest entry points in modern history. Time and events will determine who is correct.
Our goal is to present facts, numbers, estimates. We seek to counter the broad-brush, fear-mongering arguments. Moreover, we invite Meredith and others to cite data, not just issue assertions and opinions. Mike Schroeder has done that in his excellent essay; it shows how Meredith’s numbers for hundreds of billions in default in 2011 are nearly impossible to obtain. We thank Mike for letting us share his work with readers.
Additional supportive details may be found in a report by Natalie Cohen of Wells Fargo. She has graciously allowed us to post her research piece is on our website as a guest addition. See: http://www.cumber.com/content/special/Natalie%20Cohen.pdf .
One analytic service argued that the rise in Muni yields was parallel to the rise in treasury yields and that this yield backup was due to the increase in inflation expectations and not to the media hype. Maybe so. However, if that were true the rise in Muni yields would be about the same as the rise in treasury yields. Actually, it would be slightly less because of the tax-free nature of the Muni. Joe Mysak offers the opposite argument. He demonstrates the difference in yield change and attributes it to media hype.
Joe wrote that, “Yields on top-rated, 10-year tax-exempt bonds have risen 21 basis points, according to a Bloomberg Valuation index, since Meredith Whitney, the analyst who correctly predicted Citigroup Inc.’s dividend cut in 2008, projected as many as 100 “sizable” municipal defaults amounting to “hundreds of billions of dollars” last month. That compares with an 8-basis-point gain in 10-year U.S. Treasury yields.” At Cumberland, it appears to us that about 60% of the tax-free Muni yield backup was due to hype.
Meanwhile, the revenues of most states and local governments are starting to rise. Why shouldn’t they? The economy is recovering, although at a slow pace. There were a million net new jobs added to the payrolls of the US last year. That means higher state income taxes, and the added income means consumption spending, hence higher sales taxes. Fears of falling real estate property values are a legitimate concern, but that does not mean the local governments will fail to collect the taxes. There is a difference between the assessment of valuation and actual tax collection. Even foreclosed homes must pay their real tax levies. Real estate taxes are normally in the first lien position and ahead of any other debt.
All the media hype about default flies in the face of history. By now, most observers have heard that Arkansas defaulted during the Depression era. It is the only state to default on a bond payment since the Civil War. So what happened to those bondholders? They were eventually paid in full. That’s right, Arkansas paid 100% of what it owed. So did Orange County, California, after it defaulted in 1994. In most cases, defaults of municipal bonds are cured. In rated bonds, the cure is often 100%. Even Washington Public Power bondholders received 40%, and that was on a revenue bond pledge for a nuclear power plant that was never built.
BTW, Cumberland sold “whoops” 4s and 5s when they were still rated AA. Cumberland avoided Orange County debt and its related 167 local participants because we could not obtain transparency on the contents of the investment pool. Cumberland wasn’t around in the Great Depression era so we did not have the opportunity to reject Arkansas.
The key to Muni research is to use scenario strategies in addition to normal financial evaluations. There are ways to research Munis and make early warning determinations. Then, if you think there is a reason for raising a risk assessment, sell the bond. Sell fast. That means in most cases the bond issuer will cure the area of concern and it will appear as if you sold too soon. In Muniland, there is little margin for error, so early sales are our preferred choice.
The latest Muni bashing fad is to point to the filing failures on the part of state and local government units. This criticism of late filing is valid. Of course, we wish every governmental entity would file on time and with 100% accuracy. However, there are many reasons why they miss filing deadlines. Some are valid. In most cases, the failure is subsequently cured by the filing. In most cases, the information is transparent. Not every failure to file on time is a candidate for default. Again, the key is research. Cumberland tracks the filings of every bond in its library.
Earlier this month, failure to file notices were received by Cumberland on Aaa/AAA Yale University and on Aa1/AAA/AAA Loudon Cnty VA Water & Sewer. We own both bonds in clients’ accounts. We do not believe they will default. We did not sell them because they failed to file on time. A continuing failure to file and disclose is quite different than a timing miss. We think Yale will make its bond payments on time. At 5:09 PM on January 27, we received notice that Yale did file its required report. Better late than never. Not to be outdone, Northeastern University also filed late and has cured. To my friends and fishing buddies who attended either university, tell your alma mater to do better.
We thank readers for their many emails on this series of Muniland commentaries. We will try to articulate our views with facts wherever we can. We will leave the broad-brushing assertions to others. We end this missive with a quote from Bloomberg’s Joe Mysak (January 28, 2011).
“There are 89,526 governmental entities in the U.S. They have sold something like $2.9 trillion in municipal bonds, almost three-quarters of which were for principal amounts of $1 million or less. Most hardly ever trade. These securities are structured in an almost infinite number of ways — not too long ago, an analyst observed that municipal securities were too complicated for their own good — backed by every kind of revenue stream, and sometimes more than one. And you’re going to generalize about this market, its issuers, and their securities?”
Thank you, Joe. You said it well.
David R. Kotok, Chairman and Chief Investment Officer