The Whitney Virus Redux

The Whitney Virus Redux
May 5, 2011
David R. Kotok

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“Whitney Doubles Down” was the headline in Bloomberg BRIEF: Municipal Market. Meredith has dug her heels into the concrete with her December 2010 infamous forecast of “50 to 100 sizable defaults” that “will amount to hundreds of billions of dollars.” She gave the interview in December and answered “next year” when she was asked about timing.

We are going to dig in our heels on the other side. We do not expect nor do we forecast that defaults on Munis in 2011 will reach anywhere near $100 billion. When we use the term default, we mean the non-payment of an interest or principal amount due on a bond issue. We are not talking about technical defaults where a bond covenant may have been breached and subsequently cured. We are talking only about money payments.

So Meredith, you say “yes” on $100 billion of defaults in 2011. We say NO! On December 31, we will know who is correct.

Readers need to know that there are some Muni defaults every year. They usually run in the single-digit billions. They are mostly on issues that are project-specific, and they are usually on bonds that have not been rated or that carry junk-bond ratings. Defaults on investment-grade Munis are rare.

In addition, most of those that do default result in subsequent cures. Most Munis pay most of the time. Most bondholders are 100% whole on their Munis.

Whitney terrified the retail muni-investing public with her December remarks. She exacerbated the now 24 week old redemption of tax-free mutual funds. At its peak, the redemption rate topped $4 billion in a single week. It has been tailing off since and is now measured in the millions, not billions. Lipper estimates that investors have withdrawn over $33 billion from tax-free mutual funds since November 10.

Most of those who liquidated their muni mutual funds can look back on this decision today and wish they had not done so. Most of those fund share prices are higher.

In the retail muni-investor space there was another batch of scared bondholders who sold. They too have watched Munis rally recently. In the last few days, the rally has become very strong. Many bonds have risen 20 and 30 and 50 dollars per 1000 face. This time around, the market reaction to Whitney’s latest pronouncement was a non-event.

All the evidence is contrary to Ms. Whitney’s prediction. We see rising revenues at the state and local levels for the last four quarters. This is due to the recovery in the economy. Employment growth is weak, but it is growth and not shrinkage. Every time a job is started, there are new income-tax revenues and sales-tax revenues and user fees and other money source items that are altering the landscape of the budgets of the states and the local governmental units. For some of the positive details see the Chicago Fed Letter of May, 2011 entitled “Local Governments on the Brink.”

Meanwhile, those governments are busily slicing their budgets and cutting their spending. So we have an improvement in revenue and a pressure that is continually restraining spending. Those forces improve the state of municipal finance. They operate to trigger fewer defaults, not more of them. Note from Distressed Debt Securities Newsletter that there were “nine defaults totaling $254 million in the first three months of 2011, down from 22 and $1 billion in the first quarter of 2010.”

No, Ms. Whitney, we are not on your side.

But we thank you, Meredith, for engaging in this forecasting and in this fear mongering. You have created wonderful buying opportunities in researched and well-selected municipal bonds. We have seized them for our clients. By triggering the forced selling from the funds, you caused the pricing mechanism on bonds to become anomalous in its behavior. When all the funds are selling, none can be buying. So those of us on the buy side are able to bid down, and the fund, which is the forced seller, has no choice but to hit the lower bids. That is how we are able to obtain bargains.

We celebrate Cinco de Mayo with May as the fifth month of the year in which there are supposed to be all those Whitney virus defaults. So far, the default rate in Muniland is lower than last year. And a recovering economy is the best vaccine there is for this virus.

Meredith still has seven months before the final accounting of her prediction is completed, and we have seven months to go on our forecast that she is wrong. She has reiterated her over-$100-billion default number. We will take the under.

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David R. Kotok, Chairman and Chief Investment Officer