Meredith Whitney is raising the alarm on the fiscal imbalances at the state and municipal level, which is sending muni bond investors into a panic. But the fear of sweeping defaults is far overblown.
By Cyrus Sanati
In the past two months, the $2.8 trillion municipal bond market has gone from being one of the most boring and predictable markets to one of the most volatile and talked about – it even made it onto 60 Minutes this week. But the recent selloff in this normally sleepy but important corner of Wall Street may be a bit overdone, as fears of cascading defaults look remote.
The excitement in munis first started in November, after prices took a steep dive as the government began its second round of quantitative easing. Investors sent prices down even further this month after it became clear that Congress would not be extending the Build America Bonds program.
Now Wall Street analyst Meredith Whitney has managed to add even more fuel to the fire, suggesting on national television this past Sunday that the market was set to experience billions of dollars of crippling defaults within the next 12 months.
Whitney, who gained recognition in the early days of the financial crisis by accurately predicting that Citigroup C would have to slash its dividend to conserve capital, believes she is again ahead of the curve in predicting troubles for the muni market.
“There is not a doubt in my mind that you will see a spate of municipal bond defaults,” Whitney told veteran 60 Minutes anchor Steve Kroft. “You could see 50 to 100 sizable defaults, maybe more.”
Whitney’s comments resonated through the muni market, sparking mass selling in several major muni bond funds, like Blackrock’s BLK Muni Intermediate Duration Fund, which closed down 4% on Monday. That’s because investors in munis are normally quite risk averse – for them, Whitney’s view on the market was akin to yelling “fire” in a crowded theater.
But while there may be smoke in the building, it’s not likely to burn down. While there is no doubt that the fiscal situation of most state and local governments is precarious, there is still a myriad of safeguards in the muni market that will prevent the massive cascade of “sizable” defaults that Whitney believes is all but certain.
Bondholders always come first
First, the muni market is hardly a fungible commodity market like oil or gold. There are over 60,000 different bonds that make up this $2.8 trillion market, each with their own terms, risks and maturities. They also tend to be hyperlocal, with many tied to specific assets like toll roads and hospitals.
Lumping this highly diverse market together and making a judgment call on its future is sort of like lumping the entire stock market together and saying that all US companies are in trouble. While it is easier to think of the muni market as this large monolith, that is actually far from reality.
That is not to say that there aren’t some muni bonds that look sketchy. California’s inability to deal with its fiscal troubles has some economists likening it to one of the troubled nations in the eurozone, like Greece or Ireland.
But states are not people or corporations — they cannot declare bankruptcy. A large portion of California’s debt is in general obligation bonds, which are mandated to be paid first before anything else in the state – period. That means it comes before paying for education, pensions, state worker salaries, transportation and the thousands of entitlement programs in the state’s budget.
California is not alone. Many states have covenants mandating that the state pay its general obligation bonds first before anything else. Of course, a state could breach one of its covenants and go into technical default, if, for instance, the state’s debt to GDP ratio reaches a certain threshold. But even then the state would still be mandated to pay its bondholders. This means that a state like California could one day see 100% of its budget go to servicing its debt. But it’s more likely that the state’s notoriously dysfunctional legislature will unite far before that point and pass desperately needed tax hikes to raise revenue.
But not all munis are backed by the full faith and credit of the state. Some are tied to specific projects owned by the state, like toll roads, or private projects that are considered to be in the state’s public interest, like nursing homes and hospitals. Much of the revenue associated with these projects is highly inelastic, meaning that people will pay to use them even if the economy is bad. And if there ever is a revenue shortfall, many projects are obligated to just jack up rates in order to ensure proper payment of their debts.
Risk at the city level
But that is not to say that all projects will be economically viable – some munis will default. Municipalities in 24 states can file for Chapter 9 bankruptcy protection and defer bond payments. Towns and municipalities depend on state revenues to fund anywhere from a quarter to a third of their budgets, so troubles up high can trickle down. Strict austerity measures passed by the California legislature means less money to cities like Vallejo, which filed for bankruptcy in 2008 after failing to negotiate a settlement with its unions over unfunded pensions.
Nevertheless, muni defaults remain quite rare, even when a municipality does go into bankruptcy. For example, even though Orange County, CA declared bankruptcy in 1994 (the largest municipal bankruptcy in US history), it never defaulted on its bonds. It just cut services and raised taxes to pay off the $1.6 billion it owed its creditors. In fact, Moody’s has counted just 54 defaults in the muni market from 1970 to 2009. That’s it – 54 out of the hundreds of thousands of bond offerings that have ever been issued to the public over the last 40 some odd years.
Of course this is not to say that we won’t see many defaults in the future just because there hasn’t been many in the past. It’s possible that several dodgy municipalities will end up going into bankruptcy and becoming economic deadbeats. But bondholders will only really lose everything if the entire population connected with that municipality leaves. What’s more likely is that governments will push through higher taxes and slash services to pay their debts — losing access to the debt markets is far worse than anything they can imagine.
A municipality in trouble can also be seen from miles away. It takes months, even years, before a municipality chooses to pull the trigger and go into bankruptcy. Furthermore, the municipalities that may be at risk of bankruptcy are in the hole for dollar amounts that are mostly in the millions of dollars, not billions.
For example, the city of Central Falls, Rhode Island is mentioned frequently in the press as one of a handful of municipalities in major fiscal trouble. The town’s fiscal deficit for 2010 is just $2.1 million. Its unfunded pension liabilities and retiree health benefits total just $80 million. There are currently no major cities or counties that close to bankruptcy at this point. Furthermore, even if they do fall on hard times, most analysts who specialize in munis believe that it’s highly unlikely that they will choose bankruptcy.
“A vast proportion of the doomsday projections regarding municipal credits from individuals coming at the sector for the first time – even those with excellent track records regarding specific other sectors – are based on a misunderstanding of how state and local governments function, the role played by municipal debt and the relative strength of the municipal credit pledge,” George Friedlander, the municipal bond analysts at Citi wrote in a note to clients on Tuesday. “There are likely to be more local municipal defaults over the next two years than there have been in the past, but, in our view, they are likely to constitute a relative handful of issuers and a very tiny fraction of the ‘50-100 sizeable defaults worth hundreds of billions of dollars’ that the commentary on 60 Minutes suggested.”
In the end, Whitney is right to raise the alarm about the fiscal troubles facing state and local governments. But defaults and bankruptcies seem to be the last resort for municipalities in dealing with their fiscal deficits. Many have been able to kick the can down the road with assistance trickling down from the federal government or through accounting tricks allowing them to roll over their debt. Eventually, the states will deal with their problems and they will more than likely choose to tax, cut, or refinance before they choose to throw in the towel.