Muniland needs defenders when Meredith Whitney talks her book
Yesterday DealBook announced the dreariest news possible for muniland: Meredith Whitney is publishing a book entitled Downgraded: Why the Next Economic Crisis Will Be Local, which is due out in November. DealBook says:
In the book, Ms. Whitney — who shook [municipal] bond markets with a 2010 appearance on “60 Minutes” in which she predicted scores of municipal defaults –will “reveal why America’s cities and states are in deeper trouble than is commonly realized,” according to the publisher.
The truth is that when Whitney made her infamous muniland prediction, she spooked retail investors into fleeing the municipal bond market in droves. These investors suffered tens of billions of dollars in losses, thanks to her.
The biggest problem at the time of Whitney’s call was that no muniland market professionals stepped up to refute her “opinions.” There are several reasons for the lack of push back: Muniland professionals thought her call was so outlandish no one would believe it; the media didn’t have a deep bench of municipal bond professionals to call upon to refute her; and by tradition and compliance rules, most municipal bond professionals are hesitant to speak in public. So Whitney had the stage pretty much to herself to knock down the municipal bond market.
Now Whitney is altering her story. Whereas she previously proclaimed that weak fiscal conditions will cause hundreds of billions of dollars in municipal bond defaults, she now says only that horrific fiscal conditions are hidden away from public view. The truth is that practically every state and local entity is down in the trenches fighting the hard battles to right its fiscal position. Day after day local and national media are full of stories of program cuts, shrinking numbers of government employees, pension reforms and very low municipal bond issuance. For example Illinois, the nation’s weakest state fiscally speaking, commences its budget battle today with the governor releasing his proposal for the coming fiscal year. From the Illinois Statehouse News:
Illinois’ local governments, parks, prisons and police officers are going to have to fight over the leftovers of Gov. Pat Quinn’s budget proposal.
“There is no new money for anything,” said Quinn’s Budget Director David Vaught on Tuesday night. “Everything but Medicaid and pensions will be squeezed.”
How risky is that rating?
The Municipal Securities Rulemaking Board’s data platform for municipal bonds, EMMA, recently added credit ratings from Fitch and Standard & Poors to the system. This makes it really simple for investors to get a snapshot of the relative risk of one bond over another when doing research.
Typically the higher the rating, the lower the likelihood that a bond will default. New rules issued in 2008 for credit rating agencies required them to disclose the quantitative results of their ratings and show over time how many bonds defaulted in each rating category. This allows investors to map the performance of ratings over time and allows comparisons between agencies. The system looks at the occurrence of default 1, 3 and 10 years after the bond was issued.
The SEC views default statistics as a window into the accuracy of credit rating agencies’ analysis. Raters are required to publish this data, separated into bond classifications, on an annual basis on SEC Form NRSRO (Fitch’s 2011 NRSRO). I published the comparable data for municipal bonds from Standard & Poors in August. The two raters are broadly similar but not identical.
Investing in municipal bonds does have risk. Looking at default data is the best way to understand how much.
Fitch Ratings One-, Three-, and 10-Year Default Rates By Rating Modifier for Public Finance (%) 2010
Munis are the star performer of 2011
Bloomberg had a great piece that rounds up the factors that made municipal bonds the best performing financial asset of the past year. The story is framed as a knock on Meredith Whitney for her scare call a year ago:
This was supposed to be the year the $3.7 trillion state and local debt market would be rocked by an exploding pension time bomb and “hundreds of billions of dollars” of defaults, according to analyst Meredith Whitney.
Whitney’s Armageddon never came. Instead, munis became the star performers of 2011.
An investor who bought $10,000 of munis the day after Whitney’s Dec. 19 prediction on CBS’s “60 Minutes” television program would have made about $1,050, based on the 10.5 percent gain in the Merrill Lynch Municipal Master Index, which calculates price changes and interest income. That beats U.S. Treasuries, stocks, corporate bonds and commodities. The muni return is better still because interest income is tax-exempt.
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When returns are adjusted for price volatility, municipal bonds returned about three times more than corporate bonds and twice as much as Treasuries, according to Bank of America Merrill Lynch and Bloomberg data.
Year-end in muniland, part 1
Lots of excellent municipal bond market analysis is coming muniland’s way, and I’ll be sharing some of it through the end of the year. First up is Daniel Berger of Thomson Reuters Municipal Market Data, who makes an interesting point about the municipal bond yield curve. He notes that the 10-/30-year slope (or difference in yield on 10-year AAA bonds and 30-year AAA bonds) has rapidly steepened since August 1. Berger attributes this to the great performance of 10-year AAA bonds over that period. In a little over two months their yield has dropped from about 2.55 percent to under 2.00 percent. Investors are loving these bonds — it’s a full on “flight to quality.”
Berger next gives us a snapshot of flows in and out of municipal bond funds. After a very rough beginning to the year it looks positive going into year end:
Muni bond funds posted about $1.04bln of net inflows for the week ended December 7, according to data released on Thursday by Lipper. This was the biggest inflow since March 10, 2010, when investors put $1.13 billion into the funds. The latest week’s inflows were a sharp turnaround from the almost $298mln of outflows seen in the prior week, which was the first negative reading in seven weeks.
The four‐week moving average remained positive atabout $344mln. From early November 2010 until June 8, 2011, muni funds recorded 29 consecutive weeks of outflows. Since then,the fund flows have been mixed (but generally positive), posting inflows for seventeen weeks and outflows for eleven weeks.
And lastly, he looks into historical default data for municipal bonds:
Project Sugar has soured
Missouri has a sweet mess on its hands. A half-completed manufacturing facility, financed with industrial revenue bonds underwritten by the small municipality of Moberly, has gone bust.
The politics around the project, called Project Sugar, also appear very messy. Originated by the American and Chinese firm Mamtek, the project was shopped around to 13 communities without adequate due diligence by the Missouri state economic development agency. The SEC has issued subpoenas to most of the players in the project.
Maybe over-eagerness to create jobs in a hard-pressed area made so many public officials blind to the viability of Mamtek. On the other hand, maybe there is criminal wrongdoing. Project Sugar will surely become the poster child for improper use of municipal revenue bonds and the fallibility of government officials as they try to pick economic winners and losers.
But the saga is not over; the Bond Buyer has the latest:
In the most recent development, the former chief executive officer of Mamtek has formed a new company and hopes to take over the project. The [bond] trustee is reviewing an agreement between the city and the new company, American Sucralose Manufacturing Inc., submitted last Tuesday. “The trustee is reviewing the implications of this agreement with its counsel,” the notice read.
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The trustee also reported that last Wednesday it learned Mamtek had assigned its assets to Development Specialists Inc. to be liquidated and distributed to creditors. The trustee is reviewing the “implications of this assignment,” it wrote.
So a principal from the soon-to-be-liquidated firm, Mamtek, has rushed off to form a new corporate entity and wants to continue the project supposedly by acquiring the assets of the bankrupt company. The AP adds that the principal investors of Mamtek formed the successor company.
It really doesn’t get much richer than this. The important question for Moberly taxpayers is who will pay off the bonds. Assuming that the reconfigured corporate entity can pull it off on the second round may be foolhardy. The project has almost $39 million of municipal bonds outstanding and it’s not clear who is going to make those bond payments.
The calmest seas you will ever see
Low issuance, low defaults and low rates
For issuers, conditions are just about perfect in muniland now. Many have defered or withdrawn planned bond offerings, leading to greatly reduced supply for the year. Bloomberg estimates that 3rd quarter total issuance will be about $67 billion. This follows the $117 billion in muni securities issued in the first half of the year (data from SIFMA, Excel file link).
Defaults have also been puttering along at very, very low rates. This is due to some creative workout solutions, like Jefferson County’s negotiations with creditors, and many instances of postponement of problems, like Collingswood, NJ. I’ve seen estimates for total defaults for the year ranging from $1.8 billion (this number included unrated bonds) to $1.1 billion. Bloomberg says:
Municipal defaults have dropped this year to about $1.1 billion, a quarter of last year’s total, according to Bank of America Merrill Lynch. Local general- obligation bonds have accounted for only 1 percent of the 2011 failures [balance is revenue or conduit bonds].
The biggest benefit for state and local governments issuing debt is low rates. Low interest rates allow an issuer to bring bonds to market and pay a lower rate for the term of the bond — up to thirty years. Conversely this is bad for municipal bond investors who would like to receive higher rates for loaning money to state and local governments. One reason for low rates is that municipal interest rates tend to track U.S. Treasury rates, and those have tumbled with the European debt crisis. Secondly, there has been so little supply of new issuance that strong demand has driven rates down. Strong demand happens, in part, because yields on municipal bonds are still higher than yields on bank certificate of deposits or cash. Bloomberg one more time:
Yields on top-rated 10-year municipals were 2.02 percent yesterday after falling to 2 percent on Sept. 23, the lowest level since 2009, when Bloomberg records for the debt begins.
Meredith Whitney’s anniversary
Two big events happened on Tuesday in the municipal bond market: it was the annual conference of SIFMA, one of the industry trade associations; and it was also the one-year anniversary when Meredith Whitney began her campaign of predicting the collapse of the muni market. Whitney was of course way off-base with her prediction of hundreds of billions of dollars in bond defaults. In fact less than $1 billion of muni bonds have defaulted so far . But many believe that she did cause substantial damage to retail investors, mutual funds and insurance companies, all of whom were caught up in the downdraft of selling that followed her words of doom.
The reason that her words were so damaging to muniland was that there is little natural elasticity in the ebb and flow of the market structure — or, in market jargon, there is little liquidity. When large sell-offs happen in the equity or U.S. Treasury markets there is always a ready pool of buyers standing ready to pick up those securities at lower levels. These markets are favorites for traders and fast money because they encounter little friction, meaning the price rarely moves against them when entering and exiting the market. In contrast, there are few pools of buyers that understand the muni market and are able to do quick credit analysis of bonds for sale, not to mention the lack of shared pricing data that would let participants see if they are transacting at updated, fair-market prices. Because muniland is not really liquid, when Whitney yelled “fire” there was no orderly way for the crowd to exit the theater.
There are structural reasons why little liquidity exists in muni markets. For example, over 50,000 local and state governments have issued over 700,000 different municipal securities. On a given day only about 15,000 of these individual securities change hands in about 40,000 trades. The Municipal Securities Rulemaking Board stated in their annual fact book that about 10 million muni bond trades happened for the year 2010. In contrast, the New York Stock Exchange had 95 million trades in month of December 2010 alone.
For individual muni bonds there is generally not a daily pattern of buying and selling that would easily help establish a price. Markets instead look at similar bonds that have recently traded and try to extrapolate a current price. When the massive waves of selling happened around Whitney’s market call, the natural process of price discovery was disrupted and dealers didn’t want to take bonds into inventory as markets moved lower day after day.
Whitney’s call for muni apocalpyse scared many retail investors who promptly sold their muni bond funds and fled out the exit door. This mutual-fund selling caused fund-management groups to quickly sell bonds out of their portfolios. Unfortunately there were few buyers waiting to absorb these sales. Whitney’s call created a velocity of supply that hadn’t been seen in muni markets since the general market panic of 2008. Buyers stepped in eventually of course, but it was primarily high net worth individuals and hedge funds who had years of experience with the asset class and believed that the bonds continued to be rock-solid.
Part-time employment up in muniland
Incredible shrinking workforces
I’ve read in a few places that state and local governments were reducing the number of full-time employees and hiring more part-time workers. There is a story in the Dayton Daily News that nicely details the trend:
The data show that both the state and local Ohio governments attempted to get the work done by hiring more part-time employees. While local governments shed a little more than 11,000 full-time employees, they added almost 6,000 part-timers, a 4.6 percent increase. The state, meanwhile chopped close to 1,400 full-time workers and added 386 part-timers, a half-percent increase, according to Census data.
Ohio’s government job-shedding put it in the top third of the 50 states, although margins of error from the Census survey data make exact rankings impossible.
“This has been going on for years,” said Stanley Earley, Dayton deputy city manager.
In Dayton, the number of general fund employees, which includes police officers and firefighters, has shrunk from 1,898 people in 2001 to 1,313 people in March 2010, Earley said.
From March 2009 to March 2010 — the period covered by the recent Census survey — general fund employees shrunk from 1,436 to 1,313, he said.
“And we’re continuing to go down,” Earley said.
>> U.S. census data for state government employment
>> U.S. census data for local government employment
Rush to issue municipal bonds as rates go lower
The swirl of ratings and CDS
The Wall Street Journal ran an odd article yesterday about the unpredictability of sovereign credit ratings that are below the investment-grade cutoff (BB+ and lower). Check out the table from the IMF of S&P’s sovereign ratings.
The WSJ article seemed to air some highly paid bond-fund managers’ whining that ratings were not a useful signal for when they should buy and sell bonds of specific countries. The complaint was also that ratings don’t include certain data sets that are important, such as fund flows in banks, and that they don’t have the agility of credit default swaps.
The guys quoted in the WSJ might be right on the data sets that raters use and they are certainly right about CDS being more agile than ratings. But ratings are not intended to mirror market sentiment like CDS does. They are supposed to stand above market panics and routs and give a 30,000 foot view of an issuer’s credit condition.
Raters should incorporate every type of information available to them. Markets want hot, accurate information. Raters create reputations for themselves for good analysis, and reputations rise and fall on good predictive ability. Information is money, and markets want to make money.
It’s a well known phenomenon in fixed-income markets that once a bond falls into the junk or speculative category that its rating becomes murkier for predicting default. So maybe credit ratings are more useful for investment-grade bonds and CDS are more useful for junk-grade securities? If there are any academic studies on the subject that you know of, please add them in the comments.
An interesting thing about muniland is that all states are rated investment grade. California has the lowest rating for a state at A-. See it on the last line in the great chart above from Stateline. S&P has adjusted California’s rating 7 times in the last ten years, which is pretty active for rating change on a major issuer. But the CDS on California is moving every day!
The smallest city in the smallest state
Central Falls, Rhode Island — the smallest city in the smallest state — filed for bankruptcy today after years of decline. It is the fifth U.S. municipality this year to seek protection from the courts under the bankruptcy law. The Governor of Rhode Island stood with city officials as the bankruptcy process commenced. Reuters quoted him as saying in a statement:
“The current situation is dire and it necessitates decisive steps to put the city back on a path to solid financial footing and future prosperity,” Rhode Island Governor Lincoln Chafee said in a statement.
Central Falls’s population peaked in 1930 and has declined ever since; it currently has only 19,000 inhabitants. The town is extremely poor with median household income of $22,628 and per-capita income of $10,825, according to the 2000 Census. Central Falls, like many hidden American towns, is at the end of municipal row.
The city was placed in state receivership last year as its pension problems spiraled out of control. The twin municipal demons of debt and pension obligations have burdened this community with unsustainable costs as the population and revenue bases shrank. Bloomberg reports:
The pension’s obligations were $48 million greater than the fair value of its assets as of June 30, 2010, according to data compiled by Bloomberg.
Central Falls has about $21 million of outstanding debt, New York-based Moody’s said. The city’s per-capita income is 50 percent of Rhode Island’s, according to the company.
Below in the chart are the largest city expenses. They exceed the city’s revenues and fail to show the expenses for 21 other departments, ranging from the mayor’s office to the library budget.
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Resident Muniland expert
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