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.