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Muniland and Pensions
February 15, 2011
David R. Kotok
www.cumber.com

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“In December, projections by Meredith Whitney, the banking analyst, about possible municipal defaults began to rattle the $2.86 trillion municipal-debt market. Investors withdrew $1.2 billion from U.S. municipal-bond mutual funds, the 13th-straight outflow, Lipper U.S. Fund Flows said about the week ending Feb. 10. About $24.8 billion has been redeemed since the week ended Nov. 17, including a record $4 billion in the week ended Jan. 19, the most since Lipper started compiling data in 1992.”
Source: Bloomberg, Feb. 14.

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Panic-driven mutual fund redemptions continue to depress the prices of high-grade Munis. To us, this means the buying opportunity for well-selected issues is intact. Remember, this is an idiosyncratic securities sector. Broad-brush painting of “all Munis are going to default” is specious.

Forced selling by mutual funds depresses the pricing references that are used by the pricing series. Most Munis do not trade every day. Hence, the drop of a few prices lowers the estimated prices of all Munis. This perception issue has created a misunderstanding in the market and resulted in exacerbation of the selloff.

Think about it this way. Let us examine the case of a single mutual fund that must sell to meet redemptions. The fund manager needs the cash at once. He sells his liquid and highest-credit-quality names, which allows him to get cash as once. These same bonds are used to price the entire universe of Munis. The next day all Muni reference prices are lower, even though most of them did not trade. Since the mutual fund holds many bonds, its share price reflects the new pricing, and hence is lower. That alarms more shareholders and another round of selling triggers a downward spiral. This has been going on for 13 weeks.

Some say the cause of the selling is the opacity in the unfunded pension systems of the states. Maybe so. Moreover, maybe that is part of the hype. We think the pension issue is clear. One only needs to do the homework.

In a state like Delaware, the pension system is nearly fully funded. The credit rating of the state is AAA. There is no pension issue in Delaware. The same is true for many states.

There are 218 separate state pension plans among the 50 states. There are 2,332 local pension systems. Thank you, Natalie Cohen of Wells Fargo for the data. Natalie notes the differences by illustrating Indiana. The Indiana Public Employee Retirement Fund is about 94% funded. The Indiana teacher plan is only 43% funded. In NJ, which was just down-graded by a rating agency, Natalie reports the public fund is 56% funded, the local fund is 71% funded, and the teachers’ plan is 64% funded. As we have been saying for months, broad brushing Muniland does not work. One must drill deeply into the data.

Estimating the present value of an unfunded pension obligation is imprecise. It takes a lot of assumptions and falls into the murky realm of actuarial science. Moody’s offers that “a 100 basis point movement in the discount rate results is an inverse movement in the obligation of approximately 8-12%.” Current rules allow much flexibility to states and local government in making assumption choices.

That is about to change. The Government Accounting Standards Board (GASB) is issuing new rules on accounting and reporting liabilities for pensions and other post-employment benefits. These are in draft form now. The rating agencies are combining the actual bonded indebtedness of states or local governments with the unfunded liability estimates. That is why NJ was recently downgraded.

In addition, there is legislation at work to force pension disclosure to be more consistent and transparent. Public Employee Pension Transparency Act or H.R.6484 is under discussion in the House of Representatives. It will require timely information on al governmental pension funds and it will impose penalties for failures to disclose. Rating agencies are endorsing such legislation. So do we. The effect will be to improve funding and force clarity. We expect this to become law in this congressional session.

At Cumberland, we already look at the unfunded obligations and the assumptions. We are glad to see this issue being addressed by states and local governments and by the rating agencies. It has been a long time coming.

One group that objects strenuously is the public employee unions. They are now the largest organized labor faction in the US, and they are trying to preserve the status quo. There is where the political rubber hits the road. We expect this to be a state-by-state fight. We saw the first salvo fired in Illinois as the retirement age was extended. Major changes proposed by NJ Governor Christie currently are stymied in the state’s legislature. Watch what happens as the NJ budget fight gets down to the last minute.

In our view, these issues will get resolved because they must get resolved. State and local governments cannot continue to fund promises they cannot afford. The tide has changed. We expect nearly all of them to alter their budgets, and we expect austerity to be imposed. The notion of electing default or bankruptcy as an option seems politically dead to us.

We continue to buy well-selected Munis at tax-free yields in excess of the taxable yield references. We are witnessing a generational opportunity and want to seize it.

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David R. Kotok, Chairman and Chief Investment Officer

It’s time to measure inflation both in the US and abroad. Over the next 3 days in the US, import prices, PPI, CPI and the prices paid and received components in the NY and Philly Fed survey’s will be released. UK CPI hit 4% y/o/y, the highest since Nov ’08 while the BoE has their fingers crossed that its temporary as they have their benchmark rate at .5%. Chinese CPI rose 4.9%, below the official est of 5.4% but in line with yesterday’s leak and PPI rose 6.6% y/o/y vs the est of 6.2%. Also in China, Jan new loans totaled 1.040T yuan vs expectations of 1.2T yuan. Wholesale inflation in India rose 8.23% in Jan, down from Dec but slightly above the forecast. Euro Zone Q4 GDP rose .3% q/o/q, .1% less than expected. German ZEW 6 month economic outlook was also less than expected but the 10 yr Bund yield is at fresh 13 month high as the EU will likely double the bailout facility putting Germans further on the hook.

You may have missed Matt Phillips massive read Friday afternoon on the GSEs in the WSJ blog Marketbeat.

The entire piece is definitely worth your time, but I found one chart especially compelling: It shows Fannie & Freddie’s market share plummeting from over 70% to under 40%, as Wall Street securitized all manner of non-conforming mortgages:

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There is no way to reconcile this chart with the jihadist blatherings of folks like AEI and CATO.

The facts of the matter are simply this: During the housing boom, it was Wall Street, and their mad purchases of Sub-Prime, Alt A and non conforming loans for their privately issued securitization that drove the credit bubble. Not, as the ideologically blinded Peter Wallison claims, Fannie & Freddie.

Class dismissed.

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Source:
Fannie and Freddie: The Saga in Charts
Matt Phillips
Marketbeat, February 11, 2011
http://blogs.wsj.com/marketbeat/2011/02/11/fannie-and-freddie-the-saga-in-charts/

“At bottom, I’m not all that interested in money,” Michael Lewis tells Planet Money:

It’s peculiar that I’ve written financial books and worked on Wall Street. … I’m interested in something else, and I guess that other thing is character and action and the general drift of societies. Money, because people care so much about it … is this great prism through which to view people.

On NPR’s Planet Money, they talk about the long arc of Lewis’s work.

Some Personal Observations about Egypt by Peter Alois
February 14, 2011

Peter Alois is a director of the Global Interdependence Center and one of my colleagues there. He is retired from the Commercial Service of the US Department of Commerce, where he had many years of experience posted in the Middle East. He is also president of his own export consulting company. His website is http://www.aloisglobal.com/. His email is palois@aloisglobal.com. He first visited Egypt in 1965. Peter is organizing a GIC discussion of the Egyptian revolution and its aftermath. Details on GIC website, www.interdependence.org.

Until Feb. 11, the situation in Egypt had been unfolding quite routinely. Unanticipated changes in any government move over highly variable time intervals, from: public protest, to government paralysis, to angry but not automatically violent confrontation between the two sides, to a second pause, to low-level violence either between the two or within them, to yet a third pause, and finally to a stabilizing resolution, too often through bloodshed frequently triggered inadvertently by either the public side or the government apparatus.

Remember the trivial incident in Tunisia in which a local policeman allegedly slapped a street vendor, confiscating his stand? How many times around the world has a cop just smacked someone, and life goes on? We can only imagine the desperation that caused this individual to set himself on fire, ultimately dying in a hospital. He was truly the human match on the Tunisian and Egyptian gasoline of government incompetence.

One typical yet critical aspect is the violence between the public protesters themselves, as the factions struggle for power against the government. Think of the American, French, and Russian revolutions, where the protesters cannibalized themselves. Freedom yes, but only for me and my supporters. E.g., the Bolsheviks and the Mensheviks, culminating in the assassination of Trotsky in Mexico in 1937, years after the Russian revolution and after Lenin had died in 1924 and been replaced by Stalin.

A second and very modern phenomenon is the hyperactive and instantaneous media coverage. Literally, we witness live, on-the-spot reporting, with sound and color, from voyeuristic foreign journalists who appear to have no awareness of even where they are standing We hear towers of misleading babble, cheerfully filling network time.

Returning to Egypt, I am dazzled that to date the developments have played out with minimal violence. Hundreds of thousands of Egyptians have been on the streets, surrounded by troops with tanks. Rocks and Molotov cocktails have been hurled (the latter named in honor of the Soviet Foreign Minister, by protesting Berliners and Hungarians in the ’50s), but stunningly, there was no massive violent put-down by the military.

What’s up with this? Is the Egyptian military ready to cede power to the people? Army General Nasser seized power in 1952 with an associate, Army General Sadat. Sadat took over in 1970 with the death of Nasser. Air Force General Mubarak followed in 1981 when Sadat was assassinated. Is democracy led by the military really growing along the Nile? We shall see. The army is now back in control of Egypt. Did they ever really leave?

Certainly any governmental change will reverberate beyond the borders: in Israel, in all ways; in the Suez Canal, with regional economic ramifications; and in the other Islamic countries, in more subtle ways. Egypt has been unique for thousands of years with its sophisticated and elegant culture including: (1) a dramatic brush with apostasy under the heretic Pharaoh Akhnaton, who eliminated traditional beliefs only momentarily, in 1383 B.C., by exchanging multiple gods and goddesses for the single God, Aton; (2) rule over the eastern Med under various Pharaohs; (3) being the epicenter of European interventions, from the Greeks in Alexandria to the Brits at the Canal (until the USA firmly asked them to depart in 1956); and (4) being an admired model for all Arabs.

Now Egypt is so much more to the entire world; it has become the model for popular revolt and a military’s surrender! As all veterans everywhere know, no military is anything like a democracy. The Financial Times of February 12/13 on page 2 has the headline, “Army takes nation into uncharted territory.” This is somewhat true, but the headline would more appropriately be, “Army finds itself in uncharted territory.” The dog finally caught the car. Good luck, pal.

It occurs to me that Islam in Egypt may be like Catholicism in Latin America: the folks were doing just fine until foreigners violently forced a new religion onto a pre-existing culture with its own beliefs. Today, Christianity throughout Latin America is a special blend of Spanish Catholicism and native animism, with hints of modern Protestant evangelicalism.

Islam in Egypt has been traditionally liberal: I have enjoyed beer and wine publicly with Egyptians in open areas, the level of education for both men and women is relatively high. And women still wear (long) skirts but can have considerable authority. Sexism in the Middle East does continue. Let’s glance at the USA though: liberal, plentiful booze (plus guns), universal though questionable education, skirts, pant-suits, T-shirts, and cut-offs – and sexism is rampant in certain quarters . And we too have fundamentalists of all religious brands who expect you and me to burn in whatever hell they believe in.

As for Egypt, I am wondering what the military and the civilian security forces are thinking. My guess is that the government’s official apparatus is growing more fragmented within itself as these titular as well as would-be leaders (generals versus ministers) struggle internally. They now confront public factions whose wannabe leaders also must be jockeying among themselves (intellectuals, politicians, student council presidents). This is just normal street politics, with the intelligence civilian Omar Suleiman looming with true sphinx-like dignity. (By the way, Mubarak is still inside Egypt.) Nevertheless, historically, some piece of the security apparatus suddenly acts violently, because it has traditionally held and wielded the authority and the weapons.

The situation deteriorates bloodily until stabilization occurs at the end of a gun and the latest hefe emerges surrounded by uniforms. Throughout the Middle East, leaders and their governmental plus private supporters must be terrified right now. Their collective political failures may shortly be made public in the most appalling of ways. We are watching that saga unfold in several countries.

The foreign media report what they believe they see, influencing their own governments around the world. I doubt whether anyone anywhere in any government (including the Egyptians, certainly not the Americans, nor the Israelis) knows what is truly going on. They can only speculate about who is up and who is down, and in what directions they might take Egypt. That’s not a criticism of the serious people involved. It is merely a blunt reality check. It is a criticism of the many foreign pundits and politicians who scream for action in Egypt but are truly know-nothings just playing for political points or Nielsen ratings. Those many pauses I mentioned above within the standard revolutionary cycle implied that the real players were taking deep breaths. Foreigners need to do the same with regard to Egypt and the Middle East, and zip it.

Iran and Turkey are theoretical models of evolution, yet they are likely not to apply to the Egyptian reality. The cultures are dramatically different, the personalities are unique to this moment, and the weird and wonderful foreign influences have accumulated over the millennia.

Yet this essentially peaceful blooming of democratic potential is amazing. It may offer hope for the autocratic Middle East. The venal aristocracies of wealth and power and their front men around the world may fear the coming of spring, with possible germination of the determined seeds of liberty, justice, and opportunity for all.

In sum, most of us will continue to watch and learn from this ancient civilization, perhaps with opinions modulated but certainly with fingers crossed for the Egyptian people, for their neighbors, and ultimately for ourselves. Are we ready?

We thank Peter Alois for this guest addition to Cumberland’s website.

David R. Kotok, Chairman and Chief Investment Officer

In Re Agard 48750818 US Bankruptcy Court New York Memorandum Decision

“MERS and its partners made the decision to create and operate under a business model that was designed in large part to avoid the requirements of the traditional mortgage-recording process. The court does not accept the argument that because MERS may be involved with 50 percent of all residential mortgages in the country, that is reason enough for this court to turn a blind eye to the fact that this process does not comply with the law.”

-U.S. Bankruptcy Judge Robert E. Grossman

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To be technically precise, they lack the ability to legally transfer mortgages. That doesn’t mean they are invalid, but it does eliminate their reason for existence.

Here’s Bloomberg:

Merscorp Inc., operator of the electronic-registration system that contains about half of all U.S. home mortgages, has no right to transfer the mortgages under its membership rules, a judge said.

U.S. Bankruptcy Judge Robert E. Grossman in Central Islip, New York, in a decision he said he knew would have a “significant impact,” wrote that the membership rules of the company’s Mortgage Electronic Registration Systems, or MERS, don’t make it an agent of the banks that own the mortgages.

“MERS’s theory that it can act as a ‘common agent’ for undisclosed principals is not supported by the law,” Grossman wrote in a Feb. 10 opinion. “MERS did not have authority, as ‘nominee’ or agent, to assign the mortgage absent a showing that it was given specific written directions by its principal.”

April Charney, a senior attorney with Legal Aid in Jacksonville, Florida, who has been aggressively criticizing MERS for some time, had the quote of the day, channeling Tom Petty: “ ‘Don’t come around here no more,’ is basically the message to MERS.”

The judge has “deconstructed” MERS and determined that they cannot be both principle and agent =– you have to chose one or the other.

Happy Valentines Day to you!

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Sources:
In re: FERREL L. AGARD, Debtor
Case No. 810-77338-reg
UNITED STATES BANKRUPTCY COURTEASTERN DISTRICT OF NEW YORK
http://www.ritholtz.com/blog/2011/02/mers-decision-in-re-ferrel-l-agard-case-no-810-77338-reg/

Merscorp Lacks Right to Transfer Mortgages, Judge Says
Bloomberg Feb. 14 2010
Thom Weidlich
http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a7hKAVragHWg

Who Is Esperanza Spalding, Best New Artist Winner?

Official site
Album: Esperanza

Hat tip Craig!

As this graph from The Chart Store shows, the markets are not quite overbought yet.

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But Ron Griess has some advice to those people who have been fighting the tape:

Time Warner Inc.’s Sports Illustrated magazine is changing it’s subscription model, and is betting on the popularity of its swimsuit issue to aid new business. Bloomberg’s Michele Steele reports.

Feb. 14 (Bloomberg)