Muni Defaults: Whitney and Roubini
David R. Kotok
March 26, 2011
“The rule on staying alive as a forecaster is to give ‘em a number or give ‘em a date, but never give ‘em both at once.”
–Jane Bryant Quinn, Reader’s Digest, 1 Dec. 1980
Meredith Whitney broke the rule. This now haunts her to the point that she declined to appear before a Congressional committee that wanted to discuss Muni default issues. Nouriel Roubini is a skilled economist. He knows this rule. He, therefore, used modifiers to adhere to it.
Let’s talk about Whitney’s forecast first. With great media fanfare, she predicted “50 to 100” sizeable muni defaults, totaling about $100 billion, in 2011. That is correct: she said this year. The year in which the economy is in some sort of recovery and when the interest rate is held near zero by the Fed.
Meredith did not know about any oil shock when she made this forecast. While the current MENA turmoil is a serious new development, the resulting oil price shock will not help her be right in her forecast. In our view, there is nearly zero chance that there will be 50 to 100 sizeable Muni defaults amounting to $100 billion in the calendar year of 2011.
Nouriel Roubini suggested that there may be “close to $100 billion of defaults over five years, but typical 80% recoveries are far higher than on corporate bonds.” Nouriel outlined his view of trouble in the Muni world and attempted to measure the exposure in a very thoughtful way. He noted that most of the bonds he expected to default were in the high-yield or junk-bond category. His base-case estimate of defaults over five years for the investment-grade sector was under $30 billion, with “ultimate recovery” of nearly all the losses. Nouriel reminds us that “governments cannot be liquidated” like corporations.
Bloomberg’s Joe Mysak observed the following about Roubini:
“And so noted doomsayer Nouriel Roubini joins the numerous commentators who have opined about the municipal bond market, the most famous, of course, being Meredith Whitney, who in December on the CBS show ‘60 Minutes’’ blurted out the prediction that there would be ‘hundreds of billions’’ of municipal bond defaults in 2011. That $100 billion estimate from the Roubini firm isn’t in the same league as the Whitney call. What’s more, it may not be so outrageous, depending upon how you count defaults. The record year for municipal bond defaults was 2008, when 167 issues totaling $8.5 billion went bust, according to the Distressed Debt Securities Newsletter. In 2009, more municipal bonds defaulted, 207, on a lower dollar amount, $7.3 billion. In 2010, 82 deals failed to pay on $2.7 billion in bonds. The $100 billion over the next five years isn’t outside the realm of possibility. How are you counting? The people at Distressed Debt Securities, who have been doing it for decades now and who are the only ones with a historical database over that time, and who use a consistent methodology in their approach, count new defaults only in their calculations, which I think is the correct way to do it. Some analysts, scanning the daily material event notices at the Municipal Securities Rulemaking Board’s EMMA web site, count all notices of default that are posted by issuers. And by doing it that way, by counting bonds that are already in default, you can come up with many more billions of dollars in defaulted municipals every year. That’s because it takes years to cure some of these things. In the case of so-called dirt-bonds, used to finance infrastructure improvements to real estate developments, for example, bondholders have to wait until the real estate is foreclosed upon and sold before they see any end to their money woes. Dirt bonds are the overwhelming majority of those that have defaulted over the past few years. The same long wait is true for bonds used to build speculative projects like toll roads, or de-inking mills, or aquariums, or any of the other various quixotic stuff that has been financed in the municipal market. Actual municipalities, that is, cities and counties, rarely default on their obligations. When they do, they usually cure them in pretty short order, in months if not weeks. Jefferson County, Alabama, which defaulted on almost $4 billion in sewer debt several years ago, is an outlier. If history is a guide, it probably will remain so. So, $100 billion over five years? That’s the headline number. It’s not impossible, especially if you count continuing defaults. Still, that’s quite a crystal ball.”
We believe it is important for readers to understand the term default. Here is the official definition from the Municipal Securities Rulemaking Board (MSRB). Remember, bondholders are concerned about monetary defaults. Non-monetary defaults are important because they tell you about the management of the organization or its political structure. These non-monetary defaults actually can provide a bond buyer with opportunity for a bargain if he is willing to do the homework.
“DEFAULT–A failure to pay principal of or interest on a bond when due or a failure to comply with any other covenant, promise or duty imposed by the bond contract. The most serious event of default, sometimes referred to as a ‘monetary’ default, occurs when the issuer fails to pay principal, interest, or both, when due. Other defaults, sometimes referred to as ‘technical’ defaults, result when specifically defined events of default occur, such as failure to maintain covenants. Technical defaults may include failing to charge rates sufficient to meet rate covenants, failing to maintain insurance on the project or failing to fund various reserves. If the issuer defaults in the payment of principal, interest, or both, or if a technical default is not cured within a specified period of time, the bondholders or trustee may exercise legally available rights and remedies for enforcement of the bond contract.”
MSRB reported a Fact Book on the hundreds of thousands of items and on the 10.5 million muni trades for 2010. There were 371 disclosures of a principal & interest delinquency; these involved 1951 securities. The overwhelming majority of them were in project-specific or otherwise non-rated or “junk” bonds. So if you count them on the default list, the list gets bigger.
Does that mean you have to buy any of these bonds? Certainly not. Does delinquency mean an actual monetary default will occur? Maybe yes, maybe no. Each case is different.
When it comes to actual defaults in 2011, the statistics, so far, are improving. “Municipal-bond defaults in the first two months of 2011 are down 50 percent from the same period last year, Standard & Poor’s said. Eight bond deals totaling about $222 million have entered default this year, compared with 16 totaling more than $329 million during the same period of 2010,” said J.R. Rieger, vice-president of fixed-income indexes for S&P in New York (Bloomberg, March 4).
The media has been filled with talk about municipal bankruptcy. This is a serious subject, of course. But it, too, has been overblown. Evidence from the 2008 Vallejo, California bankruptcy demonstrated how costly this is for a city or county. Vallejo has spent nearly $10 million so far and has nothing to show for it. The Bond Buyer, a trade publication, reports that “Vallejo bonds backed by non-general fund revenues amount to $62 million of debt. They have been paid in full and on time throughout the bankruptcy proceeding. They include securities with dedicated income streams including water revenue bonds, tax allocation bonds, and assessment and improvement district bonds.”
So far, in 2011, there has been just one Chapter 9 filing. Bloomberg reported it:
“Boise County, Idaho, with a population of about 7,450, filed for bankruptcy, making it the first U.S. municipality to file Chapter 9 this year. The county sought protection after a federal jury in December found the county violated federal fair housing law in its conduct related to a developer’s plan to build a 72-bed residential treatment facility for teenagers, the Idaho Statesman reported. The jury awarded a $4 million judgment to a developer, which hasn’t been paid. The county’s budget this year is $9.3 million. The county estimated its liabilities at less than $10 million, according to a March 1 filing in U.S. Bankruptcy Court in Boise. Alamar Ranch LLC, the developer, was the largest unsecured creditor with the $4 million claim. Idaho is one of 26 U.S. states that authorize municipal bankruptcy. Like Chapter 11 under the federal bankruptcy code, municipalities allows debtor to adjust debt. Unlike corporate bankruptcies, creditors can’t force municipalities into liquidation and the bankruptcy court has little oversight of municipal operations. Six municipal entities filed for Chapter 9 last year, most of them small utility or sewer districts. The capital of Idaho, Boise, is in adjoining Ada County.”
Whitney’s report does not delve deeply into the recovery history of Munis and into the technical details of default. Nor does she examine the complexities of Chapter 9 bankruptcy.. That is a shame, since she does deserve credit for publicizing the important issue of budget stress in Muniland.
Roubini does examine recovery. He offers estimates and methodologies. And he thoroughly describes the issues involving Chapter 9. His conclusion is that Muni recovery is much higher than markets seem to be pricing and that the widespread use of Chapter 9 is unlikely.
We believe the Roubini report is straightforward and worthy of respect. It is serious research work. It examines nearly two centuries of development in state and local government debt in the United States. It explains the methodology that it used to reach conclusions and estimates. We are less respectful of the Whitney report.
Roubini also attempts to estimate the price adjustment needed in the market in order to normalize the Muni-treasury spread. He notes that the financial crisis sell-off brought Munis to “absurd panic levels.” He reminds readers that, while things are improved since these wide spreads, the Muni market is still under “extreme strain.”
Cumberland agrees with Roubini’s conclusion that the “ratio of Muni yields to Treasuries remains elevated.” We continue to be buyers of well-structured, high-grade, tax-free municipal bonds and of corresponding taxable municipal debt. They remain cheap, and spreads still have a ways to go before normalcy in pricing is attained.
David R. Kotok, Chairman and Chief Investment Officer
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