Muniland Update & Whitney on Squawk Box.
David R. Kotok
June 11, 2011
While we were in Europe, the focus there was on Eurozone sovereign debt risk, the potential restructuring in Greece, the possibility of sovereign debt default, and what it would mean for Eurozone banks. The other topic was Bernanke and QE3. Our June 8, Paris bureau interview on CNBC’s Worldwide Exchange is posted here on the CNBC website and at www.cumber.com.
While we were looking at sovereign debt globally, we learned that Meredith Whitney was interviewed on CNBC’s Squawk Box. Through emails and telephone messages we were asked for comments, because she reiterated her call for substantial Muni defaults. We have now reviewed the tape and have a few comments.
First, let me thank Jeff Cox of CNBC, who reported a text summary of Whitney’s comments and quoted our criticism of her work as well. He suggested my writings and comments were those of a “detractor.” He is correct regarding the substantive issue of Muniland defaults. Whitney and I disagree; however, there is no personal animosity on my side. I do not know her. We had planned not to comment any more on her prognostications, but we will since the volume of requests from clients and readers is so high.
We also want to compliment CNBC’s Joe Kernen and Becky Quick. They rose to the occasion with facts and direct questions to Whitney on her history since her infamous 60 Minutes quote. Becky Quick used her TV journalist skills, which are now superbly honed. She probed politely yet directly into Whitney’s views. Kernen and Quick are to be credited for this effort. As journalists, they brought out the issues so viewers could form their own judgments about Whitney and her assertions.
Notice my use of the word assertions. There is a significant difference between an assertion and a fact backed by direct, specific research. You be the judge. We invite readers who choose to spend the time to view the Whitney CNBC interview on CNBC’s website. You will find it here. It is 22 minutes. Meredith had no opposition; no other side was represented. This is not a debate. She is defending and explaining her quotes that have been widely reported in the media. Viewers can decide for themselves how much or how little direct evidence she introduces. They can decide how she handles herself when precisely questioned in a polite and friendly environment but still has to confront the statements she has made in the past.
We will now move on from Whitney’s comments to a detailed discussion on our position. Whitney gave disclosures at the end of her interview, we will do the same.
Cumberland Advisors has a 38-year history of giving independent advice in the municipal finance world.
We remember overruling an underwriter recommendation and avoiding long-term high-cost debt in the midst of the 1973-4 energy shock. Our client was building a sewer plant. We used shorter-term notes for interim financing and then rolled them two and a half years later when interest rates had declined. Townspeople are still paying lower sewer charges thanks to that financial decision. We kept a coal power plant from being built in 1980. The municipal political fight was fierce. The point is that we have personally acted as a lead independent advisor for nearly forty years. There are other extensive histories among the rest of Cumberland staff. Many are posted on our website.
Cumberland is not affiliated with any underwriting or brokerage firm. We are not brokers. We are independent advisors to separate account portfolios that invest in municipal bonds. Our role is as a fee-for-service advisor. We do not manage any mutual fund. We do not act as a rating agency. We do not sell reports. Our credit decisions and recommendations are internal and proprietary on behalf of our clients. We make them every day.
Now to the default issue. When engaging in municipal research, one must look at the structure of the credit. Gather data on how it is secured. Ask questions. What is the priority of liens? What is the senior or subordinated pledge that secures each specific bond? We agree with Meredith when she says that local debt is idiosyncratic. It is. That is why Muni investing requires work and research.
We have written at length concerning default and will take this opportunity to restate our position. The only default that matters to a Muni bond investor is not getting paid principal or interest when due. Technical defaults can mean nothing, or they can be viewed as indicators of possible future financial trouble. When AAA-rated Yale University failed to file a financial requirement in a timely way, one could argue that it engaged in a technical default. We take a different stance. Yale misfiled for some administrative reason. It subsequently cured; there was no default in any payment. The AAA rating assigned to Yale is valid and well supported by a huge amount of economic data to prove that the University will pay interest and principal on its bonds under almost any imaginable circumstance. We own Yale’s bonds for some of our clients.
At Cumberland, when the word default is used, it means interest was not paid on time or principal was not paid when due. At Cumberland, a default happens when money is not paid when it is supposed to be paid. It is as simple as that.
It is easy to survey the debt of all fifty states in our nation. Many services report details on each state. We see nearly all of them. We track them constantly.
In addition, anyone can subscribe to Bloomberg and obtain data continuously on the nearly 90,000 separate jurisdictions in Muniland. If a bond has been issued in a publicly traded form, it is likely to be found in the Bloomberg database. Bloomberg shows that Muniland is $3.8 trillion in size, not the $2.9 trillion offered by the Fed (Citigroup). There are numerous other sources of economic, budgetary, and financial information about states, cities, counties, and agencies. It is there for the examination.
It is our assertion from our economic analysis that there is very little likelihood of $50 to $100 billion in defaults in the near term, certainly not in 2011. By way of fact, the worst recent default year was 2008; it was under $10 billion. The trend of defaults has been falling since. Year-to-date, in 2011, defaults are under $1 billion.
Remember, our focus is on being paid the interest and principal on the bond. By default, we mean not getting paid. It is not about the difficulties of government budgeting. Here Meredith is correct. They have those difficulties. They have to fix them, and it will be painful.
There will be some defaults this year and every year. Most are in the non-rated category and most are tied to projects.
It is true that federal government payments to the states will change in the coming federal fiscal year. On this assertion, Meredith is correct. States will get less money from Uncle Sam. It is also true that states are cutting headcount. “Cities, towns and counties cut 28,000 jobs in May” (Labor Department). States are rebalancing their budgets and closing their deficits. States are cutting services.
Look at New Jersey and Governor Christie, who has become a model for the other 49 states. In NJ, you can see activity underway to change the structure of a state government. Christie inherited a huge amount of unfunded liability in New Jersey’s pension system. He has to address unfunded payments in post-employment retirement benefits for New Jersey employees. He has to deal with a very heavily taxed state. If you look at the news flow, you can see the evolution of a political process. Teachers will pay more into their pensions. So will police and firefighters. Employee healthcare contribution formulas will change.
Skeptics say Christie will never succeed. We witness this in emailed responses to writings and commentary. Sometimes, skeptics are right, especially if they are talking about Greece or Argentina. However, if they are talking about the fifty sovereign states of the United States, they need to check their facts. In the last century, only one state defaulted, meaning it failed to make an interest or principal payment in a timely way. That state was Arkansas and the default occurred during the Great Depression era of the 1930s. Arkansas subsequently cured the default and paid every penny due. Other than that, the 50 states are the American version of a successful sovereign debt model. Simply put: they eventually balance their budgets and they pay their interest and principal on bonds.
That said, a bond investor can make choices. We do. Why own Illinois if you are concerned about them? We are. We do not own the GO debt of that state. We would own Virginia or Utah instead.
Have some states accumulated unfunded benefit liabilities? Absolutely. Did they operate their budgets under cash-basis accounting and therefore not account for the accruals that were building? The answer is yes. Could anyone in the public domain find the accruals and information if they chose to? The answer here is also yes.
The fact is that state and local government accounting and budgets are prepared in a very complex way and differ from corporate accounting and corporate budgets. Nevertheless, the information is there if you seek it out. When comparing state and local government budgets to restatements from corporations and federal agencies like Fannie Mae, one can see significant differences in the levels of transparency. There is very little amendment or restatement coming from state and local agencies. Moreover, the details are a matter of public record, available to anyone choosing to seek them out and understand them. They disclose, albeit in a complex way, their accounting, their liabilities, their revenues, and their debt service coverage.
In our writings we have pointed to specific issues multiple times. You may note that in her interview Whitney was specifically asked by Kernen for an example, a CUSIP number. She declined to provide one. We have demonstrated our assertions with facts. We mention CUSIP numbers, the names of the issues, and how they are structured and secured. We follow about four thousand municipal bonds in our library. What we have found is this: you can research municipal bonds specifically by state, by county, by city, and by local agency, and you can determine the likelihood that you are going to be paid. You can determine whether the structure of the issue is sound, as well as whether the issuing agency is well-constructed. You can establish your own credit assessment. There is no need to rely on a failed bond insurer. You can do this yourself.
Here is an example of a tax-free municipal bond that we own for some clients. It is the Colorado Housing Finance Authority, Single Family Program, CUSIP 196479ua5. This is a state agency of Colorado. The coupon is 5%. The maturity is May 1, 2029. There is a May 1, 20 21 par call. This bond is backed by a pool of mortgages. Those mortgages are all guaranteed by Ginnie Mae. The mortgage pool is over 100 percent of the outstanding bond issue. The collateral that secures the bondholder is guaranteed by the USA. It is as sound a fiscal guarantee as can be found. It is a promise to pay, just like a US Treasury obligation. Under all stress scenarios, investment revenues are more than adequate to pay debt service on the bonds. Examine this tax-free municipal bond tied to this housing agency and you will find the structure that will help you determine that the federal government is backstopping your payment of interest and principal. Simply put, that bond is a natural AAA, very high-grade, very reliable credit. It will pay interest and principal as scheduled. It will not default. Furthermore, when we bought this bond on April 13, the purchase yield-to-call was 4.968% and the purchase yield-to-maturity was 4.979%. These yields are tax-free. They exceeded the corresponding yield on the equivalent-duration US Treasury obligation, which is taxable.
Those who want to dedicate time and effort can find hundreds of such instruments of various constructions. All are not fully guaranteed by the federal government, but many of them have revenue pledges and structures that essentially mean that you will be paid.
So what about the default question if the aggregate includes bonds like this? If you take bonds like this out of the aggregate calculation, if you also remove the pre-refunded bonds, if you subtract the bonds issued by the 50 states and their agencies, if you remove the other bonds that have structure and credit support of high grade – if you perform the calculation – it is very hard to find enough bonds left to meet the mass-default description of $100 billion in this year or this cycle.
Simply put: Whitney’s numbers do not add up in our view. We have not seen her new report, so we cannot say what is in it to support her conclusion. But we have seen our data. Our position is that there will be some defaults. There always are. They will be much less than $100 billion this year or this cycle.
Furthermore, why buy the troubled bonds? Do the work and avoid them. The idea is to buy the good ones and avoid the bad ones.
Markets are starting to figure that out.
At the peak of the 60 Minutes notoriety, the redemption rate in tax-free municipal bonds hit a weekly extraction of four billion dollars. That is a huge sum, illuminating the fears of investors who did not track detailed information but responded to the Whitney media scare. We received hundreds of emails and phone calls from our clients and others concerning that period. We advised investors to take advantage of the selloff. We bought bonds heavily during the panic selling period.
Now, six months later, we are actually seeing inflows into tax-free municipal bonds. Investors added $274 million last week (Lipper). Those who panicked and sold the tax-free bond when the yield was close to six percent are buying the bond at a yield closer to four percent. This is what media hype and scare did to the market.
Today, highest grade municipal bonds in the short and intermediate space yield below the US Treasury yield curve. They have restored some of the natural tax arbitrage that is available to American citizens in higher tax brackets. That transition is underway in the long maturities as well. We are seeing a curative process underway. We see rising revenues in state and local government entities, and we see the political will to rebalance budgets, cut spending, and alter the structure of state and local government finance in the United States. It is a good thing and it is about time it happened.
We are back in the US. The work continues. We hope readers appreciate our discussion and debate. We thank Meredith Whitney for publicizing the issues regarding municipal finance. She did it and received the notoriety on 60 Minutes. We agree with her that the issue is important and needs to be aired. And we certainly thank CNBC’s Kernen and Quick for the job they did in that interview.
We continue to see pricing in Muniland as normalizing. In the middle of the curve, the tax-free vs. taxable spread is getting close to historical norms. At the long end it is closing fast. Muni investors who held their bonds and bought more six months ago should be very pleased with their results.
David R. Kotok, Chairman and Chief Investment Officer
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