A Tale of Two Cities and a County in Muniland

A Tale of Two Cities and a County in Muniland
November 29, 2010
David Kotok


What do Menasha WI, Harrisburg PA, and Cumberland County NJ have in common? All have issued municipal bonds for infrastructure projects. All have projects that failed to meet expectations. All stressed about what action to take.

Where are they different? Two engaged in financial misbehavior. One, Cumberland County, demonstrated quality governance and acted correctly.

In Menasha, a steam plant financing payment was due in September, 2009. Instead of paying, the city allegedly reneged on its pledge to make deficiency payments. Therefore, they are now spending taxpayer money on legal fees instead of doing a debt workout. (Source WSJ archives)

Harrisburg, the capital of the State of Pennsylvania, made national news with its attempt to use bankruptcy as a means of avoiding payments that were promised. Harrisburg is a scandal and an embarrassment for PA and its Governor Rendell, who has tried to find workable alternatives and must deal with uncooperative and irresponsible local officials.

No one has heard about Cumberland County NJ. Why not? The board of the Cumberland County Improvement Authority (CCIA) made a difficult governance decision. They determined not to build a landfill expansion because the economics that drove the original decision had changed. They had lost a large customer of a landfill facility after it redirected its flows. The customers were forced to do so because of particularities under NJ’s flow-control laws. So, CCIA found itself with project financing that was no longer the most cost-effective alternative.

Here is a case of “good governance.” CCIA stopped the project. It is using the unexpended proceeds provision in its bond resolution to call the bonds that were originally issued to pay for the project. It is also defeasing that resolution so that it may operate the smaller facility under less financially stressful conditions during this period of national economic uncertainty.

Investors did not read headlines about CCIA. It didn’t make national news. It will not default. It won’t delay payment. Moreover, it will honor its obligations and therefore not injure the other county entities and the cities that are impacted.

The point of this commentary is that governance must be part of the investor’s credit ranking system. State and local infrastructure projects are most often viable from an economic viewpoint. In theory, they shouldn’t be built without passing that test. However, they are also subjected to political models. If local politicians choose to avoid payment responsibility, they injure their constituents for years. It is up to the constituents to throw them out of office, ridicule their decisions and, perhaps, impeach them. We get the government we deserve and sometimes we fail to act to change it.

At Cumberland Advisors, we do not and did not own Menasha or Harrisburg debt. It failed the governance test. CCIA is a consulting client and we are proud to serve them.

There are about 90,000 separate issues of state and local government securities that are traded with some frequency. They each have a governing structure and a well-defined legal framework under which they conduct business. They have many diverse and complex terms that cover their borrowing and repayment obligations. Serious investors need to understand, examine and dissect them. What is clear to us is that the information is mostly available. It may be complex but it is there. In addition, it is very transparent to any skilled analyst who will take the time to do the work. BTW, nearly all of them will make their timely interest and principal payments on their bonds.

In the old days we used to be asked: “Why do you need to do any of this work? We can just buy AAA-insured bonds and forget about it.” The world has changed. Lethargy & complacency-inducing AAA insurance is dead. However, that does not mean state and local government securities are all bad and are all going to default.

There are some great bargains available right now in the tax-free and taxable Muniland space. Investors are getting well paid for participating. The case for Munis is now classic by market standards. Buy something when no one wants it; sell it when it is very popular.

Lazy investors or those who are scared by the headlines are running from Munis in droves. That selling is why they are very cheap. Investment Company Institute reports that a record-setting $4.78 billion was pulled out of Muni mutual funds in the week ending Nov. 17. Lipper FMI says another $2.3 billion was withdrawn in the week ending November 24. This is evidence of huge panic selling; it suggests a selling climax in Muniland.

So we argue the contrary case. It is time to do the homework. Read the bond indentures. Examine the governance structure. And buy the good ones. We do.

As for Harrisburg and Menasha, they may be nice places to visit, but I wonder what communal life will be like when the governing body wants to hide behind the courts in order to avoid confronting a bad financial decision. Menasha and Harrisburg each need to determine a work-out plan and stop the bleeding. Time will reveal the true costs of their poor governance to date. Markets and vendors will punish defaulting debtors without mercy.

Note that there were 54 cases of Moody’s-rated municipal debt default during the 40 years from 1970 to 2009. Of them, 78% were in stand-alone housing and health-care projects (source: WSJ, November 11). Considering that there were thousands of bond issues, that is a pretty good record. Also, note that a disciplined governance structural review and an examination of the credits would have likely kept a high-grade bond buyer from purchasing most, if not all, of the 54 issues. It did for us.

Happy holidays.


David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors

Category: Think Tank

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Category: Foreclosures

Recessions are on the Margin

Recessions are on the Margin
November 26, 2010
By John Mauldin


Recessions Are on the Margin
A Rose is Still a Rose
If It Feels Like a Recession
The Rough Road Back
Mexico, New York, and The Endgame


I’ve got to admit it’s getting better
A little better all the time
I have to admit it’s getting better
It’s getting better since you’ve been mine
Getting so much better all the time

- John Lennon / Paul McCartney, Sgt. Pepper’s Lonely Hearts Club Band

And the data out over the last few weeks tells us it is getting better. Does this take us out of the double-dip woods, even as the Fed is lowering its forecast? And what is a recession? Yes, we all know it’s when the economy doesn’t grow, but we are in a rather unique economic environment, this time. Maybe things are getting better, but is it enough to get us back on the road to full employment?

Let’s start off with what is going right. We had a slate of news over the past few weeks that was good. The ECRI weekly Leading Index, after some ugly downtrends, is showing signs of turning around. We have had small increases each week since October 15, and the annualized growth rate of the index is now only -3.1%, having increased for 12 weeks. Its recent low was in July. Yes, I know that a large part of that growth is in the financial sector, as the stock market is up and interest rates are low, but it does suggest that 2011 should not be a recession year.

The Federal Reserve Bank of Chicago’s National Activity Index improved in September and is now only slightly negative, again suggesting that there should be no recession in ’11. The Richmond Fed Manufacturing Survey was up this last week, as well, to its highest level since August. And the Kansas City Fed survey was up for the third month in a row.

Moody’s World Business Confidence Survey is up slightly. “Business sentiment has taken on a slightly better hue in late November. Although overall confidence has remained largely unchanged since early July, responses in regard to current business conditions, sales strength, and investment in equipment and software have improved in recent weeks. The survey results suggest that global growth may be gaining some traction at year’s end after a lull this summer and fall. It is also encouraging that hiring intentions remain firm, and while pricing is soft, there is no indication that deflation is a serious problem. Nonetheless, businesses do not anticipate a significant acceleration in activity anytime soon, as expectations regarding the outlook into mid-next year have shown no meaningful improvement.” (www.dismal.com)

Third-quarter GDP was revised up to 2.5%, although inventories accounted for just over half of the growth. Building inventories counts as a plus in GDP accounting, and selling them deducts from GDP growth. Just the way it’s done. But at some point inventories will stabilize. That headline number will be harder to get up over 3% when that happens. (I decided to go back and look at the BEA historical inventory numbers. Interestingly, there seems to be a bug in that particular data and it shows up as -9999 in both online and printed formats. All the other data was fine. Someone should fix that. After 20 minutes of trying to find it elsewhere, I decided I needed to get on with writing.)

Initial jobless claims dropped to a seasonally adjusted 407,000 this week, a rather amazing number, as the actual number was 462,000 (although the week before the actual number was just 409,000). That is why most people pay attention to the seasonally adjusted number, as this data series is extremely noisy. Let us hope this is a trend.

And what’s this? Personal income was actually up 0.5% for the month? That’s positive, as personal income growth has not been all that good, and is now up 4.1% over the last year. Just six months ago, in May, it was up only 1.8% over the preceding year.

Mortgage applications were up, although new-home sales dropped a rather dismal 8.1%. New-home sales are close to the 47-year record low set last August, and down 29% from a year ago. The median sales price is down 9% from a year ago. The good news in all this is that as prices drop and foreclosures keep on coming, homes will become more affordable to people who want to buy. The cure for low prices is low prices. While it may be well into 2012 before we work through the excess inventory and the aftermath of the housing bubble, as I wrote here in 2008 (I was told I was such a doom and gloomer!), we are closer to that point than we were a year ago. These things work themselves out over time.

The economy has now grown at a rate of 3.1% over the last four quarters. That is the good news and it’sthe best growth we have had for four quarters since 2005. We have been slowing down somewhat the last two quarters, but are still north of 2%. With inventory growth slowing, it is really possible to be below 2% for the 4th quarter.

A Rose is Still a Rose

There is a theme to a lot of the positive news we’ve been getting lately: it is positive, but not by much. Normally at this time in a recovery we would be seeing 4-5% (or more!) GDP growth and some real recovery in employment.

Still, 2% is not a recession. And given what we have seen, there should now not be a recession in 2011, barring some “exogenous” shock. Something that is from outside the normal system. I have written for a long time that the one thing I really am concerned about is that the Bush tax cuts will not be kept. If the Bush tax cuts on the middle class are not kept, it seems a lock to me that we’ll be in recession rather soon in 2011.

At 2% growth, the economy MAY be able to handle it if we only end up taking away the tax cuts for those with over $250,000 in income. It will slow things down, but probably not enough to cause a recession, if we are growing at 2.5%.

I know a lot of my readers think it is just me being political, but that is what the research and the data tells us. Maybe if I called them the 2001-03 tax cuts and didn’t use the name Bush it would be less offensive to some. I really get that. But the research is the same no matter what name I use. A rose is still a rose.

Take capital gain taxes. An increase in capital gains taxes has never – NEVER – increased tax collections as much as forecast. And a decrease in capital gains taxes has always – ALWAYS – produced more tax revenue than forecast, and often more in taxes than was being collected before the tax cut. People change their behavior over what seem like small changes in capital gains taxes. The data and history are clear.

Right now the people who seem to know think those tax cuts will get extended. If they do, is there anything else that could shock the system? The first thing that leaps to my mind is a real credit and banking crisis in Europe. European banks are in bad shape and own a massive amount of government debt in Greece, Ireland, Spain, and Portugal. Truly massive.

This is a graph of the exposure of French, German and UK banks to Spain, Portugal, Ireland, and Greece. For those who are seeing this in black and white, the top part of each bar is Spain, and going down to Greece. Any wonder why the markets get nervous when Germany starts talking about the need for bond holders to take a haircut in any debt restructuring?

We will take a look at Europe next week. But as I have written on numerous occasions, and as should be very clear by now, the international credit and banking systems are very connected. While US banks are not overly exposed to European sovereign debt, we are exposed to their banks. We just simply do not know what the ramifications of a credit crisis will be here. But it bears watching.

If It Feels Like a Recession

The old joke is that a recession is when your neighbor loses their job and a depression is when you lose yours. As noted above, the economy is growing, so why does it feel like a recession? Maybe because the data is still in recession territory. Let’s look at a few items.

Capacity utilization is well off its lows but is in territory normally thought of as a recession. Look at the latest data from the St. Louis Fed FRED research database (a treasure trove of all sorts of data; love this site!). 75% capacity utilization has only been seen in past recessions, and indeed in many recessions never got this low!

We all know unemployment is high, but it bears looking at how high, to get an historical perspective. Only once has it been this high. Notice that it took almost 8 years in the ’80s, with a powerhouse economy, for the unemployment rate to drop 6.5%, and in the ’90s it took 9 years to drop 3.5%. It only dropped by about 2% over five years in the middle of the last decade. We are now at an effective 10%. Nine years to get back to 6.5%? Five years to get back to 8%?

Read More

Category: Think Tank