12/28/10…munificent muni’s

…thanks to Meredith Whitney’s appearance December 19th on 60 Minutes, there has been a lot written on municipal bonds. TB respects her for her forecast on bank stocks but believe she is out of her league on muni bonds. Having nearly 39 years experience in muni’s he believes her comments are way too pessimistic although there is a lot of complacency out there…be it in stocks or bonds.

It would appear that while Whitney is a worthy analyst of corporate credits she doesn’t fully understand the municipal bond market and in particular the meaning of the phrase “full faith, credit, and taxing power,” as she sees massive defaults in municipal bonds that would trump the defaults during the Great Depression. Note the use of the word defaults which are not the same as ‘bankruptcy.’

If we go back to that prior era, the defaults were largely in issues rated ‘AA’ or better…the same areas which will have the longest-lived problems this time around: primarily major cities with large ‘core city’ areas characterized by poverty, and leading to crime, which in turn produced mass migrations by those who could afford to do so.

The majority of those defaults however were temporary in nature and did not result in municipal bankruptcies. The key is in knowing how we got there then and how it is happening now, and the structure of the municipal bond market. Also, in the instance of states very few even allow them to file for bankruptcy protection.

As in 2007, in 1929 people believed all was well…then came the crash, the dustbowl (see we just have massive global blizzards today), and a global depression. The culprit for making the situation worse was the Federal Reserve along with the other central banks who were too conservative and tightened bank credit rather than easing it as has been done this time around. Bernanke himself wrote of this in his study.

In TB’s career, he has seen three major municipal bankruptcies:

New York City – caused by massive use of debt to fund unprofitable operations and plug deficit holes (didn’t Schwarzenegger just do the same thing in California but it still is in a better situation than NYC was. The debt was restructured and eventually came out of bankruptcy.

Washington Public Power Supply System (WPPS…or later OOPS!) – this overbloated attempt to bring nuclear power to the state with the lowest power cost (hydro) was derailed by massive overruns which resulted in more and more debt issued and capitalizing the interest on each new issue with years of indebtedness. It finally blew up when a judge ruled that local governments did not have the power to put future ones in debt. Also note that there were two classes of bonds ‘AAA’ Bonneville Power Authority backed and Single ‘A’ bonds with no federal backing but which the late First Boston recommended swapping into as they were convinced that the BPA backing would be extended to all debt (TB had a friend who did this and it cost him his job when they defaulted).

Orange County – this was strictly due to malfeasance by the treasurer, Bob Citron, who in an ego battle with his friend, Sol Levin, from L.A. County who also went to jail later while investing for San Bernardino County, destroyed the county’s finances by massively leveraging the portfolio in a bet against interest rates rising…which predictably they did. Within three years OC emerged from bankruptcy.

There are more municipal bond issues in numbers than any other asset class. That is because unlike corporate bonds are issued serially with the goal of level debt service until the final maturity and thus spreading the cost over the period of benefits and that is one of the strengths of muni’s – in most cases you do not get a balloon at the end as with corporate bonds. It also allows the buyer to pick the maturity that suits their time horizon and risk tolerance.

Despite all that has happened with the rating agencies, for the most part they do a good job of rating muni bonds…and recent developments will force them to do an even better one. Their problem was getting into what they did not understand and relying on the street to provide them with the information (isn’t this like our government relying on lobbyists for their information?).

The point is that sans the fledgling BAB’s market (taxable muni’s), which may or may not be extended…as for now it is dead…the power to borrow for a municipal entity is their only way to finance longer term projects. Already, some entities are making drastic cuts to improve their financial condition which was largely a result of giving in to the unions on wages and benefits…especially retirement. This is what happens when a large portion of your constituency is represented by those who stand the most to gain from your largesse. The pendulum is beginning to swing the other way however…they have no choice!

Also, while municipal bond insurance has gotten a bad name if you understand it and that they only have to make the debt service payments as they come due, you see that they are safer, for the shorter maturities at least, than they appear.

This is not a recommendation to buy municipal bonds, merely to realize that the risks have been greatly overstated.

Tomorrow some risks, other than default that pertain to muni bonds.

Now to yesterday’s markets. Bond yields are not going to head up in a linear fashion as they did since early October and could even decline again if the economy doesn’t improve like the stock market expects. Yesterday was a very boring day in stocks with only minor changes at the end of the day…albeit from very strong…overbought?...levels. Look at the volume on the NYSE since 12/17, it’s a graveyard out there!

12/17 2.02B – Quadruple witching! Highest volume since 6/25/10

12/20 829M

12/21 811M

12/22 784M

12/23 617M

12/27 468M – 2nd lowest of 2010, 11/26’s 428M was THE low of year and 3rd lowest since the 12/24/09 319M day which was lowest in decades!

Today is the last day for T+3 settlement, coming as close to yearend as this one is and coupled with the low volume, it might produce just a whimper. Still, don’t ignore it as the impact could be substantial.

. . . - - - . . .    . . . - - - . . . (S.O.S.)

Not much else to reflect upon today...most activity after today will be focused on yearend tax swaps, etc.

Have a great day!


Trader Bill thinks it is clear to anyone reading these missives that they are merely commentaries...as he sees it...and do not necessarily reflect the views of anyone other than his own. Information is gathered from sources he has found reliable, but no guarantees of accuracy are implied. These are merely observations of events in the marketplace offering in an attempt to offer a non-mainstream viewpoint. Copyright TBD Capital LLC, December 28, 2010.


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