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Far from the madding crowd

Bond Girl

The biggest problem with the muni market these days is that it has become the unlikely host of various opportunists: an opportunistic analyst (Meredith Whitney); opportunistic reporters (like the New York Times‘ Mary Williams Walsh); and opportunistic political figures (like Senator John Cornyn and Newt Gingrich). All of these individuals seem to regard hyping credit risk in the muni market as a means of achieving some degree of popularity. To the extent that their fear-mongering has contributed to funds hemorrhaging and irrationally higher market interest rates in recent weeks, the personal ambitions of these individuals are coming at an unnecessary cost to investors and taxpayers. I think most people would be outraged by this situation if they had a technical appreciation of the muni market; unfortunately, most people are only familiar with the caricature of the muni market and muni issuers that these people peddle.

I am sure that everyone has read about the massive outflows from muni mutual funds recently. Per the Bond Buyer:

Investors established a new record for withdrawals from municipal bond mutual funds last week as headline risk continued to chase people from state and local government debt funds.

Municipal bond mutual funds that report their figures weekly posted an outflow of $4 billion during the week ended Jan. 19, according to Lipper FMI. That new mark beats the old record of $3.1 billion, set the week ended Nov. 17, by 29%.

Much of the hot money that flooded the $470.6 billion municipal bond mutual fund industry the past two years has escaped in the past two months.

A steady drumbeat of fear-mongering news stories about potential municipal insolvencies has clearly had a real impact on demand.

“The retail investor is just getting the impression that the entire municipal market is in trouble and all municipals are going to default,” said Ron Schwatrz, who manages the $1.14 billion Investment Grade Tax-Exempt Bond fund for RidgeWorth Investments. “They’re a little bit concerned obviously, and they’re selling the mutual funds and redeeming quite a bit throughout the municipal market.”

Spooked investors have reacted by withdrawing money from muni funds at an unprecedented clip that has broken nearly every important record the past two months.

Mutual funds have now reported $29.3 billion of redemptions in the past 10 weeks. That’s 65% more than the previous record for outflows in a 10-week period of $11.5 billion established in 2000.

It would be useful to make two observations here. First, as far as retail investors are concerned, this phenomenon has been unique to dumb money; private wealth has mostly left its investments in place, and some managers have become increasingly vocal about the opportunity this situation presents. This and light supply has helped the market continue to function properly. Second, although headline risk is undeniably a factor, we are also in an economic recovery, so one can expect investors to shift the weight of their portfolios toward equities. That is a factor that extends beyond muni bonds.

Many people have attributed fund outflows to Whitney’s remarks last September (which she reiterated in a 60 Minutes segment and elsewhere) that there would be 50 to 100 “sizeable” muni defaults, totaling hundreds of billions of dollars, within the next 12 months. Her prediction assumed an air of legitimacy as it was recycled almost daily by the mainstream media, despite having been immediately and unanimously disputed by muni market professionals – who noted, among other things, that the 100 largest county and city issuers do not in aggregate have $100 billion of debt outstanding. (Whitney has yet to reconcile her numbers.) How would the public reaction to Whitney’s remarks have been different if reporters had published balanced articles from the beginning that included such observations?

In fact, the mainstream media has irresponsibly implied that Whitney’s numbers could be credible by endlessly repeating phrases such as the “$2.8 trillion municipal bond market” without the qualification that the “$2.8 trillion municipal bond market” is mostly comprised of borrowers that are not captured by Whitney’s default prediction, such as state borrowers; hundreds of billions of dollars of corporate and nonprofit debt issued by governments on behalf of third-parties on a conduit basis / as private activity bonds; and special revenue bonds issued by public entities like utilities that are financially and legally isolated from governments’ budget issues.

To give credit where credit is due, the folks at CNBC have made a noble effort to get Whitney to flesh out her arguments and have allotted considerable airtime to investment managers and others offering fact-based counterpoints. I think one of the reasons her critics’ positions have gained some currency in the financial media is that her interviews betray a lack of basic competency to anyone who is intellectually comfortable with the microstructure of the muni market.

When asked to defend her default figures, Whitney invariably attacks her critics (they are brokers in the business or investment managers just talking their book, even when they are not – apparently, Whitney does not believe that charging upwards of $100,000 in advisory fees for her “research” gives her a pecuniary dog in this fight) or launches into some bizarre autobiographical tantrum about how hard she has worked studying this issue over the past two years. She does not put her default figures into the context of the overall market or discuss specific kinds of issuers in the kind of detail that one would expect from an analyst. If she honestly believes she has the goods on this topic, why doesn’t she make a bona fide case for it, just like any other market analyst would make?

Toward the end of this CNBC interview, Whitney seems to confuse traditional debt restructurings (a phrase muni underwriters commonly use in discussing certain kinds refundings – e.g., refundings where the issuer is replacing existing debt with debt that has a different structure of serial maturities, in such a way that it produces a cash flow savings as opposed to a net present value savings) with a debt restructuring that effectively changes the terms of a bond issue (which are in fact akin to default and often restricted by state law, as I have discussed at length in previous posts). She then laments that the rating agencies are not counting muni debt restructurings as defaults. Any experienced muni market participant would know that when the phrase “debt restructuring” is used in this context, it is referring to shifting the maturity structure within an issuer’s portfolio of outstanding debt. In this context, “restructuring” is being used as a portfolio management term. From a credit perspective, the main difference between these two situations is that one can produce an economic loss for the issuer (due to increased interest costs over time) and one produces an economic loss for the investor (due to not getting paid according to the original terms of the contract). That is kind of a significant distinction when one is discussing default.

It is, in fact, not uncommon for muni issuers to refund debt for reasons other than to reduce interest costs. Other examples would include restructurings to comply with specific rating agency guidelines or to reorganize existing debt under a new trust indenture. This is just a matter of weighing the benefits of the transaction from a portfolio management or policy standpoint against projected transaction costs.

I would say (quite conservatively) that most of the municipalities that have engaged in this kind of transaction are not even remotely close to a monetary default. Whitney is also factually incorrect in suggesting that refundings undertaken specifically to produce a cash flow savings have been ignored by the rating agencies. The rating agencies routinely explain their rationale on this matter in their ratings reports. They treat such refundings not as defaults, but as non-recurring sources of revenue, which is exactly what they are, and have actually downgraded some issuers that have engaged in such transactions. From a credit perspective, the use of any non-recurring source of revenue is relevant and should be considered relative to the size of the issuer’s overall budget. (Examples of other non-recurring sources of revenue would be things such as leaseback transactions or expiring federal funds.) Non-recurring sources of revenue are not negative things in and of themselves; it is just a matter of whether they are used excessively to offset recurring expenditures and thus perpetuate or contribute to a structurally imbalanced budget.

One also has to recognize that there are inherent limitations, unrelated to market events and fiscal pressures, to an issuer’s ability to engage in such refundings, because the issuer’s ability to refund its debt at all hinges upon the callability of their bonds and very strict provisions within the federal tax code that would risk changing the tax status of the bonds if not observed. In short, this would not be perceived as a systemic credit concern by anyone that actually understands what is going on and has worked with public finance through previous economic downturns. [Wow that was a long tangent… Sorry.]

My point here is not to harp on Whitney for making the novice mistake of misappropriating market vocabulary, which while embarrassing is still harmless. My point here is that Whitney does not have enough experience working with this specific market even to identify what exactly constitutes a default, and yet mainstream reporters, policymakers, and dumb money still take her opinions about muni defaults seriously. Why is this, exactly? Well, even though Whitney may not possess the competence to make her case effectively to large investors (many of whom have publicly disagreed with her assessment of the market), she is fluent in the language of populists – blaming the rating agencies (although the rating agencies have a fairly good record for gauging default in this particular space – even during the financial crisis / economic downturn, and mostly because until just recently, they had inexplicably imposed a stricter scale on muni issuers than other kinds of borrowers) and lashing out broadly at government spending and workers’ benefits (although that is largely conflating debt management with public policy in general and is an incredibly crude way of characterizing muni credit risk for a trained credit analyst).

It is a shortcoming of financial regulation, in my opinion, that such a situation can come to pass – that a financial advisory firm like Whitney’s shop can make outrageous and unsubstantiated claims, that are demonstrably destructive to the market and cause financial harm to the small investors regulators purportedly protect, without her being held accountable at all. Alas, the only discipline for a bad call is time. I look forward to Whitney’s explanation in roughly eight months as to why she provoked so many people to dump money-good bonds for no real reason.

The natural terminus of market hysteria is of course absurd and counterproductive public policy, which in this instance, has surfaced in the form of Senator John Cornyn’s idea that states need a federal bankruptcy mechanism. (For background on existing municipal bankruptcy law, see my posts, Default and Bankruptcy in the Municipal Bond Market, Part One and Part Two.)

Although many people (including some astute commenters on this blog) assumed something like this was in the works because the idea had already been tossed around in partisan rags, the idea more or less made its public debut in Walsh’s NYT article, A Path is Sought for States to Escape Their Debt Burdens. The article is typical of Walsh’s recent fare in its bias and backhanded sensationalism. (In her last article on public finance, Walsh played up market analysts’ fears of muni credit risks without quoting a single muni market analyst, probably because it would have been impossible for her to locate one that agreed with her conclusions.)

Walsh does two interesting things to distort the issue of possible state bankruptcy legislation. First, Walsh does not quote a single state official about whether the legislation is even necessary or desired, which anyone familiar with public bankruptcy or the 10th Amendment of the US Constitution would realize is the crux of this entire issue. States are sovereign entities, and the federal government cannot impose its will on how states collect revenues or conduct their affairs. If state officials do not want this legislation, this debate is an exercise in futility. (Of course, Walsh’s work would not have landed her on the front page if she had effectively communicated that such legislation is moot. Ethics, schmethics.)

If you actually want to know where this issue stands, practically speaking, read this Bond Buyer article:

State officials on Friday angrily denounced reports that senators may be quietly developing a proposal to allow states facing fiscal crisis to seek protection in federal bankruptcy court so that a judge could alter their obligations, including outstanding debt levels.

The officials warned that giving credibility to the idea of state bankruptcy will harm the municipal market, particularly in the current environment of alarmist headlines about munis.

Passage of such a law, even if it authorized a restructuring less extreme than bankruptcy, would trigger fears of a pending wave of filings and lead to higher yields, many issuer and market participants said.

“To the folks in Congress cooking this baloney: Don’t bother,” said California Treasurer Bill Lockyer in a release. “States didn’t ask for it. We don’t want it. We don’t need it.”

Second, while Walsh seems to have consulted James Spiotto (Chapman & Cutler) – who is far and away the nation’s foremost authority on Chapter 9 bankruptcy and has opined that state bankruptcy legislation would only have a considerable net negative effect on the muni market – most of the background she supplies on the concept comes from David Skeel, a law professor at the University of Pennsylvania. Many of the arguments that Skeel has made regarding public bankruptcies absolutely fly in the face of the advice that any attorney that specializes in Chapter 9 would give a government that is considering filing: all a bankruptcy filing does is provide a government with breathing room from legal actions so that the municipality can undertake the same exact political negotiations with creditors that would take place outside the bankruptcy process, and the benefits of this flexibility should be weighed against the inevitable loss of access to the credit markets. I think the article also leaves uninitiated readers with the highly mistaken impression that public bankruptcies are similar to corporate bankruptcies with respect to their convenience and possibility for resolution.

I have not seen any argument in support of state bankruptcy legislation that does not essentially boil down to politicians wanting to undermine collective bargaining agreements and pension commitments. (“We’ll tank the markets, but damn it, we will stick it to those unions!” Sounds vaguely like, “We’ll tank the markets, but damn it, we will get our $50 billion in spending cuts!” Seriously, can someone offer an approach to policy that does not involve an idle threat of a government becoming a deadbeat? Is a little maturity too much to ask here?)

Skeel seems to suggest that bankruptcy would be a good way to address labor relations. He writes, “the governor and his state could immediately chop the fat out of its contracts with unionized employees, as can be done in the case of municipal bankruptcies.” Immediately? Vallejo has been in Chapter 9 since May 2008 – before the financial crisis – because its unions have aggressively challenged almost every aspect of the proceedings. That’s for a relatively small municipality – does anyone think things would go smoothly for a large state in comparison? While it is true that collective bargaining agreements are subject to assumption / rejection in bankruptcy, there are hurdles for governments to prove that they have negotiated in good faith on the issue. This gets even funnier when one talks about the complexities of pensions and retiree health care commitments, and how state and local governments overlap in their responsibilities in that domain, both legally and functionally. How long would it take for that to be resolved in court? Whatever one thinks about labor relations generally, this is not a practical way of addressing political stasis and it is not providing state governments with any advantages that they do not already possess. Does anyone really think state officials would want to be locked out of the credit markets for literally years, and provide job security for idiots like Walsh, while these dramas play out in court and precedents are fought for and established?

If Cornyn & Co. have a shred of integrity, they will not impose a crisis on the muni market for legislation that is dead on arrival.


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