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The Muni Bond Myth
Have I seen This movie before? Two years ago, analysts were predicting default rates as high as 17% for Junk bonds in the wake of the financial meltdown, taking yields on individual issues up to 25%. Liquidity in the market vaporized, and huge volumes of unsold paper overhung the market. To me, this was an engraved invitation to come in and buy the junk bond ETF (JNK) at $18. Since then, the despised ETF has risen to $40, and with the hefty interest income, the total return has been over 160%. What was the actually realized default rate? It came in at less than 0.50%.
Fast forward three years to today (has it been that long?). Bank research analyst Meredith Whitney is predicting that the dire straits of state and local finances will trigger a collapse of the municipal bond market that will resemble the Sack of Rome. She believes that total defaults could reach $100 billion. Since September, the main muni bond ETF (MUB) has plunged from $106 to $97.
I don’t buy it for a second. States are looking at debt to GDP ratios of 4% compared to nearly 100% for the federal government, which still maintains its triple “A” rating. They are miles away from the 130% of GDP that triggered defaults and emergency refinancing’s by Greece, Portugal, and Ireland.
The default risk of muni paper is being vastly exaggerated. I have looked into several California issues and found them at the absolute top of the seniority scale in the state’s obligations. Teachers will starve, police and firemen will go on strike, and there will be rioting in the streets before a single interest payment is missed to bond holders.
How many municipal defaults have we actually seen in the last 20 years? There have only been two that I know of. The nearby City of Vallejo, where policemen earn $140,000 a year, is one of the worst run organizations on the planet. And Orange County got its knickers in a twist betting their entire treasury on a complex derivatives strategy that they clearly didn’t understand sold by, guess who, Goldman Sacks. To find municipal defaults in any real numbers you have to go back 80 years to the Great Depression.
My guess is that we will see a rise in muni bond defaults. But it will be from two to only 20, not the hundreds that Whitney is forecasting. The market is currently pricing in the triple digit number.
Let me preface my call here that I don’t know anything about the muni bond market. It has long been a boring, quiet backwater of the debt markets. At Morgan Stanley, this is where you sent the new recruit with the “C” average from a second tier school who you had to hire because his dad was a major client. I have spent most of my life working with major offshore institutions and foreign governments for whom the tax advantages of owning munis have no value.
However, I do know how to use a calculator. Decent quality muni bonds now carry 8% yields. If you buy bonds from you local issuer, you can duck the city, state, and federal tax due on equivalent grade corporate paper. That gives you a pre tax yield of 16%, almost as high as the peak we saw in the junk market in 2008. While the market has gotten a little thin, prices from here are going to get huge support from these coupons.
Since the tax advantages of these arcane instruments are highly local, sometimes depending on what neighborhood you live in, I suggest talking to a financial adviser to obtain some tailor made recommendations. There is no trade for me here. I just get irritated when conflicted analysts give bad advice to my readers and laugh all the way to the bank. Thought you should know.
There is one additional instructive thing that is going on in the muni market. The mayhem that we are seeing is but a preview to the real violence that we will see when the US Treasury bond market starts to collapse, possible in a few months. That I can trade, through the leverage short ETF (TBT). This is the real lesson of what is going on in muni land.
To see the data, charts, and graphs that support this research piece, as well as more iconoclastic and out-of-consensus analysis, please visit me at www.madhedgefundtrader.com . There, you will find the conventional wisdom mercilessly flailed and tortured daily, and my last two years of research reports available for free. You can also listen to me on Hedge Fund Radio by clicking on “This Week on Hedge Fund Radio” in the upper right corner of my home page.
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i have a calculator, too. it's right on my Start button. but i don't know how to use it. that's the problem with being a procrastinator: one never gets started.
if i knew how to use it, i, too, would be able to successfully predict the future.
i know! split infinitive. bfd.
my approach would be as follows:
first let's factor in the hemlines: upskie! bull market!
then, let's factor in the necklines: plunging! bull market!
finally, let's see if that pierced navel is gonna be the centerpiece of the bare midriff look for 2011: YES!!! now we have a raging bull!
how CAN this BE? negative interest rates, forever? free money, non interruptus?
hell no! we won't go! there. even a luddite with a slip stick would know this is bad for whatchamacallit---fixed, uh, in...in...income, right? i think so...but i'm usually wrong, as we know...
global warming, BiCHeZ! do the SCIENCE!
it's gonna be so fuking HOT this year that even moronic whipsocks, like you, who have come this far (dear reader), are a mortal lock to get some lipstick on yer dipstick.
City of Bell CA, population 34000, percapita average income $24,000 percapita average family size 7, bond debt, over $170,000,000.00
We are at an historically unique moment. We have spent generations allowing local politicians to rack up debt to mollify public unions, and fund pet projects (they are often invested in). The result is unsustainable debt as far as the eye can see. Of course, Wall St. played a role in 'convincing' near amateur muni officials into borrowing up to their eyeballs, then borrowing a bunch more. Wall St. believed its own hype that these guys were good for any amount of debt because they could just 'tax' their way out of it.
Now some of this debt requires immediate interest service, which is very visible and can crush cash flow if the rate is variable. There is also the 'unfunded liabilities', which don't charge interest and can sit there for decades before finally crushing everything.
The real issue is that it is illegal for municipalities (etc) to default on pension and health care obligations .... unless they default on everything. This is the risk, that the only way out for these guys is to declare general bankruptcy solely for the purpose of renegotiating union contracts, pension benefits, as well as giving bond holders haircuts etc etc. So as you look at individual bonds, they would appear to be well within the entity's ability to pay, however, legally they are balled up with much less transparent obligations.
Details of union contracts are not in the prospectus for a sewer bond. Although, many sewer bonds are revenue bonds and theoretically will treated separately, a judge may not agree. If the sewer system is an asset of the town, then it could go into the bankruptcy pot too. This might be a good reason for towns to privatize important infrastructure to keep it out of the BK settlement.
Right now, EVERYONE is just waiting and hoping The Bernank can inflate our way out of this gigantic mess, munis being only one small part of an overall orgy of debt. If the inflation works, wages will go up (even if the economy doesn't), taxes revenues will go up, but obligations will stay fixed (unless there are inflation adjustments in the pension benefits ... oops).
Are you sure you can pick winners and losers in this fiasco? And if you do pick a winner, you're only getting a few percent, and you took on enormous 'information risk' guessing which guys will make good on which bonds.
Like so many of these issues, by itself this is a solvable problem, but given eveything else that's going on, we have systemic failure and can't just 'solve' this one shortfall.
Munis are tied to growth and revenue. Where's the growth? Where's the revenue? Government jobs and Federal subsidies like unemployment insurance and food stamps are the only thing keeping this house of illusions from vanishing. Counties and cities overspent, expecting growth ad infinitim. Each will be worse than the preceding one for a very long time.
Well, I don't think the word you want is "plunged".
No MHFT, you havn't seen this one before.
Municipalities need to and will be GM'd in order to renegotiate benefits.
How that plays out is up is still up in the air (if unions will negotiate benefits down, so much the better. In the recent example of the Camden NJ Police Dept and Union, this does not seem to have sunk in yet).
The probability of high default rates is not certain, but neither is it negligible.
State debt to GDP is only 4%? That's a great analogy. Because US States can impose 40% income taxes, 20% capital gains taxes, 30% corporate taxes, 20% VAT, gasoline taxes and the rest of the stuff European Countries like Greece can!
**ROLLS EYES**
MHFT are you fucking retarded? Stick to your line of not knowing much about Munis!
When Meredith Whitney made her prediction about bank collapses she was met with the same type of brush-off bravado by the old boys club. In the end...she became a legend and those that brushed her off became...CNBC guest commentators or went into "early retirement"..
+10
Support this.
Meredith on 60-Mins "Day of Reckoning" for the 02/02 crowd:
http://www.youtube.com/watch?v=nP3b0_fnPxQ
~Misstrial
The banks benefit as usual from the shortfall as anybody that does business with the states waits to get paid. Being forced to utilizes loans,lines of credit, and selling of assets to survive until they get paid.
I agree with the bottom line (but not necessarily everything in-between) since Munis will be bailed-out by the States which are ultimately financed by Benny and the Ink-Jets at the FED. The money supply expansion for bail-outs in the 30’s was limited to/by gold confiscation and dollar re-valuation. Not so today.
>> the main muni bond ETF (MUB) has plunged from $106 to $97.
That is a plunge?
Lol. ETF (MUB) is now at $98.83. Where is the "plunge" ?
All this boils down to the practical ability of states to increase taxes.
Ultimately the prediction of "trivial number of defaults" rests on the assumption of a normal cyclical recovery. Absent a normal cyclical recovery the states and municipalities must either raise taxes or cut jobs and services. The oft cited 4% debt to gdp factoid is completely irrelevant in an environment where states must, under their own constitutions, balance their budgets. Interest on debt is part of the budget that must be balanced, so if states take their indebtedness higher, it means less revenue for jobs and services absent that blistering cyclical recovery.
A sub par recovery is all that is needed to trigger continuing defaults or layoffs.
But then perhaps the Chaircreature can inflate the municipal debt away, but then that won't be so great for those who are now lusting after those 8% coupons.
I love all the magical thinking that is now surfacing to justify ever higher prices for ever more asset classes.
I was going to wait till mid April to begin shorting, but I might have to keep my finger on the trigger now that visions of Santa Claus are dancing in most investors heads.
This guy is amazing! He states that there is low risk but high yields on munis. Everyone else in the world is stupid by requiring high yields to offset the low high risks. Sometimes I worry about the intelligence of analysts.
where are high yields, states paying 3.5% for a 10 year bond?? i'll take that borrowing cost, taken into the fact they are tax free makes the yield look much better, but that is still cheap borrowing costs.
we have one month under our belt, how many defaults?? Anyone, anyone? Should have 4 to 8 according to Whitney. or are we not into the crisis enough??
We will not bail out muni bonds, but if the fed sends a bunch of money to the states and it frees up state money for bond payments then it is a backdoor bailout to fool the anti bail out tea party crowd.
meredith, bitches!
I would fuck her for sure. I like smart blonde bitchez.
After she called the bottom falling out, I guess she's had less time to exercise/eat correctly... if she'd knock off about 15 lbs, the dominatrix would be unstoppable... that said, +1 on the hit it call... certainly above the bar... and vastly over for real women of finance standards.
Instead of wanting to cuddle afterward, I could see her wanting to do research and talking about financial stuff... but I'm sure the novelty would wear out before too long... kinda like when your wife wants to go duck hunting, so you finally decide to take her on the day, coincidentally, that it's 35 degrees and pelting rain... for some reason, she never asks to go back...
meredith and blythe should go ass-to-ass. Turd!
"Let me preface my call here that I don’t know anything about the muni bond market."
Fly, meet windshield.
How many municipal defaults have we actually seen in the last 20 years? There have only been two that I know of.
Well, I don't really follow the muni market either, but a quick look at the ol' Google service (as my father calls it) turned up a <a href="http://www.publicbonds.org/public_fin/default.htm">Fitch study</a> showing 2,395 muni defaults in the 22 years ending in 2002, so I'm guessing there are a few more than the two you know about.
So, maybe that link is wrong. I dunno. I found another from Moody's with the actual report and I see a bunch more than two <a href="http://docs.google.com/viewer?a=v&q=cache:BeKvEXLr3YcJ:v2.moodys.com/cus...">there </a>as well.
Thanks Dark Space for that first link. Brings back memories of the WPPSS default and the resultant settlement (years later) wherein 'debt speculators' got mightily shafted by the judge's arbitrary creation of different classes of bondholders.
"madhedgefundtrader" vs. Meredith Whitney?
Holy crap, what a contrarian signal. Compare the track records. My money's on Whitney.
I will second that.
so put your money on her, short muni bonds, tell us when you get in. i think she is wrong and is clueless on the muni bond market, pretty good bank analyst though. her stock picking success rate is crap, she isn't even ranked in the top 50%
How about some examples. Wachovia Bank she downgraded in 2008 and it more than doubled after that, then in 2009 was bought out by Wells Fargo for $1 a share. It was around $8 when she made that call.
Wells Fargo downgrade Nov-Dec. 2008 went from a high of 35.25 to a low of $7.80 in March 2009, and everybody knows about Citi.
Her GS upgrades and downgrades have been good too. The only really bad calls I am aware of are COF and Visa.
yeah, my guess is the money will just "appear" via the Fed with no addition announcement of QE.
"Listed debt" is a total BS number. The US, if you include all off-balance sheet items and unfunded liabilities, has a total debt north of $200 Trillion. As for the states, what would we really find if we did a true forensic accounting of liabilities, especially pensions? There have been many revelations of accounting gimmickry to extend and pretend. Sorry, MHFT, your analysis is too shallow.
Let me preface my call here that I don’t know anything about the muni bond market. It has long been a boring, quiet backwater of the debt markets. At Morgan Stanley, this is where you sent the new recruit with the “C” average from a second tier school who you had to hire because his dad was a major client. I have spent most of my life working with major offshore institutions and foreign governments for whom the tax advantages of owning munis have no value.
However, I do know how to use a calculator. Decent quality muni bonds now carry 8% yields. If you buy bonds from you local issuer, you can duck the city, state, and federal tax due on equivalent grade corporate paper. That gives you a pre tax yield of 16%, almost as high as the peak we saw in the junk market in 2008. While the market has gotten a little thin, prices from here are going to get huge support from these coupons.
Ok. So default can't happen, regardless of the underlying financial condition of the municipalities, because interest rates will increase to generate sufficient demand. Got it.
I thought you were going to take the approach that uncle sugar would step in before cities went tits up... but, this approach is so nonsensical it took me by surprise. Kudos.
Seems to me that everyone is reacting as if MHFT is saying that defaults can't or won't happen. I read him to evaluate a risk return tradeoff - effective returns up to 16% or so in return for some risk of default. Do your homework and there may be some worthwhile investments in Munis.
Exactly. He/you/me will still be able to get out of the door when someone shouts fire!
And the 16% is only reverse-calculated gross. Not to say 8% net is ugly, but the tail risk is considerable.
And in real terms 8% just covers The Benank's dollar devaluation rate.
All I can say is that if you believe you can accurately predict risk in the current financial environment then you had better be not only an insider, but someone with a place holder in the liferaft. If these concepts do not apply to you, then you're the mark. No one is saying you will not stand to make gains... you do stand to gain... the problem is that you have no viable way to quantify your risk... best of luck.
My guess is that we will see a rise in muni bond defaults. But it will be from two to only 20, not the hundreds that Whitney is forecasting. The market is currently pricing in the triple digit number.
Is this what you were referring to? He has made a call as to the number of defaults. Not sure about timeframe, but I suppose he's right until he's wrong given the nature of his call... but, what everyone is reacting to is that his call is replete of any fundamental understanding of the financial conditions underlying the assets he is telling us to purchase... he has made a historical analysis of the default rate without comparing the historical conditions to the present environment... In short, he is throwing darts and he can do it with someone else's money.
then we get meredith whitney to say gold is dead making that friday 5% washdown be the exact spot to buy cheers!
Let me preface my call here that I don’t know anything about the muni bond market. It has long been a boring, quiet backwater of the debt markets.
Right, and public sector employees, who are driven by their nature to create more public sector employees, have been seriously taking advantage of that - especially in the last 15 years or so. Now they have taxpayers over a barrel and will slowly strip them bare because everyone was bored and not paying attention.
MHFT is right, there won't be mass muni defaults (although there should be). But there won't be fireman and teachers rioting in the streets either (I think the SEIU has people for that). Municipal governments, backed ultimately by the federal government will simply, flat-out start confiscating private property before they miss enough coupon payments worth raising eyebrows over.
Get a government job. That will be the last shoe to drop.
Oh, yeah. And here was the clincher for me:
Uh-huh. I'll get right on that.
all that fuzzz....
why can't we just give them the money and let them keep it?
...
Did I ever said you look like that cat I once found?
http://farm4.static.flickr.com/3251/2370322288_71895465a6_o.jpg
That's one ugly possum... er, cat.
We coons don't even mess with them. If you think a coon can get nasty, don't cross a possum. We call 'em Arkansas road kill because they really are stupid.
when the cefs were down 4% a couple fris back i was shopping and dropping now ive moved on to to see how little true value there is in gold since all the dictators on the run seem to prefer it maybe we need to squash the price down till its all flushed out eh
Thank you, madhedgefundtrader. I defended munis as an investment class on this board and was junked to death. Some folks here have their heads buried so deep in the sand that they could see China.
The unfortunate circumstances present in Vallejo, California DO NOT portend a broad muni bond crisis of biblical proportions.
hello dude.
raise taxes 5% in my town, and the town will own 1/3 of the houses within the year.
raise state taxes 5%, and we will see a tax migration of probably everyone under thirty five to the state next door....no personal income tax.
so....you should count every bond in my state as "problematic".
"raise taxes 5% in my town, and the town will own 1/3 of the houses within the year."
Illinois did that, and some. We'll soon see if this prediction is true. History supports this claim, as any state that raised taxes (MD and NJ, for example) found less revenue in the coffers the next year.
http://www.nytimes.com/2011/01/13/us/13illinois.html
Dude,
What town and what state are you talking about? Fantasyland, USA?
I suppose your neighboring state has jobs waiting for all those folks under the age of 35 years when they migrate in protest over a tax hike?
I don't care what state you live in. Every bond in your state is not problematic. Your generalizations are absurd.
It is true that some munis, like tax anticipation bonds, are more secure than others. They also pay very little. But most of the states in real trouble are in cold weather areas, where many of the most affluent citizens already own homes or have other ties to low tax warm weather states. So the citizens who can painlessly establish residence in Florida, etc, are precisely those who are paying most of the taxes. The poor will stay put, hardly helpful. And if you or madman think that politicians or union employees will starve to make bond payments, you are extremely deluded, since unions and public employees own the govt.
Bonded Muni, like a roman slave, dragged to Rome where the FED is, begging for a handout, like a pardon, to a harlot hardened. Pray for Mary Magdalene, whose forwarding agent is Meredith Whitney, much maligned brave woman...Keep your chin up MW!
Alas, the oversimplifications, non-sequitors, context-dropping, and factoid citations are typical of what passes for thinking today.
Forget aggregates like debt/GDP. Look at the reality on the ground. For example, I know of one bullshit little town not far from where I live. Population during the boom was maybe 15,000 people. Many have walked away from the underwater homes to live closer to the city and the jobs. The town levered up to buy and build tons of things. I think they took on a debt of well over $100M. A declining population of perhaps 12,000 people with declining home values and declining incomes is going to pay the debt service on this? I don't care what the ratio of debt to the "town's GDP" is, they can't have that GDP. It isn't theirs, and long before they could take it people would refuse to pay, vote the bums out, file lawsuits, and move out of town.
Yes, it doesn't matter what any of these ratios are, the State of ILLinois and many municipalities simply do not have the money, and can't get the money, to pay their obligations in the next 10 years, absent hyperinflation.