Is the Muni Bond Market Really in Dire Straits?
Some argue that the municipal bond market's recent upheaval is the fault of a single 60 Minutes segment.
It took just a minute of 60 Minutes to set the municipal bond market on edge. Days before Christmas last year, Meredith Whitney, a Wall Street analyst, told 60 Minutes correspondent Steve Kroft that the fiscal state of states and localities is "the largest threat to the U.S. economy," and that there was no doubt in her mind "that you will see a spate of muni bond defaults." Asked to put a number on said spate, Whitney pegged her prediction at "50 to 100 sizeable defaults" amounting "to hundreds of billions of dollars' worth of defaults."
After generations of being tagged as the sleepy, plain-vanilla backwater of the capital markets, the municipal bond market and its issuers, investors and underwriters were now center stage and at "headline risk." Investors began fleeing the market -- $38.7 billion of outflows in the past three months. Issuers were saddled with higher costs to issue bonds -- interest rates on the highest-rated municipal bonds are up by more than one-third since late August. Issuers also were struggling to borrow money from the market. The number of new offerings from state and local governments is down to a level not seen in 11 years.
It's no wonder the bond market is spooked. But is the situation as dire as Whitney and others suggest? It's taken a while, but a group of analysts, underwriters and economists are stepping up to suggest that the market and its issuers may have their troubles but the problems are not insurmountable.
One of those with a less-volatile view of state and local finances is Mike Nicholas, chief executive officer of the Bond Dealers of America (BDA). I talked to him recently about the market's instability, how it affects issuers and what he sees for the near future. An edited version of our conversation follows:
How do you counter Meredith Whitney's argument that bankruptcies and muni-bond delinquencies are imminent and will be widespread?
Historically, the default rate for governmental debt is negligible. The average 10-year cumulative default rate from 1970 to 2009 for investment-grade municipal debt was only .09 percent, with only 54 defaults on rated credits and just three general obligation defaults. In the last four years and during the height of the recession, only 7 municipal governments filed for bankruptcy, yet all bondholders were paid in full. By comparison, AAA corporate credits were three times more likely to default than BBB municipal credits. Further, municipal debt service is only about 3 to 5 percent of state and local budgets.
When some folks talk about problems in the muni market and the probabilities of multiple defaults in the hundreds of billions of dollars, they are not focused on state GOs [general obligation bonds] and rated revenue bonds. It's the unrated bonds -- the nursing home bonds -- that would experience turmoil. So even though things are tough economically, we don't see a big change there. And even if a locality declares bankruptcy, that doesn't mean it will default on its bonds. Vallejo hasn't defaulted.
Nonetheless, there has been an enormous outflow of funds from the muni market. What does that mean for issuers?
The cause of the outflows is a combination of Meredith Whitney's very public comments and the fact that more attention is now being paid to fiscal conditions in state and local government. There was a story a few days ago about how state governments overestimated their revenue intake for 2009 and 2010: 70 percent overestimated revenue by at least 5 percent. People also are concerned about what's going on in Wisconsin and how pension and state-employment situations may impact state refinancing or issuing new debt. So a lot of things are coming together at the same time to impact the market.
The outflows have had a direct effect on issuers. They drive up rates. There's a fixed amount of demand in the muni market. When investors started selling, the market was flooded with supply. Rates shot up and that prevented issuers from being able to refinance and discouraged them from coming to market with new issues.
Our sense is that outflows have slowed down. What we see now are buying opportunities because the underlying credits are very good. The outflows have been based on headline risk. The market has been beaten down irrationally. In terms of price, the bonds are more attractive than before Meredith Whitney went on 60 Minutes.
The Securities and Exchange Commission is talking about improving transparency -- disclosure of information by states and localities. Will improvements there help stabilize the market?
Disclosure has been an issue for years and years and years. As an organization, BDA is certainly in favor of greater disclosure. The issue always has been that disclosure and regulation of disclosure have been on the shoulders of broker-dealers because the Tower Amendment prohibits the SEC and the MSRB [Municipal Securities Regulating Board] from regulating state and local issuers.
We had a meeting a week ago at the SEC with Commissioner [Elisse B.] Walter, who has been very vocal on disclosure, and she drew a lot of attention to the fact that she thinks the Tower Amendment should be looked at for possible repeal. I can't speak for the SEC, of course, but I can tell you that the feeling we get from meetings with the SEC is that there are other ways to go about improving disclosure without touching Tower. We can still finds ways to improve disclosure. One example: Maybe we don't need to wait for audited financials, maybe unaudited financials should be posted in lieu of audited financials to give investors some kind of snapshot of what's going on. Issuer groups along with investment groups are working on this to find market-based solutions to muni market disclosure.
What's your forecast for the market in the near future?
We represent middle-market dealers working with issuers all over the country, from Wisconsin to Florida to Texas. From our perspective, the market is healthy and artificially beaten down. We think there is going to be a resurgence in the muni market in 2011 when investors realize the underlying value and credit is good and that massive defaults are very unlikely.