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Meredith Whitney was on CNBC yesterday discussing “The Tragedy of the Commons,” her new 600-page report on the financial condition of the 15 largest states. She described municipal finance as the next banking crisis, and drew a parallel in pointing out the complacency of investors, issuers and rating agencies in today’s municipal market with the participants in mortgage backed securities leading up to 2007-08.

There is no doubt that state and local finances have been run irresponsibly. To pick just one example that’s close to home, last month, Federal regulators accused New Jersey of securities fraud, claiming that the state had been properly funding public workers' pensions, when in fact it had not. The state had issued municipal bonds, while misrepresenting the underfunded status of its pension liability. As often happens, the case was settled with the state accepting the SEC’s findings and neither admitting or denying the charges – it’s a mystery to me why no one was criminally charged, but that is the sad lot of a New Jersey taxpayer today.

To find examples of the investor complacency to which Ms. Whitney refers, one need go no further than Nuveen Municipal Value (NYSE:NUV), a closed end fund that currently pays a dividend yield of 4.6%. NUV uses no leverage to achieve this return, and does not supplement its distribution with return of capital like some other closed end funds do. In other words, the municipal bonds that NUV holds are generating current income of around 4.6% (after covering Nuveen’s expense ratio of around 0.64%, the portfolio yield is approximately 5.2%).

Morningstar breaks down its portfolio by state. Four of NUV’s top five credits are also among those Ms. Whitney rates the worst (Texas has run its affairs quite differently). Issues include the Tobacco Settlement Financing Corporation, Golden State TOB (tender option bonds) and the New Jersey Economic Development Authority (for my part I have quite enough exposure to New Jersey by being a taxpayer). Fascinatingly, 90% of this portfolio which yields 5.2% is rated investment grade. What could possibly be wrong with high grade, tax-exempt debt yielding above 5%?

NUV 5 Biggest State Exposures











This is precisely the type of complacency to which Ms. Whitney refers. The yields on these securities have risen above taxable high grade corporate bonds, generating a substantial after tax yield advantage. This may be a free lunch; alternatively, it may reflect the developing risk that not every municipal bond will be money good to its owner.

The rating agencies evidently see nothing to be concerned about; nor do municipal bond investors who, in their eagerness to escape the tyranny of today’s confiscatory interest rates have bid up the price of NUV to a premium over its NAV.

In a bond market that is witnessing mutual fund flows greater than those into equity funds in 2000 (according to Morgan Stanley), in a sector with apparently widely complacent participants sits NUV, $2 billion in market cap trading at a $60 million premium to the value of its assets. Sometimes it’s better to be a spectator than a participant.

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Disclosure: No positions