By Kerri Shannon
Wall Street analyst Meredith Whitney triggered panic in many municipal bond holders when she declared last year that municipal bond defaults -- possibly 50 to 100 -- were on the horizon, due to the debt-laden condition of state and local government budgets.
Although some financial analysts have criticized Whitney for muni-bond warnings they say are overblown, she's not the only one predicting municipal bond market trouble. JPMorgan Chase & Co (JPM) Chief Executive Officer Jamie Dimon said last month he expected more defaults this year, and Money Morning Contributing Editor Shah Gilani said Whitney is not crying wolf, as others have claimed.
"Make no mistake: The so-called ‘deadbeat states' problem is real, and muni-bond defaults are almost certainly unavoidable," said Gilani.
Gilani supported Whitney's argument in an appearance on CNBC's The Kudlow Report, and his take on the muni-bond default threat prompted a broad range of Money Morning reader comments. But others still wondered if the threat of so many muni-bond defaults was just a hyped-up overreaction to state and local government budget trouble. Gilani addressed the following reader comment sent in by a muni-bond analyst who doubts a slew of defaults are the real deal.
Question: I don't want to offend anyone here, but it's clear from [reader] comments that everyone has gotten their info from headlines and Ms. Whitney's inflammatory rhetoric. Let me ask everyone: Did you know that since the Great Depression, less than 1% of all municipal bonds default in any given year? Do you know that for Whitney's prediction to come true, we would have to have a recession greater than the 1930s? That the deficits occurring now have occurred in every recession since 1975? (That's when I started as a muni-bond analyst.) Do you know that the percentage of unfunded pension liabilities today is almost exactly the same as it was in 1994? -- Richard L.
Gilani's reply: While it's great that you can cite these statistics out of the historical record, it's always dangerous for investors to drive while only looking at the rearview mirror.
With regard to less than 1% of muni bonds defaulting in any given year since the Great Depression, that's likely of little comfort to holders of any of the defaulted bonds. Let's just ask the holders of "Whoops" (a nickname for the Washington Public Power Supply System's $2.25 billion municipal bond default, the largest in U.S. history. WPPSS in the 1970s sold public bonds to finance construction of five nuclear power plants, but poorly managed project management, altered safety regulations and decreased support for nuclear power led the WPPSS project cost to jump to $23.8 billion from $4.1 billion. Investors settled in 1988, receiving only between 10 and 40 cents per dollar invested).
Although 1% historically sounds very small, did you know that since the Great Depression only one money center bank has ever failed in this country, that being Continental Illinois National Bank? At least that was until two of the world's largest investment banks went under (Bear Stearns Cos. Inc. and Lehman Brothers Holdings Inc.), then two others (Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS)) had to become bank holding companies to be saved by the U.S. Federal Reserve, and a fifth (Merrill Lynch (MER)) was taken over by Bank of America Corp. (BAC), which had to be rescued along with the then-largest bank in the United States, Citigroup Inc. (C). Things can and do happen faster now to bigger and more integrated institutions than in the "good old days."
Yes, deficits have occurred before, but nothing like the absolute numbers now. "Back then" tax revenues were more stable because companies didn't have the ability to move out of any state on a day's notice, or ship off jobs and manufacturing (revenue producers) offshore or off-line altogether because of technological innovation. I'm not sure how you're measuring deficits, but on an absolute basis they are gargantuan. And as a percent of gross domestic product, at the municipal, state and federal level, it's unprecedented that they are all where they are concomitantly.
In 1994, we weren't in the middle of the worst housing crisis in this nation's history, very possibly in the history of the modern world. Commercial real estate wasn't as bad off as it is today. Leverage was nothing like it became. And unemployment (which should be pointed out is now a "structural" condition) wasn't hovering in the 9-17% neighborhood (depending on whether you're talking headline unemployment or the more honest U.S. Labor Department U-6 number). All these factors will certainly reduce tax revenue.
Furthermore, the federal deficit and national debt weren't the burden that they've become, which means the federal government won't be the source of funds for state and local governments that it has traditionally been.
It's not that we want Whitney to be right. It's just that we think that an ounce of prevention may well be worth a pound of worthless muni paper.