Meredith Whitney Doubles Down But There Are No Such Things As Oracles

Includes: MUB
by: Kyle Spencer

Like a Center for the Philadelphia Flyers emerging from the penalty box with two goals down and murder on her mind, Meredith "The Prophet" Whitney is back.

Whitney, if you recall, is the former Oppenheimer & Co. Managing Director who correctly predicted in 2007 that Citigroup (NYSE:C) would be forced to cut its dividend and shed its assets. As a result of her correct call on Citi, Whitney was elevated to the status of a modern-day financial Oracle of Delphi by some Very Serious People on Wall St. Whitney then tried to top her Citi forecast by predicting a rash of municipal defaults. 50 to 100 governments would default in a wave on debt obligations and cause $100 billion or more in damages, Whitney told 60 Minutes. The result was a stampede for the exits. $25 billion dollars was pulled out of the muni bond funds within 2 months of the Whitney's December, 2010 interview.

Not only did the predicted wave of defaults fail to occur, but municipal bonds took off. As of this writing, munis have yielded a 16.6% total return based on their net asset values over the last 12 months, handily outperforming virtually every other asset class. In fact, according to the 3Y (NYSEARCA:MUB) chart below, the worst thing that happened to the municipal bond market after the 2009 crash was Meredith Whitney.

"I never advise my clients on municipal bonds." Whitney told CNBC That was never part of my argument," she said. "It was an aside. It happened to be what '60 Minutes' focused on."

Shame? Non-existent. Attempting to rewrite history? Check!

Okay, maybe Whitney is telling the truth about 60 minutes; but to be fair, her Cassandra-esque prediction of blood in the streets would have been the focus of any nightly news program. Think about it: A feted Wall St. C-level executive and bête noire of financial oracles was predicting a 1,219%+ increase in economic pain over the height of the collapse in mid 2009. What television news producer in their right mind wouldn't focus on that?

Wrong calls have been made left and right since the collapse of Lehman Brothers upended the world financial system, but rarely on such an epic scale. Past performance, it seems, is no guarantor of future performance. Yet, despite the black eye she was dealt by the municipal bond market, Whitney has doubled down on her prediction of a Munipocalypse.

Fast-Forward To Now

In Major League Baseball, a .500 batting average is a Hall Of Fame-worthy achievement; but in financial circles, it's a wash.

Still, it's reasonable to assume that Whitney has at least some supporting data. No one wants to be burned in effigy twice in two years. Maybe she's right this time. After all,

"You haven't seen state and local governments cut to the degree they have. Now you reach a point where it's an inflection point: At what cost am I going to honor my pension obligations?"

Let's take a look for ourselves, shall we?

Exhibit A: State tax revenue is more volatile than the economy

Macroeconomic conditions tend to be magnified at the state level, resulting in increased volatility. Whitney's prediction assumes a double-dip recession is in the cards.

MEREDITH WHITNEY: I see most importantly, and to step back for a second, there's been so much focus on debt at the federal level. But there's no such sense of urgency at debt at the federal level. There's a sense of urgency at the state of the debt at the state level. And that's because 49 states have to balance their budgets every year.

Exhibit B: Property Tax Receipts Are Down

Property tax is the backbone of municipal governments, accounting for nearly three-quarters of total local tax collections. It is the most significant local revenue source for financing K-12 education, police, fire, parks, you name it. For most of the period during and after the last recession, local tax collections remained relatively strong. However, the trends are now shifting due in part to the lagged impact of falling housing prices on property tax collections.

Reliance on the property tax as a revenue source is greater in the Northeast and upper Midwest, and lower in the South and Southwest. In 13 states, fiscal 2009 local property taxes made up over 90 percent of total local taxes, and were highest in Maine at 99 percent. Conversely, such taxes accounted for less than 70 percent in 15 states, with the lowest being Alabama at 41 percent.

MEREDITH WHITNEY: And so, debt at all these variations, at the municipal level, at the state level, impacts everything, impact housing, the price of your home. And so, if you think about states cutting off aid, so the numbers work like this, most recent data is that federal transfers to states account for 35 percent of state revenues. States then transfer 40 percent of municipal revenues down the food chain. What states are doing across the board is cutting off that aid. So, when states are imbalanced, and for the last four years they've run over $400 billion in imbalances, the easiest thing they can do is cut off aid to municipalities.

The significant declines in housing prices caused by the Great Recession had a noticeable impact on local property tax revenues. Recent research suggests that property taxes respond to housing price declines, but often with a lag of three years or more. Overall, local property taxes declined by 0.9 percent in the first quarter of 2012 compared to the same quarter of 2011. After adjusting for

inflation, local property tax collections showed a -2.8 % decline in the first quarter of 2012 compared to the same quarter of 2011, marking the sixth consecutive quarterly decline in real revenues.

Exhibit C: Education Spending Is Down

One important measure for calculating the risk associated with long term fixed investment instruments, such as 20 Y or 30 Y bonds, is to look at the investments the state or local community is making in itself. For example, increased spending on education, all else being equal, will tend to lead to more affluent citizens and ultimately higher property tax revenues. At least 22 states (among those for which we have data) have seen declines in local education positions over the past year, ranging from 0.3 percent to 6.8 percent. The largest reductions appear in Vermont and Oregon at 6.8 and 4.5 percent respectively. Fourteen states added jobs in this sector, with particularly large increases in California and Tennessee. More troubling is that the states are making much deeper cuts to education than they have during previous recessions:

Exhibit D: Public Sector Employment Continues To Decline

Private sector employment has been recovering steadily but slowly over the last two years, while state and local governments have been shedding jobs almost continuously for the last three years. The gap between reductions in private versus public sector employment is narrower if we compare current employment levels to peak levels. As of January 2012, for the nation as a whole, private sector employment is down -4.5 % or 5.2 million jobs from the peak level recorded in January of 2008. By contrast, public sector employment is down -3.4% or 668,000 jobs from the peak level recorded in August of 2008.

The following Table illustrates the change in employment by sector. (November-January moving average)

MEREDITH WHITNEY: So, what this means then is, the service, the debt service at these levels then starts crowding out monies that states would use to reinvest back in their states. And so, you have examples like in Nevada that 50 percent of their budget goes to fixed cost expenses. This isn't debt; this is debt including minimum payments to unfunded pensions, and other post-employment benefits. So, you have an issue in the country whereby certain states are going to look so much less attractive to businesses and to individuals, and certain states are going to look so much more attractive to individuals and businesses. That has an absolute effect on home prices. That has an absolute effect on demographics.

The decline in public-sector employment is significantly sharper during the Great Recession than it was during previous recessions.

MEREDITH WHITNEY: So, you have an issue in the country whereby certain states are going to look so much less attractive to businesses and to individuals, and certain states are going to look so much more attractive to individuals and businesses. That has an absolute effect on home prices. That has an absolute effect on demographics.

Exhibit E: Shaky Demographics

Of course, there are substantial regional variations. The chart below details changes in State revenue by region.

The Great Recession has acerbated long term regional trends in the West, while both the Midwest and the South are undergoing marked demographic re-alignment. Note the change in population composition by region between 1999-2010:

The largest increases occur in the regions with the highest dependence on federal benefits, many of which are about to be cut back.

Here is the % increase to food stamps/SNAP by region:

While the number of people employed has surged over the last decade in the South and the West, increases in population have failed to translate to increases in state revenues. Aside from the political antics in Washington, the most plausible reasons for this anomaly include the prolonged negative employment environment, and an across-the-board decline in home ownership.

So far, all the arguments seem to back Whitney's case. Is there any data to contradict her forecast of a coming state/municipal apocalypse?

Contra Whitney

NINA EASTON: What are we going to see? Are we going to see defaults? Are we going to see spending cut to the bare bones? Are we going to see tax increases? What's coming down the pike in the next year?

MEREDITH WHITNEY: So, there have only been three years in the past decade where states haven't had to remedy imbalanced budgets. So, what has happened has been in order to - and today states, this is on a U.S. basis, spend 2-1/2 times that of their revenues, two-and-a-half times. And for all of you in the audience that is not sustainable. Since 2006, tax revenues, and this is on a national basis, tax revenues, state tax revenues are tracking 2006 levels, but expenses are $270 billion beyond 2006 levels. And there's no relation between your revenues and your expenditures, so there are built-in escalators on expenditures. So, this is a runaway train - a lot of this has to do with pensions and entitlement programs - a runaway train that is simply not sustainable.

I think Meredith Whitney is a brilliant bank analyst. The problem arises when she attempts to port the business philosophy of a bank to municipalities.

What's the difference? For starters, the dominoes don't line up. Pension/legacy problems tend to be restricted to large government states, like California, Texas, New York and Illinois. The states that are under fire from federal cutbacks, on the other hand, are located primarily in the South, Mountain, and Midwest regions, with the Midwest outperforming the nation.

Unlike financial institutions, municipal bankruptcy is rarely an option for financial, legal, and practical reasons. Governments, at every scale, love to spend money. The only way that municipal governments can afford to offer semi-annual coupon payments and an annual rate of interest is because the real value of their tax receipts increases with inflation. When a municipality defaults, it must either go back to its tax base or re-borrow at prohibitive interest. If a municipality has to go back to operating off its tax base alone, it loses that advantage.

Much ado has been made about local government's faulty projections. From 1987 to 2009, the median estimating error (high or low) was 3.5%. In 2009, the median error was a 10.2% overestimate. Fortunately, most of the errors are underestimates. Budget staffs tend to err on the conservative side. During most recent economic expansion, for example, 36% of forecasts were under actual revenue by 5%+.

Despite what you may read in the New York Post, it is by no means a Thunderdome-style battle to the death between pension payments and bond payments. Municipal interest and principal payments are not that stressful. According to S&P, principal and coupon payments accounted for less than 10% of total government spending in all but three states. Historically, the default rate of municipal bonds is about 1%.

Some of the states with the largest government footprint, like New York, also have the best pension liabilities, while some of the states with the worst pension liabilities are selling their municipal bonds at record low rates (New Jersey, Massachusetts), and it becomes evident why the "perfect storm" has failed to materialize, even in the most adverse economic environment in 80 years.

As Barney Frank, speaking as the Ranking member on the House Financial Services Committee, noted in July:

(in the recent bankruptcies) the bondholders are getting paid.


No one is forcing anyone to buy bonds in states facing, say, a rash of factory closures, sky-high unfunded pensions, or a battered real estate market. The primary reason that investors continue to do so is due to the higher yield and local tax free status these instruments offer. In the latter case, investors may want to diversify their bond holdings with out-of-state issues in order to offset the risk. What's important is to be clear about what those risks include (the occasional default), and what they don't (a munipocalypse). The watch-word, as always, is due diligence.

There are no such things as oracles.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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