Contagion And Confidence

by: Douglas Tengdin, CFA

Whatever happened to the muni meltdown?

Four years ago there was mounting hysteria regarding municipal finance. Jefferson County, Alabama; Harrisburg, Pennsylvania; and Stockton, California—places with hundreds of thousands of residents—were in or near bankruptcy. Investors from Warren Buffett to Felix Rohatyn commented on the many problems states and municipalities were facing—especially pension problems—in the aftermath of the Financial Crisis. And they had a point: pensions are what finally brought Detroit down.

In the midst of this discussion, Meredith Whitney—a prominent bank analyst who correctly pointed out significant problems at Citigroup (NYSE:C)—went on national TV and predicted a massive contagion that would result in “hundreds of billions” of municipal defaults within the next 12 months. It was a bold call—or a foolish one. The previous record had been set in 2008 when $8.5 billion went into default.

As if on cue, the municipal market began to sell off. For technical reasons, several prominent mutual funds ticked lower in price. This was enough to spark significant selling by the public. The lower prices prompted more selling. People feared a replay of the Financial Crisis, and wanted to get out with a loss of “only” 10%. Muni funds faced substantial outflows for the next 7 months.

But a funny thing happened on the way to the cataclysm. It dried up. The particularities of the municipal bond market preempted any kind of contagious crisis. The $3.7 trillion muni market consists of tens of thousands of borrowers from dozens of sectors who issue secured, senior, and junior debt backed by various kinds of collateral. Most issuers are fine credits, whose debt is self-amortizing and for whom debt service represents a small portion of the budget. To be sure, there are some bad eggs out there. But the market is structured such that hundreds of billions in defaults in a single year is almost impossible.

Types of Muni Bonds Outstanding:

Source: Barclay’s US Muni Bond Index

In fact, over the next four years less than $30 billion of muni bonds defaulted. Munigeddon didn’t happen. Issuers and investors have moved on. What can we learn? First, don’t believe everything you read—even demi-gods like Buffett have their blind-spots. Second, markets can be complex and more nuanced than most people think; and finally, never, ever, underestimate the appetite of the news media for a spectacular sound-bite.

Munis have been around for a long time and have seen a lot of ups and downs. Those who predicted massive defaults were really saying, it’s different this time. And we know how dangerous that phrase can be.