Wednesday, February 9, 2011

How Risky are Municipal Bonds?

Easily one of the most "popular" topics in my client meetings these days is municipal bonds.

I have written several posts over the last few weeks about municipals. I strongly believe that while there are doubtlessly some municipal credits that should be avoided, in general munis are one of the most attractive segments in the capital markets these days.

This seems to be a minority opinion, however.

Indeed, while munis are a source of worry for my clients, no one has any serious problem with either stocks or corporate bonds (a complacency which may be a cause for concern, but that's another story). Hence the reason I often spend more time discussing municipal bonds.

Meredith Whitney is one of the reasons that munis are under such pressure.

Ms. Whitney appeared on the television show 60 Minutes in December to announce that the municipal market was facing "hundreds of billions of dollars of defaults" in the coming months. Since she had been quite prescient in seeing the major problems facing the U.S. banks in 2007, her comments received a lot of attention.

Most of the major municipal bond dealers, as well as numerous trade groups, have come out with voluminous reports essentially debunking Ms. Whitney's work. Some of the attacks seem almost personal, which has lead other commentators to try to defend her analysis.

Problem is, Ms. Whitney has refused to publish her research that supports her dire predictions, although copies are apparently leaking out. In addition, she declined an opportunity to appear before a Congressional subcommittee to go over her thoughts in more detail.

Many are now suggesting that she is motivated less by her concerns about municipal bond investors than her desire to build her own business.

Here's an excerpt from an article in Monday's New York Times discussing the controversy:

“We believe the financial challenges facing states could be the next systemic risk within the U.S. financial markets,” {Ms. Whitney} wrote in the report, a copy of which was provided to The New York Times. Ms. Whitney also draws comparisons between the risk-taking on Wall Street and the budget practices at many state governments.

In fact, there are important differences between the problems facing states and municipal governments, bad as they may be, and those the banks encountered during the financial crisis.

For starters, states have the power to raise taxes — something private companies with a shortfall cannot do, Mr. Rosner of Graham Fisher said. They can also try to force concessions from their workers in terms of reduced pay and benefits, in some cases.

Even if municipal issuers run into distress, a financial control board can shield bondholders from a default, as happened recently in Nassau County. These boards usually create a so-called intercept, or a structure that can grab new tax dollars as they come in, before they can go into the locality’s general fund. The money goes into a special fund to pay the bondholders their interest and principal, a system that prevents elected officials from spending it on other things.

Meredith Whitney’s Muni Bond Prediction Draws Scrutiny -