What’s eating Municipal Bonds?
In December a Wall Street analyst with a big mouth and a business to build (The Meredith Whitney Advisory Group), declared that there would be “hundreds of billions” of dollars of municipal bond defaults in 2011.
Meredith Whitney is a bit of a media darling. She is often given credit for “predicting” the subprime mortgage crisis when she said that Citigroup should cut its dividend.
She dropped her latest bomb, which predicts hundreds of billions of municipal bond defaults, on “60 Minutes,” as well as countless network interviews. This is a staggering sum for a $2.9 trillion market.
You’ve heard of “shoot first, ask questions later”? Well, that is exactly what people started doing. Investors began selling their municipal bond funds. There were more than $25 billion in fund redemptions, which forced fund managers to sell high quality municipal bonds.
The question, of course, is this: Does her prediction have any merit?.
We ran across some impressive gathering of statistics put together by Michael Schroeder of Wasmer, Shroeder & company, that analyzes Whitney’s assertions. There’s a problem with Whitney’s math. It seems to be off, by at least an order of magnitude.
Whitney did not specify exactly how many “hundreds of billions.”
Schroeder explains the error of magnitude this way: Whitney acknowledges that states will likely make good on their bond debt, so starting with $2.8 Trillion in outstanding muni debt, less $200 billion in pre-refunded U.S. government obligations, leaves $2.6 Trillion owed by some form of municipal government. There are about exist 91,000 such entities — in the form of cities, towns, townships, counties, school districts, housing and other state or local agencies, water and sewer and redevelopment authorities, fire districts, special taxing districts, etc.
“The states and their agencies owe 40% of the total (1 Trillion), leaving $1.6 Trillion owed by various counties and parishes, cities and towns, taxing districts, local authorities, colleges, universities, tribal governments and electric coops,” Schroeder writes.
He continues explaining, in this way: If you assume 1/3 of these municipalities have outstanding bond debt, that’s $53 million for each of them. Whitney says that 50-100, maybe more, will default in the next 12 months. And that’s where the number don’t add up. Schroeder uses an even higher number – 200 – to show the math error that’s going on.
He writes:
“200 issuers times $53 million equals a grand total of $10 billion of defaulted municipal bonds, or 0.6% of the $1.6 trillion of non-escrowed, not state-issued debts.”
That is a very different number, than “hundreds of billions” of municipal defaults. In fact, it is only 1/20th or 1/30th of Whitney’s claim.
Schroeder goes on to acknowledge that if you count the biggest cities, you won’t get there either. He talks about how even if the 20 biggest cities went broke, it would just be over $100 billion.
But Whitney’s prediction was dramatic, and she is credited with making dramatic predictions that have come true.
But the dramatic prediction, needless to say, led to a huge sell off in all municipal bonds, including the highest quality ones. Sellers were terrified. We bought tax-free yields of 5 and 6 and 7 percent all month long.
Remember the aphorism, BUY at times of maximum fear. In the muni market, that was last month. Remember this next time.
Oh, and buying individual municipal bonds is not easy for individual investors. It is an area of investing where a skilled money manager really adds significant value.
In Conclusion
Never expect the crowd to act rationally. Some investments are ill-suited to being held in mutual fund structure. Muni’s are an example of this.
We remain believers in the solid returns of strong dividend-paying stocks, covered call writing, and municipal bonds, including California General Obligation bonds, and Gold and Silver allocations.
Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area. We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visitwww.barnescapital.com.
