the muni-meltdown that wasn't

The MUNI-MELTDOWN THAT WASN’T.

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11.25.14 www.bloombergbriefs.com Bloomberg Brief | Muni Meltdown 2

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MUNI MANIA: A TIMELINEFEBRUARY 2009

“If a few communities stiff their creditors and get away with it, the chance that oth-ers will follow in their footsteps will grow.”

– Warren Buffett APRIL 2009 Moody’s assigns the U.S. Local Govern-ment Sector a negative outlook

SEPTEMBER 29, 2009

“Dark Vision: The Coming Collapse of the Municipal Bond Market”

– Frederick J. Sheehan, published by Weeden & Co.

DECEMBER 2009

“Are State Public Pensions Sustainable?” – Joshua D. Rauh

MARCH 30, 2010

“State Debt Woes Grow Too Big to Camouflage”

– The New York Times APRIL 4, 2010

“Once a few municipalities default, there is a risk of a widespread cascade in defaults.”– Richard Bookstaber, blogAPRIL 15, 2010

“This isn’t capitalism. It’s nomadic thievery.”– “Looting Main Street,” by Matt Taibbi, Rolling Stone

SPRING 2010

“Beware the Muni Bond Bubble: Inves-tors are kidding themselves if they think that states and cities can’t fail.” – Nicole Gelinas, City Journal

SUMMER 2010

“How to Dismantle a Muni-Bond Bomb”

– Steven Malanga, City JournalSEPTEMBER 2010

“The Tragedy of the Commons” – Meredith Whitney

OCTOBER 5, 2010 “Cities in Debt Turn to States,

Adding Strain” – The New York Times

NOVEMBER 16, 2010 “California will default on its debt.” – Chris Whalen to Business Insider

NOVEMBER 29, 2010

“Give States a Way to Go Bankrupt”

– David Skeel, The Weekly StandardDECEMBER 5, 2010

“Mounting Debts by States Stoke Fears of Crisis” – The New York Times

DECEMBER 19, 2010

“Hundreds of billions”

– Meredith Whitney, on 60 Minutes

DECEMBER 24, 2010:

“I can’t make the numbers work. If you look at the 10 largest cities and the 25 largest counties in the country, that’s $114 bil-lion in debt outstanding. So you gotta basically have New York, Chicago, Phoenix, Los Angeles — these cities start to default.” – Ben Thompson, Samson Capital, on CNBC

JANUARY 20, 2011:

“Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm” – Center on Budget and Policy Priorities 21-page white paper AUGUST 2011:

“[I don’t care about the] “stinkin’ municipal bond market.” – Meredith Whitney to Michael Lewis



INTRO

An old-media kind of guy, I still keep file folders of stories, blog entries, clippings, messages and reports printed out and more or less sorted. Back in early 2009, I started a file labeled “Hysteria’’ to hold the physical evidence of what I thought the most unusual and even outlandish claims being leveled against an asset class I have spent 33 years writing about — municipal bonds.

Over the next couple of years, the file swelled. I started another. And another. I didn’t even include Meredith Whitney. She got an entire file of her own.

I collected so much material that I decided to use it as a presentation to the Bond At-torneys Winter Workshop one year. Even then I only got to use the high-points, or low points, if you prefer, entering each exhibit into evidence. I considered this clever.

“Show me a revenue stream and I’ll show you a bond issue,” is an old banker’s axiom. The writer’s equivalent is probably, “Show me a box of research and I’ll show you a book.” Or, in this case, a special supplement. And so here we are.

In 2010, municipal bonds, hitherto known only as secure, boring investments, if some-times a little weird, were front-page news. It was stated with some confidence that the entire market was going to go bust.

Of the Great Municipal Market Meltdown – so confidently predicted for 2010, 2011, 2012, and so on – I think we are now finally able to say, “That didn’t happen.” As it was being predicted, I observed that the reason it wasn’t happening was because “that doesn’t hap-pen.” In other words, the various “experts’’ then weighing in about state and local govern-ments’ coming mass insolvency and/or repudiation didn’t know what they were talking about. That didn’t stop what I termed their “Inexpert Testimony” from being offered. And widely (and unfairly, I thought) quoted.

I define “meltdown’’ here as its proponents did: widespread default or outright repudiation of municipal bonds. There were a number of (non-muni) analysts and observers eager to forecast just this possibility. Others contented themselves with stoking hysteria in regard to public pensions. One even expressed outrage over Wall Street’s underwriting and banking relations with Main Street borrowers. The blowup to come, we were assured, was going to be almost operatic.

The more I leafed through these bulging files — in retrospect, and recollected in tranquil-ity, as the poet says — the more I asked, How did this come about? Why were so many people who were little more than tourists in MuniLand taken so seriously?

Why was the opinion of those who did know what they were talking about so heav-ily discounted? What lessons can investors learn from this? Because lots of investors, especially after Meredith Whitney made her famous call on “60 Minutes” in December of 2010, sold both muni mutual fund shares and individual bonds, sometimes at fire-sale prices. They wanted to get out at any price. Panic was in the air.

There’s no one answer. There are lots of answers.

Inside

In the Beginning Particular and Specific .....................5

The Undiscovered Country Just Look! .........................................8

The End of Something Splendid Isolation No More ..............9

‘Dark Vision’ Bombs Away ..................................10

The Coming Collapse In Sum ............................................11

Into the Abyss ‘Dump Munis’ ..................................12

Public Pensions We Have a Problem ........................13

Media Frenzy Everyone’s Meltdown ......................16

The Market Responds to Its Critics First Responders ............................19

Oh, Meredith ‘Hundreds of Billions’ ......................23

After ‘Hundreds of Billions’ Victory Lap .....................................24

Returning Fire That’s Enough! ................................26

What Happened, Lessons Learned Age of Twitter ..................................27

Appendixes To the Foregoing Work ...................30

There’s no one answer. There are lots of answers.



I: In the Beginning

Faced with Wall Street firms going bust, mass firings, the housing price collapse and 401(k) plans evaporating as the stock market plummeted, it was hard for munici-pal bonds to make the front page.

They tried. Two events in particular had rocked munis in 2008. In February, the $330 billion auction-rate securities market froze after Wall Street banks stopped providing backstop bids for the stuff. The market had long relied on a convention the Street could no longer afford – instant liquidity. The result: Investors in many auction issues could see their money, but couldn’t lay their hands on it. It would take years to remedy the situation.

Rise of the InsurersThis was damaging enough to the mar-

ket’s psyche. Even worse was the down-grade of most of the AAA-rated municipal bond insurers. Bond insurance was per-haps the most successful franchise in the municipal bond market, originating in 1971 and reaching a peak penetration of 57 percent of the new issue market by 2005.

Bond insurance was also the thing that “commoditized’’ the market. No longer did investors have to study the innumerable details of a bond issue’s structure and security. Now there was just this thing you could buy called a municipal bond that produced interest that was tax-exempt and that was incredibly safe and secure in the first place and was now even insured as to repayment of principal and interest and so rated AAA. Or so it was thought for a very brief period stretching from perhaps 1985 to the collapse of the insurers in 2008.

The insurers had proven to be in the right place at the right time. They were even, helpfully, a little early. States and

municipalities were just about to embark on a borrowing binge, spurred in part by the threat, real and imagined, of tax reform that would prohibit them from financing certain things with tax-exempt securities, and then by a decline in inter-est rates that sparked a wave of refinanc-ing, and finally by a boom in what we may term bankerly creativity. I’m sure the rise of suburbs beyond the suburbs and their concomitant needs for infrastructure like streets and sewers and schools was part of it, as was the later urban renaissance.

Analysts could take cold comfort in the fact that the insurers didn’t lose their AAA ratings because of anything they’d done in the municipal market. Their sin was expanding into asset-backed securities, a move inspired as much by stockholder interest in returns as demanded (well, almost) by the ratings companies, which urged the insurers to expand into more lucrative areas of business.

And here it might be appropriate to say why commoditization was so welcomed in this market. As investor Paul Isaac once put it to me over cocktails, “So what you’re saying is, municipal bonds are particular and specific to a remarkable degree.’’

Isaac was responding to my amaze-ment and frustration trying to understand a subject that seemed endless and unfathomable. This was back in the early 1980s. I stole his phrase and have used it ever since, only occasionally substituting “insane’’ for “remarkable.’’

This turned out to be the single most important observation about municipal bonds I have ever heard. It explains so much. It explains everything.

The multifarious (“of great variety; diverse’’ according to Webster’s) nature of municipal bonds is one of the reasons

I became so convinced that a national meltdown was unlikely. We’re not talking about dozens or scores of issuers, but tens of thousands.

The Census of Governments done by the U.S. Census Bureau every seven years shows that there are just over 90,000 governmental entities in the U.S. It has been estimated by the Municipal Se-curities Rulemaking Board, the market’s self-regulatory organization, that perhaps 50,000 have borrowed money in the mu-nicipal market at some time or other.

They have done so with serial and term bonds, with notes, with variable- and the aforementioned auction-rate securities, using their full-faith and credit taxing power pledge, their limited taxing power pledge, their mere promise to appropriate money for debt service, and more often than not (since the 1970s), with the prom-ise of specific revenue streams. And did I mention the companies, like airlines, that also borrow in the municipal market?

Sucker’s BetIn fact, it’s a rare government that uses

its general obligation, full-faith and credit pledge to sell bonds to borrow money. What was once termed the shadow gov-ernment, and not in an approving way, is the primary engine of borrowing in today’s

continued on next page...

Source: Nick Ferris/BloombergJoe Mysak

Our story begins in 2009. There may have been hysterical commentary about the condition of the municipal bond market before this. There probably was; I just don’t recall it. Maybe it lacked a certain intellectual heft, and so had little impact on me as I read it. More likely, it was sub-merged in the round-the-clock hysteria then surrounding nothing less than the state of capitalism in the free world. The recession that had begun in late 2007 and accelerated in 2008 still had a way to go.



muni market: a network of districts, agen-cies, authorities and public corporations, staffed by their own professionals and insulated, if you will, from the public and even from duly-elected government of-ficials, like a city council, for example. The decentralized nature of municipal issu-ance turns out to be one of the market’s great strengths.

Add to this the perpetual nature of most governmental entities and you can see why a mass municipal meltdown was a sucker’s bet. Perhaps only someone who has looked through 12 or 20 screens of a Bloomberg terminal’s “Municipal Bond Ticker Look Up’’ can appreciate this. Type in a name of a municipal issuer and you get screen after screen of apparent direct relations. Who are all these guys? The auction-rate freezeout and the collapse of the bond insurers were stunning stories, unimaginable for anyone familiar with the things, yet in the context of the times in 2008 just more collateral damage from the subprime mortgage implosion.

More bad news was on the way in 2009, as the recession deepened and states and municipalities saw tax revenue dwin-dle. The recession officially ended in June of 2009. State tax collections declined versus the same period the previous year in every quarter from the fourth quarter of 2008 to the fourth quarter of 2009, according to the Nelson A. Rockefeller Institute of Government.

That’s another feature of the municipal market; state and local government isn’t on the front end of recession, but on the tail. Public finance is a lagging indicator. This is why most states and municipali-ties were still hiring in 2008, even as the private sector was shedding hundreds of thousands of jobs.

Acronym MadNow we come to the first major market

“call’’ that attracted my attention as be-ing a little exaggerated if not hysterical. Because, let’s face it, Warren Buffett is no hysteric.

The reference to munis came in the February 2009 edition of the letter Buffett sends annually to Berkshire Hathaway shareholders. Berkshire had launched Berkshire Hathaway Assurance Company (or BHAC: the bond insurance business is acronym-mad) in 2008 as a municipal bond insurer. Under a section of his letter entitled, Tax-Exempt Bond Insurance, Buffett recounted BHAC’s year, which at one point included an offer to reinsure the other largest monoline municipal bond insurers’ existing books of business. The insurers rebuffed the offer.

Buffett said BHAC would “remain very cautious about the business we write and regard it as far from a sure thing that this insurance will ultimately be profitable for us. The reason is simple, though I have

never seen even a passing reference to it by any financial analyst, rating agency or monoline CEO,’’ Buffett wrote.

He continued, “The rationale behind very low premium rates for insuring tax-exempts has been that the defaults have historically been few. But that record largely reflects the experience of entities that issued uninsured bonds. Insurance of tax-exempt bonds didn’t exist before 1971, and even after that most bonds remained uninsured.’’

Buffett continued: “A universe of tax-ex-empts fully covered by insurance would be certain to have a somewhat different loss experience from a group of uninsured, but otherwise similar bonds, the only question being how different. To understand why, let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds — virtually all uninsured — were heavily held by the city’s wealthier resi-dents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. With-out one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe finan-cial losses from their bond holdings.’’

If, Buffett posited, all of the city’s bonds were insured by Berkshire, would “simi-lar belt-tightening, tax increases, labor concessions, etc.’’ have been forthcom-ing? Of course not, he answered. “At a minimum, Berkshire would have been asked to ‘share’ the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.’’

In other words, the city would have defaulted on its insured bonds, leaving the insurer to pay the debt service. At some point, it is assumed, the city and the insurer would sit down and negotiate the terms of repayment, but not in full.

‘Simply Staggering’Buffett observed that local governments

were going to face far tougher fiscal prob-lems in the future. “The pension liabilities I talked about in last year’s report will be a

“ If a few communities stiff their creditors and get away with it, the chance that others will follow in

their footsteps will grow.” — Warren Buffett

continued from previous page...




huge contributor to these woes. Many cit-ies and states were surely horrified when they inspected the status of their funding at year-end 2008. The gap between as-sets and a realistic actuarial valuation of present liabilities is simply staggering.’’

So far, so good. New York City’s near-miss with bankruptcy, I know, was a close-run thing, with the state playing a powerful role in the rescue, along with the United Federation of Teachers.

Buffett’s theory of the role insurers might play in a meltdown was somewhat prescient, as the Detroit bankruptcy has shown us: the insurers have a seat at the table, and are indeed expected to “contrib-ute’’ to Detroit’s future, by taking less than they are owed by the city.

Buffett’s concerns about public pensions were nothing new or astonishing. Numer-ous analysts pointed out how they had suf-fered after the tech bubble burst only a few years before. (It is worth noting, however, that in 2000, the so-called funding ratios of public pensions topped 100 percent).

And then Buffett went just a little bit further. “When faced with large revenue short-

falls, communities that have all of their bonds insured will be more prone to develop ‘solutions’ less favorable to bond-holders than those communities that have uninsured bonds held by local banks and residents. Losses in the tax-exempt arena, when they come, are also likely to be

highly correlated among issuers.’’ This last sentence can be parsed any

number of ways, and I’m not going to at-tempt it here.

But then, this: “If a few communities stiff their creditors and get away with it, the chance that others will follow in their foot-steps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?’’

Buffett concluded that insuring mu-nicipal bonds “has the look today of a dangerous business.’’

The headline words were “dangerous business.’’ The real story was in the previ-ous two sentences, about 1) a seeming

contagion in municipalities actively seeking to stiff their creditors and “get away with it,’’ and 2) elected officials choosing not to make some very hard choices.

I didn’t know it at the time, of course, but the Buffett letter was the first salvo in what would become a muni meltdown barrage. At the time, I thought it interesting, purely because munis were so unremarked upon in general. I also thought it a trifle over-wrought, said so in a column, and was surprised at how many e-mails I received from the Great Man’s minions, eager to denounce unbelievers. Much worse was to come.

“ Municipal bonds are particular and specific to a remarkable degree.”

– Paul Isaac, Investor



www.bloombergbriefs.com/reserve/


Source: Bloomberg/Daniel AckerWarren Buffett

II: The Undiscovered Country

In 2008, Buffett made his overtures to the beleaguered bond insurers. The pos-sibility that they might lose their top credit ratings was already a hot topic of con-versation among market participants, not least because investor Bill Ackman was shorting the stock of the biggest insurer, MBIA, and he made sure the Wall Street Journal knew it.

But there were a lot of other things being discussed in the municipal market, as well. How would a decline in tax revenue affect budgets and credit ratings? How would states and municipalities deal with stock market losses that had blown a hole in the value of the assets they had put away to cover pension liabilities? Could they manage the expense of “Other Post-Employment Benefits,’’ previously handled mainly as a pay-as-you-go expense?

Then there was the SEC’s ongoing in-vestigation into bid-rigging and price-fixing in the municipal reinvestment business, the whole murky world that exists after issuers sell bonds and need to invest the proceeds. The use and proliferation and opacity of swaps was finally getting some attention, too.

Everybody’s TalkingThe Municipal Securities Rulemaking

Board, for its part, was in the midst of a push to reform disclosure and enhance price transparency, as well as regulat-ing municipal advisers and establishing who owed issuers fiduciary responsibility, among other things.

Yes, all of these topics were being dis-cussed in the muni market. Just because these subjects only sporadically appeared in the major newspapers and almost never made it to television and cable news doesn’t mean that they weren’t being talked about, and covered by local news-papers and the very specialized financial press, that write about munis. There was a lot of ferment going on in municipals in the 2000s.

And yet, a common claim among those who would stoke the muni meltdown hysteria was that “nobody’s talking about this,’’ as if an almost $3 trillion market (at the time) was somehow being conducted entirely in secret — and I have been a critic of how private public finance can sometimes be.

Or they would claim, “the experts’’ (who-ever these people were supposed to be; perhaps even I was one of them) were so conflicted that they couldn’t possibly see this or that self-evident truth.

The other side of the argument, of course, is that nobody was talking about “it’’ (whatever it happens to be), because “it’’ isn’t true.

The mainstream media, as they call it nowadays, has always had a problem with

the municipal market. Municipal bonds are hard to understand. Bankers and the many financial professionals who assist public officials in their bond sales tend to follow a code of silence. The sales and trading of municipals is done over the counter, almost on a bespoke basis.

The press loves a simple story, and public finance is extremely nuanced. The relatively high cost of entry for investors (you need tens of thousands of dollars to invest in munis, a few hundred to buy stocks) means that municipal bonds aren’t really even part of the financial “culture,’’ in the way that stocks are.

Tourists in MuniLandThere wasn’t a lot of what I’ll call big

press coverage of municipal finance be-cause editors found the topic stupefyingly dull and so, they reasoned, few people would care to read about it. I sometimes think I would have had more readers if I wrote about Hummel figurines, or numis-matics, rather than munis.

Beginning in 2009, more people were claiming that the municipal market was the undiscovered country. Just look at what we’ve found, these critics — tourists in MuniLand — would say. And, no sur-prise, the story they so often brought back was very similar to the stories that tourists tell: by turns frightening and amusing, and of limited long-term value.

Never had so many been so misled by so few with such little actual expertise.

There wasn’t a lot of big press coverage of municipal finance because editors found

the topic almost stupefyingly dull.



III: The End of Something

The municipal market’s long period of splendid isolation, if we can call it that, was all about to end. The story of the market meltdown that wasn’t is very much a story of the media.

To repeat: Nobody was saying that states and municipalities were not facing some pretty stiff headwinds as a result of the real estate bubble and recession.

What made this time different is that house price declines played out nationally rather than, as is usual, regionally. There were of course some markets that fared much better than others, but prices fell everywhere.

In April 2009, Moody’s assigned a negative outlook to the U.S. Local Gov-ernment Sector, saying, “This is the first time we have assigned an outlook to this extremely large and diverse sector. This negative outlook reflects the significant fiscal challenges local governments face as a result of the housing market collapse, dislocations in the financial markets, and a recession that is broader and deeper than any recent downturn.’’

Note the language: “significant fiscal challenges.’’

I had long been a fan of the restrained, sober style the analysts at the rating com-panies had learned to use (it was, I was informed, very much a learned style). If you were unaccustomed to the style, you could read through thousands of words of analysts’ prose and not quite know what they were really saying, or if they were saying anything at all.

Not this time. The company continued, “Sharply falling property values, contract-ing consumer spending, job losses, and limited credit availability lead the long list of developments that will make balancing budgets in the coming year particularly difficult. The negative outlook assigned to the U.S. local government sector en-capsulates our view on this challenging environment and the strains that will be evident in credit for issuers across the industry.’’

This was a very well-crafted, detailed piece of work in nine pages. I was im-pressed by the – for them – blunt tone as well as the way it reminded its readers that this was a big market, particular and specific to a remarkable degree, in the words of my friend Isaac.

Again, Moody’s: “Credit pressures faced by local governments and their responses to these pressures will vary significantly across and within states due to uneven economic conditions, differing revenue mixes and service mandates, inconsistent property assessment practices, and differ-ent levels of revenue raising authority. The governance strength of individual issuers and behaviors which demonstrates their willingness and ability to adapt to that en-vironment will determine the overall trend in individual ratings.’’

The rating company put the entire sector on negative outlook. It didn’t say that the entire sector would respond in the same way to the extraordinary, “unprecedented’’ pressures then accumulating: unemploy-ment at more than 8 percent, stock prices off 50 percent, home prices down an aver-age 25 percent from their peak. And what might be the result? “Increased rating revisions’’ for local governments.

This was an extremely reasonable, clear piece of work from a generally recog-nized authority on the subject. Unhappily, because of their role in the subprime mortgage collapse, the rating companies in general had forfeited a certain credibility by this point, even in the municipal market.

An earlier announcement by Moody’s in March of 2007 that it would stop using a dual scale to rate municipalities and cor-porations had touched off a controversy that once would have dominated market

conversation. Now, in the midst of the recession, it was almost an afterthought.

Moody’s and Fitch finally recalibrated their ratings in 2010; Standard & Poor’s announced a change in its own methodol-ogy for rating municipalities soon after.

Looking back at 2009, I am surprised by just what a newsy year it was in munici-pals. Jefferson County, Alabama, was still trying to avoid bankruptcy. Municipali-ties were starting to file lawsuits against those Wall Street firms that had sold them swaps and derivatives.

In August, the MSRB said it was looking at “flipping’’ in the muni market, apparent in glaring fashion soon after states and municipalities started selling federally-subsidized Build America Bonds.

A federal grand jury would finally indict CDR Financial Products, the firm at the red-hot center of the market’s bid-rigging scandal, at the end of October.

There was a time I used the expres-sion “bullets don’t grow on trees’’ from the movie “Michael Collins,’’ to characterize actual municipal market news, and to cau-tion reporters to husband story ideas with care. No longer. In 2009, it seemed like news was breaking every day.

Then one day in October, I got an e-mail from a reader. His name was familiar to me as someone who occasionally com-mented on my columns. He attached a report that he said he found compelling.

“ This is the first time we have assigned an outlook to this large

and diverse sector.” — Moody’s



IV: ‘Dark Vision’

I wish I saved that first e-mail, so I could give proper credit to the sender. In the weeks to come, more correspondents would forward me the same report, most accompanied by a message written in a tone of resignation and dismay. One even sent me a copy in the mail. People wanted to make sure I saw this thing

The report was “Dark Vision: The Coming Collapse of the Municipal Bond Market,’’ published by Weeden & Co. for its clients. It was a “guest perspective’’ as they called it, by Frederick J. Sheehan. This was the first piece I had ever seen to call for the municipal market’s imminent meltdown. It was also the first piece to demonstrate to me that the muni market was entering a new media age.

I originally dismissed it. I glanced at that title, winced, and put it aside. Weeden & Co.? They weren’t in the municipal market. Frederick J. Sheehan? Who was he? I hadn’t seen him on the muni beat before. “The Coming Collapse of the Municipal Bond Market’’? Please.

It really wasn’t until I spotted it again, this time in a reference to a business blog on yet another financial news web site, that I realized that the market had a problem. In the new Internet age, anyone could write anything and it could achieve the credibil-ity and authority of “publication.’’

Anything GoesAnd it metastasized. An article or report

was no longer published once, but again, and again, and again, all over the Internet. The new reporters, or editors, or whatever you called them, sometimes did no more than put an inviting and often sensational headline on a short summary, and then provide a link to the actual underlying document, story, report, lawsuit, opinion piece, whatever it happened to be. And then dozens or scores of readers could comment on it, further legitimizing the story, no matter how inane their own commentary.

In this publication democracy, it seemed, everything was valid, all points of view le-gitimate. It would take some time, for me, to realize that the key thing in this transac-tion was for the author to say something, usually bad, was going to occur, and very soon. This seemed to be the only criterion for the new “publication’’ world: Some-thing Bad Is Going To Happen. This got you clicks, this got you viewers, this got you subscribers, this got you on televi-sion, and, in some cases, it got you book contracts.

In fact, more often than not, in public finance as in most people’s lives: Nothing happens. Things muddle along, things work out, or not, in slow and usually unspectacular fashion. Especially, might I add, in the municipal bond market, where trading in a new issue typically ceases after about 30 days, and where time is measured with a calendar.

“The Coming Collapse of the Municipal Bond Market’’? The timing of this piece was propitious. The Great Recession, it seemed, had just ended in June, but people were still ready to believe anything about everything. “The Coming Collapse of the Municipal Bond Market’’? Why not?

Hysteria Begins“Dark Vision’’ was dated Sept. 29, 2009.

This is when I date the kickoff of the Muni Market Meltdown Hysteria. So many things came together at this precise mo-ment: the rise of the Internet; the explo-sion of business and financial news web sites (it is worth noting that Business Insider only began in 2007); more cable business coverage; the greatest reces-sion since the Great Depression; the 24/7 news cycle.

Only a few years later, I suspect, any such “meltdown’’ call would have been mitigated, even refuted, by the very same Internet that had given birth to it. Twitter would kill it.

But in 2009, most of those who knew anything about the municipal market weren’t tweeting. “Bond Girl,’’ for example, didn’t start tweeting until April of 2011, Reuters’ Muniland blogger Cate Long in July of 2010.

Inexpert testimony was set for a very brief reign in the muni world.

In the new Internet age, anyone could write

anything, and it could achieve the credibility and authority of ‘publication.’

>>>>FOLLOW JOE MYSAK ON TWITTERFOR REGULAR UPDATES AND ADDITIONAL INSIGHTS @joemysak


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V: The Coming Collapse of the Municipal Bond Market

The most remarkable part of “Dark Vision’’ was the title and subhead. For the uninitiated, “Dark Vision’’ looked plausible enough, with various bits of data and almost two pages of scholarly-looking footnotes. The more I read it and considered it, the more I realized it was little more than a series of assertions, without a lot of proof.

The author had written a couple of books critical of Alan Greenspan and the Fed-eral Reserve, according to the identifying note attached to the piece. I got the feeling, as I was reading, that he was grinding a libertarian axe. Political point of view and credit analysis usually don’t mix well.

I don’t want to spend too much time on “Dark Vision,’’ which I found unpersuasive, so let me try and summarize.

It is time to get out of municipal bonds, says Sheehan. They are now to be considered speculative investments, and buyers are just not being compensated enough for the risk they are taking. Fair enough, I thought.

“The municipal market will probably repeat the pattern of the sub-prime collapse,’’ he wrote. “Although it is plain to see, the usual experts do not notice.’’ He doesn’t say who these experts are, although I infer that they are the rating companies.

He describes the “mess’’ in public finance: “Recent cost-cutting by states and munici-palities is inadequate. This much is prob-ably obvious. What may go unrecognized is that filling these gaps using conventional

measures is impossible. Parties to suffer from unconventional measures include bondholders.’’

This pretty much sums up the Sheehan argument. States and municipalities spend too much, borrow too much, promise too much to their employees. Faced with the “impossible,’’ many municipalities will seek bankruptcy court protection.

Bondholders can’t rely on issuers’ pledg-es to levy taxes to pay debt service. Nor can they trust that the courts will ensure that they are paid.

Had Sheehan limited his remarks to “De-troit,’’ I might have hailed him as a visionary today. Had he somehow limited his thesis to “some’’ or even “a handful’’ of municipali-ties, even that would have been somewhat acceptable. But no. The entire market will “collapse.’’ On the other hand, who wants to publish “The Coming Collapse of an In-finitesimal Number of Municipalities’’? Who would read it, beside the hard core?

That all states had borrowed too much was a typical canard. Taking a look at Moody’s annual State Debt Medians Re-port published in July of 2009, the author could have seen that net tax-supported debt per capita drops fairly quickly after you look at the top 10 states. In first place was Connecticut, at $4,490; in 10th was California, at $1,805. In 30 of the states, the figure was below $1,000.

A similar story could be told about public pensions, as well as public employee pay. A few states were bad at making their actuarially-required contributions to their pension systems. Some states and cities had sweetened pensions, and salaries, without much apparent regard of how to pay for them.

And then there were some errors:“Current bond issues will need to be

rolled over when they mature, since budget gaps are rising.’’ Sheehan takes a hallmark of the sovereign debt market and transfers it to munis. That’s not how munis work. Municipalities pay off their debts over time, usually through the use of serially maturing bonds. Yet this “rollover’’ error would be repeated.

Note here that Sheehan wasn’t talking about the letters of credit or liquidity facili-ties backing variable-rate demand obliga-

tions expiring. This would become one of the market’s typical non-issue issues in 2010 and 2011. As it turned out, the market handled the, in Moody’s words, “unprec-edented’’ number of expirations handily.

Sheehan wasn’t talking about VRDOs. He was describing “the next Greece,’’ as critics of the time put it.

“One of the largest municipal expendi-tures is coupon interest on bond obliga-tions.’’ That’s not true. Debt service is actually one of the smaller items in most municipal budgets. As analysts would eventually point out, why would public officials go out of their way to anger the investors they need and target debt ser-vice, since it would be of so little help in a financial emergency?

Why did I go back and read “Dark Vi-sion’’? Because more than a month after it was published, it was mentioned on a business news web site, which linked to a piece on the Seeking Alpha blog, which in turn linked to a piece on a Harvard Law School blog, picking up approving com-ments from the uninformed every step of the way.

And so the “coming collapse’’ of the mu-nicipal bond market had been announced.

In 2011, Bloomberg Brief: Municipal Market’s Brian Chappatta asked Sheehan what happened — why hadn’t the market collapsed? He gave a very detailed re-sponse, which I include here as Appendix 2. I called him on Nov. 17 of this year, and he gave me a very similar response: “One thing I didn’t understand was how hard states would work to pay their bonds so they could continue to legislate. I thought there’d be much more of a battle between paying bonds and other expenses like pensions. I still think that has to come at some point, as the asset price bubble starts to deflate. [States and municipali-ties] have continued to spend as if they learned nothing from how close they did come to defaulting in 2009.’’

Source: Bloomberg/Andrew HarrerAlan Greenspan



VI: Into The Abyss

The crush of news in 2009 meant that it took a while for the market to confront the municipal bond meltdown scenario being presented. The Sheehan piece achieved what I sensed was wide circulation, show-ing up around the Internet without much in the way of rebuttal.

Sheehan was first. James Chanos, noted short-seller, appeared in Barron’s in the Nov. 9 “Current Yield’’ column: “Dump Munis,’’ was the headline. The culprit: “platinum-plated health-care and retirement benefits,’’ said Chanos. I asked Chanos on Nov. 17 if he had any further thoughts about the municipal market, and he declined comment.

On Dec. 16, 2009, Standard & Poor’s published a paper entitled “Credit FAQ: The Recession’s Impact on U.S. State and Local Government Credit Risk.’’

I now see this as the first defense of munis. Whether it was done in response to Sheehan, I do not know.

The FAQ format is, of course, a feature of the Internet; I’m not sure how much circulation this piece got. It was detailed and reasonable and accurate. But of course Collapse trumps Muddle Along in the Internet popularity stakes.

My favorite answer came in response to the question: “Then why do state and local governments keep talking about the dire straits they are in?’’ S&P said: “As this all plays out, we think that new headlines will likely capture elected officials’ and oth-

ers’ efforts to make the public aware of the circumstances of their austerity measures and what they think will be the conse-quences of inaction.’’

Do the Right ThingThe important thing about the S&P

piece, as well as the earlier Moody’s commentary tagging the entire sector with a negative outlook, was that both rating companies expected most public officials to do the right thing by their bondholders. Also noteworthy, especially in retrospect, is how S&P took pains to say how “condi-tions do vary.’’ Once again: particular and specific. It’s very much like that old legal expression: all facts and circumstances.

Even in 2009, you could see several themes playing out here. On the one hand, you had outside critics saying that municipalities were all in the same boat, that they had exhausted their resources, and that default and repudiation were inevitable. On the other, you had analysts saying that it was impossible to general-ize about issuers, that most of them had plenty of resources still available to them, and that most of them could actively man-age their way out of the situation.

The final piece of the puzzle appeared at the very end of the year, although it didn’t gain traction until later: a white paper by Joshua D. Rauh of the Kellogg School of Management at Northwestern University:

“Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities.’’

Of course, we all know what the answer to the title’s question was.

This was a provocative piece of work. Up to this point, as far as I know, nobody had predicted that pension funds would run out of cash altogether, or that pen-sion underfunding might drive states “to insolvency,’’ as Rauh claimed. Rauh also introduced his notion that state and local pension plans should “discount the benefit cash flows at Treasury rates.’’

In other words, they should stop as-suming that the assets they had put in their pension systems would produce 8 percent a year. Discounting benefit flows at Treasury rates produced a gap between assets and liabilities of $3 trillion at the end of 2008, Rauh wrote. He also mod-eled which states’ plans would run out of money, and when.

Rauh’s chief assumption was that states would contribute enough money to their pension plans “to fully fund newly accrued or recognized benefits at state-chosen discount rates (usually 8 percent) but no more.’’ This was “broadly in keeping with states’ recent behavior.’’

The paper itself was no easy read, but the “Table 1: When Might State Pension Funds Run Dry?’’ was clear enough. Rauh predicted that Illinois would run out in 2018, Connecticut, Indiana and New Jersey in 2019, Hawaii, Louisiana and Oklahoma in 2020. Alaska, Florida, Ne-vada, New York and North Carolina would never run out.

Rauh is now at the Stanford Graduate School of Business. He didn’t respond to a request for comment. He has continued to publish, and his views are now well-known. It used to be that public pension funding was one of those things cov-ered by rating companies perhaps on a quarterly basis. Now, it seems that we get regular, detailed updates on their condi-tion almost weekly. This is a good thing.

People didn’t really start to discuss the Rauh study until 2010. This would prove to be the cauldron year for the muni meltdown.

“Are State Public Pensions Sustainable? Why the Federal

Government Should Worry About State Pension Liabilities.” — Title of paper by Joshua Rauh, Kellogg School

of Management at Northwestern University



VII: Public Pensions

The year 2010 was the peak year for meltdown mongering.It was as if with the real estate bubble burst, banks failing and companies from auto manufacturers to Wall Street broker-ages in bankruptcy, gloomsters could finally turn their attention to states and municipalities.

Not all the material being published about public finance was incendiary. Some was salutary. As the old saying goes, never waste a crisis. So it was with public pensions. In February, the Pew Center on the States published “The Trillion Dollar Gap: Underfunded State Retirement Systems and the Roads to Reform,’’ a thoughtful, comprehensive 61-page study.

Pew said the difference between what states had on hand and the pension and other retirement benefits they had promised amounted to $1 trillion, and that was conservative, because it was based on June, 2008, data and thus hadn’t taken into account all investment losses.

The Pew report was unhysterical and exhaustive, filled with maps and tables of data. It showed the extent of investment losses, and ranked how the states were managing the situation. On pensions, it said, 16 were solid performers, 15 needed improvement and 19 were “serious con-cerns,’’ while in the area of health care and other benefits, which most states had treated as a pay as you go expense, 9 were solid performers in terms of quantify-ing the obligation and putting aside money for it. The report also noted that 15 states in 2009 had passed legislation reforming some aspect of their pension systems, usually by making new employees contrib-ute more.

As if any reminder were needed, the results showed how the subject of public pensions resisted generalization. New York’s pensions were 107 percent funded, Florida’s 101 percent. Illinois had only 54 percent of the money it needed, Kansas 59 percent, Colorado, 70 percent.

The study also examined investment return assumptions, just then becoming a fat target for critics. Recall that in Septem-ber 2009, Pimco’s Bill Gross coined the

term the New Normal to characterize the low-growth, low-yield future.

The Carolinas calculated they would earn 7.25 percent, Colorado, Connecticut, Illinois, Minnesota and New Hampshire 8.50 percent. By far the most states, 22, were at 8 percent, which, as the report pointed out, was the median investment return for pension plans over 20 years.

The report examined the factors that contributed to the $1 trillion gap, such as the volatility of investments, states failing to make their annual actuarially-required contributions and “ill-considered benefit increases’’ during good times. It also examined the “road to reform.’’

Of course the Internet focused on the “$1 trillion gap,’’ and even more on the Rauh $3 trillion gap.

A subject that had received scant atten-tion – except among the rating com-panies, municipal analysts, some local newspapers, and the blog that since 2004 collected coverage of the topic, pensiont-sunami.com – was now in the spotlight. Public pension analysis was, almost, the flavor du jour. At least three more aca-demic reports on public pension liabilities were published during the year.

‘Distinct Risk to Taxpayers’In April, the American Enterprise Insti-

tute for Public Policy Research present-ed resident scholar Andrew Biggs’s “The Market Value of Public-Sector Pension Deficits,’’ basically an endorsement of the Rauh $3 trillion pension gap figure.

Then in June came a working paper by Eileen Norcross and Andrew Biggs, published by the Mercatus Center at George Mason University entitled “The Crisis in Public Sector Pension Plans: A Blueprint for Reform in New Jersey.’’ Norcross and Biggs repeated the Rauh $3 trillion gap and advocated defined contri-bution over defined benefit pension plans. The latter, they said, presented “a distinct fiscal risk to taxpayers.’’

And in October, Rauh and Robert Novy-Marx of the University of Rochester produced a paper, “The Crisis in Lo-cal Government Pensions in the United States’’ for a conference on retirement and institutional money management post-financial crisis. The authors looked

at the unfunded pension obligations of local governments, and concluded that, if already-promised benefits were dis-counted at riskless, zero-coupon Treasury yields, the total unfunded obligation for the municipalities they studied was $383 billion rather than the $190 billion the localities themselves calculated.

I was of two minds about the explosion of interest in public pensions. On the one hand, I thought it good to focus on the subject, because it seemed that certain of our elected representatives over time had sweetened the salary and public pen-sion pot in exchange for union peace and votes, with no consideration for the way even little enhancements add up. They also all too often neglected to keep up with their actuarially-required contributions to their pension plans.

On the other hand, I objected to the “cri-sis’’ terminology which made it seem to the uninitiated as if states and localities had to come up with the money to fill the gaps overnight. As always, I worried that gener-alizing about the subject was distracting.

What we really needed was focus: Which states and municipalities had done the worst jobs managing public pensions? More importantly, why? These things aren’t easy to trace, but glossing over the subject in favor of big numbers lets the guilty parties off the hook. What hap-


Source: Bloomberg/Andrew Harrer‘The New Normal’: Bill Gross



pened, when, why, and how can we guard against it happening again?

Amplified AlarmI think it was around this time, too, that

I became very skeptical of all “studies’’ and “reports.’’ It had taken almost three decades, and the dawn of the Internet age, for me to realize that data was not definitive, that analysts could make the numbers dance.

I also began growing impatient with what I came to call the media’s “denomi-nator problem.’’ Such-and-such costs “$3 BILLION dollars,’’ radio and television an-nouncers would declare, all but reaching a full windup to deliver the plosive “BIL-LION.’’ And that was fine. But it matters a great deal if the “$1 BILLION’’ is part of a budget, say, of $5 billion, or part of one amounting to $50 billion or $150 billion. We emphasize the numerator and ignore, if we even know, the denominator.

In March, the National Association of State Retirement Administrators released two short but meaty reads,

the first on public pension plan invest-ment return assumptions, the second an analysis of the Rauh paper. Both attempted to reassure readers that there was a basis in fact for investment return assumptions: Over a 20-year period, median annualized investment returns were 8.1 percent; over 25 years, 9.3 per-cent. In other words, the 8 percent return assumptions prevalent among public pensions weren’t fictional.

The analysis of the Rauh paper, “Are State Public Pensions Sustainable?’’ said that the author ignored incremental changes being made to improve the long-term sustainability of public pensions, and that his central assumption, that states would make contributions sufficient to fund newly accrued or recognized ben-efits but no more, was unsupported by current practice.

There was, it appeared, another side of the story. How many Internet commenters read it, I have no idea. Who cared about the facts when alarm and exaggeration could be echoed and amplified?


It had taken almost three decades, and the

dawn of the Internet age, for me to realize

that data was not definitive, that

analysts could make the numbers dance.

BloomBerg Brief group SuBScriptionSBloomberg newsletters are now available for group purchase at very affordable rates. Share with your team, firm or clients.

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BLOOMBERG RANKINGS

Most Underfunded Pension Plans: StatesFor the fourth year in a row, Illinois, Kentucky and Con-necticut top the list of most underfunded pension plans

METHODOLOGY:Bloomberg ranked U.S. states based on their pension funding ratios in 2013. The Bloomberg municipal data and municipal fundamentals teams collected and supplemented data from each state’s Com-prehensive Annual Financial Report, a set of government financial statements. Data are for individual states’ respective fiscal year-ends as of the date of publication of the CAFR.

Supplemental pension reports intended to augment a partic-ular year’s CAFR were added to that year’s fundamentals. Fiscal year-end of supple-mental pension reports may differ from the state’s CAFR. All other reports were carried forward to the next fiscal year. The funding ratio provides an indication of the financial resources available to meet current and future pension obligations. Percentages were calculated by dividing the ac-tuarial value of plan assets by the projected benefit obliga-tion. Where specific data were missing in the consolidated reported totals, the pension funds were contacted directly.

The District of Columbia had a funding ratio of 103.6% in 2013.

Source: Bloomberg

AS OF: October 2, 2014

RANK STATEFUNDING

RATIO 2013 %

FUNDING RATIO 2012

%

FUNDING RATIO 2011

%

FUNDING RATIO 2010

&

FUNDING RATIO 2009

%

FUNDING RATIO 2008

%MEDIAN

%

1 Illinois 39.3 40.4 43.4 45.4 50.6 54.3 44.42 Kentucky 44.2 46.8 50.5 54.3 58.2 63.8 52.43 Connecticut 49.1 49.1 55.1 53.4 61.6 61.6 54.34 Alaska 54.7 59.2 59.5 60.9 75.7 74.1 60.25 Kansas 56.4 59.2 62.2 63.7 58.8 70.8 60.76 New Hampshire 56.7 56.2 57.5 58.7 58.5 68.0 58.07 Mississippi 57.6 57.9 62.1 64.0 67.3 72.8 63.18 Louisiana 58.1 55.9 56.2 55.9 60.0 69.6 57.29 Hawaii 60.0 59.2 59.4 61.4 64.6 68.8 60.710 Massachusetts 60.8 65.3 71.4 68.7 63.8 80.5 67.011 North Dakota 61.0 63.5 68.8 72.1 83.4 87.0 70.512 Rhode Island 61.1 62.1 62.3 61.8 64.3 59.7 62.013 Michigan 61.3 65.0 71.5 78.8 83.6 88.3 75.214 Colorado 61.5 63.2 61.2 66.1 70.0 69.8 64.715 West Virginia 63.2 64.2 58.0 56.0 63.7 67.6 63.516 Pennsylvania 64.0 65.6 71.7 77.8 85.5 86.9 74.717 New Jersey 64.5 67.5 68.1 66.0 71.3 76.0 67.818 Indiana 64.8 61.0 64.7 66.5 72.3 69.8 65.719 Maryland 65.3 64.2 64.5 63.9 64.9 77.7 64.720 South Carolina 65.4 67.9 66.5 68.7 70.1 71.1 68.320 Virginia 65.4 69.5 72.0 79.7 83.5 81.8 75.922 Alabama 66.2 66.9 70.1 73.9 75.1 79.4 72.023 Oklahoma 66.5 64.9 66.7 55.9 57.4 60.7 62.824 New Mexico 66.7 63.1 67.0 72.4 76.2 82.8 69.725 Vermont 69.2 70.2 72.5 74.6 72.8 87.8 72.726 Nevada 69.3 71.0 70.1 70.5 72.4 76.2 70.827 Ohio 71.9 65.1 67.8 67.2 66.8 86.0 67.528 Montana 73.3 63.9 66.3 70.0 74.3 83.4 71.729 Arizona 74.1 74.5 73.2 77.0 79.9 80.8 75.730 Arkansas 74.5 71.4 72.5 74.8 77.5 87.2 74.631 Minnesota 74.7 75.0 78.4 79.8 77.1 81.4 77.732 Utah 76.5 78.3 82.8 85.7 84.1 100.8 83.433 Missouri 76.6 78.0 81.9 77.0 79.4 82.9 78.734 California 76.9 77.4 78.4 80.7 86.6 87.6 79.535 Wyoming 78.7 79.6 83.0 85.9 88.8 79.3 81.336 Nebraska 79.2 78.2 81.9 83.8 87.9 92.0 82.837 Maine 79.6 79.1 80.2 70.4 72.6 79.7 79.338 Texas 80.4 82.0 82.9 83.3 84.1 90.7 83.139 Georgia 80.6 82.5 84.7 87.1 91.6 94.6 85.940 Iowa 80.7 79.5 79.5 81.0 80.9 88.7 80.841 Florida 80.8 81.6 82.3 83.7 84.1 101.7 83.042 Idaho 85.5 84.9 90.2 78.6 73.9 93.2 85.243 New York 87.3 90.5 94.3 101.5 107.4 105.9 97.944 Delaware 88.2 88.3 90.7 92.0 94.4 98.3 91.345 Oregon 90.7 82.0 86.9 85.8 80.2 112.2 86.446 Tennessee 91.5 91.5 89.9 89.9 95.1 95.1 91.547 Washington 95.1 93.7 94.9 92.2 93.9 92.9 93.848 North Carolina 95.4 95.3 96.3 96.8 99.3 103.4 96.349 South Dakota 99.9 92.6 96.3 96.1 91.7 97.4 96.249 Wisconsin 99.9 99.9 99.9 99.8 99.8 99.7 99.9

Median 69.3 68.7 71.6 74.3 75.9 82.3 73.0



VIII: Media Frenzy

It wasn’t long before it seemed like everyone was talking about a Muni Meltdown. The following is a by no means exhaustive list of some of the alarming stuff published on munis in 2010. I’m not including the bloggers who at this point were advocating defaulting on bonds on behalf of “the taxpayers’’ or “clickbait’’ compilations like “The 10 Cities That Will NEVER Come Back’’ that were such a favorite of Business Insider at the time. I should note here that Joe Weisenthal, then of Business Insider, now works for Bloomberg as Digital Content Officer.

Consider this, from the newspaper of record: “California, New York and other states are showing many of the same signs of debt over-load that recently took Greece to the brink — budgets that will not balance, accounting that masks debt, the use of derivatives to plug holes and armies of retired public workers who are counting on benefits that are proving harder and harder to pay.’’

Greek MythsThe story appeared on Page One of the

March 30 New York Times, headlined, “State Debt Woes Grow Too Big to Cam-ouflage.’’ Reporter Mary Williams Walsh

continued, “Some economists fear the states have a potentially bigger problem than their recession-induced budget woes. If investors become reluctant to buy the states’ debt, the result could be a credit squeeze, not entirely different from the financial markets in Europe, where mar-kets were reluctant to refinance billions in Greek debt.’’

Then there was the April blog posting by Rick Bookstaber, a senior policy adviser at the SEC. The next big crisis was the municipal market, he wrote. The culprit: overleverage, “in the form of high pension benefits and post-retirement health care.’’ He observed: “Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobri-um will be lessened, all the more so if the defaults are spurred by a taxpayer revolt — democracy at work.’’

Bookstaber was among those asked by Brian Chappatta at the end of 2011 about what happened. His response is contained in Appendix 2. I chatted with Bookstaber, who now works for the U.S. Treasury in the Office of Financial Research, in mid-November, and he told me he had nothing to do with the muni market, and declined further comment.

I knew we had reached an entirely dif-ferent level of muni crisis coverage when Matt Taibbi of Rolling Stone, who had achieved a certain notoriety in 2009 when he likened Goldman Sachs to “a giant vampire squid wrapped around the face of humanity,’’ weighed in with an article entitled “Looting Main Street’’ in the April 15 edition of the magazine.

The Taibbi piece concerned Jefferson County, Alabama’s use of interest-rate swaps, and was subtitled, “How the na-tion’s biggest banks are ripping off Ameri-can cities with the same predatory deals that brought down Greece.’’ The message was that municipalities were “now reeling under the weight of similarly elaborate and ill-advised swaps,’’ which the author termed a “financial time bomb.’’

It had been quite a few years since I had read Rolling Stone. I’ve been pretty exer-cised about municipalities’ use of swaps, myself. I’m not sure how many Americans get their investing advice from Rolling Stone, but they couldn’t have found comfort in yet another tale of predatory Wall Street

and feckless or corrupt public officials. The right-leaning Manhattan Institute’s

Nicole Gelinas in the think-tank’s City Journal advised readers of the Spring 2010 issue to “Beware the Muni-Bond Bubble.’’ Gelinas wrote: “Investors in municipal bonds don’t have to worry about a thing, the thinking goes, because the states and cities that issue them will do anything to avoid reneging on their obligations — and even if they fail, surely Washington will step in and save investors from big losses.’’

She continued: “These are dangerous assumptions. Just as with mortgages, the very fact that investors place unlimited faith in a market could eventually destroy that market. If investors believe that they take no risk, they will lend states and cities far too much — so much that these borrow-ers won’t be able to repay their obligations while maintaining a reasonable level of public services. The investors, then, could help bankrupt state and local governments — and take massive losses in the process.’’

Interesting Point of ViewThis was, I thought, an interesting point

of view. And then: “The uncomfortable truth is that as municipal debt grows, the risk mounts that someday it will be politically, economically, and financially worthwhile for borrowers to escape it,’’ Gelinas wrote.

Four years on, I asked Gelinas about the relative resilience of the market. In an e-mail dated Nov. 16, she replied, “The ‘resi-lency’ is shallow. Pension funds are doing well because [of] the Fed’s extraordinary actions to push up asset prices. But around the nation, from state-level credits such as Illinois and New Jersey to rich cities like New York to poorer and smaller cities and towns all over the place, many places are still pretty much insolvent,’’ she wrote. “They cannot make good on the healthcare promises they have made to current and future retirees, and many will not be able to make good on their promises to pensioners. In the meanwhile, infrastructure deteriorates because money that should be going to the future is going to the past. The 2009 recovery act was a missed opportunity to help states, cities, and other municipal credits fix their long-term structural problems, mostly pensions and health promises, in return for immedi-


Source: Svein Erik Dahl/John Wiley & Sons Christopher Whalen



Source: Bloomberg/Ramin Talaie

‘American Repudiation Gene’: James Grant

ate cash; instead, Washington treated it as a cyclical revenue shortfall.’’

She continued, “That we haven’t seen bondholder panic is more a sign of the desperation for yield and the principal-agent problem (do retail investors really know the risks that they are taking or do they see bonds as ‘safe’). It’s harder today than it was five years ago to assess the “too-big-to-fail risk” — that is, it is unclear whether Washington would step in to save, say, Citigroup bondholders, this time around, and it is similarly unclear whether Washington would step in to save, say, Illinois or New Jersey bondholders or pen-sioners. In the end, the clearest action that Congress takes may — or may not — be in not bailing out Puerto Rican bondholders. ‘‘

Warren Buffett opined on the muni market at least twice in 2010, telling shareholders at the Berkshire Hathaway annual meeting in May, “It would be hard in the end for the federal government to turn away a state having extreme financial difficulty when they’ve gone to General Motors and other entities and saved them.’’ In June, Buffett appeared before the U.S. Financial Crisis Inquiry Commission and predicted a “terrible problem’’ for municipal bonds “and then the question becomes will the federal government help.’’

Buffett hasn’t moderated in his views. In the Feb. 28, 2014 letter to Berkshire shre-holders, he wrote: “Local and state financial problems are accelerating, in large part because public entities promised pensions they couldn’t afford. Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made that conflicted with a willingness to fund them.’’

On June 14 of 2010, Ianthe Jeanne Dugan wrote in the Wall Street Journal that investors were “ignoring warning signs’’ in the municipal market. The article was headlined, “Investors Looking Past Red Flags in Muni Market.’’

James Grant — a friend, for whom I worked from 1994 to 1999 — offered another take on repudiation in the June 25 Grant’s Interest Rate Observer, in a scholarly article headlined, “Concerning the American Repudiation Gene.’’

“So low are yields, so complacent are investors, so persistent are fiscal deficits, so heavy is the weight of post-retirement

employee benefits and so ill-equipped are mutual funds to deal with anything resembling a shareholders’ run that we are prepared to take the analytical leap. On the length and breadth of the muni market, we declare ourselves bearish,’’ wrote Grant.

“The repudiation gene is ever present,’’ Grant continued, well into a very scholarly article. “The question is whether circum-stances in the tax-exempt market may coax it out of latency and back into action.’’

I asked Jim about his call this year. On Nov. 17, he e-mailed: “A swing and a miss.

The muni market has continued to mosey, there was no run on mutual funds. Perhaps more to the point, there turned out to be no homogeneous market on which to be comprehensively bearish. What’s Paul Isaac’s line?’’

Grant continued: “As to surprises: Where we erred was in expecting surprises. The muni market has not surprised. No drama, no short-selling, no credit upheaval, no volatility to speak of.’’ He concluded: “As to the current Grant’s stance toward munis, we judge that yields are too low. In that they resemble yields nearly everywhere.’’

‘A Muni-Bond Bomb’On Aug. 23, Steve Malanga of the

Manhattan Institute wrote an OpEd piece

in the Wall Street Journal about the SEC charging the state of New Jersey with fraud for misleading investors; the article was entitled, “How States Hide Their Budget Deficits,’’ and implied that other states may be guilty of the same thing.

Malanga also had a story in the Sum-mer 2010 edition of City Journal, “How to Dismantle a Muni-Bond Bomb.’’ He wrote: “State and local borrowing, once thought of as a way to finance essential infrastructure, has mutated into a source of constant abuse. Like homeowners before the housing bubble burst, states and cities have gorged on debt, extended repayment times, and used devious means to avoid limits on borrowing — all in order to finance risky projects and kick fiscal problems down the road.’’

He offered a handful of reforms, and said if the state and local debt bomb “can’t be defused, we’re all at risk.’’

I chatted with Malanga about the lack of a muni explosion since then in mid-November of this year. He noted that rating companies were now putting much more weight to pension debt in assess-ing credit, and, “What we’re seeing is a little more skepticism in the marketplace because of what happened in Detroit.’’ He added, “It’s a very uncertain time’’ for the municipal market.

In September, Meredith Whitney pro-duced “The Tragedy of the Commons,’’ a report on the 15 largest states. This would have gotten a lot splashier coverage when it appeared had Whitney actually published it.

As it was, she sent out a press release, but refused to show it to anyone but clients. I asked for a copy and was told I’d have to pay for it.

Seeking RefugeWhitney at the time said she had spent

two years working on the report, which didn’t predict any state defaults. Yet she began making the rounds, appearing on business radio and television and warning about how overleveraged states were, and how they needed a federal bailout. In the Nov. 3, 2010 Wall Street Journal, she wrote an OpEd piece entitled, “State Bailouts? They’ve Already Begun.’’

On Oct. 5, the New York Times’s Mary Williams Walsh wrote about how Harris-





burg, Pennsylvania, was seeking to enter the state’s Act 47 distressed-cities pro-gram, in a story headlined “Cities in Debt Turn to States, Adding Strain.’’ She wrote “Across the country, a growing number of towns, cities and other local governments are seeking refuge in similar havens that many states provide as alternative to fed-eral bankruptcy court.’’

The Wall Street Journal led its Money and Investing section on Oct. 10 with “New Risks Emerge in Munis: Debtholders Are Left Steamed as Some Cities Forgo Repayment Promises.’’ The story detailed Menasha, Wisconsin’s, failure to make an appropriation to pay debt service on a failed steam plant.

CALIFORNIA WILL DEFAULT ON ITS DEBT screamed the Business Insider headline on a Nov. 16, 2010, story about bank analyst Chris Whalen’s appearance on TechTicker. Henry Blodget wrote: “He says there’s no bailout coming for Califor-nia — or, for that matter, any of the other

bankrupt states. And that means big losses for muni-bond holders ...”

On the BrinkNicole Gelinas offered a prescription for

Congress to aid states, in a Nov. 17 New York Post piece, “States on the Brink.’’ In it she quoted Felix Rohatyn, the banker who helped craft New York City’s res-cue in 1975, who earlier that month told Charlie Rose, “We are facing bankruptcy on the part of practically every state and local government.’’ Even Gelinas thought Rohatyn “overstates the case today.’’ She advised Washington to get ready to bail out states: municipal market turmoil could “prove contagious.’’

The Weekly Standard’s cover story on Nov. 29 was “Give States a Way to Go Bankrupt,’’ by University of Pennsylvania law professor David Skeel. He suggested that both California and Illinois might avail themselves of such a law.


Skeel didn’t return a call for comment. His views on Chapter 9 municipal bank-ruptcy seem not to have changed at all. In August, he wrote a piece for the Wall Street Journal, approving Puerto Rico’s new law allowing certain public corporations to restructure their debt. “If Puerto Rico can restructure its debt,’’ he wrote, “there could be hope for states — particularly Illinois — whose own finances are sketchy.’’ He continues to advocate a federal bankruptcy law covering the states.

The lead story in the Dec. 5 Sunday New York Times was “Mounting Debts by States Stoke Fears of Crisis’’ by Mary Williams Walsh. And on Dec. 7, then-Business Insider’s Joe Weisenthal wrote about a Facebook post by Sarah Palin: “Sarah Palin Knows Where The Next Battle Is, As She Blasts The Idea of Bailing Out States.’’

Palin wrote: “American taxpayers should not be expected to bail out wasteful state governments. Fiscally liberal states spent years running away from the hard deci-sions that could have put their finances on a more solid footing.’’

Now, you might well ask what kind of sto-ries Bloomberg News was running at this time. Among the stories filed by the States & Municipalities team were “Moody’s Muni Bond Ratings Will Move to Global Scale,’’ “U.S. States Expect Taxes to Rise After Facing $84 Billion Gaps,’’ and “Wall Street Takes $4 Billion From Taxpayers as Swaps Backfire,’’ this last an investigative piece quantifying how much in swap termi-nation fees municipal issuers had paid to banks since 2008.

And then on Sunday evening, Dec. 19, “60 Minutes’’ ran a segment entitled “State Budgets: The Day of Reckoning.’’

“State and local borrowing, once thought of as a way to finance

essential infrastructure, has mutated into a source of constant abuse.”

— Steven Malanga, the Manhattan Institute

REAL ESTATETHIRD QUARTER 2014

CLICK HERE


http://www.bloombergbriefs.com/real-estate/


Before we turn to the events of Sunday, December 19, a day that will live in mu-nicipal market infamy, let’s briefly consider some of the stuff that was published and subsequently rattled around on the Inter-net, and the market’s response to it.

The articles that appeared in 2010 were generally long on headline, short on specifics.

They shared a common theme: Some-thing terrible is going to happen. And that is: States and municipalities are going to default on their bonds, because they are all being overwhelmed by debt and pen-sion obligations.

Most of the stories contained no fine shading, no nuance, and, unless the various articles described exceptional in-cidents that were already well-known and previously-reported — Harrisburg, Jef-ferson County, the Menasha, Wisconsin steam plant, Vallejo’s bankruptcy, various silly economic development, stadium and convention center financings — there was very little that was new. Beyond this rather large generalization: California, Illinois and New York, staggering along under seeming mountains of debt, are all going to go bust.

Missing DetroitI suppose if you had wanted to look at

things “nobody was talking about’’ back then, nobody was talking about Detroit staggering along toward an eventual bankrutpcy filing in 2013, or that Puerto Rico had its own crushing mountains of debt, or that Jefferson County, Alabama, would file for bankruptcy in 2011 or that Stockton, California, would file in 2012. That would have all been very useful, but it also would have required a lot of digging and a ton of luck. Along with predicting that Michigan Governor Rick Snyder would specifically authorize Detroit to file for Chapter 9.

The articles that appeared in 2010 almost all seemed intent on proving “the market’’ wrong, but only by way of innu-endo. Most of the authors were confound-ed by the lack of movement in what they called “prices,’’ although what they usually referred to was one or another of various yield indexes rather than actual trading.

That’s because most bonds only trade

for the first 30 days after being sold. So when someone writes, for example, “the municipal market tanked,’’ I want to ask: How do you know? That’s an equity mind-set. What really happens is: The bid-side dried up. It’s not as though you can go someplace and say, “Okay, I’d like to buy all the cheap munis now.’’

Finally, some of the provocative material that was published in 2010 was frankly political, aimed at public-employee labor unions, now fingered as the culprits behind massive state and local pension

liabilities. Their 401(k) accounts and retire-ment dreams now in shambles, many Americans were prepared to indulge in pension-envy.

The municipal bond industry reacted slowly and thoughtfully to the hysteria. By the fall of the year, though, the industry had produced a number of solid, compre-hensible reports spelling out, basically, That’s Not How This Market Works.

One of the first responders was Tom Kozlik, a municipal credit analyst at Jan-ney Montgomery Scott in Philadelphia. In the firm’s July 14, 2010, Municipal Bond Market Monthly, Kozlik wrote, “Many sto-ries published of late in the popular press have included overblown perspectives of municipal market risk.’’

His piece was entitled, “Municipal Market ‘Myths’ and ‘Truths’ and ‘Veritas Vos Liberabit’ Which Means, ‘The Truth Shall Set You Free.’ ’’ He discussed headline risk, and observed, “Although recent articles in the popular press try to portray a balanced opinion about the status of the municipal market, too often writers and commentators are not relying on municipal market experts for facts about the realities stressing the municipal market.’’ He continued, “The confusion, lack of knowledge and resulting fear mongering we have seen in the print and televised media has occurred because

Tom Kozlik


IX: The Market Responds to Its Critics

“ The confusion, lack of knowledge and resulting fear mongering we have seen in the print and televised media has occurred

because of the media’s misunderstanding of the municipal market.” – Tom Kozlik, municipal credit analyst at Janney Montgomery Scott



of the media’s misunderstanding of the municipal market.’’

The myths Kozlik addressed: That there was going to be a “‘Municipal Meltdown’ or a percentage of defaults or municipal bankruptcies’’ significantly above the his-torical norm; that the market would crash like the sub-prime loan market; that there would somehow be a default or bank-ruptcy “contagion effect;’’ that California, Illinois, or New Jersey would be “the next Greece;’’ that ratings and bond insurance were worthless.

I’m not sure how many reporters or com-mentators saw Kozlik’s piece, or the vari-ous other rejoinders that started to appear thereafter. Maybe some of this material

got through and was disregarded because it didn’t fit the narrative, or was dismissed because the writers felt the analysts in-volved were somehow discredited.

So much of what I thought passed for “dialogue’’ in those days was, after all, privately disseminated. Reporters only received some of it.

People UnfamiliarAs Kozlik wrote in a retrospective piece

on Aug. 27 of this year, “Several report-ers were dead set on the idea that the municipal market was the next sub-prime market and the municipal market would melt-down.’’

Most of the stories stoking the hyste-ria about munis featured quotes by, as I would characterize them now, people unfamiliar.

The go-to guy for the insider’s point of view, someone who actually knew what he was talking about and wasn’t afraid of being quoted, was Matt Fabian of the research firm Municipal Market Advi-sors. He was the Voice of Reason, the To Be Sure source in a sea of inexpert tes-timony. He must have been a very busy man. In some ways, I performed a similar role briefly in 1995, after Orange County, California, went bust. You can look it up.

On Sept. 30, 2010, Fabian produced a one-sheet “Special Report on Vilifying State Creditworthiness,’’ a sort-of re-sponse to Meredith Whitney’s “Tragedy of the Commons,’’ which he admitted he had not seen yet. After acknowledging the report might have some salutary effect in regard to budget-cutting, pension-building, debt-deferral and increased disclosure, Fabian wrote: “We are reluctant to directly rebut the report without having the docu-

ment itself. However, based on media cov-erage, it appears to succumb to what has been a common problem of non-municipal observers of our market: the conflation of various state stakeholder exposures.’’

Misunderstood LeverageStates are unlikely to default on their

bonded debt, he said, because of a num-ber of legal protections. What meltdown proponents were predicting was a mass, anarchic, political and legal abdication.

He also addressed “rollover risk,’’ first broached by Frederick Sheehan the previous year in his “Dark Vision.’’ Re-member, wrote Fabian, “that ‘leverage’ is an often misunderstood term. While states have greatly increased debt borrowings over the last five years, essentially all outstanding municipal debt is self-amor-tizing. Meaning, similar to a residential mortgage, principal is paid down regularly via level annual debt service payments funded with tax receipts. ‘‘

He continued: “Municipal issuers do not borrow as do international sovereigns or the US treasury: via large short maturity notes that in practice can only be refi-nanced with more debt, creating a crip-pling reliance on market acceptance for solvency. As we saw in 4Q08, an extend-ed primary market ‘closure’ produced no knock-on defaults; states simply stopped funding new infrastructure until rates fell far enough to justify the cost.’’

John Hallacy, head of municipal research at the then-new combination, Bank of America Merrill Lynch, con-fronted “Apocalypse Muni’’ in a comment piece on Oct. 1. He acknowledged that the federal government had already as-sisted the states: “The ARRA or stimulus provided several different levels of assis-tance including extending Unemployment Insurance benefits. Additional legislation in the amount of $26 billion was approved to provide extension of a higher level of Medicaid reimbursements for two quarters in the amount of $16 billion, and addition-al education assistance with the remain-ing $10 billion.’’

Hallacy also noted, “Debt and the amount of leverage on the part of the issuer have never been the best predic-tors of creditworthiness,’’ and observed:



Source: Bloomberg/Jin Lee “Tragedy of the Commons”: Meredith Whitney

“Most U.S. states are lightly indebted compared with regional governments

elsewhere in the world.” — Gabriel Petek, Standard & Poor’s



“The ratio that matters the most to us is the debt service carry on the budget. Most issuers keep this ratio well within 10 percent, and the level is typically closer to 5 percent. If the debt service carry is over 10 percent, the reason is most often because said issuer prefers to amortize its debt on a more rapid schedule.’’

So maligned had the asset class be-come by this time that Hallacy added at the end of his piece, “We are not apolo-gists for the Municipal Market.’’

Moody’s on Oct. 5 published a Special Comment, “Why US States Are Better Credit Risks Than Almost All US Corpo-rates.’’ The Comment described Illinois, at the time the lowest-rated state at A1, and then detailed why all of the states, even Illinois, were of better credit quality than 96 percent of corporate borrowers.

Munis Not CorporatesFundamental strengths of states, ac-

cording to Moody’s, include the capacity to increase revenue by taxes; the ability to cut expenses and capital outlays without reducing revenue; strong legal protection for debt service payments; limited conse-quences to running deficits and accumu-lating negative balances; less competitive pressure; lower event risk; and potential federal support.

This was probably one of the more important pieces produced during the crisis, describing as it did the unique char-acteristics of states (and, by extension, municipalities) compared to companies. People unfamiliar have long confused the equity and municipal markets, in the way they trade and in the way they respond to bad news. It is little wonder, then, that they also likened municipal issuers to companies. In fact, as Moody’s pointed out, “Game Over’’ looms over companies much more closely than it does over states and municipalities.

On Nov. 8, Gabriel Petek of Standard & Poor’s published two reports: “U.S. States’ Financial Health and Debt Compare Favorably With Other Regions’’ and “U.S. States and Municipalities Face Crises More of Policy Than Debt.’’

In the first, S&P reminded readers that, “From a global perspective, most U.S.

states are lightly indebted compared with regional governments elsewhere in the world. In our opinion, various constitu-tional or legal requirements for balanced budgets — more unusual outside the U.S. — have kept U.S. states’ debt burdens at moderate levels.’’

The report compared Ontario, Bavaria, Basel, Texas, New York, Illinois and California, and concluded, “in our assess-ment of U.S. states’ creditworthiness, we consider debt service payments to be a very modest proportion of expenditures and admit that most administrators are able to manage through severe economic turbulence, due in part to their relative lack of leverage. We believe that some discussions about financial catastrophe are meaningful only if governments prove unwilling to use their powers of adjust-ment to manage their positions.’’

Economic EnginesThe analysis included a table of various

financial measures and showed how states stacked up — pretty favorably, especially in terms of revenue. California and New York in particular are economic engines.

The larger piece emphasized state and local government agency. That is, these governments have the ability to man-age their way out of financial crises, and Standard & Poor’s expected them to do so: “We believe the crises that many state and local administrators find themselves in are policy crises rather than questions of governments’ continued ability to exist and function. They’re more about tough decisions than potential defaults.’’

The report stated that debt service is usually a payment priority, a legal obliga-tion, and then considered California, Illinois, New York and Texas, as well as a number of localities, including Las Vegas and Detroit.

From our perspective today, perhaps Detroit is the most interesting of the bunch. The rating company was unequivo-cal: “Michigan has repeatedly indicated to Standard & Poor’s that it would take all steps necessary to prevent a[n emer-gency financial] manager from filing for bankruptcy protection.’’

Fitch offered a Frequently Asked Ques-

tions written by lead analyst Richard Raphael called “U.S. State and Local Government Bond Credit Quality: More Sparks Than Fire’’ on Nov. 16. I liked it because it was full of common sense and treated the subject in straight English, and reiterated the strengths of the market:

“Due to the 20- to 30-year principal amortization of debt that is common in the U.S. municipal market, large bullet maturities and consequent refinancing risk is limited,’’ and “Debt service is a rela-tively small part of most budgets, so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action),’’ for example.

And then the company treated “systemic risk,’’ or the chance that the entire market would melt down somehow: “The munici-pal bond market is diverse, with thou-sands of issuers, over a dozen distinct sectors, and multiple security structures. The legal framework for municipal bonds depends upon a multitude of constitution-al, statutory, local ordinance, and con-tractual provisions. Each municipal bond sector has unique criteria and risks. Fur-ther, in many cases, a single municipality will issue several series of bonds, each secured by a different type of security.’’

I think the two pieces I enjoyed most emanated not from the industry but from the media itself. On Nov. 22, Brett


Source: Bloomberg/Jennifer S. Altman ‘Bold prediction! Don’t back down now!’: Henry Blodget




Arends of MarketWatch responded to the Christopher Whalen “California Will Default’’ interview with Henry Blodget the previous week.

“Can everyone please stop talking total nonsense about the California budget?’’ wrote Arends. “I know that facts and truth seem to be optional these days. I know that in the exciting new world of infinite media everyone can choose to believe whatever fantasies they want. But in the case of California, it’s getting on my nerves.’’

Arends recounted an e-mail exchange he had with Whalen, who said “My gen-eral comments have to do with my guess as to the impact of mounting foreclosures and flat to down GDP on state revenues.’’

‘All Henry’s Fault’Arends replied, “Your guess? These are

important problems, to be sure. But do you have any actual numbers?’’ To which Whalen replied, “Revenues fall and man-dates rise to the sky. You do the math.’’ Arends pressed: “Er, no, actually, it’s your assertion. You do the math.’’ Whalen finally blamed Blodget. “I am a bank analyst. I have not written anything on this. My com-ments have taken on a life all their own. This is all Henry’s fault. Call him.’’

“Some prediction,’’ Arends wrote, and then: “Meanwhile Blodget chimed in on the e-mail exchange: ‘It’s a bold predic-

tion! Don’t back down now!’ ‘’ Arends concluded: “Bah. Welcome to the media world in 2010.’’

He then produced a piece showing that California, far from being the Greece of America, was actually the Germany of America, an economic powerhouse with a high standard of living, where entrepre-neurs still wanted to do business and one of the states that sent far more money to Washington than Washington redistributed.

It didn’t end there. On Nov. 23, Felix Salmon wrote about the incident for the Columbia Journalism Review’s “The Audit’’ blog, which discusses financial journalism: “In reality, what we’re seeing here is ex-pertise mission creep, and a rare example of an expert admitting to it. Whalen’s com-pany is highly regarded when it comes to analyzing banks’ balance sheets, and as a consequence of that regard, Whalen has gotten for himself a nice perch in the punditosphere, as well as a new book. But Whalen, as he admitted to Arends, is no more an expert on municipal finance than Freeman Dyson is on global warming. And so the proper stance for Blodget to take was not to deferentially pose questions to Whalen and then passively receive his oracular words of wisdom, but rather to push back and have a proper debate about Whalen’s assertions, as Arends might have done.’’

This was the clincher for me, though:

“More generally, the municipal bond market is a very complicated place, where expertise is hard-earned and voluble new entrants are inherently mistrusted, normally for good reasons.’’

Whalen, now a Senior Managing Direc-tor at Kroll Bond Rating Agency,was one of those interviewed by Brian Chappatta at the end of 2011 about the lack (so far) of a Muni Meltdown, and his comments lead off Appendix 2. I also e-mailed him on a recent Sunday to ask him about it. On Nov. 16, he e-mailed: “The process has proceeded about as I thought. Cases like Detroit and Stockton, CA, are the extreme examples where default has oc-curred, but in general the political class has proven able to extend and pretend with respect to sovereign credits of vary-ing sizes. Puerto Rico is another case where the threat of a general default is being used to forcibly restructure debt. In the case of GM, which was a sovereign credit for a time, the fact of default was used to ride over investors’ rights. Indeed, GM may well end up back in bankruptcy because of unresolved pension liabilities and chronic operational problems. CA was saved, for now, by Governor Brown, who is not afraid to say no to both parties in the CA assembly.’’

Which brings us to “60 Minutes’’ and its segment “Day of Reckoning.’’


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“Hundreds of billions.’’ With these three words, analyst Meredith Whitney won fame and notoriety and, eventually, ignominy.

The payoff: Prominent mention in scores of newspaper, magazine and blog articles, dozens of appearances on business radio and television and of course (in February of 2012) the inevitable book contract.

The phrase came almost at the end of a “60 Minutes’’ episode entitled “State Bud-gets: The Day of Reckoning,’’ an otherwise unremarkable and succinct look at public finance by CBS correspondent Steve Kroft, which aired on Dec. 19.

Whitney appeared at the end of the segment, in the role of Expert on the Mu-nicipal Bond Market. She was, said Kroft, convinced that some cities and counties wouldn’t be able to meet their obligations to bondholders. She said there would be a “spate’’ of defaults. Asked to define a spate, she replied, “50 sizeable defaults. Fifty to 100 sizeable defaults. This will amount to hundreds of billions of dollars’ worth of defaults.’’

Patted on the HeadKroft observed that Moody’s and Stan-

dard & Poor’s, “who got everything wrong in the housing collapse’’ said there was “no cause for concern.’’ Whitney, who, we were reminded by Kroft, had spent (with her staff) “two years and thousands of man hours trying to analyze the financial condition of the 15 largest states,’’ wasn’t buying it: “When individual investors look to people that are supposed to know better, they’re patted on the head and told, ‘It’s not something you need to worry about.’ It’ll be something to worry about within the next 12 months.’’

Then Kroft said, “No one is talking about it now, but the big test will come this spring. That’s when $160 billion in federal stimulus money, that has helped state and local governments limp through the great recession, will run out. The states are going to need some more cash and will almost certainly ask for another bailout. Only this time there are no guarantees that Washington will ride to the rescue.’’

Cue the stopwatch. “Hundreds of billions’’ was the key

takeaway from this segment. Municipali-ties would default on hundreds of billions of dollars in bonded debt, and within the next 12 months, or at least starting within the next 12 months. Everything else in the segment, you could say, yeah, every-one knows that, everyone knows that, everyone knows that, until you struck the “hundreds of billions’’ line, and, well, not everyone knows that.

Bold call! The record year for defaults until then was 2008, when $8.5 billion in bonds went into actual or technical default. And Whitney said — I went back and listened to the entire broadcast sev-eral times, just to make sure I had heard what I thought I’d heard — “hundreds of billions.’’ As in, not $100 billion, but a mul-tiple, meaning, at least $200 billion. And this would be something to be concerned about within the next 12 months.

Keep in mind when this “60 Minutes’’ epi-sode aired. It was Sunday, Dec. 19. Most of the market was either already on the end-of-the-year holiday or looking forward to beginning it. Most banks and rating companies probably weren’t anticipating putting out municipal market commentar-ies until January.

There are some columns you can’t wait to write. This was one of them, for me (see Appendix I). “Hundreds of billions’’ seemed to me to be in the realm of the fabulous, and I said so. It made no sense to me that a boatload of municipali-ties would all choose to renege on their bonds, especially since, as Fitch and others had pointed out just weeks before, debt service usually makes up a small part of their costs. Not paying debt service wouldn’t do much to solve their fiscal prob-lems. I also included my own prediction for defaults in 2011: Between 100 and 200, totaling between $5 billion and $10 billion.

I wrote the column on Monday (the same day, Whitney appeared on CNBC); it was edited on Tuesday, and was pub-lished later that night. It appeared on our Page One on Wednesday.

Inexpert WitnessBy then, both research firm Municipal

Market Advisors and Tom Kozlik of Jan-ney Capital had responded to “hundreds

of billions,” MMA saying late Monday, “Given the dire certainty presented by Whitney, it is a wonder the US equity mar-kets did not collapse on Monday under the weight of the anticipated demise of the state and local government entities.’’ On Tuesday, Kozlik put out a strategy piece headlined, “There is Not a Loom-ing Municipal Market Crisis, Although Many Factors are Stressing Issuers.’’ He advised: “Investors should not panic and sell-off municipal holdings.’’

For the next year, and the next, and even well into 2013, when her book, “Fate of the States’’ was published, Meredith Whitney was Topic #1 in the municipal market. Never had a personality become such a polarizing obsession. Whitney, whose remarks were really just a punc-tuation mark on the “Muni Meltdown’’ hysteria, after all, came to represent all the inexpert witnesses who had forecast the market’s imminent demise.

To paraphrase Winston Churchill on the Battle of El Alamein, before Meredith Whitney, the asset class never had a win. After Meredith Whitney, it almost never suffered a defeat.

The terms of the debate narrowed. Now instead of a vague “meltdown’’ forecast, municipal bond defenders, if that is the right word, could just point to “hundreds of billions’’ and say, That’s not going to hap-pen, and explain why.

I think my column was the most-read on Bloomberg that Wednesday, and I even got a call from our television producers to come on and explain myself. This one column also cast me in a new, heroic role: Municipal market champion. E-mails of thanks and praise came in.

This was unfamiliar ground for me. If anything, I was regarded as a scold by many bankers, especially for my general opposition to the use of interest-rate swaps by all but the most sophisticated municipal bond issuers.

E-mails ran about four-to-one in my favor, all of which I duly saved. The pro-Meredith Whitney ones generally reminded me that Whitney had called Citigroup dropping its dividend and how dare I, a mere journalist, declare myself a better analyst?

X: Oh, Meredith



There were lots of things for the mu-nicipal market to focus on in 2011: Bond ratings, new regulations, the future of tax-exemption, bid-rigging, swap termina-tion fees, accounting rules, bankruptcies, defaults. And it did, of course. But the main focus was all-Meredith Whitney-all-the-time.

Oh, there were a few last gasps of ge-neric big-media hysteria. On Jan. 21, The New York Times led the paper with a story headlined, “A Path Is Sought for States To Escape Debt Burdens,’’ about how “policy makers are working behind the scenes’’ to come up with a way to allow states to declare bankruptcy. In fact, it seemed that states wanted no part of access to bankruptcy.

And in March, Nouriel Roubini pre-sented “States of Despair,’’ which, despite the title, was really anti-hysterical. In it, the firm explained all the reasons why a meltdown of apocalyptic proportions, i.e., “hundreds of billions,” was extremely un-likely, and observed: “Our base case sees close to $100 billion of defaults over five years, but typical 80 percent recoveries are far higher than on corporate bonds.’’

Not the TitanicMore importantly, Roubini stated that it

was incorrect to “assume the Titanic is set on autopilot heading for the North Pole.’’ In other words, state and local governments weren’t passive observers, and could be expected to try and address the situa-tion. And he called any state bankruptcy discussions “dead on arrival.’’

The full title of the Roubini report was “States of Despair Part 1: Muni Stress — Past, Present and Future.’’ I’m not aware

of any Part 2 ever being published. But the real story was Meredith Whitney.

In February, the New York Times acknowl-edged as much with a story, “A Seer on Banks Raises a Furor on Bonds.’’

Redefining DefaultFor someone who had studied state and

local finance for at least a couple of years, she didn’t seem familiar with the nomen-clature. In 2010, she very briefly tried to redefine “default.’’

Rather than meaning missing a debt service payment, or violating a bond cov-enant, Whitney said that when she used the word “default’’ it meant something like breaking the “social contract’’ by reduc-tions in spending. Using this definition, everything from curtailing library hours to reducing retiree health-care benefits could be considered a “default.’’ You can see how easily “hundreds of billions” could add up.

But of course this was an absurdity. Eventually, in 2011, Whitney said she stuck by her “60 Minutes” phrase “hun-dreds of billions’’ of dollars in defaults, but added that “it was never a precise estimate over a specific period of time.’’ Yet it sure sounded that way to anyone who watched “60 Minutes.’’

She also used the word “restructur-ings’’ in a corporate way. In the municipal market, when bankers and issuers talk about “restructuring,’’ they usually mean refunding a deal so as to extend matu-rity — or at least they did until the Detroit bankruptcy.

In the corporate world, restructuring usually means some form of a cramdown. Whitney hinted darkly that there were lots

of “restructurings’’ going on out there in MuniLand, secretly.

Whitney also believed the Build America Bond program that was featured as part of the Obama fiscal recovery act repre-sented a kind of hidden bailout to states: “These states might have already reached some type of tipping point had the federal program not been in place’’ she wrote in the Wall Street Journal.

Such was the critical opposition to Whitney and her “hundreds of billions’’ call immediately post-”60 Minutes’’ that journalistic bigfoot Michael Lewis eventu-ally felt called upon to defend her, in his August Vanity Fair magazine piece on California, part of a series he was writing on the financial crisis. “Her words were being misrepresented so that her mes-sage might be more easily attacked,’’ Lewis wrote.

Well, let me stop right there. Whitney did have a larger story to tell, but all most people had to go on was her brief appear-ance on “60 Minutes’’ with its explosive conclusion. It’s not as though the show’s non-municipal-market-expert viewers could be presumed to have watched all the various cable news and business radio episodes featuring Whitney. And on the “60 Minutes’’ segment, the most im-portant thing she had said was “hundreds of billions’’ in defaults.

Whitney’s larger message was expound-ed in Lewis’s article, and later in her own

XI: After “Hundreds of Billions’’

Source: Bloomberg/Simon DawsonAnti-hysterical: Nouriel Roubini

“Her words were being misrepresented so that her message might

be more easily attacked.” — Michael Lewis, Author, referring to Meredith Whitney




book, “Fate of the States.’’ Boiled down, it goes something like this: Some states and their municipalities have borrowed too much and promised too much to their employees. This overleveraging will become apparent to all as these govern-ments are forced to cut services and raise taxes. People and companies who can afford to will decamp to greener pastures, those states that haven’t borrowed too much and that have low taxes. The new power region of the country is going to be the formerly flyover American heartland, and certain states in the South and West. In April of 2012, at a Grant’s Interest Rate Observer conference, Whitney said this would play out over the next two decades.

This was indeed a message, a very plausible, reasoned theory, even if I thought it wrong and not a little derivative.

Whitney protested to Lewis that she didn’t care about the “stinkin’ municipal bond market.’’ And this seemed to be very true, although in November of 2010 she told the Financial Times that she was seeking approval from the SEC to set up

a credit rating firm, which would grade municipal bonds, among other things. And on Bloomberg radio’s “Surveillance,’’ in May of 2012, Whitney said that she only looked at the big picture, not the Cusip-by-Cusip (and particular-and-specific) world of munis.

Which means that the “hundreds of bil-lions’’ call was meaningless, unless some-how also attached to a multi-generational forecast of fundamental demographic shift. The idea that people would vote with their feet and flee the high-cost, high-tax coastal states isn’t a new one.

I’m not sure that this nuanced theory would have garnered the attention, and subsequent book deal, and all the rest of it, that “hundreds of billions’’ did.

Meredith Whitney didn’t respond to my calls and e-mail for comment.

Stinkin’ Municipal MarketI’d like to say that the Muni Meltdown

hysteria died of natural causes. The economy revived, tax collections rose,

municipal officials did their jobs, defaults didn’t explode. That happened. I’d also like to say that the hysteria was dispatched by those who knew what they were talking about returning fire with articles and blog-postings and pieces of research dense with unassailable facts and statistics. That also happened. And I’d like to say that the willingness of people like David Kotok and Dick Larkin and Alexandra Leb-enthal and Matt Fabian, among many others, to appear on business television to explain the municipal market in slow motion — I’d like to say that quieted the Meltdown hysteria. Because that, too, happened.

I suspect the real reason the Melt-down hysteria subsided was because of Whitney. As she told Michael Lewis, she didn’t care about the stinkin’ municipal bond market. Yet that was all the report-ers on the Muni Meltdown Hysteria beat cared about, now that there was a specific target: “hundreds of billions.’’

Whitney refused to engage. Game over.


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Market participants began returning fire on the meltdown proponents during the second half of 2010. Meredith Whitney’s “60 Minutes’’ appearance at the end of the year quickened the pace.

In the Muni Meltdown Hysteria media game of 2010 and 2011, the burden of proof was always on the market. Meltdown adherents sent screaming headlines hur-tling around the web about how the entire municipal market was going to implode, and watch out below. Responsible analysts eager to retain their credibility had to respond with detailed, sometimes ponder-ous, explanations of why that amorphous and incendiary possibility wasn’t the case.

Then came Whitney. As I said, it was one thing to respond to the vague meltdown business, quite another to say why “hun-dreds of billions’’ was utterly implausible.

SmackdownSome of the best analysis was done im-

mediately after “60 Minutes.’’ The New York Post on Friday, Dec. 24, termed the week post-”60 Minutes’’ a Whitney “smackdown’’ (Whitney’s husband had been a profes-sional wrestler) and quoted Ben Thomp-son of Samson Capital, who appeared on CNBC and said the “numbers just don’t add up.’’ He said, “I can’t make the numbers work. If you look at the 10 largest cities and the 25 largest counties in the country, that’s $114 billion in debt outstand-ing. So you gotta basically have New York, Chicago, Phoenix, Los Angeles — these cities start to default.’’

On Dec. 21, Citigroup’s George Fried-lander responded at length in the firm’s Municipal Market Comment wihout naming Whitney: “For one thing, all of the top 50-100 municipalities in total do not have ‘hundreds of billions of dollars’ of debt out-standing. Achieving an outcome anywhere close to this projection would require not just that some major local governments would fail in the near future, but that virtually all of them would. If such a result were at all possible, it would be far from a secret, suggestions that municipal market participants — rating agencies, municipal finance departments, dealers and portfolio managers — are somehow ‘complacent’ notwithstanding.’’

Friedlander also paused to reflect on the meltdown hysteria: “We note that there has been a virtual avalanche of reports of this type over roughly the past fourteen months. The reports had several attributes in common: They were written by individu-als whose main expertise was in sectors other than municipal bonds and whose main claim for credibility was that they had been accurate in forercasting disaster in some other sector; They projected that there would be a very sharp upswing in the magnitude of defaults on rated municipal credits in the future, over a relatively short time period (i.e., over the next year or two); and The projections did not appear to treat effectively the differences between corpo-rate credits and state and local credits.’’

Sometimes the simplest questions are the best. How do you even get to “hundreds of billions’’? On Jan. 4, 2011, Michael J. Schroeder, CIO of Wasmer, Schroeder & Co. put out a comment on the subject, showing just how difficult it was, once you netted out the states and bonds that were escrowed with U.S. Treasury securities or their equivalents.

1 in 7If 200 “average’’ issuers defaulted, that

might add up to $10 billion, wrote Schro-eder. If you took the top 20 cities, they had about $115 billion in direct and overlapping debt, and none of them seemed about to go bust over the next 12 months.

Finally: “To arrive at a figure of ‘hundreds of billions’ of par amount defaulting in the next 12 months, by my estimate, over 5,000 issuers would have to default on their municipal debt, or about 1 in 7 that have debt outstanding.’’

At least two more white papers designed to challenge the hysteria appeared. On Jan. 20, the Center on Budget and Policy Priorities published a 21-page white paper entitled, “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm,’’ a nice primer that addressed every aspect of the meltdown hysteria, although it didn’t men-tion Whitney by name.

And in February, the Center for Economic and Policy Research published a paper on “The Origin and Severity of the Public Pension Crisis,’’ which sought to remind everyone that the real reason so many pension plans were underfunded was because of the shellacking they had taken in the stock market.

Any bibliography of bank and rating company responses to the Muni Meltdown Hysteria would probably run to 40 or 50 separate items. Most were distributed privately to clients, but several managed to surface and broaden the debate.

That is, to the extent there was any lon-ger any debate. By the middle of the year, it was apparent that Whitney’s “hundreds of billions” and Munigeddon weren’t imminent. All that remained was counting defaults and watching the calendar, and pointing out how silly it had all been.

XII: Returning Fire

“ For one thing, all of the top 50-100

municipalities in total do not have ‘hundreds of billions of dollars’ of debt outstanding.”

— George Friedlander, Citi

Source: Bloomberg/Jin Lee Asking simple questions: Citi’s George Friedlander



XIII: What Happened, and Lessons Learned

So, the Great Municipal Market Meltdown — that didn’t happen. Or did it?“Jeffco, Detroit, Rhode Island, Puerto

Rico. Harrisburg, San Bernardino, Vallejo, Stockton, all before getting to the usual suspects,’’ a colleague e-mailed me. To this I might add, the redefining of the General Obligation bond in the wake of the Detroit Chapter 9 bankruptcy.

Point taken. Each of them is exceptional. Each is worth an extended piece on its own merits. First, let’s look at what did happen.

The recession ended in June of 2009. 2010 was the year of hysteria, culminating in Meredith Whitney’s “60 Minutes’’ pre-diction. In 2011, 133 issuers defaulted on $6.56 billion in municipal bonds, accord-ing to Municipal Market Advisors.

This being the municipal market, of course, not everyone agreed at the time about the definition of default. Richard Lehmann, publisher of the Distressed Debt Securities Newsletter, put the 2011 figure at almost $26 billion, if you counted tobacco bonds and the munis backed by American Airlines in the total, and if you counted both actual and technical default.

If you counted only actual payment de-fault, the figure was $6.56 billion in 2011, $1.94 billion in 2012 and $8.54 billion in 2013, according to MMA. The total for 2014 will likely top the 2013 total, because of Detroit, says MMA.

Now let’s consider municipal bankrupt-cies. Vallejo, California, went bust in May of 2008, pre-hysteria. Central Falls, Rhode Island, filed for Chapter 9 in August of 2011. Harrisburg, Pennsylvania, filed in October of 2011, but this was thrown out. The then-record municipal bankruptcy was filed by Jefferson County, Alabama, in November of 2011, the proximate cause failure by the state to allow the county to levy a tax.

In the summer of 2012, San Bernardino, Stockton and Mammoth Lakes, California, all declared bankruptcy. Bloomberg News carried a story on July 13: “Buffett Says Muni Bankruptcies Set to Climb as Stigma Lifts.’’ In 2012, there were a dozen Chapter 9 filings, most of them for things like sani-tation and irrigation districts.

In July of 2013, Detroit became the new record municipal bankrupt. Meredith Whitney penned an opinion piece for the Financial Times, headlined: “Detroit Aftershocks Will Be Staggering,’’ or as Business Insider put it in their pickup: “Meredith Whitney: Detroit Will Start a Wave of Municipal Bankruptcies.’’

In 2013, there were eight Chapter 9 fil-ings. In the first nine months of this year, there were nine Chapter 9s, none by a city or town or what most people think of

when they hear the word “municipality.’’ They included hospital, levee and sanitary improvement districts.

In 2009, investors added almost $81.1 billion to municipal bond funds, according to Lipper US Fund Flows. In 2010, they added $5 billion. In 2011, as investors panicked after the Meredith Whitney call, they withdrew $14.4 billion. In 2012, they added $46 billion.

Yield indexes shot higher. The old-est gauge of municipal yields, the Bond

140 133

107

65

45

$4.03 $6.56 $1.94 $8.54 $8.76

0

20

40

60

80

100

120

140

160

2010 2011 2012 2013 2014

Num

ber o

f Def

aults

Number of Defaults

Par Value (in Blns)

Source: Municipal Market Advisors

Number of Defaults Dropped . . .

-$9.9

$9.4 $21.1 $17.3 $15.8

$81.1

$5.0

-$14.4

$46.0

-$64.2

$18.1

-80

-60

-40

-20

0

20

40

60

80

100

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014Q1-Q3

Muni Bond Flows

Source: Lipper US Fund Flows

In B

illio

ns o

f U.S

. Dol

lars

. . . Investors Withdrew Funds After Meredith Whitney Call




Buyer’s 20-Bond General Obligation Index, rose from 3.82 percent on Oct. 14, 2010 to 5.41 percent on Jan. 20, 2011. The index fell throughout 2011 and 2012, rose in 2013, fell in 2014, and is now in the 3s.

States and municipalities reduced spending, raised taxes and fees, balanced their budgets and fired employees. States had 5.2 million employees on Jan. 31, 2009, which they cut to just over 5 million by the end of July 2013. Local govern-ments had 14.6 million employees in Oc-tober of 2008; they fired almost 600,000 by March of 2013. Both have resumed hiring, albeit slowly.

States and municipalities slowed their borrowing in the bond market. In 2010, they sold almost $408 billion in long-term, fixed-rate municipal bonds. This declined to $258 billion in 2011, rose to $352 billion in 2012, dropped to $298.7 billion in 2013, and currently stands at about $220 billion.

If I can generalize: If a Municipal Market Meltdown did not and has not occurred, what did happen?

States and municipalities, with a few exceptions, muddled along. Federal assis-tance in varying degrees and interest-rates held near zero by the Fed eased the way.

Beware Inexpert TestimonyWhat can we learn from the hysteria?

Are there any lessons that investors can learn from the panic of 2010?

First: Remember my friend Paul Isaac’s dictum: The municipal market is particu-lar and specific to a remarkable degree. Hysteria proponents either ignored, or (my bet) didn’t know about the incred-ible variety of securities and credits sold generically as “municipal bonds.’’ They generalized.

Second: Beware inexpert testimony of-fered on the Internet. Not all points of view are legitimate and credible.

Third: Politics and municipal credit analysis make strange bedfellows. Many of the dire predictions about the market were politically informed, driven by an almost visceral hatred of municipal labor unions.

Consider, for a recent example, a Sep-tember editorial in the Wall Street Journal about Sen. Chuck Schumer’s support for munis as high quality liquid assets for banks. Schumer urged federal regulators to reconsider their decision to prohibit banks from considering munis as such assets, saying it might even slow or halt infrastructure projects.

The Journal observed: “That ‘infrastruc-ture’ line sounds nice, but Mr. Schumer’s real purpose is to keep the money flowing to his friends in local government so they in turn can keep the money flowing to union employees.’’ I thought: Is this really what the Journal editorial board considers the only pupose of municipal borrowing?

Fourth: Municipalities — that is, those who are legally allowed to (not all states

allow it) — will do all they can to avoid filing for Chapter 9, which by design is onerous, extremely expensive and, yes, carries a stigma. The corollary to this observation is that when they do file, the corporate attorneys and advisers involved will target bondholders as easy prey. Even the conservatives in Orange County for a very brief period early in the county’s bankruptcy in 1995 talked of “repudiating’’ certain bonds sold only the year before. One of Detroit emergency financial man-ager Kevyn Orr’s very first gambits was to declare that general obligation bondhold-ers were unsecured and entitled to only cents on the dollar.

Fifth: Twitter is a good source of breaking news and analysis. Dismiss it at your risk.

Source: Bloomberg/Pete MarovichDefending Munis: Sen. Chuck Schumer


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Bloomberg Brief: Muni-Meltdown That Wasn’t

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Appendix 1: Meredith Whitney Overreaches With Muni Meltdown Call

COMMENTARY BY JOE MYSAK

Dec. 22, 2010 (Bloomberg) There will be between 50 and 100 “significant’’ municipal bond defaults in 2011, totaling “hun-dreds of billions’’ of dollars.

So said banking analyst and new mu-nicipal bond expert Meredith Whitney on the “60 Minutes’’ show on Sunday, in perhaps the boldest, most overreaching call of her career.

Hundreds of billions of dollars? The one-year record, set in 2008, is $8.2 billion. You can see how an estimate of “hundreds of billions’’ would get people’s attention.

There are a lot of reasons to be doubtful about the health of the municipal market right now, as elucidated by “60 Minutes’’ correspondent Steve Kroft. Tax revenue is down, public pension and health-care liabilities are up, the federal government’s bailout money to the states is running out and the chances that those funds will be replenished are remote.

And yet — hundreds of billions of dollars in default? The number is in the realm of the fabulous. If pressed, I would say that we might see between 100 and 200 mu-nicipal defaults next year, maybe totaling in the $5 billion or $10 billion range.

Whitney doesn’t believe the states will default. That leaves us with local govern-ments and authorities as the ones failing to pay debt service on their bonds, which makes this an even bolder call.

Most defaults in the modern era aren’t governmental or what we might call mu-nicipal at all. The majority are corporate or nonprofit borrowings in the guise of some municipal conduit — nursing homes, hous-

ing developments, biofuel refineries — so they could qualify for tax-free financing.

Whitney’s VisionAnd those are the ones I think will still

comprise the majority of defaults in 2011.This isn’t the Whitney scenario. No, she

envisions between 50 and 100 — or more — counties, cities and towns making the choice to renege on their bonded debt.

My question is: Why?Why would a governmental entity go out

of its way to provoke or alienate its best source of finance? In the old days you might say that bondholders were a distant class of banks and plutocrats mainly cen-tered in the Northeast. That’s no longer true, and hasn’t been since at least the passage of the Tax Reform Act of 1986, which made bonds less attractive for banks and insurance companies, among other things. Today, a city’s bondholders might live in the municipality itself, and almost certainly reside within the state.

Debt ServiceWhy would a governmental entity

choose to default on its bonds, especially if they make up a relatively small propor-tion of its costs?

“Debt levels for U.S. local and state governments are relatively low, with an-nual debt service representing a relatively small part of budgets,’’ Fitch Ratings said in a special report in November.

Entitled “U.S. State and Local Govern-ment Bond Credit Quality: More Sparks Than Fire,’’ the report said, “The tax-sup-ported debt of an average state is equal to just 3 percent to 4 percent of personal

income, and local debt roughly 3 percent to 5 percent of property value. Debt ser-vice is generally less than 10 percent of a state or local government’s budget, and in many cases much less.’’

The lead analyst on the report was Richard Raphael, who has been cover-ing municipal finance for 31 years. He is not one of the analysts “who got every-thing wrong in the housing collapse,’’ in the words of correspondent Kroft. In his report, Raphael said, “debt service is a relatively small part of most budgets, so not paying it does not do much to solve fiscal problems (particularly as compared to the costs of such an action).’’

Headline GrabberWhat irks me about this Whitney call is

that it generalizes about a market that resists generalization, a market that is particular and specific to a remarkable degree. And it doesn’t answer the question “Why?’’ It is instead an assertion aimed at getting attention.

Whitney made headlines in 2007 when she predicted Citigroup would lower its dividend and that it was time to sell bank stocks. She made headlines in September when she said she produced a report on 15 states’ financial condition, and said the federal government might be called upon to bail them out. Whitney only let clients see the report, so I don’t know if her con-clusions are supported. She said it was 600 pages long and had taken two years to produce.

Perhaps Whitney should stick with bank stocks.

“ Debt levels for U.S. local and state governments are relatively low, with annual debt service representing a

relatively small part of budgets.” — Richard Raphael, Analyst



Dec. 13, 2011Before Meredith Whitney predicted that

municipal defaults in 2011 would total “hundreds of billions of dollars’’ in a Dec. 19, 2010 broadcast of CBS Corp.’s “60 Minutes,’’ several analysts made similar claims about the imminence of defaults and bankruptcies at the state and local levels. Four people who previously wrote or spoke about the problems facing the market in 2011 discussed their previous statements, why the market held together this year, and what the future holds for state and local issuers with Municipal Market’s Brian Chappatta.

‘California Will Default’ Christopher Whalen: My basic view

hasn’t changed, and my comment was re-ally more of a medium-term issue. In other words, they’re going to try to raise taxes in California, but they’re not going to get very far. The whole West is like this. They’re antithetical to taxes, especially property taxes. The whole point of the comment was that eventually, the politicians are go-ing to have to use the threat of default to move the political process. And I still think that’s the case. Illinois is arguably worse than California now, because they haven’t done anything.

I was pretty critical of New York last year, but Andrew Cuomo is doing very well. He’s well ahead of the other two states. My sense is we still have a risk of at least threatened political default, like we went through with the budget last summer.

The question is: What do you do in a flat environment in terms of employment and the real estate market, where there’s no automatic appreciation in the tax base? That’s the big issue I see. If we’re going into a period with flat or down real estate prices, that’s not going to help anybody maintain revenues versus rising expenses. So there’s a squeeze here between revenues and expenses and I don’t think that’s going to change.

I’m not an end-of-the-world guy. What I do think is everyone’s premise about revenue and growth has to change, and that’s going to ripple through politically, especially in Illinois. I could see them default, simply because the politics are not aligned correctly for people to deal with the issue.

In the 80s, when we had the S&L crisis, it took us almost 10 years — three con-gressional elections — to change the mix in Congress so they would actually deal with it. And we’re going through the same thing now. We may have to not only have an election next year but also an election two years later before you get the mix in Congress changed so they’ll actually do this. The old guard politically, they don’t want to deal with this.

I haven’t really changed my outlook, but I’m not a doom-and-gloomer. I just think politics, especially in the West, are going

to have to get involved at some point, because the population there is still pretty recalcitrant, and they don’t think they should have to pay more taxes. They’re talking about raising expenditures for the schools. Yet we don’t have the money. But they don’t want to hear it.

Christopher Whalen is managing direc-tor of Institutional Risk Analytics, a Torrance, California-based bank-rating firm. He said in an interview with Henry Blodget on Yahoo Finance’s Tech Ticker in November 2010 that California will default. Blodget, who is also the chief executive officer and editor-in-chief of Business Insider, later posted on the site the headline: “CALIFORNIA WILL DEFAULT ON ITS DEBT, Says Chris Whalen.’’

‘Let States Go Bankrupt’ David Skeel: Politically, things have

changed since I wrote that piece in terms of the likelihood of it going anywhere in Congress. The political enthusiasm for the state bankruptcy idea has temporarily dimmed. The problems haven’t gone away. I still think bankruptcy would significantly improve our ability to deal with a crisis. If the Eurozone crisis were to deteriorate further and have ripple effects here, things could quickly get worse than they are.

It has always been quite possible that nobody would get to the edge of default. One of the arguments against bankruptcy for states is the downturn is largely cycli-cal and they’ll almost certainly be able to muddle through. I think that may be right, but it doesn’t seem to be a basis for saying we don’t need to do anything else. It’s like saying there’s no need to have a fire department because we haven’t had a fire. So the arguments for a state bank-ruptcy framework remain compelling.

One of the criticisms of bankruptcy as a solution is it doesn’t solve the political problems. The reason states get into so much trouble is usually because there’s some breakdown in the political process. Bankruptcy is not a silver-bullet solution to that. If you’ve got political problems, they’re probably not going to disappear, but bankruptcy does point in the right direction.

Another criticism of bankruptcy is if you

Appendix 2: Muni Meltdown That Wasn’t Confounds Market’s Earliest Critics

“The biggest thing I didn’t understand when I wrote that

paper, which I understand now after I talked to some

people who have really been involved in municipal govern-ment, is how hard a state will work to avoid any default on a

GO bond.” — Frederick Sheehan, Author

Source: Bloomberg/Andrew HarrerAndrew Cuomo




put a bankruptcy framework in place, states would find it really hard to buy, and it would just cripple them in terms of bor-rowing. If you look at countries that have defaulted, they’re regularly able to go back to the market within a year or two. It’s not like they’re shut out forever. In the short-run, they often pay more for credit, but sometimes it’s not that much more.

What we’re seeing now is that the higher levels of government are suffer-ing so they’re cutting off funding to lower levels of government. States are being hit because the federal government is in worse shape, and localities are being hit because states are in worse shape. It’s quite possible that these trends are go-ing to increasingly come to the surface, and we may end up with a very serious debate about whether bankruptcy is something we should be doing. My guess is it probably doesn’t happen before next November. It’s a political hot potato, so I doubt anybody is going to be pushing it during the election season. But I could easily see it coming quickly thereafter.

The disclosure issues with municipal debt, state debt and pension obliga-tions, that’s the sort of thing that could get bipartisan political support. That’s what I would expect to see in the coming months: measures short of state bank-ruptcy getting serious attention, and then if things get radically worse, we might have that bankruptcy debate again.

We’re seeing significant bankruptcies in the municipal context. It’s possible Harrisburg will end up back in bank-ruptcy next year. Jefferson County is in bankruptcy now. So the old argument that significant municipalities don’t file for bankruptcy isn’t true anymore. If signifi-cant municipalities are finding them-selves in bankruptcy, it’s certainly not out of the question it would be an issue for the states.

David Skeel is a professor of corporate law at the University of Pennsylvania Law School. He wrote an article for The Weekly Standard in November 2010 titled “Give States a Way to Go Bankrupt,’’ in which he said bankruptcy would be the best option to avoid a “massive federal bailout.’’

The Next Bubble Richard Bookstaber: I can’t speak with

the press because of my government positions. Also, I have not kept abreast of the muni market.

Richard Bookstaber is a senior policy adviser at the Securities and Exchange Commission. On April 4, 2010, he wrote on his blog, rick.booksta-ber.com, an entry titled “The Municipal Market,’’ in which he said the municipal market was the next source of crisis. He cited a variety of criteria, and said ``once a few municipalities default, there is a risk of a widespread cascade.’’

‘Dark Vision’ Frederick Sheehan: In that paper, if I

had predicted any timing, I would have been wrong. I expected many more defaults than there have been by now. What I think at this point is that there are some real problems that are going to lead to a lot more defaults. Incomes are falling in the country, so taxes are going to continue to fall in municipalities. Even through there’s talk about reducing costs and cutting back, they’re continually short of where they’re going to need to be with reduced revenues.

I think there will be a lot of trouble, and a lot of defaults. I think it will be, in the end, at least a couple hundred billion dollars in general obligation bonds. It depends on the project, but they are generally more risky.

Defaults will come within two or three years, because the trend I mentioned is going to keep working against municipali-ties and states. Incomes are not going to improve. House prices are not going to rise. Pension contributions will go up. Weariness will set in, where they are doing what they think they need to do in order to reduce costs, but they have to run harder just to stay in place.

The biggest thing I didn’t understand when I wrote that paper, which I under-stand now after I talked to some people who have really been involved in municipal government, is how hard a state will work to avoid any default on a GO bond. If you just look at the numbers, you would expect the state is really up against it and doesn’t have long to go. But after talking to some

people, it’s clear that is the last thing that a state wants. To not be able to borrow — they will do anything to avoid that.

Municipal bonds are not well under-stood, and I have found that out since I wrote that paper. The people who own municipal bonds, and even the people who sell them often don’t understand what they’re really buying. They can’t really approach what they own or what they’re selling other than as an aggregate class of municipal bonds. They are not large, aggregate classes. They are individual bonds and that’s not well understood.

There is generally a presumption, even if it’s not stated, even if it’s just out of a tacit understanding, that if things get really bad, the federal government will be able to come to the states’ aid. But there is the possibility that the federal government will not be able to come to their aid, probably a good chance, especially if it is in the bil-lions of dollars. States and municipalities could be surprised by that.

Federal money has helped prevent default. They haven’t reached that critical point where they couldn’t bridge the gap by issuing more bonds. Being able to do that has given them some time. Also, over the past couple of years, it has become much better understood that municipalities are having difficulties and are addressing them. Whether they will have addressed those problems enough, when the addi-tional costs of the reduced revenues start to hit, I don’t know. It has given them a chance to look at the situation and make some changes that have allowed them to continue paying the bonds.

Frederick Sheehan is the author of “Pan-derer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession.’’ He wrote a piece for Weeden & Co. called ``Dark Vision: The Coming Collapse Of The Municipal Bond Market’’ in September 2009. In it, he said: ``The municipal market will probably repeat the pattern of the sub-prime collapse. Although it is plain to see, the usual experts do not notice.’’




REVIEW BY JOE MYSAK

June 3, 2013 (Bloomberg)We’re all moving to North Dakota.Or South Dakota. Or somewhere out

there in the middle of the country.This is the thesis of Meredith Whitney’s

“Fate of the States: The New Geography of American Prosperity.’’ The country’s “central corridor,’’ largely untouched by the housing bust, is going to drive the economy for decades to come.

The “smart money,’’ she writes, “is flock-ing to states with lower tax burdens and less strained budgets.’’

Fleeing the coasts is not a new idea. I trace its modern incarnation to Rich Karlgaard’s 2004 “Life 2.0,’’ in which the Forbes publisher asserted that people were leaving the crowded, overpriced coastal states to seek “larger lives in smaller places.’’

Now Whitney, with a barrage of numbers, percentages, gross generalization, bald assertion and outright error, joins the ranks of the demographic determinists. Perhaps the favorite word of these proponents of the decline and fall of New York and Cali-fornia is “already.’’ Whitney doesn’t disap-point: “The United States is already in the process of rebalancing itself demographi-cally based upon opportunity and standard of living.’’ This is already happening, she writes. In other words: I’m right!

‘60 Minutes’Not so fast. The idea, based purely on

dollars and cents, sounds reasonable. Yet the evidence is thin. And using the last five years as predictor of the next 30 is questionable. There are lots of reasons people move. Tax policy is low on the list. And some states possess advantages others just can’t overcome.

What Whitney, a banking analyst who in 2007 made her name with the call that Citi-group was going to suspend its dividend, is doing here is defending her December 2010 appearance on “60 Minutes.’’

At the time, Whitney had spent two and a half years on an otherwise unremark-

able piece of research, a punctuation mark to the hysteria about public finances common during the latter stages of the financial crisis.

To correspondent Steve Kroft, Whitney predicted that the unhysterical experts were wrong, and that the municipal market would see “50 to 100’’ significant defaults.

‘Hundreds of Billions’Nobody had a problem with that figure.

The average since 1980, according to Distressed Debt Securities Newsletter data, is 111 defaults per year totaling an average of $3 billion.

Asked to put a dollar amount to the pre-diction, Whitney blurted out, “hundreds of billions’’ of dollars. Instead of challenging this absurd figure, Kroft just gave one of his crinkly-eyed, sorrowful shakes of the head, pitying all those bondholders.

Investors panicked and pulled $26 billion out of muni mutual funds over the next few months, according to Lipper U.S. Fund Flows data. Whitney got a ton of attention, and not coincidentally a book contract.

Connect the DotsWhether we will all move to Kansas is

debatable. What isn’t are the factual errors on display here.

Experts, Whitney writes, are “quick to point out that states have never defaulted.’’ Who are these experts? The ones I know

acknowledge that Arkansas was the last state to default, in 1933.

Cities “just assumed that their states would be there to bail them out.’’ On the contrary, most local officials know that re-course to the states is limited and punitive.

“Jefferson County’s finances were sunk by a water-and-sewer project that, thanks to graft and engineering blunders, never actually got built despite the county’s bor-rowing and spending billions.’’ Never got built? That isn’t true.

Orange County, California, bondholders “would not have been repaid had it not been for a bailout by the state of California.’’

Bailout? State lawmakers allowed the county to divert tax revenue from certain county agencies to back a bond issue used to repay obligations. No one consid-ered this a bailout.

In the introduction to “Fate of the States,’’ Whitney writes, “My brain instinctively works to connect the dots in life, turning mosaics of information into narrative tales of how things came to be and what I think will happen as a result.’’

That way madness lies. There are 89,004 local governmental entities in the U.S. Take four or five or a dozen headlines and “connect the dots,’’ and you no doubt have a trend, maybe even a book. What you don’t have is an accurate picture of municipal finance.

Appendix 3: Meredith Whitney Says ‘I’m Right’ With Number Barrage: Books

The “smart money is flocking to states with lower tax burdens and less

strained budgets.” — Meredith Whitney, Author



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