Schroeder: Gist of Whitney’s Muni Forecast ‘Valid’
Alice Schroeder, a former Wall Street analyst and the author of the only approved biography of Warren Buffet, has Meredith Whitney’s back. She says the macro view that Whitney presents on U.S. states and municipalities is largely correct. Her view is that many with a vested interest in the muni market staying afloat are tearing her down over some specifics that are less relevant to the broader macro picture, the "Ponzification of municipal finance".
I would agree with that assessment with a few caveats. Looking back at calls by both Meredith Whitney and another bear David Rosenberg, I think their macro case was too bearish. Their comments on unemployment reinforced my sense that their macro cases were based on expectations of a double dip. Without the dip, the macro case is a lot more benign (at least until the next dip and then we have to see). For example, in November 2009, I wrote that both Whitney and Rosenberg were expecting at least 13% unemployment in this cycle:
David Rosenberg thinks the unemployment rate is headed much higher than anyone anticipates. If you recall, back in January when the stimulus package was crafted, the Obama Administration felt that passing the bill would mean an unemployment rate which would top out at 8.0%. As the situation deteriorated, the President recognized that 10.0% was more likely – a number we just got last week. But Rosenberg is the only one (except Meredith Whitney) who is talking about 12-13%.
As an aside, it was interesting to hear Whitney at about 3:15 into the third video in the link above from July. Right before she gives us the dreaded 13% number, she admits to lowballing her house price decline estimates in order not to be dismissed as wildly out of step with consensus…
As I indicated when the employment numbers came out last week, we should expect the labor force participation rate to increase during recovery as discouraged workers come back into the labor force. The fact that the opposite is still happening means the unemployment rate will move higher (although 13% is sure to induce a double dip and I am not seeing this as a base case at this time).
Isn’t the municipal question really about the economy? What are the chances of large defaults without a recession? For example, when I first heard Whitney had released her report in September, I wrote:
My view is that states, like banks, are very much dependent on an improved economy because of their leverage to the housing market. There are numerous chinks in the armour which could spell disaster for the most indebted states. I mentioned the leverage to the housing market, but there are the underfunded pension problems, unemployment insurance borrowing, and the inability to just print money to meet debts and other problems as well. For investors, the message is buyer beware because, while CDS are soaring for the weaker debtors, clearly municipal bond prices do not reflect the financial stress. And while I broached the idea of the Fed stepping in to the situation with municipal bond purchases as the ECB had done (and continues to do) with euro zone states, this is unlikely.
So I really don’t see how you get the hundreds of billions of defaults in 2011 when the economy is still in recovery. I think the heart of the matter for muni investors goes to whether, now that munis have sold off as expected, municipal bond prices reflect the financial stress of the states and municipalities. Retail investors are a large portion of the investor pool here as munis have ben sold as very safe, near risk-free assets, not ones beset by default risk. I don’t think they have the skill set to make that determination. Hence the panic and fund redemption.
Now, in October I profiled Christopher Mier talking about the state budgets. At the time, I wrote:
Mier believes the odds of a bailout are "very, very low" because of the taxing power of states. He says "states are strong financial entities, inherently." He considers this a "non-productive discussion." Mier’s view is that “the problem in the municipal market is much more on the level of local units of government. They have less resources, they have smaller economies, and they have limited abilities to tax.”
This was a good analysis by Mier. States have a lot of ways including taxing authority to make sure they can pay their bondholders. President Obama is attempting to ‘fix’ the state problem with a rescue plan for states with unemployment insurance debt burdens. Like Mier, I don’t see bailouts here. I don’t see this plan getting any traction as Congressmen like Patrick McHenry do not want to put off the day of reckoning; they want to accelerate it.
I also said in that post
If the U.S. economy does not double dip, the bailout scenario will likely not come to pass. However, if the U.S. economy double dips, the loss of taxes due to a fall in house prices and the loss of employment will severely damage state and municipal balance sheets. Moreover, given recent reports of shortfalls in state and municipal pension funds, a fall in the stock market would add additional downside risk.
In the end, my takeaway is that recovery means no crisis. Municipalities are the most vulnerable and they aren’t large enough to result in seismic defaults. Also, I see the muni problem as problematic due to secular factors, but acute and crisis-ridden primarily due to cyclical factors like income taxes, property taxes, unemployment insurance, and pension assets values. Translation: secular issues will have a cyclical trigger for states just as with housing and tech stocks. The Rosenberg/Whitney macro case is good. But extrapolating the present into the future doesn’t work. Nevertheless, when the recovery and employment/economic/asset price growth fade, given the stress in municipalities and states, the initial stages of crisis could precede and help precipitate the downturn. But, in general, I say wait for the next downturn and then we’ll see a lot of defaults.
As for the next downturn, remember that rates are now at zero percent. Policy makers benefitted over the last 30 years from being able to cut rates into and during a downturn. I think it’s the end of the line next go round. We will see a lot of QE and other unconventional policy options and even that won’t preclude a very serious downturn.
With all that in mind, here’s the Schroeder clip.