Meredith Whitney Was Right, Technically

Meredith Whitney

Many pundits, including yours truly, have taken issue with Meredith Whitney’s bold prediction that on CBS’s 60 Minutes that “you could see 50 sizeable defaults, 50 to 100 sizable defaults, more” of municipal bonds that “will amount to hundreds of billions of dollars’ worth of defaults.”

We, the nay-sayers, have argued:

A. that her report lacked specificity;

B. that the historical default rate of municipalities has been exceptionally low;

C. that there is a significant contrast between a “cash flow-driven” crisis leading to a default versus a “long term structural issue” that can be addressed over the years by raising revenues (taxes, fees, levies), reducing expenditures, raising retirement ages, lowering benefits packages, etc.;

D. that municipalities and their politicians have significant economic reasons, let alone career risk, that drive their decision-making processes toward avoiding defaults other than as acts of last resort; and

E. that the “contagion effect” of municipal defaults is so feared by other municipalities that state and federal resources may well come to bear, if needed, to prevent the default of a prominent municipality and the outright chaos in the municipal bond market that would result from such a high-profile event.

To be clear, I am confident that a holder of a diversified basket of high-quality general obligation and essential revenue municipal bonds will avoid being subjected to defaults. In fact, I figured I’d leave this debate alone and attribute Whitney’s comments to a more salutary cause: Basically, she rightfully wanted to advise complacent investors that not all municipal bonds are created equally. Caveat emptor.

But then I read this comment in Monday’s New York Times from a fellow nay-sayer:

“I’ve seen a copy of the report, and frankly, I’ve seen better papers from graduate students in finance,” said Richard P. Larkin, director of credit analysis at Herbert J. Sims & Co., a municipal bond broker and underwriter. “It’s ludicrous, reckless and irresponsible, and it’s being done without any regard for the consequences.”

Wow — talk about taking off the gloves! And that got me to thinking, as heretical as it might sound: What if Meredith Whitney is technically correct? Believe me, she is no fool, and she certainly wouldn’t put the entirety of her reputation on the line by making such a bold call without some substance to back her assertions. In fact, she spent two years and countless hours researching this subject before publishing her report.

Well, truth be told, she may well be proven “technically” correct, albeit the magnitude of economic harm (i.e. interest payments not paid to bondholders) may be far less severe than initially feared. This boils down to your definition (and hers) of the term “default.”

Investors associate the term default with a sense of dread as they perceive that an issuer (a municipality, in this case) will fail to make an interest payment to its bondholders. “Uh-oh. This must mean that the municipality is broke and I might not get any of my money back” is what runs through an investor’s mind under this definition of default.

However, a “technical default” is triggered by a number of factors that have no immediate bearing on whether an investor will be paid interest income in a timely manner. A technical default simply means, under this definition, that the issuing municipality fails to meet its legal obligations according to the bond contract. Such a technical default does not necessarily impair the municipality’s ability to continue paying its interest obligation to bondholders. Examples of such technical defaults (which are also often called violations of loan covenants) include failing to maintain a certain level of capital (called reserves), failing to maintain a certain debt service coverage ratio; or failing to maintain a certain amount of short-term liquidity.

So who’s right? And can we, the nay-sayers, find a happy compromise with Meredith Whitney, despite Richard Larkin’s acerbic lashing? I think so.

It’s fair to say there are numerous small municipalities that issued non-rated bonds (these typically are not general obligation bonds nor essential revenue bonds) and whose financial conditions are clearly under stress. When a recession hits, municipalities have the unhappy coincidence of declining revenues (sales, income and property tax collections fall) and increasing costs (higher dependency for support and social services). Whitney certainly calls to attention this unfortunate set of economic realities. Even worse, as these smaller, local municipalities face the task of formulating a balanced budget for fiscal 2012 (which starts July 1, 2011), they will be receiving less, if any, state revenue support. We may indeed be hearing about a number of “technical” defaults as we approach mid-year.

But for Whitney to paint the idiosyncratic universe of 90,000 municipal bond issues with a wide homogenous brush and claim there is a systemic crisis seems to be an exaggeration.

The bottom line: If you have done your homework, and if you own bonds whose credit qualities, structures and priorities in the credit stack can weather a severe economic downturn, you have nothing to worry about.

This post originally appeared at The Street.

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