Michael Lewis’ latest piece in Vanity Fair, “California and Bust,” begins with a lengthy defence of Meredith Whitney’s prediction that there would be a wave of defaults in the municipal bond market. I was not planning on writing a response to his article – frankly, defending Whitney’s call at this point is very much like defending Harold Camping’s prophesy on May 22nd, after even the most gullible people have realised that they euthanized their pets for nothing. Who really cares about the intransigent believers that remain, for whom a forceful narrative has always been more relevant than facts?
Whitney’s call for “50 to 100 sizeable defaults” totaling “hundreds of billions of dollars” has not even come close to materialising. According to Richard Lehmann’s Distressed Debt Securities Newsletter, there have been $1.18 billion of municipal defaults through September 22, 2011, compared with $3.61 billion for 2010. In an earlier post, Default and Bankruptcy in the Municipal Bond Market, I suggested that conduit debt for healthcare and housing would continue to be the largest source of municipal defaults this year. In fact, healthcare credits have accounted for 39% of this year’s monetary defaults. The single largest monetary default was a housing project. The Clare at Water Tower in Chicago, a retirement facility that was financed in 2005 with $229 million of bonds, failed to make an instalment payment to cure a shortage in its debt service reserve fund, which was a default event that triggered a mandatory tender on $125 million of floating-rate bonds. This meant the trustee had to make a draw on the credit facility that supported the debt. Lehmann has noted that defaults on Florida dirt bonds (which are secured by special assessments on real property) have been the “single biggest [on-going] default event in the history of the municipal market,” with 77% of bonds issued since 2003 having defaulted. (That figure includes bonds that have tapped debt service reserve funds.)
Even more to the point, all but one of these defaults have been on revenue bonds. The only monetary default on the general obligation debt of a municipality this year involved the city of Brighton, Alabama (population 2,945). According to Bloomberg, the city (which is located just outside of Birmingham) lost 19% of its residents from 2000 to 2010. It missed a $22,783 interest and $35,000 principal payment on its $1.2 million of GO warrants. While I am sure this event is tragic for someone, it hardly represents the Armageddon that Whitney predicted.
For much of the first half of the article, Lewis seems to be trying to support Whitney’s argument that states do “a poor job of providing information about their finances to the public,” and that “the scary thing about state treasurers … is that they don’t know the financial situation of their own municipalities.”
Lewis decides to test her assertion, at least as it pertains to California, which is the state Whitney says is in the worst position. Of course, Lewis does not interview Bill Lockyer, who is the state’s treasurer, but Arnold Schwarzenegger, the former governor. His rambling interview with Schwarzenegger, which takes place while the two ride bicycles along the beach, mostly covers the governor’s improbable ascent to political leadership and struggles while in office. Lewis leaves his audience with the impression that the state’s political leadership lacked a nuanced appreciation of the state’s financial management, and that the administration was pretty much winging it. Schwarzenegger likewise confessed to being clueless about local governments in the state: “I’m not into the local stuff … I was born for the world.” Um, OK…
I have the feeling that if Lewis had interviewed Lockyer instead of Schwarzenegger, he would have come away with a very different understanding of state and local finance and a very different view of public officials. But Lewis would not have had to interview anyone to see that Whitney was wrong about the level of financial information that the state government provides its residents and potential investors – he could have just visited Lockyer’s website. On the website, Lewis would have found: a summary of the enacted budget; agency-level detail of the enacted budget; the Legislative Analyst’s Office’s analysis of the enacted budget; the latest monthly General Fund cash receipts and disbursements; a discussion of trends in cash receipts and disbursements; the state’s annual debt affordability report; the latest report on outstanding and authorised state bonds; a searchable database for state and local debt; California state and local government debt issuance data; the California Debt and Investment Advisory Commission’s monthly newsletter; or any of a myriad other publications related to the financial condition of the state and its political subdivisions. Of course, Lewis could also review the state’s financial statements for the last decade at the controller’s website. While state policymakers have spent considerable time debating spending issues, I think it would be difficult to argue that financial trouble catches officials off guard. And while disclosure can and should always be improved, is this not a commendable effort at transparency? How would Lewis’ audience view state officials’ awareness of state and local financial affairs differently if he had mentioned that this information is publicly available and not a mystery as Whitney suggests? (Note: I do not own or work with California bonds.)
What about the monthly seminars the state hosts to educate local government officials on bond maths, derivatives, and similar topics? Lewis could have also attended one of the financial management-related conferences the state hosts for issuers, market participants, and the media each year. (They are excellent and informative events.)
As I was reading Lewis’ defence of Whitney’s arguments, it struck me that he probably did not read Whitney’s Tragedy of the Commons report (as I have). If he had, it probably would have occurred to him that she mostly used data and analysis provided by organisations like the National Association of State Budget Officers (which publishes reports explaining the logistics of states’ individual budget processes and comparing state budget actions) and the Pew centre on the States (to name only a couple). She doesn’t really do any of her own analysis at all – her work reads like an incredibly verbose high school student’s book report. The only remarkable thing about Whitney’s research is that she somehow convinced her clients to pay $100,000 for information that was easily a Google search away (plus a considerable amount of political bloviating). He also would have known that her opinions about local governments were not based on any specific analysis of local credits. She said there would be hundreds of billions of dollars’ worth of defaults in a sector of the municipal market that she had not even studied. And Lewis seriously wishes to defend this kind of reckless and irresponsible behaviour?
Lewis makes two other undeveloped arguments in support of Whitney. The first is that her claims have been misrepresented. It seems fairly silly to say that her words have been misrepresented when they have been captured on video and repeated ad nauseam over the past twelve months. And much has been made of how Whitney conflates what she calls “defaults on social contracts” and what most rational people would consider a default, which is a failure to observe terms of the bond contract or a failure to make timely principal and interest payments. (That is not misrepresenting her views, but providing a legitimate criticism of her sense of what constitutes a credit event.) In interviews, Whitney has generally moved back and forth between the two as is convenient.
But “she was referring to the complacency of the rating agencies and investment advisers who say there is nothing to worry about,” Lewis offers. As I have already explained, until recently, the rating agencies inexplicably rated munis on a tougher scale than other kinds of credits, and most of the monetary defaults the market sees are on bonds that had junk ratings or were unrated when issued. Lewis would know this if he had actually researched credit events in the marketplace before writing his article.
Lewis’ other defence is that:
Whatever else she had done, Meredith Whitney had found the pressure point in American finance: the fear that American cities would not pay back the money they had borrowed. The market for municipal bonds, unlike the market for US government bonds, spooked easily. American cities and states were susceptible to the same cycle of doom that had forced Greece to seek help from the International Monetary Fund. All it took to create doubt and raise borrowing costs for states and cities was for a woman with no standing in the municipal-bond market to utter a few sentences on television.
Ah, yes, the inevitable analogy to Greece. I have explained in prior posts why this analogy makes no sense, and how state and local governments are not dependent on short-term market access in the same way the US government and European sovereigns are. When municipal rates increased, state and local governments simply stopped issuing bonds. The fact that they could do so and not have immediate, bailout-inducing debt crises communicates volumes about the financial strength of the credits in this market. Also, the highest the benchmark Bond Buyer 20-Bond GO index reached following Whitney’s 60 Minutes interview was 5.41% on January 20. What conclusions would Lewis’ audience have drawn from his article if he had compared that to yields on Greek bonds? I would also submit to you that the market will be less vulnerable to such hysteria going forward precisely because Whitney has been so embarrassingly incorrect. Trusting Whitney was an expensive lesson for dumb money. (It was a terrific opportunity for private wealth and more savvy investors, however.)
The truth is that Whitney’s 60 Minutes interview coincided with the expiration of the Build America Bond program, which had caused a glut of new issuance in the market and was already driving rates up. Major structural shifts were already underway in the market, and the BAB program had been the last support. Either accidentally or deliberately, Whitney made her call in the middle of a perfect storm for munis. And she was still wrong.
I do not have much to say about the remainder of Lewis’ piece except to express a general frustration with the way journalists seem to equate anecdotal evidence with genuine financial analysis in terms of credibility. Yes, Vallejo’s situation is a prime example of how political paralysis can morph into a vicious economic feedback loop and legal industry stimulus program. But presenting Vallejo as indicative of a trend is another matter. Did other governments make generous commitments during periods of economic prosperity? Sure, it is almost impossible for political officials not to do this kind of thing. But are other governments pushing themselves to the brink by not addressing this issue? Lewis’ audience wouldn’t know, because he did not interview the mayors of any of the two-thirds of the 296 California municipalities (as surveyed by the League of California Cities) that are in the process of renegotiating changes to their retiree benefits plans. I suspect if Lewis had, he would have discovered that other cities have internalized Vallejo’s situation.
I hope no one will read this and think that I believe the municipal bond market is without risks. This is not true. (The most likely source of a major disruption in the municipal bond market in the near future is the tax status of the bonds – not massive defaults – in my opinion. But that is a topic for another post.) The municipal bond market is a complicated market. Many investors I have spoken with fail to appreciate the differences between claims, that there are different sectors in the market, the difference between conduit and government bonds, etc. This is a market where the difference between issuers matters. People like Lewis and Whitney, who are trying to sell a canary-in-the-coal-mine version of the market, are doing investors a disservice. There are hundreds of municipal bond market professionals that understand these matters on a granular level, have more than a couple years’ acquaintance with the market, and have actually analysed local government debt, but you are unlikely to read about them in Vanity Fair or see them interviewed on 60 Minutes offering a counterpoint to Whitney. Why is that?
As a postscript, someone should ask Whitney why she has not formally submitted an application to the Securities and Exchange Commission for NRSRO status. (Remember how she was going to create a rating agency?) The SEC would have to waive its requirement that 10 large institutional investors pledge they have relied on Whitney’s credit analysis for three years. Is she having trouble convincing the SEC to do so, or was she not sincere about establishing a rating agency in the first place? Inquiring minds want to know.