Charlie Gasparino (and others) Call Out Meredith Whitney On Her Municipal Disaster Prediction

Meredith Whitney made a big name for herself in 2007 by being early to call out the disaster looming on the balance sheets of Wall Street banks.


In December of this year she received a lot of attention again for appearing on 60 Minutes and declaring that an unfathomable amount of muni bonds were going to default in 2011. She apparently had been studying the issue for 2 years and has a 600 page report to support her conclusions.


I have no idea if she is correct as I’m no expert in the field.


There are some people very skeptical of her claims though. Charlie Gasparino thinks Whitney should release her 600 page report so investors can make their own decisions. He wrote the following:


http://www.huffingtonpost.com/charles-gasparino/post_1575_b_810261.html


“Meredith Whitney should finally come clean.


The banking analyst who made a name for herself properly warning investors about the dire condition of the big banks a full year before the 2008 financial collapse has been making waves of late issuing similar warnings about states and cities that issue municipal debt. Whitney is saying that over the next year, dozens of large issues (between 50 and 100 to be exact) are about to default on their bonds, meaning that, at least in her view, investors will be left holding "hundreds of billions" of worthless bonds -- something not even seen during the dark days of the Great Depression.


And yet, as the municipal market is crashing on her prediction, with deals being pulled and slashed in size, with prices falling and taxpayers having to pay extra so cities and states can sell debt, Whitney is refusing to release the actual report that would tell us how she came to such a brash, and unprecedented prediction, on the grounds that her research is proprietary and for the use of the clients of her research firm only.


It's about time Whitney came clean and released her report to the public so we can determine if it should be given so much credence; and if it shouldn't, traders and investors can stop a possibly misguided prediction from causing further damage.


Aside from anything Whitney is saying, there are, of course, lots of reasons to have legitimate worries about municipal bonds, which are issued by cities and states to build infrastructure projects such as roads and bridges, and also to plug deficits when times are tough, as they are now.


The money used to repay bond holders comes from tax revenues, which are being squeezed because of a weak economy and runaway big government. For every governor like Chris Christie looking to slash spending and keep taxes low in New Jersey, many more city and state government officials still refuse to deal with the downside of the modern welfare state: The very real fact that for years they've been living beyond their means, taxing businesses out of their states while they hand out lavish and unaffordable benefits to public employees.


With that, investors have been hedging their bets on municipal bonds, demanding lower prices (and higher "yields) where the fiscal distress is highest. But with Whitney's prediction of massive defaults -- astutely marketed during a 60 Minutes segment several weeks ago and repeated on selective business networks ever since -- the market has gone from worried to crisis mode.


All we really know about the report is its overheated title -- "State Budgets: The Day of Reckoning," and what Whitney will disclose about her research, and methodology, which so far ain't much. No one I know in the municipal bond market has even a bootlegged copy.


There's nothing wrong with Whitney keeping the report private for only her clients to see; research firms do that all the time. But I have never seen an instance where a proprietary research firm markets its "proprietary" predictions on national television, and Whitney did one better: She's allowing the fallout from her prediction to fester now for nearly a month while she offers almost no insight into the methodology of her research the few subsequent times she has agreed to publicly comment (neither her or her spokesman returned email requests for comment).


Seeing the actual report might give us some idea why she thinks defaults might surpass levels over the past year not seen since the Great Depression -- a pretty outlandish claim when you think of it -- considering the general improvement of the economy. Seeing the report will also give the investing public some indication about Whitney's own motives in making such claims.


Has Whitney or her firm invested in municipal bonds or are they shorting the market (betting it would fall)? Regulators expect market positions to be disclosed in research -- even the proprietary kind that's not released to the general public. On its face, there's nothing wrong with Whitney taking a market position, but if she or her firm is short the market, it gives us some more insight into her call and why it's so aggressive.


Meredith Whitney is a great banking analyst and someone I believe did investors a great service during the early days of the banking crisis, when at a small brokerage firm, Oppenheimer & Co., she stood up to the large and powerful banks, namely Citigroup, and told everyone the truth about the dire state of the banking industry.


Yet those calls -- and her research -- were released publicly; we all got to see why she believed Citigroup was destined to fail over the next year as it nearly did before the federal government stepped in with a bailout.


That's not the case with her municipal research so it's impossible to know whether it should be taken as seriously as her prior research.


In the meantime, the municipal bond market continues to suffer as do taxpayers.”


And Gasparino isn’t the only person who feels this way. Here is Joe Mysack of Bloomberg:


http://www.bloomberg.com/news/2010-12-22/meredith-whitney-overreaches-in-muni-default-call-commentary-by-joe-mysak.html


“There will be between 50 and 100 “significant” municipal bond defaults in 2011, totaling “hundreds of billions” of dollars.


So said banking analyst and new municipal 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 municipal 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 governments 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 municipal at all. The majority are corporate or nonprofit borrowings in the guise of some municipal conduit -- nursing homes, housing developments, biofuel refineries -- so they could qualify for tax-free financing.


Whitney’s Vision


And 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 centered 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 Service


Why would a governmental entity choose to default on its bonds, especially if they make up a relatively small proportion of its costs?


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


Entitled “U.S. State and Local Government Bond Credit Quality: More Sparks Than Fire,” the report said, “The tax- supported debt of an average state is equal to just 3 percent - 4 percent of personal income, and local debt roughly 3 percent - 5 percent of property value. Debt service 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 covering municipal finance for 31 years. He is not one of the analysts “who got everything 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 Grabber


What 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 conclusions are supported. She said it was 600 pages long and had taken two years to produce.


Perhaps Whitney should stick with bank stocks. “


And well known bond managers Lyle Fitterer and Bill Gross also think she has gone a bit off the deep end on this one:


http://www.bloomberg.com/news/2011-01-19/best-muni-bond-manager-fitterer-says-whitney-call-on-defaults-is-overblown.html


“Lyle Fitterer, the top manager of U.S. municipal-bond funds in the past decade, sides with Bill Gross and against Meredith Whitney in his view that fiscally strained states and cities will avoid widespread defaults.


“The baby has been thrown out with the bathwater,” said Fitterer, who runs the $2.3 billion Wells Fargo Advantage Municipal Bond Fund from Menomonee Falls, Wisconsin. “For every bad story there are hundreds of good ones.”


Investors have pulled money from mutual funds that buy municipal bonds for nine straight weeks, spooked by rising interest rates and warnings that defaults will escalate. Fitterer used the selloff to buy what he sees as bargains, including debt from Illinois and California, which have the lowest state credit rating from Moody’s Investors Service.


Whitney, the bank analyst who correctly predicted Citigroup Inc.’s dividend cut in 2008, in December forecast 50 to 100 “significant” municipal-bond defaults this year totaling “hundreds of billions” of dollars. Gross, manager of the $241 billion Pimco Total Return Fund, disputes her call.


“I don’t subscribe to the theory that there will be lots of them,” Gross said in a Jan. 12 interview on Bloomberg Television’s “InBusiness.”


The Total Return Fund, the biggest mutual fund in the world, holds about 3 percent of its assets, or more than $7 billion, in municipal debt, according to the website of Pacific Investment Management Co., the Newport Beach, California-based firm where Gross is co-chief investment officer.


‘Hard Time’


“I am not saying there won’t be defaults,” Fitterer, 43, said in a telephone interview. “But I have a hard time getting to $10 billion, let alone $50 or $100 billion.”


Municipal bonds with a combined value of $2.7 billion defaulted in 2010, according to Distressed Debt Securities Newsletter.


Fitterer’s fund returned an annual average of 5.4 percent in the 10 years ended Dec. 31, the most among the almost 1,500 tax-exempt municipal-bond funds tracked by Chicago-based Morningstar Inc. The average gain for the group was 3.7 percent.


Thomas Metzold, co-director of municipal investments at Boston-based Eaton Vance Corp., called Whitney’s comments “outlandish and outrageous.” Metzold, who oversees $17 billion in municipal securities, said in a telephone interview that he has been putting more of his own money into muni bonds in the past few months.


“We are encouraged by what we are seeing from cities and states,” Robert Amodeo, head of municipal investments at Western Asset Management, the bond unit of Baltimore-based Legg Mason Inc., said in a telephone interview. Amodeo, who helps manage $23 billion in long-term municipal bonds, said local governments are starting to bring spending in line with revenue.


‘Fairly Adventurous’


Fitterer, a graduate of the University of North Dakota in Grand Forks, has worked on the fund since 2000. He and his team look for mispriced bonds by studying the economy and researching the creditworthiness of individual securities. They manage $17 billion in municipal-bond mutual funds.


Wells Fargo Advantage Municipal Bond holds more low-rated bonds than the average for peers, said Greg Brown, a mutual-fund analyst with Morningstar. “It’s a fairly adventurous fund,” Brown said in a telephone interview.


Morningstar gives the fund five stars, its highest rating. The fund’s 10-year Sharpe ratio was 0.61, compared with 0.55 for its benchmark, the Barclays Capital Municipal Bond Index, according to Morningstar. The Sharpe ratio measures performance adjusted for risk.


More BBB Bonds


In the third quarter, Fitterer’s holdings of AAA and AA bonds, the top ratings assigned by Standard & Poor’s, was about half that of the Barclays index, according to the fund’s quarterly report. The fund held more BBB bonds than the benchmark because their higher yields more than compensate for the extra risk, Fitterer said. BBB is two steps above the high end of the junk, or high-risk, ratings.


Municipal bonds lost 4.52 percent in the fourth quarter, the largest quarterly loss since 1994, according to the Bank of America Merrill Lynch Municipal Master Index. The bonds lost an additional 2.49 percent this year through Jan. 17. Fitterer’s fund fell 3.34 percent and 1.76 percent in those periods.


Over the past nine weeks, investors withdrew a net $22.7 billion from municipal-bond funds, according to the Investment Company Institute, a Washington-based trade group.


New Jersey


There was more bad news for the municipal market last week when the New Jersey Economic Development Authority scaled back a bond offering in response to weak demand after Governor Chris Christie said health-care spending “will bankrupt” the state unless it requires workers to pay more for medical coverage.


Vanguard Group Inc. of Valley Forge, Pennsylvania, the world’s largest mutual-fund company, canceled plans to open three municipal-bond index funds amid concern that state finances may deteriorate.


Whitney didn’t respond to phone and e-mail messages.


Jamie Dimon, chief executive officer of JPMorgan Chase & Co., said this month he expects more U.S. municipalities to declare bankruptcy and urged caution when investing in the $2.9 trillion public-debt market. JPMorgan, based in New York, is the second-largest U.S. bank by assets.


Liberty Mutual Holding Co., a Boston-based insurer, reduced its holdings of municipal debt of Connecticut, California and Illinois, Chief Executive Officer Edmund “Ted” Kelly said at a Jan. 11 conference. “The market is being held up to some extent by the belief that the federal government will bail out” state and local issuers, he said.


Revenue Rising


Fitterer said the “positives” in the municipal-bond story are being ignored. Chief among them: rising tax receipts.


Tax revenue for states increased 4.8 percent in the three months through September, the third-straight quarter of gains, the Census Bureau said in December. Property-tax receipts, which mainly benefit local governments, increased 7.8 percent.


Cities and towns have boosted property-tax rates to offset the decline in home prices, Fitterer said. While acknowledging that “there is a lot more work to be done,” he said states are taking steps to shrink deficits.


Illinois lawmakers Jan. 12 passed a 67 percent income-tax increase, the largest in the state’s history, to help close a $13 billion budget deficit. California Governor Jerry Brown proposed $12.5 billion in spending cuts and $12 billion in revenue increases to plug the hole in that state’s budget.


Illinois remains “the poster child” for underfunded pensions, Fitterer said.


Fix for Pensions


The state had assets to pay for about half its benefits last year, the lowest ratio among the states, according to data compiled by Bloomberg. Fewer than half the 50 state retirement systems had assets to pay for 80 percent of promised benefits in their 2009 fiscal years. Actuaries say that ratio shouldn’t be less than 80 percent.


A decade of poor stock-market returns has hurt public pension plans, said Fitterer. “Two years from now we could wake up and the story may look different,” he said.


States and cities can trim future pension costs by switching new workers to 401(k)-style plans, which limit the government’s obligations, said Fitterer.


His fund added to holdings of Illinois and California general-obligation bonds in the fourth quarter as concerns that the states’ fiscal health will weaken pushed up yields, Fitterer said. The extra yield that buyers want for 10-year California bonds compared with top-rated municipal bonds peaked at 134 basis points in the fourth quarter, Bloomberg Fair Market Value data show. The top spread for Illinois bonds was 86 basis points. A basis point is 0.01 percentage point.


Non-Government Munis


Fitterer has also invested in both states through what he calls “backdoor plays,” bonds issued by entities other than the government that provide greater protection for investors.


The fund owns bonds from the Norwalk-La Mirada Unified School District in California because school debt in California must legally be paid before the state’s, Fitterer said. In Illinois, the fund holds bonds of the Metropolitan Pier & Exposition Authority, which are backed by sales-tax receipts.


“If the state were to file bankruptcy, I have a bond with a dedicated revenue stream,” Fitterer said.


Fear of defaults has driven down prices of municipal bonds that have nothing to do with state or local governments, including tax-exempt bonds linked to corporate credit, Fitterer said. He cites as an example bonds the fund owns issued by the Indianapolis Airport Authority, which are backed by Memphis, Tennessee-based Federal Express Corp., the second-largest U.S. package-shipping company.


Tax Advantage


The 4.34 percent yield on the BBB rated bond is as good or better than the yield available on a similarly rated corporate bond, Fitterer said. As a bonus, investors are getting a tax break. Municipal bonds are generally exempt from federal taxes as well as state and local levies for residents in most states where they’re issued.


Corporate tax-exempt bonds represent 14 percent of his fund, Fitterer said.


The tax-exempt market is dominated by individual investors seeking income-tax breaks. Households own more than $1 trillion in municipal bonds directly, while almost $1 trillion more is held in mutual funds, according to the Federal Reserve Board.


Fear is driving bondholders to sell at a time when valuations are most attractive, Fitterer said.


“Two years from now, when municipal-credit conditions are better and there is less money to be made, everyone will want to buy.”


One thing will be certain, and that is that at the end of 2011 it will be easy to see if there has been hundreds of billions of dollars in defaults. I hope she is forced to eat crow if she is incorrect. And if correct she should make a lot of money for a bold and correct call.