Here we go again. Meredith Whitney, the Wall Street analyst who appeared on CBS’ 60 Minutes in December and predicted “50-100 sizeable municipal defaults” totaling “hundreds of billions of dollars,” appeared on CNBC this morning and claimed that there would be “indiscriminate selling” of municipal bonds because “local leaders want to default on debt investors and not on their constituents.”
Whitney’s comments reveal a stunning lack of understanding of the municipal sector and, unfortunately, seem based more on conjecture than facts.
Defaults or Cuts?
Whitney contends that local and state leaders do not have the political will to take policy actions to pay their debts, whether that is cutting services or raising revenues.
But, local governments have been and will continue to cut services. NLC’s annual survey of City Fiscal Conditions found that 79% of cities cut personnel in 2010, 69% canceled or delayed infrastructure projects, 44% made cuts in services other than public safety, and 25% cut public safety or made across the board service cuts. The latest U.S. jobs report revealed that state and local government employment levels were at a 4-year low. In contrast, as of November 2010, there were 72 muni sector defaults, down from 204 in 2009 and 162 in 2008 (these numbers include technical defaults that do not result in losses to investors).
Furthermore, it is standard practice for many local governments to budget to pay their debt service before they fund other operational costs.
Just this week, state policy makers in Illinois, the poster child for state and local revenue shortfalls, moved to raise the state’s income tax rate in order to improve the state’s ability to pay its debts. All Whitney had to say about Illinois was that the state is now “less favorable to business.”
The “Daisy Chain” of State & Local Finance
Whitney’s claims appear to be based on research that her consulting group has conducted over the last couple of years, analyzing the budgets of 15 states. Yet, Whitney herself says it’s unlikely that states will default on their debt.
Instead, she says, her fears are for local governments – cities and counties. Whitney predicts that states will cut aid to local governments – the “daisy chain” of state and local finance. Whitney is right about the daisy chain. States do provide aid to local governments, although there is considerable variation across the 50 states, and states are likely to cut aid to local governments as they continue to struggle with revenue shortfalls.
But, cutting aid doesn’t necessarily translate to defaults. State cuts are common during economic downturns. Yet, of the 54 municipal defaults (excluding technical defaults) that have occurred since 1970, only 4 came from cities and counties. In other words, the overwhelming preponderance of local governments respond by cutting spending or raising other revenues, not by defaulting on debt.
When asked for details, such as naming the top three cities at risk of default, Whitney balked, saying “I don’t want to do that.”
On 60 Minutes, Whitney remarked that defaults would total in the “hundreds of billions of dollars,” a claim that she back peddled from in her CNBC interview. When presented with a critique of the magnitude of her prediction, Whitney responded “It’s not a severity issue. It’s a frequency issue.” In other words, her prediction is that there will be an increase in the number of defaults, but the magnitude of the defaults may not be as significant as her earlier projection.
This is not a minor concession. It’s the crux of the matter for investors. It seems reasonable to suggest that we might see a few more defaults in the next couple of years. But, a few more defaults, on top of a historical default rate of less than 1/3 of 1% hardly suggest investors should exit the market. Bloomberg’s Joe Mysak recently cautioned that the defaults we might see in the next year would total between $5 billion and $10 billion – a small share of the total market of $2.7 trillion.
The Real Story
The bottom line is that sky-is-falling reports about the muni market are lacking in evidence, but are receiving a lot of airtime and print coverage because they make for attention-grabbing headlines.
The real story comes back to Whitney’s question about whether local leaders will default on investors or constituents. It’s a false choice. Defaulting on debt has dire ramifications for the shorter- and longer-term fiscal stability of local governments. The overwhelming majority of local leaders will protect debt obligations and will, if necessary, make cuts in services and personnel or raise revenues via taxes and fees. Those actions have ramifications for local economies and quality of life, issues which deserve considerably more attention.
We think Whitney finally got it right when she said “investors can still make money on munis, but need to be careful in how they proceed.”