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Thursday, September 30, 2010

Municipal JENGA...new and improved.....*Now with much larger pieces.....

Today the policies of the FED are punishing savers and rewarding debtors, as a result investors are searching hungrily leaving no stone unturned for higher yield. Just today as I was in the car in the space of 1 hour I heard 5 separate ads for investments stressing yield, two ads were for annuities and the balance for municipal bonds. To start with due to my inflationary bias I would not want to be invested in annuities even with an inflation kicker nor would I want to hold bonds of any duration at this juncture.

As I drove along and listened one of the ads was touting the safety of Municipal bonds and how they never defaulted during the “Great Depression”. The statement that municipal bonds did not default in the 19030’s is patently false. In a 1964 study entitled “The Post War Quality of Municipal Bonds” the author George Hempel at University of Michigan -  Ann Arbor, showed that at the peak of the great depression in 1935 as many as 3,252 municipal bonds recorded default.  Furthermore, the quality of the bonds was considered to be investment grade; about 80% of the bonds were rated Aaa at the beginning of the depression and roughly 95% were rated Aa or better.

So while the general public has rushed in to the US Government bond bubble driving rates to the basement, they are now taking aim at municipals through the same prism of safety and yield. The companies on the radio and I am sure TV are looking to capitalize upon this trend and are feeding into the yield safety play. The municipal bond market of today is significantly more treacherous than is being billed.

Just yesterday the Analyst Meridth Whitney released a report that she has compiled for the past two years entitled the “Tragedy of the Commons”. In this report she points out that the states are highly levered to the housing market for tax revenue and that housing is not projected to do very well creating another hit to revenue. She does not go on and make the connection that the municipalities are more dependent on housing taxes than most states since many states impose income taxes as well; although both are vulnerable since neither can print money or run deficits like the US Government. Whitney does state that Municipalities do receive 1/3 of their budgets from the State so there is a ”trickle down” effect if there are shortfalls. The study goes on to explain that the State funding gap which is the deficit between spending and revenue is estimated at 192 billion or 27% of total budgets for Fiscal 2010, so there is a worry about the municipalities.

According to Whitney the worst states are 1) California, 2) New Jersey, Illinois, Ohio (Tie), 3) Michigan, 4) Georgia, 5) New York and 6) Florida. She lists the best states as 1) Texas, 2) Virginia, 3) Washington and 4) North Carolina. As for Pennsylvania, Maryland and Massachusetts they are rated neutral.    Moreover, Whitney’s contention is that States will make their budgets at the expense of Municipality funding, which will be left on the side of the road.  This coming shortfall has potential negative implications for the way things are funded or not funded in various states as well as politicians eyeing large pools of money dedicated for other uses or programs, but will now instead be raided to close budget gaps. This will only temporarily fix any shortfalls and will exacerbate the future shortfalls in multiple areas.

So on the one hand we have analysts talking about the problems with the states and their revenue and on the other hand bond houses promoting Municipal bonds as safe and in some cases guaranteed investments. The investing public is being warned but the siren song of safety and yield is drawing in investors. At the same time we find out that the companies that provide the insurance for these securities face their own problems. The municipal insurer MBIA has lost it coveted AAA rating and just two days ago was downgraded by Morningstar to BAnother insurer AMBAC was also rated on the 27th by Morningstar with a C. While Assured Guaranty, the one being touted as the insurer on the radio ads here, received a rating of BBB by Morningstar. None of the major insurers that play in the Municipal bond space are in such strong shape that they could withstand a string of defaults, leaving the investor holding the bag.

The bottom line, to paraphrase quote the Oldsmobile ad(remember them a victim of the last recession) “This is not your grandfather’s depression”. While there can be parallels drawn to the great depression this situation has the potential to play out very differently. My recommendation is to fully research the bond you are interested in if you plan to play in the Municipal market. One must check the detailed situation and financials of each level, the state, and municipality because they are interdependent. Moreover, if you must invest in Municipals avoid revenue bonds and stick to GO or General Obligation bonds as those are required to be paid from the budget. The reason this is a small but critical factor is that if there are defaults GO bonds will be paid if there are bailouts. Conversely, revenue bonds which the state or municipality are not obligated under the budget to pay but is paid through funds collected via revenue from the project which could falter. Lastly, if the bond sports a guarantee make sure to check the company ratings and see how well they are reserved. In light of the ratings fiasco's during the sub-prime meltdown one has to do their own diligence and can not blindly accept the ratings as their fail safe.

Right at this moment the Municipal bond market reminds me of a big game of financial "Jenga". one wrong default and the tower could come crashing down, just like the kids game with the little wooden blocks.

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Do As I Say Not As I Do…. | Moneta Advisors, LLC. said...

[...] as a quick follow up to further bolster my case from a prior post “Municipal Jenga” comes the following two articles out [...]

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