Meredith Whitney Warns Tough Times Ahead for Municipal Bonds

Meredith Whitney, the analyst whose claim to fame is predicting the financial crisis of 2008 is back at it with the municipal bond market. Today she penned an op-ed in the Wall Street Journal entitled "The Hidden State Financial Crisis." She writes in the subtitle: "My latest research into opaque state financial statements suggests taxpayers will be surprised by how much pensions are underfunded." The article then goes on to discuss how state revenue has fallen to 2006 levels but unfunded pension obligations continue to eat up a bigger and bigger portion of state budgets. She writes:

"What concerned us the most was the fact that fixed debt-service costs are increasingly crowding out state monies for essential services. For example, New Jersey's ratio of total tax-supported state obligations to gross state product is over 30%, and the fixed costs to service those obligations eat up 16% of the total budget. Even these numbers are skewed, because they represent only the bare minimum paid into funding pension and retirement plans. We calculate that if New Jersey were to pay the actuarially recommended contribution, fixed costs would absorb 37% of the budget. New Jersey is not alone."

Sounds scary and the numbers are concerning but there are several things to consider.

First, this is not Meredith Whitney's first doomsday scenario about the municipal bond market. About five months ago, Ms. Whitney appeared on 60 Minutes and boldly predicted 100 local government defaults within the next year, worth $200B. Since that day, there have been 3 defaults totaling $68MM. For Ms. Whitney's prediction to occur at this point, there will need to be three defaults a week with an average loss of $900MM per default.

Second, this is hardly news. Investors and even the general public has known for some time that local and state government budgets were in trouble and that unfunded pension obligations were huge. Indeed, on the day that the news came out, the municipal bond market shrugged it off and recorded a slight gain. WSJ's Mark Gongloff points out that "Muni-bond ETFs such as the iShares S&P National AMT-Free Muni Bond fund, are basically unchanged on the day — at six-month highs." These are highs coming off lows that Meredith helped create with her last public statement about municipal bond debt. In her defense, it's true that everyone also knew the housing market was overvalued and look what happened. So knowledge is not always an antitode to an oncoming crisis.

Should municipal bond investors be concerned? Yes. But there are several important things to note. First, not all municipal bonds are the same. Like the housing market, not all cities and states are in the same financial shape. Muni bonds are local affairs and it's important to do due dilligence on the issuing territory.

Second, municipalities have tremendous firepower should they choose to use it. They can cut services, which will happen, and also raise taxes, which has also happened and will continue to occur. Defaulting on debt is a last-resort which almost never happens.

Third, municipal bonds may become a more attractive investment if and when taxes rise, since they are federal and often state tax exempt.

So be wary and understand that higher taxes, less services, and reductions in future pensions and retirement plans are probably more likely than a massive, sustained default on state and local municipal debt.