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MSRB Steps Up Its Game To Warn “Play Fair or Else”

Monday, August 8th, 2011

The MSRB took a defensive posture in the wake of the S&P’s downgrade on the USA by warning dealers that despite the potential market disruption, investor protection rules continue to apply and that all trading activity will be monitored as usual. As an example the MSRB said it would be unfair for a bond purchase by a dealer at a low price followed by a resale shortly thereafter at a considerably higher price. What effect this will have on the markets are unclear until we see the trickle down to prices as a result of S&P’s downgrade on the USA’s long term debt. Here is the release or you can read below

MSRB INFORMATION RELEASE As a result of actions and statements by certain Nationally Recognized Statistical Rating Organizations regarding the credit rating of the United States and the associated review of scurities of some states and municipalities, the Municipal Securities Rulemaking Board (MSRB) is publishing a reminder to dealers relating to the application of MSRB investor protection rules in the context of the potential impact of such ratings action on the municipal securities market.

The MSRB reminds brokers, dealers, and municipal securities dealers that, in spite of any market disruption that may result from such rating actions, all MSRB rules continue to apply, including rules on fair practice, trade pricing, suitability and disclosure.

MSRB ADVISES DEALERS ON CERTAIN OBLIGATIONS IN LIGHT OF POTENTIAL MUNICIPAL RATINGS ACTIONS
On August 5, 2011, Standard & Poor’s Ratings Service reduced the sovereign credit rating of the United States from “AAA” to “AA+.” On August 2, 2011, Moody’s Investors Service (“Moody’s”) confirmed its United States government bond rating at “Aaa,” although Moody’s assigned the rating a “negative outlook.” On August 2, 2011, Fitch Ratings announced that it has maintained its “AAA” U.S. sovereign debt rating but said that it continued to review the credit and expected that the review would be complete by the end of August 2011. Certain of these Nationally Recognized Statistical Rating Organizations (“Rating Agencies”) have also said that the securities of some states and municipalities are under review for possible downgrade as a result of their direct or indirect links to the credit of the United States. They had previously stated that, should they take negative rating actions on the debt of the United States, they also would likely downgrade debt directly or indirectly linked to the United States sovereign rating, as well as the ratings of certain municipal issuers that either have large numbers of federal employees in their jurisdiction or that are significantly reliant on federal government funding.

Although to date the Municipal Securities Rulemaking Board (“MSRB”) has observed no unusual municipal market activity, as a result of this continuing uncertainty concerning the ratings of such states and local governments the MSRB is publishing this reminder notice relating to the application of MSRB investor protection rules in the context of the potential impact of such ratings actions on the municipal securities market.

The MSRB reminds brokers, dealers, and municipal securities dealers (“dealers”) that, in spite of any market disruption that may result from such rating actions, all MSRB rules continue to apply, including rules on fair practice, trade pricing, suitability and disclosure. The MSRB is particularly concerned about the treatment of retail investors. MSRB Rule G-17 prohibits dealers from using a situation of market disruption to attempt to manipulate the pricing of municipal securities, either alone or in concert. Further, such situation does not negate a dealer’s duty under MSRB Rule G-30 (on prices and commissions) to purchase bonds from a customer or sell bonds to a customer as a principal at prices (including any markdown or markup) that are fair and reasonable based on prevailing market conditions.

As always, if the MSRB becomes aware of allegations that any dealer has attempted to take advantage of clients by trading in municipal securities at prices that are not fair and reasonable, the MSRB will notify the appropriate enforcement agencies and, if the allegations are true, recommend severe sanctions. One potential indication of such unfair behavior would be a purchase by a dealer at a low price followed by a resale shortly thereafter at a considerably higher price. While the MSRB recognizes that market disruption can present significant challenges to establishing a fair and reasonable price with precision, Rules G-17 and G-30 do not permit dealers to improperly take advantage of their clients by executing trades at prices that are not fair and reasonable. The MSRB encourages dealers that utilize computerized or other pricing models to review them carefully to determine that the prices they generate are fair and reasonable, particularly if such models were not designed to take into consideration the direct or indirect impact of a material downgrade in United States credit ratings.

The exretailistence of a market disruption also does not negate a dealer’s duty to ensure that their recommendations are consistent with their obligations under MSRB Rule G-19 (on suitability of recommendations), which can be a significant concern in the context of investors who may rely on the recommendations of their dealers during this time of uncertainty. Further, dealers are reminded that all material facts concerning a transaction known to the dealer or available from established industry sources must be disclosed to the client at or prior to the time of sale, under MSRB Rule G-17.

The MSRB will continue to monitor developments in the marketplace and any potential concerns resulting from any ratings actions.

August 8, 2011

Tags: bondview, credit ratings, investor protection, MSRB, Muni bond Defualts, S&P downgrade
Posted in AAA Downgrade, investor protection, Material Events, MSRB, municipal bond defaults, S&P's downgrade | No Comments »

With U.S. AAA Downgrade, Could Munis Default As Meredith Predicted?

Sunday, August 7th, 2011

The tax-free municipal bond market looks vastly different as we head toward the end of the second quarter of 2011 than it did when we were in the middle of the Meredith Whitney-led meltdown in January of this year.

In January the muni market was battered by the continued onslaught of municipal bond fund redemptions. Most of this damage occurred after Ms. Whitney’s appearance on 60 Minutes in December, when she forecast “hundreds of billions” of municipal defaults in 2011. This started the unmitigated selling, which peaked at over $4 billion per week in January. Because bond fund selling was mostly long-maturity bonds (and the funds own higher-yielding, longer-term bonds to pay their dividends), municipal bond yields soared, with long-term yields reaching 5.15% in the AAA range and between 5.5 and 6% on many high-grade revenue bonds. The bid side was often nonexistent, and liquidity was very spotty.

As Cumberland readers know, the signs were very evident that this was liquidity-driven, not credit-driven. Among these signs was the opposite movement of FALLING yields in the Build America Bonds taxable market, on the very same credits whose yields were being driven higher in the tax-free market. This was because pension funds, foreigners, and other taxable buyers were embracing the municipal credit that the retail investor was rejecting. The other sign was the fact that shorter-term yields had moved very little in the tax-free municipal market – if a true credit event had taken place, yields across the whole maturity spectrum would have moved up sharply.

As we hit the halfway point of the year, we see that 30-year AAA tax-free yields have fallen from 5.11% to 4.37% (source: Bloomberg), a drop of 75 basis points; and 10-year AAA yields have fallen from 3.47% to 2.63%, a drop of 84 basis points. Now, of course, there have been movements in Treasury yields, as well as market concern of a possible slowing economy, that have sent those yields down.

It is important to remember that this is AAA scale. Many high-grade bonds in the A and AA categories traded MUCH cheaper in January. But it is useful to look at the relative value of Treasuries and Munis from January to now. The biggest improvement in ratios was in the 10-year range. But because of the longer duration of 30-year bonds, the biggest improvement in price was in the longer end of the market.

The reasons behind this lie in the fact that most of the damage was in the long-maturity end of the market, since this was where most of the bond fund selling was concentrated. This is the area which could cure the most. Also, new-issue municipals this year are substantially reduced. Part of this was the “move up” of municipal supply at year-end from what would have been early-2011 issuance. This, of course, helped start the downdraft in the muni market in November, as issuers wanted to beat the expiration of the Build America Bonds program. Also, many state and local governments that had flexibility did not issue bonds at the nominally high yields that persisted early this year. We expect the first half of this year to close with approximately $110 billion in issuance. We expect the current lower rates will induce MORE supply in the second half of this year, but 2011 will most likely end up close to $250 billion – a marked decline from recent years.

The overall improvement in municipal finances has also contributed to improvement in the market. State and local governments (in total) are heading toward the sixth quarter in a row of RISING tax receipts. Also, problems in the pension area, which have gotten widespread press coverage, have started to be addressed. We expect this trend to continue.

The selling has abated in the municipal fund arena. Though most weeks have seen outflows, they are much smaller, and there were actually inflows a couple of weeks. Part of this is just the normal abatement of pressures, but it is also the recognition, even among retail investors, that things had really reached a point where the market was severely oversold.

The stock market, after turning in a very good performance through April of this year, has turned jittery with the Dow Jones shedding almost 900 points since the start of May. This has caused somewhat of a re-assessment of the needs of fixed income in overall investment portfolios. Presumably some of the fund selling went into equities and, depending on the timing, these assets could have been whipsawed.

We are now in the middle of a large reinvestment period where approximately $100 billion is rolling off through a mixture of coupon payments, maturing bonds, and called bonds. With fund selling reduced and some wariness in the stock market, we expect a lot of this money to now be reinvested in the bond market.

We realize that, while the municipal market is still cheap on a relative basis in the very short end and in the long end, the “giveaway market” of January and February has certainly turned around. This is causing us to be more cautious from a maturity and duration standpoint as we manage portfolios.

Reprinted with permission from our friends at Cumberland Advisors

Tags: bondview, credit ratings, municipal bond defaults, S&P, S&P downgrade
Posted in AAA Downgrade, bond pricing, muni rates, municipal bond defaults, Ratings, S&P, S&P's downgrade, Standard & Poors | 1 Comment »

Central Falls Turned Upside Down By Unions

Friday, August 5th, 2011

One mans’ garbage is another mans gold. The painful truth is that as muni debt increases, so do the risks that someday it will be politically, economically and financially worthwhile for borrowers to escape it. The Central Falls bondholders seem to have dodged the bullet for now. The question is when the union sue the town, will the bondholders be vulnerable to losses as pensions and health-care obligations are re-negotiated. Muni bonds are great until your local town bond issuer declares Chapter 9 like bankruptcy. Then all bets are off until the smoke clears.

To see a real live insolvent Central Falls GO bond that last traded at 58 cents on the dollar, go to bondview. For more about this situation, here is a good piece from our smart friends at the WSJ’s Op-Ed on Muni bonds, bankruptcies and unions….

On Monday the small Rhode Island town of Central Falls declared bankruptcy because its sky-high labor costs had impaired its ability to pay its bills. The ratings agencies say the development is no surprise, but we wonder whether they’ll be saying the same thing when a bigger city falls off a cliff.

Central Falls’s financial problems are not much different from many states and municipalities. Inflexible and costly collective bargaining agreements have driven up its labor costs and crowded out services. The city is running $5 million annual structural deficits on a $16 million budget. Its pension and retiree health-care bills add up to $80 million. Public safety officers contribute a mere 7% of their salaries to pensions and can retire after 20 years with pensions equal to 50% of their final year’s salary. Such a system in which employees spend more time in retirement than working is unsustainable. Greece, Q.E.D.

In the last year the state has appointed two receivers to bring the city back from the dead, but neither has been able to repeat the miracle of Lazarus. The city’s first receiver Mark Pfeiffer raised property and car taxes by more than 20%, but higher taxes merely drove residents out of town.

In February Governor Lincoln Chafee replaced Mr. Pfeiffer with retired state supreme court judge Robert Flanders. He, too, asked the unions for concessions but came up empty-handed. Mr. Flanders then shut down the city library and community center. In a last ditch effort to save the city from bankruptcy, Mr. Flanders asked retirees to accept scaled-back pensions and to contribute more to their health benefits. The retirees overwhelmingly voted no.

The bright side of Central Falls’s saga is that it’s causing Rhode Island lawmakers to double down on pension reform. As Governor Chafee said earlier this week, “This is not just a Central Falls issue, this is a state issue.” Dozens of towns in Rhode Island, including Providence, have similar pension problems. The state’s pension system, which has a $7 billion unfunded liability, is one of the worst funded in the nation.

Mr. Chafee, an independent, and the Democratic state legislature have committed to tackling pensions in the fall. State treasurer Gina Raimondo, a Democrat, recently issued a report that suggests modifying retirees’ cost-of-living adjustments, raising the retirement age and creating new hybrid pensions that include a 401(k)-style plan and a modest defined benefit. These all sound like good ideas, but the test of Democrats’ sincerity will be when the unions turn out en masse at the capitol to denounce them for betraying their party and trashing collective bargaining.

Tags: credit ratings, municipal bond defaults
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Muni Investors Looking Good in Vallejo, CA

Saturday, May 28th, 2011

Vallejo, California, the biggest U.S. city in bankruptcy, won court permission to send its exit plan to creditors, its municipal bondholders for a vote after retired workers dropped their objections. In summary, “The plan doesn’t alter securities tied to designated revenue sources, such as about $175 million in water revenue bonds, and other special tax obligations secured by special revenue of the city’s restricted funds, according to the documents. ”

U.S. Bankruptcy Judge Michael S. McManus in Sacramento, California, approved a disclosure statement for the plan in an order. McManus will take creditors’ votes into account when he decides whether to approve the plan at a hearing to be scheduled in the coming weeks. A hearing on the disclosure statement had been set for today. The retirees, represented by a court-sanctioned committee, were the last major objectors to the plan, which would cut labor costs and stretch out payments to other creditors.“The committee was concerned if the bankruptcy dragged on, their actual pensions might be jeopardized,’’ R. Dale Ginter, an attorney for the committee, said in a May 23 interview. During the bankruptcy, the city succeeded in cutting costs by firing employees, renegotiating union contracts and reducing what it pays to subsidize retiree health care. Vallejo, a onetime U.S. Navy town of about 120,000 on San Francisco Bay, sought protection from creditors in May 2008 under Chapter 9 of the U.S. Bankruptcy Code, after the recession eroded tax revenue and unions rejected wage cuts. Chapter 9 allows municipalities to reorganize debt rather than liquidate. The plan doesn’t alter securities tied to designated revenue sources, such as about $175 million in water revenue bonds, and other special tax obligations secured by special revenue of the city’s restricted funds, according to the documents. The case is In re City of Vallejo, 08-26813, U.S. Bankruptcy Court, Eastern District of California (Sacramento).” Source: Today’s (5-27-11) Bloomberg Municipal Market Brief.

Another great American tradition is found in the millions of decisions that pass through and from our court system. We are a nation of law. We have a system that respects contracts. It carries with it the notion that obligations that are undertaken are to be fulfilled in economic terms if they are reasonable.

Vallejo’s municipal bankruptcy occurred because the politicians who ran the city ignored these fundamental values and obligated the city taxpayers to unreasonable burdens. Now the court is throwing these excessively costly burdens out. After $10 million of litigation, we are getting to some resolution. Meanwhile, please note the highlighted portion of this news report. It states that the payment stream for the essential-service revenue bond that funded the supply of water to the city is intact.

Many have emphasized importance of essential-service revenue and of the legal construction that protects these bond holders. Here is a prime example. The city is in bankruptcy, yet the bond holder is getting paid.

Reposted with permission from our friends at Cumberland Advisors.

Tags: bondview, credit ratings, municipal bond defaults, S&P downgrade
Posted in Market Commentary, municipal bond defaults | 1 Comment »

Chicago Federal Reserve Says Dont Worry About Muni Defaults

Monday, May 2nd, 2011

There is good news and bad news from the Chicago Federal Reserve which said that 2011 will be a tough year in local government finance. Minimal growth or outright declines in property tax revenues, reduced assistance from state governments, and requirements to make larger payments to underfunded public pension funds will loom large for many local governments. However, if history is any guide, few local governments will either default on their municipal bonds or end up in bankruptcy. The aftermath of actual local government bankruptcies—such as that of Vallejo, CA, in 2008—suggest that governments are hurt badly when they emerge from bankruptcy, particularly in their ability to issue debt. And so, in all but the most dire cases, local governments under stress are likely to take alternative steps to shore up their fiscal positions.

Tags: bondview.com, municipal bond defaults, municipal bonds
Posted in Market Commentary, municipal bond defaults, municipal bonds | 1 Comment »

Miami Could Have A Higher Credit Rating Than The USA

Tuesday, April 26th, 2011

Standard & Poor’s Ratings Services downgraded refunded municipal bonds that were rated AAA in a follow-up to its downgrade notice of the U.S. triple-A outlook to negative from stable.

S&P suggests that in a scenario of economic or political stress a local government could have a higher credit rating than the USA. So could Miami one day have a higher credit rating than the USA? Sounds like a stretch.

Interestingly, S&P said it does not tie ratings on state and local governments to that of the United States and as a result, existing outlooks on their triple-A ratings will not change because of the revision for the federal government.

But this seems inconsistent with the market realty. The entire muni bond industry estimates prices based on various factors. The spread to the US treasury is a main criteria. BondView research So are Pre Refunded muni bonds since they are a key benchmark and are backed by US treasuries. Common sense suggests there will most certainly be a price and yield effect on the benchmark Pre Refunded muni bond since they are priced at a spread to the AAA US tres bond.

If and when the AAA US Tres is downgraded, so will Pre-Re muni bonds backed by US treasuries also known. But thats just the effect on the top of the food chain. We would expect to see a wild ride for all other muni bonds since they are also priced relative to the AAA US treasury bond. But to make matters worse, about 1/2 of all muni bonds are not rated by a major credit rating agency. These unrated muni bonds will be in worse limbo then they are today.

What S&P actually said was that only about 4 percent of state and local issues are rated AAA with a stable outlook by S&P, which said the possibility exists that a state or local government could have a higher rating than their sovereign government “in a scenario of economic or political stress.” But its a stretch to suggest that say swinging Miami, Florida could have a higher credit rating than the US government, long considered the global benchmark for stability.

To see the real effect of interest rate changes on muni bond prices, go to bondview.com, a free resource for muni bond investors.

Tags: credit ratings, Muni bond Defualts, S&P downgrade
Posted in Bond Ratings, muni rates, municipal bond defaults, municipal bonds, Ratings, S&P's downgrade, Standard & Poors | 2 Comments »

Beware of wounded credit-rating agencies

Wednesday, April 20th, 2011

As the U.S. has just discovered, a wounded credit-rating agency is a dangerous beast.

The raters stood accused of contributing to, even precipitating, financial crisis by awarding top grades to securities, institutions and even countries which proved unworthy of them, to put it mildly. They then compounded the error by lowering these ratings too slowly, or so the charge sheet reads.

Stung by such barbs, Standard & Poor’s Corp ., Moody’s Investors Service Inc. and Fitch Ratings have clearly resolved not to get caught behind the curve again. Hence, presumably, S&P’s seismic decision to give the U.S.’s gold-standard credit rating a negative outlook Monday.

Quite a start to the week.

In one sense, of course, the action tells us little we didn’t already know, and is merely a response to the agonizing budgetary wrangling taking place in Washington. It’s those pesky voters again, you see. They generally favor deficit reductions, but are not so keen on any measures which would hit their personal finances (this is the post-crisis catch-22 for governments all over the spent-out west).

However, brightening the structural fiscal outlook in Washington will require painful adjustments, and these are generally rare in the year or so prior to a Presidential election. What S&P has done is highlight the threat to both the dollar’s status as the world’s reserve currency, and the “risk free” position of U.S. debt if the next few months don’t prove an exception to this rule.

Posted in AAA Downgrade, municipal bond defaults, Ratings, S&P's downgrade, transparency | No Comments »

New SEC Rules Makes It Harder For Muni Bond Issuers To Hide Bad News

Monday, April 11th, 2011

On Dec 2010, the Securities Exchange Commission put into effect Rule 15c2-12 which prohibits dealers from underwriting most muni bond deals unless the issuers have contractually agreed to disclose annual audited financial and operating information, as well as the occurrence of key events. The rule also makes it harder for municipal bond issuers to hide financial problems behind the “material events” defense since certain new Listed Events, would no longer be subject to a materiality determination before triggering a requirement to provide notice. Click here to see a real a portfolio of defaulted municipal bonds.

The list of material events were expanded to include IRS notices, missed payments, etc. The full list now includes: (i) principal and interest payment delinquencies; (ii) unscheduled draws on debt service reserves reflecting financial difficulties; (iii) unscheduled draws on credit enhancements reflecting financial difficulties; (iv) substitution of credit or liquidity providers or their failure to reform; (v) defeasances; (vi) rating changes; (vii) adverse tax opinions, the issuance by the Internal Revenue Service of proposed or final determinations of taxability or Notices of Proposed Issue (IRS Form 5701-TEB); (viii) tender offers; and (ix) bankruptcy, insolvency, receivership or similar event of an issuer or Obligated Person. “adverse tax opinions, the issuance by the Internal Revenue Service of proposed or final determinations of taxability, Notices of Proposed Issue (IRS Form 5701-TEB) or other material notices or determinations with respect to the tax status of the security or other material events affecting the tax status of the security”.

More details of the ruling are below:

Brokers, dealers and municipal securities dealers (“Participating Underwriters”), issuers of municipal bonds, and borrowers of municipal bond proceeds (“Obligated Persons”). Rule 15c2-12 generally requires Participating Underwriters to reasonably determine, prior to purchasing municipal bonds, that an issuer or Obligated Person is contractually obligated to provide annual reports, including financial information, and notices of the occurrence of certain events (“Listed Events”) with a nationally recognized municipal securities repository. Currently, the only nationally recognized municipal securities repository is the Electronic Municipal Market Access System, which is maintained by the Municipal Securities Rulemaking Board.

The Amendments: (i) expanded disclosure obligations under the Rule by (a) adding additional “Listed Events”, and (b) eliminating the exemption for variable rate demand obligations from continuing disclosure requirements; (ii) provided that the occurrence of certain Listed Events, including certain new Listed Events, would no longer be subject to a materiality determination before triggering a requirement to provide notice; and (iii) established a strict ten-day time frame for submitting required event notices. The SEC also provided interpretive guidance to Participating Underwriters with respect to certain of their obligations under the Rule. The Amendments became effective on December 1, 2010 and apply to municipal securities issued on or after December 1, 2010 in a principal amount equal to or greater than $1,000,000 and to any remarketing that would be considered a primary offering under the Amendments.

Expanded Disclosure Obligations

Tender Offers;

Bankruptcy, insolvency, receivership or a similar event;

Merger, Consolidation, Acquisition, and sale of all or substantially all assets; and

Appointment of a successor or additional trustee, or a change of name of a trustee.

In addition, the Amendments expanded the “adverse tax opinions or events” Listed Event to include “adverse tax opinions, the issuance by the Internal Revenue Service of proposed or final determinations of taxability, Notices of Proposed Issue (IRS Form 5701-TEB) or other material notices or determinations with respect to the tax status of the security or other material events affecting the tax status of the security”. This amendment was designed to, among other things, “focus the disclosure on information relevant to investors, whether the municipal security is taxable or tax-exempt”.

Primary Offerings of Variable Rate Demand Obligations Are Now Subject to Continuing Disclosure Requirements. The Amendments also eliminated the exemption from continuing disclosure requirements for primary offerings of variable rate demand obligations (including remarketings that are primary offerings) that occur after December 1, 2010. The Amendments included a “limited grandfather provision” for remarketings of variable rate demand securities that were outstanding in the form of demand securities on November 31, 2010 and that continuously have remained outstanding in the form of demand securities.

Elimination of Materiality Determination for Certain Events

Prior to the Amendments, the occurrence of a Listed Event only needed to be disclosed if a determination was made that the occurrence of such event was “material.” The Amendments now require that the occurrence of the following Listed Events must be disclosed without regard to whether the issuer or Obligated Person determines the event to be material: (i) principal and interest payment delinquencies; (ii) unscheduled draws on debt service reserves reflecting financial difficulties; (iii) unscheduled draws on credit enhancements reflecting financial difficulties; (iv) substitution of credit or liquidity providers or their failure to reform; (v) defeasances; (vi) rating changes; (vii) adverse tax opinions, the issuance by the Internal Revenue Service of proposed or final determinations of taxability or Notices of Proposed Issue (IRS Form 5701-TEB); (viii) tender offers; and (ix) bankruptcy, insolvency, receivership or similar event of an issuer or Obligated Person. The other Listed Events (namely: non-payment related defaults, other material events affecting the tax status of a security, modifications to rights of security holders, bond calls, release, and substitution or sale of property securing repayment of the securities and appointment of a successor or additional trustee or the change of a name of a trustee) need only be disclosed upon a determination that the occurrence of such event is material.

Event Notices Must be Filed within Ten Days of the Occurrence of the Event

Prior to the Amendments, Rule 15c2-12 only required that Listed Events be disclosed in “a timely manner”. The Amendments now require that Listed Events be disclosed “in a timely manner not in excess of ten business days after the occurrence of the event” (emphasis added).

Interpretive Guidance to Underwriters of Municipal Securities

The SEC affirmed previous guidance that, under the Rule, it is doubtful that an underwriter could form a reasonable basis for relying on the accuracy or completeness of an issuer’s or obligated person’s ongoing disclosure representations if such issuer or obligated person has, on multiple occasions during the previous five years, failed to provide on a timely basis continuing disclosure documents, event notices and failure to file notices as required in a continuing disclosure undertaking for a prior offering. Under such circumstances, it is the SEC’s view that it would be very difficult for an underwriter to make a reasonable determination that the issuer or Obligated Person would provide such information under a continuing disclosure undertaking in connection with a subsequent offering. The SEC also noted that an underwriter should affirmatively inquire as to an issuer’s or Obligated Person’s filing history and that reasonable belief should be based on the underwriter’s independent judgment, and not solely on representations or certifications of the issuer or Obligated Person.

Posted in Material Events, municipal bond defaults, municipal bonds | No Comments »

Muniland and Pensions, (2/15/11)

Friday, April 1st, 2011

“In December, projections by Meredith Whitney, the banking analyst, about possible municipal defaults began to rattle the $2.86 trillion municipal-debt market. Investors withdrew $1.2 billion from U.S. municipal-bond mutual funds, the 13th-straight outflow, Lipper U.S. Fund Flows said about the week ending Feb. 10. About $24.8 billion has been redeemed since the week ended Nov. 17, including a record $4 billion in the week ended Jan. 19, the most since Lipper started compiling data in 1992.” Source: Bloomberg, Feb. 14.

Panic-driven mutual fund redemptions continue to depress the prices of high-grade Munis. To us, this means the buying opportunity for well-selected issues is intact. Remember, this is an idiosyncratic securities sector. Broad-brush painting of “all Munis are going to default” is specious.

Forced selling by mutual funds depresses the pricing references that are used by the pricing series. Most Munis do not trade every day. Hence, the drop of a few prices lowers the estimated prices of all Munis. This perception issue has created a misunderstanding in the market and resulted in exacerbation of the selloff.

Think about it this way. Let us examine the case of a single mutual fund that must sell to meet redemptions. The fund manager needs the cash at once. He sells his liquid and highest-credit-quality names, which allows him to get cash as once. These same bonds are used to price the entire universe of Munis. The next day all Muni reference prices are lower, even though most of them did not trade. Since the mutual fund holds many bonds, its share price reflects the new pricing, and hence is lower. That alarms more shareholders and another round of selling triggers a downward spiral. This has been going on for 13 weeks.

Some say the cause of the selling is the opacity in the unfunded pension systems of the states. Maybe so. Moreover, maybe that is part of the hype. We think the pension issue is clear. One only needs to do the homework.

In a state like Delaware, the pension system is nearly fully funded. The credit rating of the state is AAA. There is no pension issue in Delaware. The same is true for many states.

There are 218 separate state pension plans among the 50 states. There are 2,332 local pension systems. Thank you, Natalie Cohen of Wells Fargo for the data. Natalie notes the differences by illustrating Indiana. The Indiana Public Employee Retirement Fund is about 94% funded. The Indiana teacher plan is only 43% funded. In NJ, which was just down-graded by a rating agency, Natalie reports the public fund is 56% funded, the local fund is 71% funded, and the teachers’ plan is 64% funded. As we have been saying for months, broad brushing Muniland does not work. One must drill deeply into the data.

Estimating the present value of an unfunded pension obligation is imprecise. It takes a lot of assumptions and falls into the murky realm of actuarial science. Moody’s offers that “a 100 basis point movement in the discount rate results is an inverse movement in the obligation of approximately 8-12%.” Current rules allow much flexibility to states and local government in making assumption choices.

That is about to change. The Government Accounting Standards Board (GASB) is issuing new rules on accounting and reporting liabilities for pensions and other post-employment benefits. These are in draft form now. The rating agencies are combining the actual bonded indebtedness of states or local governments with the unfunded liability estimates. That is why NJ was recently downgraded.

In addition, there is legislation at work to force pension disclosure to be more consistent and transparent. Public Employee Pension Transparency Act or H.R.6484 is under discussion in the House of Representatives. It will require timely information on al governmental pension funds and it will impose penalties for failures to disclose. Rating agencies are endorsing such legislation. So do we. The effect will be to improve funding and force clarity. We expect this to become law in this congressional session.

At Cumberland, we already look at the unfunded obligations and the assumptions. We are glad to see this issue being addressed by states and local governments and by the rating agencies. It has been a long time coming.

One group that objects strenuously is the public employee unions. They are now the largest organized labor faction in the US, and they are trying to preserve the status quo. There is where the political rubber hits the road. We expect this to be a state-by-state fight. We saw the first salvo fired in Illinois as the retirement age was extended. Major changes proposed by NJ Governor Christie currently are stymied in the state’s legislature. Watch what happens as the NJ budget fight gets down to the last minute.

In our view, these issues will get resolved because they must get resolved. State and local governments cannot continue to fund promises they cannot afford. The tide has changed. We expect nearly all of them to alter their budgets, and we expect austerity to be imposed. The notion of electing default or bankruptcy as an option seems politically dead to us.

We continue to buy well-selected Munis at tax-free yields in excess of the taxable yield references. We are witnessing a generational opportunity and want to seize it Muniland and Pensions

David R. Kotok, Chairman and Chief Investment Officer

Published with permission by our friends at Cumberland Advisors

Tags: municipal bond defaults, municipal bonds, pensions
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Muni Defaults: Whitney and Roubini (3/26/11)

Friday, April 1st, 2011

“The rule on staying alive as a forecaster is to give ‘em a number or give ‘em a date, but never give ‘em both at once.”

–Jane Bryant Quinn, Reader’s Digest, 1 Dec. 1980

Meredith Whitney broke the rule. This now haunts her to the point that she declined to appear before a Congressional committee that wanted to discuss Muni default issues. Nouriel Roubini is a skilled economist. He knows this rule. He, therefore, used modifiers to adhere to it.

Let’s talk about Whitney’s forecast first. With great media fanfare, she predicted “50 to 100” sizeable muni defaults, totaling about $100 billion, in 2011. That is correct: she said this year. The year in which the economy is in some sort of recovery and when the interest rate is held near zero by the Fed.

Meredith did not know about any oil shock when she made this forecast. While the current MENA turmoil is a serious new development, the resulting oil price shock will not help her be right in her forecast. In our view, there is nearly zero chance that there will be 50 to 100 sizeable Muni defaults amounting to $100 billion in the calendar year of 2011.

Nouriel Roubini suggested that there may be “close to $100 billion of defaults over five years, but typical 80% recoveries are far higher than on corporate bonds.” Nouriel outlined his view of trouble in the Muni world and attempted to measure the exposure in a very thoughtful way. He noted that most of the bonds he expected to default were in the high-yield or junk-bond category. His base-case estimate of defaults over five years for the investment-grade sector was under $30 billion, with “ultimate recovery” of nearly all the losses. Nouriel reminds us that “governments cannot be liquidated” like corporations.

Bloomberg’s Joe Mysak observed the following about Roubini:

“And so noted doomsayer Nouriel Roubini joins the numerous commentators who have opined about the municipal bond market, the most famous, of course, being Meredith Whitney, who in December on the CBS show ‘60 Minutes’’ blurted out the prediction that there would be ‘hundreds of billions’’ of municipal bond defaults in 2011. That $100 billion estimate from the Roubini firm isn’t in the same league as the Whitney call. What’s more, it may not be so outrageous, depending upon how you count defaults. The record year for municipal bond defaults was 2008, when 167 issues totaling $8.5 billion went bust, according to the Distressed Debt Securities Newsletter. In 2009, more municipal bonds defaulted, 207, on a lower dollar amount, $7.3 billion. In 2010, 82 deals failed to pay on $2.7 billion in bonds. The $100 billion over the next five years isn’t outside the realm of possibility. How are you counting? The people at Distressed Debt Securities, who have been doing it for decades now and who are the only ones with a historical database over that time, and who use a consistent methodology in their approach, count new defaults only in their calculations, which I think is the correct way to do it. Some analysts, scanning the daily material event notices at the Municipal Securities Rulemaking Board’s EMMA web site, count all notices of default that are posted by issuers. And by doing it that way, by counting bonds that are already in default, you can come up with many more billions of dollars in defaulted municipals every year. That’s because it takes years to cure some of these things. In the case of so-called dirt-bonds, used to finance infrastructure improvements to real estate developments, for example, bondholders have to wait until the real estate is foreclosed upon and sold before they see any end to their money woes. Dirt bonds are the overwhelming majority of those that have defaulted over the past few years. The same long wait is true for bonds used to build speculative projects like toll roads, or de-inking mills, or aquariums, or any of the other various quixotic stuff that has been financed in the municipal market. Actual municipalities, that is, cities and counties, rarely default on their obligations. When they do, they usually cure them in pretty short order, in months if not weeks. Jefferson County, Alabama, which defaulted on almost $4 billion in sewer debt several years ago, is an outlier. If history is a guide, it probably will remain so. So, $100 billion over five years? That’s the headline number. It’s not impossible, especially if you count continuing defaults. Still, that’s quite a crystal ball.”

We believe it is important for readers to understand the term default. Here is the official definition from the Municipal Securities Rulemaking Board (MSRB). Remember, bondholders are concerned about monetary defaults. Non-monetary defaults are important because they tell you about the management of the organization or its political structure. These non-monetary defaults actually can provide a bond buyer with opportunity for a bargain if he is willing to do the homework.

“DEFAULT–A failure to pay principal of or interest on a bond when due or a failure to comply with any other covenant, promise or duty imposed by the bond contract. The most serious event of default, sometimes referred to as a ‘monetary’ default, occurs when the issuer fails to pay principal, interest, or both, when due. Other defaults, sometimes referred to as ‘technical’ defaults, result when specifically defined events of default occur, such as failure to maintain covenants. Technical defaults may include failing to charge rates sufficient to meet rate covenants, failing to maintain insurance on the project or failing to fund various reserves. If the issuer defaults in the payment of principal, interest, or both, or if a technical default is not cured within a specified period of time, the bondholders or trustee may exercise legally available rights and remedies for enforcement of the bond contract.”

MSRB reported a Fact Book on the hundreds of thousands of items and on the 10.5 million muni trades for 2010. There were 371 disclosures of a principal & interest delinquency; these involved 1951 securities. The overwhelming majority of them were in project-specific or otherwise non-rated or “junk” bonds. So if you count them on the default list, the list gets bigger.

Does that mean you have to buy any of these bonds? Certainly not. Does delinquency mean an actual monetary default will occur? Maybe yes, maybe no. Each case is different.

When it comes to actual defaults in 2011, the statistics, so far, are improving. “Municipal-bond defaults in the first two months of 2011 are down 50 percent from the same period last year, Standard & Poor’s said. Eight bond deals totaling about $222 million have entered default this year, compared with 16 totaling more than $329 million during the same period of 2010,” said J.R. Rieger, vice-president of fixed-income indexes for S&P in New York (Bloomberg, March 4).

The media has been filled with talk about municipal bankruptcy. This is a serious subject, of course. But it, too, has been overblown. Evidence from the 2008 Vallejo, California bankruptcy demonstrated how costly this is for a city or county. Vallejo has spent nearly $10 million so far and has nothing to show for it. The Bond Buyer, a trade publication, reports that “Vallejo bonds backed by non-general fund revenues amount to $62 million of debt. They have been paid in full and on time throughout the bankruptcy proceeding. They include securities with dedicated income streams including water revenue bonds, tax allocation bonds, and assessment and improvement district bonds.”

So far, in 2011, there has been just one Chapter 9 filing. Bloomberg reported it:

“Boise County, Idaho, with a population of about 7,450, filed for bankruptcy, making it the first U.S. municipality to file Chapter 9 this year. The county sought protection after a federal jury in December found the county violated federal fair housing law in its conduct related to a developer’s plan to build a 72-bed residential treatment facility for teenagers, the Idaho Statesman reported. The jury awarded a $4 million judgment to a developer, which hasn’t been paid. The county’s budget this year is $9.3 million. The county estimated its liabilities at less than $10 million, according to a March 1 filing in U.S. Bankruptcy Court in Boise. Alamar Ranch LLC, the developer, was the largest unsecured creditor with the $4 million claim. Idaho is one of 26 U.S. states that authorize municipal bankruptcy. Like Chapter 11 under the federal bankruptcy code, municipalities allows debtor to adjust debt. Unlike corporate bankruptcies, creditors can’t force municipalities into liquidation and the bankruptcy court has little oversight of municipal operations. Six municipal entities filed for Chapter 9 last year, most of them small utility or sewer districts. The capital of Idaho, Boise, is in adjoining Ada County.”

Whitney’s report does not delve deeply into the recovery history of Munis and into the technical details of default. Nor does she examine the complexities of Chapter 9 bankruptcy.. That is a shame, since she does deserve credit for publicizing the important issue of budget stress in Muniland.

Roubini does examine recovery. He offers estimates and methodologies. And he thoroughly describes the issues involving Chapter 9. His conclusion is that Muni recovery is much higher than markets seem to be pricing and that the widespread use of Chapter 9 is unlikely.

We believe the Roubini report is straightforward and worthy of respect. It is serious research work. It examines nearly two centuries of development in state and local government debt in the United States. It explains the methodology that it used to reach conclusions and estimates. We are less respectful of the Whitney report.

Roubini also attempts to estimate the price adjustment needed in the market in order to normalize the Muni-treasury spread. He notes that the financial crisis sell-off brought Munis to “absurd panic levels.” He reminds readers that, while things are improved since these wide spreads, the Muni market is still under “extreme strain.”

Cumberland agrees with Roubini’s conclusion that the “ratio of Muni yields to Treasuries remains elevated.” We continue to be buyers of well-structured, high-grade, tax-free municipal bonds and of corresponding taxable municipal debt. They remain cheap, and spreads still have a ways to go before normalcy in pricing is attained.

David R. Kotok, Chairman and Chief Investment Officer

Published with the permission of our friends at Cumberland Advisors

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