Tuesday, July 19, 2011

Why Meridith Whitney's concerns do not matter

Meridith Whitney has made a fuss of late pointing out the (more or less obvious) insolvency of many State and local governments.

She seems to think this is the end of the world.

Maybe there will be a lot of defaults though if something like California defaults it will be by choice rather than by force. (California is plenty rich and has plenty of taxing power if they don't want to give it away in citizens initiated referendums...)

But that is irrelevant to the point I wish to make.

Ultimately I don't care if there is a wave of municipal defaults. I think it will have next to no economic effect. Here is why.

I like to draw a distinction between money lost by unlevered players and money lost by levered players.

Plenty of wealth was destroyed in the dot-com bubble. But it caused no systematic crisis because the wealth was lost by individuals and unlevered players. If you lost money in dot-com you probably spent less (there was a recession) but it did not destroy the system.

However when money is lost by levered players it leads to cascade effects. 50 billion lost by Lehman Brothers (not more than 200 billion anyway) had huge effects because Lehman was a levered entity that had its claws everywhere. It had widespread destabilizing effects - whereas a similar amount lost in dot-com like events has next to no effect (except on the losers).

Well muni-bonds are ultimately held by unlevered individuals usually for their tax advantage. They are not held by people with large mortgages or credit card debt and they are mostly not held by financial institutions.

In other words their default will have economic effects similar to dot-com rather than similar to Lehman.

And in fact they are held by the people with the most excess saving and the lowest marginal propensity to spend incremental income - so their default will have low wealth effects.

It won't matter. Meridith Whitney might be right - or she might be wrong - but unless you hold muni-bonds I can't see why you should care.


I don't think you are going to find a Goldman strategist who will say that muni-bonds are owned by rich people and you can f--k rich people and they won't spend any less and hence muni-default does not matter.

Nah - nobody from The Squid will say that.

So I will. Somebody has to.



Ben Hacker said...

I generally see your point, but I think you are missing that many levered insurance companies (US at least) own these as well. There may be knock on effects from that.


Anonymous said...

A wave of municipal defaults and next to no economic effect? I do not subscribe to this view.

The comparison with the dot-com bust is somewhat misleading. Much of what was lost was the bezzle, as J.K.Galbraith termed it. A recent example: Paulson's actual loss on Sino Forest was the difference between the price at which he purchased and the one at which he sold. Many observers were quick to compute the difference between the highest price and the price at which he sold and give this as his loss. However, there is no bezzle in munis.

The muni market is huge and it seems reasonable to me that a lot of middle-class people invested a chunk of their savings in munis. So a wave of muni defaults would impoverish an important group of society which accounts for a lot of consumption and other economic activity. As these people retrench overall economic activity will suffer severely and for a long time.

Charles Butler said...


Your point is well taken, and may even be applicable elsewhere.

But it's even more relevant given that Whitney's entire take on muni defaults, kicked off in fine style with the 100 bn 'default' prediction last year, has purely and exclusively been an exercise in branding - the staking out of some exclusive, headline generating turf in the ultra-competitive black swan universe.

If there were only a market in which you could go short these attention seekers, we might be spared the endless barrage of analysis that moves backwards from the desired conclusion.

But What do I Know? said...

Good analysis, JH, but I would caution you against assuming that muni holders aren't leveraged. There are plenty of leveraged muni closed end funds here--I'm not sure of their size versus the market, but they did get hammered pretty good in 2008. . .

Anonymous said...

(Sorry if this is a double post)

John, my understanding is that under U.K. law, assets held at the Lehman U.K. entity were part of the bankruptcy process, as opposed to U.S. law where a clearing customer has access to their securities if the clearing firm declares bankruptcy. How much of the Lehman disaster do you think can be attributed to this difference in laws? My theory is that the problem wasn't that Lehman was so intercontected, but rather that leveraged players holding assets in the U.K. entity had to immediately sell off other assets held elsewhere once their "collateral" at Lehman wasn't accessable. Do you think we would have had anywhere near the same problem if assets held at all Lehman enitties were protected by U.S. law?

Ben said...

Meredith Whitney wasn't even a good financial services analyst, she was known as being kind of a joke before the crisis occurred and she "made headlines." Now she's trying to capitalize on her fame and that's about it. Same with Nouriel Roubini but replace financial analyst with economist.

Troy Peterson said...

There are tens of billions in muni defaults already occurring- but, you will not hear about them because they are largely contained in non-rated, esoteric deals that are tied up in structured vehicles or institutional accounts.

Many of these deals are drawing down from their debt-service reserves and will wind up worthless, because they were originated in the 2007 bubble with poor structure/terms. Examples abound, including garbage like an airport in Branson Missouri (+$100mln=zero), Retirement homes in NY (67Mln= 40% occupied, losing millions per quarter), Empty prisons in Texas ($77Mln= zero/bagel), etc. etc.

Just because you don't see the trees falling (massive defaults, left and right) does not mean they arent happening. So, Meredith Whitney may be proven right, but it probably doesnt matter... as $100Bln in defaults is only 3% of the muni market.

yoyodyne said...

Why do so many otherwise smart people struggle to spell Goldman Sachs?!

As in Marcus Goldman, and Samuel Sachs.

Not Samuel Sach. Obviously!

Anonymous said...

you like to sound logical, in one minute, and irrational, in another, choose one..

muni's default has no impact?

give me a break...

all your beloved PMI insurance industry, life insurers and tons of close end funds, guess what they are holding?

also guess what will happen to CDS underwriters of those insurance co's... and again guess who wrote them the most..

i think, this time, your post is delusional

John Hempton said...

The closed end funds are held by unlevered people. I do not care whether the unlevered people hold muni bond funds or muni bonds straight.

Didn't matter they held tech funds either.

PMI - nobody cares about mortgage insurance any more.

There are some insurance companies that still hold some of this sh-t.

Not many though. They got smart and sold it retail.


NotATeabagger said...

I agree w/John's post. In addition, MW was on Bloomberg Surveillance about a week ago talking about how she really was focused on towns/cities going bankrupt. Even aside from the key things John has pointed out, if the most intense and best opportunities are on munis tied to towns adn cities, who the hell is writing a CDS for some dink 50,000 population city, the bid/ask spread would be ridiculous and no legit players could ever put enough capital to work on a trade like that.

Anonymous said...

Short Bronte Capital, that's all I can say. Bonds compared to stocks? No impact? I think the greater point of states/local governments not having revenue and the trickle down impacts on the economy of a whole is ENORMOUSLY missed here. This is like Whitney all over again. Only, this guy, somehow, sounds more ignorant!

sanchk said...

I'm curious, would a default by choice in California be considered an issue with liquidity or an issue with solvency?

Logically it sounds like it would be a liquidity default, since California has the ability to pay off their debts, though not the means. However, since the state doesn't technically have access to the 'assets' which could be used to pay off their debts, because of the nature of tax regulation in California, I'm equally that California would be considered insolvent, not illiquid.

Really, what it would be is a default of lunacy.

Anonymous said...

You can't be serious.

"... next to no economic effect..."

Okay, what about the public employees who are forced to work only partial hours, who are furloughed, or who are fired because municipalities can't afford to pay them?

What about the pension fund destabilization going on, with municipalities trying to reduce long-term debt in the face of this crisis?

What about the halt to construction work, park maintenance and critical upgrade/maintenance projects?

Fortunately, many states, universities and localities have seen improvements in sales tax, income tax and/or property tax revenue in 2011, or have raised taxes to account for budget shortfalls. But I really can't see how thousands of people losing their jobs or their expected retirement income has no effect on the economy. Just thinking about how school programs and teacher cuts are going to affect the next few years of student development is really unpleasant.

If what you really meant to say was "no effect on RICH people" then I'd still disagree with you there too. High risk munis have been a bad place to be, but their numbers certainly aren't growing to Whitney-expected proportions. But with the debt ceiling debacle ongoing, and the importance of prerefunded bonds, and Build America Bonds in the market, yeah, even if I were a wealthy muni investor who could afford to lose the money, I'd still be concerned.


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