The MUNI- MELTDOWN THAT WASN’T. November 2014

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MUNI MANIA: A TIMELINE

FEBRUARY 2009 “If a few communities stiff their creditors and get away with it, the chance that oth- ers will follow in their footsteps will grow.” – Warren Buffett APRIL 2009 Moody’s assigns the U.S. Local Govern- ment Sector a negative outlook

SEPTEMBER 29, 2009 “Dark Vision: The Coming Collapse of the Municipal Bond Market” – Frederick J. Sheehan, published DECEMBER 2009 by Weeden & Co. “Are State Public Pensions Sustainable?” – Joshua D. Rauh

MARCH 30, 2010 “State Debt Woes Grow Too Big to Camouflage” – The New York Times APRIL 4, 2010 “Once a few municipalities default, there is a risk of a widespread cascade in defaults.” APRIL 15, 2010 – Richard Bookstaber, blog “This isn’t capitalism. It’s nomadic thievery.” – “Looting Main Street,” by Matt Taibbi, Rolling Stone SPRING 2010 “Beware the Muni Bond Bubble: Inves- tors are kidding themselves if they SUMMER 2010 think that states and cities can’t fail.” “How to Dismantle a – Nicole Gelinas, City Journal

Muni-Bond Bomb” SEPTEMBER 2010 – Steven Malanga, City Journal “The Tragedy of the Commons” – Meredith Whitney OCTOBER 5, 2010 “Cities in Debt Turn to States,

Adding Strain” NOVEMBER 16, 2010 – The New York Times “California will default NOVEMBER 29, 2010 on its debt.” “Give States a Way to – Chris Whalen to Business Insider Go Bankrupt” DECEMBER 5, 2010 – David Skeel, The Weekly Standard “Mounting Debts by States DECEMBER 19, 2010 Stoke Fears of Crisis” “Hundreds – The New York Times DECEMBER 24, 2010: of billions” “I can’t make the numbers work. If you look at the 10 largest – Meredith Whitney, on 60 Minutes cities and the 25 largest counties in the country, that’s $114 bil- JANUARY 20, 2011: lion in debt outstanding. So you gotta basically have New York, “Misunderstandings Regarding State Debt, Pensions, Chicago, Phoenix, Los Angeles — these cities start to default.” and Retiree Health Costs Create Unnecessary Alarm” – Ben Thompson, Samson Capital, on CNBC – Center on Budget and Policy Priorities 21-page white paper AUGUST 2011: “[I don’t care about the] “stinkin’ municipal bond market.” – Meredith Whitney to Michael Lewis

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INTRO

An old-media kind of guy, I still keep file folders of stories, blog Inside entries, clippings, messages and reports printed out and more or less sorted. Back in early 2009, I started a file labeled “Hysteria’’ In the Beginning to hold the physical evidence of what I thought the most unusual Particular and Specific...... 5 and even outlandish claims being leveled against an asset class I have spent 33 years writing about — municipal bonds. The Undiscovered Country Just Look!...... 8 Over the next couple of years, the file swelled. I started another. And another. I didn’t even include Meredith Whitney. She got an entire file of her own. The End of Something Splendid Isolation No More...... 9 I collected so much material that I decided to use it as a presentation to the Bond At- torneys Winter Workshop one year. Even then I only got to use the high-points, or low ‘Dark Vision’ points, if you prefer, entering each exhibit into evidence. I considered this clever. Bombs Away...... 10 “Show me a revenue stream and I’ll show you a bond issue,” is an old banker’s axiom. The writer’s equivalent is probably, “Show me a box of research and I’ll show you a book.” The Coming Collapse Or, in this case, a special supplement. And so here we are. In Sum...... 11

In 2010, municipal bonds, hitherto known only as secure, boring investments, if some- Into the Abyss times a little weird, were front-page news. It was stated with some confidence that the ‘Dump Munis’...... 12 entire market was going to go bust. Public Pensions Of the Great Municipal Market Meltdown – so confidently predicted for 2010, 2011, 2012, and so on – I think we are now finally able to say, “That didn’t happen.” As it was being We Have a Problem...... 13 predicted, I observed that the reason it wasn’t happening was because “that doesn’t hap- pen.” In other words, the various “experts’’ then weighing in about state and local govern- Media Frenzy ments’ coming mass insolvency and/or repudiation didn’t know what they were talking Everyone’s Meltdown...... 16 about. That didn’t stop what I termed their “Inexpert Testimony” from being offered. And widely (and unfairly, I thought) quoted. The Market Responds to Its Critics First Responders...... 19 I define “meltdown’’ here as its proponents did: widespread default or outright repudiation of municipal bonds. There were a number of (non-muni) analysts and observers eager to Oh, Meredith forecast just this possibility. Others contented themselves with stoking hysteria in regard ‘Hundreds of Billions’...... 23 to public pensions. One even expressed outrage over Wall Street’s underwriting and banking relations with Main Street borrowers. The blowup to come, we were assured, After ‘Hundreds of Billions’ was going to be almost operatic. Victory Lap...... 24 The more I leafed through these bulging files — in retrospect, and recollected in tranquil- ity, as the poet says — the more I asked, How did this come about? Why were so many Returning Fire people who were little more than tourists in MuniLand taken so seriously? That’s Enough!...... 26 Why was the opinion of those who did know what they were talking about so heav- What Happened, Lessons Learned ily discounted? What lessons can investors learn from this? Because lots of investors, Age of Twitter...... 27 especially after Meredith Whitney made her famous call on “60 Minutes” in December of 2010, sold both muni mutual fund shares and individual bonds, sometimes at fire-sale Appendixes prices. They wanted to get out at any price. Panic was in the air. To the Foregoing Work...... 30 There’s no one answer. There are lots of answers. There’s no one answer. There are lots of answers.

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I: In the Beginning

Our story begins in 2009. There may have been hysterical commentary about the condition of the municipal bond market before this. There probably was; I just don’t recall it. Maybe it lacked a certain intellectual heft, and so had little impact on me as I read it. More likely, it was sub- merged in the round-the-clock hysteria then surrounding nothing less than the state of capitalism in the free world. The recession that had begun in late 2007 and accelerated in 2008 still had a way to go.

Faced with Wall Street firms going bust, municipalities were just about to embark mass firings, the housing price collapse on a borrowing binge, spurred in part and 401(k) plans evaporating as the stock by the threat, real and imagined, of tax market plummeted, it was hard for munici- reform that would prohibit them from pal bonds to make the front page. financing certain things with tax-exempt They tried. Two events in particular had securities, and then by a decline in inter- rocked munis in 2008. In February, the est rates that sparked a wave of refinanc- $330 billion auction-rate securities market ing, and finally by a boom in what we may Source: Nick Ferris/Bloomberg froze after Wall Street banks stopped term bankerly creativity. I’m sure the rise Joe Mysak providing backstop bids for the stuff. The of suburbs beyond the suburbs and their I became so convinced that a national market had long relied on a convention concomitant needs for infrastructure like meltdown was unlikely. We’re not talking the Street could no longer afford – instant streets and sewers and schools was part about dozens or scores of issuers, but liquidity. The result: Investors in many of it, as was the later urban renaissance. tens of thousands. auction issues could see their money, but Analysts could take cold comfort in the The Census of Governments done by couldn’t lay their hands on it. It would take fact that the insurers didn’t lose their AAA the U.S. Census Bureau every seven years to remedy the situation. ratings because of anything they’d done years shows that there are just over in the municipal market. Their sin was 90,000 governmental entities in the U.S. It Rise of the Insurers expanding into asset-backed securities, has been estimated by the Municipal Se- a move inspired as much by stockholder This was damaging enough to the mar- curities Rulemaking Board, the market’s interest in returns as demanded (well, ket’s psyche. Even worse was the down- self-regulatory organization, that perhaps almost) by the ratings companies, which grade of most of the AAA-rated municipal 50,000 have borrowed money in the mu- urged the insurers to expand into more bond insurers. Bond insurance was per- nicipal market at some time or other. lucrative areas of business. haps the most successful franchise in the They have done so with serial and term And here it might be appropriate to say municipal bond market, originating in 1971 bonds, with notes, with variable- and the why commoditization was so welcomed in and reaching a peak penetration of 57 aforementioned auction-rate securities, this market. As investor Paul Isaac once percent of the new issue market by 2005. using their full-faith and credit taxing put it to me over cocktails, “So what you’re Bond insurance was also the thing that power pledge, their limited taxing power saying is, municipal bonds are particular “commoditized’’ the market. No longer did pledge, their mere promise to appropriate and specific to a remarkable degree.’’ investors have to study the innumerable money for debt service, and more often Isaac was responding to my amaze- details of a bond issue’s structure and than not (since the 1970s), with the prom- ment and frustration trying to understand security. Now there was just this thing you ise of specific revenue streams. And did I a subject that seemed endless and could buy called a municipal bond that mention the companies, like airlines, that unfathomable. This was back in the early produced interest that was tax-exempt and also borrow in the municipal market? 1980s. I stole his phrase and have used it that was incredibly safe and secure in the ever since, only occasionally substituting first place and was now even insured as to “insane’’ for “remarkable.’’ Sucker’s Bet repayment of principal and interest and so This turned out to be the single most rated AAA. Or so it was thought for a very In fact, it’s a rare government that uses important observation about municipal brief period stretching from perhaps 1985 its general obligation, full-faith and credit bonds I have ever heard. It explains so to the collapse of the insurers in 2008. pledge to sell bonds to borrow money. much. It explains everything. The insurers had proven to be in the What was once termed the shadow gov- The multifarious (“of great variety; right place at the right time. They were ernment, and not in an approving way, is diverse’’ according to Webster’s) nature even, helpfully, a little early. States and the primary engine of borrowing in today’s of municipal bonds is one of the reasons continued on next page...

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muni market: a network of districts, agen- That’s another feature of the municipal never seen even a passing reference to it cies, authorities and public corporations, market; state and local government isn’t by any financial analyst, rating agency or staffed by their own professionals and on the front end of recession, but on the monoline CEO,’’ Buffett wrote. insulated, if you will, from the public and tail. Public finance is a lagging indicator. He continued, “The rationale behind even from duly-elected government of- This is why most states and municipali- very low premium rates for insuring ficials, like a city council, for example. The ties were still hiring in 2008, even as the tax-exempts has been that the defaults decentralized nature of municipal issu- private sector was shedding hundreds of have historically been few. But that record ance turns out to be one of the market’s thousands of jobs. largely reflects the experience of entities great strengths. that issued uninsured bonds. Insurance of Add to this the perpetual nature of most tax-exempt bonds didn’t exist before 1971, governmental entities and you can see Acronym Mad and even after that most bonds remained why a mass municipal meltdown was a Now we come to the first major market uninsured.’’ sucker’s bet. Perhaps only someone who “call’’ that attracted my attention as be- Buffett continued: “A universe of tax-ex- has looked through 12 or 20 screens of ing a little exaggerated if not hysterical. empts fully covered by insurance would be a Bloomberg terminal’s “Municipal Bond Because, let’s face it, Warren Buffett is certain to have a somewhat different loss Ticker Look Up’’ can appreciate this. Type no hysteric. experience from a group of uninsured, but in a name of a municipal issuer and you The reference to munis came in the otherwise similar bonds, the only question get screen after screen of apparent direct February 2009 edition of the letter Buffett being how different. To understand why, relations. Who are all these guys? The sends annually to Berkshire Hathaway let’s go back to 1975 when New York City auction-rate freezeout and the collapse of shareholders. Berkshire had launched was on the edge of bankruptcy. At the time the bond insurers were stunning stories, Berkshire Hathaway Assurance Company its bonds — virtually all uninsured — were unimaginable for anyone familiar with the (or BHAC: the bond insurance business heavily held by the city’s wealthier resi- things, yet in the context of the times in is acronym-mad) in 2008 as a municipal dents as well as by New York banks and 2008 just more collateral damage from the bond insurer. Under a section of his letter other institutions. These local bondholders subprime mortgage implosion. entitled, Tax-Exempt Bond Insurance, deeply desired to solve the city’s fiscal More bad news was on the way in 2009, Buffett recounted BHAC’s year, which at problems. So before long, concessions as the recession deepened and states one point included an offer to reinsure the and cooperation from a host of involved and municipalities saw tax revenue dwin- other largest monoline municipal bond constituencies produced a solution. With- dle. The recession officially ended in June insurers’ existing books of business. The out one, it was apparent to all that New of 2009. State tax collections declined insurers rebuffed the offer. York’s citizens and businesses would have versus the same period the previous year Buffett said BHAC would “remain very experienced widespread and severe finan- in every quarter from the fourth quarter cautious about the business we write and cial losses from their bond holdings.’’ of 2008 to the fourth quarter of 2009, regard it as far from a sure thing that this If, Buffett posited, all of the city’s bonds according to the Nelson A. Rockefeller insurance will ultimately be profitable for were insured by Berkshire, would “simi- Institute of Government. us. The reason is simple, though I have lar belt-tightening, tax increases, labor concessions, etc.’’ have been forthcom- ing? Of course not, he answered. “At a minimum, Berkshire would have been asked to ‘share’ the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.’’ If a few communities stiff their In other words, the city would have defaulted on its insured bonds, leaving “ the insurer to pay the debt service. At creditors and get away with it, the some point, it is assumed, the city and the insurer would sit down and negotiate the chance that others will follow in terms of repayment, but not in full. ‘Simply Staggering’ Buffett observed that local governments their footsteps will grow. were going to face far tougher fiscal prob- — Warren Buffett lems in the future. “The pension liabilities I ” talked about in last year’s report will be a continued on next page...

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huge contributor to these woes. Many cit- ies and states were surely horrified when they inspected the status of their funding at year-end 2008. The gap between as- sets and a realistic actuarial valuation of present liabilities is simply staggering.’’ Municipal bonds are So far, so good. New York City’s near- “ miss with bankruptcy, I know, was a close- run thing, with the state playing a powerful particular and specific to role in the rescue, along with the United Federation of Teachers. Buffett’s theory of the role insurers a remarkable degree. might play in a meltdown was somewhat – Paul Isaac, Investor prescient, as the Detroit bankruptcy has ” shown us: the insurers have a seat at the table, and are indeed expected to “contrib- ute’’ to Detroit’s future, by taking less than they are owed by the city. highly correlated among issuers.’’ contagion in municipalities Buffett’s concerns about public pensions This last sentence can be parsed any actively seeking to stiff their creditors and were nothing new or astonishing. Numer- number of ways, and I’m not going to at- “get away with it,’’ and 2) elected officials ous analysts pointed out how they had suf- tempt it here. choosing not to make some very hard fered after the tech bubble burst only a few But then, this: “If a few communities stiff choices. years before. (It is worth noting, however, their creditors and get away with it, the I didn’t know it at the time, of course, but that in 2000, the so-called funding ratios of chance that others will follow in their foot- the Buffett letter was the first salvo in what public pensions topped 100 percent). steps will grow. What mayor or city council would become a muni meltdown barrage. And then Buffett went just a little bit further. is going to choose pain to local citizens in At the time, I thought it interesting, purely “When faced with large revenue short- the form of major tax increases over pain because munis were so unremarked upon falls, communities that have all of their to a far-away bond insurer?’’ in general. I also thought it a trifle over- bonds insured will be more prone to Buffett concluded that insuring mu- wrought, said so in a column, and was develop ‘solutions’ less favorable to bond- nicipal bonds “has the look today of a surprised at how many e-mails I received holders than those communities that have dangerous business.’’ from the Great Man’s minions, eager to uninsured bonds held by local banks and The headline words were “dangerous denounce unbelievers. Much worse was residents. Losses in the tax-exempt arena, business.’’ The real story was in the previ- to come. when they come, are also likely to be ous two sentences, about 1) a seeming

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II: The Undiscovered Country

There wasn’t a lot of big press coverage of municipal finance because editors found the topic almost stupefyingly dull.

Everybody’s Talking the municipal market. Municipal bonds The Municipal Securities Rulemaking are hard to understand. Bankers and the Board, for its part, was in the midst of a many financial professionals who assist push to reform disclosure and enhance public officials in their bond sales tend to price transparency, as well as regulat- follow a code of silence. The sales and ing municipal advisers and establishing trading of municipals is done over the who owed issuers fiduciary responsibility, counter, almost on a bespoke basis. Source: Bloomberg/Daniel Acker among other things. The press loves a simple story, and Warren Buffett Yes, all of these topics were being dis- public finance is extremely nuanced. The cussed in the muni market. Just because relatively high cost of entry for investors (you need tens of thousands of dollars In 2008, Buffett made his overtures to these subjects only sporadically appeared in the major newspapers and almost to invest in munis, a few hundred to buy the beleaguered bond insurers. The pos- stocks) means that municipal bonds aren’t sibility that they might lose their top credit never made it to television and cable news doesn’t mean that they weren’t being really even part of the financial “culture,’’ in ratings was already a hot topic of con- the way that stocks are. versation among market participants, not talked about, and covered by local news- least because investor Bill Ackman was papers and the very specialized financial shorting the stock of the biggest insurer, press, that write about munis. There was Tourists in MuniLand a lot of ferment going on in municipals in MBIA, and he made sure the Wall Street There wasn’t a lot of what I’ll call big the 2000s. Journal knew it. press coverage of municipal finance be- And yet, a common claim among those But there were a lot of other things being cause editors found the topic stupefyingly who would stoke the muni meltdown discussed in the municipal market, as dull and so, they reasoned, few people hysteria was that “nobody’s talking about well. How would a decline in tax revenue would care to read about it. I sometimes this,’’ as if an almost $3 trillion market (at affect budgets and credit ratings? How think I would have had more readers if I the time) was somehow being conducted would states and municipalities deal with wrote about Hummel figurines, or numis- entirely in secret — and I have been a stock market losses that had blown a hole matics, rather than munis. critic of how private public finance can in the value of the assets they had put Beginning in 2009, more people were sometimes be. away to cover pension liabilities? Could claiming that the municipal market was Or they would claim, “the experts’’ (who- they manage the expense of “Other Post- the undiscovered country. Just look at ever these people were supposed to be; Employment Benefits,’’ previously handled what we’ve found, these critics — tourists perhaps even I was one of them) were so mainly as a pay-as-you-go expense? in MuniLand — would say. And, no sur- conflicted that they couldn’t possibly see Then there was the SEC’s ongoing in- prise, the story they so often brought back this or that self-evident truth. vestigation into bid-rigging and price-fixing was very similar to the stories that tourists The other side of the argument, of in the municipal reinvestment business, tell: by turns frightening and amusing, and course, is that nobody was talking about the whole murky world that exists after of limited long-term value. “it’’ (whatever it happens to be), because issuers sell bonds and need to invest the Never had so many been so misled by “it’’ isn’t true. proceeds. The use and proliferation and so few with such little actual expertise. The mainstream media, as they call it opacity of swaps was finally getting some attention, too. nowadays, has always had a problem with

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III: The End of Something

The municipal market’s long period of Again, Moody’s: “Credit pressures faced conversation. Now, in the midst of the splendid isolation, if we can call it that, by local governments and their responses recession, it was almost an afterthought. was all about to end. The story of the to these pressures will vary significantly Moody’s and Fitch finally recalibrated market meltdown that wasn’t is very much across and within states due to uneven their ratings in 2010; Standard & Poor’s a story of the media. economic conditions, differing revenue announced a change in its own methodol- To repeat: Nobody was saying that mixes and service mandates, inconsistent ogy for rating municipalities soon after. states and municipalities were not facing property assessment practices, and differ- Looking back at 2009, I am surprised by some pretty stiff headwinds as a result of ent levels of revenue raising authority. The just what a newsy year it was in munici- the real estate bubble and recession. governance strength of individual issuers pals. Jefferson County, Alabama, was still What made this time different is that and behaviors which demonstrates their trying to avoid bankruptcy. Municipali- house price declines played out nationally willingness and ability to adapt to that en- ties were starting to file lawsuits against rather than, as is usual, regionally. There vironment will determine the overall trend those Wall Street firms that had sold them were of course some markets that fared in individual ratings.’’ swaps and derivatives. much better than others, but prices fell The rating company put the entire sector In August, the MSRB said it was looking everywhere. on negative outlook. It didn’t say that the at “flipping’’ in the muni market, apparent In April 2009, Moody’s assigned a entire sector would respond in the same in glaring fashion soon after states and negative outlook to the U.S. Local Gov- way to the extraordinary, “unprecedented’’ municipalities started selling federally- ernment Sector, saying, “This is the first pressures then accumulating: unemploy- subsidized Build America Bonds. time we have assigned an outlook to this ment at more than 8 percent, stock prices A federal grand jury would finally indict extremely large and diverse sector. This off 50 percent, home prices down an aver- CDR Financial Products, the firm at the negative outlook reflects the significant age 25 percent from their peak. And what red-hot center of the market’s bid-rigging fiscal challenges local governments face might be the result? “Increased rating scandal, at the end of October. as a result of the housing market collapse, revisions’’ for local governments. There was a time I used the expres- dislocations in the financial markets, and This was an extremely reasonable, clear sion “bullets don’t grow on trees’’ from the a recession that is broader and deeper piece of work from a generally recog- movie “Michael Collins,’’ to characterize than any recent downturn.’’ nized authority on the subject. Unhappily, actual municipal market news, and to cau- Note the language: “significant fiscal because of their role in the subprime tion reporters to husband story ideas with challenges.’’ mortgage collapse, the rating companies in care. No longer. In 2009, it seemed like I had long been a fan of the restrained, general had forfeited a certain credibility by news was breaking every day. sober style the analysts at the rating com- this point, even in the municipal market. Then one day in October, I got an e-mail panies had learned to use (it was, I was An earlier announcement by Moody’s in from a reader. His name was familiar to informed, very much a learned style). If March of 2007 that it would stop using a me as someone who occasionally com- you were unaccustomed to the style, you dual scale to rate municipalities and cor- mented on my columns. He attached a could read through thousands of words of porations had touched off a controversy report that he said he found compelling. analysts’ prose and not quite know what that once would have dominated market they were really saying, or if they were saying anything at all. Not this time. The company continued, “Sharply falling property values, contract- ing consumer spending, job losses, and limited credit availability lead the long list of developments that will make balancing budgets in the coming year particularly difficult. The negative outlook assigned to This is the first time we have the U.S. local government sector en- capsulates our view on this challenging “ environment and the strains that will be assigned an outlook to this large evident in credit for issuers across the industry.’’ This was a very well-crafted, detailed and diverse sector. piece of work in nine pages. I was im- pressed by the – for them – blunt tone as — Moody’s ” well as the way it reminded its readers that this was a big market, particular and specific to a remarkable degree, in the words of my friend Isaac.

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IV: ‘Dark Vision’

I wish I saved that first e-mail, so I could give proper credit to the sender. In the weeks to come, more correspondents would forward me the same report, most accompanied by a message written in a tone of resignation and dismay. One even sent me a copy in the mail. People wanted to make sure I saw this thing In the new Internet age, anyone could write The report was “Dark Vision: The Coming Collapse of the Municipal Bond anything, and it could achieve the Market,’’ published by Weeden & Co. for its clients. It was a “guest perspective’’ as they called it, by Frederick J. Sheehan. credibility and authority of ‘publication.’ This was the first piece I had ever seen to call for the municipal market’s imminent meltdown. It was also the first piece to demonstrate to me that the muni market was entering a new media age. I originally dismissed it. I glanced at that In this publication democracy, it seemed, Hysteria Begins title, winced, and put it aside. Weeden & everything was valid, all points of view le- “Dark Vision’’ was dated Sept. 29, 2009. Co.? They weren’t in the municipal market. gitimate. It would take some time, for me, Frederick J. Sheehan? Who was he? I This is when I date the kickoff of the Muni to realize that the key thing in this transac- Market Meltdown Hysteria. So many hadn’t seen him on the muni beat before. tion was for the author to say something, “The Coming Collapse of the Municipal things came together at this precise mo- usually bad, was going to occur, and very ment: the rise of the Internet; the explo- Bond Market’’? Please. soon. This seemed to be the only criterion It really wasn’t until I spotted it again, this sion of business and financial news web for the new “publication’’ world: Some- sites (it is worth noting that Business time in a reference to a business blog on thing Bad Is Going To Happen. This got yet another financial news web site, that I Insider only began in 2007); more cable you clicks, this got you viewers, this got business coverage; the greatest reces- realized that the market had a problem. In you subscribers, this got you on televi- the new Internet age, anyone could write sion since the Great Depression; the 24/7 sion, and, in some cases, it got you book news cycle. anything and it could achieve the credibil- contracts. ity and authority of “publication.’’ Only a few years later, I suspect, any In fact, more often than not, in public such “meltdown’’ call would have been finance as in most people’s lives: Nothing mitigated, even refuted, by the very same Anything Goes happens. Things muddle along, things Internet that had given birth to it. Twitter And it metastasized. An article or report work out, or not, in slow and usually would kill it. was no longer published once, but again, unspectacular fashion. Especially, might I But in 2009, most of those who knew and again, and again, all over the Internet. add, in the municipal bond market, where anything about the municipal market The new reporters, or editors, or whatever trading in a new issue typically ceases weren’t tweeting. “Bond Girl,’’ for example, you called them, sometimes did no more after about 30 days, and where time is didn’t start tweeting until April of 2011, than put an inviting and often sensational measured with a calendar. Reuters’ Muniland blogger Cate Long in headline on a short summary, and then “The Coming Collapse of the Municipal July of 2010. provide a link to the actual underlying Bond Market’’? The timing of this piece Inexpert testimony was set for a very document, story, report, lawsuit, opinion was propitious. The Great Recession, brief reign in the muni world. piece, whatever it happened to be. And it seemed, had just ended in June, but then dozens or scores of readers could people were still ready to believe anything comment on it, further legitimizing the story, about everything. “The Coming Collapse no matter how inane their own commentary. of the Municipal Bond Market’’? Why not?

FOLLOW JOE MYSAK ON TWITTER @joemysak FOR REGULAR UPDATES AND ADDITIONAL INSIGHTS >>>>

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V: The Coming Collapse of the Municipal Bond Market

measures is impossible. Parties to suffer tions expiring. This would become one of from unconventional measures include the market’s typical non-issue issues in bondholders.’’ 2010 and 2011. As it turned out, the market This pretty much sums up the Sheehan handled the, in Moody’s words, “unprec- argument. States and municipalities spend edented’’ number of expirations handily. too much, borrow too much, promise too Sheehan wasn’t talking about VRDOs. He much to their employees. Faced with the was describing “the next Greece,’’ as critics “impossible,’’ many municipalities will seek of the time put it. bankruptcy court protection. “One of the largest municipal expendi- Bondholders can’t rely on issuers’ pledg- tures is coupon interest on bond obliga- es to levy taxes to pay debt service. Nor tions.’’ That’s not true. Debt service is can they trust that the courts will ensure actually one of the smaller items in most that they are paid. municipal budgets. As analysts would Had Sheehan limited his remarks to “De- eventually point out, why would public troit,’’ I might have hailed him as a visionary officials go out of their way to anger the today. Had he somehow limited his thesis investors they need and target debt ser- to “some’’ or even “a handful’’ of municipali- vice, since it would be of so little help in a ties, even that would have been somewhat financial emergency? Source: Bloomberg/Andrew Harrer acceptable. But no. The entire market will Why did I go back and read “Dark Vi- Alan Greenspan “collapse.’’ On the other hand, who wants sion’’? Because more than a month after The most remarkable part of “Dark Vision’’ to publish “The Coming Collapse of an In- it was published, it was mentioned on a was the title and subhead. For the uninitiated, finitesimal Number of Municipalities’’? Who business news web site, which linked to “Dark Vision’’ looked plausible enough, with would read it, beside the hard core? a piece on the Seeking Alpha blog, which various bits of data and almost two pages of That all states had borrowed too much in turn linked to a piece on a Harvard Law scholarly-looking footnotes. The more I read was a typical canard. Taking a look at School blog, picking up approving com- it and considered it, the more I realized it was Moody’s annual State Debt Medians Re- ments from the uninformed every step of little more than a series of assertions, without port published in July of 2009, the author the way. a lot of proof. could have seen that net tax-supported And so the “coming collapse’’ of the mu- The author had written a couple of books debt per capita drops fairly quickly after nicipal bond market had been announced. critical of Alan Greenspan and the Fed- you look at the top 10 states. In first place In 2011, Bloomberg Brief: Municipal eral Reserve, according to the identifying was Connecticut, at $4,490; in 10th was Market’s Brian Chappatta asked Sheehan note attached to the piece. I got the feeling, California, at $1,805. In 30 of the states, what happened — why hadn’t the market as I was reading, that he was grinding a the figure was below $1,000. collapsed? He gave a very detailed re- libertarian axe. Political point of view and A similar story could be told about public sponse, which I include here as Appendix credit analysis usually don’t mix well. pensions, as well as public employee pay. 2. I called him on Nov. 17 of this year, and I don’t want to spend too much time on A few states were bad at making their he gave me a very similar response: “One “Dark Vision,’’ which I found unpersuasive, so actuarially-required contributions to their thing I didn’t understand was how hard let me try and summarize. pension systems. Some states and cities states would work to pay their bonds so It is time to get out of municipal bonds, had sweetened pensions, and salaries, they could continue to legislate. I thought says Sheehan. They are now to be considered without much apparent regard of how to there’d be much more of a battle between speculative investments, and buyers are just pay for them. paying bonds and other expenses like not being compensated enough for the risk And then there were some errors: pensions. I still think that has to come at they are taking. Fair enough, I thought. “Current bond issues will need to be some point, as the asset price bubble “The municipal market will probably repeat rolled over when they mature, since starts to deflate. [States and municipali- the pattern of the sub-prime collapse,’’ he budget gaps are rising.’’ Sheehan takes a ties] have continued to spend as if they wrote. “Although it is plain to see, the usual hallmark of the sovereign debt market and learned nothing from how close they did experts do not notice.’’ He doesn’t say who transfers it to munis. That’s not how munis come to defaulting in 2009.’’ these experts are, although I infer that they work. Municipalities pay off their debts are the rating companies. over time, usually through the use of He describes the “mess’’ in public finance: serially maturing bonds. Yet this “rollover’’ “Recent cost-cutting by states and munici- error would be repeated. palities is inadequate. This much is prob- Note here that Sheehan wasn’t talking ably obvious. What may go unrecognized about the letters of credit or liquidity facili- is that filling these gaps using conventional ties backing variable-rate demand obliga-

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VI: Into The Abyss

The crush of news in 2009 meant that it ers’ efforts to make the public aware of the “Are State Public Pensions Sustainable? took a while for the market to confront the circumstances of their austerity measures Why the Federal Government Should municipal bond meltdown scenario being and what they think will be the conse- Worry About State Pension Liabilities.’’ presented. The Sheehan piece achieved quences of inaction.’’ Of course, we all know what the answer what I sensed was wide circulation, show- to the title’s question was. ing up around the Internet without much in This was a provocative piece of work. the way of rebuttal. Do the Right Thing Up to this point, as far as I know, nobody Sheehan was first. James Chanos, The important thing about the S&P had predicted that pension funds would noted short-seller, appeared in Barron’s piece, as well as the earlier Moody’s run out of cash altogether, or that pen- in the Nov. 9 “Current Yield’’ column: commentary tagging the entire sector with sion underfunding might drive states “to “Dump Munis,’’ was the headline. The a negative outlook, was that both rating insolvency,’’ as Rauh claimed. Rauh also culprit: “platinum-plated health-care and companies expected most public officials introduced his notion that state and local retirement benefits,’’ said Chanos. I asked to do the right thing by their bondholders. pension plans should “discount the benefit Chanos on Nov. 17 if he had any further Also noteworthy, especially in retrospect, cash flows at Treasury rates.’’ thoughts about the municipal market, and is how S&P took pains to say how “condi- In other words, they should stop as- he declined comment. tions do vary.’’ Once again: particular and suming that the assets they had put in On Dec. 16, 2009, Standard & Poor’s specific. It’s very much like that old legal their pension systems would produce 8 published a paper entitled “Credit FAQ: expression: all facts and circumstances. percent a year. Discounting benefit flows The Recession’s Impact on U.S. State and Even in 2009, you could see several at Treasury rates produced a gap between Local Government Credit Risk.’’ themes playing out here. On the one assets and liabilities of $3 trillion at the I now see this as the first defense of hand, you had outside critics saying that end of 2008, Rauh wrote. He also mod- munis. Whether it was done in response municipalities were all in the same boat, eled which states’ plans would run out of to Sheehan, I do not know. that they had exhausted their resources, money, and when. The FAQ format is, of course, a feature and that default and repudiation were Rauh’s chief assumption was that states of the Internet; I’m not sure how much inevitable. On the other, you had analysts would contribute enough money to their circulation this piece got. It was detailed saying that it was impossible to general- pension plans “to fully fund newly accrued and reasonable and accurate. But of ize about issuers, that most of them had or recognized benefits at state-chosen course Collapse trumps Muddle Along in plenty of resources still available to them, discount rates (usually 8 percent) but no the Internet popularity stakes. and that most of them could actively man- more.’’ This was “broadly in keeping with My favorite answer came in response age their way out of the situation. states’ recent behavior.’’ to the question: “Then why do state and The final piece of the puzzle appeared at The paper itself was no easy read, but local governments keep talking about the the very end of the year, although it didn’t the “Table 1: When Might State Pension dire straits they are in?’’ S&P said: “As this gain traction until later: a white paper by Funds Run Dry?’’ was clear enough. all plays out, we think that new headlines Joshua D. Rauh of the Kellogg School of Rauh predicted that Illinois would run out will likely capture elected officials’ and oth- Management at Northwestern University: in 2018, Connecticut, Indiana and New Jersey in 2019, Hawaii, Louisiana and Oklahoma in 2020. Alaska, Florida, Ne- vada, New York and North Carolina would never run out. Rauh is now at the Stanford Graduate Are State Public Pensions School of Business. He didn’t respond to “ a request for comment. He has continued to publish, and his views are now well- Sustainable? Why the Federal known. It used to be that public pension funding was one of those things cov- Government Should Worry About ered by rating companies perhaps on a quarterly basis. Now, it seems that we get State Pension Liabilities. regular, detailed updates on their condi- tion almost weekly. This is a good thing. — Title of paper by Joshua Rauh, Kellogg School” People didn’t really start to discuss the Rauh study until 2010. This would prove to of Management at Northwestern University be the cauldron year for the muni meltdown.

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VII: Public Pensions

term the New Normal to characterize the The year 2010 was low-growth, low-yield future. The Carolinas calculated they would the peak year for earn 7.25 percent, Colorado, Connecticut, meltdown mongering. Illinois, Minnesota and New Hampshire 8.50 percent. By far the most states, 22, It was as if with the real estate bubble were at 8 percent, which, as the report burst, banks failing and companies from pointed out, was the median investment auto manufacturers to Wall Street broker- return for pension plans over 20 years. ages in bankruptcy, gloomsters could The report examined the factors that finally turn their attention to states and contributed to the $1 trillion gap, such as municipalities. the volatility of investments, states failing Not all the material being published to make their annual actuarially-required about public finance was incendiary. contributions and “ill-considered benefit Some was salutary. As the old saying increases’’ during good times. It also goes, never waste a crisis. So it was with examined the “road to reform.’’ public pensions. In February, the Pew Of course the Internet focused on the Center on the States published “The “$1 trillion gap,’’ and even more on the Trillion Dollar Gap: Underfunded State Rauh $3 trillion gap. Retirement Systems and the Roads to A subject that had received scant atten- Reform,’’ a thoughtful, comprehensive 61- tion – except among the rating com- Source: Bloomberg/Andrew Harrer page study. panies, municipal analysts, some local ‘The New Normal’: Bill Gross Pew said the difference between what newspapers, and the blog that since 2004 at the unfunded pension obligations of states had on hand and the pension collected coverage of the topic, pensiont- local governments, and concluded that, and other retirement benefits they had sunami.com – was now in the spotlight. if already-promised benefits were dis- promised amounted to $1 trillion, and that Public pension analysis was, almost, the counted at riskless, zero-coupon Treasury was conservative, because it was based flavor du jour. At least three more aca- yields, the total unfunded obligation for on June, 2008, data and thus hadn’t taken demic reports on public pension liabilities the municipalities they studied was $383 into account all investment losses. were published during the year. The Pew report was unhysterical and billion rather than the $190 billion the exhaustive, filled with maps and tables of localities themselves calculated. data. It showed the extent of investment ‘Distinct Risk to Taxpayers’ I was of two minds about the explosion losses, and ranked how the states were In April, the American Enterprise Insti- of interest in public pensions. On the one managing the situation. On pensions, it tute for Public Policy Research present- hand, I thought it good to focus on the said, 16 were solid performers, 15 needed ed resident scholar Andrew Biggs’s “The subject, because it seemed that certain of improvement and 19 were “serious con- Market Value of Public-Sector Pension our elected representatives over time had cerns,’’ while in the area of health care Deficits,’’ basically an endorsement of the sweetened the salary and public pen- and other benefits, which most states had Rauh $3 trillion pension gap figure. sion pot in exchange for union peace and treated as a pay as you go expense, 9 Then in June came a working paper by votes, with no consideration for the way were solid performers in terms of quantify- Eileen Norcross and Andrew Biggs, even little enhancements add up. They ing the obligation and putting aside money published by the Mercatus Center at also all too often neglected to keep up for it. The report also noted that 15 states George Mason University entitled “The with their actuarially-required contributions in 2009 had passed legislation reforming Crisis in Public Sector Pension Plans: to their pension plans. some aspect of their pension systems, A Blueprint for Reform in New Jersey.’’ On the other hand, I objected to the “cri- usually by making new employees contrib- Norcross and Biggs repeated the Rauh $3 sis’’ terminology which made it seem to the ute more. trillion gap and advocated defined contri- uninitiated as if states and localities had As if any reminder were needed, the bution over defined benefit pension plans. to come up with the money to fill the gaps results showed how the subject of public The latter, they said, presented “a distinct overnight. As always, I worried that gener- pensions resisted generalization. New fiscal risk to taxpayers.’’ alizing about the subject was distracting. York’s pensions were 107 percent funded, And in October, Rauh and Robert What we really needed was focus: Which Florida’s 101 percent. Illinois had only 54 Novy-Marx of the University of Rochester states and municipalities had done the percent of the money it needed, Kansas produced a paper, “The Crisis in Lo- worst jobs managing public pensions? 59 percent, Colorado, 70 percent. cal Government Pensions in the United More importantly, why? These things The study also examined investment States’’ for a conference on retirement aren’t easy to trace, but glossing over the return assumptions, just then becoming a and institutional money management subject in favor of big numbers lets the fat target for critics. Recall that in Septem- post-financial crisis. The authors looked guilty parties off the hook. What hap- ber 2009, Pimco’s Bill Gross coined the continued on next page...

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pened, when, why, and how can we guard the first on public pension plan invest- against it happening again? ment return assumptions, the second an analysis of the Rauh paper. Both attempted to reassure readers that there Amplified Alarm was a basis in fact for investment return It had taken almost I think it was around this time, too, that assumptions: Over a 20-year period, I became very skeptical of all “studies’’ median annualized investment returns three decades, and the and “reports.’’ It had taken almost three were 8.1 percent; over 25 years, 9.3 per- decades, and the dawn of the Internet cent. In other words, the 8 percent return age, for me to realize that data was not assumptions prevalent among public dawn of the Internet definitive, that analysts could make the pensions weren’t fictional. numbers dance. The analysis of the Rauh paper, “Are age, for me to realize I also began growing impatient with State Public Pensions Sustainable?’’ what I came to call the media’s “denomi- said that the author ignored incremental that data was not nator problem.’’ Such-and-such costs “$3 changes being made to improve the long- BILLION dollars,’’ radio and television an- term sustainability of public pensions, and nouncers would declare, all but reaching that his central assumption, that states definitive, that a full windup to deliver the plosive “BIL- would make contributions sufficient to LION.’’ And that was fine. But it matters a fund newly accrued or recognized ben- analysts could make great deal if the “$1 BILLION’’ is part of a efits but no more, was unsupported by budget, say, of $5 billion, or part of one current practice. amounting to $50 billion or $150 billion. There was, it appeared, another side of the numbers dance. We emphasize the numerator and ignore, the story. How many Internet commenters if we even know, the denominator. read it, I have no idea. Who cared about In March, the National Association the facts when alarm and exaggeration of State Retirement Administrators could be echoed and amplified? released two short but meaty reads, BloomBerg Brief group SuBScriptionS Bloomberg newsletters are now available for group purchase at very affordable rates. Share with your team, firm or clients.

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BLOOMBERG RANKINGS

Most Underfunded Pension Plans: States

FUNDING FUNDING FUNDING FUNDING FUNDING FUNDING For the fourth year in a row, RANK STATE RATIO 2013 RATIO 2012 RATIO 2011 RATIO 2010 RATIO 2009 RATIO 2008 MEDIAN Illinois, Kentucky and Con- % % % & % % % necticut top the list of most 1 Illinois 39.3 40.4 43.4 45.4 50.6 54.3 44.4 underfunded pension plans 2 Kentucky 44.2 46.8 50.5 54.3 58.2 63.8 52.4 3 Connecticut 49.1 49.1 55.1 53.4 61.6 61.6 54.3 METHODOLOGY: 4 Alaska 54.7 59.2 59.5 60.9 75.7 74.1 60.2 Bloomberg ranked U.S. states based on their pension 5 Kansas 56.4 59.2 62.2 63.7 58.8 70.8 60.7 funding ratios in 2013. The 6 New Hampshire 56.7 56.2 57.5 58.7 58.5 68.0 58.0 Bloomberg municipal data and 7 Mississippi 57.6 57.9 62.1 64.0 67.3 72.8 63.1 municipal fundamentals teams 8 Louisiana 58.1 55.9 56.2 55.9 60.0 69.6 57.2 collected and supplemented 9 Hawaii 60.0 59.2 59.4 61.4 64.6 68.8 60.7 data from each state’s Com- 10 Massachusetts 60.8 65.3 71.4 68.7 63.8 80.5 67.0 prehensive Annual Financial 11 North Dakota 61.0 63.5 68.8 72.1 83.4 87.0 70.5 Report, a set of government 12 Rhode Island 61.1 62.1 62.3 61.8 64.3 59.7 62.0 financial statements. Data are 13 Michigan 61.3 65.0 71.5 78.8 83.6 88.3 75.2 for individual states’ respective fiscal year-ends as of the date 14 Colorado 61.5 63.2 61.2 66.1 70.0 69.8 64.7 of publication of the CAFR. 15 West Virginia 63.2 64.2 58.0 56.0 63.7 67.6 63.5 16 Pennsylvania 64.0 65.6 71.7 77.8 85.5 86.9 74.7 Supplemental pension reports 17 New Jersey 64.5 67.5 68.1 66.0 71.3 76.0 67.8 intended to augment a partic- 18 Indiana 64.8 61.0 64.7 66.5 72.3 69.8 65.7 ular year’s CAFR were added to that year’s fundamentals. 19 Maryland 65.3 64.2 64.5 63.9 64.9 77.7 64.7 Fiscal year-end of supple- 20 South Carolina 65.4 67.9 66.5 68.7 70.1 71.1 68.3 mental pension reports may 20 Virginia 65.4 69.5 72.0 79.7 83.5 81.8 75.9 differ from the state’s CAFR. 22 Alabama 66.2 66.9 70.1 73.9 75.1 79.4 72.0 All other reports were carried 23 Oklahoma 66.5 64.9 66.7 55.9 57.4 60.7 62.8 forward to the next fiscal year. 24 New Mexico 66.7 63.1 67.0 72.4 76.2 82.8 69.7 The funding ratio provides 25 Vermont 69.2 70.2 72.5 74.6 72.8 87.8 72.7 an indication of the financial 26 Nevada 69.3 71.0 70.1 70.5 72.4 76.2 70.8 resources available to meet 27 Ohio 71.9 65.1 67.8 67.2 66.8 86.0 67.5 current and future pension obligations. Percentages were 28 Montana 73.3 63.9 66.3 70.0 74.3 83.4 71.7 calculated by dividing the ac- 29 Arizona 74.1 74.5 73.2 77.0 79.9 80.8 75.7 tuarial value of plan assets by 30 Arkansas 74.5 71.4 72.5 74.8 77.5 87.2 74.6 the projected benefit obliga- 31 Minnesota 74.7 75.0 78.4 79.8 77.1 81.4 77.7 tion. Where specific data were 32 Utah 76.5 78.3 82.8 85.7 84.1 100.8 83.4 missing in the consolidated 33 Missouri 76.6 78.0 81.9 77.0 79.4 82.9 78.7 reported totals, the pension 34 California 76.9 77.4 78.4 80.7 86.6 87.6 79.5 funds were contacted directly. 35 Wyoming 78.7 79.6 83.0 85.9 88.8 79.3 81.3 The District of Columbia 36 Nebraska 79.2 78.2 81.9 83.8 87.9 92.0 82.8 had a funding ratio of 103.6% 37 Maine 79.6 79.1 80.2 70.4 72.6 79.7 79.3 in 2013. 38 Texas 80.4 82.0 82.9 83.3 84.1 90.7 83.1 39 Georgia 80.6 82.5 84.7 87.1 91.6 94.6 85.9 Source: Bloomberg 40 Iowa 80.7 79.5 79.5 81.0 80.9 88.7 80.8 41 Florida 80.8 81.6 82.3 83.7 84.1 101.7 83.0 AS OF: October 2, 2014 42 Idaho 85.5 84.9 90.2 78.6 73.9 93.2 85.2 43 New York 87.3 90.5 94.3 101.5 107.4 105.9 97.9 44 Delaware 88.2 88.3 90.7 92.0 94.4 98.3 91.3 45 Oregon 90.7 82.0 86.9 85.8 80.2 112.2 86.4 46 Tennessee 91.5 91.5 89.9 89.9 95.1 95.1 91.5 47 Washington 95.1 93.7 94.9 92.2 93.9 92.9 93.8 48 North Carolina 95.4 95.3 96.3 96.8 99.3 103.4 96.3 49 South Dakota 99.9 92.6 96.3 96.1 91.7 97.4 96.2 49 Wisconsin 99.9 99.9 99.9 99.8 99.8 99.7 99.9 Median 69.3 68.7 71.6 74.3 75.9 82.3 73.0

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VIII: Media Frenzy

continued, “Some economists fear the and feckless or corrupt public officials. states have a potentially bigger problem The right-leaning Manhattan Institute’s than their recession-induced budget woes. Nicole Gelinas in the think-tank’s City If investors become reluctant to buy the Journal advised readers of the Spring 2010 states’ debt, the result could be a credit issue to “Beware the Muni-Bond Bubble.’’ squeeze, not entirely different from the Gelinas wrote: “Investors in municipal financial markets in Europe, where mar- bonds don’t have to worry about a thing, kets were reluctant to refinance billions in the thinking goes, because the states and Greek debt.’’ cities that issue them will do anything to Then there was the April blog posting by avoid reneging on their obligations — and Rick Bookstaber, a senior policy adviser even if they fail, surely Washington will step at the SEC. The next big crisis was the in and save investors from big losses.’’ municipal market, he wrote. The culprit: She continued: “These are dangerous overleverage, “in the form of high pension assumptions. Just as with mortgages, the benefits and post-retirement health care.’’ very fact that investors place unlimited faith He observed: “Once a few municipalities in a market could eventually destroy that default, there is a risk of a widespread market. If investors believe that they take cascade in defaults because the opprobri- no risk, they will lend states and cities far um will be lessened, all the more so if the too much — so much that these borrow- defaults are spurred by a taxpayer revolt — ers won’t be able to repay their obligations Source: Svein Erik Dahl/John Wiley & Sons democracy at work.’’ while maintaining a reasonable level of Christopher Whalen Bookstaber was among those asked by public services. The investors, then, could Brian Chappatta at the end of 2011 about help bankrupt state and local governments It wasn’t long before it what happened. His response is contained — and take massive losses in the process.’’ in Appendix 2. I chatted with Bookstaber, seemed like everyone who now works for the U.S. Treasury in the Office of Financial Research, in mid- Interesting Point of View was talking about a Muni November, and he told me he had nothing This was, I thought, an interesting point Meltdown. The following is a by to do with the muni market, and declined of view. And then: “The uncomfortable truth no means exhaustive list of some of the further comment. is that as municipal debt grows, the risk alarming stuff published on munis in 2010. I knew we had reached an entirely dif- mounts that someday it will be politically, I’m not including the bloggers who at this ferent level of muni crisis coverage when economically, and financially worthwhile for point were advocating defaulting on bonds Matt Taibbi of Rolling Stone, who had borrowers to escape it,’’ Gelinas wrote. on behalf of “the taxpayers’’ or “clickbait’’ achieved a certain notoriety in 2009 when Four years on, I asked Gelinas about the compilations like “The 10 Cities That Will he likened Goldman Sachs to “a giant relative resilience of the market. In an e- NEVER Come Back’’ that were such a vampire squid wrapped around the face mail dated Nov. 16, she replied, “The ‘resi- favorite of Business Insider at the time. I of humanity,’’ weighed in with an article lency’ is shallow. Pension funds are doing should note here that Joe Weisenthal, entitled “Looting Main Street’’ in the April well because [of] the Fed’s extraordinary then of Business Insider, now works for 15 edition of the magazine. actions to push up asset prices. But Bloomberg as Digital Content Officer. The Taibbi piece concerned Jefferson around the nation, from state-level credits Consider this, from the newspaper of record: County, Alabama’s use of interest-rate such as Illinois and New Jersey to rich “California, New York and other states are swaps, and was subtitled, “How the na- cities like New York to poorer and smaller showing many of the same signs of debt over- tion’s biggest banks are ripping off Ameri- cities and towns all over the place, many load that recently took Greece to the brink can cities with the same predatory deals places are still pretty much insolvent,’’ — budgets that will not balance, accounting that brought down Greece.’’ The message she wrote. “They cannot make good on that masks debt, the use of derivatives to plug was that municipalities were “now reeling the healthcare promises they have made holes and armies of retired public workers under the weight of similarly elaborate and to current and future retirees, and many who are counting on benefits that are proving ill-advised swaps,’’ which the author termed will not be able to make good on their harder and harder to pay.’’ a “financial time bomb.’’ promises to pensioners. In the meanwhile, It had been quite a few years since I had infrastructure deteriorates because money read Rolling Stone. I’ve been pretty exer- that should be going to the future is going Greek Myths cised about municipalities’ use of swaps, to the past. The 2009 recovery act was a The story appeared on Page One of the myself. I’m not sure how many Americans missed opportunity to help states, cities, March 30 New York Times, headlined, get their investing advice from Rolling and other municipal credits fix their long- “State Debt Woes Grow Too Big to Cam- Stone, but they couldn’t have found comfort term structural problems, mostly pensions ouflage.’’ Reporter Mary Williams Walsh in yet another tale of predatory Wall Street and health promises, in return for immedi- continued on next page...

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ate cash; instead, Washington treated it as employee benefits and so ill-equipped in the Wall Street Journal about the SEC a cyclical revenue shortfall.’’ are mutual funds to deal with anything charging the state of New Jersey with fraud She continued, “That we haven’t seen resembling a shareholders’ run that we are for misleading investors; the article was bondholder panic is more a sign of the prepared to take the analytical leap. On the entitled, “How States Hide Their Budget desperation for yield and the principal- length and breadth of the muni market, we Deficits,’’ and implied that other states may agent problem (do retail investors really declare ourselves bearish,’’ wrote Grant. be guilty of the same thing. know the risks that they are taking or do “The repudiation gene is ever present,’’ Malanga also had a story in the Sum- they see bonds as ‘safe’). It’s harder today Grant continued, well into a very scholarly mer 2010 edition of City Journal, “How than it was five years ago to assess the article. “The question is whether circum- to Dismantle a Muni-Bond Bomb.’’ He “too-big-to-fail risk” — that is, it is unclear stances in the tax-exempt market may coax wrote: “State and local borrowing, once whether Washington would step in to it out of latency and back into action.’’ thought of as a way to finance essential save, say, Citigroup bondholders, this time I asked Jim about his call this year. On infrastructure, has mutated into a source of around, and it is similarly unclear whether Nov. 17, he e-mailed: “A swing and a miss. constant abuse. Like homeowners before Washington would step in to save, say, the housing bubble burst, states and cities Illinois or New Jersey bondholders or pen- have gorged on debt, extended repayment sioners. In the end, the clearest action that times, and used devious means to avoid Congress takes may — or may not — be in limits on borrowing — all in order to finance not bailing out Puerto Rican bondholders. ‘‘ risky projects and kick fiscal problems Warren Buffett opined on the muni down the road.’’ market at least twice in 2010, telling He offered a handful of reforms, and said shareholders at the Berkshire Hathaway if the state and local debt bomb “can’t be annual meeting in May, “It would be hard defused, we’re all at risk.’’ in the end for the federal government to I chatted with Malanga about the lack turn away a state having extreme financial of a muni explosion since then in mid- difficulty when they’ve gone to General November of this year. He noted that Motors and other entities and saved them.’’ rating companies were now putting much In June, Buffett appeared before the U.S. more weight to pension debt in assess- Financial Crisis Inquiry Commission and ing credit, and, “What we’re seeing is a predicted a “terrible problem’’ for municipal little more skepticism in the marketplace bonds “and then the question becomes will because of what happened in Detroit.’’ He the federal government help.’’ added, “It’s a very uncertain time’’ for the Buffett hasn’t moderated in his views. In municipal market. the Feb. 28, 2014 letter to Berkshire shre- In September, Meredith Whitney pro- holders, he wrote: “Local and state financial duced “The Tragedy of the Commons,’’ a problems are accelerating, in large part Source: Bloomberg/Ramin Talaie report on the 15 largest states. This would because public entities promised pensions ‘American Repudiation Gene’: James Grant have gotten a lot splashier coverage when it they couldn’t afford. Citizens and public appeared had Whitney actually published it. officials typically under-appreciated the The muni market has continued to mosey, As it was, she sent out a press release, gigantic financial tapeworm that was born there was no run on mutual funds. Perhaps but refused to show it to anyone but clients. when promises were made that conflicted more to the point, there turned out to be I asked for a copy and was told I’d have to with a willingness to fund them.’’ no homogeneous market on which to be pay for it. On June 14 of 2010, Ianthe Jeanne comprehensively bearish. What’s Paul Dugan wrote in the Wall Street Journal Isaac’s line?’’ that investors were “ignoring warning signs’’ Grant continued: “As to surprises: Where Seeking Refuge in the municipal market. The article was we erred was in expecting surprises. The Whitney at the time said she had spent headlined, “Investors Looking Past Red muni market has not surprised. No drama, two years working on the report, which Flags in Muni Market.’’ no short-selling, no credit upheaval, no didn’t predict any state defaults. Yet she James Grant — a friend, for whom volatility to speak of.’’ He concluded: “As to began making the rounds, appearing on I worked from 1994 to 1999 — offered the current Grant’s stance toward munis, business radio and television and warning another take on repudiation in the June we judge that yields are too low. In that about how overleveraged states were, and 25 Grant’s Interest Rate Observer, in a they resemble yields nearly everywhere.’’ how they needed a federal bailout. In the scholarly article headlined, “Concerning Nov. 3, 2010 Wall Street Journal, she wrote the American Repudiation Gene.’’ an OpEd piece entitled, “State Bailouts? “So low are yields, so complacent are ‘A Muni-Bond Bomb’ They’ve Already Begun.’’ investors, so persistent are fiscal deficits, On Aug. 23, Steve Malanga of the On Oct. 5, the New York Times’s Mary so heavy is the weight of post-retirement Manhattan Institute wrote an OpEd piece Williams Walsh wrote about how Harris-

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Skeel didn’t return a call for comment. His views on Chapter 9 municipal bank- ruptcy seem not to have changed at all. In August, he wrote a piece for the Wall Street Journal, approving Puerto Rico’s new law State and local borrowing, allowing certain public corporations to “ restructure their debt. “If Puerto Rico can once thought of as a way to finance restructure its debt,’’ he wrote, “there could be hope for states — particularly Illinois essential infrastructure, has mutated into — whose own finances are sketchy.’’ He continues to advocate a federal bankruptcy law covering the states. a source of constant abuse. The lead story in the Dec. 5 Sunday New — Steven Malanga, the Manhattan Institute York Times was “Mounting Debts by States ” Stoke Fears of Crisis’’ by Mary Williams Walsh. And on Dec. 7, then-Business Insider’s Joe Weisenthal wrote about a Facebook post by Sarah Palin: “Sarah burg, Pennsylvania, was seeking to enter bankrupt states. And that means big losses Palin Knows Where The Next Battle Is, As the state’s Act 47 distressed-cities pro- for muni-bond holders ...” She Blasts The Idea of Bailing Out States.’’ gram, in a story headlined “Cities in Debt Palin wrote: “American taxpayers should Turn to States, Adding Strain.’’ She wrote On the Brink not be expected to bail out wasteful state “Across the country, a growing number of governments. Fiscally liberal states spent Nicole Gelinas offered a prescription for towns, cities and other local governments years running away from the hard deci- Congress to aid states, in a Nov. 17 New are seeking refuge in similar havens that sions that could have put their finances on York Post piece, “States on the Brink.’’ In many states provide as alternative to fed- a more solid footing.’’ it she quoted Felix Rohatyn, the banker eral bankruptcy court.’’ Now, you might well ask what kind of sto- who helped craft New York City’s res- The Wall Street Journal led its Money ries Bloomberg News was running at this cue in 1975, who earlier that month told and Investing section on Oct. 10 with time. Among the stories filed by the States Charlie Rose, “We are facing bankruptcy “New Risks Emerge in Munis: Debtholders & Municipalities team were “Moody’s on the part of practically every state and Are Left Steamed as Some Cities Forgo Muni Bond Ratings Will Move to Global local government.’’ Even Gelinas thought Repayment Promises.’’ The story detailed Scale,’’ “U.S. States Expect Taxes to Rise Rohatyn “overstates the case today.’’ She Menasha, Wisconsin’s, failure to make After Facing $84 Billion Gaps,’’ and “Wall advised Washington to get ready to bail an appropriation to pay debt service on a Street Takes $4 Billion From Taxpayers as out states: municipal market turmoil could failed steam plant. Swaps Backfire,’’ this last an investigative “prove contagious.’’ CALIFORNIA WILL DEFAULT ON ITS piece quantifying how much in swap termi- The Weekly Standard’s cover story on DEBT screamed the Business Insider nation fees municipal issuers had paid to Nov. 29 was “Give States a Way to Go headline on a Nov. 16, 2010, story about banks since 2008. Bankrupt,’’ by University of Pennsylvania bank analyst Chris Whalen’s appearance And then on Sunday evening, Dec. 19, law professor David Skeel. He suggested on TechTicker. Henry Blodget wrote: “He “60 Minutes’’ ran a segment entitled “State that both California and Illinois might avail says there’s no bailout coming for Califor- Budgets: The Day of Reckoning.’’ nia — or, for that matter, any of the other themselves of such a law. REAL ESTATE THIRD QUARTER 2014 CLICK HERE

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IX: The Market Responds to Its Critics

Before we turn to the events of Sunday, liabilities. Their 401(k) accounts and retire- December 19, a day that will live in mu- ment dreams now in shambles, many nicipal market infamy, let’s briefly consider Americans were prepared to indulge in some of the stuff that was published and pension-envy. subsequently rattled around on the Inter- The municipal bond industry reacted net, and the market’s response to it. slowly and thoughtfully to the hysteria. By The articles that appeared in 2010 were the fall of the year, though, the industry generally long on headline, short on had produced a number of solid, compre- specifics. hensible reports spelling out, basically, They shared a common theme: Some- That’s Not How This Market Works. thing terrible is going to happen. And that One of the first responders was Tom is: States and municipalities are going to Kozlik, a municipal credit analyst at Jan- default on their bonds, because they are ney Montgomery Scott in Philadelphia. all being overwhelmed by debt and pen- In the firm’s July 14, 2010, Municipal Bond sion obligations. Market Monthly, Kozlik wrote, “Many sto- Most of the stories contained no fine ries published of late in the popular press shading, no nuance, and, unless the have included overblown perspectives of various articles described exceptional in- municipal market risk.’’ cidents that were already well-known and His piece was entitled, “Municipal previously-reported — Harrisburg, Jef- Tom Kozlik Market ‘Myths’ and ‘Truths’ and ‘Veritas ferson County, the Menasha, Wisconsin for the first 30 days after being sold. So Vos Liberabit’ Which Means, ‘The Truth steam plant, Vallejo’s bankruptcy, various when someone writes, for example, “the Shall Set You Free.’ ’’ He discussed silly economic development, stadium and municipal market tanked,’’ I want to ask: headline risk, and observed, “Although convention center financings — there was How do you know? That’s an equity mind- recent articles in the popular press try very little that was new. Beyond this rather set. What really happens is: The bid-side to portray a balanced opinion about the large generalization: California, Illinois dried up. It’s not as though you can go status of the municipal market, too often and New York, staggering along under someplace and say, “Okay, I’d like to buy all writers and commentators are not relying seeming mountains of debt, are all going the cheap munis now.’’ on municipal market experts for facts to go bust. Finally, some of the provocative material about the realities stressing the municipal that was published in 2010 was frankly market.’’ He continued, “The confusion, political, aimed at public-employee labor lack of knowledge and resulting fear Missing Detroit unions, now fingered as the culprits mongering we have seen in the print and I suppose if you had wanted to look at behind massive state and local pension televised media has occurred because things “nobody was talking about’’ back continued on next page... then, nobody was talking about Detroit staggering along toward an eventual bankrutpcy filing in 2013, or that Puerto Rico had its own crushing mountains of debt, or that Jefferson County, Alabama, would file for bankruptcy in 2011 or that Stockton, California, would file in 2012. The confusion, lack of knowledge and That would have all been very useful, but “ it also would have required a lot of digging and a ton of luck. Along with predicting resulting fear mongering we have seen in that Michigan Governor Rick Snyder would specifically authorize Detroit to file the print and televised media has occurred for Chapter 9. The articles that appeared in 2010 almost all seemed intent on proving “the because of the media’s misunderstanding of market’’ wrong, but only by way of innu- endo. Most of the authors were confound- the municipal market. ed by the lack of movement in what they called “prices,’’ although what they usually – Tom Kozlik, municipal credit analyst at Janney Montgomery” Scott referred to was one or another of various yield indexes rather than actual trading. That’s because most bonds only trade

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got through and was disregarded because ment itself. However, based on media cov- it didn’t fit the narrative, or was dismissed erage, it appears to succumb to what has because the writers felt the analysts in- been a common problem of non-municipal volved were somehow discredited. observers of our market: the conflation of So much of what I thought passed for various state stakeholder exposures.’’ “dialogue’’ in those days was, after all, privately disseminated. Reporters only received some of it. Misunderstood Leverage States are unlikely to default on their bonded debt, he said, because of a num- People Unfamiliar ber of legal protections. What meltdown As Kozlik wrote in a retrospective piece proponents were predicting was a mass, on Aug. 27 of this year, “Several report- anarchic, political and legal abdication. ers were dead set on the idea that the He also addressed “rollover risk,’’ first municipal market was the next sub-prime broached by Frederick Sheehan the market and the municipal market would previous year in his “Dark Vision.’’ Re- melt-down.’’ member, wrote Fabian, “that ‘leverage’ is Most of the stories stoking the hyste- an often misunderstood term. While states ria about munis featured quotes by, as have greatly increased debt borrowings I would characterize them now, people over the last five years, essentially all unfamiliar. outstanding municipal debt is self-amor- The go-to guy for the insider’s point of tizing. Meaning, similar to a residential view, someone who actually knew what mortgage, principal is paid down regularly he was talking about and wasn’t afraid via level annual debt service payments Source: Bloomberg/Jin Lee of being quoted, was Matt Fabian of the funded with tax receipts. ‘‘ “Tragedy of the Commons”: Meredith Whitney research firm Municipal Market Advi- He continued: “Municipal issuers do not sors. He was the Voice of Reason, the To borrow as do international sovereigns or of the media’s misunderstanding of the Be Sure source in a sea of inexpert tes- the US treasury: via large short maturity municipal market.’’ timony. He must have been a very busy notes that in practice can only be refi- The myths Kozlik addressed: That there man. In some ways, I performed a similar nanced with more debt, creating a crip- was going to be a “‘Municipal Meltdown’ role briefly in 1995, after Orange County, pling reliance on market acceptance for or a percentage of defaults or municipal California, went bust. You can look it up. solvency. As we saw in 4Q08, an extend- bankruptcies’’ significantly above the his- On Sept. 30, 2010, Fabian produced a ed primary market ‘closure’ produced no torical norm; that the market would crash one-sheet “Special Report on Vilifying knock-on defaults; states simply stopped like the sub-prime loan market; that there State Creditworthiness,’’ a sort-of re- funding new infrastructure until rates fell would somehow be a default or bank- sponse to Meredith Whitney’s “Tragedy far enough to justify the cost.’’ ruptcy “contagion effect;’’ that California, of the Commons,’’ which he admitted he John Hallacy, head of municipal Illinois, or New Jersey would be “the next had not seen yet. After acknowledging the research at the then-new combination, Greece;’’ that ratings and bond insurance report might have some salutary effect in Bank of America Merrill Lynch, con- were worthless. regard to budget-cutting, pension-building, fronted “Apocalypse Muni’’ in a comment I’m not sure how many reporters or com- debt-deferral and increased disclosure, piece on Oct. 1. He acknowledged that mentators saw Kozlik’s piece, or the vari- Fabian wrote: “We are reluctant to directly the federal government had already as- ous other rejoinders that started to appear rebut the report without having the docu- sisted the states: “The ARRA or stimulus thereafter. Maybe some of this material provided several different levels of assis- tance including extending Unemployment Insurance benefits. Additional legislation in the amount of $26 billion was approved to provide extension of a higher level of Most U.S. states are lightly indebted Medicaid reimbursements for two quarters “ in the amount of $16 billion, and addition- compared with regional governments al education assistance with the remain- ing $10 billion.’’ Hallacy also noted, “Debt and the elsewhere in the world. amount of leverage on the part of the — Gabriel Petek, Standard & Poor’s” issuer have never been the best predic- tors of creditworthiness,’’ and observed: continued on next page...

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“The ratio that matters the most to us states are lightly indebted compared with is the debt service carry on the budget. regional governments elsewhere in the Most issuers keep this ratio well within 10 world. In our opinion, various constitu- percent, and the level is typically closer tional or legal requirements for balanced to 5 percent. If the debt service carry is budgets — more unusual outside the U.S. over 10 percent, the reason is most often — have kept U.S. states’ debt burdens at because said issuer prefers to amortize its moderate levels.’’ debt on a more rapid schedule.’’ The report compared Ontario, Bavaria, So maligned had the asset class be- Basel, Texas, New York, Illinois and come by this time that Hallacy added at California, and concluded, “in our assess- the end of his piece, “We are not apolo- ment of U.S. states’ creditworthiness, we gists for the Municipal Market.’’ consider debt service payments to be a Moody’s on Oct. 5 published a Special very modest proportion of expenditures Comment, “Why US States Are Better and admit that most administrators are Credit Risks Than Almost All US Corpo- able to manage through severe economic rates.’’ The Comment described Illinois, at turbulence, due in part to their relative the time the lowest-rated state at A1, and lack of leverage. We believe that some then detailed why all of the states, even discussions about financial catastrophe Illinois, were of better credit quality than are meaningful only if governments prove 96 percent of corporate borrowers. unwilling to use their powers of adjust- Source: Bloomberg/Jennifer S. Altman ment to manage their positions.’’ ‘Bold prediction! Don’t back down now!’: Henry Blodget Munis Not Corporates Economic Engines tions written by lead analyst Richard Fundamental strengths of states, ac- Raphael called “U.S. State and Local cording to Moody’s, include the capacity The analysis included a table of various Government Bond Credit Quality: More to increase revenue by taxes; the ability to financial measures and showed how states Sparks Than Fire’’ on Nov. 16. I liked it cut expenses and capital outlays without stacked up — pretty favorably, especially in because it was full of common sense and reducing revenue; strong legal protection terms of revenue. California and New York treated the subject in straight English, and for debt service payments; limited conse- in particular are economic engines. reiterated the strengths of the market: quences to running deficits and accumu- The larger piece emphasized state and “Due to the 20- to 30-year principal lating negative balances; less competitive local government agency. That is, these amortization of debt that is common in pressure; lower event risk; and potential governments have the ability to man- the U.S. municipal market, large bullet federal support. age their way out of financial crises, and maturities and consequent refinancing This was probably one of the more Standard & Poor’s expected them to do risk is limited,’’ and “Debt service is a rela- important pieces produced during the so: “We believe the crises that many state tively small part of most budgets, so not crisis, describing as it did the unique char- and local administrators find themselves paying it does not do much to solve fiscal acteristics of states (and, by extension, in are policy crises rather than questions problems (particularly as compared to the municipalities) compared to companies. of governments’ continued ability to exist costs of such an action),’’ for example. People unfamiliar have long confused the and function. They’re more about tough And then the company treated “systemic equity and municipal markets, in the way decisions than potential defaults.’’ risk,’’ or the chance that the entire market they trade and in the way they respond The report stated that debt service is would melt down somehow: “The munici- to bad news. It is little wonder, then, that usually a payment priority, a legal obliga- pal bond market is diverse, with thou- they also likened municipal issuers to tion, and then considered California, sands of issuers, over a dozen distinct companies. In fact, as Moody’s pointed Illinois, New York and Texas, as well as a sectors, and multiple security structures. out, “Game Over’’ looms over companies number of localities, including Las Vegas The legal framework for municipal bonds much more closely than it does over and Detroit. depends upon a multitude of constitution- states and municipalities. From our perspective today, perhaps al, statutory, local ordinance, and con- On Nov. 8, Gabriel Petek of Standard & Detroit is the most interesting of the tractual provisions. Each municipal bond Poor’s published two reports: “U.S. States’ bunch. The rating company was unequivo- sector has unique criteria and risks. Fur- Financial Health and Debt Compare cal: “Michigan has repeatedly indicated ther, in many cases, a single municipality Favorably With Other Regions’’ and “U.S. to Standard & Poor’s that it would take all will issue several series of bonds, each States and Municipalities Face Crises steps necessary to prevent a[n emer- secured by a different type of security.’’ More of Policy Than Debt.’’ gency financial] manager from filing for I think the two pieces I enjoyed most In the first, S&P reminded readers that, bankruptcy protection.’’ emanated not from the industry but “From a global perspective, most U.S. Fitch offered a Frequently Asked Ques- from the media itself. On Nov. 22, Brett

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Arends of MarketWatch responded to tion! Don’t back down now!’ ‘’ Arends “More generally, the municipal bond the Christopher Whalen “California Will concluded: “Bah. Welcome to the media market is a very complicated place, where Default’’ interview with Henry Blodget the world in 2010.’’ expertise is hard-earned and voluble previous week. He then produced a piece showing that new entrants are inherently mistrusted, “Can everyone please stop talking total California, far from being the Greece of normally for good reasons.’’ nonsense about the California budget?’’ America, was actually the Germany of Whalen, now a Senior Managing Direc- wrote Arends. “I know that facts and truth America, an economic powerhouse with tor at Kroll Bond Rating Agency,was one seem to be optional these days. I know that a high standard of living, where entrepre- of those interviewed by Brian Chappatta in the exciting new world of infinite media neurs still wanted to do business and one at the end of 2011 about the lack (so far) everyone can choose to believe whatever of the states that sent far more money to of a Muni Meltdown, and his comments fantasies they want. But in the case of Washington than Washington redistributed. lead off Appendix 2. I also e-mailed him California, it’s getting on my nerves.’’ It didn’t end there. On Nov. 23, Felix on a recent Sunday to ask him about it. Arends recounted an e-mail exchange Salmon wrote about the incident for the On Nov. 16, he e-mailed: “The process he had with Whalen, who said “My gen- Columbia Journalism Review’s “The Audit’’ has proceeded about as I thought. Cases eral comments have to do with my guess blog, which discusses financial journalism: like Detroit and Stockton, CA, are the as to the impact of mounting foreclosures “In reality, what we’re seeing here is ex- extreme examples where default has oc- and flat to down GDP on state revenues.’’ pertise mission creep, and a rare example curred, but in general the political class of an expert admitting to it. Whalen’s com- has proven able to extend and pretend pany is highly regarded when it comes to with respect to sovereign credits of vary- ‘All Henry’s Fault’ analyzing banks’ balance sheets, and as ing sizes. Puerto Rico is another case Arends replied, “Your guess? These are a consequence of that regard, Whalen where the threat of a general default is important problems, to be sure. But do has gotten for himself a nice perch in the being used to forcibly restructure debt. In you have any actual numbers?’’ To which punditosphere, as well as a new book. But the case of GM, which was a sovereign Whalen replied, “Revenues fall and man- Whalen, as he admitted to Arends, is no credit for a time, the fact of default was dates rise to the sky. You do the math.’’ more an expert on municipal finance than used to ride over investors’ rights. Indeed, Arends pressed: “Er, no, actually, it’s your Freeman Dyson is on global warming. And GM may well end up back in bankruptcy assertion. You do the math.’’ Whalen finally so the proper stance for Blodget to take because of unresolved pension liabilities blamed Blodget. “I am a bank analyst. I was not to deferentially pose questions and chronic operational problems. CA was have not written anything on this. My com- to Whalen and then passively receive saved, for now, by Governor Brown, who ments have taken on a life all their own. his oracular words of wisdom, but rather is not afraid to say no to both parties in This is all Henry’s fault. Call him.’’ to push back and have a proper debate the CA assembly.’’ “Some prediction,’’ Arends wrote, and about Whalen’s assertions, as Arends Which brings us to “60 Minutes’’ and its then: “Meanwhile Blodget chimed in on might have done.’’ segment “Day of Reckoning.’’ the e-mail exchange: ‘It’s a bold predic- This was the clincher for me, though:

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X: Oh, Meredith

Cue the stopwatch. of billions,” MMA saying late Monday, “Hundreds of billions.’’ “Hundreds of billions’’ was the key “Given the dire certainty presented by With these three words, takeaway from this segment. Municipali- Whitney, it is a wonder the US equity mar- ties would default on hundreds of billions kets did not collapse on Monday under analyst Meredith Whitney of dollars in bonded debt, and within the the weight of the anticipated demise of won fame and notoriety next 12 months, or at least starting within the state and local government entities.’’ the next 12 months. Everything else in the On Tuesday, Kozlik put out a strategy and, eventually, ignominy. segment, you could say, yeah, every- piece headlined, “There is Not a Loom- The payoff: Prominent mention in scores one knows that, everyone knows that, ing Municipal Market Crisis, Although of newspaper, magazine and blog articles, everyone knows that, until you struck the Many Factors are Stressing Issuers.’’ He dozens of appearances on business radio “hundreds of billions’’ line, and, well, not advised: “Investors should not panic and and television and of course (in February of everyone knows that. sell-off municipal holdings.’’ 2012) the inevitable book contract. Bold call! The record year for defaults For the next year, and the next, and The phrase came almost at the end of a until then was 2008, when $8.5 billion even well into 2013, when her book, “Fate “60 Minutes’’ episode entitled “State Bud- in bonds went into actual or technical of the States’’ was published, Meredith gets: The Day of Reckoning,’’ an otherwise default. And Whitney said — I went back Whitney was Topic #1 in the municipal unremarkable and succinct look at public and listened to the entire broadcast sev- market. Never had a personality become finance by CBS correspondent Steve eral times, just to make sure I had heard such a polarizing obsession. Whitney, Kroft, which aired on Dec. 19. what I thought I’d heard — “hundreds of whose remarks were really just a punc- Whitney appeared at the end of the billions.’’ As in, not $100 billion, but a mul- tuation mark on the “Muni Meltdown’’ segment, in the role of Expert on the Mu- tiple, meaning, at least $200 billion. And hysteria, after all, came to represent all nicipal Bond Market. She was, said Kroft, this would be something to be concerned the inexpert witnesses who had forecast convinced that some cities and counties about within the next 12 months. the market’s imminent demise. wouldn’t be able to meet their obligations Keep in mind when this “60 Minutes’’ epi- To paraphrase Winston Churchill on to bondholders. She said there would be sode aired. It was Sunday, Dec. 19. Most the Battle of El Alamein, before Meredith a “spate’’ of defaults. Asked to define a of the market was either already on the Whitney, the asset class never had a win. spate, she replied, “50 sizeable defaults. end-of-the-year holiday or looking forward After Meredith Whitney, it almost never Fifty to 100 sizeable defaults. This will to beginning it. Most banks and rating suffered a defeat. amount to hundreds of billions of dollars’ companies probably weren’t anticipating The terms of the debate narrowed. Now worth of defaults.’’ putting out municipal market commentar- instead of a vague “meltdown’’ forecast, ies until January. municipal bond defenders, if that is the Patted on the Head There are some columns you can’t wait right word, could just point to “hundreds of to write. This was one of them, for me billions’’ and say, That’s not going to hap- Kroft observed that Moody’s and Stan- (see Appendix I). “Hundreds of billions’’ pen, and explain why. dard & Poor’s, “who got everything wrong seemed to me to be in the realm of the I think my column was the most-read on in the housing collapse’’ said there was fabulous, and I said so. It made no sense Bloomberg that Wednesday, and I even “no cause for concern.’’ Whitney, who, we to me that a boatload of municipali- got a call from our television producers were reminded by Kroft, had spent (with ties would all choose to renege on their to come on and explain myself. This one her staff) “two years and thousands of bonds, especially since, as Fitch and column also cast me in a new, heroic role: man hours trying to analyze the financial others had pointed out just weeks before, Municipal market champion. E-mails of condition of the 15 largest states,’’ wasn’t debt service usually makes up a small thanks and praise came in. buying it: “When individual investors look part of their costs. Not paying debt service This was unfamiliar ground for me. If to people that are supposed to know wouldn’t do much to solve their fiscal prob- anything, I was regarded as a scold by better, they’re patted on the head and lems. I also included my own prediction for many bankers, especially for my general told, ‘It’s not something you need to worry defaults in 2011: Between 100 and 200, opposition to the use of interest-rate about.’ It’ll be something to worry about totaling between $5 billion and $10 billion. swaps by all but the most sophisticated within the next 12 months.’’ I wrote the column on Monday (the municipal bond issuers. Then Kroft said, “No one is talking about same day, Whitney appeared on CNBC); it E-mails ran about four-to-one in my favor, it now, but the big test will come this was edited on Tuesday, and was pub- all of which I duly saved. The pro-Meredith spring. That’s when $160 billion in federal lished later that night. It appeared on our Whitney ones generally reminded me that stimulus money, that has helped state and Page One on Wednesday. Whitney had called Citigroup dropping its local governments limp through the great dividend and how dare I, a mere journalist, recession, will run out. The states are declare myself a better analyst? going to need some more cash and will Inexpert Witness almost certainly ask for another bailout. By then, both research firm Municipal Only this time there are no guarantees Market Advisors and Tom Kozlik of Jan- that Washington will ride to the rescue.’’ ney Capital had responded to “hundreds

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XI: After “Hundreds of Billions’’

There were lots of things for the mu- of any Part 2 ever being published. nicipal market to focus on in 2011: Bond But the real story was Meredith Whitney. ratings, new regulations, the future of In February, the New York Times acknowl- tax-exemption, bid-rigging, swap termina- edged as much with a story, “A Seer on tion fees, accounting rules, bankruptcies, Banks Raises a Furor on Bonds.’’ defaults. And it did, of course. But the main focus was all-Meredith Whitney-all- the-time. Redefining Default Oh, there were a few last gasps of ge- For someone who had studied state and neric big-media hysteria. On Jan. 21, The local finance for at least a couple of years, New York Times led the paper with a story she didn’t seem familiar with the nomen- headlined, “A Path Is Sought for States To clature. In 2010, she very briefly tried to Escape Debt Burdens,’’ about how “policy redefine “default.’’ makers are working behind the scenes’’ Rather than meaning missing a debt to come up with a way to allow states to service payment, or violating a bond cov- declare bankruptcy. In fact, it seemed enant, Whitney said that when she used that states wanted no part of access to the word “default’’ it meant something like bankruptcy. breaking the “social contract’’ by reduc- And in March, Nouriel Roubini pre- tions in spending. Using this definition, everything from curtailing library hours Source: Bloomberg/Simon Dawson sented “States of Despair,’’ which, despite Anti-hysterical: Nouriel Roubini the title, was really anti-hysterical. In it, to reducing retiree health-care benefits of “restructurings’’ going on out there in the firm explained all the reasons why a could be considered a “default.’’ You can MuniLand, secretly. meltdown of apocalyptic proportions, i.e., see how easily “hundreds of billions” could Whitney also believed the Build America “hundreds of billions,” was extremely un- add up. Bond program that was featured as part likely, and observed: “Our base case sees But of course this was an absurdity. of the Obama fiscal recovery act repre- close to $100 billion of defaults over five Eventually, in 2011, Whitney said she sented a kind of hidden bailout to states: years, but typical 80 percent recoveries stuck by her “60 Minutes” phrase “hun- “These states might have already reached are far higher than on corporate bonds.’’ dreds of billions’’ of dollars in defaults, but added that “it was never a precise some type of tipping point had the federal estimate over a specific period of time.’’ program not been in place’’ she wrote in Not the Titanic Yet it sure sounded that way to anyone the Wall Street Journal. More importantly, Roubini stated that it who watched “60 Minutes.’’ Such was the critical opposition to was incorrect to “assume the Titanic is set She also used the word “restructur- Whitney and her “hundreds of billions’’ on autopilot heading for the North Pole.’’ In ings’’ in a corporate way. In the municipal call immediately post-”60 Minutes’’ that other words, state and local governments market, when bankers and issuers talk journalistic bigfoot Michael Lewis eventu- weren’t passive observers, and could be about “restructuring,’’ they usually mean ally felt called upon to defend her, in his expected to try and address the situa- refunding a deal so as to extend matu- August Vanity Fair magazine piece on tion. And he called any state bankruptcy rity — or at least they did until the Detroit California, part of a series he was writing discussions “dead on arrival.’’ bankruptcy. on the financial crisis. “Her words were The full title of the Roubini report was In the corporate world, restructuring being misrepresented so that her mes- “States of Despair Part 1: Muni Stress — usually means some form of a cramdown. sage might be more easily attacked,’’ Past, Present and Future.’’ I’m not aware Whitney hinted darkly that there were lots Lewis wrote. Well, let me stop right there. Whitney did have a larger story to tell, but all most people had to go on was her brief appear- ance on “60 Minutes’’ with its explosive conclusion. It’s not as though the show’s non-municipal-market-expert viewers Her words were being could be presumed to have watched all “ the various cable news and business misrepresented so that her message might radio episodes featuring Whitney. And on the “60 Minutes’’ segment, the most im- portant thing she had said was “hundreds be more easily attacked. of billions’’ in defaults. ” Whitney’s larger message was expound- — Michael Lewis, Author, referring to Meredith Whitney ed in Lewis’s article, and later in her own continued on next page...

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book, “Fate of the States.’’ Boiled down, a credit rating firm, which would grade municipal officials did their jobs, defaults it goes something like this: Some states municipal bonds, among other things. And didn’t explode. That happened. I’d also like and their municipalities have borrowed on Bloomberg radio’s “Surveillance,’’ in to say that the hysteria was dispatched by too much and promised too much to May of 2012, Whitney said that she only those who knew what they were talking their employees. This overleveraging will looked at the big picture, not the Cusip- about returning fire with articles and blog- become apparent to all as these govern- by-Cusip (and particular-and-specific) postings and pieces of research dense ments are forced to cut services and raise world of munis. with unassailable facts and statistics. That taxes. People and companies who can Which means that the “hundreds of bil- also happened. And I’d like to say that the afford to will decamp to greener pastures, lions’’ call was meaningless, unless some- willingness of people like David Kotok those states that haven’t borrowed too how also attached to a multi-generational and Dick Larkin and Alexandra Leb- much and that have low taxes. The new forecast of fundamental demographic enthal and Matt Fabian, among many power region of the country is going to be shift. The idea that people would vote with others, to appear on business television the formerly flyover American heartland, their feet and flee the high-cost, high-tax to explain the municipal market in slow and certain states in the South and West. coastal states isn’t a new one. motion — I’d like to say that quieted the In April of 2012, at a Grant’s Interest Rate I’m not sure that this nuanced theory Meltdown hysteria. Because that, too, Observer conference, Whitney said this would have garnered the attention, and happened. would play out over the next two decades. subsequent book deal, and all the rest of I suspect the real reason the Melt- This was indeed a message, a very it, that “hundreds of billions’’ did. down hysteria subsided was because of plausible, reasoned theory, even if I Meredith Whitney didn’t respond to my Whitney. As she told Michael Lewis, she thought it wrong and not a little derivative. calls and e-mail for comment. didn’t care about the stinkin’ municipal Whitney protested to Lewis that she bond market. Yet that was all the report- didn’t care about the “stinkin’ municipal ers on the Muni Meltdown Hysteria beat bond market.’’ And this seemed to be very Stinkin’ Municipal Market cared about, now that there was a specific true, although in November of 2010 she I’d like to say that the Muni Meltdown target: “hundreds of billions.’’ told the Financial Times that she was hysteria died of natural causes. The Whitney refused to engage. seeking approval from the SEC to set up economy revived, tax collections rose, Game over. Briefs on the

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XII: Returning Fire

Market participants began returning fire on the meltdown proponents during the second half of 2010. Meredith Whitney’s “60 Minutes’’ appearance at the end of the For one thing, all of the top 50-100 year quickened the pace. “ In the Muni Meltdown Hysteria media game of 2010 and 2011, the burden of municipalities in total do not have ‘hundreds proof was always on the market. Meltdown of billions of dollars’ of debt outstanding. adherents sent screaming headlines hur- tling around the web about how the entire — George Friedlander, Citi ” municipal market was going to implode, and watch out below. Responsible analysts eager to retain their credibility had to On Dec. 21, Citigroup’s George Fried- 1 in 7 respond with detailed, sometimes ponder- lander responded at length in the firm’s If 200 “average’’ issuers defaulted, that ous, explanations of why that amorphous Municipal Market Comment wihout naming might add up to $10 billion, wrote Schro- and incendiary possibility wasn’t the case. Whitney: “For one thing, all of the top eder. If you took the top 20 cities, they had Then came Whitney. As I said, it was one 50-100 municipalities in total do not have about $115 billion in direct and overlapping thing to respond to the vague meltdown ‘hundreds of billions of dollars’ of debt out- debt, and none of them seemed about to business, quite another to say why “hun- standing. Achieving an outcome anywhere go bust over the next 12 months. dreds of billions’’ was utterly implausible. close to this projection would require not Finally: “To arrive at a figure of ‘hundreds just that some major local governments of billions’ of par amount defaulting in the would fail in the near future, but that next 12 months, by my estimate, over Smackdown virtually all of them would. If such a result Some of the best analysis was done im- 5,000 issuers would have to default on were at all possible, it would be far from a their municipal debt, or about 1 in 7 that mediately after “60 Minutes.’’ The New York secret, suggestions that municipal market Post on Friday, Dec. 24, termed the week have debt outstanding.’’ participants — rating agencies, municipal At least two more white papers designed post-”60 Minutes’’ a Whitney “smackdown’’ finance departments, dealers and portfolio (Whitney’s husband had been a profes- to challenge the hysteria appeared. On managers — are somehow ‘complacent’ Jan. 20, the Center on Budget and Policy sional wrestler) and quoted Ben Thomp- notwithstanding.’’ son of Samson Capital, who appeared Priorities published a 21-page white paper Friedlander also paused to reflect on the entitled, “Misunderstandings Regarding on CNBC and said the “numbers just meltdown hysteria: “We note that there don’t add up.’’ He said, “I can’t make the State Debt, Pensions, and Retiree Health has been a virtual avalanche of reports Costs Create Unnecessary Alarm,’’ a nice numbers work. If you look at the 10 largest of this type over roughly the past fourteen cities and the 25 largest counties in the primer that addressed every aspect of the months. The reports had several attributes meltdown hysteria, although it didn’t men- country, that’s $114 billion in debt outstand- in common: They were written by individu- ing. So you gotta basically have New York, tion Whitney by name. als whose main expertise was in sectors And in February, the Center for Economic Chicago, Phoenix, Los Angeles — these other than municipal bonds and whose cities start to default.’’ and Policy Research published a paper main claim for credibility was that they had on “The Origin and Severity of the Public been accurate in forercasting disaster in Pension Crisis,’’ which sought to remind some other sector; They projected that everyone that the real reason so many there would be a very sharp upswing in the pension plans were underfunded was magnitude of defaults on rated municipal because of the shellacking they had taken credits in the future, over a relatively short in the stock market. time period (i.e., over the next year or two); Any bibliography of bank and rating and The projections did not appear to treat company responses to the Muni Meltdown effectively the differences between corpo- Hysteria would probably run to 40 or 50 rate credits and state and local credits.’’ separate items. Most were distributed Sometimes the simplest questions privately to clients, but several managed to are the best. How do you even get to surface and broaden the debate. “hundreds of billions’’? On Jan. 4, 2011, That is, to the extent there was any lon- Michael J. Schroeder, CIO of Wasmer, ger any debate. By the middle of the year, Schroeder & Co. put out a comment on the it was apparent that Whitney’s “hundreds of subject, showing just how difficult it was, billions” and Munigeddon weren’t imminent. once you netted out the states and bonds Source: Bloomberg/Jin Lee All that remained was counting defaults that were escrowed with U.S. Treasury and watching the calendar, and pointing Asking simple questions: Citi’s George securities or their equivalents. Friedlander out how silly it had all been.

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XIII: What Happened, and Lessons Learned

So, the Great Municipal Number of Defaults Dropped . . . Market Meltdown — that 160 140 Number of Defaults didn’t happen. 140 133 Or did it? Par Value (in Blns) “Jeffco, Detroit, Rhode Island, Puerto 120 Rico. Harrisburg, San Bernardino, Vallejo, 107 Stockton, all before getting to the usual 100 suspects,’’ a colleague e-mailed me. To this I might add, the redefining of the 80 General Obligation bond in the wake of 65 the Detroit Chapter 9 bankruptcy. 60 45

Point taken. Each of them is exceptional. Defaults ofNumber Each is worth an extended piece on its own 40 merits. First, let’s look at what did happen. The recession ended in June of 2009. 20 $8.54 $8.76 2010 was the year of hysteria, culminating $4.03 $6.56 $1.94 in Meredith Whitney’s “60 Minutes’’ pre- 0 diction. In 2011, 133 issuers defaulted on 2010 2011 2012 2013 2014 $6.56 billion in municipal bonds, accord- Source: Municipal Market Advisors ing to Municipal Market Advisors. This being the municipal market, of course, not everyone agreed at the time . . . Investors Withdrew Funds After Meredith Whitney Call about the definition of default. Richard Lehmann, publisher of the Distressed 100 Muni Bond Flows $81.1 Debt Securities Newsletter, put the 2011 80 figure at almost $26 billion, if you counted tobacco bonds and the munis backed by 60

$46.0 American Airlines in the total, and if you 40 counted both actual and technical default. $21.1 $17.3 $15.8 $18.1 If you counted only actual payment de- 20 fault, the figure was $6.56 billion in 2011, $9.4 $5.0 $1.94 billion in 2012 and $8.54 billion in 0 2013, according to MMA. The total for -20 -$9.9 2014 will likely top the 2013 total, because -$14.4 of Detroit, says MMA. -40 Now let’s consider municipal bankrupt- Dollars U.S. of Billions In cies. Vallejo, California, went bust in May -60 -$64.2 of 2008, pre-hysteria. Central Falls, Rhode -80 Island, filed for Chapter 9 in August of 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2011. Harrisburg, Pennsylvania, filed in Q1-Q3 October of 2011, but this was thrown out. Source: Lipper US Fund Flows The then-record municipal bankruptcy was filed by Jefferson County, Alabama, In July of 2013, Detroit became the new when they hear the word “municipality.’’ in November of 2011, the proximate cause record municipal bankrupt. Meredith They included hospital, levee and sanitary failure by the state to allow the county to Whitney penned an opinion piece for improvement districts. levy a tax. the Financial Times, headlined: “Detroit In 2009, investors added almost $81.1 In the summer of 2012, San Bernardino, Aftershocks Will Be Staggering,’’ or as billion to municipal bond funds, according Stockton and Mammoth Lakes, California, Business Insider put it in their pickup: to Lipper US Fund Flows. In 2010, they all declared bankruptcy. Bloomberg News “Meredith Whitney: Detroit Will Start a added $5 billion. In 2011, as investors carried a story on July 13: “Buffett Says Wave of Municipal Bankruptcies.’’ panicked after the Meredith Whitney call, Muni Bankruptcies Set to Climb as Stigma In 2013, there were eight Chapter 9 fil- they withdrew $14.4 billion. In 2012, they Lifts.’’ In 2012, there were a dozen Chapter ings. In the first nine months of this year, added $46 billion. 9 filings, most of them for things like sani- there were nine Chapter 9s, none by a Yield indexes shot higher. The old- tation and irrigation districts. city or town or what most people think of est gauge of municipal yields, the Bond continued on next page...

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Buyer’s 20-Bond General Obligation First: Remember my friend Paul Isaac’s Index, rose from 3.82 percent on Oct. 14, dictum: The municipal market is particu- 2010 to 5.41 percent on Jan. 20, 2011. The lar and specific to a remarkable degree. index fell throughout 2011 and 2012, rose Hysteria proponents either ignored, or in 2013, fell in 2014, and is now in the 3s. (my bet) didn’t know about the incred- States and municipalities reduced ible variety of securities and credits sold spending, raised taxes and fees, balanced generically as “municipal bonds.’’ They their budgets and fired employees. States generalized. had 5.2 million employees on Jan. 31, Second: Beware inexpert testimony of- 2009, which they cut to just over 5 million fered on the Internet. Not all points of view by the end of July 2013. Local govern- are legitimate and credible. ments had 14.6 million employees in Oc- Third: Politics and municipal credit Source: Bloomberg/Pete Marovich tober of 2008; they fired almost 600,000 analysis make strange bedfellows. Many of Defending Munis: Sen. Chuck Schumer by March of 2013. Both have resumed the dire predictions about the market were hiring, albeit slowly. politically informed, driven by an almost States and municipalities slowed their visceral hatred of municipal labor unions. allow it) — will do all they can to avoid borrowing in the bond market. In 2010, Consider, for a recent example, a Sep- filing for Chapter 9, which by design is they sold almost $408 billion in long-term, tember editorial in the Wall Street Journal onerous, extremely expensive and, yes, fixed-rate municipal bonds. This declined about Sen. Chuck Schumer’s support carries a stigma. The corollary to this to $258 billion in 2011, rose to $352 billion for munis as high quality liquid assets for observation is that when they do file, the in 2012, dropped to $298.7 billion in 2013, banks. Schumer urged federal regulators corporate attorneys and advisers involved and currently stands at about $220 billion. to reconsider their decision to prohibit will target bondholders as easy prey. Even If I can generalize: If a Municipal Market banks from considering munis as such the conservatives in Orange County for Meltdown did not and has not occurred, assets, saying it might even slow or halt a very brief period early in the county’s what did happen? infrastructure projects. bankruptcy in 1995 talked of “repudiating’’ States and municipalities, with a few The Journal observed: “That ‘infrastruc- certain bonds sold only the year before. exceptions, muddled along. Federal assis- ture’ line sounds nice, but Mr. Schumer’s One of Detroit emergency financial man- tance in varying degrees and interest-rates real purpose is to keep the money flowing ager Kevyn Orr’s very first gambits was to held near zero by the Fed eased the way. to his friends in local government so they declare that general obligation bondhold- in turn can keep the money flowing to ers were unsecured and entitled to only union employees.’’ I thought: Is this really cents on the dollar. Beware Inexpert Testimony what the Journal editorial board considers Fifth: Twitter is a good source of breaking What can we learn from the hysteria? the only pupose of municipal borrowing? news and analysis. Dismiss it at your risk. Are there any lessons that investors can Fourth: Municipalities — that is, those learn from the panic of 2010? who are legally allowed to (not all states

Bloomberg Brief: Muni-Meltdown That Wasn’t

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Appendix 1: Meredith Whitney Overreaches With Muni Meltdown Call

COMMENTARY BY JOE MYSAK ing developments, biofuel refineries — so income, and local debt roughly 3 percent Dec. 22, 2010 (Bloomberg) they could qualify for tax-free financing. to 5 percent of property value. Debt ser- There will be between 50 and vice is generally less than 10 percent of a Whitney’s Vision state or local government’s budget, and in 100 “significant’’ municipal bond many cases much less.’’ defaults in 2011, totaling “hun- And those are the ones I think will still comprise the majority of defaults in 2011. The lead analyst on the report was dreds of billions’’ of dollars. This isn’t the Whitney scenario. No, she Richard Raphael, who has been cover- So said banking analyst and new mu- envisions between 50 and 100 — or more ing municipal finance for 31 years. He is nicipal bond expert Meredith Whitney — counties, cities and towns making the not one of the analysts “who got every- on the “60 Minutes’’ show on Sunday, in choice to renege on their bonded debt. thing wrong in the housing collapse,’’ in perhaps the boldest, most overreaching My question is: Why? the words of correspondent Kroft. In his call of her career. Why would a governmental entity go out report, Raphael said, “debt service is a Hundreds of billions of dollars? The one- of its way to provoke or alienate its best relatively small part of most budgets, so year record, set in 2008, is $8.2 billion. You source of finance? In the old days you not paying it does not do much to solve can see how an estimate of “hundreds of might say that bondholders were a distant fiscal problems (particularly as compared billions’’ would get people’s attention. class of banks and plutocrats mainly cen- to the costs of such an action).’’ There are a lot of reasons to be doubtful tered in the Northeast. That’s no longer about the health of the municipal market true, and hasn’t been since at least the Headline Grabber right now, as elucidated by “60 Minutes’’ passage of the Tax Reform Act of 1986, What irks me about this Whitney call is correspondent Steve Kroft. Tax revenue which made bonds less attractive for that it generalizes about a market that is down, public pension and health-care banks and insurance companies, among resists generalization, a market that is liabilities are up, the federal government’s other things. Today, a city’s bondholders particular and specific to a remarkable bailout money to the states is running out might live in the municipality itself, and degree. And it doesn’t answer the question and the chances that those funds will be almost certainly reside within the state. “Why?’’ It is instead an assertion aimed at replenished are remote. getting attention. And yet — hundreds of billions of dollars Debt Service Whitney made headlines in 2007 when in default? The number is in the realm of she predicted Citigroup would lower its the fabulous. If pressed, I would say that Why would a governmental entity choose to default on its bonds, especially dividend and that it was time to sell bank we might see between 100 and 200 mu- stocks. She made headlines in September nicipal defaults next year, maybe totaling if they make up a relatively small propor- tion of its costs? when she said she produced a report on in the $5 billion or $10 billion range. 15 states’ financial condition, and said the Whitney doesn’t believe the states will “Debt levels for U.S. local and state governments are relatively low, with an- federal government might be called upon default. That leaves us with local govern- to bail them out. Whitney only let clients ments and authorities as the ones failing nual debt service representing a relatively small part of budgets,’’ Fitch Ratings said see the report, so I don’t know if her con- to pay debt service on their bonds, which clusions are supported. She said it was makes this an even bolder call. in a special report in November. Entitled “U.S. State and Local Govern- 600 pages long and had taken two years Most defaults in the modern era aren’t to produce. governmental or what we might call mu- ment Bond Credit Quality: More Sparks Than Fire,’’ the report said, “The tax-sup- Perhaps Whitney should stick with nicipal at all. The majority are corporate or bank stocks. nonprofit borrowings in the guise of some ported debt of an average state is equal municipal conduit — nursing homes, hous- to just 3 percent to 4 percent of personal

Debt levels for U.S. local and state governments are “relatively low, with annual debt service representing a relatively small part of budgets. — Richard Raphael, Analyst ”

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Appendix 2: Muni Meltdown That Wasn’t Confounds Market’s Earliest Critics

Dec. 13, 2011 to have to get involved at some point, Before Meredith Whitney predicted that because the population there is still pretty municipal defaults in 2011 would total “The biggest thing I didn’t recalcitrant, and they don’t think they “hundreds of billions of dollars’’ in a Dec. understand when I wrote that should have to pay more taxes. They’re 19, 2010 broadcast of CBS Corp.’s “60 talking about raising expenditures for the Minutes,’’ several analysts made similar paper, which I understand schools. Yet we don’t have the money. But claims about the imminence of defaults they don’t want to hear it. and bankruptcies at the state and local now after I talked to some levels. Four people who previously wrote people who have really been Christopher Whalen is managing direc- or spoke about the problems facing the tor of Institutional Risk Analytics, a Torrance, market in 2011 discussed their previous involved in municipal govern- California-based bank-rating firm. He said in statements, why the market held together an interview with Henry Blodget on Yahoo this year, and what the future holds for ment, is how hard a state will Finance’s Tech Ticker in November 2010 that state and local issuers with Municipal California will default. Blodget, who is also the Market’s Brian Chappatta. work to avoid any default on a chief executive officer and editor-in-chief of Business Insider, later posted on the site the GO bond.” headline: “CALIFORNIA WILL DEFAULT ON ‘California Will Default’ — Frederick Sheehan, Author ITS DEBT, Says Chris Whalen.’’ Christopher Whalen: My basic view hasn’t changed, and my comment was re- ‘Let States Go Bankrupt’ ally more of a medium-term issue. In other In the 80s, when we had the S&L crisis, David Skeel: Politically, things have words, they’re going to try to raise taxes in it took us almost 10 years — three con- California, but they’re not going to get very changed since I wrote that piece in terms gressional elections — to change the mix of the likelihood of it going anywhere in far. The whole West is like this. They’re in Congress so they would actually deal antithetical to taxes, especially property Congress. The political enthusiasm for with it. And we’re going through the same the state bankruptcy idea has temporarily taxes. The whole point of the comment thing now. We may have to not only have was that eventually, the politicians are go- dimmed. The problems haven’t gone away. an election next year but also an election I still think bankruptcy would significantly ing to have to use the threat of default to two years later before you get the mix in move the political process. And I still think improve our ability to deal with a crisis. If Congress changed so they’ll actually do the Eurozone crisis were to deteriorate that’s the case. Illinois is arguably worse this. The old guard politically, they don’t than California now, because they haven’t further and have ripple effects here, things want to deal with this. could quickly get worse than they are. done anything. I haven’t really changed my outlook, but I was pretty critical of New York last year, It has always been quite possible that I’m not a doom-and-gloomer. I just think nobody would get to the edge of default. but Andrew Cuomo is doing very well. politics, especially in the West, are going He’s well ahead of the other two states. One of the arguments against bankruptcy My sense is we still have a risk of at least for states is the downturn is largely cycli- threatened political default, like we went cal and they’ll almost certainly be able through with the budget last summer. to muddle through. I think that may be The question is: What do you do in a flat right, but it doesn’t seem to be a basis for environment in terms of employment and saying we don’t need to do anything else. the real estate market, where there’s no It’s like saying there’s no need to have a automatic appreciation in the tax base? fire department because we haven’t had a That’s the big issue I see. If we’re going fire. So the arguments for a state bank- into a period with flat or down real estate ruptcy framework remain compelling. prices, that’s not going to help anybody One of the criticisms of bankruptcy as maintain revenues versus rising expenses. a solution is it doesn’t solve the political So there’s a squeeze here between problems. The reason states get into so revenues and expenses and I don’t think much trouble is usually because there’s that’s going to change. some breakdown in the political process. I’m not an end-of-the-world guy. What Bankruptcy is not a silver-bullet solution I do think is everyone’s premise about to that. If you’ve got political problems, revenue and growth has to change, and they’re probably not going to disappear, that’s going to ripple through politically, but bankruptcy does point in the right especially in Illinois. I could see them direction. default, simply because the politics are Another criticism of bankruptcy is if you not aligned correctly for people to deal Source: Bloomberg/Andrew Harrer continued on next page... with the issue. Andrew Cuomo

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put a bankruptcy framework in place, The Next Bubble people, it’s clear that is the last thing that states would find it really hard to buy, and Richard Bookstaber: I can’t speak with a state wants. To not be able to borrow — it would just cripple them in terms of bor- the press because of my government they will do anything to avoid that. rowing. If you look at countries that have positions. Also, I have not kept abreast of Municipal bonds are not well under- defaulted, they’re regularly able to go the muni market. stood, and I have found that out since I back to the market within a year or two. wrote that paper. The people who own It’s not like they’re shut out forever. In the Richard Bookstaber is a senior policy adviser municipal bonds, and even the people short-run, they often pay more for credit, at the Securities and Exchange Commission. On who sell them often don’t understand what but sometimes it’s not that much more. April 4, 2010, he wrote on his blog, rick.booksta- they’re really buying. They can’t really What we’re seeing now is that the ber.com, an entry titled “The Municipal Market,’’ in approach what they own or what they’re higher levels of government are suffer- which he said the municipal market was the next selling other than as an aggregate class ing so they’re cutting off funding to lower source of crisis. He cited a variety of criteria, and of municipal bonds. They are not large, levels of government. States are being said ``once a few municipalities default, there is a aggregate classes. They are individual hit because the federal government is in risk of a widespread cascade.’’ bonds and that’s not well understood. worse shape, and localities are being hit There is generally a presumption, even because states are in worse shape. It’s if it’s not stated, even if it’s just out of a quite possible that these trends are go- ‘Dark Vision’ tacit understanding, that if things get really ing to increasingly come to the surface, Frederick Sheehan: In that paper, if I bad, the federal government will be able and we may end up with a very serious had predicted any timing, I would have to come to the states’ aid. But there is the debate about whether bankruptcy is been wrong. I expected many more possibility that the federal government will something we should be doing. My guess defaults than there have been by now. not be able to come to their aid, probably is it probably doesn’t happen before next What I think at this point is that there are a good chance, especially if it is in the bil- November. It’s a political hot potato, so I some real problems that are going to lions of dollars. States and municipalities doubt anybody is going to be pushing it lead to a lot more defaults. Incomes are could be surprised by that. during the election season. But I could falling in the country, so taxes are going Federal money has helped prevent easily see it coming quickly thereafter. to continue to fall in municipalities. Even default. They haven’t reached that critical The disclosure issues with municipal through there’s talk about reducing costs point where they couldn’t bridge the gap debt, state debt and pension obliga- and cutting back, they’re continually short by issuing more bonds. Being able to do tions, that’s the sort of thing that could of where they’re going to need to be with that has given them some time. Also, over get bipartisan political support. That’s reduced revenues. the past couple of years, it has become what I would expect to see in the coming I think there will be a lot of trouble, and a much better understood that municipalities months: measures short of state bank- lot of defaults. I think it will be, in the end, are having difficulties and are addressing ruptcy getting serious attention, and then at least a couple hundred billion dollars in them. Whether they will have addressed if things get radically worse, we might general obligation bonds. It depends on the those problems enough, when the addi- have that bankruptcy debate again. project, but they are generally more risky. tional costs of the reduced revenues start We’re seeing significant bankruptcies Defaults will come within two or three to hit, I don’t know. It has given them a in the municipal context. It’s possible years, because the trend I mentioned is chance to look at the situation and make Harrisburg will end up back in bank- going to keep working against municipali- some changes that have allowed them to ruptcy next year. Jefferson County is in ties and states. Incomes are not going continue paying the bonds. bankruptcy now. So the old argument to improve. House prices are not going that significant municipalities don’t file for to rise. Pension contributions will go up. Frederick Sheehan is the author of “Pan- bankruptcy isn’t true anymore. If signifi- Weariness will set in, where they are derer to Power: The Untold Story of How Alan cant municipalities are finding them- doing what they think they need to do in Greenspan Enriched Wall Street and Left a selves in bankruptcy, it’s certainly not out order to reduce costs, but they have to run Legacy of Recession.’’ He wrote a piece for of the question it would be an issue for harder just to stay in place. Weeden & Co. called ``Dark Vision: The Coming the states. The biggest thing I didn’t understand Collapse Of The Municipal Bond Market’’ in when I wrote that paper, which I under- September 2009. In it, he said: ``The municipal David Skeel is a professor of corporate law stand now after I talked to some people market will probably repeat the pattern of the at the University of Pennsylvania Law School. who have really been involved in municipal sub-prime collapse. Although it is plain to see, He wrote an article for The Weekly Standard government, is how hard a state will work the usual experts do not notice.’’ in November 2010 titled “Give States a Way to avoid any default on a GO bond. If you to Go Bankrupt,’’ in which he said bankruptcy just look at the numbers, you would expect would be the best option to avoid a “massive the state is really up against it and doesn’t federal bailout.’’ have long to go. But after talking to some

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Appendix 3: Meredith Whitney Says ‘I’m Right’ With Number Barrage: Books

REVIEW BY JOE MYSAK June 3, 2013 (Bloomberg) We’re all moving to North Dakota. Or South Dakota. Or somewhere out there in the middle of the country. The “smart money is flocking to This is the thesis of Meredith Whitney’s “Fate of the States: The New Geography states with lower tax burdens and less of American Prosperity.’’ The country’s “central corridor,’’ largely untouched by strained budgets.” the housing bust, is going to drive the economy for decades to come. — Meredith Whitney, Author The “smart money,’’ she writes, “is flock- ing to states with lower tax burdens and less strained budgets.’’ Fleeing the coasts is not a new idea. I trace its modern incarnation to Rich able piece of research, a punctuation acknowledge that Arkansas was the last Karlgaard’s 2004 “Life 2.0,’’ in which the mark to the hysteria about public finances state to default, in 1933. Forbes publisher asserted that people common during the latter stages of the Cities “just assumed that their states were leaving the crowded, overpriced financial crisis. would be there to bail them out.’’ On the coastal states to seek “larger lives in To correspondent Steve Kroft, Whitney contrary, most local officials know that re- smaller places.’’ predicted that the unhysterical experts course to the states is limited and punitive. Now Whitney, with a barrage of numbers, were wrong, and that the municipal market “Jefferson County’s finances were sunk percentages, gross generalization, bald would see “50 to 100’’ significant defaults. by a water-and-sewer project that, thanks assertion and outright error, joins the ranks to graft and engineering blunders, never of the demographic determinists. Perhaps ‘Hundreds of Billions’ actually got built despite the county’s bor- the favorite word of these proponents of rowing and spending billions.’’ Never got Nobody had a problem with that figure. the decline and fall of New York and Cali- built? That isn’t true. The average since 1980, according to fornia is “already.’’ Whitney doesn’t disap- Orange County, California, bondholders Distressed Debt Securities Newsletter point: “The United States is already in the “would not have been repaid had it not been data, is 111 defaults per year totaling an process of rebalancing itself demographi- for a bailout by the state of California.’’ average of $3 billion. cally based upon opportunity and standard Bailout? State lawmakers allowed the Asked to put a dollar amount to the pre- of living.’’ This is already happening, she county to divert tax revenue from certain diction, Whitney blurted out, “hundreds of writes. In other words: I’m right! county agencies to back a bond issue billions’’ of dollars. Instead of challenging used to repay obligations. No one consid- this absurd figure, Kroft just gave one of ered this a bailout. ‘60 Minutes’ his crinkly-eyed, sorrowful shakes of the In the introduction to “Fate of the States,’’ Not so fast. The idea, based purely on head, pitying all those bondholders. Whitney writes, “My brain instinctively dollars and cents, sounds reasonable. Yet Investors panicked and pulled $26 billion works to connect the dots in life, turning the evidence is thin. And using the last out of muni mutual funds over the next mosaics of information into narrative tales five years as predictor of the next 30 is few months, according to Lipper U.S. Fund of how things came to be and what I think questionable. There are lots of reasons Flows data. Whitney got a ton of attention, will happen as a result.’’ people move. Tax policy is low on the list. and not coincidentally a book contract. And some states possess advantages That way madness lies. There are others just can’t overcome. 89,004 local governmental entities in the What Whitney, a banking analyst who in Connect the Dots U.S. Take four or five or a dozen headlines 2007 made her name with the call that Citi- Whether we will all move to Kansas is and “connect the dots,’’ and you no doubt group was going to suspend its dividend, debatable. What isn’t are the factual errors have a trend, maybe even a book. What is doing here is defending her December on display here. you don’t have is an accurate picture of 2010 appearance on “60 Minutes.’’ Experts, Whitney writes, are “quick to municipal finance. At the time, Whitney had spent two and point out that states have never defaulted.’’ a half years on an otherwise unremark- Who are these experts? The ones I know

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